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What you need to know before investing in a real estate investment trust (REIT)

Interested in real estate investment trusts (REITs)? Take the time to delve into this before investing.

Income trusts

When interest rates are low, many investors turn to income trusts, as they seek alternatives to investments whose returns are considered too low.
Income trusts usually hold securities in an underlying business, allowing investors to share in the distributable income (i.e. net cash flows), or in income-producing assets owned by the trust.

The main income trust categories are royalty trusts (resource-based), business trusts and real estate investment trusts (REITs).

REITs have been around since the 1980s. They enable you to invest in income-producing properties via a trust, without having to hold or manage these properties.

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What is a REIT?

A REIT owns and manages properties. These properties include office buildings, shopping centres, residential properties, industrial properties, hotels, etc., which are income-producing assets. A REIT therefore holds a portfolio of properties that generate income, mainly from leasing.

To raise the funds required to purchase properties, a REIT issues units to investors. If you invest in a REIT, you become a unitholder: each unit usually entitles you to vote at unitholder meetings and to an equal and proportional share in distributable income.

Trusts regularly distribute a major portion of their distributable income to investors (usually on a monthly or quarterly basis). The objective of a REIT is to provide stable and sustainable distributions, although these are neither guaranteed nor cumulative, and remain at the discretion of the REIT’s managers.

If you hold units, you do not directly own the properties; instead, you have units in a trust that holds the properties.

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Why purchase REIT units

A corporation pays out dividends, but reinvests part of its income for long-term growth. A REIT distributes almost all of its income to investors (usually between 70 and 95%), looking instead to maximize stable and sustainable income distributions by reinvesting on a smaller scale to maintain its properties and acquire new ones. You may therefore receive more distributions from a REIT than from a corporation.

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How to purchase REIT units

You can purchase REIT units from an investment broker. The units are usually traded on the stock market, such as the Toronto Stock Exchange. Those not traded on an exchange are much less liquid. The liquidity of an investment refers to its ability to be quickly converted to cash for a minimal fee.

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Forms of a REIT distribution

You will receive distributions in the form of ordinary income (e.g. rental income), capital repayment and capital gain (loss) when the REIT sells a property or other asset. Since the return on your units will depend on the composition for tax purposes of the distributions, it may therefore fluctuate over time.

A REIT’s distributable income depends on the operating results of its assets, capital requirements and borrowings. There may be a ceiling on distributions as a result of restrictive clauses. For instance, a financial institution that has loaned money to a REIT may impose a ceiling or suspension of distributions until specific results are obtained. You should understand these restrictions, which are detailed in the prospectus, and ask for your investment broker’s help as required.

The income that the trust does not distribute may be set aside for the eventual acquisition of other properties or to constitute a reserve for maintaining distributions in lean years. The REIT will be taxed on the amounts kept.

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Risks of investing in a REIT

As with most other investments, there are risks to investing in a REIT. Like shares, the price of trust units depends on supply and demand, and is affected by market conditions. A decrease in distributions lowers the value of units, while an increase boosts it. While distributions are usually stable, they are not guaranteed, as opposed to safer investments like guaranteed investment certificates (GICs).

Investing in a REIT is more like investing in shares than in bonds —a REIT is not required to make distributions to its investors. A REIT may reduce or suspend distributions, if justified. In addition, since the initial investment is not guaranteed, you could lose all your money.

While a REIT is not a fixed income investment, a rise in interest rates could decrease the value of its units, since investors can then choose investments with higher rates. A trust’s income may also decrease if it needs to renegotiate mortgage debts at variable or higher rates.

Risk also depends on the type and performance of properties owned by a trust and the competence of its managers.

Like other sectors, the real estate rental market is cyclical, with periods of growth and slowdown.

To mitigate the risk associated with a decrease in income, a REIT will usually diversify the types of real estate properties in its portfolio, e.g. by holding both office buildings and shopping centres. A REIT could also seek geographic diversification, by acquiring properties in Québec and the Maritimes, for instance.

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Are REITs right for you?

As for any investment, you must take your investor profile into account: your financial and personal situation, risk tolerance and investment knowledge. As necessary, you can consult your representative.

A REIT unit should not be considered a fixed income security. Do not choose a REIT solely for its distribution level—also consider the quality of its assets and management.

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Tax benefits of REITs

REITs do not pay tax on the distributable income they pay to investors, but pay tax on the income they keep. Usually, other types of income trusts and corporations are taxed on their income before distributions to investors, who are in turn taxed on the distributions they receive. Since a REIT’s distributions are only taxed in the investors’ hands, the marginal tax rate that applies to investor distributions is less than the combined corporate and investor tax rates for corporations. In short, REITs are not subject to the double taxation applied to dividends.

REIT distributions to investors keep their original form. For instance, if a REIT distributes what it originally received as rental income, you will be taxed at your marginal tax rate as though you had received rental income. The composition of these distributions for tax purposes may change over time, thereby affecting your after-tax returns.

REITs sometimes distribute amounts higher than what they can distribute, without compromising their production capacity and sustainability of distributions. In such cases, the surplus distribution may be considered a capital repayment. These are not usually taxable for investors, but reduce the basic price of the investor’s units for tax purposes. In other words, if you sell your units, you pay tax on the capital gain of any difference between the sales proceeds and the adjusted cost base at the time of sale. This is referred to as a deferred tax.

To ensure that you benefit from the tax advantages of an investment in REIT units, make sure the REIT complies with the conditions applicable to specified investment flow-throughs (SIFTs). An investment broker can help you determine if the units are eligible.

REIT units are eligible for RRSPs, RRIFs, TFSAs and RESPs.

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What to do before investing in a REIT

Do your homework before investing. Check to make sure REIT units are easily negotiable, i.e. that you can quickly sell them. Some trust units are not traded often and are therefore less liquid.

Make sure the REIT holds quality properties with good tenants. Do the tenants have long-term leases? What is the occupancy rate of the buildings? Are the properties geographically well diversified? The rental market may be stagnating in some regions, but in full growth in others. Are you comfortable with the manager’s investment philosophy?

Securities legislation governs the disclosure specific to REITs that are traded on an exchange and/or are traded by reporting issuers. You will easily find information on them on SEDAR.com, including the continuous disclosure record, plus the annual notice and prospectus. Take the time to carefully read and understand these documents and ask your investment broker if you have any questions.

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