Latest / How Canadian Markets Work / Episode 91: REITs and Income Trusts (The Depreciation Illusion)

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Episode 91: REITs and Income Trusts (The Depreciation Illusion) · How Canadian Markets Work

0:00
Last time we looked at hedge funds where, you
0:02
know, that whole two and 20 fee asymmetry can
0:05
just eat half your returns, like even when the
0:08
strategy works perfectly. Oh, yeah. You can literally
0:10
have a strategy return 22 % and you, the investor,
0:14
walk away with under 12. It's brutal. Right.
0:17
But today we're flipping the script entirely.
0:20
We're looking at a financial structure that seems
0:22
to do the complete opposite. It pays out distributions
0:25
that look, well, completely impossible on paper,
0:28
but are actually completely sustainable. Yeah,
0:31
I mean, it looks like a math error just waiting
0:32
to collapse. If you try to apply a standard corporate
0:36
lens to these vehicles, the numbers simply do
0:39
not work. No, they really don't. But that's because
0:41
we're dealing with a structure that was designed
0:43
from the ground up to systematically break the
0:46
traditional rules of how we measure corporate
0:49
health. Exactly. So for anyone listening who
0:51
has ever looked at a real estate company's stock
0:54
metrics and just felt completely lost, this deep
0:58
dive is your shortcut. It's a very necessary
1:00
shortcut, honestly. Yeah. We are digging into
1:02
the mechanics of real estate investment trusts
1:05
or REITs and income trusts. Our mission today
1:08
is to figure out why traditional stock metrics
1:11
fall apart the second a property is involved
1:14
and how a hidden tax quirk could be quietly building
1:19
this massive tax bill for you years down the
1:22
line. Which nobody wants to find out about the
1:24
hard way. Definitely not. Okay, let's unpack
1:25
this because to grasp how a REIT operates, we
1:29
really need to look at why this structure was
1:31
permitted to exist in the first place. Right.
1:33
Right. Because it certainly wasn't an accident.
1:36
A REIT is essentially just a trust that holds
1:38
income producing real estate. So we're talking
1:40
about apartment buildings, retail malls, industrial
1:43
warehouses, data centers, stuff like that. And
1:45
when you invest, you're not actually buying shares
1:47
in a traditional corporation. Exactly. You're
1:50
buying units of a trust, and that trust acts
1:52
as the entity that owns the physical buildings.
1:54
So the whole point of this setup. is this concept
1:57
called flow -through. It's like a bypass vowel
1:59
for double taxation. Which is huge. Right. Because
2:02
in a normal corporate structure, the company
2:04
makes a profit, pays corporate tax on that profit,
2:06
and then pays a dividend to you, the shareholder.
2:09
And then you pay personal income tax on that
2:11
dividend, double tax. Exactly. But a trust allows
2:14
the income to flow directly through to the unit
2:17
holders without being taxed at the trust level.
2:19
The catch, though, is that to keep this special
2:22
status, they have to distribute the vast majority
2:25
of their taxable income to the investors. Right.
2:28
And this brings us to a massive structural shift
2:30
in Canadian tax history because prior to 2006,
2:35
Canada had this booming general income trust
2:38
sector spanning dozens of different industries.
2:41
Oh, everyone was doing it. Yellow Pages companies,
2:43
meat packers, energy providers. Literally everyone
2:46
was realizing that converting their standard
2:48
corporation into a trust structure was a highly
2:51
effective way to legally avoid corporate taxes.
2:54
They were converting en masse. It was wild. It
2:56
essentially became this water pipeline that goes
2:59
straight from the river to the town, completely
3:01
bypassing the municipal reservoir, the reservoir
3:04
being the government's tax revenue. I love that
3:07
analogy. And once one company figured out they
3:09
didn't have to leave a cut for the government,
3:11
every single board of directors wanted to build
3:12
their own pipeline. Well, sure. But the drain
3:16
on federal tax revenue became really severe.
3:18
So in 2006, the federal government stepped in.
3:22
The financial press at the time called it the
3:24
Halloween Massacre. Sounds intense. It was. They
3:29
effectively killed off the general income trust
3:32
structure for most sectors. They just closed
3:35
the loophole. But wait, real estate investment
3:37
trusts were explicitly carved out of those new
3:40
rules. They were. provided they met very strict
3:42
conditions regarding what percentage of their
3:44
revenue actually came from real estate. Which
3:46
I think reveals a lot about the government's
3:48
economic priorities. They shut down the trust
3:50
structure for telecom companies and manufacturers,
3:53
but they spared real estate. Yeah, they had to.
