Is Timber an Overhyped Investment?

(WY: 37.85*, +1.30, +3.55%), the forest-products company whose most valuable asset is two million acres of prime forest in the Pacific Northwest. Plum Creek, whose shares are flat this year, at 34, is expected to generate most of its 2009 profits from land sales, prompting analysts at Off Wall Street Consulting to write in a recent report that the company "increasingly looks like a self-liquidating entity rather than an ongoing business concern."

Plum Creek currently pays a dividend of $1.68 a share, and Potlatch, $2.04. Both dividends could be vulnerable because they're not generated from operations. Rayonier (RYN: 39.57*, +0.96, +2.48%), another timber REIT, is in better shape because it has a more diversified business mix.

Credit Suisse analyst Chip Dillon downgraded Weyerhaeuser last week to Underperform from Neutral, citing its ongoing losses, a low dividend yield of less than 1% and potential tax and other hurdles if it tries to convert into a tax-advantaged REIT in the next two years. Weyerhaeuser, whose shares have moved up to 37 from 28 amid a rally in commodity stocks, is expected to lose about $2 a share this year. Dillon pegs "peak earnings" at about $4.45 a share in 2013.

If timber prices crash, the biggest losers could be university endowments and other institutional investors that plowed an estimated $40 billion into timber investments in the past decade as part of a major shift toward so-called alternative investments. The private market for timber is even more inflated than the timber values embedded in public REITs. Plum Creek, for instance, is valued at about $1,100 an acre, versus an average national private-market price of $1,800 an acre, according to NCREIF.

"If you look at income per acre, you're earning about a 1% return. A bank will pay you 2% or 3%," says Dillon. "The price of timberland is up two times in 10 years, while the income stream has gone down."

Dillon thinks timberland prices may decline as timber-investment-management organizations, or TIMOs, which hold millions of timber acres on behalf of institutional investors, begin to sell holdings in the next several years. Their funds hit predetermined liquidation dates, often eight to 10 years after inception.

IT'S TOUGH TO ASSESS THE STATE OF THE U.S. timber market because it is illiquid. It has gotten even harder to gauge the market lately because there have been no significant transactions since the global financial crisis erupted last fall. It is rumored that some sizable deals were shopped in late 2008 but were pulled from the market because of big gaps between what sellers wanted and what buyers would pay. On Plum Creek's earnings conference call in late July, CEO Rick Holley ventured that timber prices were down 10% from their peak. That could be an optimistic assessment.

Some small sales have been made at what Dillon considers inflated prices as TIMOs bought timberland from Plum Creek and other sellers. His view, in a recent note: TIMOs are "hustling to 'put money to work' in funds they created just before the financial crisis in order to avoid refunding these monies to fund investors" and thus getting lower management fees. Small sales at inflated prices also help maintain the value of existing timber holdings, but do a disservice to investors in the timber funds.

In the past decade, timber has migrated from the hands of long-time corporate holders such as International Paper (IP: 23.89*, +0.95, +4.14%) and Boise Cascade to TIMOs, as forest-products companies sought to rid themselves of low-return assets, bolster their balance sheets and showcase hidden assets. Forest-products stocks generally have been terrible performers in the stock market for two decades. International Paper has rallied to 19 from 4 but remains below where it traded in 1989. Despite its impressive land holdings, Weyerhaeuser, at 37, is only slightly higher than it was 20 years ago.

Corporate owners found ready buyers in the TIMOs as timber became a hot asset class. Early investors such as the Harvard University endowment racked up big returns. Yet Harvard sold its U.S. timber holdings four years ago to Hancock Timber Resource Group, the largest of the TIMOs, with about $8 billion of timber assets under management. Hancock Timber executives weren't available to comment.