Deloitte`s 8th Edition REIT Guide

8th Edition
REIT Guide
Second Print
Table of Contents
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
What is a REIT? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
1. The Origin of the REIT Vehicle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
The U.S. REIT Story . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
The Birth of the Canadian REIT Vehicle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
2. Anatomy of a REIT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
The Declaration of Trust and Management Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
How Will Investors Receive their Returns from REITs? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Statutory Requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
What Type of Property is Most Suitable for a REIT? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
3. Canadian Tax Issues for REITs and Investors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .11
REIT Tax Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .11
Investor Tax Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .15
Comparison of Open-Ended and Closed-Ended Mutual Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .19
4. The REIT Vehicle in the Canadian Marketplace . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .21
History of Capital Flows into the Canadian Real Estate Industry from 1970 to the Present . . . . . . . . . . . . . . . . . . . . . .21
REITs Provide a Vehicle for Buying Real Estate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .22
5. Challenges of Converting to a REIT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23
Transaction Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23
Matters to Consider BEFORE Proceeding with a REIT Transaction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23
Extent of Investment of the Sponsor in the Ongoing Operation of the REIT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23
Making the Economic Case for the REIT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .24
Structuring the REIT vehicle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .26
Accounting and Reporting Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .26
Legal and Administrative Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .27
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .28
6. The REIT vs. a Corporate Structure: Differences in Management Focus . . . . . . . . . . . . . . . . . . . . . . . . .29
Investment Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .31
Operating and Financial Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .33
Financial Reporting Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .37
Corporate Governance Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .40
Risk Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .41
7. Canadian vs. U.S. REITs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .42
From An Owner’s Perspective . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .42
From an Investor’s Perspective . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .44
8. Why Royalty Trusts and Investment Trusts Differ from a REIT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .45
9. Difference Between the Structure of a Non-Business REIT and a Business REIT . . . . . . . . . . . . . . . . .48
10. How to Evaluate a REIT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .52
What to look for in a REIT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .52
How Should REITs Be Evaluated? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .53
What are the Risk Factors? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .54
Other Factors to Consider . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .54
11. Scorecard and Predictions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .55
Scorecard of Predictions from 1997 Guide . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .55
U.S. Market as a Guide . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .57
Future Trends and Predictions for Canadian REITs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .58
Appendix 1 – Operating Cash Flow Available: REIT vs. Corporation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .59
Appendix 2 – Impact of Tax Deferred Distributions on the Adjusted Cost Base of Units . . . . . . . . . . . . . . .64
Appendix 3 - Comparison of Available Vehicles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .65
Appendix 4 - Continuous and Periodic Disclosure Requirements of a REIT . . . . . . . . . . . . . . . . . . . . . . . . . .68
Glossary of REIT and Real Estate Terms Commonly Used in Canada and the US . . . . . . . . . . . . . . . . . . . . .71
Acknowledgement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .78
8
eighth edition
The information and analysis contained in this book is not intended as a substitute for competent professional advice. The material that follows is provided solely
as a general guide and no action should be initiated without first consulting your professional advisor.
Introduction
Since 1994, when we issued our first edition of the Canadian Real Estate Investment
Trust (“REIT”) guide, there have been tremendous changes in the REIT marketplace.
REITs in Canada and the United States have ‘matured’ as an investment vehicle and
have strong institutional and unitholder support. Income trusts based on other types of
commercial enterprises have in recent years been extremely popular in the Canadian
equity markets, notwithstanding recent challenges with respect to the structures of
cross-border income trusts and the related tax considerations. Even more recently,
there has been discussion of potential limitations on investments in income trusts by
large institutions such as pension plans. Add to that the evolution of legislation with
respect to unitholder liability, and you have a very dynamic environment. The combined
Canadian base of real estate, business and royalty trusts has made the study and
understanding of all the issues and opportunities associated with such trusts even more
relevant.
Accordingly, we are pleased to provide our Canadian REIT Guide, 8th Edition, through a
second printing.
Don Newell
April 2004
For more information on REITs in Canada
or on the contents of this Guide,
please contact any member of our REIT team:
Toronto
Don Newell (Leader)
Elizabeth Abraham
Frank Baldanza
Pat Bouwers
Eddy Burello
John Cressatti
Ciro DeCiantis
416-601 6189
dnewell@deloitte.ca
416-643 8008
416-601 6214
416-601 6217
416-643 8724
416-601 6224
416-601 6237
Calgary
Trevor Nakka
Frank Rochon
403-267 1858
403-267 1716
Halifax
Claudio Russo
902-496 1812
Montreal
Manon Morin
514-393 5255
Vancouver
Garth Thurber
604-640 3110
What is a REIT?
A Real Estate Investment Trust ("REIT") is a term that originated in the United States and has since been
adopted in Canada to describe vehicles used for collective investments in real estate.
A REIT, from a Canadian perspective, is either a publicly listed closed or open-ended trust that allows
investors to purchase units of a trust that holds primarily income producing real estate assets. The larger
REITs are internally managed and will generally also have their own internal property management
operation, which helps to lower the cost of operations. The smaller REITs, in order to remain
competitive, have developed a shared management platform where the assets and strategic
management are shared, usually with the sponsor, and the property management function is either
internal or external to the REIT. All trusts whether open or closed are governed by trust indentures and
investment guidelines, which require the particular REIT to comply with requirements set out in the trust
indenture and to follow the stated investment guidelines. The trust indenture covers such matters as
payment of distributions and limitations on the REIT's borrowing capacity.
Some of the key features of a REIT are:
High yield through regular distributions - The REIT trust indenture typically contains a clause, which
requires the REIT to distribute a percentage of its distributable income (a defined term) to its unitholders.
Every REIT defines how it calculates its distributable income. The investment market demands that at a
minimum the REIT include in its trust indenture a clause that it will distribute at least its taxable income to
its unitholders and avoid the two levels of tax. It has been the policy of Canadian REITs to distribute
between 75% and 95% of distributable income to unitholders. Cash distributions have led to average
yields, as measured against the unit price of the REIT, of between 7% to 13%. The distributions of a
REIT are taxed very differently than a corporate dividend received by a shareholder of a publicly listed
company.
Capital appreciation - Although the REIT vehicle is viewed primarily as a risk adjusted yield investment,
it also has the potential for capital gain. Increases in asset values and anticipated income growth are
reflected in the unit price. REIT units currently tend to reflect a unit price equal to or greater than their
net asset values, whereas public real estate stocks generally trade at a discount to their net asset value.
Taxation - Another feature that makes a REIT attractive to Canadian investors is the favourable tax
treatment of income earned within a REIT and the fact that unitholders can partially manage their tax
affairs. The REIT's taxable income is initially determined in a similar manner to that of a corporation. So
long as the taxable income of the trust is allocated to its unitholders, the REIT will not be subject to tax.
Distributions to unitholders usually will be comprised of a capital distribution, generally equal to the
Capital Cost Allowance ("CCA") claimed by the REIT, and non-sheltered taxable income. An investor
can further defer the taxable portion of the distribution by holding the investment in his or her registered
retirement savings plan ("RRSP"). However, any withdrawal from the RRSP, including the tax-deferred
distribution, will be subject to tax.
2
Distributable Income - Most REITs define distributable income as net income as stated in the financial
statements of the REIT (could be consolidated if the REIT has subsidiaries) prepared in accordance with
Generally Accepted Accounting Principles ("GAAP"), adding back depreciation, capital losses and future
income tax expense, but excluding amortization of leasing costs, future income tax benefit and capital
gains.
Market Performance - REIT units have exhibited an interesting trend when compared to other Canadian
equities. Because they generate contractual revenues, they are able to maintain a high yield and are
therefore evaluated differently from other equity investments. When compared to REITs, the Canadian
equity markets tend to be much more susceptible to short-term economic conditions.
Focused Asset Base - The Canadian REITs generally have a strategic focus as to which types of assets
they wish to hold in their portfolio. This allows investors to focus on a specific category of properties
within the real estate industry. The Canadian REITs have investments in the following asset classes:
Office, Retail, Apartment, Nursing and Retirement Homes and Industrial. This encompasses almost all
areas of the real estate sector that generate stable income. Real estate development is the one
exception. Developments are usually carried out by corporations (private or public) because development
does not suit the REIT vehicle for the following reasons: (1) it requires a substantial outlay of capital,
which in turn absorbs a portion of the REIT's capacity to acquire productive assets or, if financed through
an equity issue, has a dilutive effect in the short-term on distributable income per unit; (2) it takes a
considerable length of time to become cash flow positive; and (3) it exposes the REIT to development
risks. Except for the larger REITs, which generally carry out re-development as part of their strategic plan
to enhance the value of their existing properties, REITs do not typically engage in development for the
above reasons.
3
1. The Origin of the REIT Vehicle
The U.S. REIT Story
REITs were initially created by the United States Congress in the 1960's as a vehicle through which
small investors could gain access to large-scale, income-producing real estate properties. However,
when REITs were originally set-up in the United States, they were merely allowed to own the properties,
with third-party companies being responsible for the operations. This divergence between the ownership
and management role did not receive the approval of the market place and REITs remained a secondtier investment.
Additionally, REITs suffered from a lack of popularity due to other tax sheltered real estate investments,
such as limited partnerships. These entities were able to pass on losses to investors, which were then
used to lower personal taxes. As REITs were unable to pass losses on to unitholders, they could not
compete with the tax-advantages of limited partnerships.
However, in 1986 Congress passed the Tax Reform Act of 1986 ('the Act'), which effectively limited the
tax shelter advantages of limited partnerships. The Act also enabled REITs to take on the management
function. This reform, coupled with a depressed real estate industry in the early 1990's, made REITs a
more attractive vehicle than private companies. It enabled them to access capital sources through the
public marketplace, with many eager investors taking part due to the depressed state of the industry and
belief in a recovery in the future.
REITs have gained the acceptance of both the corporate world and private investors. As a result the
REIT segment of the real estate industry has grown significantly with close to 200 publicly traded REITs
currently on the NAREIT Composite Index, which now boasts a market capitalization of over US$175
billion (as at May 30, 2002).
Diversification of US REIT Market by
Property Type
Self-Storage
4%
Hotels
6%
Health Care
4%
Specialty
2%
Mortgage
2%
Diversified
9%
Office/Industrial
32%
Residential
21%
Retail
20%
Source: NAREIT May 30, 2002
4
The Birth of the Canadian REIT Vehicle
Although Canadian tax legislation was not identical to that of the United States, Canada had investment
vehicles that provided similar results to those available under U.S. tax rules. The closest vehicles available
in Canada when REITs were beginning to boom in the United States were limited partnerships, open-ended
mutual funds and closed-end investment trusts. Any reference in this guide to a "mutual fund" or a "listed
closed-ended trust" assumes that the trust has at least 150 unitholders throughout the period of existence.
Furthermore, it is assumed that the trust complies with all other restrictions (e.g. type of assets owned and
income earned) that are imposed on a trust in order for it to qualify as a mutual fund trust for Canadian
income tax purposes.
Publicly listed limited partnerships have never been a significant market force in the Canadian public equity
markets. They were unappealing to investors due to legislation that classified them as foreign property for
the purposes of RRSPs and certain other deferred income arrangements. From the investors' point of view,
limited partnerships did not prove to be profitable. The huge collapse of the real estate market in the 19871997 period resulted in significant numbers of limited partners losing their entire investment.
Initially, the open-ended mutual funds showed significant growth and provided above average investment
returns. In the mid-1990s, they lost their appeal and marketability as public vehicles with the downturn of
the Canadian economy. The flaw of the structure of open-ended mutual funds was that they were obligated
to redeem their units for cash based on appraisal values. The appraisal values were not forward looking.
As the real estate market deteriorated, investors rushed to reduce their exposure to real estate.
Redemptions increased and in order to fund these redemptions the open-ended mutual funds sold their
liquid properties. However, due to the deteriorating market conditions it was difficult to sell the properties at
their net asset value (the basis for the redemption), which ultimately led to the collapse of the open-ended
structure, as the REITs were not able to redeem their units at the calculated redemption price. The openended mutual fund, with obligatory cash redemption prices based on appraisal values, does not fit well with
the long-term nature of real estate assets. One of the solutions to preserve the investor investment in the
open-ended mutual funds was to allow these REITs to be re-structured as closed-ended mutual funds.
The close-ended mutual fund was born out of the collapse of the open-ended mutual fund. These funds do
not have the obligation to redeem units, as any investor wishing to liquidate their investment must do so via
a trade on one of the Canadian Exchanges. However, to maintain their mutual fund status, the closed end
funds have to comply with many more tax regulations. Today's closed-end mutual fund trusts are the
Canadian equivalent to the U.S. REITs and, in many respects, have been made to function like a U.S. REIT.
In 2001 and in the first half of 2002, we have again seen the re-emergence of open-ended mutual fund
trusts. The new open-ended mutual fund trusts have severely limited the unitholder's ability to redeem units
so as to match depressed sales of real estate property (if any) with redemptions. The valuation of the units
is not based on an appraisal, but on the market value of the unit. (Refer to Section 3 for a more detailed
review of the differences between and open-ended and closed-ended mutual fund trusts).
The first Canadian REIT was listed on the Toronto Stock Exchange in 1993, and since then a further
eighteen REITs have been created by way of Initial Public Offerings (IPO's). The mergers of RealFund with
Riocan and of Avista with Summit, both in 1999, and the consolidation of CPL Long Term Care REIT and
Retirement Residences REIT in 2002, have reduced this number to sixteen REITs listed on the Canadian
Stock Exchanges as of June, 2002. To date, the most significant period for initial public listings of REITs in
Canada was 1997 when seven new REITs were formed. Since 1997, an additional seven new REITs,
excluding the effects of merger activity, have been listed to take advantage of the opportunities for
accelerated growth. REITs enjoyed another year of growth in 2001 and 2002 should see another three to
five new REITs being listed.
As the REIT market has moved from the "handcuffed days" of the late 1990's and has performed
responsibly by complying with the obligations set out in the declarations of trust and investment guidelines,
investors have tended to allow the REITs to operate more like traditional real estate companies by removing
or loosening many of the imposed restrictions.
5
2. Anatomy of a REIT
The Declaration of Trust and Management Structure
Canadian REITs have adopted self-imposed rules through their trust declarations to safeguard the
unitholders. The contents of the trust declaration are crucial as it defines the obligations and restrictions
adopted by the REIT. Every investor should read carefully the REIT's investment guidelines, the market
segment it intends to operate in, and the limitations that have been imposed on the REIT's operations.
Initially in the early 1990's, a REIT's declaration of trust reflected conditions imposed by a hostile market.
Trust declarations contained, amongst other things, the following:
1. Definition of Distributable Income.
2. The minimum amount of distributions (usually at least equal to the taxable income of the REIT).
3. The amount the REIT was permitted to borrow, usually a specified percentage of the Gross Assets.
4. Restrictions placed on the issue of new units.
5. The prohibition or the restriction of cross-collateralization of its assets.
6. Limiting recourse of its lenders and major service providers to the assets of the REIT.
7. The obligation to adopt an environmental policy.
8. Limiting the ability or restriction to acquire undeveloped property to a prescribed percentage of Total
Assets.
9. The ability to lend money with or without security.
10.The ability to invest funds in other REITs.
11. Make up of the board of trustees and requirements for independent trustees.
Amendments to the declaration of trust must be approved by a majority of unitholders, however the
amendments to the investment guidelines and certain specified operating policies require at least 66 2/3%
of the unitholders to approve the change. As the REIT industry has matured and the real estate
investment climate has continued to improve, unitholders have shown a willingness to accept certain
departures from the rigid standards established in the 1990's and allow the REITs to take on more
operational risks. Investors should be aware that the trust declaration can be amended, subject to certain
limitations, to allow the REIT to become more aggressive; however, any change will always be subject to
market acceptance. If the change is perceived by the market to be too aggressive the REIT's unit value
will tend to decrease to reflect the additional risk in relation to other REITs.
A REITs governance structure is similar to that of a corporation. The trustees represent the unitholders
and nearly all REITs have built into their declaration that the majority of the trustees must be independent
of management or the sponsor. The trust declaration will also require that the independent trustees be
appointed to key committees such as the audit and compensation committee. The trustees will implement
and oversee the management structure to operate the REITs on a day-to-day basis. The smaller REITs
still use a shared platform management structure rather than an internally managed structure. However,
unlike the external management agreements of the 90's, where the REIT entered into an arrangement
with a "third party" (usually related to the management of the sponsor) to execute the strategic and asset
management functions, the REIT today has first call on the time and energy of the shared management
and can terminate the shared arrangement at a relatively low cost. As a general rule, REITs that have
gross assets in excess of $600 million will be internally managed, while smaller REITs (gross assets of
$200 to $500 million) will utilize external management. The shared platform described above is designed
to lower the cost of what would be full time strategic and asset managers, and yet at the same time allow
the REIT to own and control its intellectual capital. The external management devotes part, but not all, of
its time to managing the REIT, hence the lower cost of management.
6
In the United States, most REITs have been forced to adopt the structure of internal management
because the investment community has placed a discount on external managers.
How Will Investors Receive their Returns from REITs?
A unitholder in a REIT will receive either a monthly or quarterly distribution (the majority of the REITs
make monthly distributions). The tax-deferred percentage of the distribution will depend on the
REIT's ability to claim capital cost allowance and other accelerated deductions for tax purposes.
Most REITs, at the beginning of the year, will announce their anticipated distributions and the
percentage of the distribution (assuming no acquisitions or dispositions) that will be deferred from tax.
The calculation of the tax deferred portion of the distributions only applies to operating income and
exclude capital gains that may be realized by the REIT during the year.
For Example:
Assume that a REIT with 20 million units issued and outstanding with an issue price of $10 each has
net income before depreciation for the year of $20 million. The REIT has the ability to claim a Capital
Cost Allowance of $10 million, which also equals their depreciation for accounting purposes, leaving a
taxable income of $10 million. The Trust declaration states the REIT is required to claim maximum
tax deductions, including CCA, and to distribute an amount equal to at least its taxable income or
90% of the distributable income - subject to the trustees' discretion. In this case, the trustees have
imposed no additional deductions or increases in computing the distributable income, and have
therefore distributed $18 million to its unitholders.
Therefore each unitholder will have received a distribution of $0.90 per unit of which $0.50 is subject
to tax. The remaining $0.40 (i.e. the excess of the distribution over taxable income) will reduce the
unitholder's adjusted cost base and will be deferred from taxation until such time as the units are
disposed of. (Refer to Appendix 3 [check final document for Appendix] for the implications of the taxdeferred portion of distributions on the adjusted cost base of units.)
At the end of the calendar year, the REIT will determine all its capital gains or losses and allocate
such gains or losses to the unitholders (usually based on the time each unit is held throughout the
year by a unitholder). Usually the 90% distribution, which is based on the operations of the REIT, is
often far in excess of the taxable income of the REIT (in this case, 50% [$20 million - $10 million =
$10 million]). Generally, if there are taxable capital gains, such additional taxable income usually will
not cause the REIT to make any further distributions as it has already made distributions far in
excess of its taxable income. Where there are taxable capital gains, the effect is to increase the
percentages of the income being taxed. Assume further that in addition to $20 million of net income
reported, the REIT recorded $1.2 million of taxable capital gains and $400 thousand of recaptured
CCA, increasing the taxable income by $1 million (i.e. 50% of the $1.2 million capital gain, plus the
$400,000 recapture).