3:56
But if this incredible ability to bypass double
3:59
taxation relies entirely on a specific tax exemption,
4:03
I mean, isn't that a regulatory moat? Like one
4:06
that could just dry up if the government changes
4:09
its mind. It is entirely a regulatory moat. And
4:13
understanding that is fundamental to understanding
4:15
the risk profile of the asset. The government
4:18
spared REITs because real estate inherently requires
4:21
massive pooled capital. You can't just build
4:24
a skyscraper with a small business loan. Exactly.
4:27
It's an incredibly capital intensive, localized
4:31
and illiquid asset class. If they had taxed real
4:35
estate at both the corporate and personal level,
4:37
the capital required to build malls and apartments
4:40
would have dried up instantly. So incentivizing
4:43
property development benefits the broader economy.
4:46
Yes, their existence is intrinsically tied to
4:48
that policy decision. OK, so the mandate is clear.
4:51
They have to distribute their income to keep
4:54
their tax exempt status. but that mandate slams
4:58
headfirst into traditional accounting. Oh, it
5:00
completely breaks traditional accounting. It
5:02
creates one of the most bizarre realities you
5:03
will ever see in a financial statement. Let's
5:06
pull a scenario straight from the sources we've
5:08
got. Let's do it. Say you pull up a REIT on your
5:10
brokerage app and the earnings per unit, like
5:13
the official accounting profit, is 40 cents.
5:15
but they are paying out an annual distribution
5:17
of a dollar and 10 cents. Right. So traditional
5:20
financial analysis screams that a company paying
5:22
out 275 percent of what it earns is a catastrophe.
5:26
Yeah. In any other sector, that looks like a
5:29
dividend that is about to be violently cut, usually
5:32
followed by the CEO resigning. Exactly. If I
5:34
see a normal tech or consumer goods company doing
5:37
that, I just assume they're liquidating the office
5:41
furniture to pay the shareholders. Yet for a
5:43
REIT, it can be entirely healthy. Which is so
5:46
counterintuitive. It is. But the reason comes
5:48
down to why traditional price to earnings or
5:51
P -E ratios are uniquely destructive when analyzing
5:54
real estate. It all hinges on a single accounting
5:58
principle. Depreciation. Yes. Depreciation. The
6:02
tax code basically forces landlords to pretend
6:05
their pristine commercial buildings are behaving
6:07
in a way that defies observable reality. That's
6:10
a great way to put it. The accounting rules for
6:12
depreciation were largely built for the industrial
6:15
era, like factories and stuff. Right. If a manufacturer
6:18
buys a factory or heavy machinery, that equipment
6:21
physically degrades over time. It loses value
6:25
until it's eventually worthless. Makes sense.
6:28
So accountants who demand conservative uniformity
6:30
make you take a depreciation charge every year.
6:33
This systematically reduces your reported net
6:36
income on paper. But they require real estate
6:38
companies to apply this exact same logic to their
6:41
buildings. Exactly. The incur statement subtracts
6:44
this enormous depreciation chart, operating on
6:47
the assumption that a premium downtown office
6:49
tower is just slowly wearing out and marching
6:52
toward a value of zero. Here's where it gets
6:54
really interesting. Because anyone who has ever
6:57
looked at the property market knows that a well
7:00
-maintained building in a good location appreciates.
7:03
It goes up in value. Yeah. It doesn't go to zero.
7:05
Yeah. It's like writing off the value of a vintage
7:08
guitar every year for tax purposes, claiming
7:10
it's becoming worthless when you and everyone
7:13
else know it's actually becoming a priceless
7:15
collectible. That's a perfect analogy. The accounting
7:17
says you're losing money, but reality says otherwise.
7:20
Writing down the value of a premium skyscraper.
7:23
As if it were a rusting tractor on a farm is
7:26
absurd. And because of that massive non -cash
7:29
depreciation charge, a REITs reported net income
7:32
systematically understates the actual cash the
7:35
property is generating. The income statement
7:37
is completely blinded by the depreciation rule.
7:40
So to fix this, the real estate sector had to
7:42
adopt its own metric to show investors what was
7:44
actually happening with the cash flow. They call
7:46
it funds from operations or FFO. OK, looking
7:49
at the data from the sources really makes this
7:52
click. So let's walk through them. We have a
7:54
hypothetical REIT that reports a net income of
7:57
$20 million. But to arrive at that $20 million,
8:00
the accountants force them to subtract a massive
8:03
depreciation charge of, say, $45 million. Right.
