Correction: In the issue below, we wrongly asserted that Canadian REITs held within a US investor’s IRA are exempt from the Canadian government’s withholding tax of 15 percent. We apologize for the error.

In fact, that exemption only applies to Canadian corporations, not Canadian REITs. So the Canadian government does indeed withhold 15 percent of a REIT’s distribution when it’s held in a US investor’s IRA. Furthermore, unlike when Canadian REITs are held within a US investor’s taxable account, the amount withheld by the Canadian government from a REIT in an IRA cannot be recaptured via tax credits from the IRS.

Of course, it should be noted that we’re not tax professionals and, therefore, you should consult your tax advisor or accountant for clarification regarding how taxation of any securities we recommend will affect your particular situation.

What to Buy: Artis REIT (TSX: AX-U, OTC: ARESF)

Why to Buy Now: Thanks to the recent selloff among dividend stocks, we finally have the opportunity to add a high-yielding Canadian real estate investment trust (REIT) to our Portfolio.

Artis REIT has built a portfolio of commercial property with high-quality tenants that’s diversified both geographically, with holdings in the US and Canada, as well as in terms of its holdings, which consist of office, industrial and retail properties.

Over the past few years, management has shrewdly used the low interest rate environment to greatly expand its portfolio, while at the same reducing its leverage. Now it’s poised to shift its focus toward organic growth from existing properties.

The REIT pays a monthly distribution of CAD0.09, for a current yield of 7.8 percent. It maintained this distribution throughout the prior downturn, and our expectation is that it will continue to do the same, even in a rising-rate environment.

While growth will necessarily slow as financing becomes more expensive, a resurgent economy should boost rents across its portfolio. As such, investors will be well paid to await REITs’ next major expansionary cycle.

Artis REIT is a buy below USD16.

Ari: Although the selloff in dividend stocks since early May has been dispiriting for income investors, it’s also provided us with some opportunities that we didn’t have previously.

As you know, I’ve often lamented the fact that the only real estate investment trusts (REIT) that seemed to meet the criteria of our high-yield universe are mortgage REITs. Instead of investing in property, mortgage REITs invest in mortgage-backed securities.

Because the US government is perceived as the implicit guarantor of many of these securities, these bonds are perceived as relatively low-risk credits. That enables mortgage REITs to enhance their payouts by levering up their portfolios as much as four to seven times over, by using borrowings via repurchase agreements with other financial institutions to finance the purchase of more securities.

Khoa: Didn’t you analyze the mortgage REIT space recently for a possible pick?

Ari: I did, and I simply couldn’t get comfortable with this space, at least at this juncture. Though we have recommended some securities that use leverage to boost their payouts in recent issues, none come anywhere close to the amount of leverage that mortgage REITs employ. 

Beyond that, this space is simply too risky at this point in the cycle, especially once rates start to rise. If and when we enter an easing cycle again, then that might offer a more propitious entry point. But for now, mortgage REITs will not only face downward price volatility, but many will also be forced to cut their distributions, as their funding costs increase and the value of their existing portfolios plummets.

So there you have it: Some insight into the plays that don’t make the portfolio, and instead end up on the cutting-room floor.

Khoa: Interesting, to me at least, though I’m sure no one else cares about what doesn’t make the issue.

Ari: Well, anyway, the traditional property REIT space has been crushed in recent months, though not nearly as much as mortgage REITs, so we now have a couple of plays whose distributions yield more than 7 percent.

Khoa: Now that’s more exciting! But won’t even regular property REITs suffer during a period of rising interest rates?

Ari: The main thing that will change for property REITs is that they’ll have to shift from growth via expansion of their real estate portfolios to organic growth via rising rents from their existing holdings.

To be sure, REITs have enjoyed two tremendous tailwinds over the past few years: a low interest rate environment coupled with high demand from income-hungry investors. Since most REITs fund their acquisitions via a combination of secondary equity issuances and debt, this environment has enabled them to rapidly grow the size of their portfolios. As they shift to more organic growth, their heady gains in funds from operations (FFO), which is the relevant measure of profit for a REIT, will start to slow.

On the other hand, the US Federal Reserve is basing its decision to first taper its extraordinary stimulus and later raise short-term rates on a resurgent economy. In the absence of improving economic data, monetary easing will continue. But if the data show a sustained upward trend, and our economy is truly rebounding, then that will presumably flow through to the rental market, where higher rents will boost REITs’ net operating incomes.

