Deloitte REIT Guide 8th Edition

7/24/2019 Deloitte REIT Guide 8th Edition

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8th Edition

REIT GuideSecond Print


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Table of ContentsIntroduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

What is a REIT? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

1. The Origin of the REIT Vehicle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

The U.S. REIT Story . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

The Birth of the Canadian REIT Vehicle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52. Anatomy of a REIT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

The Declaration of Trust and Management Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

How Will Investors Receive their Returns from REITs? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

Statutory Requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

What Type of Property is Most Suitable for a REIT? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

3. Canadian Tax Issues for REITs and Investors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .11

REIT Tax Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .11

Investor Tax Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .15

Comparison of Open-Ended and Closed-Ended Mutual Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .19

4. The REIT Vehicle in the Canadian Marketplace . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .21

History of Capital Flows into the Canadian Real Estate Industry from 1970 to the Present . . . . . . . . . . . . . . . . . . . . . .21

REITs Provide a Vehicle for Buying Real Estate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .22

5. Challenges of Converting to a REIT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23Transaction Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23

Matters to Consider BEFORE Proceeding with a REIT Transaction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23

Extent of Investment of the Sponsor in the Ongoing Operation of the REIT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23

Making the Economic Case for the REIT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .24

Structuring the REIT vehicle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .26

Accounting and Reporting Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .26

Legal and Administrative Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .27

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .28

6. The REIT vs. a Corporate Structure: Differences in Management Focus . . . . . . . . . . . . . . . . . . . . . . . . .29

Investment Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .31

Operating and Financial Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .33

Financial Reporting Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .37Corporate Governance Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .40

Risk Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .41

7. Canadian vs. U.S. REITs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .42

From An Owners Perspective . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .42

From an Investors Perspective . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .44

8. Why Royalty Trusts and Investment Trusts Differ from a REIT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .45

9. Difference Between the Structure of a Non-Business REIT and a Business REIT . . . . . . . . . . . . . . . . .48

10. How to Evaluate a REIT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .52

What to look for in a REIT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .52

How Should REITs Be Evaluated? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .53

What are the Risk Factors? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .54Other Factors to Consider . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .54

11. Scorecard and Predictions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .55

Scorecard of Predictions from 1997 Guide . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .55

U.S. Market as a Guide . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .57

Future Trends and Predictions for Canadian REITs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .58

Appendix 1 Operating Cash Flow Available: REIT vs. Corporation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .59

Appendix 2 Impact of Tax Deferred Distributions on the Adjusted Cost Base of Units . . . . . . . . . . . . . . .64

Appendix 3 - Comparison of Available Vehicles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .65

Appendix 4 - Continuous and Periodic Disclosure Requirements of a REIT . . . . . . . . . . . . . . . . . . . . . . . . . .68

Glossary of REIT and Real Estate Terms Commonly Used in Canada and the US. . . . . . . . . . . . . . . . . . . . .71

Acknowledgement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .78

The information and analysis contained in this book is not intended as a substitute for competent professional advice. The material that follows is provided solely

as a general guide and no action should be initiated without first consulting your professional advisor.

eighth edition


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Introduction

Since 1994, when we issued our first edition of the Canadian Real Estate InvestmentTrust (REIT) guide, there have been tremendous changes in the REIT marketplace.REITs in Canada and the United States have matured as an investment vehicle and

have strong institutional and unitholder support. Income trusts based on other types ofcommercial enterprises have in recent years been extremely popular in the Canadianequity markets, notwithstanding recent challenges with respect to the structures ofcross-border income trusts and the related tax considerations. Even more recently,there has been discussion of potential limitations on investments in income trusts bylarge institutions such as pension plans. Add to that the evolution of legislation withrespect to unitholder liability, and you have a very dynamic environment. The combinedCanadian base of real estate, business and royalty trusts has made the study andunderstanding of all the issues and opportunities associated with such trusts even morerelevant.

Accordingly, we are pleased to provide our Canadian REIT Guide, 8thEdition, through asecond printing.

Don NewellApril 2004

For more information on REITs in Canadaor on the contents of this Guide,

please contact any member of our REIT team:

TorontoDon Newell (Leader) 416-601 6189

[email protected] Abraham 416-643 8008

Frank Baldanza 416-601 6214Pat Bouwers 416-601 6217Eddy Burello 416-643 8724John Cressatti 416-601 6224Ciro DeCiantis 416-601 6237

CalgaryTrevor Nakka 403-267 1858Frank Rochon 403-267 1716

HalifaxClaudio Russo 902-496 1812

MontrealManon Morin 514-393 5255

VancouverGarth Thurber 604-640 3110


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What is a REIT?A Real Estate Investment Trust ("REIT") is a term that originated in the United States and has since been

adopted in Canada to describe vehicles used for collective investments in real estate.

A REIT, from a Canadian perspective, is either a publicly listed closed or open-ended trust that allows

investors to purchase units of a trust that holds primarily income producing real estate assets. The larger

REITs are internally managed and will generally also have their own internal property managementoperation, which helps to lower the cost of operations. The smaller REITs, in order to remain

competitive, have developed a shared management platform where the assets and strategic

management are shared, usually with the sponsor, and the property management function is either

internal or external to the REIT. All trusts whether open or closed are governed by trust indentures and

investment guidelines, which require the particular REIT to comply with requirements set out in the trust

indenture and to follow the stated investment guidelines. The trust indenture covers such matters as

payment of distributions and limitations on the REIT's borrowing capacity.

Some of the key features of a REIT are:

High yield through regular distributions - The REIT trust indenture typically contains a clause, which

requires the REIT to distribute a percentage of its distributable income (a defined term) to its unitholders.

Every REIT defines how it calculates its distributable income. The investment market demands that at aminimum the REIT include in its trust indenture a clause that it will distribute at least its taxable income to

its unitholders and avoid the two levels of tax. It has been the policy of Canadian REITs to distribute

between 75% and 95% of distributable income to unitholders. Cash distributions have led to average

yields, as measured against the unit price of the REIT, of between 7% to 13%. The distributions of a

REIT are taxed very differently than a corporate dividend received by a shareholder of a publicly listed

company.

Capital appreciation - Although the REIT vehicle is viewed primarily as a risk adjusted yield investment,

it also has the potential for capital gain. Increases in asset values and anticipated income growth are

reflected in the unit price. REIT units currently tend to reflect a unit price equal to or greater than their

net asset values, whereas public real estate stocks generally trade at a discount to their net asset value.

Taxation - Another feature that makes a REIT attractive to Canadian investors is the favourable taxtreatment of income earned within a REIT and the fact that unitholders can partially manage their tax

affairs. The REIT's taxable income is initially determined in a similar manner to that of a corporation. So

long as the taxable income of the trust is allocated to its unitholders, the REIT will not be subject to tax.

Distributions to unitholders usually will be comprised of a capital distribution, generally equal to the

Capital Cost Allowance ("CCA") claimed by the REIT, and non-sheltered taxable income. An investor

can further defer the taxable portion of the distribution by holding the investment in his or her registered

retirement savings plan ("RRSP"). However, any withdrawal from the RRSP, including the tax-deferred

distribution, will be subject to tax.


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Distributable Income - Most REITs define distributable income as net income as stated in the financial

statements of the REIT (could be consolidated if the REIT has subsidiaries) prepared in accordance with

Generally Accepted Accounting Principles ("GAAP"), adding back depreciation, capital losses and future

income tax expense, but excluding amortization of leasing costs, future income tax benefit and capital

gains.

Market Performance - REIT units have exhibited an interesting trend when compared to other Canadian

equities. Because they generate contractual revenues, they are able to maintain a high yield and are

therefore evaluated differently from other equity investments. When compared to REITs, the Canadian

equity markets tend to be much more susceptible to short-term economic conditions.

