investment trusts

Starting in 2011, Ottawa will impose a tax on the distributions of Canadian income trusts. This will put trusts on an equal tax footing with regular corporations. Many trusts are converting to corporations as a result. Some are even cutting their distributions.

Tax exemption sets REITs apart from other Canadian income trusts

Real estate investment trusts, or REITs, will remain exempt from the tax on Canadian income trusts, and will likely remain in their current form. (REITs invest in income-producing real estate, such as office buildings and hotels.)

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Real estate investment trusts (REITs) may get more attractive in the next year or so as income trusts start to disappear. Ottawa will start taxing income-trust distributions in 2011. As a result of this change, many trusts will convert to regular corporations and pay corporate taxes. That will give them less cash to distribute to shareholders. REITs will remain exempt from the income-trust tax, as long as they get most of their cash flow from properties in Canada. It’s likely that income-seekers will look to REITs to replace income trusts and provide a hedge against inflation. Real estate is a cyclical business, and rental income from the underlying properties can suddenly dry up during economic slowdowns. To cut your risk, you should focus on well-established REITs with long histories of maintaining their distributions during cyclical downturns....

ISHARES CDN REIT SECTOR INDEX FUND $10.16 (Toronto symbol XRE; buy or sell through a broker) holds the 11 Canadian real estate investment trusts (REITs) in the S&P/TSX Capped REIT Index. The weight of any one REIT is limited to 25% of this index’s value. RioCan REIT makes up 24.9% of the index’s total value; H&R REIT, 14.7%; Canadian REIT, 11.5%; Boardwalk REIT, 10.3%; Calloway REIT, 8.5%; Canadian Apartment Properties REIT, 6.6%; Primaris Retail REIT, 6.1%; Cominar REIT, 5.3%; Chartwell Seniors Housing REIT, 4.6%; Extendicare REIT, 3.8%; and InnVest REIT, 2.0%. iShares CDN REIT yields 8.3%. Its expenses are 0.55% of its assets....

In 2011, the Canadian government will begin taxing income trusts (with the exception of real estate investment trusts, or REITs). The effect the tax change will have on Canadian investors’ portfolios is something we’ve often discussed in our Canadian Wealth Advisor newsletter. When the income-tax benefits of Canadian income trusts are eliminated, some may convert to conventional corporations — the same structure as most common stocks. Others may choose to remain as trusts. Either way, some Canadian income trusts will cut their distributions. That’s because their cash available for distribution to unitholders will fall after they begin to pay corporate taxes and can’t pass it all on tax-free....

Despite the recession, top-quality real estate investment trusts (REITs) continue to have high occupancy and steady lease rates. As well, today’s low interest rates will help many REITs refinance their mortgages more cheaply, or fund expansion. We still advise against overindulging in REITs. But if you stick with those with strong cash flows and sound balance sheets, like the three we recommend on this page, you should make attractive long-term returns with relatively low risk. RIOCAN REAL ESTATE INVESTMENT TRUST $15.28 (Toronto symbol REI.UN; Units outstanding: 233.1 million; Market cap: $3.6 billion; SI Rating: Average) is Canada’s largest REIT. It has interests in a portfolio of 247 shopping malls across Canada, including 13 under development. In all, these contain over 59 million square feet of leasable area. RioCan’s occupancy rate stands at 97.5%....

Right now, Canadian income trusts pay out a high percentage of their cash flows to their unitholders. This lets them avoid paying corporate taxes. It also gives many of them significantly higher yields than a lot of dividend-paying common stocks.

Canadian income trusts face tax changes in 2011

In 2011, the Canadian government will begin taxing income trusts (with the exception of real estate investment trusts or REITs)....

When we judge the investment quality of an individual company, we take nine key factors into account. These are: a record of profit; a record of dividends; an influential industry position; balance-sheet strength; geographical diversification; freedom from business cycles; freedom from excess regulation or insider abuse; ability to profit from lasting secular trends (such as global economic liberalization); and the ability to cash in on habitual customer behaviour. Mutual-fund ratings are more complex, since they are a step removed from these factors. Before we award our CWA Fund Ratings (Aggressive, Conservative or Income), we assess a fund’s strengths and weaknesses in several key areas. We start by looking at the quality of the fund’s holdings, based on our nine key factors. Then we look at the degree to which its holdings are spread out across the five main economic sectors: Manufacturing, Resources, Consumer, Finance and Utilities. Funds that focus on narrow segments are more risky or aggressive than those that diversify, even if they focus on a conservative area, such as Utilities....

GUARDIAN MONTHLY HIGH INCOME II FUND $9.16 (CWA Rating: Income) (BMO Guardian Group of Funds, Commerce Court West, Suite 4100, P.O. Box 201, Toronto, Ontario M5L 1E8. 1-800-668-5613; Web site: www.bmoguardianfunds.com. Available from brokers) is a fund we rate as Income. It invests in royalty and income trusts and real estate investment trusts (REITs). With assets of $479.5 million, this fund is large enough to diversify widely. It also focuses on stable REITs and high-quality, long-lived resource trusts. The fund’s top holdings are: Crescent Point Energy Trust, Canadian Oil Sands, RioCan REIT, ARC Energy, Boardwalk REIT, Keyera Facilities Income Fund, BFI Canada, Vermilion Energy Trust, CML Healthcare Income and Enerplus Resources. Guardian Monthly High Income II pays a $0.06 monthly distribution, for an 7.9% yield....

These are difficult times for income-seeking investors. Bonds yield around half of what they did 10 years ago, yet more and more investors are nearing retirement, when many pay close attention to investment income. Many also see income as a sign of investment quality. These factors have kept up investor interest in income trusts.

Despite Ottawa’s plan to start taxing trust distributions in 2011, income trusts should continue to pay above-average yields for years to come. Unfortunately, however, high current yields on the majority of trusts obscure their drawbacks.

Income seekers may mistakenly assume that yearly distributions on income trusts will hold steady, like interest on a bond, or rise, like dividends on a stock. But, in the long term, many trust distributions are apt to dwindle, or abruptly halt. That’s because many trusts own so-called “cash cow” businesses. These are businesses that can be milked for their cash flow for many years, but are likely to stagnate or stumble as the economy changes and competition grows.

Other income trusts borrowed to invest in cyclical industries. When the cycle turns downward, as it is now, profits and cash flow will evaporate overnight.

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First Capital Realty, $16.24, symbol FCR on Toronto (Shares outstanding: 92.1 million; Market cap: $1.5 billion), owns, develops and operates shopping centres throughout Canada. The company focuses on big cities, including Toronto, Montreal, Calgary, Vancouver, Ottawa, Edmonton and Quebec City. It mainly operates in the four largest provincial economies: Ontario, Quebec, B.C. and Alberta. First Capital owns interests in 172 properties, including five under development. These add up to about 20.1 million square feet of leasable area. It also has six parcels of land that it plans to develop in the future. First Capital’s shopping centres are anchored by supermarkets. Its five largest tenants are Sobeys, Loblaw, Metro Inc., Shoppers Drug Mart and Zellers....