Taxable Income before CCA
CCA
Taxable Income
Distribution to Unitholder
Sheltered Distribution
Non-Sheltered Distribution
Percentage of distribution
subject to tax
7
CAPITAL
GAINS
NO CAPITAL
GAINS
$21 million
$10 million
$11 million
$18 million
$7 million
$11 million
$20 million
$10 million
$10 million
$18 million
$8 million
$10 million
61.1%
55.5%
Statutory Requirements
In terms of financial disclosures and reporting rules, REITs are governed by Security Exchange
Regulations and the recommendations of the Canadian Institute of Chartered Accountants (CICA) with
most REITs also adopting the recommendations of the Canadian Institute of Public and Private Real
Estate Corporations (CIPPREC) for further guidance. REITs financial statements will generally follow a
presentation format similar to that of a real estate corporation with the major exception being the equity
section. A REIT does not have retained earnings. Movements in unitholders' equity for the current and
comparative years are disclosed in a separate Statement of Unitholders' Equity. Also, like corporations,
REITs are required to disclose in their financial statements the net income per unit on both basic and
diluted bases.
As a securities exchange registrant, a publicly traded REIT must also comply with all relevant statutory
requirements. These include compliance with:
1. Listing requirements;
2. Continuous disclosure (including quarterly financial reporting, annual reports and annual information
returns, press releases, material change reports and management's discussion and analysis); and
3. National policies and other security commission policies and regulations.
These statutory requirements impose a significant level of responsibility on the REIT's management
and also impose a cost burden, such as filing fees, printing and translation costs, professional fees
and the costs of an information system needed to comply with all these requirements. (Refer to
Appendix 4 for a table that details the typical Continuous and Periodic disclosure requirements of a
REIT.)
What Type of Property is Most Suitable for a REIT?
There are many different types of property that a REIT can hold in its portfolio and the type of property
chosen impacts the risks and returns to investors. Property types that are more susceptible to market
cycles such as Retail and Hotel properties should provide higher returns, as the stability of those returns
can be affected by short-term changes in the market. Hotels are the most susceptible to market
changes due to the short-term nature of their income stream and the impact of cyclical fluctuations on
business (e.g., consumer confidence). The impact of the percentage of occupancy and room rate, which
is directly influenced by short- term fluctuations in the economy, will be immediately reflected in the
income and cash flow of the business. This, in turn, will impact the cash available for distributions to
unitholders.
Retail properties are more stable than Hotels, but if a significant downward trend occurred in the
economy and was reflected in consumer spending, the downturn would impact on the ability of retail
tenants to maintain and meet their lease obligations. This will be further exacerbated if the rent earned
from such tenant is tied to the sales of the lessee (i.e. percentage rents). However, if consumerspending turns bullish, a Retail REIT could earn significantly higher returns than, say, fixed rental
properties.
Office and Industrial properties are less sensitive to short-term changes in the economy, largely due to
the long-term nature of their rental agreements. Tenants in these types of properties are less prone to
move to another location at expiry of their lease so long as the landlord satisfies the tenants demands
during the lease. Good management ensures lease expirations are spread out such that generally no
more than 15% of the portfolio matures in any one year. The amount of space rented to any one group
is also controlled: so should a vacancy occur because of bankruptcy or expiry, the vacant space is
unlikely to have a significant impact on the overall rental stream and therefore, will not have a material
adverse impact on distributions. This makes this class of REIT a less risky investment than a Retail or
Hotel REIT.
8
Apartment and Retirement REITs are viewed as the most stable, as they are the least sensitive to
economic cycles. The portfolio of tenants is more stable, and the percentage of space occupied by a
tenant is considerably smaller than that of a retail or office tenant. There are no anchor tenants, and a
tenant in an apartment or retirement home is unlikely to abandon leases simply due to a change in the
economy. The increased stability of this segment of the REIT sector is reflected in a higher unit price
and hence a lower distribution yield (sometimes single-digit). This class is favoured by defensive or risk
averse investors.
Some REITs believe that a diversified portfolio consisting of Retail, Office and Industrial properties
provides the investor with greater stability while at the same time offers the potential for growth. Each
REIT seeks to capture for itself a market niche and a strong following from its investors.
Significant development projects (i.e. new construction projects) have difficulty in gaining market appeal
in the REIT sector due to the lack of available cash flow for distribution to unitholders during the
development and lease-up periods. However, the appeal of these projects on a very limited basis
increases if the development is coupled with a strong underlying existing income stream (for example, in
the case of an expansion to an existing property). Most REITs have limited themselves to a relatively
minor portion of their total assets being directed to development projects.
Of the sixteen REITs in the Canadian market sector today there are five with Diversified portfolios, four
in the Apartment and Retirement sectors, four in the Hotel industry, two in the Office/Industrial sectors,
and one in the Retail sector. (Refer to pie graph below). This is in contrast to the U.S. Market, which
has a significant portion of its properties in the Industrial/Office (33.1%), Residential (21.0%) and Retail
(20.1%) markets. (Source - NAREIT).
Diversification of
The Canadian Market into Asset Type
Retail
6%
Diversified
31%
Residential
19%
CREIT, Morguard, Summit,
Cominar, IPC US
Legacy,Chip,Royal Host,InnVest
Retirement Residences
(including CPL)
O&Y, H&R
Office/
Industrial
13%
Res REIT, CAP REIT,NPR
RioCan
Retirement
6%
Hotel
25%
9
At July 30, 2002
REIT Total Returns by Property Type
120%
Diversified
100%
Hotel
Total Return (%)
80%
Office/Industrial
60%
40%
Residential
20%
Retail
0%
1997
1998
1999
2000
2001
Q1 2002
Retirement
-20%
TSE 300 Index
-40%
Source: RBC Capital Markets REIT Quarterly April 5, 2002
The REIT total returns by property type chart reflects the volatility of the types of REITs.
i. Period of measurement commences December 31, 1996 or date of initial public offering.
ii. The % return is measured by the increase or decrease of the unit price, plus distributions over the
year end price for the previous year (or the issue price of the Initial Public Offering ("IPO")).
10
3. Canadian Tax Issues for REITs and Investors
REIT Tax Issues
Basic income tax rules
In Canada, a REIT is organized as a trust, which may be either a closed end or open ended trust. To
qualify as a mutual fund trust and take advantage of the related income tax benefits, a REIT must comply
with a number of rules under the Income Tax Act, including the following:
1. The trust must be a unit trust resident in Canada.
2. The trust's only undertaking is restricted to the acquiring, holding, maintaining, improving, leasing or
managing of any real property (or interest in real property) that is capital property of the trust, and the
investing of its funds in property (other than real property or an interest in real property).
3. Generally, a class of units must be qualified for distribution to the public and there must not be fewer
than 150 unitholders of such units.
A private REIT can be established without being listed on a public exchange. However, a private REIT
does not qualify as a mutual fund trust, and therefore the units of such a REIT are not RRSP eligible.
The readers should review the actual income tax rules or obtain professional advice when assessing the
impact of the mutual fund trust rules on the establishment and management of a REIT. If a REIT should
ever fall offside of the mutual fund trust rules, the income tax consequences are severe for the REIT and
its unitholders. Refer to a comparison of open-end and closed-end mutual funds later in the section for
more details.
The Income Tax Act also provides special rules for mutual fund corporations. A REIT is usually organized
as a mutual fund trust instead of as a mutual fund corporation for a number of reasons. For example, a
mutual fund trust can distribute all of its income to its unitholders without paying income tax; generally, the
income is taxed in the hands of the unitholders. A mutual fund corporation generally is subject to income
tax on its taxable income (with some special rules for dividend income and capital gains) and the
shareholders generally are subject to income tax on the dividends from the corporation. The mutual fund
corporation, for obvious reasons, has not been favoured as a publicly listed public vehicle. A mutual fund
trust does not pay capital taxes, while a mutual fund corporation is subject to capital taxes.
A mutual fund trust cannot be established or maintained primarily for the benefit of non-resident persons;
otherwise, the trust may lose its mutual fund trust status. Usually the trust indenture of a REIT will include
a provision that non-residents cannot own more than 49% of the REIT.
A REIT cannot own real property that is inventory for income tax purposes, as it is prohibited from carrying
on business to comply with its mutual fund status. As an example, a developer in the business of building
and selling houses cannot directly use a mutual fund trust as a public vehicle.
Under certain circumstances, property can be transferred to a corporation or to a partnership on a taxdeferred basis. However, the Income Tax Act does not provide similar tax-deferral provisions for
transferring property to a trust (whether open- or closed-ended). A vendor will be subject to tax on any
capital gains and recapture of capital cost allowance realized on the transfer of property to the trust.
There may be alternative ways of deferring a vendor's income tax payable on the transfer of property to a
REIT; however, these methods are beyond the scope of this Guide and a professional tax advisor should
be consulted.
A REIT must file a T3 trust income tax return within 90 days from the end of its taxation year. Also, a
REIT generally will have to file a T3 Summary, and file and distribute T3 Supplementary slips to report
income and capital gains to unitholders. The unitholder will incorporate the T3 slips into their tax filing. A
REIT must be able to produce timely and accurate income tax information to meet its filing deadline,
which is half of the six-month period that a corporation has to file its income tax return. A trust that fails to
file and distribute the relevant information on time is liable to penalties under the Income Tax Act. A REIT
11
should also consider whether it has to file other tax forms; for example, the NR4 Summary and NR4
Supplementary slips in respect of non-resident unitholders, T3RI or T3F returns (as discussed below)
and various foreign reporting forms.
A REIT should be aware that some of its unitholders might be other trusts or partnerships that have tax
return filing deadlines that are the same as the REIT. Also, some individual investors may want to
receive their tax information slips well before April 30. In practice, a REIT will usually determine the
amount of the distributions for the year that represent taxable income and capital gains and complete the
T3 Supplementary slips well in advance of the 90-day deadline (usually between 45-60 days after its
year-end) to satisfy the needs of these investors. Failure to meet this deadline may tarnish the
administration image of the REIT.
Taxable Income and Allocation of Such Income
A REIT is subject to regular income tax on its taxable income, including taxable capital gains; however, if
all of the income and capital gains are allocated to the unitholders, (as is required by the declaration of
trust) the REIT will be able to deduct these amounts from its income to reduce its taxable income to zero.
A REIT is given the choice, like a corporation or partnership, to deduct capital cost allowance (CCA) in
respect of its depreciable property. However, the declaration of trust typically requires the REIT to claim
maximum tax deductions, including CCA, to reduce or eliminate the REIT's taxable income. However,
like individuals, a mutual fund trust is subject to CCA restrictions in respect of rental properties.
Essentially, CCA on rental property cannot create or increase a loss in respect of the net rental income
or loss of the REIT. CCA is one of the primary means by which a REIT provides tax-deferred
distributions to its unitholders.
A REIT may also deduct, over five years, the cost of issuing or selling its units. Unlike CCA, deductions
in respect of financing costs can increase the taxable loss of the REIT, which can be carried forward and
applied against future years.
If a REIT incurs a non-capital or a net capital loss for income tax purposes, the tax loss cannot be
passed to the unitholders. A non-capital loss (operating losses) can be carried forward for up to seven
taxation years and applied against future taxable income and capital gains of the REIT. A net capital loss
can be carried forward indefinitely, but can only be applied against taxable capital gains. Both types of
losses can also be carried back for up to three taxation years; however, a REIT will not typically have
any income that has been taxed in the REIT in prior years.
A mutual fund trust can receive a capital gains refund in certain circumstances. The refund is
determined by a formula that depends, in part, on the amount of redemptions during the year. A REIT
should consider the capital gains refund if it has redeemed units during the year and has (a) capital gains
for the year or (b) a balance of refundable capital gains tax on hand from the prior year.
Other Income and Capital Taxes
A REIT is not subject to Large Corporations Tax (LCT) and provincial capital taxes (if applicable) since a
mutual fund trust is not a corporation. A subsidiary of a REIT, which is a corporation, will be subject to
LCT and provincial capital taxes. A REIT is also not subject to the tax on capital of financial institutions.
While individuals, including trusts, are generally subject to alternative minimum tax, mutual fund trusts
are specifically exempt. Also, a mutual fund trust is not subject to Ontario Corporate Minimum Tax since
the trust is not a corporation.
A mutual fund trust may apply to the Canada Customs and Revenue Agency to be a registered
investment for the purposes of certain registered plans, such as registered retirement savings plans and
registered retirement income funds. A REIT that is a registered investment and holds foreign property in
excess of the 30% threshold is subject to a tax of between 0.2% and 1.0% of the cost of the foreign
property in excess of the threshold for each particular month (pursuant to Part XI of the Income Tax Act).
What constitutes foreign property for the purposes of Part XI taxes is beyond the scope of this Guide.
12
A registered investment must file a T3RI registered investment income tax return within 90 days after
the end of the taxation year.
A mutual fund trust that is not a registered investment but wants to establish that its units were not
foreign property for the year must file a T3F information return within 90 days after the end of the
taxation year.
Certain types of trusts that are registered investments are subject to a tax of 1.0% of the fair market
value at the time of the purchase of property that is not a prescribed investment for each particular
month (pursuant to Part X.2 of the Income Tax Act). However, as long as the REIT meets all of the
conditions of being a mutual fund trust, it should not have any Part X.2 taxes payable.
Certain trusts with non-resident beneficiaries are subject to a 36% tax on certain income (pursuant to
Part XII.2 of the Income Tax Act). This tax is designed to prevent non-residents from avoiding Canadian
tax by using a trust to earn income from a business carried on in Canada or to realize capital gains from
the disposition of taxable Canadian property. As long as a REIT is a mutual fund trust, it is not subject
to Part XII.2 tax.
A REIT that has one or more non-resident unitholders must withhold and remit non-resident income tax
under Part XIII of the Income Tax Act on the taxable income, other than capital gains of the non-resident
holders. To accomplish this, the REIT provides to the transfer agent the estimated taxable income and
the percentage of distribution by the trust to the non-resident(s) that will be subject to tax, other than
designated capital gains. Based on this amount, generally 25% is withheld from the taxable portion of
the distributions; however, the withholding tax percentage rate of 25% can normally be reduced where
an income tax treaty between Canada and the country in which the unitholder resides is in existence.
For example, the Canada-U.S. income tax treaty generally limits the withholding tax rate to 15% for
income distributed from a trust in Canada to a beneficiary of the trust who is a resident of the United
States.
Miscellaneous Items
When a REIT is created, it may not immediately qualify as a mutual fund trust because some of the
conditions described above are not met. If certain conditions are met within 90 days of its first taxation
year-end, a REIT can elect to be a mutual fund trust from the beginning of that first taxation year.
The Income Tax Act contains provisions that permit, under certain conditions, a tax-deferred rollover of
property on a qualifying exchange from (1) a mutual fund corporation, or (2) a mutual fund trust, to
another mutual fund trust. A discussion of these rules is beyond the scope of this Guide. Two or more
REITs may be able to merge in a tax-efficient manner under these rules. An example of the application
of these provisions was RioCan REIT's merger with RealFund REIT, and Summit REIT's merger with
Avista REIT.
In general, an inter-vivos trust must have a taxation year that ends on December 31. However, a
mutual fund trust may elect to have a December 15 year-end instead for tax purposes. A REIT may
choose this earlier year-end for administrative or other reasons. Before a REIT decides to choose a
December 15 tax year-end, it should review the other tax rules related to this election. For example, if a
REIT is a limited partner of a limited partnership that has a December 31, 2001 fiscal year-end, the
income from that partnership for the December 31, 2001 fiscal year must be included in the REIT's
income for the December 15, 2001 tax year.
13
Prior to 2001, it was unclear whether a REIT could become a limited partner in a limited partnership.
The concern was that the REIT, as a limited partner, could be considered to be carrying on the business
of the partnership. If this was true, this could put a REIT offside of the mutual fund trust rules and
therefore result in the loss of its mutual fund status. The change to the Income Tax Act in 2001 clarified
the position and allowed a REIT to be a limited partner of a limited partnership. The new rule deems a
mutual fund trust that is a limited partner in a limited partnership to undertake an investment of its funds
in the partnership and not to carry on any business of the partnership. A REIT should remember that an
investment in a limited partnership might represent an investment in foreign property for the purposes of
the foreign property rules for certain registered plans.
A REIT may issue its units, or options on its units, to employees of the REIT. Generally, an employee will
be deemed to have received a taxable employment benefit equal to the value of the REIT units when the
units are acquired, less (a) the amount paid by the employee for the units plus (b) the amount paid by
the employee for any option to acquire the units. Under certain circumstances, the employee may be
able to claim a tax deduction equal to one-half of the above taxable benefit. REITs and employees
should carefully review the various tax rules pertaining to the acquisition of REIT units and options by
employees.
A trust is generally subject to the 21-year deemed realization rules. These rules essentially require a
trust to realize its accrued capital gains on most capital property every 21 years; otherwise, a trust could
theoretically hold property with accrued capital gains and defer income tax forever. A mutual fund trust is
not subject to these rules.
A financial institution is subject to special income tax rules, including determining its taxable gains and
losses on certain debt and shares annually, i.e. the securities are valued on a mark-to-market basis. A
REIT is specifically exempt from these rules since a financial institution is defined to exclude a mutual
fund trust.
A mutual fund trust may make an election with respect to treating all Canadian securities, as defined in
the tax law, as capital property. A REIT may want to consider making such an election to ensure the
dispositions of its Canadian securities are taxed on account of capital rather than income.
Under Canadian generally accepted accounting principles, an enterprise generally accounts for current
and future income taxes in its financial statements. A future income tax liability may arise, for example,
when the undepreciated capital cost of its depreciable property (such as a building) for tax purposes is
less than its net book value for accounting purposes due to capital cost allowance claimed in excess of
depreciation. However, a REIT may not have to account for future income taxes in its financial
statements if it meets the conditions set out by the Emerging Issues Committee of the Canadian Institute
of Chartered Accountants ("EIC-108".) A REIT meeting the criteria of EIC-108 does not account for
future income tax as it applies to assets held by the REIT or its subsidiary partnerships. However, most
REITs disclose the temporary difference between the book value and tax basis of their assets and
liabilities by way of a note to their financial statements. This exemption does not apply where the REIT
carries on certain activities by way of a subsidiary corporation. In this case, the corporation is required
to account for its future income taxes; therefore, on consolidation, the future income tax liability (or asset)
will be disclosed in the REIT's consolidated financial statements.
14
Investor Tax Issues
Basic Income Tax Rules
A REIT unitholder usually receives a distribution from a REIT on a monthly or quarterly basis. The
distribution from the REIT represents income, capital gains or a return of capital, or some combination
thereof. The REIT investor is subject to income tax on the income and capital gains components of the
distribution unless an exempt holder, such as an RRSP, holds the REIT units. The taxable income
allocated to the unitholder reduces the taxable income of the REIT.
Distributions received from a REIT are different than dividends received from a corporation. Generally,
an individual is subject to income tax on 5/4 of a taxable dividend received from a Canadian corporation
and the individual will be entitled to a dividend tax credit, which overall reduces the effective tax rate on
the dividend.
Other than a few specific exceptions, the income from a REIT does not retain the character of income
that was generated within the REIT.
The income from a REIT is generally characterized as other income from trust property for income tax
purposes. For example, if a REIT's taxable income is $11 million, of which $10 million is derived from
rental income and $1 million is interest income, a 0.1% investor, for tax purposes, does not receive an
allocation of $10,000 of rental income and $1,000 of interest income on the T3 supplementary form.
Instead, that investor would simply receive $11,000 of income classified as other income.
Rental income is generally included in the definition of earned income for RRSP purposes, but the rental
income earned by a REIT is not rental income in the hands of the unitholder. Therefore, taxable income
received by an individual REIT holder does not qualify as "earned income" for the purpose of calculating
the investor's RRSP contribution limit for the following year.