It looks like traders have already priced in the prospect of a rising-rate environment into REIT unit prices. So hopefully, they’re near a bottom. Meanwhile, we expect this month’s recommendation to produce slow growth, while nevertheless maintaining its distribution. For patient investors, this means being well paid to wait for REITs’ next expansionary cycle.

Khoa: Alright, already! Let’s get into this month’s pick.

Ari: Okay, so there are a couple of Canadian REITs that we closely examined, but we favor Artis REIT (TSX: AX-U, OTC: ARESF) because it’s not only geographically diversified across Canada and the US, but its real estate portfolio is similarly diversified among office, industrial and retail properties.

Additionally, it trades at a price-to-book ratio of just 0.72 and a price-to-FFO ratio of 10.2, both of which are well below the industry average. Finally, its units currently yield 7.8 percent, and though it hasn’t raised its CAD0.09 monthly payout since May 2008, it managed to maintain its distribution throughout the Great Recession. And in its most recent quarter, the REIT’s payout ratio based on FFO improved to 77.1 percent versus 87.1 percent a year ago.

Artis’ portfolio currently consists of 232 commercial properties, with a total of 24.4 million square feet of gross leasable area (GLA). The resource-rich province of Alberta accounts for 38.6 percent of net operating income (NOI), with Ontario accounting for the next largest share of NOI, at 13.7 percent.

While Artis’ US properties currently account for just 20.5 percent of NOI, management believes that it has a brief window of opportunity to acquire properties in the US that offer higher yields than those in Canada. In pursuing a greater presence in the US, the REIT could boost its US holdings to 30 percent of NOI, while pursuing a fundamentally more conservative approach than it does with its Canadian properties. For instance, it will acquire newer properties, with superior tenant creditworthiness and greater lease durations.

Although industrial properties account for 47.4 percent of GLA, their share of NOI is just 24.2 percent. Office properties account for 34 percent of GLA, but the majority of NOI, at 50.4 percent, while retail accounts for 18.6 percent of GLA and 25.4 percent of NOI.

Since the end of the first quarter, the occupancy rate declined by seven-tenths of a percentage point, to 95.1 percent, though that rate rises to 96.6 percent when including future commitments.

Khoa: I know you mentioned that, given REITs’ numerous secondary issuances, you were concerned about unitholder dilution. How does Artis fare in this respect?

Ari: To finance its acquisitions, Artis typically uses a mix of debt and equity, so it continues to make secondary issuances, including an equity offering of 10.4 million units during the second quarter that raised CAD172.5 million. And in late July, the REIT received gross proceeds of CAD80 million from the issuance of preferred stock.

Over the past six years, this CAD1.7 billion REIT has increased its units outstanding nearly fivefold, from 26.9 million at the end of the third quarter of 2007 to 132.3 million at the end of the latest quarter.

FFO per diluted unit has grown from CAD1.38 for full-year 2007 to CAD1.40 for the trailing four quarters. From 2010-11, FFO per unit had fallen significantly below the threshold at the outset of this period, so the REIT’s results have finally caught up with all its secondary issuances.

Over that same period, the value of its property portfolio has grown almost sixfold, from CAD784.7 million to CAD4.7 billion.

Khoa: Okay, so it sounds like dilution is no longer an issue. What about its borrowings?

Ari: REITs have diligently used the easy-money environment since the downturn to improve their capital structures, while reducing leverage. Artis’ management has pursued a strategy of external growth combined with gradual improvement of its operating metrics.

The weighted average term of the REIT’s mortgages is 4.6 years, while the weighted average interest rate is just 4.1 percent.

Over the past two quarters, mortgage debt to gross book value declined 1.9 percentage points, to 45.4 percent, while total debt to gross book value declined 1.3 percentage points, to 49.2 percent. This was due to a 12.2 percent rise in gross book value, to CAD4.9 billion, which more than offset a 7.7 percent increase in debt.

In addition to proceeds from debt and equity issuances, Artis had CAD42.7 million in cash on its balance sheet at quarter-end, as well as CAD70 million available from its credit revolver.

Khoa: How did Artis perform in its most recent quarter?

Ari: Second-quarter FFO narrowly beat analyst estimates by 0.3 percent, the third consecutive quarter in which there was at least a modest upside surprise. During the quarter, overall FFO grew 31.8 percent, to CAD43.9 million, versus CAD33.3 million a year ago.

