By Shelby L. Cates, CPA
Timberland is defined as land that can be used to grow timber of merchantable quality and quantity and where timber production is not barred by legal or regulatory rules. About two-thirds of the nation's forest lands-505 million acres-is considered timberland. Relative proximity to timber consumers-most often pulp and lumber mills-is a key consideration affecting the value of timberland due to the reduced transportation costs of the cut timber. Another factor affecting value is the location of the timberland; areas with more rain will experience faster growth.
Federal, state and local governments own approximately 30 percent of
U.S.
timberland, or about 154 million acres. The remaining 70 percent, owned by private entities and individuals, include timber real estate investment trusts (REITs) as well as other timber investment management organizations. However, the large owners still represent less than 10 percent of privately held timberland. (Plum Creek, which owns approximately 8.2 million acres, is the largest private landowner in the
United States
.)
Returns and Risks
Timberland is an attractive investment for long-term holders such as pension funds because the "timber crop" is renewable, as cut trees are replaced by new growth. So-called "biological growth" is fairly predictable, although it varies by species and region. For example, timber in the western
United States
grows an average 2.4 percent a year, while northern timber grows at 3.4 percent and southern timber at 6 percent. By one estimate, biological growth is the most important factor in generating returns on investment, accounting for between 50 and 70 percent of total return.
The major physical risk to timberland is destruction from fire, pests and disease. Overall, the risk is minimal, accounting by one estimate for losses of less than one-half percent per year. The primary economic risk in timberland investment is that prices are highly volatile. If prices are at a low point when timber is harvested, anticipated profits may not be realized. Offsetting this is the option to hold off timber sale until prices improve; in effect, timber can be "stored" on the stump.
Timber REITs
In recent years, the traditional forest and paper product corporations have become vertically integrated, owning everything from the raw timber to the manufactured assets-wood, pulp, and paper mills. However, says Moody's Investors Service, while vertical integration is advantageous from the perspective of controlling the entire process, the ownership of the raw timber can result in uncertain cash flows that will affect a public company's stock price. As a result, many companies have sought to decouple timber ownership from the manufacturing business-a key factor in the evolution of pure timberland companies, including REITs. In addition, when timberlands are the sole asset of a company, investors are likely to benefit from a sharper focus on the land itself with no management concerns regarding the manufacturing process.
Moody's says that timberlands have the following attractions from an investment perspective:
- they are fungible (essentially similar) assets and are increasingly liquid
- they have a low return correlation to fixed-income investments and real estate
- they offer capital preservation against inflation
- they tend to grow in value rather than depreciate
- Another factor favoring timberland REITs is the possibility of higher dividends, especially when compared to integrated forest product companies.
Tax Benefits
As with traditional real estate, standing timber and timberland is a capital asset. Thus the usual rules relating to capital gain and loss apply to sales and exchange of timber. In addition, a timber owner's opportunity for capital gain treatment is significantly expanded by Code Section 631 to include the sale or exchange of cut timber. Thus the owner of timber or the holder of a contract to cut timber can elect to treat the cutting of the timber as a sale or exchange, whether the timber is held for sale or use in a trade or business, provided the timber or the contract has been owned for more than one year.
Furthermore, the disposition of timber pursuant to a contract under which the taxpayer retains an economic interest in the timber is treated as a sale or exchange if the timber was held for more than one year. In effect, Section 631 permits the portion of a taxpayer's gain attributable to the natural growth of the timber to qualify for capital gain treatment even if the taxpayer cuts the timber and holds it for sale in the ordinary course of business.
Shelby
L. Cates, CPA, is a principal with Mengel, Metzger, Barr & Co. LLP and may be reached at Scates@mmb-co.com
Reprinted with permission of The Daily Record 2007