Fortunately, the Income Tax Act does contain rules that permit a REIT to designate certain types of
income to essentially retain its character upon distribution to the unitholder. For example, a REIT may
designate a taxable capital gain distributed to the unitholders to be a taxable capital gain to such
unitholders. As a result, an investor will pay income tax on only one-half of the share of the capital gain
realized and distributed by the REIT. A REIT may also designate a dividend received from a taxable
Canadian corporation and distributed to the unitholders to be a dividend received by the unitholder. An
individual investor could then benefit from the dividend tax credit.
Provided the REIT has allocated its taxable income to its unitholders, each investor in the REIT will
receive a T3 Supplementary slip either directly from the REIT or indirectly through the brokerage house
with whom the units are held on behalf of the investor. The unitholder will then be able to determine
what portion of the distributions represents capital gains, dividends from Canadian corporations (usually
flowing from the REIT's corporate subsidiaries) and other income. These amounts are then reported on
the investor's personal income tax return.
The return of capital distributed by the REIT, i.e. the amount of the distribution paid by the REIT in
excess of the taxable income (which includes, if applicable, capital gains), is generally not taxable
immediately to the unitholder. However, the unitholder's adjusted cost base (ACB) of the units will be
reduced by such amount, as discussed below. A return of capital distribution is attractive to the
unitholder as it essentially represents tax-deferred cash flow from the REIT.
15
Generally, the units of a REIT represent capital property to the unitholder. As a result, a REIT investor
may realize a capital gain or capital loss on the disposition of the REIT units. A capital gain will arise
when the proceeds of disposition from the units sold exceed the adjusted cost base of the units plus any
selling costs. Conversely, a capital loss arises when the proceeds of disposition are less than the
adjusted cost base plus selling costs. For income tax purposes, a taxable capital gain is equal to onehalf of a capital gain, while an allowable capital loss is equal to one-half of a capital loss. The Income
Tax Act contains a number of restrictions in the utilization of capital losses; for example, capital losses
can only be applied to reduce capital gains in the current year, or by carrying back net capital losses
three years or forward for an indefinite period. The capital losses may also be deferred by the superficial
loss rules.
The adjusted cost base of a REIT investor's units is initially the cost of purchasing a particular REIT's
units plus any additional acquisitions of the same REIT's units less capital distributions and dispositions
of the same REIT's units. The adjusted cost base of the units will decrease by the amount, if any, by
which the distributions received from the REIT exceed the taxable income and capital gains allocated by
the REIT to the unitholder. As illustrated in Appendix 2, a REIT investor's adjusted cost base will
generally decrease over time as capital is returned to the unitholder.
The adjusted cost base calculation is required when a REIT unitholder decides to sell (or dispose) of all
or portion of his or her units. The holder has to calculate and maintain a separate adjusted cost base for
units of each particular REIT held. As most REITs do not track the individual adjusted cost base, each
unitholder must keep account of his or her adjusted cost base. To eliminate the need to calculate the
capital distributions from the date of acquisition, the unitholder should calculate annually the adjusted
cost base of their unitholdings. The adjusted cost base of the units is averaged against all units held in a
particular REIT. Also, if the adjusted cost base should become negative, the unitholder is deemed to
have realized a capital gain equal to the absolute value of the negative amount. For example, if a
unitholder's adjusted cost base of a particular holding of REIT units is $300 and the REIT distributes
$1,000 to the unitholder, of which $600 is taxable income, the adjusted cost base will become negative
$100 ($300 prior adjusted cost base - [$1,000 distribution - $600 other income]). The unitholder will
immediately realize a capital gain of $100 and is required to report, at the year-end, a capital gain of
$100. The adjusted cost base of the units would then be adjusted from negative $100 to zero.
A capital gain realized on the sale of REIT units to a qualified donee, such as a registered charity, would
attract a more favourable tax rate; that is, the gain is only one-quarter taxable to the unitholder (rather
than the normal one-half inclusion rate for capital gains).
Parents may be interested to know that the income from a mutual fund trust is not subject to the "kiddie
tax" rules. Therefore, a child who receives income from a REIT may not be subject to the highest
marginal tax rate on such income. Of course, the attribution rules must be considered and respected,
which could make the child's REIT income taxable in the parent's hands.
The purchase and sale of REIT units is not subject to various forms of provincial land transfer taxes.
16
Deferred Income Arrangements
A mutual fund trust unit is a qualified investment for (a) registered retirement savings plans ("RRSPs");
(b) registered education savings plans ("RESPs"), (c) registered retirement income funds ("RRIFs") and
(d) deferred profit sharing plans ("DPSPs"). Such plans can defer the income tax otherwise payable on
the taxable income and capital gains distributed by a REIT.
RRSPs, RRIFs, DPSPs and certain other taxpayers are subject to a 1.0% per month tax under Part XI of
the Income Tax Act in respect of holding foreign property in excess of the 30% threshold. Generally, the
units of a REIT will not be foreign property if the REIT is a mutual fund trust that (1) has not acquired any
foreign property or (2) did not have foreign property the cost of which exceeded 30% of the cost of all of
the REIT's property determined on a non-consolidated basis. If a REIT is a registered investment (as
discussed above), then its units will not be foreign property.
Corporate Unitholders
A Canadian-controlled private corporation that is a REIT unitholder will have to consider the refundable
dividend tax rules in respect of investment income and taxable capital gains from the REIT. The federal
income tax rate on such income is approximately 35.79%, which includes the additional 62/3% tax. The
corporation may receive a refund of 262/3% of the federal tax through the payment of taxable dividends
at the ratio of $1 dividend refund for each $3 of taxable dividends. The taxable dividend in turn will be
subject to tax in the hands of the individual recipient.
Recent amendments to the Income Tax Act now permit a Canadian private corporation to include in the
corporation's capital dividend account the non-taxable portion of a capital gain distributed from a trust.
Previously, there was no such mechanism within the tax law and a private corporation and its
shareholders were essentially subject to additional taxation. To illustrate the new rule, let's say a private
corporation is allocated, from a REIT, capital gains of $2,000. One-half of the capital gains, or $1,000,
will be taxable in the hands of the corporation. The non-taxable half of the capital gain, or the other
$1,000, will be added to the corporation's capital dividend account. Generally, on payment of a capital
dividend, a shareholder can receive a capital dividend from a Canadian private corporation tax-free. The
income tax "integration" has improved thanks to the change in the tax law.
A corporate investor in a REIT should be aware that the investment in a REIT is not an eligible
investment for the investment allowances provided in the LCT and provincial capital tax regimes. This
compares unfavourably to the investment in shares of corporations, which are generally eligible
investments. Also, Ontario has certain look-through rules in respect of an interest in a trust; a
corporation subject to Ontario capital tax has to include its share of the taxable capital of the trust in its
capital tax calculation.
17
Non-Resident Unitholders
As previously discussed, a non-resident that receives income from a trust is generally subject to Part XIII
of the Income Tax Act (non-resident withholding tax) at the rate of 25%, or usually less if the non-resident
resides in a country that has a tax treaty with Canada. It is interesting to note that the allocation of
capital gains designated by a trust to a non-resident is not subject to Part XIII tax. Real property in
Canada is taxable Canadian property and non-residents are generally subject to Canadian tax on the
disposition thereof. The non-taxable allocation of capital gains to non-residents from a REIT is unusual,
since Canada usually protects its right to tax non-residents on income and capital gains realized in
respect of real property in Canada. As mentioned above, a mutual fund trust cannot be established or
maintained primarily for the benefit of non-residents; therefore, the tax benefit to non-residents is
somewhat limited.
Canada imposes a further rule to tax significant non-resident unitholders of a REIT on capital gains
arising from the disposition of taxable Canadian property. A unit of a mutual fund trust is considered to
be taxable Canadian property if, at any time during the preceding five years, 25% or more of the issued
units of the trust belonged to the taxpayer, to persons not dealing at arm's-length with the taxpayer, or
any combination thereof. Otherwise, the units of a mutual fund trust are not considered to be taxable
Canadian property.
If the REIT units of a non-resident are considered to be taxable Canadian property, the disposition of one
or more units by the non-resident that results in a capital gain will be taxable in Canada. The nonresident will have to file a federal tax return (and possibly a provincial tax return), report the capital gain
and pay the applicable income tax. The non-resident should consider whether there is any relief from
Canadian tax on the gain under a tax treaty; given that a REIT will usually hold a large portion of its
assets in Canadian real estate, relief under a treaty may not be available. The non-resident seller
(vendor) of a REIT unit does not need to obtain a pre-clearance certificate under section 116 of the
Income Tax Act since a unit of a mutual fund trust is excluded property. Therefore, the non-resident
vendor and purchaser do not have to be concerned with section 116 of the Income Tax Act. The section
is designed to force the non-resident to obtain a clearance certificate, prior to the sale of the taxable
Canadian property. The non-resident will calculate the gain or loss on the disposition and, if applicable,
pay to Canada Customs and Revenue Agency a withholding tax on the capital gains.
The non-resident will have to determine the income tax consequences, in the country in which the
investor resides, of making an investment in Canada, and whether or not any relief for Canadian income
taxes paid is available in that country.
18
Comparison of Open-Ended and Closed-Ended Mutual Funds
The open-ended mutual fund trust was the birth vehicle of the modern day REIT, however it proved to
be incorrectly structured and therefore the wrong vehicle of choice during the downturn in the economy
in the late eighties and early nineties. The reason for the demise of open-ended mutual fund trusts was
the requirement of the trust to redeem the units for cash at the demand of the unitholder. This
redemption structure did not fit well with the relative illiquidity of real estate assets. With redemptions
being greater than unit sales during the fall of the real estate market, a major cash crunch caused the
REITs to sell off their real estate assets, usually at a discount, to fund the redemptions, which were paid
out on the bases of appraised values of the underlying assets. One of the underlying assumptions of
the appraised value approach was that the REIT would continue as a going concern and would not be
forced to sell off real estate assets at a discount to redeem units.
The closed end mutual funds that arose from the ashes of these open-ended structures alleviated this
problem by eliminating the redemptions requirement. Unitholders were restricted to selling their units
through stock market exchanges and were unable to redeem their units through the trust. We have
recently seen the open-ended mutual fund trust re-emerge with an adjusted structure as it applies to the
redemption obligation and sale of units. This has been achieved by essentially restricting the amount of
redemptions and limiting the cash component of the redemption amount. Also, unitholders must first
seek to sell their units through the stock market exchanges and, failing that, can request the REIT to
redeem their units under certain conditions.
The cash flow requirements associated with redemption under the adjusted open-ended structure are
minimized via two main clauses in the trust indenture. The first is the ceiling placed on the number of
unit redemptions allowed during a specified time period. This results in a limited cash requirement for
redemptions during the specified time period. The other clause that can be added allows for the
redemption amount to be honoured via an interest bearing note payable issued by the REIT in lieu of
cash. This essentially converts excess redemptions in a period into debt. The combined effect of these
two clauses considerably reduces the redemption risk associated with the original open-ended mutual
fund trust structure. The redemption structure and the ability to hold foreign property are the most
significant differences between the open-ended and closed-end mutual fund trusts. This structure also
allows for increased investment in foreign property relative to the closed ended mutual fund trust, while
maintaining the requirements under tax law to qualify as a mutual fund trust.
A mutual fund trust must be, amongst other things, a unit trust resident in Canada. A unit trust must be
an inter vivos trust and the beneficial interests in the trust must be described by reference to units of the
trust.
19
From a tax perspective, mutual fund trusts are commonly referred to as "open-ended" or "closed-ended"
based on the two types of unit trusts available under the Canadian income tax act.
Both types of mutual fund trusts must comply with specific tax rules to maintain their tax status as a
mutual fund.
A closed-end unit trust must meet a number of conditions under the Income Tax Act, including the
following:
1. The trust must be resident in Canada.
2. The trust's only undertaking is restricted to the acquiring, holding, maintaining, improving, leasing or
managing of any real property or an interest in real property that is capital property of the trust, and
the investing of its funds in property (other than real property or an interest in real property).
3. At least 80% of the trust's property must be real property and interests in real property situated in
Canada, and other qualifying property, including cash, shares, bonds, debentures and mortgages.
4. Not less than 95% of the trust's income must be derived from, or from the disposition of, investments
described in the above point number 3.
5. Not more than 10% of the trust's property may consist of bonds, securities or shares of any one
corporation or debtor (except for issuances by certain governments in Canada).An open-end unit
trust, which must also be resident in Canada, has fewer requirements under the Income Tax Act to
comply with in order to maintain its status as a mutual fund and they include the following:
1. The issued units of the trust must include units having conditions that essentially
require the trust to redeem the units at the demand of the unitholder, i.e. the units are
retractable.
2. The fair market value of the units described above must be 95% or more of the fair
market value of all of the issued units of the trust (without regard to voting rights
attaching to units of the trust).
The reader should review the actual income tax rules or obtain professional advice when assessing the
impact of the mutual fund trust and unit trust rules on the establishment and management of a REIT. If a
REIT should ever fall offside of the mutual fund trust and unit trust rules, the income tax consequences
could be severe to the REIT and its unitholders.
While the open-ended unit trust conditions are fewer in number, if market conditions change, it may be
more difficult for a new REIT to adopt the restrictive redemption requirements. Since a REIT will usually
hold a large portion of its assets in rental real estate, it may be difficult for a REIT to have the retraction
requirements when its assets are relatively illiquid. Historically, most REITs have opted to meet the
conditions of the closed-end unit trust rules, which do not contain any mandatory retraction requirements.
The downside with closed-end unit trusts is the number and type of restrictions; open-ended unit trusts
provide much more flexibility in terms of the type and amount of investments.
20
4. The REIT Vehicle in the Canadian Marketplace
History of Capital Flows into the Canadian Real Estate Industry
from 1970 to the Present
1970's
The 1970's saw a boom in the Canadian real estate market, due primarily to an influx of European
money caused by the political threat of Russian advancement and a decrease in investment risk, both
of which resulted in increased development. Companies such as TrizecHahn, Cadillac Fairview and
Cambridge Shopping Centres were formed to meet the increased development demand. In order to
access the pools of money, development took place in the form of joint ventures and syndications.
1980's
The 1980's saw the peak of syndication, coupled with exploding capital growth tied to real property.
As real estate investor confidence grew, there was a major increase in the extent of leverage used to
finance real estate activity. The increased leverage brought increased risk, which eventually caused
the banks to start calling their loans.
Real estate investors incurred large losses since the syndication agreements failed to include a "cash
umbrella'; therefore, they were unable to pay off their loans, resulting in banks and lending institutions
becoming large holders of real estate as they foreclosed on their loans. In the U.S., REITs begin to
emerge as an investment vehicle.
1990's
The large losses incurred in the 1980's caused real estate investors to shift their focus in evaluating
real estate. Investors returned to 1960 ideals of evaluating real estate based on cash flows and not as
speculative investments. Real estate was no longer able to provide investors with high returns and
money began to flow out of the sector into "new economy" (i.e. high tech companies) that were able
to provide investors with the desired rates of return.
With the collapse of the limited partnership syndicated market and the open-ended mutual fund trusts,
the closed-end mutual fund trust emerged in Canada.
2000's
The growth in the new economy has slowed and is adjusting to more sustainable levels. Inflation in
the North American economy has fallen below 2%. Interest rates have decreased in line with the
downturn in the economy, and many organizations with variable mortgage rates have benefited, as
their cost of capital has declined. As a result the risk adjusted yields of REITs have become very
attractive in comparison to a bond in the low interest rate markets of 2001. REITs now represent one
third of the TSE real estate market capitalization and have clearly become the dominant vehicle for
accessing public real estate equity; all but one of the 20 real estate equity issues in 2001 were REIT
transactions.
The Canadian real estate industry is in need of a recapitalization and REITs are one of the vehicles
that could provide the necessary new capital and liquidity. A REIT is simply a form of securitization for
real estate, an area in which Canada lags behind the United States, even though the U.S. has only 23% of its real estate market securitized. This is very low when compared to the United Kingdom
(40%) or Singapore and Hong Kong (80%). Given the capital requirements of real estate,
securitization is expected to be prevalent worldwide.
21
REITs Provide a Vehicle for Buying Real Estate
The public real estate market rebounded from its 5-year slump in the early 90's. From 1996 onwards
there has been a significant increase in the market capitalization of the public real estate sector. The
Canadian REITs created in 1997 were perceived as high yield investment funds (real estate values were
at a low enough level to provide good returns). In addition, funds flowed through the older REITs raising
equity by way of convertible debentures. The challenge for the REITs going forward will be to continue
to source accretive properties if the interest rate climate reverses, without a decrease in the yield rate on
REIT's unit. To date, because of the increase in the unit value and reduced yields coupled with the
favourable interest rate climate, REITs have been able to acquire accretive properties.
The real estate industry sees the REIT, as a stand-alone sector, and not part of the income trust sector.
In reality however, the broader market views REITs as a sub-section of the income trust group. The
challenge for the REIT sector is to change the perception of the investing public. The REIT sector has to
clearly educate and demonstrate to investors that it is a different business. The risks and rewards of
REIT ownership are different and, equally important so too are the corporate governance requirements.
A REIT is not only a yield vehicle but also offers many attributes that the income trusts generally do not
offer, such as stability where the underlying assets and related financing are of a long-term nature. As
most REITs are able to effectively pass through the CCA claim, they are able to defer the tax on a certain
percentage of the distributions. The REIT tenant base is usually spread over many tenants thereby
limiting exposure to concentration risk. The large REITs are owners of multiple geographically diverse
properties. Generally, investors have not been educated in assessing the risks and rewards of the
various subsets of the income trust group. Refer to Section 6 for a comparison of the REIT vehicle as
compared to other income trusts.
22
5. Challenges of Converting to a REIT
Transaction Costs
The formation and capitalization of a REIT is typically a long, complicated and expensive process.
The time between the initial thought process and completion of the initial public offering ("IPO") is
usually six months or more. Costs to be incurred in the formation of a REIT include:
• Underwriters' fees (often 5% to 6% of the total dollar value of the public offering);
• Legal fees for counsel to the newly formed REIT (usually in the $600,000 to $1.2 million range,
depending on the size and complexity of the issue);
• Legal fees for the underwriters' counsel ($250,000 to $600,000, again depending on the size and
complexity of the issue);
• Audit fees ($350,000 to $800,000, depending on the amount of attest work required, the condition
of the books and the availability of audited records);
• Accountants and/or legal fees for tax advisory services (depends largely on the complexity of the
transaction);
• Appraisals, Phase I environmental reports and engineering reports ($200,000 to $300,000); and
• Printing and translation cost ($200,000 to $300,000).
A rule of thumb for estimating total transaction costs is 7% to 8% of the total issue.
Other than the underwriters' fees, these costs are largely incurred prior to the closing of the initial
public offering. This means that a sponsoring entity (i.e. the company or persons promoting and
organizing the REIT) takes significant risks prior to knowing whether the public offering will be
successful. A change in economic or market conditions (e.g. interest rate movements), or an
unanticipated event (such as a terrorist attack, or not being able to close on a part of the portfolio),
can leave a sponsoring entity with a significant bill for professional fees, with nothing to show for it.
This does not include the human cost of the strain placed on the organization over the six or more
months to the IPO date.
Because of this, the sponsor of the REIT should be prepared on two fronts:
1. The sponsor must thoroughly evaluate the feasibility of the REIT that is being proposed, and obtain
the appropriate professional advice, including the reactions of the relevant investment bankers,
before proceeding in a significant manner. Some of the specific matters that need to be addressed
are set out below.
2. The sponsor must be prepared to accept the risk of having to absorb the up-front costs should the
transaction be unsuccessful and fall through; the organization should not only have the financial
capacity but also the human capacity to absorb the above-noted costs.
