Table of Contents. TABLE Of CONTENTs

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1 Table of Contents TABLE Of CONTENTs CHAPTER 1: INTRODUCTION AND HIsTORY Of THE CANADIAN REIT Introduction Origins of the Canadian REIT Development of U.S. REITs Canadian Publicly Listed Limited Partnerships Early REIT Vehicles in Canada Open-End Real Estate Mutual Funds and the Real Estate Downturn of the Early 1990s Stages of Evolution of the Canadian REIT Conversion to Closed-End Funds The Growth of Closed-End Canadian REITs A New Generation of REITs Real Estate Capital Markets from 1998 to The Re-Emergence of the REIT Strategic Development Arrangements Cross-Border REITs and the Return to the Open-End Structure Internalization of Executive Management and the Introduction of Shared Management Platforms Unshackling the Declaration of Trust October 31, 2006 The Tax Fairness Plan Changes in the Landscape Stapled Structures Changes in the Financial Environment and the Dawn of a New Era International Financial Reporting Standards ( IFRS ) External Management New Sources of Financing Cross-Border and International REITs REIT Trends REALpac 2014 Canadian REIT Handbook TOC-1

2 Table of Contents CHAPTER 2: THE TRUsT CONCEPT AND THE CANADIAN REIT Introduction Basic Principles of Trust Law The Trust Instrument Provisions of the Declaration of Trust Duration Accumulation Rule Board of Trustees Investment Guidelines and Operating Policies Conflicts of Interest Liability of Unitholders General Rule Regarding Beneficiary Liability Agent-Principal Relationship Indemnification Liability in Contract Legislative Developments Rights and Remedies of Unitholders Right to Distributions Right to Vote No Right of Dissent or Appraisal Requisitioning Meetings and Dissident Proxy Circulars Removal of Trustees Right to Obtain a List of Registered Unitholders Legal Proceedings CHAPTER 3: structure AND OPERATIONs Of THE REIT Introduction REIT Structures Basic Structure Business REITs Distributable Income Calculation Distributions Toronto Stock Exchange Compliance Investment Guidelines / Restrictions and Operating Policies Introduction TOC-2 REALpac 2014 Canadian REIT Handbook

3 Table of Contents Investment Guidelines and Restrictions Operating Policies Insurance Budgeting and Cash Management Debt Management CHAPTER 4: TAx CONsIDERATIONs for THE CANADIAN REIT Introduction Mutual Fund Trust Status Mutual Fund Trust Requirements Resident in Canada Unit Trust Investing of Funds and Inventory Restrictions Distribution and Ownership of Units Non-Resident Ownership Restrictions Unit Trust Requirements Open-End Unit Trust Closed-End Unit Trust Conversion Between Closed-End and Open-End Unit Trusts Closed-End to Open-End Open-End to Closed-End Private REITs Income Tax Considerations Recent Developments in the Taxation of REITs Taxation of REITs Taxation of Trusts Taxation of SIFTs Flow-Through of Income Reporting Income Distributions Issue Costs Capital Cost Allowance Capital Gains Dividend Income Rental Income Losses Advantages of Status as a Mutual Fund Trust Tax Implications of Loss of Mutual Fund Trust Status REALpac 2014 Canadian REIT Handbook TOC-3

4 Table of Contents Tax Implications of Loss of Qualifying REIT Status Taxation of Unitholders Canadian Residents Non-Residents of Canada Eligibility for Investment Tax Considerations on Establishment of a REIT Timing of Establishment Impact on Deductions Election Under Subsection 132(6.1) Tax-Deferred Transfers Tax Considerations of Mergers of REITs Comparison of Tax Attributes of Ownership Vehicles Harmonized Sales Tax Considerations General Purchases and Supplies of Real Property General Supplies of Real Property by a REIT Input Tax Credits Registration Requirements Other Provincial Sales Tax Considerations Provincial Sales Taxes Quebec Alberta CHAPTER 5: THE INITIAL PUBLIC OffERING PROCEss Introduction Preliminary Considerations in Going Public Benefits of Going Public Risks of Going Public Preliminary Considerations in Choosing the REIT Vehicle The REIT Initial Public Offering Process Introduction Basic Steps in the Initial Public Offering Process Key Considerations in the Initial Public Offering Process Accounting Considerations Key Documents in the Initial Public Offering Process Disclosure Requirements TOC-4 REALpac 2014 Canadian REIT Handbook