Meanwhile, diluted FFO per unit grew 12.9 percent, to CAD0.35, compared to CAD0.31 a year ago. Bay Street analysts all reaffirmed their ratings following the earnings release, and the mix of ratings for the REIT now stands at seven “buys,” three “holds,” and no “sells.” The consensus 12-month price target is CAD17.21, which is 24.3 percent above the current unit price.

Analysts expect sequential growth in FFO per unit to be flat for the remainder of the year, though full-year 2013 FFO is expected to grow 10 percent from the prior year. Growth is expected to decelerate in 2014, with FFO per unit rising just 2.1 percent year over year.

Much of the REIT’s growth is derived from acquisitions. While same-property net operating income (NOI) increased 3.1 percent versus a year ago, NOI across all properties, including acquisitions, jumped 25 percent, to CAD71.7 million.

During the quarter, Artis renewed the leases on almost 600,000 square feet of leasable area, at a rent that was 10 percent higher than a year ago. For the six-month period ended June 30, the REIT renewed a total of 1.3 million square feet, with an increase in rent of 8.6 percent. Over the long term, management projects that its office properties will be the strongest contributor to incremental rental revenue.

Artis further expanded its portfolio by acquiring eight income-producing commercial properties in the US and Canada for CAD237.9 million during the quarter, while also buying the remaining 50 percent interest in the Cara Foods Building in Ontario for CAD102.8 million. Finally, the company purchased land for development near Winnipeg as well as the Twin Cities metro area in Minnesota, for a total of CAD9.9 million.

For the six-month period ended June 30, Artis acquired a total of CAD381.7 million in investment properties. No dispositions were made during the quarter.

Khoa: Does Artis have a distribution reinvestment program (DRIP)?

Ari: It does, though unfortunately, only our Canadian subscribers will be eligible for enrollment in the DRIP. In addition to the fact that reinvestments under the DRIP are not subject to fees or commissions, with each reinvestment, participants also receive a “bonus” distribution of Units equal to 4 percent of the amount of the cash distribution that was reinvested.

Khoa: What about taxation for US investors?

Ari: Unlike US REITs, distributions from Canadian REITs are taxed at the more favorable dividend tax rate of 15 percent. Of course, that rises to 20 percent if your taxable income exceeds $400,000 as an individual or $450,000 as a couple.

However, the Canadian government will withhold 15 percent of that payout, though that amount can be recovered as a credit at tax time by filing Form 1116. But individual retirement accounts (IRA) are exempt from this withholding (Please see the correction regarding this statement at the beginning of the issue).

Additionally, US investors should know that this withholding rate has been reduced from the usual 25 percent rate for non-resident investors as the result of a tax treaty between Canada and the US.

The Canadian Revenue Agency (CRA) implemented a new rule earlier this year that requires US investors to file Form NR301 through their brokers in order to receive the reduced rate of withholding. Follow this link to learn more about the form and its requirements.

Khoa: So just how badly has this REIT been pummeled by investors?

Ari: Like many of its REIT peers, Artis has sold off over the past three months since hitting a year-to-date high of CAD17.03 on April 30. The selloff began in earnest in late May, and then reasserted itself toward the end of July. Its units currently trade near CAD13.85, down 18.7 percent from the earlier high, and just 0.2 percent above their 52-week low. Over that same period, the Bloomberg Canadian REIT Index is down 17.6 percent.

While the selling seems to have removed much of this REIT’s former premium, there could be additional downward volatility, so our more cautious subscribers should consider slowly building a full position in one-third increments. Artis REIT is a buy below USD16.

Portfolio Updates

Below, we detail the calendar second-quarter earnings for most of our Portfolio companies. For the remaining four holdings, we’ll publish our analyses in an alert distributed via email toward the end of next week.

Bonavista Energy Corp (TSX: BNP, OTC: BNPUF) reported a 4 percent increase in production volumes to 72,554 barrels of oil equivalent per day (boe/d) for the second quarter, despite scheduled and unscheduled plant turnarounds that impacted quarterly volumes by 950 boe/d. Current production is approximately 73,000 boe/d.

The company generated funds from operations of CAD123.1 million, or CAD0.63 per share, up 51 percent from CAD81.7 million, or CAD0.49 per share, a year ago. Revenue was up 26 percent to CAD244.9 million.