Matters to Consider BEFORE Proceeding with a REIT Transaction
The following matters should be addressed as early as possible in the process, and in a reasonable
amount of detail, through consultations with the lead underwriter, securities lawyers, auditors, tax
advisors and others. While it is impossible to predict all outcomes, and there will invariably be late
changes in the structuring of a REIT transaction or shifts in market conditions, significant up-front
planning can greatly improve the chances of a positive outcome and at the same reduce, or at least
control, the outsourced services costs.
Extent of Involvement of the Sponsor in the Ongoing Operation
of the REIT
The extent to which the sponsoring entity (often a public or private real estate corporation) wishes to
remain involved in the ongoing operations of the REIT will drive many of the other decisions. The
sponsor may remain involved in a number of ways:
23
1. Providing asset and strategic management and advisory services to the REIT at the REIT level.
2. Providing property management services.
3. Retaining a significant ownership interest.
4. By entering into a development relationship with the REIT whereby the REIT will acquire properties
being developed or redeveloped by the sponsor; typically, the REIT will also provide mezzanine
financing on the development projects.
The advantages of continued involvement include:
1. The REIT having access to competent and experienced management, before it has acquired the critical
mass to hire its own management.
2. The positive market perception when the sponsor retains a significant stake in the ongoing success of
the REIT.
3. The potential "symbiotic" relationship between a corporation that manages and develops properties, and
an investment vehicle that holds the mature property portfolio.
The challenges to the sponsor in maintaining involvement include:
1. Ensuring that potential investor concerns over conflicts of interest are addressed, especially where the
sponsor retains a controlling interest. Appropriate governance practices need to be in place, often in the
form of independent trustees, to address these concerns.
2. The effect on the sponsor's financial statements - The sponsor may or may not want to consolidate or
equity account for the REIT. Consolidation and/or equity accounting is likely to result in limitations on
the amount of profit that can be recognized on intercompany transactions. For example, the sale of
development properties by a sponsor to a REIT that is consolidated by the sponsor will result in deferred
or delayed gain recognition by the sponsor.
3. The potential strain on the sponsor's management resources - The additional burden caused by having
a second entity being managed out of one office can be significant.
In most cases, a REIT will retain a relationship of some sort with its sponsoring entity, at least at the outset.
In each case, the implications of this ongoing relationship need to be considered carefully from a number of
fronts:
1. Tax implications - The tax implications include the complexities of structuring the REIT and related
entities and the maintenance of the trust as a tax-efficient flow-through entity.
2. Accounting and Reporting - The sponsor should review the accounting and reporting implications of
continued involvement on its own financial statements, especially where it retains control or significant
influence over the REIT.
3. Availability of Management Resources - Again, the sponsor needs to ensure that its existing
management has the capacity to manage a second entity, which also happens to be a public entity.
4. Marketability of the REIT IPO - Market perception of the ongoing relationship needs to be carefully
considered.
Making the Economic Case for the REIT
This is usually done through consultations with investment bankers, tax and other professional advisors,
preferably ones that have been involved in numerous REIT transactions.
The following micro-economic factors should be considered in making this assessment:
1.
Return on assets - The sponsor should obtain or prepare a projection of the property operating results
for at least the next three to five years. This can be done in conjunction with obtaining independent
appraisals of the properties.
2.
Appraisal - A reputable independent appraisal firm should be involved as early as possible, to assist in
the valuation of the properties to be acquired by the REIT, usually from a related party. The
independent appraiser usually gives a market range, with a premium being assigned to the portfolio
assembly. This appraisal data and its verification usually assists the sponsor in preparing a projection
of the property operating results.
24
3.
Environmental Assessment - A Phase I study should be conducted on each property where such
Phase I reports are older than one year, to ensure that the portfolio is free of environmental risks.
4.
Quality of the Assets - The properties being transferred should be mature, well performing
properties, which do not require significant redevelopment. Because a REIT pays out much of its
income to its investors, significant property redevelopment is not something that should be carried
out in a REIT vehicle.
5.
Stability of the Cash Flows - In the case of office and industrial properties, this will largely be
determined by lease rollovers. Properties that have significant potential lease rollovers or
contractual decreases in rents will require special attention when structuring the transaction. It may
be that the sponsor will have to provide certain guarantees or "head leases" in order to make the
property stable enough to be attractive to investors.
6.
Diversification of the Portfolio - The more concentrated the portfolio is in one geographic location,
the more risky the investment is from an investor's point of view, and therefore, the investor should
demand a higher return, which, in turn, will reduce the market value of the portfolio.
7. Degree of Financial Leverage - The higher the financial leverage, the higher the potential return to
the investor, but this also serves to increase risk. REITs are usually conservatively leveraged,
especially if the portfolio includes properties that do not have contractual rents (e.g. hotels) or
properties in less stable markets.
8.
Debt Mix - REITs tend to favour fixed rate mortgages, to increase the stability of the cash flows.
9.
Tax on the Transfer of the Assets to the REIT - Because a tax-free rollover is not available on the
transfer of property directly to a REIT, tax on recaptured depreciation and capital gains is likely to be
incurred by the transferor. Although there are tax-planning strategies that can be used to minimize
these taxes, tax on the transfer of the assets could make a REIT transaction cost-prohibitive.
10. Other Taxes and Costs on the Transaction - Early in the process, management should consult its
professional advisors to identify opportunities for minimizing other costs such as land transfer tax
and GST.
11. Distributable Income and Distributions - Management must adopt a definition of distributable
income that will allow the REIT to operate within its normalized cash flow from operations and yet
remain competitive in the market, after taking into account its anticipated cash distributions to its
unitholders. Distributions are usually defined as a specified percentage of the distributable income.
12. Tax Consequences to the Eventual REIT Unitholders - A significant selling feature of a REIT unit
is the extent to which distributions will be paid on a tax-deferred basis. It is important that the
sponsor determine how much capital cost allowance and other deductions will be available to the
REIT to provide such tax-sheltered distributions to unitholders.
13. Critical Mass - The gross asset base of a proposed REIT must be large enough such that the
anticipated public float justifies the issue costs and the ongoing operating costs.
The following macro-economic factors should be considered:
1.
Overall condition of the Capital Markets - A new issue will obviously fare better when market
conditions are favourable.
2.
Appetite for Yield-Producing Investments - Throughout calendar 2001 and early 2002, there was
significant appetite for stable, yield producing investments due to the dot-com meltdown. However,
a sudden change in demand can greatly impact the offering price, to the point where the transaction
may no longer make economic sense to the sponsor.
3.
Prevailing Interest Rates - A low interest rate environment is usually positive for a REIT, as the
REIT is able to earn additional income through the spread between the yield on its properties and
the interest cost on its borrowing. When bond yields are low, investors look for higher-yield
vehicles, making REIT units an attractive alternative. Also, debt maturities of high interest rate
loans in a low interest rate environment present opportunities for increases in yield on the REITs
properties.
25
Structuring the REIT vehicle
The following are among the items that should be considered when structuring the REIT's Management
and Board of Trustee composition.
1.
Management of the REIT - REITs are either internally managed (i.e. they have their own officers
and management) or externally managed, usually by the sponsor entity. Internal management
(strategic and asset management) is now being demanded by the markets for the larger REITs that
have the requisite critical mass. More recently, where the REIT is externally managed, there has
been a move to a shared management platform with the sponsoring entity. The REIT, in these
circumstances, has first call on the time of the shared management resources. Certain conflicts
need to be addressed, such as whether the REIT will compensate the sponsor on a flat-fee basis or
on a cost-reimbursement basis. The method of compensation will have potential GST, income tax,
and accounting and reporting implications, and should be addressed in advance.
2.
Management of the Properties - Again, REITs that have attained a certain critical mass of
properties may find it more economical to internally manage their properties. Often, however, it
makes sense for external property managers to be hired, especially where the property managers
have history with the property being transferred, and the properties are geographically widespread.
3.
Composition of the Board of Trustees - This will depend somewhat on the degree of continuing
involvement that the sponsor wishes to have. In most cases, the more independent trustees there
are, the more investors are likely to feel like their interests will be protected, especially where the
sponsor retains control or significant influence.
4.
Governance - Good governance is essential for the continuing success of the REIT, as the market
places a premium on this attribute. The market needs to be made aware of the REIT's commitment
towards a strong corporate governance mandate.
5.
Degree of Continuing Involvement of the Sponsoring Entity - See the previous discussion on
this topic.
Accounting and Reporting Issues
Applicable accounting recommendations and securities commission reporting rules will significantly
impact how a REIT transaction and IPO are reported to investors. Financial, accounting and income tax
matters that should be considered prior to formation of the REIT are:
1. Does the transaction qualify for fair value accounting (both from the REIT and the sponsor's point of
view)?
2. How will the sponsoring entity report its investment in the REIT units (consolidation, joint venture,
equity or cost method)?
3. Are there any restrictions on the amount of gain or loss that the sponsoring entity can recognize on
the transfer to the REIT?
4. How will any financial instruments exchanged in the transaction be accounted for (e.g. convertible
debentures, secured debt)?
5. What reporting will be required in the future for related party transactions (i.e. between REIT and
sponsor)?
6. Accounting for current and future income taxes on the transaction.
7. Impact on the carrying values of other assets and liabilities on the balance sheet of the sponsor (e.g.
deferred financing costs, intangible assets, etc.).
26
Legal and Administrative Considerations
Legal and administrative considerations include:
Long Form Prospectus
Applicable securities legislation in most provinces will require a long form prospectus, which includes a
preliminary prospectus to be filed in advance of marketing the IPO, and a final prospectus when pricing
has been agreed upon and the securities commissions and stock exchanges have given their approval
on the prospectus documents. A long form prospectus for a REIT IPO usually includes, at a minimum:
Significant detail around the structure of the transaction, properties to be transferred, management of
the REIT and risk factors;
• Historical financial information for the properties to be acquired, which includes balance sheets for
the last two years and income statement and cash flow statement for the last three years;
• An auditors' report on the historical financial information (Note - this requirement should be
addressed early in the process in case the historical information has not previously been audited);
• Full management discussion and analysis on the historical financial statements;
• A pro-forma balance sheet and income statement for the properties, which includes the historical
financial information for the most recently completed year adjusted for the effects of the proposed
IPO and transfer of property;
• A compilation report on the pro-forma financial statements;
• Interim financial statements where a significant period of time has passed since the most recently
audited balance sheet date covered by the historical financial information in the prospectus;
• A review report on the unaudited interim financial statements from the REIT's auditors;
• An opening balance sheet and auditors' report thereon for the REIT;
• A forecast statement of net income and distributable income for the REIT, covering a period of
twelve to eighteen months (This is not a statutory requirement, but is usually required by the lead
underwriters and is); and
• An auditors' report on the examination of the forecast.
These requirements change from time to time. Guidance on the requirements should be obtained by
discussing the applicable securities legislation with the REIT's securities lawyers and auditors. The
contents and timing of the prospectus should be agreed upon and a working group established as
early as possible in the process.
When there are concerns about the interpretation of securities legislation or the requirements for the
prospectus, it is often advisable to obtain advance clearance from the securities commissions on the
reporting requirement. Potential investors do not look favourably upon a significant change in the
contents of the prospectus between preliminary and final.
Legal Agreements
Legal documents to be drafted by the REIT's legal counsel, include:
• Trust indenture;
• Underwriting agreement;
• Property management agreement
(if applicable);
• REIT management agreement (if applicable);
• Property purchase and sale documents;
• Development and Services agreements
(if applicable);
27
• Debt assignment and/or assumption consents and agreements;
• Lease assignment and consents
(if applicable); and
• Mortgage assignments and consents
(if applicable).
Although these documents will likely change several times throughout the process, it is important to
agree, in principle, with the underwriters on what material legal documents will be required and the key
elements of such agreements early in the process.
Securities Commission and Stock Exchange Approval
The filing of a preliminary prospectus allows securities commissions to review the transaction and
determine whether to give approval to the proposed sale of securities. Because there are thirteen
securities commissions in Canada (one in each of the provinces and the territories), one of the securities
commissions will usually act on behalf of all of the others, although all of the commissions have the right
to comment on the prospectus.
Comment letters issued by the commissions may include:
• Questions on the accounting treatment proposed or used in the prospectus financial statements;
• Questions and directives on the contents of the prospectus document; and
• Questions on the legal structure and compliance with securities legislation.
Responses to comment letters should be developed in consultation with the appropriate legal counsel
and the REIT's auditors.
Upon filing of the preliminary prospectus, management will obtain a conditional approval for a listing on
the relevant stock exchange, which may also comment on the prospectus, its contents and the marketing
of the units.
Other Matters and Legal Documents Required
The securities commissions, underwriters and other parties to the transaction will require, among other
items:
• A comfort letter from the REIT's auditors on the financial information contained in the preliminary
prospectus, since the various auditors' reports will not be signed until the final prospectus.
• Consent letters from any parties whose reports will be referred to or reproduced in the prospectus
(such as the auditors, appraisers, etc.). At a minimum, the auditors' consent letter will need to be filed
with the final prospectus.
• A comfort letter from the auditors to the underwriters to assist the underwriters in fulfilling their due
diligence requirements under securities legislation. The contents of the letter should be agreed upon
between the underwriters, management and the auditors well in advance of the date of the final
prospectus to minimize last minute disruptions to the IPO process.
• The due diligence process by the underwriters' legal counsel. This will include, among other things, a
review of material agreements, leases and financial information, as well as questions of management
and the auditors.
Summary
Because the REIT formation process is so complex, it is imperative that as little as possible be left to
chance. The probability of a successful REIT formation and IPO is greatly increased by appropriate, upfront consultation and planning.
28
6. The REIT vs. a Corporate Structure: Differences in
Management Focus
Having discussed the current investor appetite for REITs, why they are growing and at present are the
vehicle of choice for real estate ventures to access the capital markets. We have also highlighted some
of the key considerations in the process of forming a REIT; the next logical step is to discuss certain
aspects of management's focus or behaviour once an entity is up and running as a REIT.
To give this discussion the proper context, let's briefly recap some of the characteristics that make
REITs so appealing to today's investors. This is by no means meant to be an exhaustive analysis of
REIT attributes, but simply an attempt to highlight those attributes that the market rewards and which in
turn influence management's behaviour.
High current prevailing yields relative to other yield-oriented investments
• In the moderate-growth real estate industry of recent years, the high income distribution of REITs is
strongly preferred by investors who seek to own real estate investments as a yield instrument;
conversely, non-REIT equities with low payout ratios are generally valued by the market only if they
offer unique assets, such as development or high growth.
Stability and predictability of income
• In most cases, income is contractual in nature, arising from leases with initial lease terms ranging
from five to ten years.
• These contractual revenue streams are appealing to investors, particularly in a weakening economy,
a low interest rate and low inflation environment, and/or in the volatile equity markets of recent
years.
Conservative financial structures and operating policies
• The extent of leverage in REITs tends to be conservative, limited by self imposed provisions of the
trust declaration to anywhere from 40% to 60% of the gross assets (with a current trend towards
higher than 60%), resulting in lower debt/equity ratios and higher interest coverage.
• The strong financial position and solid fundamentals, coupled with the high current yields and
moderate growth offered by REITs, are very appealing on a risk-adjusted basis.
29
The mutual fund trust structure provides significant tax flow-through
benefits to investors
• Approximately 40% to 80% of 2001 distributions were paid to investors on a tax-deferred basis.
• Such tax-deferred distributions are treated as a reduction in the unitholders' adjusted cost base
("ACB") and, accordingly, will be afforded taxable gains treatment when the units are ultimately sold
(assuming, of course, that the unit price remains constant to the price paid).
These attributes, while making REITs attractive to investors, create some unique challenges for the
management of a REIT and require a mindset or a focus that is in many respects quite different from that
applied to a traditional corporation.
At a high level, this mindset is epitomized by discipline and to a large extent, a culture of conservatism.
While discipline and some element of conservatism would seem to be the cornerstones of prudent
management in any organization, the need for these in a REIT is heightened by the substantially lower
materiality and increased sensitivity with which the market views fluctuations in the earnings of a REIT,
due to the immediate impact that such fluctuations could have on a REIT's ability to sustain its
distributions. The high degree of precision used by the market to evaluate a REIT's distributable income
leaves little room for "surprises" in its results, and negative surprises will have a punitive result on the
unit price.
To help illustrate how this mindset manifests itself in practice, we will examine management's focus
within the context of four broad categories:
• Investment considerations - how do these attributes affect the investment opportunities that a REIT
will pursue?;
• Operating and financial considerations - how do these attributes affect the operational and
financial practices of a REIT?;
• Financial reporting considerations - how do these attributes influence the financial reporting
practices of a REIT?; and
• Corporate governance considerations - how do these attributes impact the corporate governance
practices of a REIT?
30
Investment Considerations
As with any organization, the investment decisions that a REIT makes need to be aligned with the
interests and objectives of its stakeholders. As we previously outlined, REIT investors are, for the
most part, motivated largely by yield (cash they receive / cash they invest) whereas investors in a
corporation tend to be motivated largely by earnings and long-term capital growth.
In order to meet unitholders' expectations of stable monthly cash flows, the management of a REIT
will, by necessity, tend to adopt a more conservative investment approach that will generate secure
monthly cash flows. To highlight this tendency, we will look at a few common investment
considerations and the specific factors that the management of a REIT must consider relative thereto:
REIT
Corporation
Speculative
Investments
Although certain speculative
opportunities, such as the acquisition
of land for future development, may
make good business sense (i.e. offer
the potential for significant returns in
the long run), the lack of current
earnings and cash flows to support
distributions would effectively preclude
a REIT from directly pursuing any
material speculative opportunities.
A corporation is not compelled to
make recurring cash distributions and
therefore it is able to pursue more
speculative opportunities that offer the
potential for significant future growth.
Development
Projects
A REIT will typically participate in
development projects by way of
mezzanine financing arrangements that
include an option to acquire an interest
in the property once it is fully
developed. This type of arrangement
provides a REIT with earnings and
cash flows (in the form of interest on
the mezzanine debt) to make
distribution payments during the
development period.
Again, because a corporation is not
compelled to make recurring cash
distributions, it can engage in
development activities directly.
Quality of
Property
The management of a REIT must
balance the need to generate secure
stable earnings and cash flows with the
yield objectives of its stakeholders.
Income-oriented investors tend to
undervalue REITs with portfolios of,
relatively speaking, higher quality
assets and lower yields. This is
evidenced by the absence of "trophy"
assets in REIT portfolios, as they would
not meet the REIT's yield threshold.
The composition of a corporation's
portfolio is shaped by management's
strategy and investor demands, rather
than any specific yield criteria.
31
Investments Considerations (continued)
REIT
Corporation
Diversification
Diversification in a REIT portfolio
increases the inherent stability of its cash
flows and therefore its distributions, by
reducing the exposure to individual
markets and risks (i.e. geographic,
sectors, etc.).
While diversification is also a sound
risk management strategy for a
corporation, the negative effects of
an over-exposure to a particular
depressed market is not as
immediate as in a REIT since the
corporation has retained earnings to
help "weather the storm" and it is not
compelled to make monthly
distributions.
Other
In recent years, the larger Canadian
REITs have virtually all elected to
internalize their asset management and
property management functions.
Provided that a REIT has the appropriate
critical mass, an internalization strategy is
an attractive proposition because it allows
a REIT to:
• Better control its operating costs
• Remove investor perception regarding
conflict of interest
• Increase the return on its assets,
including the spread on new
acquisitions, to the extent of the profit
element embedded in property and
asset management expenses
• Compete for joint venture capital (i.e.
from institutional investors that do not
possess internal real estate expertise),
thereby allowing it to increase the size
of its portfolio resulting in increased
earnings, cash flow, economies of
scale and diversification
• Increase the return on its interest in
co-owned assets by earning
management and other fees from its
co-owners
• Build its own Brand Name.
