Watch out for stobor.

- R.A. Heinlein, Tunnel in the Sky.

REITs, Royalty Trusts, and Income Trusts

What are Income Trusts?

Real Estate Investment Trusts (REITs), royalty trusts, and business income trusts are all considered to be income trusts. These are securities which must, by law, pay out most of their earnings in cash distributions. The trust structure enables the underlying business entities to reduce taxes; the tax due is essentially passed on to the unitholders.

On October 31, 2006, the Finance Minister announced that currently-trading income trusts, except for REITs that satisified proposed Canadian content regulations, would be taxed starting in 2011. Although the regulations could be changed by future governments, cautious investors should be careful about investing significant sums without careful evaluation. At this time, it is expected that many non-REIT trusts will cease to exist by 2011, either converting to corporations or being acquired.

For individuals who are accumulating a portfolio while still working, income trusts should be held in an RRSP to minimize tax drag. They can be switched to the non-registered account after retirement to provide tax-advantaged income.

An excellent, but cautionary, read on the process of establishing a trust is given in Selling the Downside. which was written in 1997 at the time a large number of new income trusts were issued. Income trusts based on power generation or pipelines are usually considered the least risky, followed by REITs, business income trusts, and finally by royalty and commodity trusts. A primer on income trusts is available here (pdf). Standard and Poor’s and DBRS give stability ratings for several trusts; these should be consulted before purchase. A list of current trusts, including many analyst targets, is available on Canadian Trader.

Note that all trusts will carry interest rate risk; that is, the unit prices will tend to drop (and yields go up) if interest rates increase (i.e. if bond prices drop).

Many — but not all — trusts provide a significant Return of Capital component which is tax-deferred until the unit is sold if it is held outside an RRSP. REITs, royalty trusts, and power-generation trusts usually fall in this category. Some trusts, including many business-income trusts, have little tax deferral, and should be held inside an RRSP. The investor should consult the trust’s web site before purchase to determine the tax status.

Real Estate Investment Trusts (REITs)

REITs provide the unitholder with the rental income from various types of properties. REITs based on commercial property (shopping centers); office spaces; light industrial property; retirement residences; apartments; hotels; and U.S. properties are all available on the Toronto stock exchange. The Deloitte and Touche REIT Guide (pdf) should be reviewed before investing in REITs. Additional information on REITs can be found at the Canadian Institute of Public and Private Real Estate Companies (CIPPREC). Some of the distributable income from REITs represents the depreciation of the underlying real estate, and is tax-deferred in a non-registered account. Note that hotel REITs are considered more risky than other REITs, and should reward the investor with a higher dividend yield. Some REITs available on the Toronto stock exchange hold US properties.

REITs holding Canadian properties were specifically exempted from the taxes announced in late 2006. However, the details of the exemption are still being established. Individual REIT news releases should be checked for further information.

Barclay’s Canada has introduced an iREIT ETF based on the Standard and Poor’s Canadian REIT index (stock symbol: XRE, MER 0.55%). However, most of the iREIT holdings are in the four or five largest REITs. Investors with more than about $25000 can obtain about a one-year payback on the underlying MER by purchasing the largest five holdings directly at a discount brokerage.

Four US ETFs based on REITs are available. They are: the iShares Cohen and Steers Realty Majors (stock symbol: ICF, MER 0.35%); the iShares Dow Jones US Real Estate (stock symbol: IYR, MER 0.60%); the State Street StreetTRACKS Wilshire REIT (stock symbol: RWR, MER 0.32%); and the Vanguard Morgan Stanley REIT Index (stock symbol: VNQ, MER 0.18%). These ETFs have a significantly lower yield than do Canadian REITs, and the dividends are subject to US withholding tax if the ETFs are held in a non-registered account.

Business Income Trusts

Trusts providing the income from a large variety of businesses are available. Examples include: power generation, pipelines, northern telephones, cold storage, sardine sales, trucking, mattresses, northern stores, restaurants, and many others.

