Canadian real estate investment trusts, which are celebrating their 20th anniversary, were born out of the carnage that devastated the commercial real estate industry in the late 1980s and early 1990s.
Property values tumbled as the recession hammered away at the economy. Real estate giants such as Cadillac Fairview Corp. were forced to restructure, and some, such as Olympia & York, declared bankruptcy. Industry veterans still grimace at the memories.
“Starting in late 1989 you had the perfect storm of tenants going bankrupt right, left and centre, and almost no liquidity from either buyers, banks or mortgage companies,” recalls RioCan Real Estate Investment Trust chief executive officer Edward Sonshine. “Values were just plummeting.”
Many office landlords were forced to lower rents to levels at which they were losing money. “Rents were zero, and it was just a disaster,” says Alfred Apps, who in 1993 became the CEO of Lehndorff Group, a commercial real estate firm that would go on to become Residential Equities Real Estate Investment Trust, one of Canada’s earliest REITs. “There was blood everywhere.”
The precursors to REITs that existed at the time were open-ended mutual funds that had been established to invest in real estate. Investors could buy into them for as little as $100, notes the REALpac Canadian REIT Handbook. Those investors had the right to redeem their units for cash if they chose. When the market soured, many did.
Investors cashed out as property values sank, and the funds were forced to try to sell their assets into a weakening market to raise money. Eventually, the funds asked regulators to let them halt redemptions.
“The day that you started getting more redemptions than new sales, you had a problem,” says Mr. Sonshine, who then ran one of the mutual funds.
In late 1993, three of the open-ended real estate funds converted to closed-end funds, which no longer gave investors a right of redemption, and then listed on the Toronto Stock Exchange, so that investors could sell their investment any time they wanted.
“REITs allowed people to participate in the ownership of commercial real estate through a publicly listed tax-efficient security,” says Stephen Johnson, the CEO of Canadian Real Estate Investment Trust (CREIT), which claims the title of Canada’s oldest REIT.
The structure already existed in the United States, where President Dwight Eisenhower signed a law in 1960 enabling REITs to exist, REALpac notes.
But the concept was still new to Canadians, and there were some hiccups. For one thing, “there was this legal theory that, because we were a trust structure, liability flowed through to the shareholders of the REIT,” Mr. Sonshine recalls. “I don’t think it was ever tested, but there was this fear, so it was always a problem and then some of the provincial governments eventually passed legislation saying no, there’s no legal liability.”
“REITs at the time were kind of a fringe product, a fringe retail product,” says Michael Smith, a REIT analyst at Macquarie Securities.
The industry sought to educate investors. Back then investor meetings would be comprised of a few dozen people in a restaurant.
“It was a hard sell, I used to do a lot of marketing in those days,” Mr. Sonshine says. (RioCan, like CREIT, was one of the first REITs).
“People were really scared about real estate investing in the 1994-1995 time because of what had happened in the previous years, so that’s why all the REITs worked to self-imposed leverage limits,” he says.
Mr. Apps adds, “Like any new type of investment vehicle, it had to earn and build confidence.”
By late 1996 there were five REITs, and in 1997 there were seven more initial public offerings (IPOs.) But the growth spurt was quickly followed by what Mr. Smith calls “the doghouse period,” from 1998 to 2000, when the technology sector stole the limelight and REITs traded at a discount.
It wasn’t until 2005 that the REIT vehicle finally became widely accepted, Mr. Smith says. In the wake of the tech bubble bursting, investors were hunting for companies that owned hard assets.
When Finance Minister Jim Flaherty stunned the market on Halloween night of 2006 with a new tax on income trust distributions, REITs were exempted (although the definition of a REIT narrowed).
The financial crisis in 2008 took a toll on the REITs as it did most industries. But then as interest rates sank to historically low levels and investors went searching for yield, the REITs entered their heyday.
The amount of new equity issued by the real estate sector hit a record $6.8-billion last year, amounting to 15 per cent of all the issuance on the S&P/TSX, according to Canadian Imperial Bank of Commerce.
Investors’ appetite for all things real estate spurred a flood of IPOs, to the point that many industry players worried that bad apples might crop up. They disparagingly referred to “build-a-REITs” as seemingly everybody tried to cash in on the sector’s popularity.
With property values high and opportunities more scarce, industry players say two trends are gaining momentum as the sector looks for ways to maintain its growth: REITs developing new properties on their own, and looking further afield for assets.
“I think as opportunities for high-quality property acquisitions become tougher and tougher in Canada, you’ll see REITs go more into development,” Mr. Johnson says. “You will also see REITs go to other countries for acquisitions.”
The popularity of REITs has also spurred retailers to get in on the action. Loblaw spun off Choice Properties Real Estate Investment Trust this summer, Canadian Tire has filed a prospectus for its own REIT, and Hudson’s Bay Co. is contemplating one. Industry players had been wondering when retailers would get into the game, and some suggest their move might signal the industry has hit the peak of this cycle.
Indeed, the sector’s upward trajectory began reversing itself in May when long-term interest rates began to rise. That has pushed the REITs into hunker-down mode. They accounted for just 29.3 per cent of the $14.7-billion that was invested in Canadian commercial real estate during the first half of this year, compared with 48.2 per cent of the $14.8-billion spent in the same period last year, according to CBRE Ltd. The volume of acquisitions that the REITs made in June tumbled 49.7 per cent from May. IPOs and financings have become more difficult.
But just last week the U.S. Federal Reserve announced that it would continue its quantitative easing program in full, an announcement that gave REITs a shot in the arm, Bank of Montreal analyst Heather Kirk points out in a research note.
Mr. Johnson says that investors should not be thinking of REITs as bond investments in any case, but rather as a way to own commercial real estate.
“The well-run REITs are going to be able to cope with rising or falling interest rates,” he says. And he adds that “right now we’re still getting the benefit of lower interest rates, even though people are fussed about higher rates. We’re still rolling off higher rates, because the debt we put on is generally term debt, and the term debt could be as long as 10 years. So we have debt rolling off that we put on 10 years ago. This debt has a much higher interest rate than the debt we’re going to refinance it with today.”
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