The only difference for corporations
that have internal management
expertise is that corporations are not
restricted from providing third-party
management services.
However, it is important to recall that, in
general, a REIT is precluded from directly
providing third party management
services for assets in which they do not
have an interest. Such services do not
qualify as an allowable activity for a
mutual fund trust under the Income Tax
Act (Canada).
32
Operating and Financial Considerations
Much like the investment considerations just reviewed, the operations of a REIT are significantly
influenced by investor expectations of stable monthly cash distributions. Consequently, management
of a REIT must constantly evaluate the impact of their operating and financial decisions on monthly
cash flows. This focus is quite different from a corporation where management can operate with a
focus on long-term growth and capital appreciation.
To facilitate this discussion we will examine the operations of a REIT within the following categories:
• Budgeting and Cash Management
• Leasing
• Tenant Inducements
• Financing
• Distributions
This categorization is by no means intended to be a comprehensive framework for examining the
operations of a REIT but simply to highlight certain considerations that are unique to a REIT as
compared to a corporation.
REIT
Budgeting
and Cash
Management
Corporation
An effective budgeting and cash
management process is central to a
REIT's ability to deliver the stable and
reliable distributions that the market
expects. This expectation forces a
REIT to:
• Have a detailed monthly budget
that is well planned and well
monitored to avoid any
unanticipated or overlooked cash
expenditures
The focus of in a corporation tends to
be more on earnings, with a quarterly
time horizon. Also, the cash
management in a corporation does
not require the same degree of
precision as in a REIT since a
corporation is not required to pay out
substantially all its earnings on a
monthly basis.
• Spread any large expenses over a
period of time to preclude a "cash
crunch" in any given month
• Perform accurate cut-off and accrual
procedures - once a cash
distribution is made in a month, it
can't be recalled.
Leasing
Effective management of lease
maturities significantly increases the
stability of a REIT's cash flows and, as
a result, distributions by:·
• Limiting the REIT's exposure to
renewal risk
• Spreading out cash flow demands
for leasing costs.
The current rule of thumb is to limit
lease maturities to no more than 10 to
20% of leaseable space in any given
year.
33
While the benefits of effectively
managing lease maturities accrue to
corporations in the same way as they
do for REITs, the risk of not doing so
is compounded in a REIT format due
to the potentially negative effect on
the stability of a REIT's cash flows
and distributions.
Operating and Financial Considerations (continued)
REIT
Tenant
Inducements
Corporation
In a REIT, decisions with respect to the
nature of inducements granted to
tenants are significantly influenced by
the definition of distributable income in
the trust declaration. For example,
certain REITs define their distributable
income to add back the amortization of
deferred leasing costs while others do
not; without "crunching" the numbers,
the impact of different forms of tenant
inducements (i.e. free rent or
inducements) on the cash flows of the
REIT can vary significantly depending
on the definition adopted (please refer
to Appendix 1).
• If amortization of deferred leasing
costs is not added back in the
determination of distributable
income, the decision whether to
grant a cash inducement or provide
the tenant with a period of free or
lower than market rate rent is cash
neutral to a REIT
• If, on the other hand, amortization of
deferred leasing costs is added back
in the determination of distributable
income, inducements in the form of
free or lower than market rate rent
would provide significant cash flow
advantages to the REIT.
It is also worth noting that by not
adding back amortization of deferred
leasing costs in the calculation of
distributable income, a REIT can, to
the extent that such amortization
exceeds actual leasing costs for the
same period, retain cash to finance
ongoing capital expenditures and
leasing activity (please refer to
Appendix 1).
In recent years, all of the public REITs
have moved towards a definition of
distributable income that does not add
back amortization of deferred leasing
costs.
34
Since the concept of distributable
income does not exist in a corporation
and a corporation is not compelled to
make monthly distributions, decisions
regarding the nature of tenant
inducements are cash flow neutral to
the corporation.
Operating and Financial Considerations (continued)
REIT
Financing
Corporation
In looking at some of the unique
financing considerations in a REIT, we
will consider debt and equity financing
separately.
Debt:
We previously noted the conservative
leverage of REITs, which is limited by
the self-imposed restrictions of the trust
declaration. Optimizing the use of this
limited leverage to finance accretive
acquisitions is a key objective for
management. An important statistic in
evaluating a REIT's growth prospects
is its "leverage capacity", which is a
dollar measure of the acquisitions that
a REIT could complete without having
to issue additional units.
In addition to managing its leverage
capacity, it is important for
management to effectively stagger the
maturities of its existing mortgages in
order to:
• Limit the REIT's exposure to
renewal risk
• Spread out cash flow demands for
financing costs
The current rule of thumb is to limit
maturities to no more than 10 to 15%
of its mortgages in any given year.
Equity:
Where a REIT is at or near its leverage
capacity, its ability to access the capital
markets on favourable terms is
essential for asset base growth and, by
implication, for increases in
distributions and cash flows.
In all cases (debt or equity),
management's ability to quickly and
effectively invest the proceeds from
financing transactions in accretive
opportunities is essential to avoid the
temporary dilution of investor returns.
35
The existence of retained earnings
and the absence of strict leverage
restrictions in a corporation allow for
greater flexibility in its financing.
Operating and Financial Considerations (continued)
REIT
Distributions
Corporation
Market expectations of REIT
investments are such that investors
demand high-yielding (relative to other
income oriented investments) and
moderately growing distributions with
minimal volatility. One of the primary
criteria that investors use to evaluate a
REIT is the sustainability of its
distributions. For this reason, the trend
among Canadian REITs has been to
increase distributions at a marginally
slower rate than distributable income
so as to build a margin that would
allow the REITs to withstand volatility in
their underlying cash flows and still
maintain their distributions.
Over time this approach will also allow
the REITs to retain more of their
distributable income and thereby
internally generate cash flows to
contribute towards covering ongoing
capital expenditures and leasing costs.
36
This is not a consideration that
management in a corporation needs
to address since a corporation is not
compelled to make distributions.
Financial Reporting Considerations
REIT
Unique
implications of
certain GAAP for
REITs
Corporation
REITs and corporations alike are
required to follow GAAP. However,
certain accounting standards can have
some unique implications for a REIT.
For example, in 2000, CIPPREC
introduced a new recommendation
regarding accounting for tenant
inducements in the form of free or
lower than market rate rent. Under this
standard, the total amount of cash to
be received from leases that provide a
free rent concession is accounted for
on a straight-line basis over the term of
the lease and rental revenue
recognized during free rent periods
(representing future cash receipts) is
reflected in accounts receivable. Such
straight-lining creates potentially
significant differences between cash
flows and earnings that are not
adjusted for in the calculation of
distributable income. As such, during
free rent periods, a REIT would be
required to pay distributions in excess
of its actual cash flows and,
conversely, the REIT would have cash
flows in excess of its distributable
income during the remainder of the
lease. In a mature, well-staggered
lease portfolio, the net effects of
straight-lining rents would generally not
be material.
37
Because a corporation is not
compelled to make recurring monthly
distributions, the potential implications
of straight-lining rents are not as
significant.
Financial Reporting Considerations (continued)
REIT
Selection and
application of
accounting
policies
Corporation
Within GAAP there may also be more
than one acceptable accounting
treatment for a particular transaction,
requiring management to exercise
professional judgement in the selection
and application of accounting policies
(although these situations are
becoming fewer as GAAP becomes
more prescriptive). Management's
judgment in this regard can have a
significant impact on reported net
earnings and, in the case of a REIT,
since net earnings is the starting point
for calculating distributable income,
these choices also impact monthly
distributions and cash flows. Generally
speaking, REITs tend to be
conservative in their financial reporting
practices.
This conservatism stems from the fact
that aggressive accounting policies
result in higher earnings and
distributable income but without the
corresponding cash flows to make
distributions to unitholders.
For example, consider the timeless
capitalize vs. expense scenario:
In a REIT, if an expenditure is treated
as a period cost, the impact on cash
flows is limited to the amount of the
actual expenditure.
If that same expenditure was judged by
management to be capital in nature,
the impact on cash flow is equal to the
amount of the actual expenditure plus
the incremental distributions to
unitholders (equal to the payout ratio
times the expenditure).
It is important to note the trade-off
here. If an item is expensed, more
cash is retained in the REIT, however,
if the same item is capitalized, less
cash is retained in the REIT as
distributions will be higher and
therefore the yield to investors will be
higher.
38
Again, because a corporation is not
compelled to make monthly
distributions its cash flows do not
necessarily need to mirror its earnings
as closely as in a REIT format.
Financial Reporting Considerations (continued)
REIT
Margin for error
Corporation
We previously noted the high degree of
precision with which the market
evaluates REIT earnings and the need
for management to avoid "surprises"
The same can be said for errors.
Management must adopt the same
degree of precision relative to
identifying and correcting errors in its
financial reporting because errors could
result in excessive cash distributions
being paid out to investors. Because
market pressures will not allow a REIT
to decrease its distributions without
significant penalty to its unit price,
there is no economically feasible
means of recouping such payments.
In a perfect world, a corporation
would also report results with a high
degree of precision, however, in
practice, materiality in a corporation
tends to be slightly higher because
there is not the same immediate and
direct effect on cash flows as in a
REIT.
Also, since misstatements in one
period eventually reverse themselves,
immaterial amounts in a given period
can be compounded by additional
misstatements in the subsequent
period of reversal.
Transparency of
disclosure
The nature of a REIT as a yieldoriented vehicle makes transparency of
disclosure essential to allow investors
to properly evaluate REITs against
other less dynamic yield investments,
such as bonds. After all, there is less
trepidation in what you know than what
you don't know.
39
Transparent disclosure is equally
desirable in a corporation. The only
difference is that the market will
generally consider a number of other
variables, in addition to yield, in
evaluating a corporation, depending
on the nature of the unique assets or
management.
Corporate Governance Considerations
While the substance of good governance applies to all organizations equally, the yield-oriented nature of
REITs makes certain elements of corporate governance, namely risk management practices, particularly
relevant and worth mentioning.
Since the first edition of this REIT Guide was published, much has happened with respect to corporate
governance. Particularly in the United States, the Securities and Exchange Commission (the "SEC") has
been very aggressive in setting out its expectations of boards of directors, audit committees,
management and auditors. The Blue Ribbon Committee report in 1999 was one of several recent
publications that have attempted to drive the evolution of board membership and mandates.
The Enron debacle, the economic downturn, the unprecedented events of September 11, 2001 and other
recent business failures have combined to create a financial reporting environment unlike any in recent
history, bringing the role of the audit committee to the forefront. This environment is creating significant
challenges for public entities and their management, boards of directors, audit committees and auditors.
Reliable and transparent financial reporting is particularly important in this troubled environment. This
requires the attention of all these major constituencies to execute their responsibilities without exception
and requires them to work together to produce high-quality financial reporting.
In Canada, the Joint Committee on Corporate Governance issued its report in 2001. The report contains
many recommendations and descriptions of good governance practices that can be useful to most public
entities. In addition, the sponsoring organizations and the securities regulators are likely to enact rules,
regulations or professional standards related to the proposed recommendations.
In March 2002, The Toronto Stock Exchange (the "TSX") issued its draft corporate governance disclosure
guidelines (the "Amended Guidelines") applicable to TSX listed issuers. This set of guidelines, subject to
comments received, will influence the direction of Canadian public entities with respect to board
composition and behaviour.
In a "post-Enron" world, Canadian boards and audit committees will need to:
• be able to demonstrate (if necessary) that they have applied appropriate governance practices with
respect to the identification and management/control of "principal business risks";
• learn from each other (i.e., what are "current practices" in this area);
• understand what constitutes "best practice" (i.e., what boards should be doing).
The value proposition for boards and audit committees is that with a better understanding of both "current
practices" and "best practices" in this time of great change, these boards and audit committees will:
• be able to discharge their responsibilities for providing assurance to unitholders and stakeholders
about the integrity of the entity's reported financial performance, and
• have greater confidence with respect to the effectiveness of internal controls and the management of
principal business risks, resulting in reduced anxiety about their litigation exposure and an enhanced
ability to add value in the deliberations of the board of trustees.
40
For the immediate future, boards and audit committees will focus their attention on:
• exposures to and disclosures of:
– off-balance sheet financing
– related-party transactions
– special purpose enterprises
– stock or unit options
• internal controls
• identification, measurement and management of business risks
• auditor independence and scope of services
• quality of accounting policies and disclosure
There will continue to be scrutiny of corporate governance by regulators, government and the
marketplace at large for the foreseeable future, so it is very important that REIT boards and
management pay particular attention to all aspects of this fast-moving environment.
Most REITs have followed the corporate governance guidelines issued by the Toronto Stock Exchange
(TSX). The REITs have all adopted a policy whereby the majority of the trustees are independent.
Most REITs have adopted and incorporated into their declaration of trust that the members of the audit
committee must consist solely of independent trustees. Likewise, the makeup of the compensation
committee is nearly always made up of independent trustees.
Risk Management
It has been stressed several times throughout this Guide that the market rewards those REITs that can
deliver stable, reliable cash flows and attractive risk-adjusted yields (the key phrase here being riskadjusted). Since investors typically benchmark REIT performance against other less dynamic yield
instruments, such as bonds or utilities, implementing effective risk identification and management
processes can reduce the risk premium investors attach to the REIT investment, and thereby enhance
the market's perception of its value. An effective risk management process that is well articulated and
disclosed to the public and internally can also help a REIT distinguish itself from its competitors when
competing for capital. The lower the perceived risk of a REIT, the greater the value that investors will
place on the returns it delivers. After all, if comparing two REITs that offer substantially the same
returns, the market will favour the REIT with the lower degree of risk associated with it: the same or
higher prospective returns combined with lower perceived risks is a compelling combination for any
investor. Therefore, risk management should not necessarily be viewed as a matter of compliance but
rather an opportunity to create a competitive advantage in attracting capital, which, as we previously
noted, is central to a REIT's ability to grow.
Please see Appendix 3 for further detail on the principal differences between operating a REIT versus
a corporation.
41
7. Canadian vs. U.S. REITs
From An Owner's Perspective
What are the decisions that holders of real estate must make as far as determining which capital
markets to access (i.e. US or Canadian)? While Canadian REITs were created based on the U.S.
REIT vehicle, there are significant differences in the operational facets of each. These differences,
while not affecting the overall nature and function of the REIT, could affect the decision made by an
organization or investor as to which is the most appropriate for their purposes. The operational
differences tend to arise due to the government-regulated nature of the U.S. REIT as opposed to the
self-regulated nature of the Canadian REIT.
The following table outlines some of the operational differences that exist between U.S. REITs and
Canadian REITs:
Feature
U.S. REIT
Canadian REIT
Governed by
• Requirements of Internal Revenue
code.
• Self Imposed Trust Declaration and
certain requirements of the Income
Tax Act.
Vehicle
• May be a corporation, trust or
association (most are corporations)
• Must be an open- or closed-ended
mutual fund trust.
• As long as the corporate vehicle
meets the requirements of the tax
law, then it can have the
appearance and tax advantages of a
trust.
Investors
• Minimum of 100 investors, with no
more than 50% of units held by five
or fewer individuals.
• Minimum of 150 unitholders, and
be listed on a recognized Canadian
Exchange.
Revenue Rules
• At least 75% of gross income must
consist of real property rents,
mortgage interest, gains from sale
and other real estate related
sources
• At least 95% of its income must be
derived from the disposition of, or
income earned from, qualifying
investments.
• At least 95% must be from the
sources in the 75% test plus
"passive income" sources such as
dividends and interest.
42
(This rule does not apply to openended mutual funds.)
Feature
U.S. REIT
Asset Rules
At the close of each quarter of the
taxable year:
1. At least 75% of gross asset value of
total assets is represented by real
estate assets, cash and cash items,
and government securities
2. Not more than 25% of the value of
total assets is represented by
securities other than those included
in 1 above
3. Not more than 20% of the value of
total assets is represented by
securities of one or more taxable
REIT subsidiaries
Canadian REIT
• At least 80% of its property must
be held in any combination of real
property in Canada and other
qualifying investments
• No more than 10% of its property
(on a non-consolidated basis)
consisted of bonds, securities or
shares in the capital stock of any
one corporation or debtor.
(The above rules do not apply to
open-ended mutual funds.)
4. Not more than 5% of the value of
the assets is represented by
securities of any one issuer, other
than those securities included in
1 & 3 above
5. The REIT does not hold securities
possessing more than 10% of the
total voting power or having more
than 10% of the total value of the
outstanding securities of any one
issuer, other than those securities
included in 1 & 3 above.
Distributions
• Generally, must be at least 90% of
Taxable Income without regard to
distributions and excluding net
capital gains.
• Set individually by the trust
declaration, however usually
around 85%-95% of distributable
income.
Taxation
• Income is not taxed as long as it is
distributed to investors. Income that
is not distributed will be taxed at
normal corporate rates.
• Income is not taxed within the trust
as long it is distributed to
unitholders.
Transfer of Real
Estate to the REIT
• Companies able to move assets to
REIT on a tax deferred basis.
• Limited ability to move assets to
REIT on a tax deferred basis.
43
Feature
Liability of
Investors
U.S. REIT
Canadian REIT
• Liability of investors is limited due to
use of corporate structure.
• Unlimited Liability (However, it is
generally believed that there are no
material differences between a
trust and a corporation)
• All REITs have adopted a strategy
to reinforce their limited liability
only to the assets of the REIT and
not to unitholders. They have done
this by incorporating a clause in
their material contracts under
which the service providers (i.e.
Mortgages, lease contracts, and
other material service providers)
acknowledge that their only
recourse is either to a specific
asset of the REIT (e.g. the
mortgage over a property) or all
the assets of the REIT
• Some REITs have partially
achieved legal limited liability
through the use of corporations or
limited liability partnerships.
From an Investor's Perspective
Given the above differences between the Canadian and U.S. REIT structure, is there an opportunity for
Canadian investors to choose a U.S. REIT as their investment vehicle rather than a Canadian REIT?
Generally speaking, Canadian investors can freely invest in a U.S. REIT, unless it is through an RRSP in
which case the investment must adhere to the applicable restrictions regarding foreign content limits in
an RRSP. The "Foreign Content" Rule requires that an investor only hold up to 30% of his or her RRSP
in foreign investments, otherwise penalties will be imposed. Therefore, Canadian investors wishing to
use U.S. REITs as an investment vehicle in their RRSP must be careful to ensure that an acquisition of a
U.S. REIT is less than 30% of the total portfolio market value, when considered together with any other
foreign holdings in the RRSP. The only other option to increase foreign content is to invest in a
Canadian mutual fund which has up to 30% invested in foreign securities, as they are designated as a
100% Canadian investment for RRSP purposes (The Canadian REIT structure restricts foreign
ownership to 30% of its assets). In this way an investor can increase his or her foreign content to a
maximum of 51% of the total investment (30% directly foreign owned and the remaining 70% invested in
Canadian Mutual funds with 30% foreign investment) and still remain eligible for the RRSP.
44
8. Why Royalty Trusts and Investment Trusts Differ
from a REIT
In the current environment of low interest rates and volatile equity markets, a variety of Income Trusts
have gained widespread appeal among investors. Royalty Trusts and Investment Trusts are often
confused with a REIT. While both REITs and these other trusts are forms of income trusts and are similar
in many respects, there are also significant differences that investors should be aware of in evaluating
investment alternatives. Trusts that are established primarily to earn royalty income are referred to as a
Royalty Trust, whereas trusts that are established to earn income from debt and shares are referred to
as an Investment Trust.