Focused Asset Base - The Canadian REITs generally have a strategic focus as to which types of assets

they wish to hold in their portfolio. This allows investors to focus on a specific category of properties

within the real estate industry. The Canadian REITs have investments in the following asset classes:

Office, Retail, Apartment, Nursing and Retirement Homes and Industrial. This encompasses almost all

areas of the real estate sector that generate stable income. Real estate development is the one

exception. Developments are usually carried out by corporations (private or public) because developmen

does not suit the REIT vehicle for the following reasons: (1) it requires a substantial outlay of capital,

which in turn absorbs a portion of the REIT's capacity to acquire productive assets or, if financed through

an equity issue, has a dilutive effect in the short-term on distributable income per unit; (2) it takes a

considerable length of time to become cash flow positive; and (3) it exposes the REIT to developmentrisks. Except for the larger REITs, which generally carry out re-development as part of their strategic plan

to enhance the value of their existing properties, REITs do not typically engage in development for the

above reasons.


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1. The Origin of the REIT Vehicle

The U.S. REIT Story

REITs were initially created by the United States Congress in the 1960's as a vehicle through which

small investors could gain access to large-scale, income-producing real estate properties. However,

when REITs were originally set-up in the United States, they were merely allowed to own the properties,

with third-party companies being responsible for the operations. This divergence between the ownershipand management role did not receive the approval of the market place and REITs remained a second-

tier investment.

Additionally, REITs suffered from a lack of popularity due to other tax sheltered real estate investments,

such as limited partnerships. These entities were able to pass on losses to investors, which were then

used to lower personal taxes. As REITs were unable to pass losses on to unitholders, they could not

compete with the tax-advantages of limited partnerships.

However, in 1986 Congress passed the Tax Reform Act of 1986 ('the Act'), which effectively limited the

tax shelter advantages of limited partnerships. The Act also enabled REITs to take on the management

function. This reform, coupled with a depressed real estate industry in the early 1990's, made REITs a

more attractive vehicle than private companies. It enabled them to access capital sources through the

public marketplace, with many eager investors taking part due to the depressed state of the industry andbelief in a recovery in the future.

REITs have gained the acceptance of both the corporate world and private investors. As a result the

REIT segment of the real estate industry has grown significantly with close to 200 publicly traded REITs

currently on the NAREIT Composite Index, which now boasts a market capitalization of over US$175

billion (as at May 30, 2002).

Mortgage

2%

Specialty

2%Health Care

4%

Office/Industrial32%

Retail

20%

Residential

21%

Diversified

9%

Hotels

6%

Self-Storage

4%

Diversification of US REIT Market byProperty Type

Source: NAREIT May 30, 2002


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The Birth of the Canadian REIT VehicleAlthough Canadian tax legislation was not identical to that of the United States, Canada had investment

vehicles that provided similar results to those available under U.S. tax rules. The closest vehicles available

in Canada when REITs were beginning to boom in the United States were limited partnerships, open-ended

mutual funds and closed-end investment trusts. Any reference in this guide to a "mutual fund" or a "listed

closed-ended trust" assumes that the trust has at least 150 unitholders throughout the period of existence.

Furthermore, it is assumed that the trust complies with all other restrictions (e.g. type of assets owned and

income earned) that are imposed on a trust in order for it to qualify as a mutual fund trust for Canadian

income tax purposes.

Publicly listed limited partnerships have never been a significant market force in the Canadian public equity

markets. They were unappealing to investors due to legislation that classified them as foreign property for

the purposes of RRSPs and certain other deferred income arrangements. From the investors' point of view,

limited partnerships did not prove to be profitable. The huge collapse of the real estate market in the 1987-

1997 period resulted in significant numbers of limited partners losing their entire investment.

Initially, the open-ended mutual funds showed significant growth and provided above average investment

returns. In the mid-1990s, they lost their appeal and marketability as public vehicles with the downturn of

the Canadian economy. The flaw of the structure of open-ended mutual funds was that they were obligated

to redeem their units for cash based on appraisal values. The appraisal values were not forward looking.

As the real estate market deteriorated, investors rushed to reduce their exposure to real estate.

Redemptions increased and in order to fund these redemptions the open-ended mutual funds sold their

liquid properties. However, due to the deteriorating market conditions it was difficult to sell the properties at

their net asset value (the basis for the redemption), which ultimately led to the collapse of the open-ended

structure, as the REITs were not able to redeem their units at the calculated redemption price. The open-

ended mutual fund, with obligatory cash redemption prices based on appraisal values, does not fit well with

the long-term nature of real estate assets. One of the solutions to preserve the investor investment in the

open-ended mutual funds was to allow these REITs to be re-structured as closed-ended mutual funds.

The close-ended mutual fund was born out of the collapse of the open-ended mutual fund. These funds do

not have the obligation to redeem units, as any investor wishing to liquidate their investment must do so via

a trade on one of the Canadian Exchanges. However, to maintain their mutual fund status, the closed end

funds have to comply with many more tax regulations. Today's closed-end mutual fund trusts are theCanadian equivalent to the U.S. REITs and, in many respects, have been made to function like a U.S. REIT.

In 2001 and in the first half of 2002, we have again seen the re-emergence of open-ended mutual fund

trusts. The new open-ended mutual fund trusts have severely limited the unitholder's ability to redeem units

so as to match depressed sales of real estate property (if any) with redemptions. The valuation of the units

is not based on an appraisal, but on the market value of the unit. (Refer to Section 3 for a more detailed

review of the differences between and open-ended and closed-ended mutual fund trusts).

The first Canadian REIT was listed on the Toronto Stock Exchange in 1993, and since then a further

eighteen REITs have been created by way of Initial Public Offerings (IPO's). The mergers of RealFund with

Riocan and of Avista with Summit, both in 1999, and the consolidation of CPL Long Term Care REIT and

Retirement Residences REIT in 2002, have reduced this number to sixteen REITs listed on the Canadian

Stock Exchanges as of June, 2002. To date, the most significant period for initial public listings of REITs in

Canada was 1997 when seven new REITs were formed. Since 1997, an additional seven new REITs,

excluding the effects of merger activity, have been listed to take advantage of the opportunities for

accelerated growth. REITs enjoyed another year of growth in 2001 and 2002 should see another three to

five new REITs being listed.

As the REIT market has moved from the "handcuffed days" of the late 1990's and has performed

responsibly by complying with the obligations set out in the declarations of trust and investment guidelines,

investors have tended to allow the REITs to operate more like traditional real estate companies by removing

or loosening many of the imposed restrictions.


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2. Anatomy of a REIT

The Declaration of Trust and Management Structure

Canadian REITs have adopted self-imposed rules through their trust declarations to safeguard the

unitholders. The contents of the trust declaration are crucial as it defines the obligations and restrictions

adopted by the REIT. Every investor should read carefully the REIT's investment guidelines, the market

segment it intends to operate in, and the limitations that have been imposed on the REIT's operations.Initially in the early 1990's, a REIT's declaration of trust reflected conditions imposed by a hostile market.

Trust declarations contained, amongst other things, the following:

1. Definition of Distributable Income.

2. The minimum amount of distributions (usually at least equal to the taxable income of the REIT).

3. The amount the REIT was permitted to borrow, usually a specified percentage of the Gross Assets.

4. Restrictions placed on the issue of new units.

5. The prohibition or the restriction of cross-collateralization of its assets.

6. Limiting recourse of its lenders and major service providers to the assets of the REIT.

7. The obligation to adopt an environmental policy.

8. Limiting the ability or restriction to acquire undeveloped property to a prescribed percentage of Total

Assets.

9. The ability to lend money with or without security.

10.The ability to invest funds in other REITs.

11.Make up of the board of trustees and requirements for independent trustees.

