What to Look for When Choosing an Income Trust

In yesterday’s PROFIT CONFIDENTIAL, I wrote about dividend funds as an alternative for income-oriented investors. I also mentioned that most of the new investors in dividend funds turned out to be former income trust investors.

Just to give you a quick refresher course, an income trust is an investment vehicle composed of income-generating assets. Income trusts are traded on stock exchanges, just like stocks, and they distribute income to investors through monthly or quarterly distributions. Typically, income trust distributions are much higher than stock dividends. For example, some of the income trusts offer yields of up to ten percent, and riskier plays go even as high as 20%.

Basically, owning shares, or units, in an income trust gives a holder the right to participate in the trust’s earnings and capital. This is why income trusts invest in underlying assets that provide steady cash flows, such as commodities or real estate. Currently, income trusts are most active in Canada.

So far, so good! However, much like dividend funds, not all income trusts were created equal. In ultra-low interest rate environment that we have been experiencing in the past few years, many income trusts have placed income generation at the highest pedestal, and often at the expense of investing back into the trusts’ assets.

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Not surprisingly, there has been just as much controversy surrounding income trust as there have been benefits to investors. At the core of the problem is the fact that Generally Accepted Accounting Principles (GAAP), both in Canada and the U.S., do not provide a specific definition of capital expenditures (CAPEX) when income trusts are concerned. In fact, how capital expenditures are accounted for is entirely at the managements’ discretion. So, naturally, abuses of the system have occurred, spooking the investors away from this potentially very profitable type of investment.

Without a GAAP definition of CAPEX, an accounting loophole was created. In order for an income trust to grow and continue delivering high distributions, the management has to invest some of the cash flow back into the trust. But, how do you keep up with the tough distribution schedule if most of your money is needed for future growth.

The only way around this dilemma is to find the right balance between the distributions payout ratio and capital expenditures. In most cases, giving precedence to capital expenditures at the expense of a lower payout ratio did not win anyone the popularity contest. However, such a strategy often did result in steady performance and strong distributions as well.

This is why, amidst all the controversy, I am still a big fan of income trusts, especially the ones that have gold, oil, or gas as an underlying asset. Income trusts based on such hot commodities offer solid distributions, excellent market performance, all the while generating enough money to invest back into the trust.

Just remember, when and if you decide to invest in an income trust, to compare the trust’s payout ratio with its peers. Go for the ones with moderate distributions in comparison to the cash flow. Also, check the trust’s balance sheet and how much money went back into the business. It will result in more income and profit down the road.