As politicians in Ottawa beat their drums louder in the looming battle with Bay Street over whether to change the rules that govern income trusts, some investors are taking refuge in REITs.
Real estate investment trusts are an internationally recognized model on which Canada's recent crop of business trusts were developed. But unlike the new business trusts, many analysts believe REITs may dodge the spectre of taxation changes or ownership limitation that could occur, potentially putting the brakes on Canada's income trust craze.
"Some will benefit with the uncertainty we're seeing," says Patrick Kim, vice-president of investments at KBSH Capital Management. "There is a reasonable expectation that REITS and certain infrastructure trusts will be carved out of any new tax measures."
Lending greater odds to the government maintaining the existing taxation structure for REITs is this fact: Similar structures are already in place in other major countries such as Norway, Japan, Australia, and the United States, while Britain and Germany are also looking at adopting REIT legislation next year, says Gail Mifsud, a real estate analyst at Raymond James Ltd.
The structure is particularly beneficial to the real estate sector, she adds. "It's a universally accepted structure for real estate investment, and it ensures that managers in real estate have discipline. In the past, there was a lot of speculative development that occurred and a lot of corporations that went belly up. But the fact that REITs pay out their taxable earnings means there's discipline when it comes to building and development."
If the government really wanted to go after real estate assets in Canada, it wouldn't start with REITs, she adds. "If you think about the REIT market in Canada, it has a total market capitalization of $25-billion or so. It's really a drop in the bucket compared to the amount of real estate assets held by pension funds" where taxes are sheltered, Ms. Mifsud says.
As Rossa O'Reilly of CIBC World Markets points out, REITs were exempt when rules were proposed in the 2004 budget to limit pension fund ownership in trusts. The move was abandoned after being strongly opposed by the big pension funds.
Still, past precedents are not a guarantee that REITs will escape government changes now and even if some exceptions are made, not all may qualify, Mr. O'Reilly says. Even so, he says the reason to buy REITs over business trusts isn't simply an issue of attempting to avoid unfavourable tax legislation.
"At this point, it's all speculation and there's no clear indication from Ottawa of what will happen," Mr. Kim says, but "no matter what happens, REITs are a good place to be."
That's because even without favourable tax treatment, REITS offer an opportunity to invest in areas of real estate aside from a housing market that some market watchers say can't keep up with its recent annual gains in today's environment of rising mortgage rates.
"REITs aren't engaged in the housing market, so if there is a bubble, it won't affect them. It has no relation at all to commercial or industrial REITs," says Mr. O'Reilly, adding that higher rates mean renters may stay in apartment longer, which would give a positive boost to residential apartment REITs.
Mr. Kim is currently attracted to REITs with a larger market capitalization, greater liquidity for buying and selling, and that will likely be included in the S&P/TSX composite index next year. To ensure the payout is stable, he also looks for a longer established track record of stable free cash flow.
One of his top picks is RioCan REIT, which focuses on retail commercial properties, such as open malls anchored by a major retailer, such as a Wal-Mart. Another is H&R REIT, which owns office buildings and some industrial properties.
As interest rates rise, income trusts generally get hurt because it affects their cost of capital and drives down valuations, Mr. Kim says. But rates generally rise as the economy grows, meaning people have jobs and are spending money at malls and retailers are paying steady, and possibly higher, rents.
Mr. O'Reilly shares this opinion, and singles out RioCan, Calloway, another retail commercial play, and Primaris Retail REIT, which deals with enclosed malls.
"The retail space is doing well," he says. "Rents are rising at the rate of inflation or better in some cases."
While Mr. Kim doesn't see many bad picks in the sector, there are some REITs that are going to profit far less than their peers. He says he would rather avoid adding to his position in multiresidential units, such as Canadian Apartment Properties REIT.
"It's one of the very well-run REITs with a long history of good operations," he says. "But there are still a lot of challenges. It's not an easy outlook because the high level of home affordability continues to keep vacancy rates high. Also the rising cost of energy is a negative factor, because heating costs are included in many rents. We own it -- but cautiously."
Mr. Kim is also avoiding hotel names such as Canadian Hotel Income Properties REIT and Legacy Hotels REIT.
"This is a much more cyclical industry, a lot more tied to economic growth and prosperity," he says. "Tourism properties are being hurt by the strength of the Canadian dollar versus the U.S. dollar, a slowdown in traffic from U.S. tourists, and we're not seeing that kind of strong bounce everyone has been hoping for since September, 2001."
But even investing in these underperformers wouldn't drastically hurt investors, the analysts says.
"The sector is low risk and stably structured and experiencing pretty decent fundamentals," Mr. O'Reilly says. "It's not as if we expect one REIT to go up and the other to go down. We still expect a positive return from our underperform-rated REITs. Some are just going to make you more money than others."
© The Globe and Mail
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