experts: real estate column Monday, May 12, 2008

Rule Change Sweetens Deal For Trusts

A Real Estate Investment Trust (REIT) is like a mutual fund that deals only in real estate investments.

By Ozzie Jurock

REITs are like those books that everybody quotes, but nobody has read.

So, let's just say that a Real Estate Investment Trust (REIT) is like a mutual fund that deals only in real estate investments.

You put your money in a common pool with which properties are bought, sold and moved in and out by a fund manager.

As an owner of shares in the REIT, you will get a proportional profit as share value appreciates.

Of course, you may also have your proportional share of the losses.

However, shares of publicly traded REITs remain attractive to investors because they can offer great yields and receive favourable tax treatment.

Plus, REITs are required to pay 90 per cent of their taxable income in dividends (after depreciation expense).

They are RRSP (Registered Retirement Savings Plan) and RRIF (Registered Retirement Income Fund) eligible investments -- and enjoy a level of liquidity that cannot be matched by owning the underlying investments outright.

The history of real estate-oriented mutual funds and REITS is quite checkered.

In the mid-'80s, REITs experienced huge losses when values of business properties in certain cities went over the cliff. But since 1992, some of the trusts saw strong gains.

The essential difference between a REIT and owning the real estate outright is liquidity.

REITS may invest in commercial or apartment block type properties.

If "X" number of units are issued and traded on the stock exchange, they rise and fall with the market value of the properties in the trust.

However, the REIT has no obligation to redeem the units. Just like any other stock market investment, the REIT holder sells it in the market for whatever it will bring.

There may be all kinds of options for you to pick a particular REIT.

REITs invest in apartment buildings, commercial or industrial properties and so on. To identify which represents the best opportunity is your task.

In Western Canada, REITs deep into the industrial sector may offer fine opportunities -- plus those for offshore markets, as in the troubled U.S. commercial real estate market, for people with sufficient capital muscle.

When Canada's federal government slapped a fair tax policy on income trusts in 2006, REITS were largely spared.

As long as they met the requirement of the new trust rules -- a REIT must maintain 95 per cent of its income from properties.

This has already caused some trusts that were close to the real estate market to be rearranged into a pure real estate play.

Now, with another change in policy, the government has sweetened the outlook for REITS.

In December, Ottawa announced "technical amendments" that removed limits on the amount of foreign property REITs can hold.

The government said the changes will allow REITs to better compete internationally.

"Among the proposed amendments is the removal of the distinction between Canadian and foreign real and immovable properties in determining whether a trust is a real estate investment trust (REIT)," said a federal news release.

Previously, a Canadian REIT had to receive 75 per cent of its income from properties in Canada. As well, 75 per cent of its physical property holdings had to be in the country -- but now that regulation is history.

"The 75 per cent value and 75 per cent revenue tests ... will continue to apply, but the geographic location of the real or immovable property will not be relevant," said the federal government in December.

However, some Canadian REITs have or will be posting losses over the next few quarters, as they take a future tax charge to reflect Ottawa's income trust tax policy, which becomes effective in 2011.

Certain REITs - particularly those with "operating" components, such as senior care and hospitality REITs and some apartment REITS -- may not qualify for the REIT exemption.

Such trusts may need to restructure in order to meet the requirements of the exemption.

But the opening of foreign ownership is a major move, freeing REITs to play in the weakened U.S. market, for example.

Things to remember when considering REITS:

- Buy for dividend yields and participation in capital gains.

- Diversify by property type and geographic location for a reliable income stream.

- There are many kind of REITs. Some REITs are structured to invest in apartment buildings, some in hotels, some in mini-storage units. Make sure the REIT you like to invest in has the required "operating income" component (as mentioned earlier in this column.)

- Look for staggered lease maturities and mortgage dates, and a stable tenant with potential for rent increases, re-development of properties, and future acquisitions.

- Find out about the REIT's management track record.

- Investigate liquidity.

- For above-average return, invest during a period of low interest and mortgage rates, with rising rents and falling vacancy rates.

The following are three inherent REIT risks:

- In a fast rising market, many REITs overpay and rely too much on future rent increases to make purchases pay off.

The buildings owned by the trust may not generate enough cash flow to carry them.

The result: a drop in income.

The consequence: shares fall in value.

- If the stock market slips, in general, REITs could slide down in tandem even if they have great assets. (That is happening in the U.S. right now.)

- In order to control the maximum assets, REITs usually invest in highly-leveraged properties.

The result could be higher risk.

The consequence: the potential to lose a lot, so check on debts carried by REITs.

Major point: Remember to look closely at the portfolio of your REIT and its contents to see just what kinds of things are done with the money.

Look even more carefully at the management and/or the principals' previous performance.

When Forbes magazine published its U.S. REIT gold list last month, some in the retail market were top performers.

They were mid-level shopping malls with bread-and-butter anchors, such as hardware stores, food stores and drugstore chains.

These are the kind of strip malls that survive when the glitzy shopping centres with the brand-name fashion outlets are struggling.

Topping the Forbes list were apartment property

REITS, perhaps because of the mortgage sub-prime debacle has caused about three million foreclosures.

All those people are now renting -- and so are many others spooked out of home ownership.

Meanwhile, the once strongest sector in the U.S. REIT market, office and industrial properties, has seen less than stellar performance.

Published in the Calgary Herald, Saturday, March 22, 2008

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