Investors should be aware that not all businesses will be sufficiently stable to provide reliable trust income. Businesses with a natural monopoly or long-term contracts will usually provide stable income. However, other businesses will be subject to the business cycle or pricing constraints and may be forced to reduce or eliminate distributions in difficult economic times. Prospective buyers should consult the Standard and Poor’s and DBRS stability ratings.

Most business trusts are expected to cease to exist in that form by 2011.

Royalty Trusts

Royalty trusts are based on the royalties paid by oil and gas companies. With these and other resource-based trusts, the yield is, in part, due to the depletion of the resource. If oil reserves (or an ore body) will be depleted in a certain number of years, the value of the resource will be zero at that time. This depletion is included in the yield as return of capital — but the investor is simply getting his own money back. Although oil and gas trusts frequently issue new units to acquire new reserves, in this Financial Post story. it is argued that oil and gas trust unit prices will decline sharply in the last half of 2003 as current reserves are depleted and replacements are increasingly hard to find because of the maturity of the Western Canadian oil basin.

Because of the risks involved with their purchase and the uncertainty of future distributions, royalty trusts should form only a small part of the trust portion of most portfolios.

Another criticism of many oil and gas trusts relates to their management structure. In many of the trusts, and external management company is used. The management company frequently is given extra fees for purchasing new reserves — that is, for doing its job. Because the interests of the managers of externally-managed trusts are not aligned with those of unitholders, some trusts are now internalizing management. Although this is viewed as a positive development, a multi-million dollar fee is usually associated with this change — and is paid by the trust unitholders.

Oil and gas trusts can be used as a lifestyle hedge. The payout from these trusts varies with oil and gas prices (sometimes with a delay that depends upon the trust’s strategy). By including just enough of an oil and gas trust in your portfolio so that the dividends offset your monthly gasoline and heating bills, you protect yourself against future price increases. If the price of oil and/or gas drops, so will your dividends — but then so will your gasoline and heating bills.

The purchase of an oil and gas trust can also be viewed as prebuying your oil and gas. Prospective purchasers should ask themselves whether it is better to prebuy when energy prices are high, or when they are low.

Most royalty trusts may also cease to exist in that form by 2011.

Other Trusts and ETFs

Other types of trusts include trusts of trusts (which purchase other trusts, but include an extra layer of management fees) and trust ETFs. The trusts of trusts and trust ETFs are available in a bewildering variety of forms, including passive, active, capitalization-weighted, and equally-weighted. Trusts-of-trusts are available which focus on the oil and gas sectors or business sectors, or which use a screening mechanism to select certain types of trusts. Investors are encouraged to carefully review the prospectus of these securities before purchase. Things to consider include desired portfolio oil and gas weighting, tax efficiency, and degree of concentration or diversification.

Discussion

The October 31 2006 announcement on tax law changes came as a shock to most income trust investors, many of whom lost money as a result of the following abrupt price drops. Unfortunately, many of those who lost money were counting on trusts to provide significant income at a time when bond yields were very low. Even though there was no immediate change in income from the announcement, the immediate loss of capital came as a severe shock to many.

Although REITs, royalty trusts, and income trusts are often sold as bond replacements, particularly during times with low interest rates, neither the capital nor the income is guaranteed. Unit prices are also affected by the price of the long (30-year) bond, and will tend to go down when interest rates go up. Although bonds provide a return-of-capital guarantee at maturity, trusts do not; hence, the yields of even high-stability trusts will always be higher than bond yields. In addition, commodity-based trusts like royalty trusts will have a dividend that depends on the price of the underlying commodity. Payouts will decline, and may even be halted, if the price of the commodity declines. In fact, if a large number of new trusts appear in a particular area (see section on IPOs), that’s a good indication that the price of the underlying commodity is near a peak.

Consider REITs and income and royalty trusts to be part of your equity (high-risk) allocation. Since they are a sector investment, they have higher risk than more diversified securities, over and above the political risk associated with tax law changes, and should not constitute a major part of your portfolio.