A Royalty Trust is used to pool capital, generally through
the sale of units to public investors, to acquire a royalty
interest in energy related resource properties, such as oil
and gas, synthetic oil, coal and iron ore. Typically, a
Royalty Trust will acquire a 99.99% royalty interest in a
resource property from a corporation, which continues to
operate the property and earn fees there from. The
purchase of the royalty interest in an oil and gas property
results in the trust incurring a Canadian oil and gas property
expense ("COGPE"). The COGPE can be claimed as a
deduction against the royalty income earned. The diagram
below illustrates a simple structure for a Royalty Trust.
Investors
Trust
99.99%
Royalty
Interest
Management
Company
Operating
Company
Resource
Property
(Oil and Gas)
The income earned by a Royalty Trust is generally derived
from the extraction and sale of the energy related commodities. The operating income generated by a
Royalty Trust is generally higher than that of a resource corporation because a Royalty Trust will focus on
mature producing properties, thereby minimizing the substantial risks and costs of exploration.
Much like a REIT, investors in a Royalty Trust receive cash distributions based on the available cash flow
and income of the trust. There is no income tax payable at the trust level if all taxable income, including
any taxable capital gains, is distributed to unitholders annually. Also similar to a REIT, such distributions
generally exceed the taxable income of the trust, due to non-cash resource deductions claimed in the
trust (COGPE is similar to a CCA claim for a REIT). As such, a portion of the cash distribution is sheltered
from current income taxes at the investor level.
However, as noted in Section 3, distributions in excess of allocated income (i.e. the tax sheltered portion
of the distribution) represent a return of capital, which reduces the adjusted cost base of the investors'
trust units, resulting in a larger capital gain when the units are ultimately sold or redeemed (albeit such
capital gain is only 50% taxable under current inclusion rates). It is worth noting that in the early years of
its reserve life, the tax-deferred portion of Royalty Trust distributions is generally larger than that of a
REIT, due to certain special deductions relating to the acquisition of resource properties; in fact, it is
common for Royalty Trust distributions to be free of current income tax for a number of years. The tax
efficient attributes of REIT and Royalty Trust distributions distinguish these two vehicles from other
income trusts, which generally provide substantially less tax deferral.
Other similarities between a REIT and a Royalty Trust include:
• Access to investment opportunities and markets that would not otherwise be available to individual
investors that have limited funds
• Diversification across various types of properties and geographic markets
• Liquidity as compared to direct investment since these trust units are generally listed on a stock
exchange and publicly traded.
Despite the forgoing similarities, there are two fundamental differences between a Royalty Trust and a
REIT: A Royalty Trust is dependent upon a depleting asset base; and its returns are inextricably linked to
resource commodity prices, subject to hedging strategies, which tend to be extremely volatile and
economically sensitive.
45
The funds advanced to the trust by public investors are used to invest in the debt and equity of an
Acquisition company ("Acquico"). Acquico will be used to purchase the shares of the operating company,
immediately followed by an amalgamation of Acquico and the operating company. The allocation of the
initial capitalization of the Acquico (debt and equity) will depend on the anticipated future income
generated by the operating company ("Opco"). Normally, the debt and interest rate will be set such that
the current and future taxable income of the company will be reduced to zero through the interest charged
on the debt.
Unlike a REIT and a Royalty Trust, the CCA deduction will be taken by the Opco and not the trust, and the
remaining taxable income is usually reduced to zero by way of an interest charge on the loan from the
trust to Opco. Excess cash remaining in the Opco after the payment of such interest can be paid to the
trust as follows:
• Reduce the paid up capital of the corporation (capital dividend), which results in a lower ACB of the
shares of the corporation but the dividend flows to the trust tax-free.
• Repurchase shares of the corporation - may result in a deemed dividend and a capital gain or loss.
• Pay a taxable dividend.
Any cash that is distributed to the trust by Opco on a tax-deferred basis (i.e. through the capital dividend
option noted above) will be flowed through to the unitholders on a tax-deferred basis, reducing the ACB of
their units by the same amount.
The trust will include any capital gain or taxable dividend in computing its taxable income and
consequently each unitholder will be responsible for the tax on his / her personal share of that taxable
income. This dual structure of a corporation and a trust may result in certain tax inefficiencies, which need
to be carefully monitored.
Where a corporation is used to operate the business, any gains and recapture on the sale of the assets
held by the operator may be subject to tax at the operator level, and such tax may not be deferred.
The popularity of the Royalty Trusts, Investment Trusts and REITs is partly due to the significant tax
advantages offered by their returns. For tax purposes, certain income distributed by the trust will retain its
nature (dividends and capital gains); distributions are received by unitholders in some combination of
income, dividends, capital gains and return of capital. Consequently, the overall tax rate applicable to trust
investments is generally lower than for other steady-yield investments such as bonds. Where a portion of
the distribution is treated as a return of capital, it would not be immediately taxable to an investor; instead,
it would reduce the adjusted cost base of the units. As previously noted, the capital portion of the
distribution results from the tax shield created from depreciable or depletable assets held directly through
the trust or the capital dividend received by the trust from an underlying operating company.
The following table summarizes key attributes of the various types of income trusts.
Type of Trust
Underlying
Asset
Royalty Trust
Oil and gas
Royalty Trust
Oil and gas/coal
Investment Trust
Commercial activity
(e.g. storage,
shipping)
REIT
Income producing
properties
47
Risk
Category
Average
Yield
Life of
Asset Base
High
11% - 14%
7 - 15 years
Medium
9%
20 - 30 years
Medium / Low
8.5-10%
Indefinite
Low
7%- 10%
Indefinite
10. How to Evaluate a REIT
What to look for in a REIT
The following characteristics appear to be prevalent, in varying degrees, among those Canadian REITs
that have been most widely accepted and rewarded by the market:
• An experienced sponsor with a proven track record for the property type of the REIT;
• A focused portfolio (i.e., by either property type or location);
• Strong net operating income, cash flow and sustainable income growth (at present, investors are
looking for a 7% to 10.5% current return, with a 3% growth factor);
• Limited debt (REITs that have debt of more than 60% of their market capitalization have been
penalized by the market in the past. This philosophy has changed in recent times; as investors gain
confidence in the REIT they are willing to allow a greater amount of leverage.) If debt exists, it should
have a fixed rate of interest, and have a long-term maturity to eliminate the effects of interest rate
swings on the REIT's yield;
• Management that holds a significant investment in the REIT (10% to 20%) as this aligns
management's behaviour with investors' goals;
• Sufficient size to capture the brokerage community's interest, to ensure adequate liquidity and attract
institutional investors. The REIT must have also achieved economies of scale with respect to its fixed
overhead costs (to achieve this, the REIT's initial asset size should be in excess of $250 million with
an ability to quickly grow its asset base to over $500 million);
• An infinite life (rather than a finite one), and the ability to use sales proceeds to finance accretive new
property acquisitions, and not be required to distribute capital gains; and
• Distributions in the range of 80% to 95% of its distributable income. This will allow the REIT to use its
retained operating funds to grow its asset size without going to the market for potentially dilutive (at
least in the short-term) capital injections.
Secondary Factors
• management fees;
• other REIT costs;
• degree of tax deferral;
• exposure to lease rollovers;
• obligations to distribute income;
• degree of reliance on acquisitions for future income;
• amount of cash in the REIT and anticipated timing of future market issues;
• historical performance of REIT and its manager;
• level of disclosure in reporting to unitholders;
• investment criteria for new properties;
• operating plan of the REIT;
• environmental risks and controls;
• guidelines on dilution;
• sunset provisions;
• non-conflict and non-competition provisions for the manager; and
• governance issues.
52
The Canadian REIT market is still very active. However, the size of new issues has risen for a number of
reasons: need to create a greater critical mass of properties, complexity of the transaction, need to create
liquidity for investors, need to reduce trustee and general operating costs as a percentage of revenue,
and to be competitive with the established REITs. As a result, the typical size of a REIT has increased
significantly from 1997. Currently, the recommended minimum asset base of a REIT is between $250 and
$350 million, with a built-in capacity through the declaration of trust to take on more debt (generally
subject to a 60% limitation). It is possible for a potential REIT to access the market below $250 million;
however, the REIT must have a dominant niche or be able to grow very rapidly.
How Should REITs Be Evaluated?
The price of a REIT is based primarily on its anticipated income stream and, in recent years, some
recognition has also been given to the management structure, the underlying asset values and the
potential for capital appreciation. Assuming an investment in a REIT yields x% compared with alternative
investments yielding y%, the investor assesses whether or not the spread provides adequate
compensation for the incremental risk associated with a REIT investment.
Recently there have been conflicting views among investors, analysts and management about how REITs
should report profitability and what is the most effective measure of a REIT's performance. This debate is
ongoing, as many believe that current reporting practices of REITs do not allow for comparability with
other companies in the market.
A REIT's value is derived from its ability to deliver consistent cash distributions, as well as appreciation in
the underlying assets. In periods of low expected capital appreciation and low interest rates, the emphasis
in valuation will be on yield. Yield is typically calculated by dividing the following year's target distributions
per unit by the current market price per unit. Taxable investors will be interested in the post-tax yield,
while non-taxable investors will concentrate on pre-tax yield. Even if the pre-tax income of the trust
remains constant, the post-tax yield will change over time as the tax shelter in the REIT changes.
In times of rising interest rates, the implied inflation may result in higher rents and thus capital
appreciation of the underlying real estate assets. During such times, investors who seek a means by
which to measure the future capital appreciation potential will likely begin considering the discount or
premium to net asset value (NAV) in their valuation.
53
What are the Risk Factors?
There are risks associated with owning a REIT, including all the usual risks of real estate ownership.
Other major risks faced by REITs include:
• Volume of trading in units may be low (in 2001, the average trading volume increased significantly
over the previous period);
• Potential dilution from new issues;
• Because Canadian REITs are unincorporated trusts, they do not offer limited liability (in practice,
liability to unitholders is minimized through the use of non-recourse debt, insurance, and low debt to
equity ratios);
• Non-compliance with the Canadian Income Tax Act rules, results in the REIT losing mutual fund
status;
• Possible decline, over time, of pre-tax equivalent yield as CCA deductions will decline if no new
significant properties are purchased;
• Possible decline in pre-tax equivalent yield if the REIT invests the maximum amount allowed under its
trust declaration in mortgage receivables, since the interest income cannot be shielded by CCA;
• Unit market values will fluctuate with changes in interest rates and market conditions;
• Management's ability to buy quality real estate at high capitalization rates with positive leverage (if
new issue proceeds are kept in cash or if poor purchases are made, yield expectations may not be
sustained and returns to unitholders may be diluted); and
• The tax shelter is a partial deferral only; unitholders will be subject to capital gain on the ultimate sale
of their units as a result of their cost base being reduced over time by the tax-sheltered portion of
distributions (taxation of this gain can be further deferred if the units are held in an RRSP).
Other Factors to Consider
In addition to the above risks, other factors to consider in owning units of a REIT include:
• Conflict of interest by management/unitholders;
• Government regulations;
• Competition for REIT-quality real estate property - limited product;
• The bar for entering the REIT market has gone up to over $200 million in assets and is increasing;
• Evaluation of environmental risk (with underwriters and lenders becoming increasingly concerned
about environmental risks, the trust will need to implement policies to monitor the risk, and it will be
necessary for these risk exposures to be reflected in the financial statements of the REITs); and
• Challenges by the Ontario Securities Commission and other regulatory authorities - as GAAP evolves
for the REIT segment.
54
11. Scorecard and Predictions
In the 7th Edition of the Guide that was released in 1997, we commented on developments in the
REIT market and the evolution of the market in the not too distant future. We have now revised the
accuracy of our predictions relative to the actual developments in the table below. We have also used
our knowledge and experience in this sector and looked to the U.S. REIT industry to hypothesize
what the future holds for the REIT market in Canada.
Scorecard of Predictions from 1997 Guide
How did we fare on our predictions for our last issue of the REIT Guide?
Prediction
Response
REITs will become a large market in Canada.
With the disappearance through acquisition of
Cambridge, Bentall, Cadillac and Oxford, and the
creation of 10 new REITs, this has become a
reality. REITs are now the dominant vehicle for
public ownership of real estate in Canada.
REITs may enter into joint venture
developments by financing a turnkey
development by way of mortgage financing. In
other words, the developer leases the space
and pre-sells the project to the REIT. The REIT
acts as the project's financier.
This structure was more prevalent in the initial
years of the REITs, and is still a preferred
structure of certain REITs that engage in
mezzanine financing arrangements to pursue
development opportunities.
REITs may acquire new properties through lines
of credit, and then approach the capital market
for new capital by way of public issues. This
eliminates the dilution of earnings and the blind
pool concept, while also allowing for more
predictable cash flows.
This is now a standard strategy of the REITs.
REITs may move into investing a greater
percentage of their capital in U.S. properties.
This has not really transpired to date, except for
CPL Long Term Care REIT (now part of
Retirement Residences REIT) and IPC US
Income Commercial REIT.
New REITs will eventually emerge in the
hospitality and apartment sectors.
There has been the emergence of REITs in both
these sectors, including RES REIT, CAP REIT
and NP REIT in the apartment sector and Legacy
REIT, CHIP REIT and Royal Host REIT in the
hotel sector.
Look for REITs to return to the market on a
periodic basis in order to raise capital. New and
existing REITs will also likely be considerably
larger than those that exist today, the greater
size being necessary for them to compete in
the marketplace. Portfolios may be exchanged
for REIT units if access to the market becomes
too difficult.
All these predictions have become a reality.
55
Prediction
We may see the emergence of Master Trusts,
which are trusts that hold units in the existing
REITs as well as other income trusts. More
quasi-corporate REITs will also enter the
market, as existing portfolio holders will look to
sell their portfolios through the use of taxdeferred rollovers. (In quasi-corporate REITs,
the structure is such that income is flowed out
as participating interest to the investors.)
Response
This has not happened to the extent we had
anticipated.
Other future trends include:
Continued downward pressure on base-fees for
externally managed REITs;
More REITs have converted from external to
internal management.
External and internal managers rewarded by
performance;
H&R REIT has recently moved to reward senior
management through distribution performance.
Monthly distributions to better match yield
instruments (i.e. GIC's, T-Bill's);
This is standard for nearly all REITs.
Expansion of distribution reinvestment plans
(DRIP);
This has been slow to take-off but is now
accelerating as a method used by the REITs to
raise equity.
Expansion of option plans for the manager
(external and internal);
Unit option plans are now in place and has been
expanded since 1997.
REITs reducing distributions as a percentage of
distributable income, but not the dollar amounts;
This trend has become a reality.
Growth being favoured to the overall yield
performance of the REIT;
This has not happened. With few exceptions,
corporations have not been able to deliver
growth, which has been reflected in their share
price.
Re-emergence of the mortgage REIT; and
This has not happened.
Pension funds selling real estate portfolios in
exchange for units.
Has not yet happened with a few exceptions,
e.g.: Canada Life. Rather, pension funds have
acquired large Canadian corporations such as
Cambridge, Cadillac Fairview and Oxford
Properties.
56
U.S. Market as a Guide
The U.S. REIT Market has been in existence for a substantially longer period of time than the
Canadian Market and has already undergone a significant number of developments and changes.
Given that the Canadian Market tends to follow the examples of the U.S. Market, we would expect that
these developments in the U.S. will provide a guide as to potential changes in the Canadian REIT
Market in the future. Some of the major changes in the U.S. REIT Market have arisen from the
introduction of the REIT Modernization Act ("RMA") in 1999, effective 2001.
• Taxable REIT Subsidiaries: Prior to the RMA, REITs in the United States were only able to own up
to 10% of the voting securities of a non-REIT corporation and the securities of a single non-REIT
corporation was not allowed to exceed 5% of the REIT's assets. The result was that REITs could
not control a subsidiary to provide non-customary services to tenants, such as concierge systems,
parking garages, fitness centres, etc. Independent contractors had to be used to provide these
services resulting in a loss of control in relation to the quality of the service and a loss of income to
the REIT. The REIT Modernization Act has removed this impediment by allowing REITs to own up
to 100% of a "Taxable REIT Subsidiary" - a company set up to provide non-customary services to
the REIT's tenants. This will enable REITs to generate more revenue via service opportunities not
previously available to them. This expansion of services beyond the traditional real property rents
could also provide significant growth opportunities for Canadian REITs, who do not have the
restrictions of their U.S. counterparts.
• Reduction in Distributions: Another result of the RMA was to reduce the required distribution to
unitholders from 95% of taxable income (which excludes distributions and net capital gains) to 90%.
This will enable highly leveraged REITs to hold earnings for the purpose of repaying debts or for
expenditures to improve the capital value of properties through renovations. This will also allow
REITs to hold cash reserves to help cover expenses in times of economic slowdown. These
reductions in distribution percentages may flow through to the Canadian market, with
REITs retaining a larger portion of their income to help fund acquisitions and reduce debt.
• Consolidation of REITs: Another development that is being predicted for the U.S. REIT market is
the consolidation of REITs as they follow the trend of other industries moving from regional to
national entities. The experts believe that the U.S. REIT Market will eventually consist of a few
"Mega-REITs" and a large number of smaller sized REITs. The creation of "Mega-REITs" is
attractive to the industry and investors alike as it provides a number of benefits, including being able
to take advantage of significant economies of scale, creating a vehicle that will appeal to large
institutional investors (especially pension funds), greater liquidity, and diversification benefits. The
consensus is that while consolidations will occur, each REIT will remain focused on a specific
property type and seek instead to diversify within that area, for example - adding a more upscale
type of property to the portfolio or geographical diversification.
Other expectations for developments in the United States include:
• Disposition of properties in markets or asset classes where the REIT does not have the ability to
become a major player
• Increasing asset holdings in areas where there is a shortage of supply in the current environment
• Re-developing or re-tenanting properties to create higher yield in existing properties
• Reviewing internal processes and technology to create cost savings and increase effectiveness
• Focussing on Human Resources to promote REITs as an employer to choice to attract high quality
personnel.
57
Future Trends and Predictions for Canadian REITs
It is difficult to predict the future of any industry with absolute certainty; however, here are some trends
that we believe Canadian REITs may follow in the future:
• REITs become the vehicle of choice to access public capital for real estate investment;
• Increased use of leverage to create improved yields;
• New REITs being formed as open-ended Mutual Fund Trusts rather than closed-end trusts;
• Federal tax concessions to allow REITs to use corporate structures similar to U.S. REITs for legal
liability and tax purposes;
• More Canadian REITs entering the U.S. market through open-ended Mutual Fund Trusts;
• Pension funds or similar institution selling real estate portfolio’s (Direct or IPO) in exchange for REIT
units holding between 10-20% of the outstanding units of a particular REIT;
• Distributions as a percentage of distributable income will continue to decline and stabilize around 75%;
• Barriers to entry continue to rise, with smaller REITs being niche players;
• Large Canadian corporations with U.S. properties converting to a U.S. REIT;
• Pressure on REITs to continue to build asset base in excess of $.5 billion and increase equity float;
• Consolidation of REITs to achieve asset base in excess of $3 billion and equity in excess of $1billion,
which will create a "Super REIT" category;
• Significant increase in market transaction volumes for the REIT sector with increased liquidity being
rewarded in the unit price value, especially in the Super REITs;
• Market will give more weight to potential growth in the unit pricing;
• External managers, except for the smaller REITs, will not be acceptable to the market; the smaller
REITs will pursue a shared management platform (typically with the sponsor), with the REIT having
first call on the intellectual capital of management;
• Where external management exists, the cancellation of such contracts will not have a material
financial impact on the REIT;
• More REITs will enter into strategic relationships with a developer (usually the sponsor). The REIT
taking a financial risk via its mezzanine loans and being compensated with a higher interest yield on
such loans, and the developer assuming the development risk;
• REITs accessing capital through bought deals or private placement, and
• Transparency of results, corporate governance and make up of the independent trustees will become
increasingly important in assessing management's performance, good corporate governance and risk
levels.