On Aug. 15, management confirmed that the September payout will remain steady at a level of CAD0.07 per share. Bonavista Energy Corp remains a “hold.”

BreitBurn Energy Partners LP (NSDQ: BBEP) reported that production during the second quarter grew 26 percent to 2.45 million barrels of oil equivalent (boe). Liquids production increased 58 percent to 1.29 million boe. Natural gas production increased 2.2 percent to 6,994 million cubic feet.

Total average daily production for the second quarter was 26,956 boe per day (boe/d), up 25.6 percent from the previous year. The average sales price per boe also rose to $58.98 from $47.08 last year. 

Oil, natural gas liquids (NGL) and natural gas revenues grew 57 percent to $149.3 million from last year.

The LP posted a $67 million gain on commodity derivatives, which boosted the top line, compared to a $24 million loss in the first quarter. Total revenues grew 6.8 percent to $216.3 million from the previous year.

The company declared a cash distribution of $0.48 per share–its 13th consecutive quarterly increase–representing a 4.3 percent increase from last year.

BreitBurn declared a distributable cash flow (DCF) per unit of $0.47, which came just shy of fully covering the quarter’s $0.475 distribution. Management expects its DCF coverage ratio to improve to 1.4 to 1.5 by the fourth quarter. Breitburn Energy Partners LP remains a buy below 21.

Lightstream Resources Ltd (TSX: LTS, OTC: LSTMF) is trading at an even steeper discount to the value of its resources, with a price-to-book value of just 0.43.

Lightstream’s debt-to-assets ratio is just 23 percent, though there’s CAD1.2 billion drawn on a CAD1.4 billion revolving facility that matures in June 2016.

Lightstream’s market capitalization is currently around CAD1.4 billion, which could make it a tempting target for a potential acquirer, though debt is nearly equal to market cap. As indicated by its “quick ratio” of just 0.2, Lightstream’s margin of error for debt service is perilously thin.

Lightstream generates high netbacks for its light oil output, but is extremely sensitive to swings in commodity prices. And its share price simply hasn’t responded to oil’s upward trend since December 2012, largely because investors are pricing in a dividend cut that management has thus far resisted.

The decline from CAD15.08, as of mid-September 2012, to an all-time low of CAD7.07 on Aug. 22 could make it a target for a bigger, more liquid company.

Lightstream is currently the cheapest oil and gas producer with a market capitalization greater than CAD1 billion on the Toronto Stock Exchange. And it’s the fourth-cheapest among those valued at more than CAD100 million.

Second-quarter production averaged 46,045 barrels of oil equivalent per day (boe/d), down 6 percent from the first quarter, but up 19 percent year over year. Light oil and liquids dominated the production mix, at 82 percent of total production. Operating netback for the second quarter was USD50.08 per barrel of oil equivalent, a slight increase over the first quarter.

Funds from operations were CAD168 million, or CAD0.86 per share, down 5 percent sequentially, but up 39 percent year over year. Total dividends of CAD47 million were declared, representing 28 percent of funds from operations.

Average production for July is estimated to be approximately 44,000 boe/d, relatively flat to June production. Management reiterated its annual average production guidance of 46,000 to 48,000 boe/d, reflecting growth of 8 percent to 12 percent over 2012 levels.

Lightstream boosted its CAPEX forecast by 5 percent to CAD700 million to CAD725 million, as a result of cost overruns as well as higher-than-anticipated drilling and completion costs on exploration wells drilled in its emerging play areas, where it’s applying innovative techniques to delineate and de-risk new plays.

Management also boosted its annual funds from operations guidance by approximately CAD40 million for a new range of CAD680 million to CAD720 million. Lightstream Resources remains a buy up to USD10.

LRR Energy LP’s (NYSE: LRE) revenues in the second quarter fell 10.6 percent to $41.38 million, due to lower production and average realized price per barrel of oil equivalent (boe). The company’s production fell 9.8 percent during the second quarter, to 6,484 barrels of oil equivalent per day (boe/d), due to a negative impact by disruptions at its Red Lake and Pesco Slope fields. The average realized price per barrel of $37.42, compared to $45.21 per barrel the previous year, also dampened sales.

LRR reported total distributable cash flow (DCF) for the quarter of $14.06 million, which covered its $12.7 million in cash distributions by a ratio of 1.1. LRR also declared a dividend boost of $0.485 in July, up from the previous dividend of $0.48, and its sixth straight quarterly bump.