8:07
So to calculate the FFO, you take that $20 million
8:10
reported net income and you just add the $45
8:12
million depreciation charge right back in. You
8:15
just reverse the accounting fiction. Exactly.
8:18
You also have to subtract any one -time gains
8:20
or losses from selling a property, because selling
8:23
a building is a singular event, not a recurring
8:26
measure of how well you operate your properties
8:28
month to month. That drastically changes the
8:31
picture. You aren't generating 20 million. You're
8:34
actually generating 65 million in operating cash.
8:37
Huge difference. Let's say this REIT has 50 million
8:40
units outstanding. If you blindly calculate the
8:43
traditional earnings per share using that 20
8:45
million dollar net income, you end up with that
8:48
terrifying 40 cents a unit we talked about. But
8:50
when you calculate the per unit metric using
8:52
the FFO of 65 million dollars, you get an FFO
8:56
per unit of a dollar and 30 cents. that impossible
9:00
payout of a dollar and 10 cents isn't a red flag
9:02
at all. Not at all. I mean, it looks completely
9:04
insane against 40 cents of accounting earnings.
9:06
But against a dollar and 30 cents of actual FFO,
9:09
that payout ratio is about 85%. Which is perfectly
9:13
fine. Distributing 85 % of your cash flow when
9:16
you are legally required to distribute the majority
9:18
of it is a perfectly normal, sustainable operation.
9:21
So this is why price to FFO replaces the traditional
9:24
P -E ratio when evaluating real estate. Oh, 100%.
9:27
If you rely on P -E, every single REIT looks
9:31
like an overpriced, failing business on the verge
9:34
of bankruptcy. Wow. But FFO is really just the
9:37
starting point. Many analysts take this one step
9:39
further to a metric called adjusted FFO, or AFFO,
9:44
to get to the true bottom line. Right, because
9:46
even though the physical footprint of the building
9:48
appreciates, the components inside the building
9:51
absolutely do degrade over time. Exactly. A prime
9:54
location appreciates, but the roof still leaks.
9:57
Elevators break down. HEAC systems need replacing.
10:00
Parking lots need repaving. All those glamorous
10:02
things. Right, these are recurring maintenance
10:04
capital expenditures, and they require real cash.
10:08
So, AFFO takes the funds from operations number
10:11
and subtracts those real unavoidable maintenance
10:14
costs. By doing so, AFFO provides an even more
10:18
accurate conservative picture of the cash the
10:21
business is truly producing after keeping the
10:23
properties in working order. Okay, so, rule number
10:26
one for real estate. Toss the net income out
10:29
the window and look for FFO and AFFO. Always.
10:33
That proves the dollar and 10 cent payout is
10:36
mechanically safe from a cash flow perspective.
10:39
But if those distributions are mathematically
10:41
safe, it's really tempting to just treat these
10:44
vehicles like supercharged savings accounts.
10:47
And this is where we have to look at the psychological
10:49
trap hidden in the payout itself. Because we
10:51
need to know exactly what that cash is. It's
10:54
not all income. Right. The composition of that
10:57
cash when it lands in your account is complex.
10:59
If you are holding these investments in a non
11:02
-registered taxable account, the tax implications
11:04
of that composition become absolutely critical.
11:07
Because when a REIT pays you a distribution,
11:09
it is rarely just standard income. Right. It's
11:11
usually a mixture. It might be a part ordinary
11:13
income, part capital gains, and part something
11:15
called return of capital or ROC. Think about
11:18
opening your brokerage app right now. you see
11:22
a REIT offering a green 8 % dividend yield and
11:26
you feel like a genius collecting all this passive
11:29
income. It feels great until tax season. Right.
11:32
Because what your brokerage app doesn't actively
11:34
warn you about is that part of that quote -unquote
11:38
income is just an accounting illusion giving
11:40
you your own money back. Exactly. Return of capital
11:44
is exactly what the name implies. The REIT is
11:46
basically returning a piece of your original
11:49
investment principle. OK. Because it is your
11:52
own money being handed back to you, the government
11:54
doesn't tax it in the current year. It effectively
11:57
defers the tax. Which sounds good at first. It
11:59
does. However, it achieves this deferral by reducing
12:03
your adjusted cost base, or ACB. So what does
12:06
this all mean in practice? Let's run the numbers
12:08
from the sources to see how this trap closes
12:11
over time. OK, let's say you buy units of a REIT
12:13
at $20 a share. You receive your distribution
12:16
of $1 .10 every year. And when you get your tax
12:19
slip in the spring, it indicates that $0 .30
12:22
of that payout was return of capital. OK, so
12:25
$0 .30 is ROC. Because you weren't taxed on that
12:28
$0 .30 this year, you must subtract it from your
12:31
original purchase price, your adjusted cost base.