Amendments to the declaration of trust must be approved by a majority of unitholders, however the

amendments to the investment guidelines and certain specified operating policies require at least 66 2/3%

of the unitholders to approve the change. As the REIT industry has matured and the real estate

investment climate has continued to improve, unitholders have shown a willingness to accept certain

departures from the rigid standards established in the 1990's and allow the REITs to take on more

operational risks. Investors should be aware that the trust declaration can be amended, subject to certain

limitations, to allow the REIT to become more aggressive; however, any change will always be subject to

market acceptance. If the change is perceived by the market to be too aggressive the REIT's unit value

will tend to decrease to reflect the additional risk in relation to other REITs.

A REITs governance structure is similar to that of a corporation. The trustees represent the unitholders

and nearly all REITs have built into their declaration that the majority of the trustees must be independent

of management or the sponsor. The trust declaration will also require that the independent trustees be

appointed to key committees such as the audit and compensation committee. The trustees will implement

and oversee the management structure to operate the REITs on a day-to-day basis. The smaller REITs

still use a shared platform management structure rather than an internally managed structure. However,

unlike the external management agreements of the 90's, where the REIT entered into an arrangementwith a "third party" (usually related to the management of the sponsor) to execute the strategic and asset

management functions, the REIT today has first call on the time and energy of the shared management

and can terminate the shared arrangement at a relatively low cost. As a general rule, REITs that have

gross assets in excess of $600 million will be internally managed, while smaller REITs (gross assets of

$200 to $500 million) will utilize external management. The shared platform described above is designed

to lower the cost of what would be full time strategic and asset managers, and yet at the same time allow

the REIT to own and control its intellectual capital. The external management devotes part, but not all, of

its time to managing the REIT, hence the lower cost of management.


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In the United States, most REITs have been forced to adopt the structure of internal management

because the investment community has placed a discount on external managers.

How Will Investors Receive their Returns from REITs?

A unitholder in a REIT will receive either a monthly or quarterly distribution (the majority of the REITs

make monthly distributions). The tax-deferred percentage of the distribution will depend on the

REIT's ability to claim capital cost allowance and other accelerated deductions for tax purposes.

Most REITs, at the beginning of the year, will announce their anticipated distributions and thepercentage of the distribution (assuming no acquisitions or dispositions) that will be deferred from tax

The calculation of the tax deferred portion of the distributions only applies to operating income and

exclude capital gains that may be realized by the REIT during the year.

For Example:

Assume that a REIT with 20 mill ion units issued and outstanding with an issue price of $10 each has

net income before depreciation for the year of $20 million. The REIT has the ability to claim a Capita

Cost Allowance of $10 million, which also equals their depreciation for accounting purposes, leaving

taxable income of $10 million. The Trust declaration states the REIT is required to claim maximum

tax deductions, including CCA, and to distribute an amount equal to at least its taxable income or

90% of the distributable income - subject to the trustees' discretion. In this case, the trustees have

imposed no additional deductions or increases in computing the distributable income, and have

therefore distributed $18 million to its unitholders.

Therefore each unitholder will have received a distribution of $0.90 per unit of which $0.50 is subjec

to tax. The remaining $0.40 (i.e. the excess of the distribution over taxable income) will reduce the

unitholder's adjusted cost base and will be deferred from taxation until such time as the units are

disposed of. (Refer to Appendix 3 [check final document for Appendix] for the implications of the tax-

deferred portion of distributions on the adjusted cost base of units.)

At the end of the calendar year, the REIT will determine all i ts capital gains or losses and allocate

such gains or losses to the unitholders (usually based on the time each unit is held throughout the

year by a unitholder). Usually the 90% distribution, which is based on the operations of the REIT, is

often far in excess of the taxable income of the REIT (in this case, 50% [$20 million - $10 million =

$10 million]). Generally, if there are taxable capital gains, such additional taxable income usually will

not cause the REIT to make any further distributions as it has already made distributions far in

excess of its taxable income. Where there are taxable capital gains, the effect is to increase the

percentages of the income being taxed. Assume further that in addition to $20 million of net income

reported, the REIT recorded $1.2 million of taxable capital gains and $400 thousand of recaptured

CCA, increasing the taxable income by $1 million (i.e. 50% of the $1.2 million capital gain, plus the

$400,000 recapture).

CAPITAL NO CAPITALGAINS GAINS

Taxable Income before CCA $21 million $20 million

CCA $10 million $10 million

Taxable Income $11 million $10 million

Distribution to Unitholder $18 million $18 million

Sheltered Distribution $7 million $8 million

Non-Sheltered Distribution $11 million $10 million

Percentage of distribution

subject to tax 61.1% 55.5%


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Statutory Requirements

In terms of financial disclosures and reporting rules, REITs are governed by Security Exchange

Regulations and the recommendations of the Canadian Institute of Chartered Accountants (CICA) with

most REITs also adopting the recommendations of the Canadian Institute of Public and Private Real

Estate Corporations (CIPPREC) for further guidance. REITs financial statements will generally follow a

presentation format similar to that of a real estate corporation with the major exception being the equity

section. A REIT does not have retained earnings. Movements in unitholders' equity for the current andcomparative years are disclosed in a separate Statement of Unitholders' Equity. Also, like corporations,

REITs are required to disclose in their financial statements the net income per unit on both basic and

diluted bases.

As a securities exchange registrant, a publicly traded REIT must also comply with all relevant statutory

requirements. These include compliance with:

1. Listing requirements;

2. Continuous disclosure (including quarterly financial reporting, annual reports and annual information

returns, press releases, material change reports and management's discussion and analysis); and

3. National policies and other security commission policies and regulations.

These statutory requirements impose a significant level of responsibility on the REIT's management

and also impose a cost burden, such as filing fees, printing and translation costs, professional fees

and the costs of an information system needed to comply with all these requirements. (Refer to

Appendix 4 for a table that details the typical Continuous and Periodic disclosure requirements of a

REIT.)

What Type of Property is Most Suitable for a REIT?

There are many different types of property that a REIT can hold in its portfolio and the type of property

chosen impacts the risks and returns to investors. Property types that are more susceptible to market

cycles such as Retail and Hotel properties should provide higher returns, as the stability of those returns

can be affected by short-term changes in the market. Hotels are the most susceptible to market

changes due to the short-term nature of their income stream and the impact of cyclical fluctuations onbusiness (e.g., consumer confidence). The impact of the percentage of occupancy and room rate, which

is directly influenced by short- term fluctuations in the economy, will be immediately reflected in the

income and cash flow of the business. This, in turn, will impact the cash available for distributions to

unitholders.

Retail properties are more stable than Hotels, but if a significant downward trend occurred in the

economy and was reflected in consumer spending, the downturn would impact on the ability of retail

tenants to maintain and meet their lease obligations. This will be further exacerbated if the rent earned

from such tenant is tied to the sales of the lessee (i.e. percentage rents). However, if consumer-

spending turns bullish, a Retail REIT could earn significantly higher returns than, say, fixed rental

properties.

Office and Industrial properties are less sensitive to short-term changes in the economy, largely due tothe long-term nature of their rental agreements. Tenants in these types of properties are less prone to

move to another location at expiry of their lease so long as the landlord satisfies the tenants demands

during the lease. Good management ensures lease expirations are spread out such that generally no

more than 15% of the portfolio matures in any one year. The amount of space rented to any one group

is also controlled: so should a vacancy occur because of bankruptcy or expiry, the vacant space is

unlikely to have a significant impact on the overall rental stream and therefore, will not have a material

adverse impact on distributions. This makes this class of REIT a less risky investment than a Retail or

Hotel REIT.


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Apartment and Retirement REITs are viewed as the most stable, as they are the least sensitive to

economic cycles. The portfolio of tenants is more stable, and the percentage of space occupied by a

tenant is considerably smaller than that of a retail or office tenant. There are no anchor tenants, and a

tenant in an apartment or retirement home is unlikely to abandon leases simply due to a change in the

economy. The increased stability of this segment of the REIT sector is reflected in a higher unit price

and hence a lower distribution yield (sometimes single-digit). This class is favoured by defensive or risk

averse investors.

