Buildingwealth.ca

Next Update Edition:Week Sept. 3

Next regular issue: Sept. 26

A few readers have written to ask why we have never recommended U.S. mortgage REITs, or mREITs as they are commonly called. The answer is twofold. First, after the sub-prime debacle many people are highly suspicious of any investment based on American mortgages. Second, the risks are on the high side – but then, so are the returns,

These are not REITs as we understand them in Canada. They do not own shopping centres, office buildings, nursing homes, hotels, or industrial properties. Rather, they invest in portfolios of mortgage-backed securities (MBS) which they leverage by borrowing heavily to increase the asset base. The strategy is to take advantage low short-term rates to amass a huge portfolio of higher-yielding longer-term mortgages. The spread between the borrowing cost and the return on the portfolio represents the profit. For a simplified example, if an mREIT borrows at 2.5% to acquire a portfolio that yields 4%, the spread is 1.5 percentage points, or 150 basis points.

As we know from investing 101, leveraging can significantly improve returns if the value of the portfolio increases. Conversely, it will magnify losses when things go bad.

The big attraction of mREITs is the eye-popping yields they offer, some of which are in mid-double digit territory. For example, American Capital Agency Corp. (NDQ: AGNC) is one of the oldest and largest of the mREITs with $101 billion under management. The stock closed on Aug. 17 at $33.78 (all figures in U.S. currency). So far in 2012, quarterly dividends have been paid at a rate of $1.25 per share, or $5 annually. If payments were to continue at that level for the next 12 months, the yield based on the current price would be 14.8%. That’s mouth-wateringly tempting for yield-hungry investors.

What could go wrong? The main risk is a rise in borrowing rates, especially a sudden one. Going back to my illustration, if the interest rate on short-term money moved from 2.5% to 3%, the spread would drop to 100 basis points, a decline of one-third. That would dramatically affect the mREIT’s profitability and would probably result in a dividend cut which in turn might prompt a sell-off in the shares. That doesn’t always happen, however; AGNC cut its quarterly dividend from $1.40 to $1.25 at the start of 2012 but the share price continued to trend higher. The yield fell but was still high enough to attract investors.

At the moment, the outlook for U.S. interest rates is benign with the U.S. Federal Reserve Board on hold until at least late 2014. This is the kind of environment in which mREITs thrive, which is why they are so popular among U.S. income investors. But eventually rates will rise and when they do we are likely to see both dividend cuts and capital losses in the mREITs. If you want to avoid that, you’ll need to be nimble when the time comes.

Another consideration for Canadians is the tax implication of investing in mREITs. In most cases, the payments are classified as dividends for purposes of the Canada-U.S. Tax Treaty. This means they will be subject to a 15% withholding tax if the shares are held in a non-registered account or a TFSA. In the case of non-registered accounts, you can claim a foreign tax credit for the withholding tax when you file your return. That does not apply for TFSAs.

Dividends paid on shares held in RRSPs, RRIFs, and similar plans are exempt from withholding tax. However, you are adding risk to your retirement plan if you invest in mREITs at this point.

Since these are U.S. corporations, the payments are not eligible for the dividend tax credit. Also, capital gains in a non-registered account are not eligible for the 50% inclusion rate and will be fully taxed.

To sum up, mREITs offer excellent cash flow – much more than you will get from any Canadian REIT. The downside is more tax exposure in non-registered accounts and TFSAs, currency risk, and a high degree of interest rate risk. People who are concerned about capital preservation should think carefully about the risk factors before investing.

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By Tom Slee, Contributing Editor

Yellow Media’s astonishing reorganization plan is now before the courts where it belongs. It’s unethical and if allowed to stand could undermine the convertible debenture market. The company, in effect, is claiming that when it comes to the crunch, debenture holders have no creditor status; they are just common shareholders. Preferred shareholders outrank them in the pecking order. Contentious is hardly the word to describe this scenario and management has made matters worse by refusing to discuss the arrangement with investors. It’s almost as though they were inviting a legal challenge.

