On Dec. 16, 2010, the Dept of Finance proposed amendments to the rules defining “Qualifying REITs” for Canadian tax purposes, the final act in a drama the government started on Oct. 31, 2006, when Finance Minister Jim Flaherty announced a new proposal–the “Tax Fairness Plan”–that would impose an entity-level tax on income trusts.
The short story is REIT investing in Canada remains a viable proposition, particularly if you bank on the recommendations in the Canadian Edge Portfolio and buy-recommended names in the “Real Estate” section of the How They Rate coverage universe. Focusing on best-in-class retail and residential REITs in a market that largely avoided the worst of the most severe global economic downturn in eight decades is one way to build a foundation of 6 percent-plus yielders that promise consistent dividend growth.
The long of it begins with the critical legal fact that “Qualifying REITs” are exempt from the new entity-level, “specified investment flow-through” (SIFT) tax. Generally speaking, all publicly traded income trusts and partnerships are paying it as of Jan. 1, 2011.
There’s been a lot of drama in the four years-plus since Mr. Flaherty’s announcement. Starting with his, Prime Minister Stephen Harper’s and the Conservative Party’s betrayal of voters trust, we then had an estimated $35 billion hole blown into the portfolios of Canadian and American investors.
And only then did the bigger nightmare begin, as fissures in the US subprime housing market became cracks became chasms that swallowed, among others, Lehman Brothers. During the Great Recession the Canadian story, much bigger than just the income trust story, began to make its way around the world. People liked its energy, as they always had; people now took notice of its fine financial system, too, calling it “the best in the world” and using it as a template for extra-governmental international discussions of how to fix the mess that had been made.
One thing, though, is that the chasms that ate venerable institutions left untouched a lot of the folks who made decisions that weakened the foundation, as it were. No worries, though, as what started, to return to the narrower tale of the trusts, on Oct. 31, 2006, has unfolded in a way that even the most optimistic observer would enjoy the upside surprise. Sound businesses were able to survive a drastically weakened macro environment, many of them adding market share at the expense of less nimble, debt-heavy competitors.
And many have taken advantage of generations-low borrowing rates to shape up weaknesses that did exist on balance sheets. The particularly strong expanded their footprints, reduced debt costs and grew cash available for distribution to shareholders. The “high-yield Canada” story is a durable story. And one place to start is with Canadian REITs.
RioCan REIT (TSX: REI-U, OTC: RIOCF), now one of North America’s most dynamic retail property developers, is an example of Canada’s newfound and subtle strength. There’s nothing flashy about shopping malls. RioCan’s dazzle is about consistent delivery over time, and that’s a function of high-quality management.
Relationships with anchor tenants such as Wal-Mart Stores (NYSE: WMT), operating under long-term leases, provide the portfolio a lot of ballast. The REIT is now expanding into the US via a partnership with Cedar Shopping Centers (NYSE: CDR).
Good management is also a hallmark of residential standout Canadian Apartment Properties REIT (TSX: CAR-U, OTC: CDPYF). CAP REIT recently refinanced CAD60 million of mortgage debt at an average interest rate of 3.03 percent and locked in low prices for 85 percent of its winter natural gas needs, required to provide heating for tenants.
The REIT added properties in British Columbia and sold others in Ontario, enhancing geographic diversification while boosting overall portfolio quality. Occupancy and rents are trending up, expenses are trending down.
The reality of the “Tax Fairness Act” has been much kinder than the horror threatened that long ago Halloween night. The proposed changes, effective as of Jan. 1, 2011, generally expand the definition of “Qualifying REIT.”
Proposed changes to the income tax rules will:
- allow REIT subsidiaries to hold certain non-capital property in respect of their real estate investment activities;
- allow REITs to hold up to 10 percent of their non-portfolio property as non-qualifying REIT property without losing REIT status (with an associated clarification of the circumstances under which property can be considered to be ancillary REIT property);
- allow REITs to derive up to 10 percent of their revenues from sources that are not qualifying sources (currently, a REIT must derive 95 percent of its revenues from qualifying sources);
- clarify that a trust’s revenue for purposes of the two revenue tests in the definition “real estate investment trust” is to be computed on a gross, rather than net, basis and that it will include capital gains;
- allow REITs to earn, as qualifying REIT revenue, gains realized by virtue of foreign currency fluctuations in respect of revenues derived from foreign real or immovable property including certain financing and hedging arrangements in respect of such property;
- ensure that amounts distributed to a REIT, by an entity in which the REIT has a significant interest, will retain their character for purposes of the revenue tests;
- allow an entity to hold investments in a REIT without those investments being treated as Canadian real, immovable or resource property in determining whether the entity itself is a SIFT.
The proposed rules (although already with effect, the Dept of Finance is accepting comments through Jan. 31 pending final promulgation) set the stage for another solid year of returns for Canada’s REITs. Primarily, the North American economy is rounding into strength, and at the same time, even after a noteworthy uptick in recent weeks, interest rates remain historically low.
REITs that were able to use cheap capital to grow during the last couple years will be able to complement growth in same-property metrics because of the improving employment picture.
After bottoming in recent months the fundamentals for real estate, across all major classes, are starting to turn: Growth in tenant demand is starting to outpace new supply. And that should set the table for lower vacancies and higher rental rates in 2011.
That bodes well for Canadian REIT investing.