Subject: Stocks - Income and Royalty Trusts

Last-Revised: 24 Jul 2001
Contributed-By: John Carswell (webmaster at

Income and Royalty Trusts are special-purpose financing vehicles that are created to make investments in operating companies or their cash flows. Investors supply capital to a trust, a legal entity that exists to hold assets, by purchasing "trust units". The trust then uses these funds to purchase an interest in the operating company. The trust then distributes all its income to holders of the trust units.

Income and Royalty trusts are neither stocks nor bonds, although they share some of their characteristics. Investment trusts are created to hold interests in operating assets which produce income and cash flows, then pass these through to investors. A "trust" is a legal instrument which exists to hold assets for others. A "trust" investment which uses a trust (the legal entity) to hold ownership of an asset and pass through income to investors is called a "securitization" or an "asset-backed security".

The trust can purchase common shares, preferred shares or debt securities of an operating company. Royalty trusts purchase the right to royalties on the production and sales of a natural resource company. Real estate investment trusts purchase real estate properties and pass the rental incomes through to investors.

Royalty and Income Trusts are attractive to investors because they promise high yields compared to traditional stocks and bonds. They are

attractive to companies wishing to sell cash flow producing assets because they provide a much higher sale price, or proceeds, than would be possible with conventional financings. The investment characteristics of both types of trusts flow from their structure. To understand the risks and returns inherent in these investments we must go beyond their promised yield and examine their purpose and structure.

Cashflow Royalty Created!

For example, let's say that we own an oil company,CashCow Inc., that has many mature producing oil wells. The prospect for these wells is fairly mundane. With well known rates of production and reserves, there is not much chance to enhance production or lower costs. We know that we will produce and sell 1,000,000 barrels per year at the prevailing oil price until it runs out in a forecasted 20 years. At the current price of $25 per barrel, we will make $25,000,000 per year until the wells run dry in 2017.

We're getting a bit tired of the oil business. We want to sell. Our investment bank, Sharp & Shooter, suggest that we utilize a royalty trust. They explain the concept to us. CashCow Inc., our company, sells all the oil wells to a "trust", the CashCow Royalty Fund. The trust will then pay CashCow Inc a management fee to manage and maintain the wells. The CashCow Royalty Fund then gets all the earnings from the wells and distributes these to the trust unit holders. We ask, "Why we just wouldn't sell shares in our company to the public". Sharp & Shooter tells us that we will get more money by setting up the trust since investors are "starved for yield". We agree.

Sharp & Shooter then do the legals and proceed with an issue. They offer a cash yield of 10%, based on their projections for oil prices, the cost structure, and management fee to CashCow Inc. This means they hope to raise $250,000,000. We're rich!!

Yield to the Poor Tired Investment Masses

What about the poor tired investment masses? Starving for yield in the low interest rate revolution, the CashCow Royalty Fund lets them have their investment cake and eat it too. Thanks to the royalty courtiers of Sharp & Shooter, yield starved investors can buy a piece of a "high yield" investment. Sounds a bit strange, but the royalty trust turns the steady income that made the operating company CashCow Inc. financially mundane and boring into a scintillating geyser of high yield.

Since the operating company, CashCow Inc., no longer has to explore for oil or develop technologies to increase production, its expenditures will be much lower under the royalty trust structure. Remember, the purposes of the trust is to pay out the earnings from the oil sales until the oil fields are exhausted. No more analysts and shareholders complaining about "depleting" resources. Paying out the steadily depleting oil sales are now the idea. This means that none of the revenues and profits from production have to be expended on securing new supplies. The continuing operations of CashCow Inc. can be downsized now that maintenance is the only need. No more exploration department, huge head office staff, or worldwide travel bills.

The investor, who might shun a low dividend yield of 3% on an oil stock or worry about the risk of a lower grade corporate bond, sees the bright lights of high yield beckoning. Our $25,000,000 in revenues is only reduced by a management contract of $1,000,000 paid to the now shrunken CashCow Inc. to keep the fields maintained. All the earnings will be passed through to the CashCow Royalty Trust which will be taxed in the hands of the investors. We can offer a 10% yield to the trust unit holders which means that we can raise $250,000,000.

What's Wrong with this Investment Picture?

One of the first questions to ask about an investment is, "What's in it for them?". Why would the owners of CashCow Inc. part with their $25,000,000 in income? Not just to provide a higher yield for the yield starved investment masses. Logically, the owners of an operating company would only sell their interest if they could use the money to more effect somewhere else. Think about it for a minute. If the owner of CashCow Inc. can take $250,000,000 and put it into another investment with a higher yield, it should be done. The fixed return of 10% on established, tired wells might be a tad low next to the upside on a new oil field, or a well diversified portfolio of growth stocks.

Another question to ask is,"Why didn't the owner just sell the company to another oil company?". The simple answer is that they get more money by selling to the income trust. Which begs the question, "Why is the price so high?". Other companies realize that the price of oil goes up and down and that the price of $25 a barrel today is very high compared to the $10 it was a few years ago. At $10 per barrel, the cash flow would only be $10,000,000 a year. That is why the prospectus for these trust deals talks about 'forecasted' revenues and earnings. The other oil companies also realize that 'proven reserves' has an element of guesswork, and that there might be less oil in the ground, or it may be 'more difficult to recover' than expected.

All this means that the 10% "yield" is not fixed in stone, as we now realize. As with all investments, we must take our time and do our analysis. As Uncle Pipeline says, "It's all in the cash flows!"

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