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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 Owners Perspective . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .42
From an Investors 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.
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.
Health Care
4%
Specialty
2%
Mortgage
2%
Diversified
9%
Office/Industrial
32%
Residential
21%
Retail
20%
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.
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.
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.)
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%
Office/
Industrial
13%
Retirement
6%
Hotel
25%
120%
Diversified
100%
Hotel
Total Return (%)
80%
Office/Industrial
60%
40%
Residential
20%
Retail
0%
1997
1998
1999
2000
2001
Q1 2002
Retirement
-20%
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
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.
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
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
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
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
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
22
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.
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
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.
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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
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
29
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
Development
Projects
Quality of
Property
31
Corporation
Diversification
Other
Corporation
Corporation
34
Corporation
35
Corporation
36
Corporation
37
Corporation
38
Corporation
39
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
U.S. REIT
Canadian REIT
Governed by
Vehicle
Revenue Rules
42
Feature
U.S. REIT
Asset Rules
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.)
Taxation
Transfer of Real
Estate to the REIT
43
Feature
Liability of
Investors
U.S. REIT
Canadian REIT
44
Investors
Trust
99.99%
Royalty
Interest
Management
Company
Operating
Company
Resource
Property
(Oil and Gas)
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
Royalty Trust
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
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.
53
54
Response
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.
56
57
58
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
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
10,100,000
10,100,000
9,590,000
3,644,200
275,000
5,670,800
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%
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
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
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)
(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)
(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)
(5,000,000)
(4,000,000)
(317,660)
(5,000,000)
(1,000,000)
(423,056)
(5,000,000)
(1,000,000)
(511,330)
(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
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
63
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
Public
Corporation
A REIT is an open-ended or
closed-ended mutual fund
trust.
Incorporated
Private
Corporation
Incorporated.
Increased capital
Increased capital
Improved financial
position
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)
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).
Tax
Considerations
66
Public
Corporation
Activities governed by
Board of Directors
Activities governed by
major shareholders
Management is accountable
to unitholders and analysts
Management is
accountable to
shareholders, analysts
Private
Corporation
decisions on covenants.
Reporting
67
When
To Whom
OSC
Shareholders
OSC
Shareholders
Annual Report
Notice of shareholder
meetings and
management's proxy
solicitation information
circular
Shareholders
OSC
Shareholders
Distribution declaration
Media Release
Monthly
OSC
Insider reports
Initial insider report
Report of insider trade
OSC
Material Information
Media release (If
information is a material
change, file material
change report with the
OSC within 10 days of
change)
Market Surveillance
News Service
68
What
Rights offering
When
To Whom
Additional listing
Issue of shares or increase
in number of shares
reserved
Changes in capital
Pre-approval of share
compensation plan
OSC
OSC
Exercise of options or
issue of units under
approved unit
compensation arrangement
Redemption of listed
securities
Unit consolidation
Letter of transmittal.
69
OSC
Unitholders
OSC
Unitholders
Unitholders
What
When
To Whom
Charter amendments,
including change of name
Supplemental listing
To list units of a class not
already listed
Capital reorganization
Issue of securities upon
exchange of securities,
amalgamation /
reorganization
OSC
70
OSC
OSC
Unitholders
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.
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.
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.
72
EBIT
Earnings before interest and taxes.
EBITDA
Earnings before interest, taxes, depreciation and amortization.
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.
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).
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
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
76
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.
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
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