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By James Speakman                            September 20, 2007 

Having recently completed acting on behalf of Sunstone Realty Advisors in respect of their Pure Industrial Real Estate Trust (PIRET) prospectus offering and listing on the TSX Venture Exchange, and having established several private REITs and mortgage trusts over the past 12 months for clients seeking to raise funds for a variety of real estate purposes, I thought it would be interesting to take in the RealREIT conference in Toronto this week. Much like the annual Vancouver Real Estate Forum, RealREIT offered a program of industry experts speaking in panels on a variety of topics relevant to the investment and real estate communities which make up the REIT world in Canada.

More than anything, I was struck by how different the mood was at the conference from that of the Vancouver Forum held this past April. Buoyed by high rates of economic growth in British Columbia and Saskatchewan, consistently low cap rates, and interest rates that remain low despite rising of historic lows, the mood of attendees in Vancouver was highly optimistic, with issues including the lack of available properties or development sites, labour shortages and the abundance of investment capital unable to find a home.

In contrast, the mood in Toronto this week was, at best, cautious and, at worst, sombre. Panellists spoke of possible recession in the United States affecting global prices for Canadian commodities, of capitalization rates having already increased by as much as 200 basis points in the United States and 80 to 100 basis points in Canada, and of the liquidity bubble having burst, never to resume, affecting the ability of all borrowers to finance or refinance properties. To me and my colleague Walter Pela of KPMG LLP (who was a conference panellist on the topic of adapting to the new Specified Investment Flow-Through (SIFT) rules) it was striking how the distance of five months and 2,800 miles so dramatically affects the industry’s mood and outlook.

The Conference was kicked off by Carolyn Blair, Managing Director of RBC Capital Markets Real Estate Group, who provided a Canadian REIT Market Update. She noted that against a backdrop of decent economic fundamentals, in the last 12 months the Canadian REIT market has gained five REITs on the TSX and four on the TSX Venture Exchange; lost 6.67 REITs to privatization (with GE Capital having acquired two-thirds of Dundee REIT); raised $3.9 billion in new equity, bringing the total REIT capitalization to $28.4 billion; and achieved a total return of 9.2%. Despite this good news, the REIT market has been characterized since September 2006 by government intervention, in the form of new tax policies addressed at income trusts; quarter-to-quarter volatility; the replacement of large REITs lost to privatization with new smaller REITs (such as PIRET); and increasing interest rates. All of these factors are expected to dampen the REIT market through the remainder of 2007 and into 2008.

The panel discussion which followed examined investment portfolio strategies and what role REITs can play in an investment portfolio. Those around me who were attending the conference to learn more about using REITs as a proxy form of investing in real estate (i.e., they are real estate investors with available capital who have been unable over the past 24 months to find properties suitable for direct investment), were interested to learn that U.S. REITs are now, on average, trading at prices which represent a 20% discount to their net asset values (described by one panellist as a “fire sale”) with Canadian REITs estimated to be trading at a 3% to 4% discount to their net asset values. Given that REITs have been shown over the longer term (8 to 10 years) to have a strong correlation to property values, this was felt to provide an investment opportunity.

I was interested to learn that 90% of real estate in Canada is held privately (as opposed to by a public company or REIT, but including pension funds) which is a significantly higher percentage than in the United States, where the REIT market is more mature, and Australia, where the reverse may be true, with perhaps 90% of the real estate is held by public entities. Panellists believe that despite the current trend to privatization, over the long-term, this concentration of private ownership in Canada will be reversed.

I believe that as investors become more accustomed to the public ownership of real estate, opportunities will arise for existing REITs and, in particular, newly formed entities to create very significant pools of public capital and create large publicly-held real estate portfolios. Opportunities will arise for those interested in tapping into available equity for real estate purposes.

The remainder of the morning included panel discussions on a comparison of the Canadian REIT market to those in the United States, Australia, Europe and Asia and the evolution of small-cap REITs, and a debate on the advantage of “pure play” versus diversified REITs and internal versus external management.

Following a luncheon presentation on investment risks and opportunities in various asset classes, we heard a panel discussion on the new SIFT rules and how Canadian REITs will need to adapt to them. Michael Brooks, Executive Director of the Real Property Association of Canada, outlined the issues arising from the October 31, 2006 Ministry of Finance pronouncement on the taxation of income trusts, the December 2006 exclusion of REITs from the impact of those rules, and the June 22, 2007 announcement by the Ministry clarifying the applicability of the rules to REITs and SIFTs.

