Anybody whose memory predates 1992 will recognize the signs. An investment too good to pass up. An opportunity to salt money away in something that is touted as more lucrative and more secure than anything else on the market. A chance to put one’s personal fortunes in the hands of some of the best managers in the country. The latest in a long list of can’t-lose products is the real estate investment trust, a mutual fund-type entity that sprang up, mushroom-like, in the wake of the commercial property recovery. REITs, as they are known, were the hottest investment product to hit the bull markets in recent years, accounting for $3.5 billion of the $14 billion Canadians have plowed into income trusts since 1993. Until recently, REITs appeared to offer small investors everything: a stake in some of the best apartment buildings, shopping malls and office towers in the country, experienced management, liquidity and better returns than they could get anywhere else, all available in one risk-free package.
Predictably, it looks as though it was all too good to be true. The market has soured on new REIT issues. Even worse, prices for existing trusts are falling. Two of the leading REIT indices, published by Bloomberg and CIBC Wood Gundy, show that the market for the units, which are sold and traded like shares on public stock exchanges, turned south in February. According to the CIBC Wood Gundy index, the REIT market as a whole had fallen 5.5 per cent by the end of June compared with last winter’s peak.
A closer look at individual trusts, moreover, shows that the value of the leading Canadian REITs has plummeted. The average is buoyed by the presence of CPL Long Term Care Real Estate Investment Trust, the Central Park Lodges chain of nursing homes owned by Toronto’s Reichmann family. CPL, which is viewed as more of an operating business than a true REIT, outperformed the rest of the market because of the rosy outlook for nursing homes.
The rest of the REIT pack, with one or two exceptions, has lost considerable ground. Avista, which Canada Life Assurance Co. launched a year ago to sell units in its office and shopping centre portfolio, has dropped 20 per cent in value since January. Royal Host, which owns a chain of economy hotels managed by Calgary-based Royco Hotels & Resorts, fell even further, losing almost 30 per cent.
But nothing underlines the sad state of the business more than the fortunes of Legacy Hotels Real Estate Investment Fund, the REIT spun off by Canadian Pacific Hotels last October. CP Hotels raised
$600 million by selling units in a trust that now owns the cream of Canada’s hotels, including landmarks such as Toronto’s Royal York, the Hotel Vancouver and the Château Laurier in Ottawa. Legacy’s financial results, which are measured by the amount of cash available for distribution to unit-holders, were substantially better than CP Hotels forecast in its offering prospectus. Second-quarter results coming out this week are expected to be even stronger, according to William Fatt, president of Legacy and CP Hotels, which retains a one-third share. “Generally, we are operating extremely well,” Fatt says, predicting further gains when Legacy absorbs additional assets, including some of the plums acquired when CP bought Delta Hotels and Resorts in March.
So far so good. The problem is that investors, even those who view
Legacy as one of the best REITs, do not think its units are worth anything near what CP Hotels received for them. Trust units, which trade on the Toronto Stock Exchange, have shed 11 per cent of their value this year. Related securities, tied to future value, have fallen by 22 per cent.
When it comes to predicting where REITs go from here, the majority of Bay Streeters—for whom income trusts, in their various incarnations, have proved an unbelievable gold mine in the past year—are playing it safe. REIT prices are being treated like this summer’s big financial mystery. Most real estate investment analysts, who have a habit of seeking safety in numbers at the first rumble of
a falling market, claim not to understand why prices are so low. The consensus is that it is a temporary setback. Asked, for example, to pinpoint when the market for new REITs peaked (CP Hotel’s Fatt says it happened around the time his company went public last fall), Mark Hoogeveen, associate director of equity trading for Scotia Capital Markets, said: “Today.”
Canadian REITs, roughly modelled on U.S. investment trusts, rose from the ashes of the commercial real estate meltdown in the early 1990s. Around 1993, companies that survived the recession with property portfolios no longer viewed as core assets started bundling them up into income trusts and selling units to outside investors. Rolling assets into a trust allows these firms to free up cash,
while continuing to run whatever business they have sold, usually for hefty management fees. Moreover, they pay lower taxes, because the trusts pay all income—including most or all of their taxfree depreciation allowance, the money they would normally be reinvesting in their business—to outside investors. On the other hand, it means the companies are giving away the money that they are meant to set aside to replace whatever gets used up or run down in their business. The practice has led Toronto portfolio manager Richard Rooney of Burgundy Asset Management, no fan of REITs, to label them “self-liquidating entities”—the financial equivalent of keeping the fire going by burning the furniture.
At first, the pace of REIT sales was slow, partly because investors worried about their potential legal liability. This reluctance changed when interest rates bottomed out in 1996 and 1997. Conservative investors who did not want to risk their capital in the stock market—but looked longingly at the gains being made in equities—flocked to REITs instead. The theoretical chance that they could someday be held responsible for the trust’s debts seemed to pale in comparison with the money that could be made. “This was largely yield-driven,” says analyst Harry Rannala of Research Capital Corp., referring to the fact that a year ago, REITs were paying, on average, 2.5 percentage points more than government bonds. Along with tax-efficient cash distribution, he adds, unit-holders also expected the value of their investments to increase as the trust grew.
What is happening in the REIT market, Rannala says, shows that the smart money has decided the trusts have seen as much growth as they are going to, using conventional methods. The real estate market is approaching the peak of its economic cycle. REITs have already gobbled up just about every available asset in the country. For an encore, they are going to have to spend more money, and assume greater risk. Managers are faced with a choice of watching distributable income drop, or branching out into a new line of business. Some are choosing to become real estate developers, while others are becoming bankers. H&R, an industrial REIT based in Toronto, has started to provide construction financing in exchange for interest payments and an option to buy completed properties. CP Hotels’ Legacy helped its parent finance the Delta hotel purchase under a similar arrangement.
As is the case with bonds, the perception that risk is on the rise means the prices for the underlying security will continue to drop until investors are satisfied with the potential rewards. Rannala’s figures show REITs were paying their investors 4.2 per cent more than government bonds at the end of June, a 70-per-cent increase from a year ago. Rooney, the money manager, warns that whatever happens, the brunt of the downside will be borne by investors, who will have no recourse should REITs run out of distributable cash, or, even worse, reach the point where their assets are worth less than their debts. “This is a very equity-like product that seems to have been sold to the public as a bond-like product,” he says. “Canadians don’t like junk bonds. But at least junk bonds carry the obligation to pay the investor.”
The implication that REIT investors could be badly burned might seem far-fetched. Then again, as recently as February, nobody thought prices could fall as much as 30 per cent. □
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