Canada: New Balance Sheets And REITs

Last Updated: June 12 2013
Article by Claude Désy

The public announcements by Loblaw and Canadian Tire that they will soon transfer a major portion of their real estate portfolio to a real estate investment trust ("REIT") are indicative of the changes in strategy and means of financing of certain businesses, namely corporations owning mature real estate properties. Other corporations are currently considering the possibility of creating such an investment vehicle.

The demand for REIT securities is such that it is leading to the listing on the stock exchange of new real estate investment funds owning foreign property. REITs owning real estate and other buildings could also emerge.

On May 24, 2013, the Choice Properties REIT filed its preliminary prospectus of which Loblaw is the promoter. It will transfer to the REIT real estate valued approximately at 7.2 billion dollars.1 At the time of the announcement of the creation of this REIT, it was expected that the latter would hold approximately 80% of the REIT units. In turn, Canadian Tire announced on May 9, 2013 that it would create a REIT. It expects to transfer to it real estate valued approximately at 3.5 billion dollars and to hold 80% to 90% of its units.2

Following these announcements, the market value of Loblaw's and Canadian Tire's securities increased. Why did the market react by giving these corporations a bump in value following these announcements? First of all, one should observe that, over the past few decades, these corporations acquired real estate assets that are favourably positioned and their value has increased.

Background

The real estate sector is currently the darling of the capital markets. In Canada, the market capital of issuers in this sector represents 4% of the market capital of the two equity markets belonging to the TMX Group. Furthermore, over the past twelve months, this sector garnered 20% of the capital raised on these public markets. The TMX Group is of the following view:

        "Toronto Stock Exchange and TSX Venture Exchange, together form one of the most active exchange groups in the world for the public real estate sector," said Ungad Chadda, Senior Vice President, Toronto Stock Exchange. "Real estate companies from all over the world have started to look more closely at their options for listing and raising growth capital in Canada."3

Real estate investment trust

A REIT is a passive investment vehicle owning mature real estate generating a stable cash flow distributed on a monthly basis. Its securities are listed on a stock exchange and are therefore freely tradeable. Generally, the securities appreciate in value over the long term and in modest fashion. Over the past twelve months, the Canadian and US S&P TSX Capped REIT Index and MSCI US REIT Index respectively had total yields of 11.05% and 24.64%.

Previously, securities issued by entities in the real estate sector were treated as alternative investments. Now, some are of the opinion that they no longer fall in this category. Many retirement funds are currently significant holders of such securities. Some specialists are of the opinion that the real estate should represent between 5% and 15% of their total portfolio.4 Also, we are witnessing a proliferation of mutual funds, specifically exchange-traded funds, the strategy of which is to invest in the securities of public real estate entities.

New balance sheets

The balance sheet of a business enables one to better assess its financial health. In most cases, the strength of a business is evident from the state of its balance sheet. The quality of the items on the balance sheet and its strength demonstrate the capability of the business to attain its goals, namely its organic or external growth objectives, and allows one to assess if, on the mergers and acquisitions market, it will be a predator or a prey. It also shows its ability to pay dividends or to redeem its securities.

For one, pursuant to the new accounting standards, some corporations will include in their balance sheet the market value of their real estate properties. Hence, the relative value of this item compared to the value of the other assets of the corporation could in certain cases be surprising. The balance sheet might evidence the fact that the real estate represents a significant portion of the value of the corporation. Analysts will group the assets of these corporations by category, namely the market value of real estate and the value of one or several of their active businesses. Among others, an attempt will be made to discover the ability of the corporation to monetize its real estate portfolio in the short and medium term.

Also, the balance sheets of corporations which decide to monetize their real estate through a REIT will be considerably different. In exchange for the transfer of assets to the REIT, the transferor will receive a mix of, for instance, cash, units of the REIT (or securities of one of its subsidiaries) and the assumption, by the REIT, of some of its debts. The balance sheet will, therefore, have been transformed by the conversion of a real estate asset into cash and into freely-tradeable securities and by a reduction of the debt.

The fact that the transferor holds units of the REIT indicates a convergence of the interests of the investors and those of the transferor. The significance of the interests retained is a reassuring factor for the investors. As well, depending upon the significance thereof, on the agreements entered into between the transferor and the REIT and on the REIT's investment policy, there will be some level of control over the direction of this vehicle.

Management of the REIT

REITs fall into two types of management models, namely the internally managed and the externally managed. In the first case, the REIT is managed by its sponsor. Its asset management is entrusted to a subsidiary of the sponsor in exchange for compensation including some of the following items: a percentage of the value of the portfolio, income, returns on the portfolio and the value of certain transactions (sales, purchases, financing transactions, real estate development...). This asset manager is also responsible for the management of the real estate. This managed component may be entrusted to one or several subcontractors.

