Early in April, I attended the 70th Intermountain Logging Conference in Spokane. This year, we heard the gospel from such public-sector big shots as Idaho Gov. Butch Otter, Idaho director of state lands George Bacon and Washington lands commissioner Doug Sutherland.
But a panel featuring three big private-sector wheels – Mike Covey, CEO of Potlatch; Tom Ray, Northwest Region manager for Plum Creek; and Matt Donegan, co-president of Forest Capital Partners (FCP) – caused my personal “Jesus Moment.”
Few people are aware that since 1999, the timber industry has undergone a massive institutional shift. Led by Plum Creek, a cavalcade of timber companies – otherwise known as Vertically Integrated Forest Products Companies, or VIFPCs – have morphed either into Real Estate Investment Trusts (REITs) that kept sawmills as subsidiaries, or into Timberland Investment Management Organizations (TIMOs) that completely separated from manufacturing, like FCP.
Whether you work or play in the woods, this shift matters to you.
First, this morphing is happening because there’s a huge tax incentive to do so, in the form of a giant loophole in commercial real estate tax law. Ordinary corporate income is taxed at a rate of 35 percent over $18.3 million, plus shareholders pay additional income tax on their dividends. In contrast, most if not all of a REIT’s taxable income is distributed every year to shareholders, who are then responsible for paying a capital-gains tax rate of “only” 15 percent.
Second, REIT capital gains income not distributed to shareholders is subject to corporate tax. At the same time, a REIT is prohibited from making more than 10 percent of its net income from manufacturing operations.
Therefore, as a REIT, Plum Creek Timber makes substantially all of its operating income (treated as long-term capital gain) from the sale of standing timber under certain pay-as-cut contracts. Manufacturing is a sideshow.
Because timber and land sales have to generate most of the profit, not manufacturing, it’s kind of obvious where investments in hope of future profit will be made. Simply put, goodbye King Timber, hello King Real Estate.
I expect very few forest-products companies will stay integrated. Some are Oregon sawmills that bought themselves a timber supply in the wake of the spotted-owl shutdown of federal harvest in that state, yet not enough land to comply with REIT limits on proportionate manufacturing income.
The Big of Bigs, Weyerhaeuser, initially resisted the REIT trend, leading unsuccessful lobbying efforts to pass federal legislation that would tax integrated timber companies on an equal footing with REIT’s. But last month, Weyerhaeuser promoted the head of its real estate division to the CEO position – a pretty clear signal.
With that in mind, I’m glad I got to hear Covey, Donegan and Ray. They made it very clear that the REIT express has left the station, and it ain’t stopping. Congress just blew its last chance … and you might want to ask Sen. Max Baucus and Sen. Jon Tester why.
The world of forest products has fundamentally changed. But the public is about to see huge changes, too. The recent controversy about road access negotiations between Plum Creek and the Forest Service is merely the headlight at the end of the tunnel.
For starters, Potlatch has implemented public recreation-user fees on its land. Covey noted that while the income is still small, it has established Potlatch’s property right to charge the public for recreation access. Expect more companies to jump on that bandwagon.
Both Matt Donegan and Tom Ray explained how their organizations are looking to acquire and keep good timber-growing ground while selling the remainder. Ray explained that Plum Creek intends to keep about 6 million acres of its ground as “core” to be managed for its highest value as timber land. Three-hundred thousand acres are “non-strategic,” to be sold. Another 1.7 million acres have a “highest and best use” (HBU) classification as either recreation (1 million acres), conservation (500,000 acres) or development (200,000 acres) ground. What lands are those?
Well, you’ll all see Jesus soon enough. I suggest you see your stockbroker sooner.