Eliminating REITs

Benj Gallander and Ben Stadelmann
Friday, August 16, 2013

While Benj has been highly critical of the federal government’s economic policies and is oh-so tired of paying for the droning publicity for Canada’s Economic Development Plan, he does give the Conservatives full credit for the elimination of income trusts, circa Halloween, 2006.

The proliferation of these investments was sucking tax revenue away from the government, making it far more difficult to attempt to keep the debt and deficit in check. And when the banks threatened to form income trusts of their own, Ottawa took action and prudently eliminated them. That has helped to keep the government’s cash aquifers from being in worse shape.

However, trusts still exist in the real estate sector. These descended on the Canadian landscape in 1993, not so long ago really, and have become an excellent tax efficient modus operandi for corporations and Canadians investing in them.

Currently, there are about 40, but the number is set to dramatically increase. Loblaw (L-TSX) recently joined the party. Canadian Tire (CTC-TSX) will have an initial public offering in the fall. Hudson’s Bay (HBC-TSX) has one in the works. Tim Hortons (THI-TSX) is threatening to form one. There are at least another half dozen brewing.

Finance Minister Jim Flaherty stated, “We did not eliminate REITs back in 2006 because they were not considered to be passive investment vehicles.” Hmm, that is also true of many of the income trusts that were abolished.

One has to question whether today’s REITs are costing the government too much money. From Benj’s angle, this is definitely true and more so if the Feds want to eliminate the deficit under Flaherty’s watch, which he has stated is his goal. If this objective was a stock, Benj would be shorting it, as he does not consider it probable, given their track record.

Historically, the Conservatives have been poor in the deficit department, from the second largest in Canadian history under the watch of former prime minister Brian Mulroney, to an even bigger one under Prime Minister Harper. Perhaps if the Tories hold power for another 100 years, deficit elimination might be doable. But Flaherty would be 164 and likely too old to hold office.

This is definitely a tricky time to invest in REITs. While it has been a field day of returns over the past number of years, with interest rates near rock bottom and having pretty much only one direction to go (up), these investments become less attractive.

In addition, the increased competition in the sector makes it harder to stick out in the growing field. Plus as REITs ranks swell, the government might indeed decide it is time to do away with these in the same way that investment trusts were eliminated — a move that caused prices in the sector to swoon and many investors to call for compensation (which did not occur).

Especially risky as investments are the IPOs in this arena. Statistically, the vast majority of IPOs decrease in value from their issuance price. When this is combined with the view by most metrics that Canadian real estate prices are high, indicating that a downturn in this sector could easily occur, odds are that most of these offerings will prove to be overpriced. One can easily argue the real estate arena is overheated with Toronto being a shining example. This past quarter $4.9 billion was spent on commercial real estate, shattering the old mark by about $1 billion. That is bubble territory.

The only REIT holding in our two portfolios is RioCan (REI-UN-TSX), which is in the vice-president’s portfolio. Purchased at $19.52, it has had an excellent run, currently sitting at $23.50. It also pays a lovely monthly distribution of 11.75 pennies. The target sell range is $30-32. Benj got tantalizing close to hitting the eject button in April when it hit $29.60, but he is waiting for another spike.

From Benj’s perspective, the government would be wise to eliminate REITs. He acknowledges that many who proffer and make a pretty penny from them, along with those receiving distributions, would counter that REITs are worthwhile. That being said, anyone who owns these vehicles or is considering their purchase should recognize that often enough it is the worst time to buy when the market is offering a fat supply. And purchasing an IPO is especially questionable. While many sales people are pushing REITs hard, from this viewpoint, it looks like buyers could soon be crying into their retirement savings.