Some REITs believe that a diversified portfolio consisting of Retail, Office and Industrial properties

provides the investor with greater stability while at the same time offers the potential for growth. Each

REIT seeks to capture for itself a market niche and a strong following from its investors.

Significant development projects (i.e. new construction projects) have difficulty in gaining market appeal

in the REIT sector due to the lack of available cash flow for distribution to unitholders during the

development and lease-up periods. However, the appeal of these projects on a very limited basis

increases if the development is coupled with a strong underlying existing income stream (for example, in

the case of an expansion to an existing property). Most REITs have limited themselves to a relatively

minor portion of their total assets being directed to development projects.

Of the sixteen REITs in the Canadian market sector today there are five with Diversified portfolios, four

in the Apartment and Retirement sectors, four in the Hotel industry, two in the Office/Industrial sectors,

and one in the Retail sector. (Refer to pie graph below). This is in contrast to the U.S. Market, which

has a significant portion of its properties in the Industrial/Office (33.1%), Residential (21.0%) and Retail

(20.1%) markets. (Source - NAREIT).

Retail

6%Residential

19%

Office/

Industrial

13%

Retirement

6%Hotel

25%

Diversified31%

CREIT, Morguard, Summit,Cominar, IPC US

Retirement Residences(including CPL)

Res REIT, CAP REIT,NPR

Legacy,Chip,Royal Host,InnVest

O&Y, H&R

RioCan

Retail

6%Residential

19%

Office/

Industrial

13%

Retirement

6%Hotel

25%

Diversified31%

CREIT, Morguard, Summit,Cominar, IPC US

Retirement Residences(including CPL)

Res REIT, CAP REIT,NPR

Legacy,Chip,Royal Host,InnVest

O&Y, H&R

RioCan

Diversification ofThe Canadian Market into Asset Type

At July 30, 2002


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The REIT total returns by property type chart reflects the volatility of the types of REITs.

i. Period of measurement commences December 31, 1996 or date of initial public offering.

ii. The % return is measured by the increase or decrease of the unit price, plus distributions over the

year end price for the previous year (or the issue price of the Initial Public Offering ("IPO")).

-40%

-20%

0%

20%

40%

60%

80%

100%

120%

1997 1998 1999 2000 2001 Q1 2002

TotalReturn(%)

Diversified

Hotel

Office/Industrial

Residential

Retail

Retirement

TSE 300 Index

Source: RBC Capital Markets REIT Quarterly April 5, 2002

REIT Total Returns by Property Type


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3. Canadian Tax Issues for REITs and Investors

REIT Tax Issues

Basic income tax rules

In Canada, a REIT is organized as a trust, which may be either a closed end or open ended trust. To

qualify as a mutual fund trust and take advantage of the related income tax benefits, a REIT must comply

with a number of rules under the Income Tax Act, including the following:

1. The trust must be a unit trust resident in Canada.

2. The trust's only undertaking is restricted to the acquiring, holding, maintaining, improving, leasing or

managing of any real property (or interest in real property) that is capital property of the trust, and the

investing of its funds in property (other than real property or an interest in real property).

3. Generally, a class of units must be qualified for distribution to the public and there must not be fewer

than 150 unitholders of such units.

A private REIT can be established without being listed on a public exchange. However, a private REIT

does not qualify as a mutual fund trust, and therefore the units of such a REIT are not RRSP eligible.

The readers should review the actual income tax rules or obtain professional advice when assessing theimpact of the mutual fund trust rules on the establishment and management of a REIT. If a REIT should

ever fall offside of the mutual fund trust rules, the income tax consequences are severe for the REIT and

its unitholders. Refer to a comparison of open-end and closed-end mutual funds later in the section for

more details.

The Income Tax Act also provides special rules for mutual fund corporations. A REIT is usually organized

as a mutual fund trust instead of as a mutual fund corporation for a number of reasons. For example, a

mutual fund trust can distribute all of its income to its unitholders without paying income tax; generally, the

income is taxed in the hands of the unitholders. A mutual fund corporation generally is subject to income

tax on its taxable income (with some special rules for dividend income and capital gains) and the

shareholders generally are subject to income tax on the dividends from the corporation. The mutual fund

corporation, for obvious reasons, has not been favoured as a publicly listed public vehicle. A mutual fund

trust does not pay capital taxes, while a mutual fund corporation is subject to capital taxes.

A mutual fund trust cannot be established or maintained primarily for the benefit of non-resident persons;

otherwise, the trust may lose its mutual fund trust status. Usually the trust indenture of a REIT will include

a provision that non-residents cannot own more than 49% of the REIT.

A REIT cannot own real property that is inventory for income tax purposes, as it is prohibited from carrying

on business to comply with its mutual fund status. As an example, a developer in the business of building

and selling houses cannot directly use a mutual fund trust as a public vehicle.

Under certain circumstances, property can be transferred to a corporation or to a partnership on a tax-

deferred basis. However, the Income Tax Act does not provide similar tax-deferral provisions for

transferring property to a trust (whether open- or closed-ended). A vendor will be subject to tax on any

capital gains and recapture of capital cost allowance realized on the transfer of property to the trust.There may be alternative ways of deferring a vendor's income tax payable on the transfer of property to a

REIT; however, these methods are beyond the scope of this Guide and a professional tax advisor should

be consulted.

A REIT must f ile a T3 trust income tax return within 90 days from the end of its taxation year. Also, a

REIT generally will have to file a T3 Summary, and file and distribute T3 Supplementary slips to report

income and capital gains to unitholders. The unitholder will incorporate the T3 slips into their tax filing. A

REIT must be able to produce timely and accurate income tax information to meet its filing deadline,

which is half of the six-month period that a corporation has to file its income tax return. A trust that fails to

file and distribute the relevant information on time is liable to penalties under the Income Tax Act. A REIT


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should also consider whether it has to file other tax forms; for example, the NR4 Summary and NR4

Supplementary slips in respect of non-resident unitholders, T3RI or T3F returns (as discussed below)

and various foreign reporting forms.

A REIT should be aware that some of its unitholders might be other trusts or partnerships that have tax

return filing deadlines that are the same as the REIT. Also, some individual investors may want to

receive their tax information slips well before April 30. In practice, a REIT will usually determine the

amount of the distributions for the year that represent taxable income and capital gains and complete the

T3 Supplementary slips well in advance of the 90-day deadline (usually between 45-60 days after its

year-end) to satisfy the needs of these investors. Failure to meet this deadline may tarnish the

administration image of the REIT.

Taxable Income and Allocation of Such Income

A REIT is subject to regular income tax on its taxable income, including taxable capital gains; however, if

all of the income and capital gains are allocated to the unitholders, (as is required by the declaration of

trust) the REIT will be able to deduct these amounts from its income to reduce its taxable income to zero.

A REIT is given the choice, like a corporation or partnership, to deduct capital cost allowance (CCA) in

respect of its depreciable property. However, the declaration of trust typically requires the REIT to claim

maximum tax deductions, including CCA, to reduce or eliminate the REIT's taxable income. However,

like individuals, a mutual fund trust is subject to CCA restrictions in respect of rental properties.

Essentially, CCA on rental property cannot create or increase a loss in respect of the net rental income

or loss of the REIT. CCA is one of the primary means by which a REIT provides tax-deferred

distributions to its unitholders.

A REIT may also deduct, over five years, the cost of issuing or selling its units. Unlike CCA, deductions

in respect of financing costs can increase the taxable loss of the REIT, which can be carried forward and

applied against future years.

