Real Estate Investment Trusts for Income and Diversification

Income trusts are quickly disappearing due to the tax change announced by the federal government in 2006 whereby they will be taxed like corporations as of January 2011. However that tax change will not apply to one sector within income trusts - qualifying REITs (Real Estate Investment Trusts). REITs will thus continue to exist and they will continue to be able to pass through distributions free of tax to be taxed in the hands of the investor. This means higher distributions can continue to flow through to investors who will have no income tax to pay if the REITs are held within a registered account (unless and until a withdrawal is made from the registered account per the usual rules).

What is a REIT?
A real estate investment trust is a collective fund that pools the capital of investors to invest in various forms of real estate, usually income producing assets like apartments, shopping centers, offices, nursing/retirement homes and hotels that are structured to generate regular distributions of cash. REITs actively manage real estate assets.

Key Features:

• a form of equity - distributions are not guaranteed like debt, hence riskier
• frequent (often monthly) and substantial cash distributions - useful to investors for regular income
• traded on a stock exchange but are called units not shares and are distinguishable by the addition of the suffix UN to the symbol, e.g. CWT.UN

Resource: Though now outdated on the state of individual REITs, Deloitte's 8th Edition REIT Guide describes in detail how they work and how to assess them.

Why have REITs in a portfolio?

• Diversification -REITs tend not to move with the overall stock market, which reduces the volatility of a portfolio; see links to tables of correlation coefficients on Bylo Selhi
• Attractive Yields of 5% to 11+% - This table from Investcom.com shows a sample of REITs and their yields as of June 23

That's not the end of the story, however, since cash distributions can be and might be suspended or reduced. Globe and Mail columnist Fabrice Taylor recently expressed skepticism of current value in It's getting harder to see the value in REITs.

What are the risks to distributions?

1. Payouts too high to sustain the business' underlying needs to service debt and make capital expenditure re-investments. REITs may pay out 50-90% of profits on an on-going basis; when it is over 100%, watch out, that will deplete the business if more than temporary or short-term. Some businesses grow their distributions, they are not just stagnant "cash cows" though most of the expected return will be distributions, not gains on the unit price.
2. Leverage - if the underlying business has a lot of debt relative to revenue, downturns can be fatal.
3. Rising interest rates - can damage two ways: a) the underlying business runs into debt servicing problems and b) the fund units lose value since the distribution is less competitive with other sources of regular income like bonds; though the distribution may not decline, its value is less.

Resource: Bond rating agency DBRS has just published a financial profile with key data about leverage and its judgment on the sustainability of distributions of 13 major REITs. Standard & Poor's also provides ratings for some REITs under the Funds A-Z link.

Where to find REITs

• Investcom.com - Comprehensive listing of 34 Canadian REITs, shows their distribution yield and whether it has recently gone up, down or stayed the same as well as news and links to background reports and books
• ETFs - REIT Sector Index Fund (XRE) and BMO Equal Weights Index ETF (ZRE). There are also ETFs available through US exchanges for US and international REITs (see list on Stock Encyclopedia), though the distributions from these are not tax-advantaged as they are from Canadian REITs
• Mutual Funds - Use GlobeFund's filter set to Real Estate Equity to find funds that invest in REITs
  

DisclaimerThis post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.