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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.
Good Investing!
Tom Hutchison
Carla Pasternak's Dividend Opportunities
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.
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