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Timber investments are proving to be surprisingly lucrative, in conjunction with a record of business growth and an increased following on Wall Street. Their annual returns have topped the Standard & Poor’s 500 Index during the last decade, and this trend is apt to continue.

Demand for timber is gradually improving, as U.S. home-construction activity recovers lost ground. This, together with voracious demand from Asian markets, has positioned timberlands in the western states to perform especially well. Monetary and fiscal stimuli are lifting consumption in China, Japan, and South Korea. Timber values in southern states should improve as high inventory levels continue to subside. Several other factors, including a blooming domestic manufacturing base and timber depletion caused by the mountain pine battle infestation in British Columbia, Canada, are contributing to firming fundamentals.

One way for investors to benefit from this lucrative resource is through exchange-traded funds ishares S&P Global Timber & Forestry Index Fund (WOOD) and Guggenheim Timber ETF (CUT). Given their correlation to the resurgent home building market, both ETFs are performing well. Investors, though, should be cognizant of minor differences between these funds. CUT tracks the Beacon Global Timber index, which is a benchmark that includes 30 companies focusing on timber harvesting for commercial use in lumber, paper, or paper packaging. One-third of assets are in equities of producers based in the United States, while Japanese and Brazilian stocks accounting for 10% each. On the other hand, WOOD directs its resources on to 30 forest products, real estate investment trusts, and paper companies. But half of it investments are made domestically, and Canadian firms receive a 10% allocation.  Moreover, CUT has a relatively greater exposure to international markets.     

Investments in real estate investment trusts (REITs) are another option. During the real estate market crash, REITs Weyerhaeuser (WY) and Rayonier (RYN) deferred timber harvest. But with construction activity on the mend, these entities are now expanding operations.

Rayonier leases or manages 2.7 million acres of timberland and real estate located in the United States and New Zealand. Included in this portfolio is 200,000 acres of high value property located primarily along the coastal corridor from Savannah, Georgia to Daytona Beach, Florida.

While many REITs mirror each other’s business models, Rayonier’s Performance Fibers unit is a difference maker. Under a cellulose specialties expansion initiative, this REIT is working to convert capacity from absorbent materials to cellulose specialties (CS). Once this is complete, the company will focus solely on a product that commands relatively higher prices. Its advantage stems from the fact that most customers operate in industries considered non-cyclical.  In 2013, total annual CS production will grow materially, to 675,000 tons. With demand for CS healthy, the company has secured vendor commitments for the lion’s share of capacity planned for the next several years.

Weyerhaeuser is one of the world’s largest private owners of timberlands, with more than six million acres under ownership primarily in the United States and another 13.9 million acres under long-term licenses in Canada. The domestic housing market has a pronounced effect on this company’s Real Estate, Wood Products, and Timberlands segments. Demand for timber is largely determined by the production of wood-based building products and export demand, with home-construction markets in Japan and China being instrumental. Wood products’ material is consumed by new residential building and repair & remodel markets. Given the rebound in demand for building materials, Weyerhaeuser’s Real Estate unit (WRECO) is benefiting from an influx of orders for single-family homes.

In order to build up its asset base, Weyerhaeuser recently acquired Longview Timber LLC from Brookfield Asset Management (BAM) for $2.65 billion. In the process, it added 645,000 acres in Washington and Oregon. As part of the same announcement, the company announced that it was exploring strategic alternatives for WRECO.

Weyerhaeueser’s Cellulose Fibers segment makes absorbent fluff pulp (used primarily in sanitary disposable products) and various forms of packaging. Unfortunately for this REIT, the market for absorbent material is experiencing turbulence, as new capacity and demand concerns in China loom large.

Overall, the timber-related sector stands out for investors seeking income. Besides paying out 90% of their taxable income, timber REITs’ income is taxed as long-term capital gains, instead of ordinary income. Their operations should forge ahead during the current housing up cycle, enabling investors to realize healthy returns.

At the time of this article's writing, the author did not have positions in any of the companies mentioned.