On Dec. 16, 2010, the Dept of Finance proposed amendments to the rules defining “real estate investment trusts” (REIT) in Canada, the final act in a drama that started on Oct. 31, 2006, when Finance Minister Jim Flaherty announced a new proposal by the then-new minority Conservative government to impose an entity-level tax on income trusts.

Much like the intervening four years, the reality has been much kinder than the horror threatened that long ago Halloween night. The proposed changes, effective as of Jan. 1, 2011, generally make it easier for trusts to qualify as REITs.

Proposed changes to the income tax rules will:

• allow REIT subsidiaries to hold certain non-capital property in respect of their real estate investment activities;
• allow REITs to hold up to 10 percent of their non-portfolio property as non-qualifying REIT property without losing REIT status (with an associated clarification of the circumstances under which property can be considered to be ancillary REIT property);
• allow REITs to derive up to 10 percent of their revenues from sources that are not qualifying sources (currently, a REIT must derive  95 percent of its revenues from qualifying sources);
• clarify that a trust’s revenue for purposes of the two revenue tests in the definition “real estate investment trust” is to be computed on a gross, rather than net, basis and that it will include capital gains;
• allow REITs to earn, as qualifying REIT revenue, gains realized by virtue of foreign currency fluctuations in respect of revenues derived from foreign real or immovable property including certain financing and hedging arrangements in respect of such property;
• ensure that amounts distributed to a REIT, by an entity in which the REIT has a significant interest, will retain their character for purposes of the revenue tests;
• allow an entity to hold investments in a REIT without those investments being treated as Canadian real, immovable or resource property in determining whether the entity itself is a SIFT.

The proposed rules (although already with effect, the Dept of Finance is accepting comments through Jan. 31 pending final promulgation) set the stage for another solid year of returns for Canada’s REITs. Primarily, the North American economy is rounding into strength, and at the same time, even after a noteworthy uptick in recent weeks, interest rates remain historically low.

REITs that were able to use cheap capital to grow during the last couple years will be able to complement growth in same-property metrics because of the improving employment picture.

After bottoming in recent months the fundamentals for real estate, across all major classes, are starting to turn: Growth in tenant demand is starting to outpace new supply. And that should set the table for lower vacancies and higher rental rates in 2011. But be sure to stick to buy targets.

Here’s a rundown of CE Portfolio REITs, focusing on third-quarter 2010 results (the most recent available).

Artis REIT (TSX: AX-U, OTC: ARESF) earned a CE Safety Rating boost from 4 to 5 this month. Artis narrowly misses a perfect 6 only a payout ratio that should come down as funds are invested. The REIT plans to bring its asset management in house over the next year, which should provide another spur to growth, even as its portfolio gains strength from improving property market conditions in western Canada.

Third-quarter revenue surged 17.1 percent sequentially and is up 51 percent over the past year. Occupancy rates rose to 97.8 percent from 96.6 percent at the beginning of the year, as the REIT expanded its base of income-producing properties to CAD1.84 billion, up from CAD1.19 billion at the end of 2009.

Funds from operations (FFO) and distributable cash flow (DCF) rose 9.5 and 7.2 percent, respectively, from second-quarter levels. Dilution from equity issues pushed down per-unit totals and pushed up the payout ratio to 96.4 percent of FFO and 100 percent of distributable income. That increase, however, should reverse in coming quarters, as dollars raised are invested.

The massive investment of the past year has also diversified Artis geographically as never before, reducing exposure to the still slack Calgary market and enabling the REIT to capitalize on strength in other regions. The company has also taken a stake in several US properties, with the goal of eventually collecting 15 percent of overall rents from that market.

Artis’ units have backed off from recent highs, following the release of numbers. Now yielding closer to 9 percent again, it’s a good time for those without a stake to pick up some units. Artis REIT is a buy up to USD14.

Canadian Apartment Properties REIT (TSX: CAR-U, OTC: CDPYF) turned in another steady quarter, as a 5.3 percent boost in normalized FFO pushed the payout ratio down to just 74.5 percent. Operating revenue rose 4.9 percent on a 2.6 percent increase in average monthly rents and a rise in occupancy from 98.4 to 98.7 percent. Net operating income (NOI) rose 6.8 percent with margin rising to 58.7 percent, indicating rising profitability at existing properties.

The company also refinanced CAD60 million of mortgage debt on its properties at an average interest rate of 3.03 percent and locked in low prices for 85 percent of its winter natural gas needs, required to provide heating for tenants at its properties. And the REIT added properties in British Columbia and sold others in Ontario, further enhancing geographic diversification while boosting overall portfolio quality.

Average rents rose in every region except for Alberta, where the market is still hurt by overbuilding of past years. Revenue from suite turnovers rose 1 percent, versus a decrease of that size last year. Operating expenses as a percentage of revenue were cut to 41.3 percent, from 42.3 percent a year earlier, and debt service coverage ratios improved as well.

Despite the strong coverage numbers, management continues to show little inclination to raise the dividend. Rather, available cash is more likely to be used to make acquisitions or pay off more debt. Canadian Apartment Properties REIT and its safe yield of 6.4 percent–paid monthly–is a buy anytime it trades below USD17.

Northern Property REIT (TSX: NPR-U, OTC: NPRUF) turned in another solid third quarter, with distributable income per unit rising 8.9 percent on a 9.1 jump in revenue. The payout ratio was again very low at 63.1 percent, supporting the 3.4 percent dividend boost effective in September 2010.

Management reported that overall vacancy levels have now returned to pre-recession levels, as “robust” conditions in the Far North, Newfoundland and northern British Columbia offset continuing weakness in Alberta, though that province too saw improvement. Same-door growth–which excludes the impact of acquisitions and divestitures–ticked up 3.6 percent.

Northern’s investment in its ExecuSuite properties forced it to make some restructuring moves in advance of Jan. 1, and before the Dept of Finance introduced new rules for REITs. Unitholders approved the creation of a new taxable corporation, NorSerCo, to hold all of Northern’s assets that didn’t qualify for the REIT exemption under extant rules, mainly ExecuSuite properties. Northern retains ownership but will get its cash indirectly through NorSerCo.

The only change for unitholders is the REIT units become NPR/NorSerCo staple shares, combining a portion of debt with equity into a single security. Cash distributions remain the same, and the move isn’t a taxable event. In fact, there’s potential upside for US investors regarding taxation. The debt interest portion of the dividend is no longer be withheld the 15 percent, either inside or outside IRA accounts, while the equity portion should escape withholding inside IRAs like other corporations. Northern Property REIT is a buy up to USD25.

RioCan REIT (TSX: REI-U, OTC: RIUOCF) sports a perfect 6 CE Safety Rating, getting the boost this month with the revised system described in Portfolio Update. Recently executed contracts with Wal-Mart Stores (NYSE: WMT) shore up an already strong portfolio that’s backed by a falling payout ratio and little debt.

The owner of high-quality shopping malls across Canada has used the last two years to dramatically boost its portfolio growth potential. Canada’s biggest REIT, RioCan had no problem raising capital even in the darkest days of the credit crunch. And management used that to full advantage, filling its cash coffers to overflow with the goal of deploying the money into acquisitions of quality properties from distressed owners.

Unfortunately, bargain acquisition opportunities took longer to materialize than expected. And RioCan suffered several quarters of depressed profits, as dilution from equity issues and interest paid on new debt far offset what it could from cash in the bank.

Management’s patience, however, is now paying off in spades. For the second consecutive quarter, the REIT posted explosive growth (20 percent) in per unit FFO, fueled by net operating income (NOI) growth of CAD21.8 million due in large part to successful acquisitions of shopping mall properties across Canada, as well as in the US through the partnership with Cedar Shopping Centers (NYSE: CDR).

RioCan also reported same-store NOI growth of 2.2 percent, reflecting higher rents, lower bad debt and fewer vacancies. That rate is expected to accelerate to 3.5 percent in the fourth quarter, even as several greenfield, or new, construction projects come on line. RioCan completed 16 separate acquisitions in North America last quarter. The company has another 197 million prospective deals on which it has “completed due diligence” and has “waived conditions.” And it expects to complete CAD1 billion total purchases by year-end 2011.

Mortgage financings in the third quarter were for an average term of 6.1 years at an average rate of 4.9 percent. And management is currently securing rates at or below 4.75 percent versus paper coming due in the next six months at an average rate of 5.8 percent. That will further boost the balance sheet and widen profit spreads on new deals. Debt-to-adjusted book value is 51 percent, or less than 50 percent factoring in current property values.

RioCan’s secret during every downturn is quality. High-quality tenants like Wal-Mart operating under long-term leases anchor all of its properties. That ensures superior occupancy rates (97.1 percent in the third quarter) as well as strong rent growth even in lean times. Renewal retention is better than 90 percent in 2010, with an average rent increase of 10.8 percent. Unbudgeted vacancies fell nearly in half over the past year, a testament to the REIT’s ability to pick prime spots as well as customers.