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Published: November 13, 2009
Canadian royalty trusts (CanRoys), which
typically own oil and natural gas wells, have provided investors
with high yields for years.
You see, these trusts avoid taxation at the corporate level
provided they pay the bulk of their income to unitholders. The
Canadian government created this incentive to encourage
investment in the country's energy infrastructure.
For much of the last decade energy prices soared and so did
earnings and dividends from the royalty trusts. Then came
October 31, 2006... known among trust investors as "The
Halloween Massacre."
On that date, the Canadian government announced plans to end
favorable taxation of these trusts as of December 31, 2010. When
these tax changes take hold, much of what was paid to investors
as dividends will instead go to the Canadian government.
But here's the million dollar question. If money seeking high
income in Canada leaves these trusts, where will it go? I've got
one strong possibility: Canadian real estate investment trusts (REITs).
Canadian REITs offer the same taxation benefits and high yields
the CanRoys currently enjoy. However, most REITs won't be hit by
the tax changes, leaving them to continue paying their yields of
up to 10%.
And even without the benefit of money flowing from Canadian
trusts into REITs, this asset class has a few other catalysts
behind it that are likely to spur a bull market.
A Massive Shift Could Mean a Bull Market for Canadian REITs
When the market closed on October 30, 2006, Canadian royalty
trusts enjoyed a total market capitalization of roughly C$210
billion. But then the tax bombshell hit. Almost instantly that
market cap was severed, with CanRoys plummeting a combined -13%
or C$27 billion in the week following the announcement.
And the exodus is continuing as we get closer to the tax
changes going into effect. For example, Enervest Diversified
Income Trust (EIT-UN.TO), Canada's largest diversified
closed-end fund, has reduced its position in trusts to 38.8% of
assets as of September -- down from 60% in February.
Many tens of billions more could flee these trusts in search of
a new home as the new tax rules are implemented in 2011. But why
should Canadian REITs end up with the lion's share of this cash?
Canadian REITs: The Only Game in Town
The biggest incentive for investment is that Canadian REITs
still won't be taxed at the corporate level provided they pay at
least 90% of taxable income to shareholders. After 2010, this
means REITs will be the biggest game in town with this tax
break.
Meanwhile, the markets are recovering. Sky-high yields on
oversold bonds and stocks are fading away quickly. As markets
return to normal, other securities will have difficulty
competing with the yields these REITs can pay.
I know what you're thinking.
Aren't most REITs in trouble? After all, real estate has been a
dirty word in the U.S. Over the past year, rents have plummeted
as vacancies have soared. All this is true, but things are
better in Canada.
According to a recent study by Canadian rating agency DBRS,
Canadian REITs are generally "in much better shape than the ones
in the U.S." The agency said that Canadian REITs are still well
capitalized, have excellent debt structures and generally
high-quality assets.
In addition, analysts at Canadian brokerage Canaccord Adams say
that commercial real estate in Canada has lower vacancy rates
and less supply than real estate in the United States.
The "Once-in-a-Decade" Opportunity
But perhaps the biggest boon to Canadian REITs is the
acquisition opportunities beginning to open up in this market --
especially in the United States.
Not only are U.S. real estate prices cheaper than anytime in the
last few years, but the Canadian dollar is relatively strong
against the U.S. dollar. The combination of cheaper prices and a
stronger currency has many Canadian REITs looking to take
advantage of the opportunity. As one CEO said, "We intend [...]
to take advantage of what we believe is a once-in-a-decade
opportunity to buy quality properties."
So how can you get in on the action? Canadian REITs trade
primarily on Canadian exchanges. But buying Canadian securities
isn't as exotic as it sounds. Just about any brokerage offers
access to these exchanges. And if you're looking for Canadian
REITs to investigate, I uncovered
this list a little bit
ago that is a useful place for retail investors to start their
hunt.
P.S. -- How big is the opportunity in Canadian REITs? Well, my
colleague Carla Pasternak just uncovered one promising REIT in
her November issue of
High-Yield International.
This gem yields 7.5% and just made its first foray into the U.S.
market. To read Carla's full profile of this company, you'll
need to be a subscriber.
Follow this link to learn more.
-- Tom Hutchinson
Staff Writer
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