5 Table of Contents Securities Regulatory Review and Waiting Period CHAPTER 6: ACQUIsITIONs AND financings Introduction The Concept of Accretion Direct and Indirect Acquisitions Direct Acquisitions Indirect Acquisitions Long-Term Leases Joint Ventures Acquisition Considerations Title Nominees Timing of Acquisitions Acquisition Agreement Requirements in the Declaration of Trust Land Transfer Tax Regulatory Requirements Lender Consents Public Financing Public Offerings Private Placements Distribution Reinvestment Plans Convertible Debentures Debt Financing Operating and Acquisition Lines Mortgage Financing Secured by Real Property CHAPTER 7: TRUsTEEs AND REIT GOVERNANCE Introduction Duties of Trustees and Standard of Care Liability of Trustees and Protection from Liability Liability to Third Parties Indemnification of Trustees Liability to Beneficiaries Investment Requirements Governance of a Public REIT Introduction Governance of REITs Election of Trustees REALpac 2014 Canadian REIT Handbook TOC-5

6 Table of Contents Committees of Trustees Compensation of Trustees National Instrument Certification of Disclosure in Issuers Annual and Interim Filings Audit Committees Other Corporate Governance Initiatives CHAPTER 8: MANAGEMENT Of THE REIT Introduction Management Arrangements External Management Internal Management Shared Platform Management Property Management Management Compensation Unit Option Plans Long-Term Incentive Plans Non-Competition Agreements CHAPTER 9: ONGOING securities LAW COMPLIANCE Introduction Continuous Disclosure Timely Disclosure of Material Changes Selective Disclosure Insider Reporting Insider Trading Prohibition against Tipping Periodic Disclosure of Financial Information Annual Information Forms Material Documents Proxies and Information Circulars SEDAR National Policy Income Trusts and Other Indirect Offerings OSC Filing / Listing Fees Enforcement and Penalties The Securities Act (Ontario) The Criminal Code (Canada) Other TOC-6 REALpac 2014 Canadian REIT Handbook

7 Table of Contents 905 Civil Liability for Secondary Market Disclosure General Right of Action Potential Defendants Potential Liability Proof of Claims Defences Leave of Court Required CHAPTER 10: DEVELOPMENT ARRANGEMENTs Development by REITs Economics of Development Development Skills and Labour Force Development Risks Construction Risk Cost Risk Revenue Risk Leasing Risk Structure of Development Arrangements Financing Development Activities Conditions for Acquisition of Development Property Use of Convertible Debentures CHAPTER 11: COMBINATIONs AND TAKE-OVER BIDs AMONG REITs Introduction Combinations Acquisition Agreement Unitholder Approval Third Party Consents Take-over Bids Introduction Process Integration Collateral Agreements Insider Bids Early Warning Requirements Defensive Tactics Exempt Bids MI REALpac 2014 Canadian REIT Handbook TOC-7

8 Table of Contents Formal Valuation Minority Approval Enhanced Disclosure Issuer Bids Introduction Formal Issuer Bids Exemptions from the Issuer Bid Requirements Requirements Under MI Business Combinations Exemptions from MI Formal Valuation Minority Approval Enhanced Disclosure Related Party Transactions Definition of Related Party Transaction Exemptions from MI Formal Valuation Minority Approval Enhanced Disclosure Regulatory Approvals The Competition Act The Investment Canada Act CHAPTER 12: INVEsTMENT CONsIDERATIONs Introduction Yield Net Asset Value Performance Measurements Distributable Income and Recurring Distributable Income Funds from Operations Adjusted Funds from Operations Tax-Deferred Portion of Distributions Evaluating a REIT Management Geographical Concentration Debt Level Percentage and Short-Term Funds Debt Management Cost of Funds TOC-8 REALpac 2014 Canadian REIT Handbook

9 Table of Contents Cash Flow Tenants Geographical Location and Liquidity of Assets Environmental Management Foreign Exchange Exposure Inflation Liquidity of Trust Units Acquisition of Properties and Dilution Fully-Diluted Distributions per Unit and 17 its Impact on Value Convertible Debentures GLOssARY... GLOS-1 short forms...sf-1 REALpac 2014 Canadian REIT Handbook TOC-9

