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Canadian income trusts have always involved far more risk than most investors realize. This is why we’ve recommended so few of them in the past.
Income trusts are a type of investment trust that holds income-producing assets. Their units trade on stock exchanges, but they flow much of their income through to unit holders as “distributions.”
On January 1, 2011, Ottawa imposed a tax on distributions of income trusts. The new tax put income trusts on an equal tax footing with regular corporations.
Virtually all Canadian income trusts then converted into conventional corporations. But some are still out there: mostly real estate investment trusts (REITs).
Investing in trusts — and in particular oil and gas trusts — was risky, as the businesses that underpinned them needed steady cash flow. But that could stagnate during economic downturns. At the same time, we believed that investors should have looked for trusts with low capital expenditures and mature businesses.
More about Canadian Income Trust taxes
Canada offers special tax treatment for Canadian income trusts. When they flow their income through to their unitholders, they don’t pay much if any corporate tax. Investors pay tax on most of the distributions as ordinary income (although some distributions qualify as a tax-free return of capital).
Ottawa feels the income-trust business structure is appropriate for real estate investment trusts, or REITs, so it has exempted REITs from the income-trust tax.
Real estate investment trusts resemble Canadian income trusts, but with a key difference: REITs invest in income-producing real estate, such as office buildings, shopping centres and hotels. (We cover a number of carefully selected income trusts and real estate investment trusts in our Canadian Wealth Advisor newsletter.)
Regardless of whether or not they have converted, the basic tests we use to ferret out good investments and reject bad ones still apply, not only to Canadian income trusts, but to other types of investments, as well.
Keep “Investment Inputs” in mind when judging income trusts, or any investment
In evaluating investments, many investors focus on what we’d call “investment outputs,” such as earnings, dividends, cash flow, return on equity, sales growth and so on. These are all important, of course, but you shouldn’t focus on them to the exclusion of what you might call “investment inputs.”
Investment inputs are harder to work with than investment outputs, since it takes a judgment call to determine their risk or value. To give you a better idea of what we mean, here are 10 keys to picking the best Canadian income trusts and real estate investment trusts. We look each before recommending any income trust:
- Do you have any doubts about the integrity of the insiders? If so, stay out.
- Did the Canadian income trust or REIT buy its assets in the midst of a recent boom, or has it owned them for some time? Bidding for assets in the midst of a boom tends to be risky, since it can lead to unpleasant investment surprises.
- Which of the five economic sectors is it in: Manufacturing & Industry, Resources & Commodities, Consumer, Finance or Utilities? In trusts, as in ordinary stocks, the first two tend to be riskier, the last two tend to be safer, and Consumer is somewhere in between.
- How much debt is the Canadian income trust or REIT carrying? You need to gauge the debt in relation to all assets, including hidden assets and those that appear on the balance sheet. Too much debt in relation to assets can lead to a steeper downturn in distributions when the business hits a snag.
- Is the business dominant or at least prominent in its industry? If the answer is no, risk is higher.
- How much of its cash flow is it paying out? Paying too much leaves it vulnerable to a cut in distributions. This can have a devastating effect on the unit price.
- Has its cash flow and profitability shown acceptable performance in relation to the rest of its industry? If it can’t make money when business is good, when can it make money?
- Are there any special factors worth considering? With resource trusts, you need to look at how long reserves are likely to last; with REITs, you need to look at the quality of tenants, length of leases and the possibility of improving the use or expanding the occupancy of existing properties.
- Is the Canadian income trust (or the industry it’s in) the subject of a lot of favourable broker and media attention? If so, investor expectations may be excessively high, and that leaves the trust vulnerable to a steep downturn on any hint of bad news.
- Is the current and prospective yield high enough to justify the risk?
Don’t invest In speculative Canadian income trusts
One of the more reassuring aspects of the long-term rise now underway in the stock market is that the strength is concentrated in well-established companies. Investors are bidding up the prices of stocks with a history of sales and earnings, if not dividends. Speculative areas like penny stocks, new issues, junior techs and so on appear to be out of investor fashion.
This contrasts sharply with, say, the income-trust boom of the mid-2000s. Back then, investors were plunging into new issue income trusts, many of which were of low investment quality. Today’s situation contrasts even more with the Internet stock mania of the late 1990s. Many of the new issue Internet stocks back then were little more than stock promotions.
Chasing after low-quality investments like these becomes common when inexperienced investors enter the market. These newcomers lack the healthy sense of skepticism that you need to succeed as an investor. So they naturally zero in on the least desirable stocks on the market. Almost by definition, these are extremely risky and/or overpriced stocks that seem to offer high rewards with little risk. They generally deliver precisely the opposite.
Chemtrade Logistics (Toronto symbol CHE.UN) is one of Canada’s last reliable Canadian income trusts. It’s one of North America’s largest providers of removal services for resource firms, such as oil refineries and base metal processors, whose operations create sulphur, acid and other by-products. Chemtrade converts these substances into useful chemicals, like sulphuric acid.
How interested are you in real estate investment trusts considering the 2019 market? Share your opinions in the comments.
Pat McKeough has been one of Canada’s most respected investment advisors for over three decades. He is the founder and senior editor of TSI Network and the founder of Successful Investor Wealth Management. He is also the author of several acclaimed investment books. This article was originally published in 2011 and is regularly updated, most recently on Dec. 21, 2018. It is republished on the Hub with permission.