To recap briefly, on July 21 Yellow Media unveiled a reorganization proposal that sheds $845 million of debt. Senior debt holders would receive a combination of notes and 82.5% of new equity in exchange for their present holdings. Existing debentures, preferred shares, and common shares are cancelled and replaced by 17.5% of the new equity. Debenture holders are first converted to shareholders and receive 0.625 new common shares and 0.357 warrants for each original $1,000 principal. Preferred shareholders, who are junior in the capital structure, receive 1.875 common shares and 1.07 warrants for each 100 preferred shares. That is considerably more.

Nobody is disputing that Yellow Media has to put its house in order. However, any reorganization permitted by the Canada Business Corporations Act (CBCA) has to be “fair” and in the best interests of all stakeholders. It’s hard to see how Yellow Media’s proposal comes even close to meeting that requirement. Consequently, two classes of stakeholders have filed formal complaints in the Quebec Superior Court. The banks, who have kept the troubled company afloat, are saying that they were not consulted as required and the plan is unacceptable. The convertible debenture holders maintain that their rights have been violated.

So far the company has made no effort to defend its actions, although one Yellow Media lawyer said “a good plan is one that everyone hates a little”.

I am concerned that we are even going down this path. The way the debenture holders are being discriminated against is obviously wrong and excluding the banks probably makes the process illegal. But there is much more at stake. Yellow Media’s plan, if approved, rides roughshod over the convertible debenture prospectus. Investors bought $200 million of these securities believing that they were creditors. In fact, the prospectus states “…the debentures are unconditionally guaranteed…as to payment of principal and interest.” It also states that the debentures will be exchangeable into stock at the option of the holder. Now management has decided that it no longer has the $200 million debt and that it alone, and not the holder, can convert the debentures into stock when it chooses.

Keep in mind that this is not liquidation under the Bankruptcy and Insolvency Act where an appointed trustee takes charge and completely restructures or distributes assets in order of priority. In this case, Yellow Media’s directors have arbitrarily reshuffled the deck and intend to carry on running the company. They decided that the debenture holders are just common shareholders without consulting them even though these investors had bought fixed-income securities in good faith, choosing to avoid the risks attached to common shares and foregoing the chance at dividend increases and capital gains.

We are breaking new ground. If a management can eliminate its convertible debenture holders when the going gets tough then the prospectus, our supposed cornerstone, is not worth the paper it’s written on. At the very least, from now on a prospectus should contain a warning that the company can override the terms and conditions just by applying the CBCA. As small investors we should look for much more attractive terms to pay for this new exposure especially when buying convertible securities. I will keep you informed about court challenges.

The bond market

Turning to the bond market, mid- and long-term Government of Canada yields hit record lows in July, dipping to 1.62% for 10-year issues. Short-term rates stayed flat as traders remained cautious and tried to judge whether the U.S. Federal Reserve and the Bank of Canada would apply more stimulus. So far, the central bankers have remained on the sidelines and there is a growing consensus that there will be no Canadian rate hikes until the second quarter of next year when the U.S. election is safely behind us.

On the bright side, inflation is running at a safe 1.3%, down from 2.5% in January thanks to lower energy prices. This is one of the reasons why Bank of Canada Governor Mark Carney is in no hurry to raise interest rates. It’s also why we have no real return bonds on our Buy List, although we may need some if the recovery takes off. Inflation eats away at fixed income and for those readers who would like to have some of these safeguards in place, here is a reminder of how real return bonds (RRBs) work.

RRBs, issued primarily by the Government of Canada and a few of the provinces, have terms that allow your return to adjust for inflation. For example, if a $1,000 RRB is issued with a 5% coupon and there is no inflation, the bond will pay interest of $25 at the end of six months. However, if the consumer price index goes up 1% in that time the $1,000 principal owed to you increases to $1,010 ($1,000 multiplied by 1.01). The semi-annual interest payment would then increase to $25.25 (5% multiplied by $1,010). These adjustments continue over the life of the bond so your purchasing power remains intact.

One caveat: the interest payments and principal increases are fully taxed as income when made even though you may not receive the principal increase until sale or maturity years later.