In the event of an internal management, the management is entrusted to employees of the REIT.

In the event of a start-up REIT, with a modest initial portfolio, it is unable to bear significant fixed management fees, which frequently explains that it would opt instead for the external management method. Generally, a provision in the asset management agreement provides for the possibility of repatriating the asset management once the portfolio has achieved a certain size.

Other agreements are included in the fundamental structure of a REIT. For instance, a right of first refusal on real estate disposed of by the sponsor of the REIT or which it develops. Non-competition and cooperation agreements are also possible. Lease agreements in respect of building leased by the REIT to the sponsor are also of interest.

Subsequently...

Once the structure of a REIT has been finalized, the value and potential of a corporation and its REIT are more clearly established. Investors wishing to acquire securities of either will have a better understanding of the value of their various components.

Some corporations will have become strong predators mainly for the following reasons:

  • Their strengthened balance sheet will now include significant liquid assets, a reduced cost of capital and an access to various types of financing.

  • They will have in their hand an additional investment vehicle dedicated to their acquisition strategy. For instance, the acquisition of a target corporation could take place as follows: the corporation could acquire the active business of the target whereas the REIT could seek to acquire the real estate of the target.

The infatuation for REIT securities will allow those who now adopt such a strategy to be the first to acquire significant targets, which would have otherwise been much more difficult to achieve.

The demand for REIT's securities has, in turn, led to a demand on their part for real estate which generates stable cash flows. One can, therefore, expect REITs with new types of real estate to come onto the market. As stated above, one is already witnessing the stock exchange listing of real estate funds (which are not necessarily REITs within the meaning of the Income Tax Act) with assets located outside Canada (United States and Europe).

If one compares the assets of Canadian REITs to those of American REITs, one observes that several classes and subclasses of real estate do not yet form part of the investment strategy of Canadian REITs. For instance, US REITs include infrastructures, golf courses, telecommunication towers, mini storage facilities, etc. By way of illustration, in the United States, some REITs own buildings housing server banks. The latter lease space to businesses to house their servers. Generally speaking, businesses which, on an annual basis, spend significant amounts acquiring real estate assets are good candidates for the establishment of a REIT.

By way of conclusion, the public real estate sector, over the next few years, is likely to influence other sectors. 

Footnotes

1. In its press release dated December 6, 2012, Loblaw was on the verge of creating one of the largest real estate investment trusts in Canada and it stated as follows:

"Loblaw Companies Limited (TSX: L) ("Loblaw" or the "Company") today announced its intention to create a Real Estate Investment Trust ("REIT") to acquire a significant portion of Loblaw's real estate assets and to sell units of the REIT by way of an Initial Public Offering ("IPO"). Loblaw estimates that it will initially contribute real estate with a current market value exceeding $7 billion to the REIT and intends to retain a significant majority interest. The IPO is expected to be completed in mid-2013, subject to prevailing market conditions and receipt of required regulatory approvals including approval to list the units on the Toronto Stock Exchange."

"Highlights:

  • Unlock value for Loblaw shareholders
  • Create a standalone real estate-focused vehicle to maximize the value of the Company's real estate portfolio
  • Lower the cost of capital for real estate and accelerated store development projects

[...]

Loblaw expects that as a standalone entity, the REIT will benefit from a lower cost of capital, which will support its development and expansion. Growth will also come from Loblaw's contribution of additional properties over time as well as opportunities outside of the Loblaw footprint. The REIT will have a dedicated management team focused on overseeing the contributed properties and growing the portfolio, while Loblaw will provide support and various services."

2.  On May 9, 2013, the corporation, in its press release titled "Canadian Tire Corporation on Offence", wrote as follows:

"The Company today announced its intention to create a high-quality REIT that would: surface the value of Canadian Tire's real estate holdings; create a stand-alone vehicle for Canadian Tire's real estate which will support continued real estate investment and provide Canadian Tire with increased financial flexibility to pursue new opportunities to invest in and grow its business."

"We are executing a strategy that reinforces the strength of our Company while pursuing new growth opportunities organically and through acquisition," said Stephen Wetmore, President and CEO, Canadian Tire Corporation. "Today's announcement regarding a REIT would increase CTC's financial flexibility, providing us with the ability to access funds at an attractive cost of capital as we continue to invest in and grow our business."

3.  News release dated May 1, 2013, by the TMX Group.

4.  Stan Hamilton and Robert Heinkel, The Role of Real Estate in Pension Portfolio; see also Barry Critchley, Financial Post, May 15, 2013, page FP-2.

The foregoing provides only an overview. Readers are cautioned against making any decisions based on this material alone. Rather, a qualified lawyer should be consulted.

© Copyright 2013 McMillan LLP

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