For clients seeking additional assets for their portfolios, it’s time to consider timberland real estate investment trusts (REITs), experts say.

Kent Croft (below, right) and Russell Croft, co-portfolio managers of the Croft Value Fund (CIVFX) in Baltimore, believe there is a strong case for investing in selected timberland REITs.

The four reasons the portfolio managers cite include:

1.Their investment characteristics

As trees grow, both per-unit price and volume increase at the same time.

Kent CroftThe harvestable tonnage per tree increases, and the value of each ton increases as larger logs have more valuable uses. Together, these factors, even using depressed current prices, lead to nearly a 10% average annual growth rate in the value of a typical southern yellow pine tree from years 13 to 24.

Additionally, timberlands have very low capital requirements; all that’s required is planting and periodic harvesting.

Low capital requirements lead to strong cash flow and attractive dividend yields from timberland REITs.

2. Use as an inflation hedge

Timber tends to increase in price with inflation.

Timberland operators may also exploit the mineral rights (the ownership of underground minerals) they have retained on their land; these rights also tend to appreciate in an inflationary environment. 

3. Strong underlying demand

The Crofts believe that the demand outlook for timber is positive for the long term. They forecast that U.S. housing will continue to drive demand for the foreseeable future as each 200,000 in incremental housing starts increases North American lumber demand by 5%.

U.S. housing starts have improved significantly to about a 900,000 annual pace so far in 2013 from the 2009 trough below 500,000.

Russell Croft“Compared to the 2006 peak of approximately 2.2 million starts and an estimated normalized level of 1.6 million, we feel confident that housing activity has room to improve from current levels,” said Russell Croft (left) in a recent report.

“During the worst of the U.S. downturn, Chinese demand for lumber partially filled the domestic demand vacuum and over the long term, and exports should still represent a larger amount of timber demand than in the previous decade,” he explained.

Another potential long-term use for North American timber is cellulosic biofuels (wood pellets) used for power generation and transportation.

Cellulosic biofuels are more attractive politically than first-generation biofuels such as ethanol, because they come from non-food sources and generate fewer emissions.

Large timberlands operators have taken note of the potential upside from biofuel demand. In 2012, Plum Creek (PCL) announced a deal to provide 13 million tons of wood to a European utility provider starting in 2013; Weyerhaeuser (WY) and Chevron are working together on a biofuel joint venture.

(In addition to Plum Creek and Weyerhauser, other RIETS with over a million acres of timberland include Rayonier (RYN) and Potlatch (PCH).)

4.  Positive supply dynamics.

There are positive trends on the supply side. The mountain pine beetle has killed up to 80% of British Columbia’s mature pine forest since the mid-1990s and could ultimately reduce total North American supply by 15%.

Dead trees rot and become unusable for lumber and that has forced accelerated harvesting over the past decade.

Artificially high supply has depressed prices for lumber, but the Crofts believe the market is nearing an inflection point as British Columbian harvesting is set to return to more normal levels in the next several years.

This should aid pricing for the U.S. suppliers whose lands have not been affected. 

The Croft Value Fund currently has slightly less than 4% of its assets invested in Weyerhaeuser and Plum Creek. The Crofts stress that they view timberland REITs as a long-term holding and note that there are risks to their projections. These risks include a slowdown in the demand for housing in the U.S. and China, and natural disasters on the timberlands, for example.

To a large extent, though, the Crofts believe market risks are manageable because the timber companies can control the timing of their harvests.

When the housing markets are weak, Kent Croft says, timber managers can let the trees stand. Trees are not like seasonal agricultural products that spoil quickly, so uncut trees continue to grow in value.

“If you don’t sell, your assets are growing and increasing in value of use in that a larger tree is used for more things,” he said. “So you can choose to harvest later with a more valuable product, if you will, and leave and not sell into a market where prices might not be so good.”