Tempering Concerns on New REIT Rules - The Bomb
Tempering Concerns on New REIT Rules and U.S. Proposal to Increase Tax on Distributions - The Bomb - March 30, 2007 - Highlights "highlighted" in green.
New Proposed REIT Rules
In response to a number of concerns regarding the new proposed REIT rules, we reiterate/highlight the following:
We expect all of the multi-residential and commercial REITs in our coverage universe* should qualify for the new proposed REIT rules
and thus be exempt from the government's proposed tax on distributions and limitations on growth until 2011.
There were initially some concerns regarding H&R not meeting the Canadian asset/revenue tests; RioCan not meeting the passive income test (because of its management fee streams and gains on properties held for resale); and Northern Property not meeting the passive income test (because of its Execusuite business and possibly, triple-net long-term care income). However, in our discussions with these REITs, we expect all should ultimately qualify, and be exempt from the proposed tax.
*Artis, Boardwalk, Calloway, CAP, CREIT, Cominar, Dundee, H&R, Northern Property REIT, Primaris, RioCan, Scott's.
Seniors housing (incl. Chartwell and Sunrise) and hotel REITs (incl. CHIP, InnVest, Legacy, and Royal Host) appear to be exposed to the proposed tax
on distributions beginning in 2011, or earlier if they exceed the Safe Harbour growth provisions.
However, we do not see this as an immediate near-term concern for the following reasons:
- 1)
the proposed tax will have no impact on underlying value (NAV), and in a market of "many bidders", M&A is the theme of the day and privatization is a real option. Sunrise REIT is currently subject to one (and possibly two) takeover bids; while Chartwell, Legacy, and CHIP have all formed special committees to review their strategic options, which may include the sale of the companies;
- 2)
certain REITs may be able to re-structure and/or sell assets before 2011 to remain on side with the new rules
. Australian stapled unit structures are also being considered;
3) industry groups, like RealPac, will continue to lobby the Department of Finance, which could lead to a relaxation of the rules before the end of the four-year grace period; and
4) in the event that certain REITs are subject to the tax, the impact can be partly mitigated by interest and capital cost allowance deductions that reduce taxable income. As an example, Chartwell recently announced that it expects the tax on its distributions will be modest ($0.00-0.05/unit in each of 2007/2008) and so is considering paying the tax in order to pursue growth outside the Safe Harbour limits.
It appears that the market agrees with our view, as unit prices for the hotel and seniors housing REITs under coverage are down only 2.3% (on average) over the last two days (since the Minister of Finance released its Ways and Means Motion clarifying the new proposed REIT rules) compared to -1.9% for the S&P/TSX REIT index.
Details of Revised Draft Legislation – What Qualifies as a "REIT"?
The Minister of Finance released its Ways and Means Motion to implement provisions of last week's federal budget, including the requirements that REITs must meet to qualify for exemption from the proposed taxation of trusts. It is a difficult read (link to file).
The best summary we have found on this topic can be found on the Goodmans website: (https://www.goodmans.ca/index.cfm?fuseaction=PublicationDetail&primaryKey=734)
Proposed U.S. Bill to Increase Tax on Canadian REIT Distributions
U.S. Congressman, Richard Neal, recently filed a bill in the House of Representatives to stop giving preferential tax treatment to income generated from non-U.S. tax-advantaged investment vehicles, including Canadian REITs and income trusts. The bill has been referred to the ways and means committee, and if passed, would cause distributions paid by Canadian Income Trusts to U.S. unitholders to be taxed at a rate up to 35% versus the current 15%. We understand that the preferential tax treatment was expected to be eliminated in 2010 anyway.
Distributions from Canadian REITs are currently considered "qualified dividend income", which entitles them to the more favourable 15% tax rate in the U.S.
Although the Bill has the potential to reduce U.S. interest in Canadian REITs and thus, negatively affect fund flows and unit prices, we highlight the following:
- •
the bill is currently in preliminary stages with no assurance of being passed. Moreover, the process could be subject to delays and changes, which may alter the Bill from its current form;
• we suspect that tax is not a key consideration for most U.S. investors in Canadian REITs, since many are pension funds or mutual funds measuring returns on a pre-tax basis. As long as Canadian REITs continue to look attractive (vis-à-vis US REITs), we believe we will continue to attract the U.S. fund flows.
In summary, we expect the impact of this Bill, if passed, may not be as negative as initially thought. In fact, it may be neutral to valuation.
Regardless, it is important to highlight the exposure. We estimate that about 15-20% of the larger-cap. Canadian REITs are owned by US investors. Among our REITs under coverage, we estimate that Boardwalk, RioCan, H&R, CREIT, Calloway, Primaris and Dundee have the most exposure. Unit prices for these REITs are down an average of 1.7% since news of the US Bill was reported by the National Post, compared to -1.9% for the S&P/TSX REIT index.
We will continue to monitor the development and provide updates as they become available.
Summary
In summary, we believe it is too early to react to the aforementioned news/events with valuations ultimately supported by underlying value in a strong real estate market (M&A continues to be the "theme of the day").
We are maintaining our Outperform ratings on Artis, Calloway, CAP, CHIP, Dundee, H&R, InnVest, Legacy, Northern Property, and Royal Host, and are restricted on Chartwell and Cominar.