58
Appendix 1 - Operating Cash Flow Available:
REIT vs. Corporation
Table 1
Operating Cash Flow Available - After Distributions / Dividends
Assume 10,100,000 units @ $10 each.
REIT Investors want a yield of 10%
$ 101,000,000
REIT
Revenue
Base Rental Revenue
Recovery Revenue
Interest and other Income
$
Corporation
19,000,000
6,500,000
50,000
25,550,000
$ 19,000,000
6,500,000
50,000
25,550,000
Mortgage / Bank Interest
Property Operating Costs
Internal management Costs
Transfer Agent
Trustee / Directors Fees
Legal, Audit, G and A
Capital Tax
Depreciation
Amortization of Tenant Inducements
Amortization of Leasing Costs
5,000,000
7,000,000
650,000
50,000
100,000
550,000
1,700,000
300,000
100,000
15,450,000
5,000,000
7,000,000
650,000
50,000
100,000
550,000
510,000
1,700,000
300,000
100,000
15,960,000
Income Before Income Taxes
Income Taxes @ 38%
Large Corporations Tax (less surtax credit)
Net Income
10,100,000
10,100,000
9,590,000
3,644,200
275,000
5,670,800
Add: Depreciation / Amortization
Cash Available for Distribution
2,100,000
12,200,000
2,100,000
7,770,800
10,370,000
1,830,000
233,124
$ 7,537,676
10%
0.2%
Distributions @ 85% / Dividends @ 3%
Retained Operating Cash Flow
$
Yield
Conclusion
> Cash Management in a REIT is extremely important
> The better expenses can be controlled, the easier it is to meet the desired investor yield.
59
Table 2
Operating Cash Flow Available - After Distributions / Dividends Assume 10,100,000 units @ $10 each.
REIT Investors want a yield of 10%
$ 101,000,000
Note: Operations are the same as Table 1 - Except Over-accrual of Recovery income of $1,000,000 in Prior Year (Bad Debt
in Current Year)
REIT
Revenue
Base Rental Revenue
Recovery Revenue
Interest and other Income
$
Mortgage / Bank Interest
Property Operating Costs
Bad Debt
Internal management Costs
Transfer Agent
Trustee / Directors Fees
Legal, Audit, G and A
Capital Tax
Depreciation
Amortization of Tenant Inducements
Amortization of Leasing Costs
Income Before Income Taxes
Income Taxes @ 38%
Large Corporations Tax (less surtax credit)
Adjusted Net Income
Add: Depreciation / Amortization
Cash Available for Distribution
Distributions @ 85% / Dividends @ 3%
Retained Operating Cash Flow
$
19,000,000
6,500,000
50,000
25,550,000
$ 19,000,000
6,500,000
50,000
25,550,000
5,000,000
7,000,000
1,000,000
650,000
50,000
100,000
550,000
1,700,000
300,000
100,000
16,450,000
5,000,000
7,000,000
1,000,000
650,000
50,000
100,000
550,000
510,000
1,700,000
300,000
100,000
16,960,000
9,100,000
9,100,000
8,590,000
3,264,200
286,000
5,039,800
2,100,000
11,200,000
2,100,000
7,139,800
9,520,000
1,680,000
Yield
To maintain Yield of 10% - special Unit Distribution of
Corporation
9%
$
$
214,194
6,925,606
0.2%
580,000
Conclusion
> Cash Management in a REIT is extremely important
> The better expenses can be controlled, the easier it is to meet the desired investor yield.
> Assumes that all AR is collectable - distributable income will drop - drop in the unit price to reflect new yield.
> No recourse - need to assume new set of investors each year.
60
Table 3
Operating Cash Flow Available Differences in the Definition of Distributable Income
Scenario 1 - Declaration of Trust defines Distributable Income as NI Per GAAP + Depreciation + Amortization (Leasing and
Scenario 2 - Declaration of Trust defines Distributable Income as NI Per GAAP + Depreciation + Amortization (TI Only)
Scenario 3 - Declaration of Trust defines Distributable Income as NI Per GAAP + Depreciation
Revenue
Base Rental Revenue
Recovery Revenue
Interest and other Income
Scenario 1
Scenario 2
Scenario 3
$ 19,000,000
6,500,000
50,000
25,550,000
$ 19,000,000
6,500,000
50,000
25,550,000
$ 19,000,000
6,500,000
50,000
25,550,000
5,000,000
7,000,000
650,000
50,000
100,000
550,000
1,700,000
300,000
100,000
15,450,000
10,100,000
2,100,000
12,200,000
5,000,000
7,000,000
650,000
50,000
100,000
550,000
1,700,000
300,000
100,000
15,450,000
10,100,000
2,000,000
12,100,000
5,000,000
7,000,000
650,000
50,000
100,000
550,000
1,700,000
300,000
100,000
15,450,000
10,100,000
1,700,000
11,800,000
Mortgage / Bank Interest
Property Operating Costs
Internal management Costs
Transfer Agent
Trustee / Directors Fees
Legal, Audit, G and A
Depreciation
Amortization of Tenant Inducements
Amortization of Leasing Costs
Net Income
Add: Depreciation / Amortization
Distributable Income
(Refer to definitions above)
Distributions @ 85%
Retained Operating Cash Flow
$
10,370,000
1,830,000
$
10,285,000
1,915,000
$
10,030,000
2,170,000
Conclusion
Definition of Distributable Income to exclude amortization can increase the amount of cash retained in the REIT.
61
Table 4
Operating Cash Flow Available - Working Capital/Line of Credit
Assumptions:
Working Capital / Line of Credit Available
Interest @ 7%
Tenant Inducements - Year 1
Tenant Inducements - Year 2 onwards
(30,000,000)
4,000,000
1,000,000
REIT
Line of Credit - Beg of Year
Operating Cash Flow retained after Distributions (Note 1)
Year 1
(1,000,000)
900,000
(100,000)
Year 2
(9,667,000)
1,250,000
(8,417,000)
Year 3
(15,356,190)
1,600,000
(13,756,190)
Mortgage Principal Repayments
TI's (Note 2)
Interest on Increase in Line of Credit (Note 3)
(5,000,000)
(4,000,000)
(567,000)
(5,000,000)
(1,000,000)
(939,190)
(5,000,000)
(1,000,000)
(1,312,933)
Working Capital / Line of Credit - End of Year
(9,667,000)
(15,356,190)
(21,069,123)
Corporation
Working Capital / Line of Credit - Beg of Year
Operating Cash Flow retained after Dividends (Note 1)
Year 1
(1,000,000)
4,462,000
3,462,000
Year 2
(5,855,660)
4,812,000
(1,043,660)
Year 3
(7,466,716)
5,162,000
(2,304,716)
Mortgage Principal Repayments
TI's
Interest on Increase in Line of Credit (Note 4)
(5,000,000)
(4,000,000)
(317,660)
(5,000,000)
(1,000,000)
(423,056)
(5,000,000)
(1,000,000)
(511,330)
Working Capital / Line of Credit - End of Year
(5,855,660)
(7,466,716)
(8,816,046)
Note 1
Assume - operating Cash Flow increases due to lower mortgage interest. Assumes distributable income is calculated
as Net Income + Depreciation + TI Amortization
Note 2
If define Distributable Income as Net Income + Depreciation (I.e. excludes amortization on TI's) - results in higher
retention of cash flow.
Note 3 - REIT - Interest On Working Capital / Line of Credit Calculation
Increase in Line of Credit Used
Interest at 7%
$
Year 1
Year 2
8,100,000 $ 13,417,000 $
567,000
939,190
Note 4 - Corporation - Interest on Working Capital / Line of Credit Calculation
Year 1
Working Capital/Line of Credit Used
$
4,538,000 $
Interest at 7%
317,660
Conclusion
REIT's generally need to go back to the market / raise more financing every three years.
Greater emphasis on cash management given lower operating cash retained after distributions.
62
Year 2
6,043,660 $
423,056
Year 3
18,756,190
1,312,933
Year 3
7,304,716
511,330
Table 5
Impact of Different Forms of Tenant Inducements on Cash Flow
Scenario 1 - Free Rent $1,000,000
Assumptions:
5 Year Lease
Base Rent = Distributable Income
$1,000,000 per Year - First Year Free
Base Rent
Distributable Income
Distribution (80%)
Cash Received
Cash (Shortfall) / Surplus
Year 1
Year 2
Year 3
Year 4
Year 5
800,000 $ 800,000 $ 800,000 $ 800,000 $ 800,000 $
800,000
800,000
800,000
800,000
800,000
(640,000)
(640,000)
(640,000)
(640,000)
(640,000)
1,000,000
1,000,000
1,000,000
1,000,000
$ (640,000) $ 360,000 $ 360,000 $ 360,000 $ 360,000 $
$
Total
4,000,000
4,000,000
(3,200,000)
4,000,000
800,000
Scenario 2 - Tenant Inducement - Tenant Allowance of $1,000,000
Assumptions:
Base Rent = Cash Received
5 Year Lease - $1,000,000 per Year
Capitalize the TI and amortize it over the lease period.
This scenario assumes that distributable income is calculating by not adding back amortization of TI's.
If distributable income was calculated by adding back amortization of TI's, cash savings would decrease. Refer to Table 3.
Year 1
Year 2
Year 3
Year 4
Year 5
Total
Base Rent
$ 1,000,000 $ 1,000,000 $ 1,000,000 $ 1,000,000 $ 1,000,000 $ 5,000,000
Amortization
200,000
200,000
200,000
200,000
200,000
1,000,000
Distributable Income
800,000
800,000
800,000
800,000
800,000
4,000,000
Distribution (80%)
(640,000)
(640,000)
(640,000)
(640,000)
(640,000)
(3,200,000)
Tenant Allowance
(1,000,000)
(1,000,000)
Add Back Amortization
200,000
200,000
200,000
200,000
200,000
1,000,000
Cash (Shortfall) / Surplus
$ (640,000) $ 360,000 $ 360,000 $ 360,000 $ 360,000 $ 800,000
Scenario 3 - Tenant Inducement - Leasehold Improvement of $1,000,000
Assumptions:
Base Rent = Cash Received
5 Year Lease - $1,000,000 per Year
Leasehold Improvement can be capitalized with cost of building and amortized over life of Lease
Since REITs add back depreciation to calculate distributable income, the capitalized amount of depreciation
will be paid out over the life of the capitalized asset.
(If improvement cannot be capitalized with building - see scenario 2)
Year 1
Year 2
Year 3
Year 4
Year 5
Total
Base Rent
$ 1,000,000 $ 1,000,000 $ 1,000,000 $ 1,000,000 $ 1,000,000 $ 5,000,000
Distributable Income
1,000,000
1,000,000
1,000,000
1,000,000
1,000,000
5,000,000
Distribution (80%)
(800,000)
(800,000)
(800,000)
(800,000)
(800,000)
(4,000,000)
Tenant Allowance
(1,000,000)
(1,000,000)
Cash (Shortfall) / Surplus
$ (800,000) $ 200,000 $ 200,000 $ 200,000 $ 200,000 $
Conclusion
Cash management is imperative.
It is important to understand the impact of operating and leasing decisions on cash flow.
Shortfall of cash will result in the REIT drawing more from line of credit - restricted by covenants.
Note: Calculations ignore operating cost recoveries, operating expenses, G & A.
63
Appendix 2 - Impact of Tax Deferred Distributions on the
Adjusted Cost Base of Units
For example, assume a unit was purchased at the beginning of the year for $10.00, the cash distribution
for the year was $0.90 per unit and the allocation of taxable income was $0.60 per unit. At the end of the
year, the unitholder's Adjusted Cost Base (ACB) would be $9.70, calculated as follows:
Year One
Original Cost
Cash Distribution
Allocation of Taxable
Income (per T3)
ACB, End of Year One
$10.00
(0.90)
0.60
$ 9.70
In the second year, the cash distribution for the year was $1.00 per unit and the allocation of taxable
income was $0.70 per unit. The ACB of the unit would now be $9.40, calculated as follows:
Year Two
ACB, End of Year One
Cash Distribution
Allocation of Taxable Income
ACB, End of Year Two
$ 9.70
(1.00)
0.70
$ 9.40
Then assume the unit is sold for $13.50 at the beginning of the third year; the unitholder would realize a
capital gain of $4.10 (i.e., $13.50 proceeds of disposition - $9.40 ACB). Thus the tax-deferred portion of
the distributions in Years One and Two has resulted in an increase in the capital gain of $0.60.
Assume that the unitholder has held a unit in a REIT for six years and the ACB of the unit at the end of
Year Six is reduced to $0.50. In Year Seven, the REIT distributes $1.50, of which $0.90 is taxable.
ACB, Beginning of Year Seven
Cash Distribution
Allocation of Taxable Income
ACB, End of Year Seven
$ 0.50
(1.50)
0.90
($ 0.10)
As the ACB is negative, the negative amount will be deemed to be a capital gain and the $0.10 will be
subject to tax. The ACB of the unit will be readjusted to zero and any further distribution received in
excess of the taxable income will again be subject to tax at the capital gain tax rate. In the example, the
ACB of the units will only become positive if the unitholder purchases additional units of the particular
REIT.
64
Appendix 3 - Comparison of Available Vehicles
The purpose of the Appendix is to illustrate the principal differences between operating a REIT vs. a
Corporation. 1
Structure and Regulation
Real Estate
Investment Trust
Structure and
Regulation
Public
Corporation
• A REIT is an open-ended or
closed-ended mutual fund
trust.
• Incorporated
Private
Corporation
• Incorporated.
• Regulated by the stock
exchange.
• Regulation created by the
Declaration of Trust (Self
Imposed Rules), which
includes:
1. Restricted use of
Proceeds
2. Eligible investments / noneligible investments
3. Distribution Policy
4. Self Imposed Covenants
(restrictions on borrowing)
5. Restriction on issue of
new units
6. How distributable income
is calculated
• Non-compliance with
declaration of trust results in
a loss of credibility.
Advantages
• Increased capital
• Increased capital
• Improved financial position
• Improved financial
position
• Enhanced ability to raise
capital
• Enhanced ability to raise
capital
• Liquidity and valuation
• Tax effective investment
vehicle (See detailed
explanation of Tax
Implications outlined below
disadvantages)
• Set up for yield not growth.
• Liquidity and valuation
• High retention of earnings
• Shares can be used for
making acquisitions
• Stock and stock options
are useful in attracting
management.
• Easier to align
corporation with
shareholder interests
• Direct linkage between
property performance
and management
compensation
• Quicker decision making
flexibility
• Less regulation (cheaper
to operate).
1This is a general Discussion and may not be applicable to a specific REIT, Public Corporation or Private Corporation.
65
Real Estate
Investment Trust
Public
Corporation
Private
Corporation
Disadvantages
• Disclosure of increased costs
• Management demands
(operations open to public
scrutiny)
• Loss of control
• Pressure to maintain
distributable income
• Majority of earnings
distributed to unitholders
• Restricted by the definition of
a "Mutual Fund Trust", need
to comply with restrictions, no
curing process if offside with
definition and rules of mutual
fund trust for income tax
purposes
• Initial Tax Consequences for
transferring the assets to the
REIT
• Fishbowl Concept - REIT is
open to exposure and scrutiny
by the public. (Comparison to
other REITs).
• Disclosure of increased
costs
• Management demands
(operations open to public
scrutiny)
• Pressure to maintain
growth / Earnings
• Loss of control
• Fishbowl Concept Company is open to
exposure and scrutiny by
the public. (Comparison to
other real estate
companies).
• Fewer options to raise
capital (Expensive
Capital).
Tax
Considerations
• To avoid paying tax under Part
I of the Income Tax Act, a REIT
must distribute to its
unitholders, an amount equal
to its taxable income
• Tax liability is that of the
unitholder and not that of the
REIT - no deferred income tax
• Not subject to Large
Corporations Tax, Capital Tax,
Ontario Minimum Tax
• An investment in a REIT is
considered Canadian Property
as long as the REIT does not
invest more than 30%
(generally based on cost) of its
assets outside Canada
• Subject to tax on income
earned outside of the Trust i.e.
in a corporation
• Subject to tax on income
earned outside of Canada (i.e.
U.S.) - to the extent permitted
can designate as a foreign tax
credit to unitholders
• Non-compliance with the
Income Tax Act - could result in
the REIT becoming an
ineligible investment - often no
curing process
• Practically need to issue T3's
by February 28.
• Large Corporations Tax,
Capital Tax, Ontario
Minimum Tax
• Deferred income tax
• Subject to tax on income
earned in the United
States - foreign tax credit.
• Large Corporations Tax,
Capital Tax, Ontario
Minimum Tax
• Deferred income tax
• Subject to tax on income
earned in the United
States - foreign tax credit.
66
Accountability, Management Focus and Reporting
Real Estate
Investment Trust
Accountability
Public
Corporation
• Activities governed by Board
of Trustees
• Activities governed by
Board of Directors
• Activities governed by
major shareholders
• Management is accountable
to unitholders and analysts
• Management is
accountable to
shareholders, analysts
• Leeway for mistakes mistakes kept private
(only known to
shareholders and
debtholders.)
• Mistakes will be reflected in
unit value
• Analysts focus on a line-byline basis - impact on
distributable income.
Management
Focus
Private
Corporation
• Mistakes will be reflected
in share value.
• Analysts focus on
Revenue and Net Income.
• Need to consider impact
of decisions on quarterly
and annual results
• Need to consider impact of
decisions on monthly
distributions
• Need to consider user needs - • Focus is creating long
term value for
focus is cash flow
shareholders.
• Need to consider impact of
• Need to consider impact
of decisions on annual
results
• Focus is creating longterm value for
shareholders.
decisions on covenants.
Reporting
• Annual audited financial
statements, release results
140 days after year-end
• Given monthly distributions monthly accounting needs to
be accurate
• Emphasis on monthly cut-off
and accruals, also need to
produce quarterly results.
67
• Annual audited financial
Statements, release
results 140 days after
year-end
• Produce quarterly results quarterly accounting
needs to be accurate
• Emphasis on quarterly
cut-off, and accruals.
• Annual audited financial
statements - if required by
a user
• Emphasis is on an annual
basis.
Appendix 4 - Continuous and Periodic
Disclosure Requirements of a REIT
What
Quarterly financial
statements
Annual financial statements
and MD&A
When
To Whom
• Within 60 days of end of 1st,
2nd, and 3rd financial quarter
end
• TSX Company Reporting
• Within 140 days of financial
year-end
• TSX Company Reporting
• OSC
• Shareholders
• OSC
• Shareholders
Annual Report
• Within 140 days of financial
year-end
• TSX Company Reporting
Notice of shareholder
meetings and
management's proxy
solicitation information
circular
• Annual meeting must be held
within 6 months of the fiscal
year end
• TSX Company Reporting
Notice of record date and
meeting date
• At least 25 days before record
date
• TSX Market Data Services
• Shareholders
• OSC
• Shareholders
• Canadian Depository for
Securities
• OSC
Distribution declaration·
• Media Release
• Immediately after declaration
and at least 7 days before
record date
• TSX Dividend Administrator
TSE annual questionnaire
• July 31 each year (prepared
as at June 30)
• TSX Company Reporting
Change in issued capital
• Monthly
• TSX Company Reporting
Annual Information Form
• Within 140 days of financial
year-end
• OSC
Insider reports
• Initial insider report
• Report of insider trade
• Within 10 days of the trade
• OSC
Material Information
• Media release (If
information is a material
change, file material
change report with the
OSC within 10 days of
change)
• Pre-notification to TSX, prior to
issuance of media release
• Market Surveillance
• News Service
• Format of report found in OSC
Rule 55-501
• TSX Market Surveillance
• OSC
• News Service
68
What
Rights offering
When
To Whom
• Immediate notice to TSX and
OSC of proposed offering with
draft circular. Record date
must be at least seven trading
days after final acceptance.
