U.S. housing construction and timberland performance—a tale of two halves?

The financial performance of U.S. timberland is heavily influenced by the trajectories of housing and lumber markets. Coming out of the pandemic-induced recession of 2020, timberland performance was bolstered in part by the robust recovery in U.S. housing and softwood lumber markets. The positive momentum for these markets extended into early 2022 but quickly dissipated as the U.S. Federal Reserve shifted its monetary policy and began raising interest rates to combat rampant inflation. As a result, outlooks for U.S. housing and lumber markets in 2022 are set to become a tale of two distinctly different halves. During the first half of 2022, residential construction markets were still being supported by strong demand fueled by the need for additional space to accommodate the marked increase in work-from-home arrangements, financially healthy consumers, and historically low mortgage rates. However, heading toward the middle of the year, rapidly rising interest rates and persistently robust home price appreciation negatively affected affordability and weighed heavily on homebuyer and home builder sentiment. By mid-2022, any remaining upward momentum in the U.S. housing market had faded and a correction in both housing and lumber markets was under way, clouding the near-term outlook for timberland revenues.

With the slowdown in residential construction activity, lumber prices have fallen 54% from the recent high of US$1,515 per thousand board feet (MBF) for Douglas fir #2 and better 2x4 reached in early 2022 to a low of US$690/MBF by midyear. And growing uncertainty around economic conditions has permeated the lumber market and is expected to subdue both demand and prices during the remainder of 2022 and into 2023. These developments have resulted in an increasingly bearish tone for the near-term outlook for forest product and timber markets, raising the question whether the current economic cycle could precipitate a downturn in housing and wood products markets comparable to the collapse that occurred during the global financial crisis (GFC) of 2008/2009.  However, evaluating the current state of U.S. housing markets in an historical context, digging deeper into the underlying housing market fundamentals and factoring in market developments such as the growing demand for carbon offsets, and a major expansion of lumber mill capacity under way in the U.S. South, leads us to the conclusion that the sky isn’t falling for timberland investments. These factors should help mitigate both the near-term volatility and medium-term risks to the outlook for timberland returns.

Housing affordability deteriorates

In April 2022, U.S housing starts reached a cyclical peak of 1.8 million units (seasonally adjusted annual rate), but a combination of rising interest rates and soaring home prices pushed housing affordability downward and took their toll on residential construction. Housing starts retreated strongly over the next three months, falling by a total of 359,000 units in May to July to 1.45 million units. During the first half of 2022, mortgage rates spiked higher, with the average rate for a conventional 30-year fixed-rate mortgage in the United States jumping 259 basis points (bps) from 3.11% at the end of 2021 to 5.70% at the end of June. The magnitude and speed at which mortgage rates increased added an estimated 36.0%, or US$489, to a potential average homeowner’s monthly mortgage payment (30-year fixed-rate mortgage with a 20.0% down payment) required for a US$400,000 home, at a time when budgets were already stretched by rapid home price appreciation.¹ This potent combination of rising interest rates and home price appreciation continued at an elevated rate of 18.0% year over year in June, pushing the National Association of Realtors’ Housing Affordability Index down to 98.5 in June, down 31.0% from a year earlier and to the lowest level seen since at least 1990.

While affordability has deteriorated rapidly, individual homeowners aren’t as financially stretched as they were leading up to the GFC. The debt burden on individual households, as measured by the mortgage debt service payments as a share of disposable personal income, remains near the lowest level witnessed over the last 40 years, and 400bps lower than during the GFC. Many homeowners likely took advantage of historically low interest rates in 2020/2021 to refinance into fixed-rate mortgages at exceptionally low rates. Additionally, banks’ lending standards have remained much tighter compared with the period leading up to the GFC, with the Mortgage Bankers Association Mortgage Credit Availability Index hovering near the low levels experienced immediately following it, resulting in a much lower risk profile for the overall mortgage debt market. These factors should allow the market to avoid a replay of the GFC-related collapse in the housing market and provide the resilience to stage a speedier recovery.  

Demographics and supply constraints support the outlook

Although housing starts are likely to continue facing headwinds through the remainder of this year and into 2023, current demographics and exceptionally low housing inventory will remain supportive of the medium-to-longer term demand for U.S. housing and, by extension, for wood products and timber. These favorable demographics continue regardless of economic conditions, and the largest age cohort in the United States has now reached prime home-buying age.

Medium and longer-term residential construction will also be supported by the constrained supply of housing. More than a decade of underbuilding saw housing starts (production) falling well behind housing demand, creating a massive volume of pent-up demand for an estimated 4 million+ units by the end of the second quarter of 2022.² The juxtaposition of demographics indicating increasing demand for housing with housing starts that are currently trending lower raises the potential for the volume of underbuilt housing stock to continue to expand if housing starts fall much further, for much longer. This dynamic should support housing starts in the current cycle at levels well above the lows experienced during the GFC and continue to be strongly supportive through the remainder of this decade.

In addition to the positive underlying demand fundamentals for the U.S. housing market, near-term demand for sawlogs for lumber production should be supported, in part, by the growing backlog of housing that is currently under construction but not yet completed. The number of homes under construction has grown 21% (year over year) to a near all-time high of 1.68 million units as of July 2022 as supply chain disruptions and lack of available labor have severely slowed the pace of construction. As these homes move toward completion, they’ll consume additional lumber and support log demand. In the very near term, this delayed wood consumption should help offset some of the negative effects on lumber and log demand that accompany falling housing starts.

Recent setbacks and the ongoing challenges facing housing and lumber markets will weigh on the near-term outlook for timberland investments, but the combination of homeowners’ stronger financial position together with supportive underlying demographics and the exceptionally low available housing inventory (alongside a backlog of homes under construction) should help limit the scale and duration of the current reversal in U.S. housing and its impact on timber markets. And lumber producers are already betting on these strong fundamentals with plans to add nearly 4.5 billion board feet of new lumber capacity through 2024 in the U.S. South, which will generate additional demand for timber as the new volume starts up.³ Additional support and diversification for timberland investment performance will come from rapidly growing demand for timberland as a natural climate solution to sequester carbon and mitigate greenhouse gas emissions. This, along with the positive underlying market fundamentals for housing, should help the timberland market to navigate the choppy waters ahead and arrive at what we believe to be clearer skies and calmer waters on the horizon.

Timberland market indicators through Q2 2022

Second-quarter U.S. housing and lumber prices reflect softening demand as affordability declined alongside second-quarter U.S. housing starts, falling 4.0% from the first quarter and 3.8% below starts one year ago. Average softwood lumber prices in the second quarter corrected from a first-quarter spike, falling 35.0% and returning closer to prepandemic levels.    

June-ending quarterly Australia dwelling approvals rose 4.5% over the previous quarter, driven by multifamily approvals (+7.7%), despite the consecutive monthly rate hikes from the Reserve Bank of Australia seen since May, and finished with cooling dwelling prices. Gains in softwood lumber prices stalled, and there is no new reportable data for softwood stumpage this quarter.

Second-quarter bleached eucalyptus kraft pulp (BEK) prices (sold in USD) jumped 16% last quarter, reaching new highs at US$1,520 per tonne. Brazilian BEK producers benefit from their low-cost position, strengthened by the depreciation of the BRL to 0.191 per USD (5.23 BRL per USD).  

Prices gains for softwood stumpage in the second quarter slowed in the Pacific Northwest, with prices up just 1.5% from last quarter, following double-digit gains seen in the first quarter. Southern pine stumpage prices softened seasonally in the second quarter, down 5.5% while New Zealand radiata pine stumpage prices were affected by weaker demand in China and historically high shipping rates—driving stumpage prices down 24% during the second quarter, and 48.0% below prices seen one year ago.  

Cash yields from U.S. timberland operations reached 3.1% (annualized) in the second quarter, 6bps above second-quarter levels seen last year and 50bps above the prior five-year average yield. Strong stumpage prices and a steady demand for timber drove second-quarter performance.

Values for privately held timberland in the U.S. South strengthened in the second quarter, averaging US$1,881 per acre, a 4.9% increase from the second quarter last year. Average values for southern timberland held within publicly traded ownerships as measured by Timberland Enterprise Value per Southern Equivalent Acre fell 7.6% from the second quarter last year. Large corrections in both forest product prices and the broader financial markets drove valuations downward.   

1 Change in mortgage payment calculated by comparing the 30-year fixed-rate mortgage payments on US$320,000 (US$400,000 home purchased with 20.00% down payment) at the average 30-year fixed-rate mortgage of 3.11% at the end of 2021 to the average 30-year fixed-rate mortgage of 5.70% at the end of June 2022. 2 Forest Economic Advisers, underlying housing demand statistics, May 2022. 3 Forisk Research, Forisk Quarterly Report, 2022.