It all sounds good but there are several problems. For a start, RRBs are long-term securities. The longest Canada real return bond matures in 2044, the shortest in 2021. As a result, they are extremely volatile when interest rates rise and fall. They are also expensive vis-à-vis comparable long-term conventional government bonds. As I write, the Government of Canada 4.25% RRBs due Dec. 1, 2021, are priced at $209.16 to yield -0.26%. In other words, you have to pay $2,092 for $1,000 face value to earn a negative 0.26% return from now until 2021. If you add say 2%, the projected 2012 inflation rate, in order to get your likely yield increases, it’s possible to make comparisons with conventional long-term government returns.

So for this purpose the RRBs are yielding 1.74% (2% minus 0.26%) while 10-year Government of Canada 5% bonds are priced at $148.35 to yield 2.40%, a 66 point spread. There is no advantage in the real return issue. Even more important, it’s not a good idea to extend term at this time and the returns, from both RRBs and conventional government bonds, are unacceptably low for most investors.

High-yield bonds

One sector where the yields are more attractive, especially for investors able and willing to incur some risk, is high-yield bonds. For years high-yield (junk) was a small backwater market in Canada but now it`s coming to life. Small companies have been taking advantage of the record low interest rates to float new issues. Other Canadian corporations with poor investment credit ratings that had flocked to the large U.S. junk bond markets for funding are now staying home. Many junior income trusts that were forced to incorporate have been paying down bank debt by issuing high-yield debentures. Over the last three years $8.7 billion of non-investment grade bonds have been issued in Canada by 33 companies through more than 40 underwritings. On the buy side, investors who previously owned income trusts are looking for alternative high-yielding securities.

What are high-yield bonds? There is no precise definition. As a rule, though, they are issues by junior or second tier companies with a rating of BBB low or less from one of the three major credit agencies. They involve more risk than senior corporate bonds but usually offer a much better return. The trick is to shop carefully until you find the risk/return relationship that is reasonable and one that you can live with.

Tread carefully because there is a serious risk of a default and one failure could wipe out years of interest income. Keep in mind too that there is a relationship between defaults and credit ratings. U.S. studies have shown that debt with a single B rating has a 50% chance of defaulting within 10 years while a C rated security has a 70% chance of failing over the same period. My suggestion therefore is that you stay at the upper end of the rating range when shopping for high-yield bonds. Also, look for maturities of five years or less. This reduces your risk and in any event it`s a good idea to stay relatively short right now. Interest rates are going to surge and drive long bonds lower once the economy gains traction.

One high-yield issue that I think fits the bill is the Corus Entertainment 7.25% Senior Notes due Feb. 10, 2017. Trading at $105 and yielding 5.9%, these notes are close to investment grade quality but are usually included in lists of high-yield securities because media-based companies are in a volatile business. These notes are my August Pick of the Month. See the Top Picks section for details.

Tom Slee managed millions of dollars in pension money during his career and is an expert in fixed-income securities.

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By Gavin Graham, Contributing Editor

In my last article I put forward reasons why I believed that central banks would not be raising interest rates any time in the near future. That means until the end of 2013 as the aftermath of the Great Financial Recession, as some commentators are now describing the global financial crisis of 2008-09, has proved stubbornly resistant to the best efforts of the authorities.

Despite massive amounts of Quantitative Easing (QE), otherwise known as money printing, the lowest interest rates in three generations, and government initiatives to stimulate consumer demand such as the “cash for clunkers” program, GDP growth remains anemic and patchy. The U.S. saw annual GDP growth fall below 1% in the second quarter and the U.K. has fallen into its first double-dip recession in 35 years. Meanwhile, the eurozone economies, with the exception of Germany, are almost all back in recession.

Therefore, I suggested that central banks would be unwilling to raise interest rates for the foreseeable future. Investor wariness of any perceived risk would lead to government bond yields in supposedly safe countries such as the U.S., Canada, the U.K., Japan, and Germany remaining at 50 to 60-year lows. Investors are even willing to receive negative short-term nominal interest rates (i.e. they pay the bank to hold their money!) when putting their money into Swiss francs.