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11 Chapter 1 CHAPTER 1 INTRODUCTION AND HIsTORY Of THE CANADIAN REIT 101 Introduction 2011 In this chapter, the history and origins of the real estate investment trust ( REIT ) in Canada will be explored from its inception as an open-end mutual fund through its transformation to a closed-end investment trust and further evolution in the Canadian capital markets. Fluctuations in the Canadian economy and changes in tax legislation that have affected the structure of REITs will be discussed, along with other changes, such as demographic shifts that have altered the profile of REIT investors. This chapter will also highlight various attributes of the REIT that have developed over the course of its history, including specialization of REIT portfolios, internalization of management, and the use of instalment receipts and convertible debentures. Finally, this chapter will examine the re-emergence of REITs using an open-end structure with limited redemption rights. 102 Origins of the Canadian REIT Development of U.S. REITs 1 Investing in commercial properties (and diversifying across real estate types and regions) requires financial resources beyond those of most individual investors. Moreover, direct investment in real estate lacks the necessary liquidity to accommodate many investors needs. In response to these barriers to investment, the United States ( U.S. ) Congress created REITs on September 14, 1960 when President Eisenhower signed into law the 1 Historically, the first REIT was the Massachusetts business trust, which was formed in the late 1800s to avoid state restrictions on collective ownership of real estate for investment purposes. It no longer served as a viable alternative to the direct ownership of real property when it became subject to U.S. federal corporate taxation rules in The modern form of REIT in the U.S. emerged in the early 1960s. REALpac 2011 Canadian REIT Handbook 1-1

12 Chapter 1 REIT Act title contained in the Cigar Excise Tax Extension of This newly created investment vehicle acted as a pooling arrangement, enabling small investors to invest in large-scale income-producing real estate. At this time, however, REITs were only permitted to own real estate and had to retain third parties to operate and manage their properties. Thus, early REITs were passive investment vehicles, structured to simply collect rent on their property portfolios and pass this income through to investors. Early U.S. REITs were not well received by the marketplace. In contrast to limited partnerships, which were popular with investors in the 1970s and 1980s, these REITs were not permitted to pass losses on to investors who could use them to reduce their taxable income. Accordingly, they could not compete with the tax advantages of limited partnerships. In addition, early U.S. REITs had external managers, and the separation of ownership and management was perceived to create a potential conflict of interest. While U.S. REITs are still unable to pass losses on to investors, the tax advantages of the limited partnership have been greatly reduced. The Tax Reform Act of decreased the relative benefits of limited partnerships in the U.S. by limiting the tax shelter advantages of limited partnerships and removing the prohibition on REITs operating and managing their properties. These changes did not immediately increase the popularity of REITs, but REITs became an increasingly more attractive investment vehicle, especially because of the failures of a significant number of limited partnerships when real estate markets began to decline in the late 1980s Canadian Publicly Listed Limited Partnerships During the early years of REITs in the U.S., there was no Canadian equivalent. Canada did, however, have investment vehicles that provided similar economic benefits to those available under U.S. tax law. These vehicles included limited partnerships and open-end mutual funds. Most real estate speculation in the early 1980s had taken place through the limited partnership vehicle. With the collapse of the real estate market in the late 1980s, a significant number of limited partnerships (both public 2 Title 26 ( Internal Revenue Code ). 3 P.L REALpac 2011 Canadian REIT Handbook

13 Chapter 1 and private) lost their entire investments and the limited partners were forced to pay their limited partnership investment loans using their personal assets. Accordingly, the limited partnership vehicle became associated with financial failure and limited partnerships never developed as credible investment vehicles in Canada Early REIT Vehicles in Canada The modern Canadian REIT industry was born in the early 1990s with the establishment of open-end real estate mutual funds specifically created to invest in real estate. While open-end real estate mutual funds ultimately failed to sustain themselves as successful public real estate investment vehicles, they were the true precursors to the contemporary Canadian REIT. These mutual funds appealed to a greater investing market than syndicated limited partnerships, which had been designed for the high net worth investor. An investor could buy into an open-end real estate mutual fund for as little as $100, with no upward limit. Both holders of mature income-producing properties and investors were attracted to the mutual fund trust structure because of its tax efficiency, which was similar to a limited partnership, 4 and its diversification of real estate holdings. In order to qualify as a mutual fund trust, a fund had to comply with subsections 132(6) and 108(2) of the Income Tax Act. 5 Read together, these provisions permitted only two types of mutual fund trust: (a) (b) A mutual fund trust with a class of units redeemable upon demand by the unitholder. The fair market value of these units had to be at least 95% of the fair market value of all units. This was called an open-end unit trust. A mutual fund trust with at least 80% of its property consisting of shares, bonds, mortgages, marketable securities, cash, rights to or interests in any rental or royalty computed by reference to the amount or value of production from 4 Like a limited partnership, the trust itself was not subject to large corporations tax or capital tax. Rather, interest, dividends and capital gains flowed through to unitholders on a pre-tax basis. 5 R.S.C. 1985, c. 1 (5th Supp.) ( Income Tax Act ). REALpac 2011 Canadian REIT Handbook 1-3

