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Everyone is talking income these days and for good reason. When your investments have lost 30, 40, 50% over the past 3 years, it’s nice to just have money coming in. As we sit and wait for the markets to come back, and nobody can be sure when they will, it’s good to be getting tax preferential compounded income while you wait. As a result of this rush to income in Canada, the INCOME TRUSTS have become all the rage. So I thought I’d take a brief look at them. The reason they’re tax preferential is because the income is often (not always) taxed as either a capital gains dividend, or because they're trusts, the depreciation on the actual asset can be flowed through to the unit holders. REITS - Real Estate Investment Trusts - Essentially these are a trust set up to receive the majority of the monthly lease income from a commercial building, usually in the downtown core of a large Canadian city. The unit holder buys units in the trust, and then receives their proportionate share of the monthly lease income that flows into the trust. The risk with these is if the lease rates for the buildings goes down, so too does the amount of lease income flowing into the trust; and the less income flowing through to the unit holder. If the vacancy rates of the buildings goes up; the less lease income flowing in. ROYALTY Trusts - These are similar to the REITS in that they are set up as trusts and the investor purchases units in the trust, however instead of lease income from buildings, the investor receives royalties from some form of commodity, (oil and gas, lumber, minerals, etc.). As the commodity gets sold, either by the barrel or by the foot or whatever, each royalty dollar flows into the trust and the unit holder gets their proportionate share. The risks with these are that the commodity’s price, which is set on the open market, (ie. a barrel of oil) goes down, the corresponding trust income goes down. Also, IF the particular oil and gas well or lumber tract, or coal mine that’s in the trust, doesn’t end up having the reserves that were originally anticipated, then the unit value would crash. After all, once the oil well or natural gas field is tapped, the trust units are basically worthless. If you were to buy into an oil royalty trust from a particular oil company’s project, with an estimated reserve life of 30 years and it’s later revised downward to 10 years; your royalty trust units market value would plummet. This past year the U.S. slapped an outrageous tariff on Canadian Softwood lumber; this practically wiped out the market value of all the royalty trust units for most of the lumber royalty trusts. So it may be factors such as political; that could affect the unit value as well. INCOME Trusts - Due to the reasons I spoke of earlier these unit trusts have spawned an entire new industry in Canada known as "INCOME trusts." Basically these are the same as the Royalty trust, except that instead of a commodity as the asset, it’s ANYTHING else that generates a consistent, steady and reliable income stream that can be paid out in liquid form to the unit holder. SO for instance; A&W restaurants of Canada actually has a burger income trust which you could buy units in so every burger they sell in their company owned restaurants, the trust receives the income from, and the unit holders get their proportionate share. That’s the story behind income trusts. The lion’s share of these trusts have made some really good returns over the past three years, for a variety of reasons. My fear is that now that they have become so popular with Canadian investors; who really don’t even know what they're buying; they are about to experience a nasty crash, for all the reasons I’ve mentioned above. Cheers, Hugh |
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