This phenomenon is a cause of concern to Bill Gross, the Chief Investment Officer of the largest North American fixed-income manager, PIMCO. He has mused in his most recent commentaries, available for free on the PIMCO website, about whether government bonds have become unattractive as an asset class. He points out that investors are already receiving a negative real return from government bonds in safe haven countries, after taking inflation into account. For a major investor such as PIMCO, moving even a small percentage of its assets under management into other asset classes requires a long period to carry out without driving prices against it. It is reasonable to assume that if Bill Gross is publicly discussing the unattractiveness of government bonds, then PIMCO has probably already begun the process of shifting some of its money away.

Unlike large institutions, individual investors can move their money relatively easily and without causing disruption in asset prices. Some of the companies that I have recommended to Income Investor readers in the past have been small capitalization stocks but we have noted trading volumes when discussing them. This is an area where individuals are at an advantage compared to institutions, as the latter find it difficult to build up a reasonably sized position in smaller stocks, or to sell without pushing the price down. As long as the underlying companies are soundly financed and are generating positive cash flow and earnings, their size should not be an issue. Plus as smaller businesses, they find it much easier to grow rapidly, due to starting from a low base.

Whether the company is large or small, however, if it generates positive earnings and pays out some of those earnings to shareholders, then in the present low interest rate environment it is an attractive alternative to government bonds yielding less than inflation, let alone after taking taxation into account. For the top marginal rate taxpayer in Canada, almost half of interest income is taxed, unlike equity income which benefits from the dividend tax credit. If investors are buying stock for income rather than capital gains, then they should not be concerned by volatility in the share price, difficult though it may be at times to remember that. If the company maintains or increases its dividend, then eventually the value of this income stream will be reflected in the share price. In fact, some research has demonstrated well over half of the total return from the stock market over the last century has come from dividends.

Legislation used to prohibit investing in equities on behalf of charities and vulnerable investors such as widows and orphans unless they paid a dividend. The thinking behind the restriction was that companies could legally only pay a dividend if they were profitable, hence by confining investment to such types of stock, non-professional investors were protected from effectively gambling on companies that were speculative and likely unprofitable.

Reviewing the recommendations that I have made in light of their recent earnings and dividend announcements, it makes sense to begin with the sectors that investors are probably most concerned about, namely the financials. There has essentially been little change in the underlying circumstances for banks and insurance companies over the last six months, but share prices have been very volatile as investors reacted to the latest developments in the eurozone and the possible effects on the stocks. Let’s look at my financial picks.

Financial stocks

The Bank of Nova Scotia (TSX, NYSE: BNS) has continued to grow its earnings thanks to its large emerging markets exposure and effective cost controls. However, its Canadian franchise has seen its margins squeezed, as have other Canadian banks, due to low interest rates and moderating demand for loans. Despite this, BNS increased its dividend for the second time in the last twelve months. After a fall-off in the spring and early summer, the stock has been performing better recently and closed on Friday at C$53.28, US$53.86.

Meanwhile, life insurers Sun Life (TSX, NYSE: SLF) and Power Financial (TSX: PWF), through its ownership of Great West Life, have endured the worst of all worlds. With stock markets falling and government bond yields also declining, they have seen a decrease in the value of their assets. At the same time, they have substantially increased the value of their long-dated liabilities. While both companies have taken action to reduce their exposure to these factors, withdrawing from unattractive business lines and hedging much of their exposure, the market doesn`t care at the moment. The experience of 2009 demonstrated the earnings leverage such businesses possess when stock markets are rising and bond investors start to worry about inflation, rather than deflation, as they are at present. Neither company has increased its dividend for four years since the crisis began, which is one of the reasons for their lacklustre share price performance. When circumstances change, it would be reasonable to expect them to address this situation. Sun Life closed Friday at C$22.98, US$23.20. PWF finished at $25.31.