12:34
So after year one, My ACB drops from $20. down
12:38
to $19 .70. Exactly. Now, if you hold this investment
12:43
for five years, your ACB drops by 30 cents a
12:46
year, resulting in a total reduction of $1 .50.
12:50
Right. So my new adjusted cost base is now $18
12:53
.50. Correct. Well, wait. If the price of the
12:57
REIT on the public stock market never moves a
12:59
single inch for five years. Yeah. And I eventually
13:02
sell it for exactly the $20 I originally paid
13:05
for it. I still have a capital gain of $1 .50.
13:07
per unit just because of the ROC. Yes. You sold
13:11
it for what you paid, but because your adjusted
13:13
cost base was systematically lowered every year
13:16
by the return of capital, you triggered a capital
13:18
gain upon selling. That is wild. The deferred
13:21
tax is finally realized. You essentially owe
13:24
taxes on a gain even though you didn't make a
13:26
dime on the stock price itself. This raises an
13:28
important question regarding long -term holding.
13:31
What happens if you hold a high -yielding REIT
13:33
for 20 or 30 years? Oh, wow. I guess your adjusted
13:37
cost base can theoretically drop all the way
13:39
to zero. It can. And once your ACB hits zero,
13:43
any future return of capital you receive can
13:45
no longer reduce your cost base. So what happens
13:48
then? At that point, the ROC is generally treated
13:51
as an immediate capital gain in the year you
13:53
receive it, completely changing the tax efficiency
13:56
of the investment. The administrative burden
13:59
of this is terrifying. Like, if you don't track
14:02
your ACB meticulously, adjusting it downward
14:05
every single year in a non -registered account,
14:08
this error just compounds. It's a huge headache.
14:10
When the tax agency eventually audits the math
14:13
a decade later, untimeling those incremental
14:15
RSE reductions is going to be a nightmare. So
14:18
what's the solution? The simplest solution, of
14:20
course, is asset location. Right. This entire
14:22
headache is a non -issue if you hold the REIT
14:25
inside a registered tax sheltered account, like
14:27
a TFSA or an RRSP here in Canada. Because inside
14:31
those specific accounts, the government doesn't
14:33
require you to track your adjusted cost base
14:35
at all. Exactly. The tax shielding is absolute.
14:39
This makes REITs a textbook example of why choosing
14:42
which account you put a specific investment into
14:44
is just as important as choosing the investment
14:47
itself. Okay, so if the distributions are mathematically
14:50
safe using FFO and the tax traps are entirely
14:54
avoidable simply by putting the asset in an RRSP,
14:57
the yield starts looking incredibly attractive
14:59
again. It does, but... Right, there's always
15:02
a but. But that ignores the volatility of the
15:04
physical real estate itself. A high steady distribution
15:08
often tricks investors into assuming the underlying
15:10
asset acts like a safe, sleepy bond. Oh, they
15:14
behave nothing like bonds, primarily because
15:16
of the fundamental nature of commercial real
15:18
estate. It is incredibly capital intensive. Right,
15:21
you mean debt. Lots of it. To acquire, develop,
15:24
and maintain these massive properties, REITs
15:26
carry substantial amounts of debt. Because their
15:29
balance sheets are highly leveraged, their unit
15:31
prices are acutely sensitive to interest rates.
15:34
It's essentially a massive bidding war for yield.
15:37
Like, if the government suddenly offers a 5 %
15:39
guaranteed return on a risk -free Treasury bill,
15:42
a REIT offering a 5 .5 % yield with all the inherent
15:46
risks of commercial real estate and tenant defaults
15:49
suddenly looks like a terrible deal. And the
15:52
market reacts immediately to that discrepancy.
15:55
Investors sell the REIT, driving the unit price
15:57
down. And as the price falls, the yield, which
16:02
is just the distribution divided by the price,
16:04
mechanically rises. Exactly. The price will continue
16:07
to fall until the yield hits, say, seven or eight
16:10
percent, a level high enough to attract capital
16:13
back away from those safe government bonds. People
16:16
who bought REITs thinking they were a stable
16:18
bond substitute often get crushed when rising
16:21
interest rates force a repricing of the yield.
