Given the lower interest rates afforded by GICs (1-4%) and short-term government bonds (3.5-5%), investors have been attracted by the higher, quoted yields on income trusts (median 10.1%). Income trusts hold businesses that generate operating revenue and the net income flows directly to trust unit holders by way of periodic cash payments, typically monthly or quarterly. The cash payments usually consist of a portion that is taxable and a portion that is non-taxable, the latter representing a repayment of capital (“getting your own money back”). An income trust is unlike a bond in that it does not have a maturation date when capital is repaid. This uncertainty of capital repayment adds to the “risk” profile of these types of securities.
There are many different forms of income trusts including oil and gas, real estate, electrical power, ship-cargo handling, rental of cold storage space, fast food, peat moss, industrial waste, ice cubes and bottled water. Approximately 147 income trusts trade over the Toronto Stock Exchange, allowing for ease of purchase and liquidation. Note that some recently issued income trusts hold a combination of different income trusts, and are essentially an “income trust of income trusts”. We will look at two popular forms: oil and gas and real estate.
Oil & Gas Income Trusts
Money provided by primary unit holders is used to purchase oil and gas-producing properties from operating companies. Ideal properties would have long life reserves, low operating costs and environmental risk, along with good upside potential. The cash flows that investors receive can fluctuate and are based on the amount of oil and gas produced by the properties and the prices obtained for these commodities. Over time, the oil and gas generated by the properties will be depleted (be used up). The trust will eventually have to issue new trust units in order to replace the depleted reserves to maintain cash flows.
Investors can obtain above average returns with oil and gas income trusts if:
- the properties find more oil and gas than was originally considered “proven and probable” over the producing life-expectancy
- oil and gas prices rise above the prices used in original projections
- the US dollar appreciates (relative to the Canadian dollar) as oil and gas prices are in US dollars
The reverse for the above points is also true and then returns would not meet investors’ expectations. These highly variable factors lend to the “risk” of investing in oil and gas income trusts.
Real Estate Investment Trusts (REITs)
A REIT provides investors with an interest in a professionally managed portfolio of real estate that generates rental income. There are approximately 16 REITs in Canada, and they vary with respect to the type of properties they invest in and where these properties are located.
Properties include shopping centres, offices, industrial buildings, multi-family residences, hotels, nursing homes and retirement residences. When evaluating REITs, one should look for REITs with well established track records, diversification in location and/or property type, conservative levels of debt and reasonable unit prices.