Mortgage insurer Genworth MI Canada (TSX: MIC, OTC: GMICF) and property and casualty insurer Intact Financial (TSX: IFC, OTC: IFCZF) have very limited exposure to the factors that have affected life insurers. Their investments are mostly in fixed income to match the much shorter liabilities that they face. While Genworth`s revenues have fallen due to the record amount of mortgage business it insured in 2007-08 gradually being fully reflected in its accounts, it has remained solidly profitable and increased its dividend last year. So did Intact, which substantially increased its market share through its acquisition of Axa Canada while continuing to write property and casualty insurance profitably, a tribute to its conservative management. Genworth ended last week at C$19.34. The last trade in the U.S. OTC market was Aug. 10 at US$17.84. Intact Financial ended the week at C$62.04. The last U.S. trade was in July at US$62.05.

Cheque printer Davis + Henderson (TSX: DH, OTC: DHIFF) has also made several acquisitions. This means that less than half of its revenues now come from its profitable but shrinking one-time core business. The company has expanded into the provision of online mortgage software as well as credit collection services and even managed a small increase in its dividend. That makes four out of the six financial stocks that have increased their payouts over the last twelve months, in some cases a couple of times. The stock closed on Aug. 17 at C$19.48, US$19.65.

All the financial stocks are Buys except Sun Life and Power Financial. They will remain as Holds until we see a dividend increase.

Defensive stocks

Amongst the more defensive sectors where I have made recommendations, gas and renewable energy utility AltaGas (TSX: ALA, OTC: ATGFF) has made several acquisitions. These include Pacific Northern Gas in B.C. and a couple of hydro projects in the same province. These moves restricted its ability to raise its dividend after an increase last year. The stock is trading at C$31.60, US$32.20.

My recent recommendation, specialty cable company Corus Entertainment (TSX: CJR.B, OTC: CJREF) raised its dividend this year as its consolidation of its Toronto area activities in its new headquarters has helped boost margins. Trading at C$22.86, US$23.10, it is down slightly from my original recommended price.

Alberta and B.C. liquor store operator Liquor Stores (TSX: LIQ, OTC: LQSIF) has continued to deliver steady growth, helped by the pick-up in oil field activity with the recovery in energy prices. However, it has not raised its dividend, a characteristic of former income trusts, which had relatively high payout ratios. The shares closed last week at C$19.49, US$20.12.

Global liquor company Diageo (NYSE: DEO) raised its dividend when it announced growth of 7%-8% in revenues and earnings for the year ended June 30, helped by its acquisition of a Turkish liquor maker which increased its presence in the faster-growing emerging markets. The stock is now at US$106.04, up almost US$17 from my last update in January when I listed it as a Buy.

Drug and medical products giant Johnson & Johnson (NYSE: JNJ) also saw high single-digit growth in top and bottom line for the first half of this year, despite continued issues with product recalls and the strength of the U.S. dollar, which reduced its large overseas earnings. It raised its dividend last year, making four out of these five companies hat have raised payouts in the last year. The shares closed on Aug. 17 at US$67.80.

All the defensive stocks are Buys.

In the next issue I will look at the more economically sensitive stocks that have been recommended and whose share prices reflect some of investors’ concerns about a possible relapse into global recession.

Gavin Graham is the President of Graham Investment Strategy and a frequent guest on radio and television business shows.

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Here are our Top Picks for this month. Prices are as of the close of trading on Aug. 17 unless otherwise indicated.

Corus Entertainment Inc. 7.25% Senior Unsecured Guaranteed Notes due Feb. 10, 2017

Type: Guaranteed Notes
Recent price: $105
Yield to maturity: 5.9%
Entry level: Current price
Credit rating: S&P: BB, DBRS: BBB
Risk Rating: Moderate risk
Recommended by: Tom Slee

The background: Corus Entertainment was established in 1999 and is controlled by the Shaw family, which also controls Shaw Communications. With 37 radio stations, pay television franchises, and a portfolio of specialty services, Corus is one of Canada’s leading integrated media and entertainment companies. Market capital exceeds $1.8 billion and revenues of $825 million last year generated an operating profit of $285 million. We should see earnings of $1.85 a share this year, however Corus is vulnerable to competitive fast-growing services such as Netflix.

