by Patricia Koval and Simon Knowling
In June 2013, the Canadian real estate investment trust (REIT) industry will mark its 20th anniversary. The first Canadian REIT was created in 1993 – a phoenix rising from the ashes of the then-embattled Canadian real estate mutual fund industry. Throughout the year before that, retail, office and industrial real estate across Canada had experienced plummeting valuations and prices, and Canadian real estate mutual funds faced a redemption crisis. Investors in those funds were entitled to redeem their units for the net asset value per unit, which was primarily determined by often year-old real estate valuations. These investors, motivated by the ability to preserve their savings by redeeming units at prices based on significantly higher valuations than ascribed to the "break-up" value of the underlying real estate, forced Canadian real estate mutual funds to suspend their redemptions – in many cases, into near insolvency.
This gave the Canadian real estate mutual fund industry, as well as the capital markets players who drove it, an unparalleled opportunity to search for and create a better model for collective ownership of real estate assets for Canadian investors. In June 1993, after a lengthy period of study, as well as protracted discussions with Canadian securities regulators, provincial land transfer tax regulators, the Canada Revenue Agency, the Toronto Stock Exchange and existing investors, RealFund (formerly a real estate mutual fund) was reborn as a closed-end trust and subsequently listed on the Toronto Stock Exchange. It was quickly followed by two other mutual fund "converts" – Canadian Real Estate Investment Trust (CREIT), which listed in September 1993, and RioCan Real Estate Investment Trust (RioCan), which listed in November 1993; both adopted the innovative RealFund structure. While RealFund was absorbed into RioCan several years later, both CREIT and RioCan are thriving today. Torys LLP is proud to have played a critical role in the creation of the Canadian REIT structure and the birth of the REIT industry; we were the legal architects of the RealFund structure and continue to this day our involvement with CREIT and RioCan, as well as with many other REITs.
By 1994, it became evident to the Canadian real estate industry and the Canadian capital markets that the new REIT structure was popular with retail investors, including RRSP and other registered plan investors. At first instance, REITs could, and did, offer attractive yields (i.e., annualized distributions divided by unit price), with stable distributions paid regularly, usually monthly. As well, it was clear that REITs offered the potential for growth in value. The exchange-trading mechanism, compared to the former redeem-for-cash disposition method, quickly demonstrated that it could provide both the liquidity and the depth that capital markets required. For retail investors, the yields – and especially the after-tax yields generated by the REIT’s "flow-through" tax character – when compared with yields offered by alternative available yield instruments, made REITs extremely popular. Institutional investors, too, soon became comfortable with REITs, particularly after the initially perceived risk regarding unitholder liability dissipated.
Owners of Canadian real estate assets, too, saw the benefits of the monetization of their assets at prices based on the income-producing yield potential. The result was that the Canadian REIT industry grew quickly, with more and more new REITs coming to market, particularly during times of low interest rates. Canadian investors have demonstrated with REITs, as they did with royalty trusts and income trusts, that they have a virtually insatiable demand for yield. For as long as interest rates remain at near historically low levels, we expect that initial public offerings of new REITs will continue. At the same time, there has been a regular flow of additional equity, conventional debt or convertible debt offerings by established REITs, providing yet more opportunities for investors. Most REITs holding retail, office, industrial or residential real estate were not seriously affected by the Canadian government's SIFT tax imposition in 2006; recent amendments have ameliorated issues that arose in connection with the SIFT rules and the so-called REIT exception, thus further cementing the viability of REITs as attractive investment vehicles. With the rapid growth of the REIT industry, there are now a number of Canadian REITs, including the new Choice Properties REIT, with assets valued at over $7 billion, and these REITs rank among the largest publicly traded vehicles in Canada.
From 1993 to date, the original REIT structure has remained much the same – although through time, concerted focus on tax planning has led to innovations that have broadened the asset classes underlying REITs. Commencing in the early years of the last decade, cross-border legal planning, particularly Canadian and U.S. tax planning, has resulted in a number of viable structures that, in the applicable circumstances, have allowed Canadian REITs to invest tax-effectively in real estate located in the United States, Europe or elsewhere. Innovation in this regard continues, since there appears to be significant Canadian investor demand for these vehicles, including Canadian REITs that invest in assets located exclusively outside Canada (in August 2011 Dundee International REIT was the first REIT formed to invest in assets located exclusively outside Canada). At the same time, in 2013, global investors are themselves investing in Canadian REITs, corresponding to their interest in Canadian real estate assets in general. We expect this trend, too, to continue, although for Canadian tax reasons, most Canadian REITs cannot accommodate having a majority of their investors outside Canada. This factor has limited Canadian REITs in exploring multijurisdictional listings. More recently, a new generation of REITs has qualified as REITs for both Canadian and U.S. income tax purposes. We expect this structural innovation to allow for many more REITs to be formed that own exclusively U.S. assets and that enable vendors of those assets to retain a substantial ownership interest in the REITs.
While much has remained the same, some important changes in the REIT industry have taken place as it has matured. The earliest REITs were externally managed vehicles, with managers earning a variety of fees, including annual asset management fees, acquisition and disposition fees, mortgage fees, financing fees, development fees, and property management fees. Over time, "internalization" of management became popular, as REITs and their investors sought to optimize the costs of management and related expenses. Today, there are REITs whose managements range from the traditional externally managed model to a partially internalized model with an independent CEO and CFO supported by the promoter’s organization, to REITs with only internal management. As investors – particularly institutional investors – increasingly focus on costs and governance, we expect that the trend to internalization will continue. Indeed, most new REITs with external management structures incorporate a forward-looking concept of internalization in their management agreements.
Another important change has come in the nature of investments and activities that REITs are permitted to make and undertake. The earliest REITs contained tightly prescribed investment restrictions and operating policies (some remaining from the securities law rules governing real estate mutual funds, as well as some emanating from prudent management concerns). Among the strictest restrictions or guidelines were those that limited construction and development of properties owned by a REIT or new properties to be acquired by it. Today, as REITs and the market’s understanding of them have matured in concert, these investment guidelines and operating policies have been substantially relaxed; many REITs are now engaged in both construction and development to the extent permitted by applicable tax rules. Moreover, REITs often now collaborate in responsible development with other organizations. Intensification opportunities, especially in urban Canada, are now a particular focus of many Canadian REITs. We expect that this too will continue through 2013 and 2014.
Overall, after the first 20 years, it can be said that Canadian REITs have been an overwhelming success story in the Canadian capital markets. We expect this success to continue in the foreseeable future.