Most investors think of real estate investment trusts (REITs) as property owners. The best-known REITs invest in assets such as shopping malls, apartment buildings, and warehouses.
However, not all equity REITs own buildings. Timberland REITs invest in land assets. They make money from harvesting and selling timber and related products. These are interesting long-term investments and have some notable advantages. But there are a few things you should be aware of before buying your first timberland REIT.
What is a timberland REIT?
A real estate investment trust is a company whose primary business activity is investing in real estate assets. They need to meet specific criteria to be classified as a REIT. Here are a few of those criteria:
- REITs must distribute at least 90% of their taxable income to shareholders as dividends. This is the best-known characteristic of REITs. It's also why they tend to have higher-than-average dividend yields.
- REITs must invest at least three-fourths of their assets in real estate or related investments.
- REITs must derive at least three-fourths of their income from rental income or other real-estate-related sources.
- REITs must be structured as corporations.
- REITs must have at least 100 shareholders, and no five shareholders can own more than 50% of a REIT’s outstanding shares.
If a company meets these requirements, they get a big tax advantage: They don’t pay any corporate income tax, no matter how much profit they earn. This gives REITs a big advantage over most other dividend-paying businesses that are taxed on their profits at the corporate level. Dividends from those businesses are taxed again when the income is paid to investors.
For tax purposes, REITs are treated as pass-through businesses similar to LLCs or partnerships. But there's a downside to this treatment: REIT distributions generally don’t meet the definition of "qualified dividends," which are taxed at lower rates. On the other hand, REIT dividends are entitled to the new 20% pass-through tax deduction (formally known as the Qualified Business Income deduction) from the Tax Cuts and Jobs Act.
Most REITs specialize in a certain type of real estate asset, such as office buildings or shopping malls. Timberland REITs invest in forest land assets, and make their money by harvesting and selling timber and related products. There are also a few other potential income sources for timberland REITs, including minerals, oil and gas assets, and leasing land to third parties.
Timberland REITs typically make about three-fourths of their money by selling trees after they’ve been cut down or by selling refined lumber.
There are good reasons to invest in timberland REITs. For one thing, as the population grows, demand for wood products should grow as well, so prices should naturally rise over time. And wood prices tend to rise with inflation, making it a good hedge against rising interest rates.
Risks of investing in timberland REITs
There are a few risk factors that affect all REITs and some that are property-specific. Here’s what investors should know before investing in their first timberland REIT.
Interest rate risk
No discussion of REIT risks would be complete without discussing interest rates. In a nutshell, rising interest rates are bad for REIT share prices. Investors generally expect to receive higher returns from riskier assets (like stocks) than they could get from risk-free assets (like Treasury securities).
When the risk-free yields rise, REIT yields tend to rise accordingly. The 10-year Treasury yield is a good REIT indicator, so expect REIT yields to move in the same direction. Since price and yield have an inverse relationship, higher yields translate to lower share prices.
Timberland REITs can be highly sensitive to economic conditions, as wood is used to make products that are dependent on consumer demand. In particular, it's estimated that 50% of U.S. softwood lumber consumption comes from homebuilders. So the strength of the economy and housing market can make or break timberland REIT profits.
Remember that wood is a commodity, so its price is only as strong as demand at any given point. Well-run timberland REITs should do just fine over time, but investors should be aware that these are cyclical stocks.
As an example, here’s how leading timberland REIT Weyerhaeuser performed in the time period around the Great Recession in 2008. The stock lost over 75% of its value from peak to bottom: