“Earnings” seems like a simple concept. It’s just revenues less costs, right? But things are seldom as simple as they seem.
How can any corporation, income trust or other organization steadily distribute more to shareholders than it earns and remain viable over time. Our answer may sound like creative accounting. But let’s go into detail.
Most companies must, before ever opening their doors, acquire some capital goods—be it machinery, office equipment, raw materials inventory or inventory of items for resale. That takes an initial investment of capital.
As the business carries on, these capital items must be accounted for as part of the company’s costs when calculating earnings or profit. A machine, for example, may be expensed a bit at a time as it is used through its useful life to produce product for sale. And the cost should relate to the benefit to accurately state profit.
Items for resale may be easier to account for. Just take the proceeds of sale less the cost of goods.
But what about an item for rent? Can you accurately, in advance, determine how much rental activity will exhaust the useful life of the item? And what about the cost of capital tied up in the item for all of its life? Take a water heater, for example. You may rent one yourself. Let’s say the bill is about $20 a month, and you’ve had it for 18 years. How should the company that rents you that heater expense it? How much of the $240 a year should be profit?
Expenses may be too high
Companies and their accountants do their best to match costs with revenues. But they err on the side of conservatism. And for tax purposes, so does the Canada Revenue Agency. A company generally depreciates an item on a declining-balance basis. That means at an expense rate of, say, 10 per cent, it can expense 10 per cent of the remaining value each year. In other words, the expense of an item (for tax purposes) declines year by year while revenue generated remains steady and often, in fact, increases, as does the rental charge for your water heater.
Consequently, cash flow after operating expenses can and generally does exceed accounting profits. That happens more often and to a greater extent in some industries. Many companies that pay little or no dividends retain cash for expansion, plant updates, property and equipment, and further capital investment.
But industries with steady cash flow in excess of accounting profits and with low, ongoing capital requirements, little competition and little room for growth beyond population growth make excellent candidates for the income-trust structure.
Real estate generates lots of cash
In the case of real estate investment trusts, or REITs, buildings often last far longer than they take to write off as an expense. And the land underneath can change in value, often erratically. What’s more, rental revenue can and does vary based on many economic factors that have little if anything to do with costs. We have seldom seen a downswing for any length of time in rental revenue. Short recessions, sure. But over any decade since the great depression—no.
That, of course, could change. But in the minds of most business people, real estate is and will remain a one-way street with cash revenues far exceeding cash costs. That’s why a trust can regularly distribute more cash than its earnings suggest it can.
This is an edited version of an article that was originally published for subscribers in the April 22, 2022 issue of Money Reporter. You can profit from the award-winning advice subscribers receive regularly in Money Reporter.
Money Reporter, MPL Communications Inc.
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