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Income trusts — survival
of the fattest

Income trusts stuffed with cash will have the upper hand in the coming two-tier trust market.

To coin a phrase, there’s no use crying over spilt milk. There is nothing to be gained by debating the pros and cons of the government’s trust tax. It’s in the books.

So let’s put the tax in the rearview mirror and look ahead. And what we see is a surprisingly clear picture, at least according to the Income Trust Guide. This advisory is a supplement to the Money Reporter, which keeps Canadians in the know on income investments.

“What we see developing,” says the advisory, “and getting more and more enhanced as 2011 approaches, is a sort of two-tier trust market.”

And that happens to be good news.

Real estate on the radar screen

Many trusts will survive. One estimate, according to the Income Trust Guide, puts the number in the rather wide range of 50 to 100. The one thing they will all have in common is vaults full of cash.

Leading this band of survivors will be real estate investment trusts (REITs), especially those who concentrate their operations in Canada. REITs with more than 25 per cent of their investments outside Canada (i.e., most hotel and retirement REITS) will not be exempt from the tax. But this doesn’t mean they’re bound to fall by the wayside.

The Income Trust Guide has one such trust on its radar screen. Chartwell Seniors Housing REIT (TSX-CSH.UN) is “committed to the retirement sector and is building up its presence in the U.S. Evidently it has decided to abandon all pretence of qualifying for tax-free status in 2011.” Chartwell is not on the Income Trust Guide’s current list of recommended trusts (and indeed, it lost 14 per cent last month) but the advisory is following its progress with interest. Call it a test case for taxable REITs.

Also on the survival list are the big oil and gas royalty trusts, along with their pipeline and energy brethren. They should be judged, says this advisory, not on the coming tax, but on the evolving prices of oil, natural gas and electricity.

Two options for the cash-rich

Then there are the business trusts. Those that can generate lots of internal cash have two options. One, they can snap up smaller rivals. “Recall,” says the Income Trust Guide, “that each trust can expand by 100% of its October 31, 2006 equity value without attracting the tax before 2011.”

Or they can pump their balance sheets up to a level at which very little of their income will actually be taxed, thanks to higher interest expense.

Then there are all the others.

The strong get stronger still

The income trusts that can’t build up sufficient cash reserves to maintain their distributions face an uphill struggle that will probably end before the tax arrives to puts them out of their misery in 2011.

Some will be taken over by bigger trusts or private equity. Some will throw off the trust structure and go back to being corporations. If they can! When it tried to return to corporate status, True Energy Trust (TSX-TUI.UN) was voted down by its unitholders, who reckoned they would make more money in the trust setup than the corporate one. Some will simply fail.

In the past month, notes the Income Trust Guide, three trusts slashed their distributions. But several of the advisory’s favourite trusts increased theirs. “And that is symptomatic of what we expect to see more of in the next few years. The stronger trusts will get stronger still.” The weak will get weaker, and fade away.

And that means that wealth will be transfered from the weak to the strong, to the benefit on those holding the units of the hardy group of surviving trusts.

Three to buy

In conclusion, here are the three trusts the advisory recommends as its best buys for April:

Davis & Henderson Income Fund (TSX-DHF.UN) remains underappreciated by investors, despite its superior financial and distribution records and a strong 9.7 per cent yield. It could also benefit from a consolidation. A buy for income and gains.

Fort Chicago Energy Partners (TSX-FCE.UN) has a lower percentage return of capital than other pipelines. This gives it a higher pre-tax yield and makes it a good addition to a registered account. A buy for income and growth.

Bell Aliant Trust (TSX-BA.UN) is just coming off the acquisition of Bell Nordiq and has set it sights on another acquisition, Amtelecom. Despite a 4.2 per cent increase last month, it’s still scarcely trading above book value. New takeover or not, it’s a buy for income and growth.

Income trusts are still alive and kicking. Looking down the highway, this advisory sees more than three tax-free years ahead, and plenty of cash distribution stops along the way.