When Scotiabank sold its 68-storey Scotia Plaza headquarters for a record-breaking $1.27 billion in June, it was Dundee REIT and H&R REIT who emerged from the pack as winners, seeing off rival bids from pension funds and other institutional investors; traditionally the owners of such landmark properties in this country.
“I think we’re seeing an incredible maturation of the REIT market here in Canada that is creating all kinds of work for lawyers,” says David Ehrlich, a partner in the real estate group of Stikeman Elliott LLP’s Toronto office.
REITs have their roots in a mid-1990 amendment to the Income Tax Act that allowed closed-end mutual funds to hold real estate, and George Valentini, a former chair of the real estate practice group at Osler Hoskin and Harcourt LLP, says the intervening two decades have given investors a chance to understand and gain confidence in the sector.
“There’s a comfort level with REITs. The idea now is that they work, and the people behind them, like Michael Cooper at Dundee, and Rai Sahi at Morguard, are not fly-by-nighters. People have done well by them,” Valentini says. “REITs can now raise money and be incredibly competitive, perhaps even more so than pension funds. That’s why they got Scotia Plaza and the pensions didn’t.”
“Any good REIT who wants to raise money can do a deal in 10 minutes. And if you want to get one started, dealers are almost falling over themselves to get a hold of it,” says Ehrlich, who adds that many have been quick to take advantage of easy access to capital.
He sees the Scotia Plaza deal, along with Brookfield Office Properties’ 2010 conversion of most of its Canadian buildings to a REIT, as indicative of a new focus on quality assets over quantity. “In the early stages of REITs in Canada, the marketplace didn’t really discriminate a whole lot in terms of quality of assets, so that size seemed to be more important,” Ehrlich says. “Now the marketplace is sophisticated enough to say, OK, we’ll take less yield from this because of the quality of the buildings and the quality of the income.”
At Goodmans LLP, Stephen Pincus says REITs are struggling to keep up with investor demand. With just 10 per cent of Canadian real estate publicly securitized, he says the market is still relatively small compared with the U.S., where REITs have been up and running for at least 30 years longer than Canada, and other countries, such as Australia and Singapore, where more than a third of all real estate is publicly securitized. “There’s been a great hunger for this product,” says Pincus, the chairman of Goodmans’ REITs and income securities practice.
The current low interest environment is doubly beneficial for REITs. In addition to providing a solid base for the real estate market, they also make REITs an attractive port of call for yield-seeking investors. “The less money you can get in the bank with your GIC, the more you are looking for other forms of yield, and real estate has been the easiest way to get access to it,” Pincus says.
Underlying the popularity of REITs is a confluence of favourable fundamental conditions that have market analysts like Alex Avery running out of superlatives in describing their performance. “They are doing exceptionally well,” says Avery, chief economist of CIBC World Markets, who cites the S&P/TSX REIT Index as evidence.
For the last three years, it has consistently and spectacularly outperformed the composite index. In 2009, the REIT index registered a total return of 55 per cent, beating the overall market by around 20 percentage points. In 2010, it was up 23 per cent, five points better than the composite. 2011 saw the TSX overall lose nine per cent of its value, while REITs were up 22 per cent. By June 2012, REITs were already up 10 per cent, while the composite index was flat.
“You’ve got high occupancy rates and rising rental rates, an accommodating interest rate, and a disciplined and prudent development industry that has kept supply of new property very constrained, despite the strong demand,” Avery says.
Those factors make Canadian REITs look strong compared with similar products abroad, according to Avery. Canadian developers learned their lesson after getting stung by oversupply in the 1990s real estate slump, Avery says. Since then, a conservative approach to development has helped keep the real estate market hot across sectors and across the country.
“I think we have some preferred markets and less preferred in Canada, but you’re choosing between winners,” says the bullish Avery.
In July, a global survey by Investment Property Databank Ltd., singled out Calgary as the best place in the world to invest in commercial real estate in 2011. Rental income and higher property values in Calgary combined to produce a return of 21.6 per cent, according to the survey. San Diego followed on 19.5 per cent, with New York and London trailing behind on around six per cent.
Robert Aziz, the chief legal officer at Oxford Properties Group, says the city is on his radar for future projects. “Calgary is a very hot market right now, driven by the oil and gas boom. Rents have almost doubled since last fall, and it’s a supply and demand issue. There’s so many people looking for office space, and there just isn’t any,” he says.
But with a hot real estate market inevitably comes high prices, and after a three-year spending binge, Avery says REITs have slowed their acquisition rates.
At First Capital Realty, general counsel Roger Chouinard says the firm has turned its attention to its existing supermarket and drugstore-anchored shopping centres in across Canada. “Property values are at, or very close to, a peak at the moment. What the financing markets are doing for us is adding more competition for buying properties, and increasing prices. With the added competition, it just means we’re even more selective in our acquisitions,” he says. “We are reinvesting our capital heavily in our own development and redevelopment projects, because for the most part we feel that’s the best use of our capital.”
