A diversified portfolio should hold a component of real estate investments. A personal residence is the first real estate investment for many, but there are others to consider, including Real Estate Investment Trusts.
REITs are a subgroup of the broad income trust category of investments. The main subgroups of are Energy, Business, and Power & Energy Infrastructure. On October 31, 2006 the Federal government announced that they would begin taxing trust distributions from Energy, Business, and Power & Energy Infrastructure trusts at regular corporate income tax rates. These changes will take effect at the beginning of 2011.
This announcement eliminated the advantage of the trust structure as a flow through investment. The one exception to this required tax change is REITs. Most REITs are expected to make the necessary adjustments to qualify for the REIT exemption and have their income remain tax-exempt. There are approximately 34 REITs listed on the TSX and TSX Venture exchanges. REITs are classified as “financials” from a sector standpoint. One reason for this is that they are highly sensitive to interest rate movements.
Diversification: We are essentially attempting to lower overall risk with minimal impact on total potential return. The main asset mix categories are Cash, Fixed Income, Canadian Equities, US Equities, International Equities and Real Estate. A question we are asked often is whether or not a personal residence provides the “real estate” component for diversification. Residential real estate often performs different than other types of real estate investments. We can analyze investments within a portfolio to determine how closely they are correlated. Real estate investments often have a low correlation to other equity classes – this may reduce volatility.
Cash Flow: One of the benefits of income trusts is the ability to provide a steady monthly cash flow. REITs typically pay monthly distributions and are very popular among income oriented investors. A REIT collects rent revenue monthly and then flows the majority of this income to unit-holders.
Liquidity: One benefit to REITs is that they are publicly traded. They are not locked-in and investors have the ability enter limit and stop-loss orders. Other real estate type investments are often illiquid, have minimum holding periods, and higher transaction fees. The best way to determine liquidity is to look at the market capitalization of the issuer (REITS range from a market capitalization of approximately $100 million to $4 billion).
Transparency: As REITs are publicly traded, they are also audited. Audited financial statements, and regulatory disclosures provide investors access to important information that has been verified by a third party. Other types of real estate investments may not have audited statements, independence, or provide access to information.
Taxation: For those with registered and non-registered accounts we recommend holding REITs in a non-registered account. Most REITs have a Return of Capital (ROC) component within each monthly distribution making them extremely tax efficient in a taxable account. ROC is reported in box 42 (information box only) on a T3 slip but is not immediately taxable.
To illustrate we will use a person who buys $20,000 of ABC REIT (2,000 units at $10.00 unit). ABC REIT pays a monthly distribution of $0.08 per unit. Annually ABC REIT determines the ratio of taxation with respect to its distributions. For the current year, 50 per cent of distributions are considered taxable, and 50 per cent is Return of Capital.
The first monthly distribution is $160, of which $80 will be taxable and $80 will be tax deferred (reported in box 42). The term “adjusted cost base” is often used with investments because your adjusted cost base for “tax” is not necessarily equal to your original amount you paid.
For ABC REIT, the original cost is $20,000. The adjusted cost base after the first month is $19,920 ($20,000 minus the $80 ROC component). Provided you do not sell ABC REIT this amount is deferred. If the investment is held for 3 years, then we would estimate that $2,880 would be applied to reduce the original cost ($80 x 36 months).
If the investment is sold for $20,000 then a capital gain of $2,880 would result. Remember also that only one half of capital gains are taxable, meaning that $1,440 of the ROC will not be taxed at all.
REITs have three great tax features – initial flow-through from the REIT without being taxed within the trust first; deferral of the ROC component while held; and capital gains treatment upon selling.
Other important points to consider regarding REITs:
- REIT owners typically cannot file their income tax returns until the first or second week of April.
- The smaller REITs may have more price volatility.
- Key components we look for in a REIT are the quality of the properties and management, types of tenants, length of existing leases, payout ratio, and occupancy rates.