The security: The 7.25% senior notes are direct obligations of Corus and unconditionally guaranteed by the company’s subsidiaries. They mature on Feb. 10, 2017. Corus can call the issue for redemption after Feb. 10, 2013 and before Feb. 10, 2014 at a price of $103.625 and after that at descending prices to $100 after Feb. 10, 2016.

Why we like it: The notes yield 5.9% to maturity. By comparison, five-year government bonds yield 1.5% and five-year blue chip corporate bonds pay about 3%. We think that the 290 basis point spread over top-class corporates provides an acceptable risk/return ratio.

Credit rating: The notes are rated BB+ by Standard & Poor’s and BBB by Dominion Bond Rating Service (DBRS), which is almost investment grade. The BBB rating by DBRS says in part: “Adequate credit quality. The capacity for the payment of financial obligations is considered acceptable…May be vulnerable to future events”.

Risks: Corus depends on consumer trends and advertising revenues, which are fickle, and the company has no obvious acquisition targets. Therefore, a sharp downturn in operating results could increase the notes’ risk. However, this is unlikely. The Shaw family could buy-in/privatize the company but this should not affect the notes.

Distribution policy: Interest payments of $36.25 per $1,000 face value of the notes will be made on Aug. 10 and Feb. 10 of each year.

Tax implications: The interest payments are taxable in the year of payment for Canadian investors who hold the notes outside a registered plan. Any profit or loss from sale, redemption, or maturity is taxed as a capital gain in the year the notes are disposed of.

Who it’s for: The Corus Senior Notes are suitable for investors seeking regular, above average income who are able to incur and live with some risk.

How to buy: The notes are thinly traded in the Canadian corporate bond market but a good broker should be able to acquire them for you.

Action now: Corus Entertainment 7.25% Notes are a Buy at $105. – T.S.

iShares FTSE NAREIT Mortgage Plus Capped Index Fund (NYSE: REM)

Type: U.S. mortgage REIT ETF
Trading symbol: REM
Exchange: NYSE
Current price: $14.65 (prices in U.S. dollars)
Entry level: Current price
MER: 0.48%
Risk Rating: Higher risk
Recommended by: Gordon Pape
Website: www.ishares.com

The security: This U.S. ETF seeks investment results that correspond generally to the price and yield performance, before fees and expenses, of the index of the same name. The fund was launched in May, 2007.

Why we like it: The mREIT marketplace is complex and both performance and risk vary widely. This basket of 29 companies provides broad exposure to the sector, thus reducing the risk level to some degree through diversification.

The big attraction is cash flow. Dividends are paid quarterly and vary from one period to the next. For the first six months of this year, they averaged about $0.43 per quarter. If that were maintained over the next year, the projected yield based on the current price would be 11.7%. However, there is no guarantee that rate will be sustained; dividends in 2011 averaged $0.39 per quarter, including a year-end capital gains distribution.

Financial highlights: This ETF has total assets under management of almost $680 million, with 46.3 million shares outstanding. The net asset value as of Aug. 17 was $14.66, one penny more than the trading price.

Risks: Although diversification reduces the risk, the entire sector is vulnerable to a sudden, sharp rise in interest rates. That’s not likely to happen in the next 12-18 months but investors need to be mindful of the possibility and take appropriate action when the current situation changes.

To give you an example of what can go wrong, these shares traded as high as $50.95 in June 2007, shortly after the ETF was launched. By mid-August, less than two months later, they were down to $26.39 and they continued to slide until October 2008. At that point, they leveled off at around $15 and have continued to trade in that range ever since.

As a result, the fund shows a five-year average annual loss of 5.7% (to July 31). However, over the past three years the average annual gain has been 12.6% and the latest one-year return was 20.8%.

Distribution policy: Payments are made quarterly at the end of March, June, September, and December. There may also be a year-end capital gains distribution. The amounts of the payments vary from one quarter to another, sometimes significantly.

Tax implications: The dividends are subject to a 15% withholding tax if paid into Canadian non-registered accounts or TFSAs. The dividend tax credit does not apply for Canadians nor does the 50% capital gains inclusion rate.