• TSX Company Regulation
Additional listing
• Issue of shares or increase
in number of shares
reserved
• Changes in capital
• Immediate notice of proposed
transaction, prior acceptance
by TSX is required
• TSX Company Regulation
Grant of options or other
rights under share
compensation arrangement
• Pre-approval of share
compensation plan
• OSC
• OSC
• File Form 45-501F1 within ten
days for private placements.
• TSX Company Reporting
• OSC
• Monthly reporting of grants
made under share
compensation arrangement;
insider report may be required
• Annual reporting to OSC.
Exercise of options or
issue of units under
approved unit
compensation arrangement
• Monthly reporting of issue of
units under unit compensation
arrangement; insider report
may be required
• TSX Company Reporting
• OSC
• Annual reporting to OSC if
less than 1% of issued and
outstanding units issued within
one calendar month, otherwise
within ten days of the end of
the month.
Normal course issuer bid·
• Pre-clear notice and media
• File notice
release with TSX only
• Media release·
• Within 10 days of month end
• Monthly report of purchases
• File insider report within ten
• Insider report
days of trade (The REIT is an
insider of itself).
• TSX Regulatory & Market
Policy
Redemption of listed
securities
• Immediate notice to TSX at
time of sending notices to
shareholders. Pre-clear partial
redemptions at least seven
trading days before the record
date.
• TSX Company Regulation
• Prior acceptance by TSX
required before certificate of
amendment issued
• TSX Company Regulation
Unit consolidation
• Letter of transmittal.
69
• OSC
• Unitholders
• OSC
• Unitholders
• Unitholders
What
When
To Whom
Unit split by way of stock
dividend
• Prior acceptance by TSX
required. Same as dividend
declaration and additional
listing
• TSX Company Regulation
Charter amendments,
including change of name
• Prior acceptance by TSX
required. Immediate notice to
TSE after certificate of
amendment issued
• TSX Company Regulation
Supplemental listing
• To list units of a class not
already listed
• Prior acceptance by TSX
required, using a preliminary
prospectus or draft information
circular
• TSX Company Regulation
Capital reorganization
• Issue of securities upon
exchange of securities,
amalgamation /
reorganization
• Immediate notice to TSX of
proposed change, prior
acceptance by TSE is required
• TSX Company Regulation
Change to unit certificates
• Immediately after any change
to a certificate, a new
specimen must be filed
• TSX Company Regulation
Change of Transfer Agent
• Minimum two weeks notice TSX Consent required
• TSX Company Regulation
Creation of restricted units
• Prior acceptance by TSX
• TSX Company Regulation
Material change report
• Within ten days of material
change
• OSC
70
• TSE Dividend Administrator
• OSC
• OSC
• Unitholders
Glossary of REIT and Real Estate Terms Commonly
Used in Canada
Adjusted Funds from Operation (AFFO)
Adjusted funds from operations is generally defined in Canada as the funds from operations (FFO)
less ongoing capital expenditures, tenant improvements and other adjustments.
Amortization
The gradual reduction of an amount over a period of time, such as the principal amount of a mortgage
or the cost of an asset being written off against income.
Anchor Tenant
The major tenant or tenants in a shopping centre, usually a department store, discount store, or
supermarket. See Prime Tenant.
Annualized Return
Expressing the return on an investment for a period other than one year as an equivalent return on an
annual basis. Because annualized return is computed on a time value basis, it is not the same as an
arithmetic average. Under some circumstances, such as when the total amount invested varies over
the period, annualized return may provide a misleading or meaningless number.
Appraised Value
An opinion of value formally expressed in writing by an independent appraiser based upon one or
more of the three traditional analytic approaches: the cost approach, the market approach, or the
income approach.
Book Value
The carrying amount of an asset, as shown in the financial accounts of a company. The amount paid
for an asset, less depreciation and/or amortization.
Canadian Institute of Public and Private Real Estate Companies
(CIPPREC)
Formed in 1970 as a non-profit real estate industry association, to represent the interests of Canadian
real estate companies and to serve as a forum for the discussion of issues of concern to companies
and REITs in all areas of real estate.
Capital Cost Allowance (C.C.A.)
An income tax term in Canada. The equivalent of the accounting depreciation charge. C.C.A. is
usually calculated on a declining balance basis and generally results in deductions for tax purposes,
which are in excess to those claimed as depreciation for financial purposes.
Capital Improvements
Expenditures that remedy a property's deterioration, appreciably prolonging a property's useful life, or
adding to the value of the property.
Capitalization
In real estate, a valuation methodology used to convert a single year's net operating income into an
expression of a property's value. Arrived at by dividing the net operating income by the capitalization
rate.
71
Capitalization Rate
In real estate, the capitalization rate is the yield of a property computed by dividing the normalized net
operating income by the property value, expressed as a percentage. For those more familiar with
financial equities, the capitalization rate may be thought of as a measure of yield, analogous to the
inverse of "earnings per share" as applied to a share of stock. A rate of return used to derive the capital
value of an income stream. The formula is
Capitalization Rate
=
annual income
capitalization rate
Cash Flow
The cash remaining after various expenses and expenditures are deducted from income. Cash flow can
be defined in variety of ways depending upon which expenses and expenditures are deducted. In
general, the unqualified term usually means net cash flow.
Declaration of Trust
A set of rules adopted by the Trustees at the inception of the REIT, similar to the Memorandum of
Incorporation and Articles of Association of a corporation. Sets out the definition of distributable income,
prohibits investment in certain assets or activities, restricts the percentage of the REIT's assets that can
be invested or loaned, defines borrowing limitations and restricts the REIT's ability to invest in certain
activities. All material clauses usually require 2/3 of the unitholders to approve changes. Other clauses
require only 51% of the unitholders to approve a proposed change.
Depreciation
An accounting expense that allocates the cost of an asset over its estimated useful life. The
undepreciated value of the asset is referred to as the net book value. Methods of calculating depreciation
include straight line, declining balance and sinking fund. Also see Capital Cost Allowance.
Diluted Distributable Income Per Unit
Distributable income per unit adjusted for the impact of any dilutive potential units that were outstanding
during the reporting period.
Distributable Income
A defined term adopted by each REIT, it is generally defined as net income of the REIT and its
consolidated Subsidiaries (if applicable), as determined in accordance with Canadian generally accepted
accounting principles ("GAAP"), subject to certain adjustments as set out in the Declaration of Trust,
including adding back depreciation and amortization , future income tax expenses and excluding any
gains or losses on the disposition of any asset, future income tax benefit and any other adjustments
determined by a majority of the Trustees in their discretion.
Distributable Income Per Unit
Distributable income divided by the weighted average outstanding units issued by the REIT during the
reporting period.
Distribution Reinvestment Plan
The plan adopted by a REIT, pursuant to which Canadian resident unitholders of that REIT will be entitled
to elect to have cash distributions in respect of units automatically reinvested in additional units.
72
EBIT
Earnings before interest and taxes.
EBITDA
Earnings before interest, taxes, depreciation and amortization.
Fair Market Value
The value that a willing buyer would pay to a willing seller for a specific property where all material
facts are known to both parties.
Free Rent
A concession granted by a landlord to a tenant whereby the tenant is permitted, for a portion of the
lease term, to occupy its space without payment of base rent, and sometimes without payment of any
rental charges.
Funds from Operations (FFO)
The cash remaining from net operating income after deduction of debt service and ground lease
payments but not capital expenditures or income taxes.
CIPPREC defines FFO as the equivalent of income before extraordinary items adjusted for future
income taxes, depreciation and amortization of capital items and deferred leasing costs, any gain or
loss on sale of or provision against capital items and undistributed profits of equity accounted investees
and non-controlling interests.
CIPPREC attributes the importance of FFO to the following reasons:
• "properties are bought and sold based on projections of their cash flow;
• the ability to finance properties is dependent on the cash flow the properties can generate; and
• the shares of public real estate companies trade on the basis of multiples of cash flow from
operations. The relationship between share or unit price and cash flow from operations is
particularly strong for those companies or REITs engaged solely in the ownership of income
properties".
Future Income Taxes
A financial reporting practice whereby taxes are provided for in the accounts of the enterprise during
the period transactions occur, regardless of when such transactions are recognized for tax purposes. In
the real estate industry, the tax deferral generated by the difference between depreciation and capital
cost allowance is usually a major component of future income taxes.
Gross Book Value
At any time, the book value of the assets of the REIT and its consolidated subsidiaries, as shown on its
most recent consolidated balance sheet, plus the amount of accumulated depreciation and
amortization as reflected in the financial statements.
73
Head Lease
A head lease arrangement is such that one person - the head tenant - leases an entire property from the
owner and then re-leases the property to other tenants.
Independent Trustee
A Trustee who is "unrelated" (as defined in Section 474 of the Toronto Exchange Company Manual
Guidelines on Corporate Governance) and is not "related" within the meaning of the Income Tax Act.
NAREIT
National Association of Real Estate Investment Trusts, a U.S. trade association representing publicly
traded and privately placed real estate investment trusts (REITs).
Net Asset Value
Current real estate value or equity, net of debt. In common practice, current real estate value is
considered to be the most recent appraised value, or if prior to the initial appraisal following acquisition,
the asset's acquisition cost adjusted for capital expenditures and additional contributions or distributions.
Over-Allotment Option
The option granted by a REIT to the Underwriters, exercisable for a period of 30 days after Closing, to
purchase up to a stated additional number of Units on the same terms as the Offering, solely to cover
the over-allotment.
Prime Tenant
In a shopping centre or office building, the tenant who occupies the most space. Prime tenants are
considered credit worthy and attract customers or traffic to the centre.
74
Glossary of REIT and Real Estate Terms Commonly
used in the USA
(Most of these terms also apply to Canadian REITs)
Adjusted Funds from Operations (AFFO)
In part to cope with the limitations associated with the calculation of Funds from Operations (FFO),
many portfolio managers and analysts calculate adjusted funds from operations, or AFFO. Some
analysts, companies, and portfolio managers prefer the terms cash available for distribution (CAD), or
funds available for distribution (FAD) to AFFO. More important than which acronym you adopt is how
you get from FFO to AFFO. Though there is some debate, most industry veterans derive AFFO by
adjusting FFO for the straight lining of rents, as well as after establishing a reserve for costs, which,
though necessary and routine, aren't costs that can be recovered from tenants. This includes certain
maintenance costs and leasing costs.
Adjusted Funds from Operations (AFFO) Multiple
A company's AFFO yield and its AFFO multiple are reciprocals of one another. Both are valuation
measures. For a variety of reasons including P/AFFO multiples are roughly equivalent to P/E ratios
AFFO multiples are more often cited as a valuation measure than AFFO yields. Some portfolio
managers contend that comparing AFFO multiples to growth rates are a useful valuation screen. If a
company's growth rate is equal to or exceeds its AFFO multiple, the REIT isn't overpriced. Most
portfolio managers modify this screen by factoring into the equation an appropriate "discount rate."
Adjusted Funds from Operations (AFFO) Payout Ratio
This is the single best measure of a company's dividend paying ability. It is calculated by dividing the
company's per-share annual dividend by the current year's per share AFFO estimate.
Adjusted Funds from Operations (AFFO) Yield
In addition to being one measure of valuation, AFFO yield is often used as a proxy for a company's
nominal cost of capital. It is calculated by dividing a company's per-share AFFO estimate by its stock
price. If a company with an AFFO yield of 6.5% buys a property at a going-in-stabilized return of 7.5%,
it has acquired the property at a 100 basis point (or one percentage point) positive spread to its nominal
cost of capital.
Cost of Capital
Variously defined as the weighted average of the cost of equity and debt capital employed by a REIT.
Unfortunately, an incorrect definition of this term is often commonly used, which equates the cost of
equity capital to the REIT's current dividend yield or FFO yield. A REIT's "true" cost of capital is the
investor's expected rate of return on his/her investment.
Debt Service
Interest payments on debt and principal payments to retire debt. For accounting purposes, interest
payments are considered to be expenses while principal payments are treated as capital expenditures.
DOWNREIT
A side benefit of the UPREIT structure is that operating partnership units can be used as currency to
acquire properties from owners who would like to defer taxes that would come due if the property(ies)
were sold or swapped for stock. In response to this advantage of the UPREIT structure, a number of
non-UPREITs have created so-called DOWNREITs. This makes it possible for them to buy properties
using DOWNREIT partnership units. The effect is the same, however; the DOWNREIT is subordinate to
the REIT itself, hence the name.
75
Funds from Operations (FFO)
Equal to a REIT's net income after the adding back of real estate depreciation and amortization (not
including the amortization of deferred financing costs). This is the measure of REIT operating
performance most commonly accepted and reported by REITs, conceptually analogous to net income of
non-real estate companies. The principal reason for the add backs is that real estate assets tend to
appreciate, making an income statement that includes GAAP historical cost depreciation a misleading
indicator of REIT profitability.
This is a concept pioneered by the National Association of Real Estate Investment Trusts (NAREIT), a
U.S. REIT association. It is intended to measure a REIT's operating results. NAREIT defines FFO
as:"GAAP Net Income less gains or losses from sales of properties or debt restructuring plus
depreciation of real estate." NAREIT offers the following explanation:
"FFO is different from corporate 'earnings' in that historically, commercial real estate
maintains residual value to a much greater extent than machinery, computers or other
personal property."
Implicit 12-Month Total Return
This is calculated by adding the REIT's year-over-year growth rate and its current stated annual dividend.
This is a "guesstimate" of total return potential that is widely used. Some industry veterans criticize this
guesstimate of total return because, among other things, it fails to take into account potential changes in
multiples. As long as investors recognize its potential shortcomings, implicit 12-month total returns can
serve as a useful screening tool when putting together a REIT portfolio.
Implied Cap Rate
Net operating income (NOI) divided by a REIT's total market capitalization (the sum of its equity market
capitalization and its total outstanding debt).
Interest Coverage Ratio
Simplify referred to as the REIT's coverage ratio, it's the ratio of EBITDA to interest expense.
Increasingly viewed as the best means of comparing and assessing REITs' financial leverage among
REITs.
Net Asset Value (NAV)
When evaluating public companies, investors generally focus on price-to-book ratios as one valuation
measure. Unfortunately, price-to-book ratios are inappropriate for REITs insofar as a REIT's book value,
which is based on historic cost figures, may not accurately reflect the earnings capacity of otherwise wellmaintained assets. Also, the balance sheet consolidations accompanying IPOs were often pursued using
different accounting conventions, resulting in an apples-to-oranges comparison between companies.
Thus, many analysts prefer to use net asset value as a surrogate for book value, which is appropriate
insofar as book value is meant to represent an entity's liquidation value.
Positive Spread Investing
Defined as when a REIT buys a property that has a higher initial yield than the current yield on the
REIT's capital. For example, a REIT buys a property yielding 11% (property net operating income divided
by the all-in cost of the property) at a time that its debt is borrowed at 8% interest and its equity is trading
at an FFO yield (inverse of its FFO multiple) of 10%. If the REIT is funded half with equity and half with
debt, it realizes a 200 basis point (11% minus 9%) positive spread.
76
Real Estate Investment Trust (REIT)
A real estate investment trust is a private or public trust (or corporation in the United States) that enjoys
a special status under the U.S. tax code that allows it to pay no corporate income tax so long as its
activities meet statutory tests that restrict its business to certain commercial real estate activities. Most
states honour this federal treatment and do not require REITs to pay state income tax. By law, REITs
must pay out 90% of their taxable income.
Return of Capital
The portion of a REIT's dividend in excess of taxable income. Because REIT dividends are often higher
than taxable income, principally due to depreciation, the amount by which the dividend exceeds taxable
income is a return of capital to a shareholder, meaning that for a taxpaying shareholder it does not
create currently taxable ordinary income, but instead reduces the shareholder's tax basis. At the final
sale of the shares, the difference between tax basis and final net sales price is recognizable as a capital
gain. To the extent the final capital gains rate is lower than interim ordinary income tax rates, REITs
provide a tax shelter function for certain taxpaying investors, by allowing the deferral of tax on current
cash received as dividends and taxing it at a lower rate upon disposition of the shares.
Straight Lining
REITs straight-line rents because generally accepted accounting principles, or GAAP, require it.
Typically, a tenant's monthly rent will increase over the life of a lease; this applies to commercial
properties, not usually residential properties. Straight lining averages the tenant's rent payments over
the lease's life. In other words, rental revenues are overestimated in the early years and
underestimated in the later years.
Total Debt and Total Market Capitalization
Together, these measures have been used to provide an assessment of leverage. Debt-to-Total Market
Cap was the most often cited measure of leverage early on in the current REIT underwriting cycle (circa
1993). There are a number of problems associated with using it for that purpose, however. Chief
among those is that it doesn't provide meaningful information regarding a REIT's ability to service its
debt.
Umbrella Partnership REIT (UPREIT)
A REIT structure in which the REIT does not own a direct interest in properties, but rather in an umbrella
partnership that owns interests in properties. For this reason, this umbrella partnership is generally
referred to as the operating partnership. It is also common for an operating partnership in an UPREIT
structure to own interests in joint ventures in addition to properties. The UPREIT has been the structure
of choice in most REIT initial public offerings over the past several years, owing to the tax deferral
benefits this structure offers to the transferring company's principals.
In a nutshell, the UPREIT structure allows the principals, who are transferring their properties from
private ownership to public ownership via an IPO, to maintain their historical cost basis by transferring
the properties to the operating partnership ("OP") rather than directly to the REIT.
The REIT, in turn, is the general partner of, and owns a majority interest in, the operating partnership. If
the properties were transferred directly to the REIT, it would result in a stepped-up cost basis in the
properties for the new public entity and trigger a taxable event for the transferring principals. By
transferring the properties to the operating partnership in exchange for operating partnership (OP) units,
the principal's historical cost basis is maintained.
The OP units are exchangeable on a one-for-one basis into REIT common shares and, over time, the
principals can convert OP units to REIT common shares (triggering a taxable event), giving the
principals the option to incur their tax liability in smaller increments.
77
Acknowledgement
Material for the REIT Guide has been compiled from internal and external sources.
Thank you to all the people at Deloitte who played a role in compiling and sourcing the
material:
• Elizabeth Abraham
• Eddy Burello
• Tony Cocuzzo
• John Cressatti
• Scott Cryer
• Jacqui Hop Hing
• Katie Hynd
• Don Newell
• Mike Shumate
• Alan Walker
We wish to acknowledge articles and material issued by the following:
• Deloitte Touche Tohmatsu
• CIBC World Markets Inc.
• Dow Jones
• Fortune Magazine
• Green Street Advisors
• Merrill Lynch & Co.
• National Association of Real Estate Investment Trusts (NAREIT)
• National Bank Financial
• Prudential's Bernard Winograd
• RBC Dominion Securities Inc.
• Salomon Brothers Inc.
To obtain additional copies of this Guide,
please contact Don Newell at:
Tel: 416-601 6189
Fax: 416-601 6444
To obtain information on U.S. REITs, please contact Don Newell or
one of the following U.S. regional REIT experts:
Jim Berry, Dallas
Michael Carnevale, New York City
James de Bree, Los Angeles
Craig Donnan, Cleveland (U.S. REIT leader)
Joe Ferst, Atlanta
Tom Francis, San Francisco
Doug McEachern, Los Angeles
Tim Overcash, Northern Virginia
Jim Sowell, Washington
© 2004 Deloitte & Touche LLP and affiliated entities.
214-840 7360
212-436 4164
213-688 5261
216-589 1464
404-220 1313
415-783 4375
213-688 3361
703-251 1530
202-378 5234