There are compelling reasons for the Federal Government to 'carve out' REITs from the income trust sector as a result of its current review. If the REIT sector is left essentially alone and business trust are taxed, what are the consequences for business trusts? Would there be a rush by business trusts to redefine part or all of their business to become REITs?
In the U.S. there are many 'specialty REITs' that are similar to some business trusts in Canada. Their investment focus is 'highly specialized' and doesn't fall into the traditional commercial real estate categories of office, industrial, multi-unit residential and retail. There are a wide variety of U.S. specialty REITs including restaurants, college housing, prisons, race tracks, railroads, movie theatres, storage facilities, mortgage companies, golf courses, auto dealers and other kinds of retailers.
In Canada most REITs have properties in the 'traditional' commercial real estate sectors or combinations of properties from these categories. Compared to the U.S., there are relatively few REITS that can be considered specialty REITs. These include retirement home REITS, Retirement REIT (RRR.UN-T) and Chartwell REIT (CSH.UN-T) and the recently formed Scott's REIT (SRQ.UN-T) which holds a portfolio of 190 retail properties whose primary tenant is KFC restaurants. Hospitality REITs such as Legacy Hotels REIT (LGY.UN-T), Royal Host REIT (RYL.UN-T) and CHIP REIT (HOT.UN-T) are considered part of the commercial real estate sector but have the characteristics of a specialty REIT.
Shant Poladian, Real Estate Analyst with Canaccord Capital explained fewer specialty REITs in Canada by saying the "Canadian REIT industry has just come out of its infancy starting out with the more standard real estate types." The Canadian REIT legislation was established in 1993 while U.S. REITs have been around for over 25 years.
Poladian pointed out that "there are has to be a business rationale for forming a REIT, and it isn't always advantageous for businesses to spin out their real estate. For instance, a grocer may want maintain direct control over the real estate to ensure its property can be modified as necessary in order to remain competitive."
Commenting on the future of specialty REITs in Canada Poladian said "Good quality securitized real estate is in demand. It has long-term prospects with investors. Most companies that own real estate don't get credit for their real estate. It (forming a REIT) would be a way of surfacing the real estate value." He added, "I don't think that fewer number of specialty REITs exist in Canada just because we also have a large business income trust sector. As the Canadian REIT industry matures, we should see more more specialty REITs come to market."
Specialty REITs in the U.S. have faced challenges explaining their businesses to investors and analysts not experienced by traditional REITs. The differences arise from their performance being closely tied to the associated business as well as the real estate markets. They tend to have a large proportion of their real estate value in land not buildings and they often have higher rates of return than traditional REITs.
Issues concerning Specialty REITs have been the topic of two recent articles in the U.S. real estate media SPECIAL REPORT: Specialty REITs Work on Perception Issue in CPN On-line, November 4th and Companies focused on highly specialized property types may offer a lot to investors, if they can get them to notice in NAREIT Real Estate Portfolio, November/December Issue.
According to Michael Brooks, CEO of the Real Property Association (RealPac) assuming REITs survive the Federal Government review of income trusts, "There could be a rush of business trusts to redefine themselves or restructure all or part of their operations as REITs. Some may split off the active business component from the passive real estate, if the active portion becomes taxable."
"We have potentially many more specialty REITs currently characterized as business trusts: possibly Timberwest (forests), Westshore Terminals, (Ports), Medical facilities Trust, Priszm (restaurants), Atlas Cold Storage (cold storage warehouses), Gateway Casinos (casinos), Cineplex Galaxy (movie theatres) and Hothouse Growers (agriculture). Speculating further about prospective specialty REITs, Brooks added "arguably the pipelines, oil and gas, peat bogs, and power income trusts could re-define themselves or part of their operations as REITs."
Commenting on the prospect of the Federal Government changing the definition of a REIT Brooks said, "Most likely (they will change the definition) if they move to tax some of the trusts." Specialty REITs, like the hospitality REITs, might be affected by a change to the definition.
The Federal Government deadline for response to the income trust review is the end of December 2005. Given that there will be a Federal election immediately before or after Christmas, it seems unlikely that a response to the income trust review will be forthcoming before spring 2006.