Walter Pela, Partner of KPMG LLP in its Vancouver office, who has been active in working with the REIT and real estate communities in discussions with the Finance Canada and Canada Revenue Agency with respect to these rules, advised the conference of his belief that some of the issues identified by Mr. Brooks will be largely resolved through administrative rulings or possible further amendments to the rules, while others will require some REITs to restructure or make changes to their business models.

The panel which followed provided the best indication of the prevailing mood. Moderated by Stephen Sender, Managing Director and Industry Head of Scotia Capital Inc., the panel included Neil Downey, Managing Director and Real Estate Analyst of RBC Capital Markets; Bill Jandrisits, Director of Finance of Starwood Capital Group, a privately-held investment management firm with a portfolio of over $16 billion; John Kriz, Managing Director, Real Estate Finance, Moody’s Investor Services; and John Murphy, Analyst at Cohen & Steers Capital Management Inc. in New York.

The panel started by telling us that the “Wall of Capital” which existed up to mid-August, 2007, had come tumbling down, and that the “liquidity bubble” had burst, both in the United States and in the United Kingdom. They spoke of a “return to reality”, with higher cap rates, less liquidity and a focus by lenders and equity investors on entities with good management and strong balance sheets. Mr. Murphy said that the banking market had “never” before been like it has been since August, 2007, with a lack of liquidity and credit spreads widening in all asset classes, making it hard to re-finance existing loans.

We were then brought the breaking news that the U.S. Federal Reserve had lowered its official interest rate by 50 basis points, which was a surprise to many in the room who had only expected a 25 basis point reduction. Mr. Jandrisits advised that this was a good news/bad news story, the good news being that it showed that the Federal Reserve is acknowledging the current economic problems, the bad news being that the extent of the reduction showed the problem is likely much larger than people had expected.

With respect to capitalization rates, the panel said that capitalization rates in the United States are “a lot higher” than people realize, perhaps by as much as several hundred basis points. The REIT market has historically been shown to be a leading indicator of cap rates in Canada, with a six to 12 month lag, and with the average imputed cap rate of Canadian REITs having moved from 6.3% to 7.0% over the past six months, property investors should look for a similar movement at the property level, leading to property price decreases of possibly up to 10%.

On the economic front, the panel advised us that consumer spending in the United States (which, they said, makes up 20% of the world’s GDP) is slowing. As there is a very high correlation between U.S. consumer spending and Canadian GDP growth (again, with a six to 12 month lag time), we should expect a slowdown in the Canadian economy and a reduction in commodity prices. This will impact retail sales, the ability of tenants to pay rent, the opening of new retail stores, and other factors, all of which will affect REITs and other owners of commercial property. All members of the panel urged caution in property investment and borrowing decisions. They noted that public entities with strong management and an enhanced access to capital (as compared to private companies) should weather this storm better than those who had been taking advantage of easy credit up to the middle of this year.

At the same time, the panel agreed that the credit crunch will benefit the REIT market, in that it has and will reverse the recent trend to privatization of REITs, which had been fuelled by private equity firms having access to easy credit. This privatization trend had threatened the existence of the Canadian REIT market, as the recent privatizations of Summit REIT by ING, CHIP REIT by bcIMC and two-thirds of Dundee REIT by GE Capital had been expected to be followed by similar transactions, but were now on hold.

On another positive note, the panel looked back to the economic turmoil of 1998 and said there were a lot of similarities to today’s REIT market. Based on that analysis and on U.S. and Canadian REITs trading at discounts to their net asset values, they agreed that today represents a good time to invest in REITs, particularly if you have a long-term perspective.

The final panel featured the chief executives of six leading Canadian REITs: moderator Michael Emory of Allied Properties REIT; Stuart Blair of Crombie REIT; Jim Brittan of Northern Property REIT; Thomas Schwartz of Cap REIT; Dori Segal of First Capital Realty Inc.; and Stephen Suske of Chartwell REIT.

Depending on the various industry sectors, cap rates were said to have bottomed out, stabilized or to be increasing. However, with a low interest rate environment, it is still possible to find accretive buying opportunities. All panellists said that the future growth of their organizations depends on being able to add value through development, rather than simply relying on organic growth in rental rates from existing tenants or trying to acquire new properties or portfolios.

In summary, I found the RealREIT conference to be extremely informative, providing information on the state of the REIT market in Canada, investment opportunities, and the effect an economic slow down in the United States may have on the Canadian economy. In addition, for the few of us from Vancouver who were in attendance, we found a dramatically different view on the current state of the market and economy from that held in Vancouver.

James Speakman

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