In the first part of this series, I’ve painted a pretty nice picture of REITs, don’t you think? But there is nothing perfect in this world and REITs are not even close to perfection. There are several things you must look out for before considering investing in any REITs:
Be Careful – the Tax guy has an eye on you!
As opposed to dividend stocks, distributions from REITs are mostly considered as income with a portion of return of capital (ROC). Remember that income from REITs is fully taxable while ROC will reduce the average also distribute a part of their income as dividends. There are no official rules, and it is important to verify each REIT before making any purchase.
Remember that chances are you will pay higher taxes on REITs distribution than dividend stocks. Therefore, it will be important to include your REITs in your RRSP or TFSA. Holding REITs in a non-registered account will result in much higher taxes!
Interest rate could hurt
The cost of financing has risen significantly since 2008. It might sound counterintuitive as interest rates for personal consumers have never been so low. However, a 6 billion REIT doesn’t go to the branch on the corner of the street to get financing. It usually has to issue bonds at a “commercial rateâ€. This is how cost of financing in this industry has risen because it is considered riskier than it previously was. Prior to 2008, financing was easy to get as banks thought they were able to manage all the risks and still remain well capitalized. Now that the capitalÂization rules are going toward Basel III, banks will charge a higher interest to finance any commercial activities.
The effect of a higher cost of financing has been amortized by the existing long term debt structure. Most REITs have already secured their lower rates for several years (read 15 to 20). Therefore, the immediate impact on income from a rise in interest rates is minimal. Over time, it will definitely reduce income distribution abilities.
