When to invest in REITs

Real estate investment trusts (REITs) have become quite popular with income investors recently. There’s good reason for that, because the yields are much higher than you can obtain with a GIC or government bond. But before you invest, it’s important to understand how these securities function and the potential pitfalls involved.

REITs specialize in real property, anything from office buildings to long-term care facilities.

Typical REIT
The typical Canadian REIT usually distributes about 85 per cent to 95 per cent of its income (rental income from properties) to its shareholders, on a monthly or quarterly basis. This income gets a special tax break because REIT unitholders are entitled to a deduction for the pro rata share of capital cost allowance (depreciation on the properties).

As a result, a high percentage of the distributions are normally tax-deferred However, the amount will vary from year to year and will differ depending on the REIT you select.

Capital gains
This money isn’t entirely tax-free, however. The value of your tax-deferred income will reduce the adjusted cost base of your shares.

If you buy 1,000 units of, for example, Riocan at $12 per unit, receive $3,000 ($3 per share) in aggregate tax-deferred distributions over time, and then sell the shares for $14 per share, you will have a capital gain of $5,000 [1000 x ($14 – $12 + $3)] before adjustments for commissions.

The gain will be subject to capital gain treatment so 50 per cent of the gain, or $2,500, is included in income and taxed at your normal rate in the year of sale.

Interest rate impact
REIT yields and the market price of units tend to be strongly influenced by interest rate movements. As rates drop, REIT prices rise, and vice versa.

When interest rates were pushed up in 2000 by the Bank of Canada and the U.S. Federal Reserve Board, the market price of the bellwether Riocan REIT fell to as low as $7.50.

At that level, they were yielding more than 14 per cent. But by early 2002, with short-term rates way down, the same units were trading in the $12 range, with a yield of around 9 per cent.

Keep that relationship in mind if you’re considering investing in these trusts. If interest rates appear poised to rise, you may want to defer any purchases. If you own units, you may wish to consider reducing your exposure and taking some profit.

Next page: Potential problems

Potential problems
There are two potential problems with REITs.

1) Since you are a unitholder rather than a shareholder, you are potentially jointly and severally liable with all other unitholders (plus the trust itself) in the case of insolvency.

Instead of limited liability, you are relying on the REIT management to have property, casualty, and liability insurance, prudent lending policies, and other safeguards in place.

Nevertheless, there is the possibility of a problem — say, a catastrophic fire or a building collapse, something that isn’t covered by insurance. That may have seemed like a very small risk prior to the attack on the World Trade Center in September 2001. Now it is something that has to be taken seriously.

The second problem is less transparent.

2) Real estate properties depreciate in value unless significant amounts of money are earmarked for maintenance and renewal of facilities.

Since most or all of the REIT’s income is being distributed and the capital cost allowance is being allocated to you, you are in a sense getting your own capital back.

The book value of the real estate properties will be steadily depleting. Of course, if the properties are appreciating in value, this could offset the depreciation factor.

The point is that the long-term income stream is quite variable, certainly more variable than some advisors would have you believe.

Have their place
REITs have their place in a long-term investment portfolio, particularly for tax-advantaged income. But you need to understand their strengths and shortcomings.

And don’t buy them for capital gains purposes unless you have a clear strategy for doing so — buying at an interest rate peak and selling at the next interest rate low.

Adapted from Secrets of Successful Investing, a new book by Gordon Pape and Eric Kirzner, published by Prentice Hall Canada.