If a REIT incurs a non-capital or a net capital loss for income tax purposes, the tax loss cannot be

passed to the unitholders. A non-capital loss (operating losses) can be carried forward for up to seven

taxation years and applied against future taxable income and capital gains of the REIT. A net capital loss

can be carried forward indefinitely, but can only be applied against taxable capital gains. Both types of

losses can also be carried back for up to three taxation years; however, a REIT will not typically have

any income that has been taxed in the REIT in prior years.

A mutual fund trust can receive a capital gains refund in certain circumstances. The refund is

determined by a formula that depends, in part, on the amount of redemptions during the year. A REIT

should consider the capital gains refund if it has redeemed units during the year and has (a) capital gains

for the year or (b) a balance of refundable capital gains tax on hand from the prior year.

Other Income and Capital Taxes

A REIT is not subject to Large Corporations Tax (LCT) and provincial capital taxes (if applicable) since a

mutual fund trust is not a corporation. A subsidiary of a REIT, which is a corporation, will be subject to

LCT and provincial capital taxes. A REIT is also not subject to the tax on capital of financial institutions.

While individuals, including trusts, are generally subject to alternative minimum tax, mutual fund trusts

are specifically exempt. Also, a mutual fund trust is not subject to Ontario Corporate Minimum Tax since

the trust is not a corporation.

A mutual fund trust may apply to the Canada Customs and Revenue Agency to be a registered

investment for the purposes of certain registered plans, such as registered retirement savings plans and

registered retirement income funds. A REIT that is a registered investment and holds foreign property in

excess of the 30% threshold is subject to a tax of between 0.2% and 1.0% of the cost of the foreign

property in excess of the threshold for each particular month (pursuant to Part XI of the Income Tax Act).

What constitutes foreign property for the purposes of Part XI taxes is beyond the scope of this Guide.


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A registered investment must file a T3RI registered investment income tax return within 90 days after

the end of the taxation year.

A mutual fund trust that is not a registered investment but wants to establish that its units were not

foreign property for the year must file a T3F information return within 90 days after the end of the

taxation year.

Certain types of trusts that are registered investments are subject to a tax of 1.0% of the fair market

value at the time of the purchase of property that is not a prescribed investment for each particularmonth (pursuant to Part X.2 of the Income Tax Act). However, as long as the REIT meets all of the

conditions of being a mutual fund trust, it should not have any Part X.2 taxes payable.

Certain trusts with non-resident beneficiaries are subject to a 36% tax on certain income (pursuant to

Part XII.2 of the Income Tax Act). This tax is designed to prevent non-residents from avoiding Canadian

tax by using a trust to earn income from a business carried on in Canada or to realize capital gains from

the disposition of taxable Canadian property. As long as a REIT is a mutual fund trust, it is not subject

to Part XII.2 tax.

A REIT that has one or more non-resident unitholders must withhold and remit non-resident income tax

under Part XIII of the Income Tax Act on the taxable income, other than capital gains of the non-resident

holders. To accomplish this, the REIT provides to the transfer agent the estimated taxable income and

the percentage of distribution by the trust to the non-resident(s) that will be subject to tax, other thandesignated capital gains. Based on this amount, generally 25% is withheld from the taxable portion of

the distributions; however, the withholding tax percentage rate of 25% can normally be reduced where

an income tax treaty between Canada and the country in which the unitholder resides is in existence.

For example, the Canada-U.S. income tax treaty generally limits the withholding tax rate to 15% for

income distributed from a trust in Canada to a beneficiary of the trust who is a resident of the United

States.

Miscellaneous Items

When a REIT is created, it may not immediately qualify as a mutual fund trust because some of the

conditions described above are not met. If certain conditions are met within 90 days of its first taxation

year-end, a REIT can elect to be a mutual fund trust from the beginning of that first taxation year.The Income Tax Act contains provisions that permit, under certain conditions, a tax-deferred rollover of

property on a qualifying exchange from (1) a mutual fund corporation, or (2) a mutual fund trust, to

another mutual fund trust. A discussion of these rules is beyond the scope of this Guide. Two or more

REITs may be able to merge in a tax-efficient manner under these rules. An example of the application

of these provisions was RioCan REIT's merger with RealFund REIT, and Summit REIT's merger with

Avista REIT.

In general, an inter-vivos trust must have a taxation year that ends on December 31. However, a

mutual fund trust may elect to have a December 15 year-end instead for tax purposes. A REIT may

choose this earlier year-end for administrative or other reasons. Before a REIT decides to choose a

December 15 tax year-end, it should review the other tax rules related to this election. For example, if a

REIT is a limited partner of a limited partnership that has a December 31, 2001 fiscal year-end, theincome from that partnership for the December 31, 2001 fiscal year must be included in the REIT's

income for the December 15, 2001 tax year.


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Prior to 2001, it was unclear whether a REIT could become a limited partner in a limited partnership.

The concern was that the REIT, as a limited partner, could be considered to be carrying on the business

of the partnership. If this was true, this could put a REIT offside of the mutual fund trust rules and

therefore result in the loss of its mutual fund status. The change to the Income Tax Act in 2001 clarified

the position and allowed a REIT to be a limited partner of a limited partnership. The new rule deems a

mutual fund trust that is a limited partner in a limited partnership to undertake an investment of its funds

in the partnership and not to carry on any business of the partnership. A REIT should remember that an

investment in a limited partnership might represent an investment in foreign property for the purposes ofthe foreign property rules for certain registered plans.

A REIT may issue its units, or options on its units, to employees of the REIT. Generally, an employee wil l

be deemed to have received a taxable employment benefit equal to the value of the REIT units when the

units are acquired, less (a) the amount paid by the employee for the units plus (b) the amount paid by

the employee for any option to acquire the units. Under certain circumstances, the employee may be

able to claim a tax deduction equal to one-half of the above taxable benefit. REITs and employees

should carefully review the various tax rules pertaining to the acquisition of REIT units and options by

employees.

A trust is generally subject to the 21-year deemed realization rules. These rules essentially require a

trust to realize its accrued capital gains on most capital property every 21 years; otherwise, a trust could

theoretically hold property with accrued capital gains and defer income tax forever. A mutual fund trust isnot subject to these rules.

A financial institution is subject to special income tax rules, including determining its taxable gains and

losses on certain debt and shares annually, i.e. the securities are valued on a mark-to-market basis. A

REIT is specifically exempt from these rules since a financial institution is defined to exclude a mutual

fund trust.

A mutual fund trust may make an election with respect to treating all Canadian securities, as defined in

the tax law, as capital property. A REIT may want to consider making such an election to ensure the

dispositions of its Canadian securities are taxed on account of capital rather than income.

Under Canadian generally accepted accounting principles, an enterprise generally accounts for current

and future income taxes in its financial statements. A future income tax liability may arise, for example,when the undepreciated capital cost of its depreciable property (such as a building) for tax purposes is

less than its net book value for accounting purposes due to capital cost allowance claimed in excess of

depreciation. However, a REIT may not have to account for future income taxes in its financial

statements if it meets the conditions set out by the Emerging Issues Committee of the Canadian Institute

of Chartered Accountants ("EIC-108".) A REIT meeting the criteria of EIC-108 does not account for

future income tax as it applies to assets held by the REIT or its subsidiary partnerships. However, most

REITs disclose the temporary difference between the book value and tax basis of their assets and

liabilities by way of a note to their financial statements. This exemption does not apply where the REIT

carries on certain activities by way of a subsidiary corporation. In this case, the corporation is required

to account for its future income taxes; therefore, on consolidation, the future income tax liability (or asset)

will be disclosed in the REIT's consolidated financial statements.


