REIT and income trust distributions

How are distributions different from dividends?

A dividend is a payment from a corporation out of its after-tax profits. A distribution is a payment from a trust, partnership or similar structure that passes cash through to its unitholders. Real estate investment trusts (REITs) and income trusts are built to pay out a large share of their cash, so their payments are often higher relative to price than a typical corporation’s.

In your account, a distribution looks like a dividend: an amount per unit, paid on a schedule, often monthly. The differences show up in what the payment is made of, how it’s taxed and how you judge whether it’s sustainable.

What is return of capital, and why does it matter?

A distribution from a Canadian trust can be made up of different components, and one of them can be return of capital (ROC). Return of capital generally reduces your adjusted cost base (ACB), which in turn affects the capital gain or loss you work out when you eventually sell.

The trust reports the breakdown after year-end, so the split isn’t known when each payment arrives. The details of how ROC is taxed and tracked are on the DRIPs and adjusted cost base page; for your own records, consider asking a qualified tax professional.

Are US REIT dividends qualified?

For US taxpayers, REIT dividends are generally not qualified dividends, so they don’t automatically get the 0%, 15% or 20% rates that qualified dividends can receive. See US qualified dividends for how qualification works.

For Canadian residents, the general rules for US dividends are the starting point: US dividends paid to a Canadian resident are generally subject to 15% US withholding under the treaty, usually with a W-8BEN on file. In an RRSP or RRIF the treaty exempts them from US withholding, while in a TFSA the 15% is withheld and can’t be recovered. See US dividends in a TFSA and the Canada–US tax treaty page.

Why do earnings mislead for real estate?

Accounting rules require property owners to depreciate buildings, a large non-cash charge that lowers net income even when properties hold their value and rents keep flowing. An earnings payout ratio can therefore look alarming for a REIT whose cash flow comfortably covers its distribution.

The industry uses two adjusted measures instead. Funds from operations (FFO) starts with net income, adds back real estate depreciation and amortization, and removes gains or losses on property sales. Adjusted funds from operations (AFFO) then subtracts recurring capital spending needed to maintain the properties and adjusts for non-cash items such as straight-line rent. Exact definitions vary between issuers, and these are non-standard measures, so read each issuer’s reconciliation.

What else to check in a distribution payer

• AFFO payout trend: is the share of AFFO paid out rising year after year?
• Leverage and refinancing: how much debt comes due soon, and at what interest rates compared with the existing debt?
• Occupancy and leases: vacancies and short lease terms can reduce cash flow quickly.
• Unit issuance: a trust that issues many new units must grow AFFO just to keep AFFO per unit flat.
• The annual breakdown: how much of each year’s distribution was reported as return of capital, and is that changing?

Worked example: AFFO as the payout base

The earnings ratio suggests the distribution is far uncovered; the AFFO ratio shows it is covered, with a thinner cushion than the FFO figure implies. Many investors focus on AFFO because it accounts for the spending needed to keep the properties competitive. As a rule of thumb that varies by property type and leverage, an AFFO payout near or above 100% leaves little room for vacancies or higher interest costs. See payout ratio explained.

1. A hypothetical REIT, Company N, reports net income of $40 million on 100 million units, or $0.40 per unit.
2. Add back real estate depreciation of $60 million and subtract a $10 million gain on a property sale: FFO = $40M + $60M − $10M = $90 million ($0.90 per unit).
3. Subtract $15 million of maintenance capital spending and a $5 million straight-line rent adjustment: AFFO = $90M − $15M − $5M = $70 million ($0.70 per unit).
4. It distributes $0.63 per unit a year, or $63 million.
5. Earnings payout: $0.63 ÷ $0.40 = 157.5%. FFO payout: $0.63 ÷ $0.90 = 70%. AFFO payout: $0.63 ÷ $0.70 = 90%.