Who it’s for: This ETF is suitable for investors who want well above-average cash flow in U.S. dollars and are willing to accept the accompanying risk.

How to buy: The shares trade actively on the New York Stock Exchange and any broker can acquire them for you.

Summing up: High risk/high return. That pretty well says it all.

Action now: REM is a Buy for aggressive investors. – G.P.

Here are my updates for this month. Prices are as of the close of trading on Aug. 17 unless otherwise stated.

H&R REIT (TSX: HR.UN, OTC: HRUFF)

Type: Real estate investment trust
Trading symbol: HR.UN, HRUFF
Exchange: TSX, Grey Market
Current price: C$25.78, US$24.55 (July 13)
Originally recommended: Sept. 26/07 at C$22.88
Risk Rating: Moderate risk
Recommended by: Gordon Pape
Website: www.hr-reit.com

Comments: In contrast to some other REITs, H&R continues to increase its distributions. The trust announced last week that it will hike its payout by 4.2% in October to $1.25 per stapled unit on an annualized basis. That will be followed by another bump of 8% in January 2013, to $1.35 a year. At that rate, the shares will be yielding 5.2% based on the current price.

The REIT reported very good second-quarter results at the same time. Rental income totalled $204.7 million, a 31% increase from $155.9 million during the same period last year. Net income was $13.9 million, up from $9.1 million from a year ago. Adjusted funds from operations (AFFO) were $68.6 million ($0.37 per unit). On a gross basis, that was up from $57.8 million a year ago but on a per unit basis the results were flat. Cash from operations was $113.9 million compared to distributions paid of $40.1 million.

H&R continues to increase its portfolio of high-quality properties. During the quarter the trust acquired a one-third interest in the Scotia Plaza Complex in downtown Toronto for a total purchase price of approximately $422.2 million. This was financed by two bond issues. Other major Toronto properties owned by H&R include the Atrium on Bay and Corus Quay.

In July, the trust purchased a grocery-anchored retail portfolio of five properties totaling 340,742 square feet in Florida for an aggregate price of US$55.5 million and a capitalization rate of 6.75%. 

However, the trust’s flagship continues to be The Bow in Calgary, a two million square foot head office complex, pre-leased on a triple net basis to Encana Corporation for a term of 25 years. Although part of the complex has been delivered to Encana, the rest is still under development. Completion is expected in 2013.

Since briefly falling to below $5 in late 2008, H&R shares have been climbing steadily in price, fuelled by regular distribution increases. I believe there is still more upside potential, however. RBC Capital Markets has a target price on the shares of $29.

Action now: Buy.

Northern Property REIT (TSX: NPR.UN, OTC: NPRUF)

Type: Real estate investment trust
Trading symbol: NPR.UN, NPRUF
Exchange: TSX, Grey Market
Current price: C$32.84, US$32.16 (Aug. 14)
Originally recommended: Nov. 23/04 at C$15.36
Risk Rating: Moderate risk
Recommended by: Gordon Pape
Website: www.npreit.com

Comments: Northern Property also reported its second-quarter results last week but, unlike H&R, there was no hint of a distribution increase. In fact, there has been no change in the monthly payment of $0.1275 per stapled unit since September 2010 despite a low pay-out ratio of 64%. Revenue for the quarter came in at $42.5 million, an 11.4% advance over last year. Funds from operations were $18.9 million ($0.60 per unit) compared to $16.7 million ($0.59 per unit) in the same period of 2011.

This REIT is in a state of transition. It is in the process of selling off all its seniors’ properties, with only one in Newfoundland remaining to be disposed of. Proceeds from the sale, which will exceed $200 million, will be reinvested but that will take some time. So at this stage, we don’t know what the revamped portfolio will look like.

The distributions appear to be safe given the low payout ratio. However, I do not advise additional purchases at this time. Let’s give management a chance to invest the money and then take another look.

Action now: Hold.

That’s all for this issue. Look for your next Update Edition during the week of Sept. 3. The next regular issue will be published on Sept. 26.

Best regards,
Gordon Pape, editor-in-chief