14 Chapter 2 CHAPTER 2: THE TRUsT CONCEPT AND THE CANADIAN REIT 201 Introduction A REIT is a trust 1 created for a commercial purpose. Although REITs are sophisticated investment vehicles, they are generally governed by the same principles as other types of trusts. These principles are found mainly in the common law and applicable provincial trust law, such as the Trustee Act (Ontario), 2 and the civil code in Québec. In contrast to the comprehensive statutory codes and extensive common law jurisprudence governing corporations, trust law is comparatively less developed in the business context. This has afforded opportunities for creativity and flexibility in structuring REITs. This chapter reviews the basic principles of trust law and their application in the REIT context. 202 Basic Principles of Trust Law A trust is created when one person (the settlor ) conveys property to another (the trustee ) for the benefit of a third person (the beneficiary ). 3 Interests in trust property are divided into legal and beneficial interests. The trustees hold legal title to the trust property. In the REIT context, the beneficiaries are called unitholders and acquire their beneficial interest by purchasing units of the REIT. 1 In the U.S., unlike in Canada, a corporation as well as a trust may seek status as a REIT under the U.S. Internal Revenue Code. 2 R.S.O. 1990, c.t.23 ( Trustee Act (Ontario) ). 3 A person can also convert his or her own property into trust property by declaring that he or she now holds that property for the benefit of someone else. REALpac Canadian REIT Handbook 2-1

15 Chapter 2 A leading Canadian authority on trust law describes the role of the trustee as follows: [The trustee] is not only vested with title in the trust property, he contracts with third parties as if he also had the beneficial enjoyment of that title, being personally liable on those contracts. 4 Thus, trustees deal with the property of the trust for the benefit of the unitholders and, unless such obligations are modified by contract, will generally be liable to third parties with respect to those dealings. As discussed below, this general position is typically modified in the REIT context. 203 The Trust Instrument Most trusts are evidenced by a written trust instrument signed by the trustees and the settlor (who may or may not be a trustee), sometimes called the deed of trust, trust indenture or declaration of trust. In the REIT context, the trust instrument is most frequently referred to as the declaration of trust. The declaration of trust, like all trust instruments, is the governing document for the administration of the trust property and the relationship of all parties affected by the arrangement. Its function is comparable to the constating documents of a corporation but, unlike the formation of a corporation, the formation of a trust does not normally require filing with any governmental office. 5 The declaration of trust names the trustees, defines the purpose and the beneficiaries of the trust, and sets out the powers and responsibilities of the trustees. A REIT s declaration of trust may modify general trust law by, for example, narrowing the unitholders rights or broadening the trustees powers. When a declaration of trust does 4 Donovan Waters, Law of Trusts in Canada, 2nd ed. (Toronto: Carswell, 1984) at 43 ( Waters ). 5 While there is no general requirement to register a trust to make it valid, there may be circumstances where the registration or notification of the existence of the trust is required. Examples include a trust governing a pension plan under pension benefits standards legislation, a trust governing a registered retirement savings plan under income tax legislation and, in Ontario, a trust that has a charitable beneficiary or purpose under the Charities Accounting Act, R.S.O. 1990, c. C REALpac Canadian REIT Handbook