16:24
It happens all the time. And the danger isn't
16:26
just in the debt structure. It's in the physical
16:28
reality of what they actually own. Just buying
16:31
a generic mutual fund or ETF with the word REIT
16:34
slapped on it doesn't mean you have a diversified
16:36
portfolio. Not at all. Property type dictates
16:40
everything. Just consider the economic shifts
16:42
of the last decade. An industrial warehouse functioning
16:45
as an e -commerce distribution center has a fundamentally
16:49
different economic trajectory than a suburban
16:52
retail shopping mall. Right, because of online
16:54
shopping. Exactly. The exact same shift in consumer
16:59
behavior, buying goods online instead of in person,
17:04
drove unprecedented rental growth for industrial
17:06
REITs while causing an existential crisis for
17:09
retail REITs. Wow, yeah. And a commercial office
17:12
tower. facing a remote work transition has different
17:15
risks than an apartment building facing housing
17:17
shortages. You really have to look under the
17:19
hood to see what kind of concrete you actually
17:21
own. That actually brings up a massive blind
17:23
spot regarding diversification for the listener.
17:26
Think about your overall financial picture. If
17:28
you own a home in a major city, your largest
17:31
single financial asset is already heavily exposed
17:33
to the domestic real estate market. It's a huge
17:36
overlap. Furthermore, your job your human capital
17:40
is tied to the local economy. If you then tilt
17:43
your investment portfolio heavily into domestic
17:46
reads just to chase a high yield, do you really
17:49
need that? You aren't diversifying. No. You are
17:52
actively concentrating your risk. Investors frequently
17:55
silo their thinking. They treat their stock portfolio
17:57
as one bucket and their physical house as a completely
18:00
separate bucket. Which is a mistake. A huge mistake.
18:03
True risk assessment encompasses your entire
18:06
net worth. Adding heavily leveraged real estate
18:09
equities to a net worth that is already dominated
18:11
by a residential mortgage is a choice that drastically
18:14
amplifies your exposure to a single sector in
18:16
a single country. Yeah, that makes a lot of sense.
18:19
So to summarize what we've covered today. The
18:22
mechanics of this sector really force you to
18:24
look past the surface level numbers. You absolutely
18:26
have to. You have to bypass the traditional P
18:29
-E ratio because accounting depreciation creates
18:31
this illusion of loss on properties they're actually
18:34
appreciating. Right. You had to hunt down the
18:36
funds from operations the FFO and AFFO to see
18:39
the true cash flow safety of the payout. And
18:42
you have to respect the psychology of the return
18:44
of capital, knowing that the tax deferral today
18:48
comes at the cost of a lower adjusted cost base
18:51
and a higher capital gain tomorrow. Understanding
18:54
the plumbing of these financial structures is
18:56
really the only way to separate a calculated
18:58
investment from a blind gamble. Well said. Before
19:01
we wrap up though, there is one final piece of
19:04
the real estate puddle from the sources to consider.
19:07
Think about how these massive properties are
19:10
actually valued on a REITs balance sheet. Oh,
19:12
the appraisals. Yeah. Unlike stocks, which are
19:15
marked to market by millions of active buyers
19:17
and sellers every single second of the trading
19:19
day, real estate values are based on appraisals.
19:23
Which are fundamentally estimates. They are backward
19:26
looking opinions made by professionals based
19:28
on comparable recent sales. Right. And in a frozen
19:32
property market, those sales might be months
19:34
out of date. Which creates this fascinating historical
19:37
tension. What happens when a REIT's internal
19:39
appraisers look at a massive portfolio of downtown
19:42
office buildings and officially declare it has
19:44
held its value? But the public stock market fiercely
19:48
disagrees. We see this happen during commercial
19:51
real estate slumps. Right. The public market
19:53
aggressively sells the REITs units, causing them
19:57
to trade at a massive discount to the official
20:00
appraised net asset value. The appraisal says
20:03
the building is fine, but the market price is
20:05
screaming that the appraisal is wildly out of
20:07
touch with reality. And historically, when the
20:10
appraisers and the public market disagree, the
20:13
market is usually the one holding the checkbook.
20:16
Almost always. It's definitely something for
20:18
you to mull over the next time you look at a
20:20
supposedly rock -solid real estate valuation.
20:23
Just because the math looks beautiful on the
20:25
balance sheet doesn't mean the foundation isn't
20:27
shifting underneath. Exactly. It pays to know
20:29
what's under the hood. Thanks for joining us
20:31
on this deep dive. Catch you next time.