Around one third of First Capital’s 163 properties are currently undergoing some kind of work, running the gambit from green field development to lighting refurbishment. Chouinard says the projects have kept the company’s team of seven lawyers particularly busy with lease issues. “Redevelopment does add complexity for our leasing team, because if we’re doing a major renovation, our tenants need to be moved around or accommodated in temporary space, so we need to negotiate certain changes to their leases to permit us to do the work we want to do,” he says.
The continued strong performance of Canadian REITs has also made them takeover targets. In January, Dundee REIT purchased rivals Whiterock REIT for almost $600 million, just days after a $900-million takeover of Canmarc REIT by Quebec-based Cominar REIT. Avery expects more merger deals to follow, and says a big pension fund could even be tempted to take a REIT private.
Valentini says mergers are a simple way for REITs to diversify their holdings. “It’s easier to buy a big portfolio than to build it one by one, which can be a lot of work,” he says.
Looking outside Canadian borders
Another way to diversify, one of his clients found, is to look abroad. Earlier this year, Valentini represented Dundee International REIT on its $400-million IPO and its $1-billion purchase of nearly 300 properties in Germany.
Michael Cooper, the CEO of Dundee REIT and vice chairman of Dundee International REIT, says Dundee’s German connections go back to the 1998 purchase of a Canadian company with 3,600 German shareholders, which led to relationships with German institutional investors.
When the German institutions started selling Canadian assets in favour of better value properties back home, Cooper decided the time was right to give small private Canadian investors a chance to own European real estate that until then was only really available to institutional Canadian investors.
“We’ve been hearing more and more about pension funds diversifying outside Canada, in Brazil, the U.S., the U.K., and Europe,” Cooper says. “It’s never been cheaper to invest in Europe. We thought this was a great opportunity.”
Since its late 2011 launch, Dundee International has added $150 million more in assets, and Cooper says it’s still on the hunt for promising properties. The bulk of the commercial space is currently leased to mail and logistics giant Deutsche Post LG. “It’s not for the faint of heart,” Cooper says. “But the pricing seems very good.”
Ehrlich says Canadian investors are more willing than ever to take a chance on REITs with foreign assets because of their increasing confidence in the products more generally. “Brand name recognition is a trend I think we’re seeing,” he says. “Because of the demand for yield and recognition that these are players who have consistently made money for people, they’re willing to go into ventures that they may not have done a few years ago.”
According to Pincus, the huge investor demand for REIT products made it inevitable that Canadian REITs would begin looking beyond our borders. “There’s only a limited amount of income producing Canadian real estate, and therefore REITs have to look to the U.S. and elsewhere in the world to acquire,” he says.
Pincus has acted for a number of REITs raising capital in Canada, but with assets south of the border. In June, Pincus acted for HealthLease Properties REIT, an owner of seniors care homes in the American Midwest and Western Canada, in its IPO on the TSX.
Pincus says such cross-border deals can be extremely complex. “Creativity is important because you’re designing structures for regulatory requirements in more than one jurisdiction, and you tend to have a lot of moving parts,” he says, adding that they bring with them unique risks.
Although the Canadian dollar has been fairly steady recently, around parity with its U.S. counterpart, Pincus says swings are still likely and hedging should be considered to combat currency risk. This may be more of an issue for those with investments in Europe, where the economy and currency remain volatile.
Pincus says Canadian REITs taking their first steps into a particular sector or geographical region may need help establishing local management. “But you find that if people have been successful here, and have got a business model that works in a certain asset class, they can often apply that same model to other areas,” he says.
REITs operating in certain regulation-heavy areas, such as health care, may also face unique difficulties ensuring they’ve met all the requirements expected of them in a particular jurisdiction.
Pincus says Canada will remain an attractive place to go public because the market here is more receptive to IPOs in the $100-$300 million range occupied by many REITs, often considered too small for U.S. investors. An added advantage is Canadian tax rules designed to clamp down on income trusts do not apply to trust income generated outside the country. “As the financial crisis continues in Europe, owners of asset portfolios will have a hard time accessing capital. Canada has got a very strong financial sector, so it’ll be a natural place to come,” Pincus says. “Canadian investors have to be wary of economic shifts.”
“The key thing for REITs to do is to build an underlying asset base so that it’s as strong as possible to weather any shifts in interest rates, and to have a good capital structure so they’re not over-leveraged. Canadian REITs tend to be conservatively leveraged anyway,” Pincus says. “It’s important to have good tenants, good management, and high quality assets that are well maintained. All those things will keep REITS resistant to economic changes.”