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Investor Tax Issues

Basic Income Tax Rules

A REIT unitholder usually receives a distribution from a REIT on a monthly or quarterly basis. The

distribution from the REIT represents income, capital gains or a return of capital, or some combination

thereof. The REIT investor is subject to income tax on the income and capital gains components of the

distribution unless an exempt holder, such as an RRSP, holds the REIT units. The taxable income

allocated to the unitholder reduces the taxable income of the REIT.

Distributions received from a REIT are different than dividends received from a corporation. Generally,

an individual is subject to income tax on 5/4 of a taxable dividend received from a Canadian corporation

and the individual will be entitled to a dividend tax credit, which overall reduces the effective tax rate on

the dividend.

Other than a few specific exceptions, the income from a REIT does not retain the character of income

that was generated within the REIT.

The income from a REIT is generally characterized as other income from trust property for income tax

purposes. For example, if a REIT's taxable income is $11 million, of which $10 million is derived from

rental income and $1 million is interest income, a 0.1% investor, for tax purposes, does not receive an

allocation of $10,000 of rental income and $1,000 of interest income on the T3 supplementary form.Instead, that investor would simply receive $11,000 of income classified as other income.

Rental income is generally included in the definition of earned income for RRSP purposes, but the rental

income earned by a REIT is not rental income in the hands of the unitholder. Therefore, taxable income

received by an individual REIT holder does not qualify as "earned income" for the purpose of calculating

the investor's RRSP contribution limit for the following year.

Fortunately, the Income Tax Act does contain rules that permit a REIT to designate certain types of

income to essentially retain its character upon distribution to the unitholder. For example, a REIT may

designate a taxable capital gain distributed to the unitholders to be a taxable capital gain to such

unitholders. As a result, an investor will pay income tax on only one-half of the share of the capital gain

realized and distributed by the REIT. A REIT may also designate a dividend received from a taxable

Canadian corporation and distributed to the unitholders to be a dividend received by the unitholder. An

individual investor could then benefit from the dividend tax credit.

Provided the REIT has allocated its taxable income to its unitholders, each investor in the REIT will

receive a T3 Supplementary slip either directly from the REIT or indirectly through the brokerage house

with whom the units are held on behalf of the investor. The unitholder will then be able to determine

what portion of the distributions represents capital gains, dividends from Canadian corporations (usually

flowing from the REIT's corporate subsidiaries) and other income. These amounts are then reported on

the investor's personal income tax return.

The return of capital distributed by the REIT, i.e. the amount of the distribution paid by the REIT in

excess of the taxable income (which includes, if applicable, capital gains), is generally not taxable

immediately to the unitholder. However, the unitholder's adjusted cost base (ACB) of the units will be

reduced by such amount, as discussed below. A return of capital distribution is attractive to the

unitholder as it essentially represents tax-deferred cash flow from the REIT.


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Generally, the units of a REIT represent capital property to the unitholder. As a result, a REIT investor

may realize a capital gain or capital loss on the disposition of the REIT units. A capital gain will arise

when the proceeds of disposition from the units sold exceed the adjusted cost base of the units plus any

selling costs. Conversely, a capital loss arises when the proceeds of disposition are less than the

adjusted cost base plus selling costs. For income tax purposes, a taxable capital gain is equal to one-

half of a capital gain, while an allowable capital loss is equal to one-half of a capital loss. The Income

Tax Act contains a number of restrictions in the utilization of capital losses; for example, capital losses

can only be applied to reduce capital gains in the current year, or by carrying back net capital lossesthree years or forward for an indefinite period. The capital losses may also be deferred by the superficial

loss rules.

The adjusted cost base of a REIT investor's units is initially the cost of purchasing a particular REIT's

units plus any additional acquisitions of the same REIT's units less capital distributions and dispositions

of the same REIT's units. The adjusted cost base of the units will decrease by the amount, if any, by

which the distributions received from the REIT exceed the taxable income and capital gains allocated by

the REIT to the unitholder. As illustrated in Appendix 2, a REIT investor's adjusted cost base will

generally decrease over time as capital is returned to the unitholder.

The adjusted cost base calculation is required when a REIT unitholder decides to sell (or dispose) of all

or portion of his or her units. The holder has to calculate and maintain a separate adjusted cost base for

units of each particular REIT held. As most REITs do not track the individual adjusted cost base, eachunitholder must keep account of his or her adjusted cost base. To eliminate the need to calculate the

capital distributions from the date of acquisition, the unitholder should calculate annually the adjusted

cost base of their unitholdings. The adjusted cost base of the units is averaged against all units held in a

particular REIT. Also, if the adjusted cost base should become negative, the unitholder is deemed to

have realized a capital gain equal to the absolute value of the negative amount. For example, if a

unitholder's adjusted cost base of a particular holding of REIT units is $300 and the REIT distributes

$1,000 to the unitholder, of which $600 is taxable income, the adjusted cost base will become negative

$100 ($300 prior adjusted cost base - [$1,000 distribution - $600 other income]). The unitholder will

immediately realize a capital gain of $100 and is required to report, at the year-end, a capital gain of

$100. The adjusted cost base of the units would then be adjusted from negative $100 to zero.

A capital gain realized on the sale of REIT units to a qualified donee, such as a registered charity, wouldattract a more favourable tax rate; that is, the gain is only one-quarter taxable to the unitholder (rather

than the normal one-half inclusion rate for capital gains).

Parents may be interested to know that the income from a mutual fund trust is not subject to the "kiddie

tax" rules. Therefore, a child who receives income from a REIT may not be subject to the highest

marginal tax rate on such income. Of course, the attribution rules must be considered and respected,

which could make the child's REIT income taxable in the parent's hands.

The purchase and sale of REIT units is not subject to various forms of provincial land transfer taxes.


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Deferred Income Arrangements

A mutual fund trust unit is a qualified investment for (a) registered retirement savings plans ("RRSPs");

(b) registered education savings plans ("RESPs"), (c) registered retirement income funds ("RRIFs") and

(d) deferred profit sharing plans ("DPSPs"). Such plans can defer the income tax otherwise payable on

the taxable income and capital gains distributed by a REIT.

RRSPs, RRIFs, DPSPs and certain other taxpayers are subject to a 1.0% per month tax under Part XI of

the Income Tax Act in respect of holding foreign property in excess of the 30% threshold. Generally, theunits of a REIT will not be foreign property if the REIT is a mutual fund trust that (1) has not acquired any

foreign property or (2) did not have foreign property the cost of which exceeded 30% of the cost of all of

the REIT's property determined on a non-consolidated basis. If a REIT is a registered investment (as

discussed above), then its units will not be foreign property.

Corporate Unitholders

A Canadian-controlled private corporation that is a REIT unitholder wil l have to consider the refundable

dividend tax rules in respect of investment income and taxable capital gains from the REIT. The federal

income tax rate on such income is approximately 35.79%, which includes the additional 62/3% tax. The

corporation may receive a refund of 262/3% of the federal tax through the payment of taxable dividends

at the ratio of $1 dividend refund for each $3 of taxable dividends. The taxable dividend in turn will be

subject to tax in the hands of the individual recipient.

Recent amendments to the Income Tax Act now permit a Canadian private corporation to include in the

corporation's capital dividend account the non-taxable portion of a capital gain distributed from a trust.

Previously, there was no such mechanism within the tax law and a private corporation and its

shareholders were essentially subject to additional taxation. To illustrate the new rule, let's say a private

corporation is allocated, from a REIT, capital gains of $2,000. One-half of the capital gains, or $1,000,

will be taxable in the hands of the corporation. The non-taxable half of the capital gain, or the other

$1,000, will be added to the corporation's capital dividend account. Generally, on payment of a capital

dividend, a shareholder can receive a capital dividend from a Canadian private corporation tax-free. The

income tax "integration" has improved thanks to the change in the tax law.

