| Royalty trusts, in Finance, are classic | | | | drop. On the other hand, when interest rates |
| flow-through investments vehicles. The trust, | | | | rise, prices of REIT's drop thus causing |
| like a mutual fund, holds a portfolio of | | | | yields to rise.For example, when interest |
| assets, which can be anything from producing | | | | rates were pushed up by both the Federal |
| oil and gas wells to power generating | | | | Reserve Board and the Bank of Canada all the |
| stations to interests in land. The net cash | | | | way back in 2000, the typical REIT was |
| flow, i.e. the total cash flow minus | | | | yielding close to 14 percent as prices per |
| revenues, is passed on to the unit-holders as | | | | share fell. When interest rates subsequently |
| distribution.The purpose of a Real Estate | | | | dropped, yields fell to less than 10 percent |
| Investment Trusts is to reduce or eliminate | | | | as demand for REIT's increased thus pushing |
| corporate income taxes. In the United States, | | | | share prices higher.This is a very important |
| where they are generally more widespread as | | | | consideration to be kept in mind when |
| investment vehicles, Real Estate Investment | | | | investing or otherwise trading units |
| Trusts pay little or no federal income tax | | | | involving this type of trusts. If interest |
| but are subject to a number of special | | | | rates appear to be poised to rise, investors |
| requirements set forth in the Internal | | | | may want to defer purchases, and those who |
| Revenue Code, one of which is the requirement | | | | own this type of shares already may consider |
| to distribute annually at least 90 percent of | | | | reducing their exposure by selling and take |
| their taxable income in the form of dividends | | | | in some profit.There are typically two |
| to shareholders.Real Estate Investment Trusts | | | | catches with REIT's. The first is that since |
| are, therefore, a special type of royalty | | | | investors are ‘unit-holders' rather |
| trust. They specialize in real property, | | | | than shareholders, they are potentially |
| anything from office buildings to long-term | | | | jointly and severally liable together with |
| care facilities. For illiquid assets like | | | | all other unit-holders (plus the trust |
| real estate, closed-end funds of this type | | | | itself) in the eventuality of insolvency. |
| make good sense. Open-end or ‘mutual' | | | | Instead of limited liability, investors rely |
| real estate funds are subject to new money | | | | on the REIT's management to have property, |
| and redemption problems, entirely absent in | | | | casualty and liability insurance, prudent |
| closed-end trusts. The first Real Estate | | | | lending policies and other reasonable |
| Investment Trust was introduced in the United | | | | safeguards in place. Nevertheless there is |
| States in 1960. The vehicle was designed to | | | | always the possibility of a problem - say a |
| facilitate investments in large-scale | | | | catastrophic fire or a building collapse - |
| income-producing real estate by smaller | | | | that is not covered by insurance. This may |
| investors. The US model was simple, enabling | | | | have seemed like a very small matter prior to |
| small investors to acquire equity interests | | | | the attacks on the World Trade Center in |
| in vehicles holding large-scale commercial | | | | 2001. Since then, however, it is something |
| property.But the birth of Real Estate | | | | that has to be taken seriously.The second |
| Investments Trusts as a mass investment | | | | problem with REIT's is less transparent. All |
| vehicle can be traced directly to the | | | | real estate properties depreciate in value |
| liquidity crisis encountered by open-end real | | | | over time (not the land, only the buildings). |
| estate mutual funds all the way back to | | | | Depreciation can be somewhat slowed down by |
| 1991-92, during the slowdown of real estate | | | | earmarking at times significant amounts of |
| that characterized those years. Faced with | | | | money for maintenance and renewal of |
| redemption demands on the part of | | | | facilities. Since most of the REIT's income |
| unit-holders, real estate mutual funds were | | | | is being distributed and the capital cost |
| presented with the unpalatable option of | | | | allowance is being allocated to investors, |
| selling valuable real properties into a | | | | investors are factually getting their own |
| distressed market to raise cash. Many of | | | | capital back over time. As such, the book |
| them, therefore, chose to close off | | | | value of the underlying real properties will |
| redemptions and converted into Real Estate | | | | be steadily depleting.Obviously, if real |
| Investment Trusts, since then most commonly | | | | estate markets are on the upswing the |
| known as REIT's. Only a few open-end real | | | | depreciation factor will not be overly |
| estate mutual funds continue to own real | | | | important, since it will be offset by the |
| estate directly. Most now invest in shares of | | | | appreciation of the underlying assets. But in |
| real estate-related companies.The typical | | | | essence, the point is that the long-term |
| REIT usually distributes about 85 to 95 | | | | income stream is quite variable, certainly |
| percent of its income (rental income from | | | | more variable than some managers would have |
| properties) to the shareholders, usually on a | | | | investors believe.As stated above, the |
| quarterly basis. This income gets a special | | | | inverse relationship between interest rates |
| tax break, because REIT's shareholders are | | | | and prices of REIT's shares plays an |
| entitled to a deduction for the pro-rata | | | | important role. On average, it is safe to |
| share of capital cost allowance (depreciation | | | | assume that interest rate increases are |
| on the real properties). As a result, a high | | | | likely to be met by REIT's price declines in |
| percentage of the distributions are normally | | | | the Stock Exchange, because increasing rates |
| tax-deferred. However, the amount will vary | | | | correspond to a slowdown in the economic |
| from year to year and will differ depending | | | | growth and less demand. But out of the |
| on the particular REIT.As with royalty trust, | | | | context of the frantic buy and sell of Wall |
| the value of tax-deferred income will reduce | | | | Street, even a slowdown in the market for |
| the adjusted cost base of the shares owned. | | | | single-family houses can actually benefit |
| For example, if an investor purchases 1,000 | | | | REIT's. This is so, because even though real |
| units at $15.50 per unit, receives $3,000 | | | | property prices are in decline, it is still |
| ($3.00 per share) in aggregate tax-deferred | | | | cheaper to rent than to own, especially |
| distribution over time, and the sells the | | | | during a period of rising interest rates. And |
| shares for $17.50 each, the capital gain will | | | | REIT's thrive on rentals. In fact, no city is |
| be calculated as follows:[1,000 x ($17.50 - | | | | a better environment for REIT's to operate in |
| $15.50 + $3.00)] = $5,000 before adjustments | | | | than New York City, where some 70 percent of |
| for commissions. In Canada, this gain will be | | | | residents rent.Luigi FrascatiLuigi Frascati |
| subjected to capital gain treatment, so only | | | | is a Real Estate Agent based in Vancouver, |
| 50 percent or $2,500 will be included in | | | | British Columbia. He holds a Bachelor Degree |
| income and taxed accordingly. In fact, Canada | | | | in Economics and maintains a weblog entitled |
| allows preferential tax treatment to REIT's | | | | the Real Estate Chronicle where you can find |
| by making them RRSP-eligible and by not | | | | the full collection of his articles on Real |
| considering them foreign property (which | | | | Estate Economics and Finance. Luigi is |
| would taxed at a higher rate), so long as the | | | | associated with the Sutton Group, the largest |
| real estate portfolio does not contain | | | | real estate organization in Canada, and is |
| non-Canadian property in excess of the | | | | based with Sutton-Centre Realty in Burnaby, |
| allowable limit.REIT's yields and the market | | | | BC.Luigi is very proud to be an EzineArticles |
| price of units tend to be strongly influenced | | | | Platinum Expert Author. Your rating at the |
| by interest rates movements. As rates drop, | | | | footer of this Article is very much |
| prices of REIT's rise thus causing yields to | | | | appreciated. Thank you. |