Management expects daily production of 6,300 boe/d to 6,550 boe/d for full-year 2013. LRR Energy LP remains a buy below 18.

Natural Resource Partners LP (NYSE: NRP) reported second-quarter revenues of $86.8 million, down 4.3 percent from the previous year.

Although coal production grew 24 percent, to 14.89 million tons, the average price per ton of metallurgical coal (which represents about 28 percent of NRP’s production and 40 percent of coal royalty revenues) fell 26 percent, to $3.91, as coal prices remain depressed due to weak global steel demand. Coal royalty revenues for the quarter fell 7 percent, to $58.2 million.

The company’s distributable cash flow (DCF) grew 8 percent, to $90.7 million. The improvement was mainly due to a $26.9 million cash distribution received from OCI Wyoming–NRP’s equity investment–which offset some of the declines from operations. The reported DCF of $0.81 per unit more than covered its quarterly distribution of $0.55 per unit.

Management lowered its guidance for full-year coal royalty revenue to a new range of $205 million to $220 million, from $210 million to $235 million previously. It also lowered its expected full-year earnings by $0.20 per unit to a new range of $1.40 to $1.60 per unit, due to an increase in operating expenses resulting from a reserve swap in the first quarter.

However, due to its investment in OCI Wyoming, NRP boosted its DCF guidance range by $40 million, to a new range of $290 million to $320 million. The coverage ratio for 2013 is expected to remain at a comfortable 1.2. Natural Resource Partners LP remains a buy below 22.

QR Energy LP’s (NYSE: QRE) second-quarter revenue grew 69.9 percent from 2012 levels, to $105.4 million. Average production was 17,264 barrels of oil equivalent per day (boe/d), up 19 percent from the prior year.

The LP’s distributable cash flow (DCF) was $27.8 million, or $0.43 per unit, which fell short of covering its quarterly distribution of $0.4875 per unit.

On Aug 6, QR Energy closed a $109.2 million deal for oil assets from a private seller. These assets should be immediately accretive to DCF.

The company expects full-year daily production to be around 17,000 barrels per day to 18,300 barrels per day. Due to its current hedges, management continues to maintain its current payout is well supported and expects its coverage ratio to improve to 1.0 by the third quarter. QR Energy LP remains a buy below 21.

Spyglass Resources Corp’s (TSX: SGL, OTC: SGLRF) second-quarter average daily production came in at 16,362 barrels of oil equivalent per day (boe/d). The production mix consisted of 52 percent natural gas and 48 percent oil and natural gas liquids.

The company lowered its production guidance for the second half of 2013 to a new range of 17,000 boe/d to 17,500 boe/d from a previous estimate of 18,000 boe/d, as it will defer production from its Cadomin natural gas well until prices for this commodity improve. For the full year, Spyglass anticipates production of 15,500 boe/d to 16,000 boe/d, down from a prior estimate of 16,000 boe/d.

Spyglass’ paid out CAD8.6 million in total dividends during the quarter, or CAD0.0675 per share, which was well covered by its reported cash flow of CAD20.6 million, or CAD0.16 per share. Its all-in payout ratio (calculated by using dividends declared and capital expenditures) came in at 82 percent. The company is targeting an all-in payout ratio of 100 percent for 2013. Spyglass Resources Corp remains a buy below USD2.25.

Revenue and customer trends for Windstream Corp’s (NYSE: WIN) strategic broadband and business units remain steady, if unspectacular, while growth at its fixed-line business deteriorates.

Second-quarter business service revenue grew 2 percent, to $913 million, as total enterprise customers grew 6 percent year over year. Consumer broadband service revenue was up 6 percent, to $120 million.

Total sales, however, slipped by 2 percent, to $1.51 billion. And adjusted operating income before depreciation and amortization (OIBDA) was off 1 percent to $582 million.

Management has noted that a wind-down from a period of significant capital spending related to Windstream’s fiber-to-the-tower and broadband stimulus efforts will relieve pressure on cash flow. And management expects to pay down $200 million of debt by year’s end.

But management also “tempered” its revenue expectations for the second half of the year, revising its guidance to a year-over-year decline of 1 percent to 3 percent, versus a prior forecast that contemplated a small rise on 2013 sales.

The company did reiterate OIBDA and free cash flow guidance based on the success of cost-cutting efforts to date. Windstream Corp remains a buy below 11.