Super 8 Motel, Thunder Bay, Friday, Feb. 5, 2009.CP/The Chronicle-Journal Sandi Krasowski
Have I got a deal for you: It's like a savings bond that pays a 10% annual return. The catch? There isn't a catch for you, but the issuer has to sell new bonds, or borrow money at 12%, to pay you that return.
You don't need a PhD in finance to know that this isn't a good deal. Yet this scenario is very similar to what a lot of real estate investment trusts (REITs), including those that are operating companies, have been doing lately. But many investors are still snapping up high-yielding trust units anyway. They want income, and they don't care that most major Canadian REITs, while perfectly ethical, have some disturbing similarities with Ponzi schemes. Those schemes, you'll recall, pay out money to investors not from profits, but from money coming in from new investors.
Let's take Halifax-based Holloway Lodging REIT as an example-an extreme one in some ways, but typical in others. The trust was formed in 2006, and in June, 2007, it raised $140 million from offerings of convertible debt and equity, in the form of trust units priced at $5.35 apiece. This past March, the units were languishing at less than 30 cents.
What happened? Holloway's brain trust invested in real estate-mainly limited-service hotels, many of them Super 8s-at inflated prices. Cash flow from those properties has dwindled from $12 million in 2007 to less than $3 million last year.
True, Holloway was unlucky to buy just before a worldwide financial crisis in 2008 and a recession. But savvy real estate investors keep such possibilities in mind when they buy. They also keep their debt low enough to manage when revenues sink.
Not this crew. They waited far too long to stop paying out hefty monthly distributions to unitholders. From 2007 until the middle of 2009, Holloway's hotels generated cash from rents of $32.5 million, but the company paid out $40 million in distributions. How did it do that? It sold new units and took on more debt. Despite slumping revenues, Holloway continued to pay distributions until July, 2009.
Holloway is not alone. I recently read an analysis of 27 major Canadian REITs. From 2007 until early 2010, many of them paid out more in distributions than they generated in cash flow. REITs should really pay less over time, because buildings wear out. I don't mean routine things like paint and carpets. I mean big-ticket items like roofs and elevators, which have to be replaced every decade or two.
Yet many REITs delay repairs too long and, worse, don't set aside enough reserves for them. Why? Because investors want fat distributions now, and the more they get, the more they'll pay for units. The higher the unit price, the more units the REIT can issue in order to grow.
The sad truth is that a REIT can get away with this for an awfully long time-as long as investors keep buying units. But, eventually, it will hit the wall.
How do you avoid a crash like that? Rule No. 1: Generally speaking, the higher the yield, the riskier the REIT. Rule No. 2: Managers who own a lot of their own units aren't likely to play this game. Rule No. 3: Numbers can fib, but they can't lie. Every REIT annual report includes a statement of cash flows. Be skeptical of companies that pay out all of their income or more to investors.
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TIP SHEET
VALUE: Research In Motion Ltd. Trailing price-to-earnings ratio: 8.8
RIM has a problem: It's called Apple. Microsoft has a problem, too: It's also called Apple. Microsoft hasn't invented much of anything-ever. But that hasn't mattered a whole lot, because as long as desktops and laptops were devices of choice, Microsoft minted money. Unfortunately, computing is going ultra mobile. Tablets and smartphones are where the action is at, and where Microsoft really isn't. The solution: Microsoft buys RIM. You heard it here first (or early, at least).
GROWTH: Athabasca Minerals Inc. Q1 2011 Share price gain: 60%
Think of Fort McMurray and what springs to mind is oil. What doesn't come to mind, among other things, is gravel. But gravel is critical to the work oil sands producers do-it's needed for roads and construction. Athabasca Minerals manages two gravel pits for the Alberta government, which caps prices. But the company also owns leases for future pits that will sell gravel at market prices. Given the forecasted growth of the oil sands for the next two or three decades, little rocks and sand may be almost as profitable as the black gold producers strip out of the ground.