A corporate investor in a REIT should be aware that the investment in a REIT is not an eligible

investment for the investment allowances provided in the LCT and provincial capital tax regimes. This

compares unfavourably to the investment in shares of corporations, which are generally eligible

investments. Also, Ontario has certain look-through rules in respect of an interest in a trust; a

corporation subject to Ontario capital tax has to include its share of the taxable capital of the trust in its

capital tax calculation.


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Non-Resident Unitholders

As previously discussed, a non-resident that receives income from a trust is generally subject to Part XIII

of the Income Tax Act (non-resident withholding tax) at the rate of 25%, or usually less if the non-resident

resides in a country that has a tax treaty with Canada. It is interesting to note that the allocation of

capital gains designated by a trust to a non-resident is not subject to Part XIII tax. Real property in

Canada is taxable Canadian property and non-residents are generally subject to Canadian tax on the

disposition thereof. The non-taxable allocation of capital gains to non-residents from a REIT is unusual,

since Canada usually protects its right to tax non-residents on income and capital gains realized in

respect of real property in Canada. As mentioned above, a mutual fund trust cannot be established or

maintained primarily for the benefit of non-residents; therefore, the tax benefit to non-residents is

somewhat limited.

Canada imposes a further rule to tax significant non-resident unitholders of a REIT on capital gains

arising from the disposition of taxable Canadian property. A unit of a mutual fund trust is considered to

be taxable Canadian property if, at any time during the preceding five years, 25% or more of the issued

units of the trust belonged to the taxpayer, to persons not dealing at arm's-length with the taxpayer, or

any combination thereof. Otherwise, the units of a mutual fund trust are not considered to be taxable

Canadian property.

If the REIT units of a non-resident are considered to be taxable Canadian property, the disposition of oneor more units by the non-resident that results in a capital gain will be taxable in Canada. The non-

resident will have to file a federal tax return (and possibly a provincial tax return), report the capital gain

and pay the applicable income tax. The non-resident should consider whether there is any relief from

Canadian tax on the gain under a tax treaty; given that a REIT will usually hold a large portion of its

assets in Canadian real estate, relief under a treaty may not be available. The non-resident seller

(vendor) of a REIT unit does not need to obtain a pre-clearance certificate under section 116 of the

Income Tax Act since a unit of a mutual fund trust is excluded property. Therefore, the non-resident

vendor and purchaser do not have to be concerned with section 116 of the Income Tax Act. The section

is designed to force the non-resident to obtain a clearance certificate, prior to the sale of the taxable

Canadian property. The non-resident will calculate the gain or loss on the disposition and, if applicable,

pay to Canada Customs and Revenue Agency a withholding tax on the capital gains.

The non-resident will have to determine the income tax consequences, in the country in which the

investor resides, of making an investment in Canada, and whether or not any relief for Canadian income

taxes paid is available in that country.


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Comparison of Open-Ended and Closed-Ended Mutual Funds

The open-ended mutual fund trust was the birth vehicle of the modern day REIT, however it proved to

be incorrectly structured and therefore the wrong vehicle of choice during the downturn in the economy

in the late eighties and early nineties. The reason for the demise of open-ended mutual fund trusts was

the requirement of the trust to redeem the units for cash at the demand of the unitholder. This

redemption structure did not fit well with the relative illiquidity of real estate assets. With redemptions

being greater than unit sales during the fall of the real estate market, a major cash crunch caused theREITs to sell off their real estate assets, usually at a discount, to fund the redemptions, which were paid

out on the bases of appraised values of the underlying assets. One of the underlying assumptions of

the appraised value approach was that the REIT would continue as a going concern and would not be

forced to sell off real estate assets at a discount to redeem units.

The closed end mutual funds that arose from the ashes of these open-ended structures alleviated this

problem by eliminating the redemptions requirement. Unitholders were restricted to selling their units

through stock market exchanges and were unable to redeem their units through the trust. We have

recently seen the open-ended mutual fund trust re-emerge with an adjusted structure as it applies to the

redemption obligation and sale of units. This has been achieved by essentially restricting the amount of

redemptions and limiting the cash component of the redemption amount. Also, unitholders must first

seek to sell their units through the stock market exchanges and, failing that, can request the REIT to

redeem their units under certain conditions.

The cash flow requirements associated with redemption under the adjusted open-ended structure are

minimized via two main clauses in the trust indenture. The first is the ceiling placed on the number of

unit redemptions allowed during a specified time period. This results in a limited cash requirement for

redemptions during the specified time period. The other clause that can be added allows for the

redemption amount to be honoured via an interest bearing note payable issued by the REIT in lieu of

cash. This essentially converts excess redemptions in a period into debt. The combined effect of these

two clauses considerably reduces the redemption risk associated with the original open-ended mutual

fund trust structure. The redemption structure and the ability to hold foreign property are the most

significant differences between the open-ended and closed-end mutual fund trusts. This structure also

allows for increased investment in foreign property relative to the closed ended mutual fund trust, while

maintaining the requirements under tax law to qualify as a mutual fund trust.

A mutual fund trust must be, amongst other things, a unit trust resident in Canada. A unit trust must be

an inter vivos trust and the beneficial interests in the trust must be described by reference to units of the

trust.

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From a tax perspective, mutual fund trusts are commonly referred to as "open-ended" or "closed-ended"

based on the two types of unit trusts available under the Canadian income tax act.

Both types of mutual fund trusts must comply with specific tax rules to maintain their tax status as a

mutual fund.

A closed-end unit trust must meet a number of conditions under the Income Tax Act, including the

following:

1. The trust must be resident in Canada.

2. The trust's only undertaking is restricted to the acquiring, holding, maintaining, improving, leasing or

managing of any real property or an interest in real property that is capital property of the trust, and

the investing of its funds in property (other than real property or an interest in real property).

3. At least 80% of the trust's property must be real property and interests in real property situated in

Canada, and other qualifying property, including cash, shares, bonds, debentures and mortgages.

4. Not less than 95% of the trust's income must be derived from, or from the disposition of, investments

described in the above point number 3.

5. Not more than 10% of the trust's property may consist of bonds, securities or shares of any one

corporation or debtor (except for issuances by certain governments in Canada).An open-end unit

trust, which must also be resident in Canada, has fewer requirements under the Income Tax Act to

comply with in order to maintain its status as a mutual fund and they include the following:

1. The issued units of the trust must include units having conditions that essentially

require the trust to redeem the units at the demand of the unitholder, i.e. the units are

retractable.

2. The fair market value of the units described above must be 95% or more of the fair

market value of all of the issued units of the trust (without regard to voting rights

attaching to units of the trust).

The reader should review the actual income tax rules or obtain professional advice when assessing the

impact of the mutual fund trust and unit trust rules on the establishment and management of a REIT. If a

REIT should ever fall offside of the mutual fund trust and unit trust rules, the income tax consequencescould be severe to the REIT and its unitholders.

While the open-ended unit trust conditions are fewer in number, if market conditions change, it may be

more difficult for a new REIT to adopt the restrictive redemption requirements. Since a REIT will usually

hold a large portion of its assets in rental real estate, it may be difficult for a REIT to have the retraction

requirements when its assets are relatively illiquid. Historically, most REITs have opted to meet the

conditions of the closed-end unit trust rules, which do not contain any mandatory retraction requirements.

The downside with closed-end unit trusts is the number and type of restrictions; open-ended unit trusts

provide much more flexibility in terms of the type and amount of investments.


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4. The REIT Vehicle in the Canadian Marketplace

History of Capital Flows into the Canadian Real Estate Industryfrom 1970 to the Present

1970's

The 1970's saw a boom in the Canadian real estate market, due primarily to an influx of Europeanmoney caused by the political threat of Russian advancement and a decrease in investment risk, both

of which resulted in increased development. Companies such as TrizecHahn, Cadillac Fairview and

Cambridge Shopping Centres were formed to meet the increased development demand. In order to

access the pools of money, development took place in the form of joint ventures and syndications.

