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  We're not sure how much trust to put in the Legacy REIT

BENJ GALLANDER and BEN STADELMANN

Friday, April 25, 2003

For the past several months diverse opinion has raged over whether income trusts represent a safe port in a storm of uncertainty or just another bubble waiting to pop. Despite the warnings from various Cassandras, these vehicles have been wildly popular, with plenty of new "product" foisted upon eager investors.

One of the things that makes the concept of these trusts so attractive is that management has a clear-cut mission to pass on cash flow to shareholders. Without the obligation to grow the business, which is the hallmark of most enterprises, management doesn't have the "opportunity" to blow capital on dumb acquisitions. It's deeply ironic then, that so many income trusts have raised gobs of new money by selling units, and subsequently spent it on an acquisition binge. Time will tell how many of these expansions will pan out.

Recent action with Legacy Hotels REIT is a stark example of what happens when the story begins to sour. The units slumped to a 52-week low of $5.35 this past week, after reporting a $21.4 million net loss for the first quarter. This probably isn't quite what the folks who bought freshly minted units at $7.70 last October had in mind. Legacy, with a portfolio of many of Canada's most prestigious hotels, raised $150 million in the offering, primarily to fund the purchase of the Monarch Hotel in Washington D.C., gaining a toehold in the U.S. market.

Aside from a generally weak business climate for tourism resulting in lower occupancy rates, higher energy and insurance costs have reduced cash flow. Hotel renovations have also reduced revenue and sucked up capital — expenditures in this category tallied $15.4 million for the quarter.

One reason that investors like REITs is that a portion of distributions is usually not taxable as it is derived from asset depreciation. That's nice, but it is important to remember that many assets really do depreciate and require reinvestment — especially spiffy hotels that have to impress discerning guests.

The hotel business is seasonal, so a loss at this time of year is not unusual, and so far there is no indication of a cut to the 18.5 cent quarterly distribution. If it can be maintained, that's a tempting yield of over 13 percent. But bottom fishers would be wise to consider the potential impact that SARS may have on revenue. Even if the scare is brought under control, travellers have a globe full of options, and many will choose to avoid Canada this year. And a host of Canadians will venture forth to countries without a locale on the WHO danger list.

A more secure alternative, though we have not bought any ourselves, are the Legacy Hotels debentures. They offer a coupon rate of 7.75 percent and are convertible to Legacy units at $8.75 before the March 1, 2007, due date. Currently trading at a little under par, this is still an attractive rate of return with a much higher margin of safety.


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