16 Chapter 2 not address topics that form part of the general legal principles relating to trusts, these matters will be governed by general trust law at common law and under the Trustee Act (Ontario) (or its equivalent in provinces other than Ontario). When establishing a REIT, it is usual practice for the settlor to enter into a generic form of declaration of trust with a single trustee in order to establish the trust for legal purposes. This initial declaration of trust identifies the property to be settled upon the trust and the beneficiaries of the trust and sets out a statement of investment objectives. The settlor may or may not be an initial unitholder. The terms of a comprehensive declaration of trust amending or superseding the generic form are negotiated among the sponsor, the manager, if any, and the underwriters during the IPO process. REIT declarations of trust typically state the investment objectives of the REIT in general terms, and set out rules to safeguard the interests of unitholders. Since the trustees derive their authority, including investment and operating authority, from the declaration of trust, flexibility is important. Unduly restrictive or narrow language may impose impractical restrictions on the REIT s operations. Moreover, later amendments to the declaration of trust, other than minor housekeeping matters, often require the consent of either a majority or, for fundamental changes, two-thirds of unitholders. 204 Provisions of the Declaration of Trust Duration The declaration of trust sets out how long the trust will last and what steps can be taken to terminate the trust. On termination of the trust, any remaining trust property will be distributed to the beneficiaries. As described below, the outside termination date of the trust may be affected by law Perpetuities Period At common law, a trust is only valid if the interests vest in the beneficiaries at some ascertainable future date that falls within the common law perpetuities period. 6 The common law perpetuities period ends 21 years 6 There are special perpetuity rules for purpose trusts of different types. These rules are not relevant to this discussion. REALpac Canadian REIT Handbook 2-3

17 Chapter 3 CHAPTER 3: structure AND OPERATIONs Of THE REIT 301 Introduction This chapter outlines the key structural features of typical REITs, as well as investment and operating policies. The essential structure, as the term real estate investment trust suggests, is the trust. More sophisticated structures tend to be implemented for Business REITs because operating entities must be formed and utilized to ensure that the REIT does not lose its favourable tax status. Every REIT is structured to distribute its cash flow on a tax-efficient basis to unitholders of the REIT. The cash flow distributed by a REIT is typically referred to as distributable income or, where the REIT measures its performance on a Funds From Operations ( FFO ) basis 1, the cash distribution is expressed as FFO per unit or a percentage of FFO. Some REIT s also express the cash distribution as a unit or percentage of Adjusted Funds From Operation ( AFFO ). As discussed below, a REIT s declaration of trust sets out the methods and procedures for calculating and distributing its distributable income. A REIT s declaration of trust also sets out certain basic parameters within which the REIT is required to operate and invest its assets. These rules are typically referred to as investment guidelines or restrictions and operating policies. They are designed to ensure, among other things, that the REIT is operated in a manner consistent with its intended purpose and in compliance with the requirements imposed by the Income Tax Act that afford the REIT its distinct tax treatment. REITs generally adhere to other operating policies that are also discussed in this chapter. 1 For REALpac s definition of FFO, see > Financial Best Practices > White Papers & Research, or consult the REALpac IFRS Handbook ( Recommended Accounting Practices for Real Estate Investment and Development Entities Reporting in Accordance with IFRS ), available at REALpac Canadian REIT Handbook 3-1

18 Chapter REIT structures Basic Structure The following depicts a simple REIT structure for holding real property: The basic structure is generally the same for all REITs. The trustees of the REIT own the real estate and receive rental income from the property. A non-business REIT s primary focus is on generating rental revenue from income-producing real property. 2 Even in the simplest structures, nominee companies are utilized. The REIT/nominee relationship is a trust relationship whereby the trustees of the REIT hold the beneficial interest in the real property and a nominee corporation (which is usually a subsidiary of the REIT) holds legal title to the real property in trust for the REIT trustees. The purpose of the nominee corporation is twofold. First, it addresses general trustee concerns, providing a practical way of dealing with the real property. If a REIT held real property directly (in other words, if the REIT was the legal owner of real property), the property deed might list the trustees as owners. Mortgage lenders might then insist that financing documents be entered into by and registrations be made against the trustees. A title nominee 2 Under the Income Tax Act, the holding, administration and maintenance of real estate is not considered carrying on a business. 3-2 REALpac Canadian REIT Handbook

19 Chapter 3 allows the property deeds and mortgage-related documentation to name a corporation rather than the individual trustees while still permitting the REIT trustees to hold the beneficial interest in the real property. The second advantage offered by nominee corporations relates to land transfer tax. In Ontario, transfers of beneficial ownership trigger land transfer tax obligations. In other Canadian jurisdictions, however, such as British Columbia, which does not levy land transfer tax on beneficial transfers, the use of a title nominee can be advantageous since the shares of the nominee and the beneficial interest in the real property can be transferred without triggering land transfer tax Business REITs The following depicts a sophisticated publicity-traded Business REIT structure that may have been used prior to the enactment of the SIFT rules. It is provided for historical illustrative purposes only, as the introduction of the SIFT rules has significantly altered permitted activities for qualifying REITs. 3 For a detailed discussion of title nominees and land transfer tax, see 605. REALpac Canadian REIT Handbook 3-3