If you have been an active investor since the beginning of the 2000’s, you surely remember the Canadian gold mine called Income Trust. Back then, there were many oil & gas companies benefitting from a tax break as long as they distributed most of their income back to its shareholders. This system was almost perfect: you, as an investor, would benefit from the highest dividend yield to support an expanding industry. They, as companies, would benefit from the highest interest for their shares and dispose all the equity they needed to develop their business.
The system was so perfect that many other companies from different sectors jumped in the dance. It was a no brainer, since becoming an income trust would basically means 2 things:
- Less taxes to be paid;
- More interest for their shares (e.g. more money for stock option holders too!).
After a huge party for investors (from 2000 to 2006, the return on such income trust was too good to be true) the Government came to put a stop to this madness like parents coming back home “too soon” while their teenagers were holding a “quiet evening with a few friends.” On October 31st 2006, Canadian Federal Finance Minister Jim Flaherty announced that all income trust would be taxed again under a similar tax rate to corporations as of January 2011. This is how most companies decided to revert back to regular corporations and this was the end of high paying dividend income trusts.
The end? Not exactly… The Real Estate Income Trusts (called REIT’s) have been spared from this tax measure. That’s why today you still find income trusts in this industry. Since they are paying high distributions, I’ve decided to include a special section in this book dedicated to REITs. It is important to understand that while REITs are paying great distributions, you can’t use the same valuation model that you use for dividend stocks. This is why we have created Canadian REIT!
Understanding how Canadian REITs work and how to value them is crucial if you want to build a solid portfolio. Canadian REITs may look attractive with their high dividend yield but there is more than the payout you get at the end of the month!
First things first, there are 2 types of beasts in this industry:
- Mortgage REIT (which makes money out of buying mortgage debts and mortgage-based securities);
- Equity REIT (which makes money from operating, developing, selling, renting, real estate).
As the market shows, only 10% of Mortgage REIT and all those security backed mortgage environment are cloudy (remember 2008 anyone?), I’ll keep my money away from this segment. On the other hand, equity REITs can be very appealing if you are looking for a steady income.
A REIT is a type of tax structure enabling the company to not pay taxes in exchange for distributing a high percentage of its profit to shareholders. To be precise, a REIT must distribute 90% of its profit to shareholders to be considered as such. Therefore, REITs are literally passing their rents to shareholders after keeping a small portion for management and maintenance fees (including interest!).
REITs have basically 3 ways to increase benefits to their shareholders: They can raise their rents, manage the property more efficiently, or buy the right property in order to maximize the growth value of each building. As you can see, these 3 ways are directly dependent on interest rates and the general housing economy. If the rates are low, the cost of borrowing is cheap for REITs and they can easily generate income.
The REIT yield has been outperforming bonds while underperforming stocks. In other words, REIT represents a higher risk than bonds but a lower risk than stocks. If you are looking to build a 100% stock portfolio, REITs can be a great addition as it won’t lower your payouts while providing an additional hedge against volatility. It is also not as correlated to the stock market. This is why I say it’s a good match for retirees!
REITs are being traded on the stock market as any other stocks. It allows the “small” investors to participate in the real estate market without having to disburse an important amount, contract a mortgage or spend time managing his asset.
Equity REITs can be active in several markets:
- Commercial centers;
- Healthcare centers;
- Office complexes.
Some REITs are heavily concentrated in a specific sector, while others make the bet on diversification. The same applies with respect to geographic locations.
If you are starting your journey in Canadian Real Estate Investments, I suggest you go through the following articles in order to get more info on REITs: