When interest rates are low, many investors seek investments that offer good, periodic income. This is what attracts some investors to income trusts.
As the name indicates, the purpose of an income trust is to generate income for investors. An income trust usually owns businesses or income-producing assets and redistributes part of the income it receives from those businesses or assets to investors.
The main categories of income trusts are:
- Royalty (resource-based) trusts;
- Business trusts;
- Real estate investment trusts (REITs).
REITs have been around since the 1980s. They enable you to invest in income properties via a trust, without having to hold or manage these properties.
Here are eight questions that you should ask yourself before investing in a REIT.
1. What is a real estate investment trust (REIT)?
A REIT owns and manages properties. These properties include office buildings, shopping centres, residential properties, industrial buildings, hotels, etc. A REIT therefore holds a portfolio of properties that generate income, mainly from leasing.
When you invest in a REIT, you become a unitholder, and each unit usually entitles you to:
- Receive a portion of distributable income;
- Vote at meetings of unitholders.
Trusts regularly distribute a major portion of their income to investors (unitholders), usually on a monthly or quarterly basis. The objective of a REIT is to provide stable and sustainable distributions, although these distributions:
- Are not guaranteed;
- May be reduced or suspended;
- Are carried out at the discretion of the REIT’s managers.
If you hold REIT units, you do not directly own the properties; the REIT does.
2. For investors, what is the main difference between REITs and business corporations?
Corporations can pay dividends to their shareholders, but most of them will reinvest part, if not all of their income for long-term growth.
A REIT seeks instead to maximize stable and sustainable income distributions. Reinvestments may be earmarked for maintaining properties and acquiring new ones. A REIT may therefore pay more in distributions than a corporation, which is why a REIT distributes almost all of its income to investors (usually between 70 and 95%).
3. How do you purchase REIT units?
You can purchase REIT units from an investment dealer.
The units are usually traded on a stock market, such as the Toronto Stock Exchange. Those not traded on an exchange are much less liquid (as they are more difficult to resell).
4. What are the forms of a REIT distribution?
You will receive distributions in the form of:
- Ordinary income (e.g., rental income)
- Return of capital
- Capital gainA capital gain is the difference between the selling price and the purchase price of an investment, when the difference is positive.
For example, if you buy a share for $12 and later sell it for $20, then your capital gain is $8.
This is the opposite of a capital loss. /lossA capital loss is the difference between the selling price and the purchase price of an investment, when the difference is negative.
For example, if you buy a share for $48 and later sell it for $40, then there is a capital loss of $8.
This is the opposite of a capital gain. (when the REIT sells a property or other asset)
The return on your units depends on the composition of the distributions for tax purposes. The return may therefore vary over time.
A REIT’s distributable income depends on:
- The operating results of its assets
- Capital requirements
- Its debt
Restrictive clauses may limit the distributions. For instance, a financial institution that has loaned money to a REIT may impose a ceiling or suspension of distributions until specific results are obtained. It is important to understand these restrictions, which are detailed in the prospectusA prospectus is a detailed information document that a company must prepare to be able to sell securities (such as shares) to the public.
It must provide full, true and plain disclosure of all material facts likely to affect the value or market price of the security in question. , and to ask your investment dealer representative for help as need be.
The income that the trust does not distribute may be used to acquire other properties or to constitute a reserve for maintaining distributions in lean years. The REIT will be taxed on the amounts retained.
5. What are the risks of investing in a REIT?
Like sharesA share, also referred to as stock, is an equity security that entitles you to an ownership interest in a company.
The company can distribute a portion of its earnings to shareholders by paying them a dividend.
The shares of companies listed on an exchange are bought and sold at the exchange.
When a company ceases to operate, the proceeds from the sale of its assets are used to pay its debts and taxes, and the rest of the money is distributed to shareholders., the price of trust units depends on market conditions, and supply and demand.
While distributions are usually stable, they are not guaranteed, as opposed to safer investments like guaranteed investment certificates (GICs). A decrease in distributions would lower the value of units, while an increase would boost it.
Investing in a REIT is more like investing in shares than in bondsA bond is a security issued by governments and companies through which an investor lends money to the issuer.
In general, the government or company promises to pay the investor interest at a fixed rate and at certain intervals (for example, 2% per year). Interest is normally paid twice a year. At maturity, the government or company pays back a predetermined amount that is called the face value. The face value is usually $1,000.
There are several types of bonds:
Stripped bondReal return bondConvertible bondSavings bondRetractable bondUnsecured bondEtc. , because a REIT:
- Is not required to make distributions to its investors;
- May reduce or suspend distributions, if justified.
Good to know
- Since the initial investment is not guaranteed, you could lose all your money.
- A REIT is not a fixed income investment.
- A rise in interest rates can reduce the value of the units, as investors can then choose other more profitable investments. A trust’s income may also decrease if it needs to renegotiate mortgage debts at higher rates.
- Risk also depends on the type and performance of properties owned by a trust and the competence of its managers.
- Like other sectors, the real estate rental market is cyclical, with periods of growth and downturn.
End of the warning
To mitigate the risk associated with a decrease in income, a REIT will often diversify the types of real estate properties held in its portfolio, e.g., by holding office buildings, shopping centres, etc.
A REIT can also seek geographic diversification, for example by acquiring properties in Québec and other provinces.
6. Are REITs right for me?
Before investing, you must always take your financial objectives and investor profile into account, i.e.:
Speak to your representative if necessary.
Good to know
A REIT unit should not be considered a fixed income security. Do not choose a REIT solely for the amount of its distributions. Consider as well the quality of its assets and management.End of the warning
7. Do REITs offer tax benefits?
Generally, business corporations are taxed on their income before distributions to investors, who are in turn taxed on the distributions they receive. For this reason, it is often said that dividends are taxed twice: First at the level of the corporation before it issues dividendsDividends are the portion of the earnings, after taxes, that a corporation distributes to shareholders in proportion to their holdings., and then at the level of the investor who receives the dividends. REITs are exceptions. They do not pay tax on the income they distribute to investors, but pay tax on the income they retain.
You must pay tax on the distributions you receive from a REIT. However, the tax rate that you will pay on this income is less than the combined corporate and personal income tax rate in the case of business corporations.
REIT distributions to investors keep their original form. For instance, if a REIT distributes what it originally received as rental income, you will be taxed as though you had received rental income. The composition of these distributions for tax purposes may change over time, thereby affecting your after-tax returns.
REITs sometimes distribute amounts higher than the income they could theoretically distribute. In such cases, the surplus distribution may be considered a return of capital. A return of capital reduces the cost base of your units for tax purposes. In other words, if you sell your units, you will pay capital gains tax on the difference between the selling price and the adjusted cost base at the time of sale. This is referred to as a deferred tax.
Good to know
To benefit from the tax advantages of investing in a REIT, make sure the REIT complies with the conditions applicable to specified investment flow-throughs (SIFTs).
An investment dealer representative can help you determine if the units are eligible.
REIT units are eligible for RRSPs, RRIFs, RESPs and TFSAs.End of the warning
8. What to do before investing in a REIT?
Do your homework before investing. Check to make sure the REIT units can easily be traded, i.e., that you can quickly sell them. Some trust units are not traded often and are therefore less liquid.
Here are some questions to ask yourself:
- Does the REIT hold quality properties with good tenants?
- Do the tenants have long-term leases?
- What is the occupancy rate of the buildings?
- Are the properties geographically well diversified?
- Do you agree with the manager’s investment strategy?
Securities legislation governs the disclosure requirements specific to REITs whose units are traded on an exchange or by reporting issuers. You will easily find information on them on SEDAR.com This link will open in a new window. The disclosure record includes the annual information form and prospectusA prospectus is a detailed information document that a company must prepare to be able to sell securities (such as shares) to the public.
It must provide full, true and plain disclosure of all material facts likely to affect the value or market price of the security in question. . Take the time to carefully read and understand these documents and contact your investment dealer representative if you have any questions.