1980's

The 1980's saw the peak of syndication, coupled with exploding capital growth tied to real property.

As real estate investor confidence grew, there was a major increase in the extent of leverage used to

finance real estate activity. The increased leverage brought increased risk, which eventually caused

the banks to start calling their loans.

Real estate investors incurred large losses since the syndication agreements failed to include a "cashumbrella'; therefore, they were unable to pay off their loans, resulting in banks and lending institutions

becoming large holders of real estate as they foreclosed on their loans. In the U.S., REITs begin to

emerge as an investment vehicle.

1990's

The large losses incurred in the 1980's caused real estate investors to shift their focus in evaluating

real estate. Investors returned to 1960 ideals of evaluating real estate based on cash flows and not as

speculative investments. Real estate was no longer able to provide investors with high returns and

money began to flow out of the sector into "new economy" (i.e. high tech companies) that were able

to provide investors with the desired rates of return.

With the collapse of the limited partnership syndicated market and the open-ended mutual fund trusts,

the closed-end mutual fund trust emerged in Canada.

2000's

The growth in the new economy has slowed and is adjusting to more sustainable levels. Inflation in

the North American economy has fallen below 2%. Interest rates have decreased in line with the

downturn in the economy, and many organizations with variable mortgage rates have benefited, as

their cost of capital has declined. As a result the risk adjusted yields of REITs have become very

attractive in comparison to a bond in the low interest rate markets of 2001. REITs now represent one

third of the TSE real estate market capitalization and have clearly become the dominant vehicle for

accessing public real estate equity; all but one of the 20 real estate equity issues in 2001 were REIT

transactions.

The Canadian real estate industry is in need of a recapitalization and REITs are one of the vehiclesthat could provide the necessary new capital and liquidity. A REIT is simply a form of securitization for

real estate, an area in which Canada lags behind the United States, even though the U.S. has only 2-

3% of its real estate market securitized. This is very low when compared to the United Kingdom

(40%) or Singapore and Hong Kong (80%). Given the capital requirements of real estate,

securitization is expected to be prevalent worldwide.

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REITs Provide a Vehicle for Buying Real Estate

The public real estate market rebounded from its 5-year slump in the early 90's. From 1996 onwards

there has been a significant increase in the market capitalization of the public real estate sector. The

Canadian REITs created in 1997 were perceived as high yield investment funds (real estate values were

at a low enough level to provide good returns). In addition, funds flowed through the older REITs raising

equity by way of convertible debentures. The challenge for the REITs going forward will be to continue

to source accretive properties if the interest rate climate reverses, without a decrease in the yield rate onREIT's unit. To date, because of the increase in the unit value and reduced yields coupled with the

favourable interest rate climate, REITs have been able to acquire accretive properties.

The real estate industry sees the REIT, as a stand-alone sector, and not part of the income trust sector.

In reality however, the broader market views REITs as a sub-section of the income trust group. The

challenge for the REIT sector is to change the perception of the investing public. The REIT sector has to

clearly educate and demonstrate to investors that it is a different business. The risks and rewards of

REIT ownership are different and, equally important so too are the corporate governance requirements.

A REIT is not only a yield vehicle but also offers many attributes that the income trusts generally do not

offer, such as stability where the underlying assets and related financing are of a long-term nature. As

most REITs are able to effectively pass through the CCA claim, they are able to defer the tax on a certain

percentage of the distributions. The REIT tenant base is usually spread over many tenants thereby

limiting exposure to concentration risk. The large REITs are owners of multiple geographically diverse

properties. Generally, investors have not been educated in assessing the risks and rewards of the

various subsets of the income trust group. Refer to Section 6 for a comparison of the REIT vehicle as

compared to other income trusts.


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5. Challenges of Converting to a REIT

Transaction Costs

The formation and capitalization of a REIT is typically a long, complicated and expensive process.

The time between the initial thought process and completion of the initial public offering ("IPO") is

usually six months or more. Costs to be incurred in the formation of a REIT include:

Underwriters' fees (often 5% to 6% of the total dollar value of the public offering);

Legal fees for counsel to the newly formed REIT (usually in the $600,000 to $1.2 million range,

depending on the size and complexity of the issue);

Legal fees for the underwriters' counsel ($250,000 to $600,000, again depending on the size and

complexity of the issue);

Audit fees ($350,000 to $800,000, depending on the amount of attest work required, the condition

of the books and the availability of audited records);

Accountants and/or legal fees for tax advisory services (depends largely on the complexity of the

transaction);

Appraisals, Phase I environmental reports and engineering reports ($200,000 to $300,000); and

Printing and translation cost ($200,000 to $300,000).A rule of thumb for estimating total transaction costs is 7% to 8% of the total issue.

Other than the underwriters' fees, these costs are largely incurred prior to the closing of the initial

public offering. This means that a sponsoring entity (i.e. the company or persons promoting and

organizing the REIT) takes significant risks prior to knowing whether the public offering will be

successful. A change in economic or market conditions (e.g. interest rate movements), or an

unanticipated event (such as a terrorist attack, or not being able to close on a part of the portfolio),

can leave a sponsoring entity with a significant bill for professional fees, with nothing to show for it.

This does not include the human cost of the strain placed on the organization over the six or more

months to the IPO date.

Because of this, the sponsor of the REIT should be prepared on two fronts:

1. The sponsor must thoroughly evaluate the feasibility of the REIT that is being proposed, and obtain

the appropriate professional advice, including the reactions of the relevant investment bankers,

before proceeding in a significant manner. Some of the specific matters that need to be addressed

are set out below.

2. The sponsor must be prepared to accept the risk of having to absorb the up-front costs should the

transaction be unsuccessful and fall through; the organization should not only have the financial

capacity but also the human capacity to absorb the above-noted costs.

Matters to Consider BEFORE Proceeding with a REIT TransactionThe following matters should be addressed as early as possible in the process, and in a reasonable

amount of detail, through consultations with the lead underwriter, securities lawyers, auditors, tax

advisors and others. While it is impossible to predict all outcomes, and there will invariably be latechanges in the structuring of a REIT transaction or shifts in market conditions, significant up-front

planning can greatly improve the chances of a positive outcome and at the same reduce, or at least

control, the outsourced services costs.

Extent of Involvement of the Sponsor in the Ongoing Operationof the REITThe extent to which the sponsoring entity (often a public or private real estate corporation) wishes to

remain involved in the ongoing operations of the REIT will drive many of the other decisions. The

sponsor may remain involved in a number of ways:

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1. Providing asset and strategic management and advisory services to the REIT at the REIT level.

2. Providing property management services.

3. Retaining a significant ownership interest.

4. By entering into a development relationship with the REIT whereby the REIT will acquire properties

being developed or redeveloped by the sponsor; typically, the REIT will also provide mezzanine

financing on the development projects.

The advantages of continued involvement include:1. The REIT having access to competent and experienced management, before it has acquired the critical

mass to hire its own management.

2. The positive market perception when the sponsor retains a significant stake in the ongoing success of

the REIT.

3. The potential "symbiotic" relationship between a corporation that manages and develops properties, and

an investment vehicle that holds the mature property portfolio.

The challenges to the sponsor in maintaining involvement include:

1. Ensuring that potential investor concerns over conflicts of interest are addressed, especially where the

sponsor retains a controlling interest. Appropriate governance practices need to be in place, often in the

form of independent trustees, to address these concerns.

2. The effect on the sponsor's financial statements - The sponsor may or may not want to consolidate or

equity account for the REIT. Consolidation and/or equity accounting is likely to result in limitations on

the amount of profit that can be recognized on intercompany transactions. For example, the sale of

development properties by a sponsor to a REIT that is consolidated by the sponsor will result in deferred

or delayed gain recogniti

Deloitte REIT Guide 8th Edition

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