SMALL BOX BIG RETURNS

Transcription

1 SMALL BOX BIG RETURNS Annual Report 2007

2 Scott s REIT (TSX: SRQ.UN) is Canada s premier small-box retail property owner with 205 properties in seven provinces across Canada. Scott s REIT s properties are well-located and geographically diverse across Canada and nearly all properties are long-term quadruple net leases. The REIT has a 70.6 per cent interest in Scott s Real Estate LP. To find out more about Scott s Real Estate Investment Trust, visit our website at

3 DOUBLING ASSET BASE IN 3 YEARS

4 SCOTT S REIT is truly unique. Our niche business model, quadruple net leases, quality properties and tenants, and outstanding growth set us apart.

5 2007 To Our Unitholders 2007 was another great year at Scott s REIT. We continue to make progress and are well ahead of our original goals. I am pleased to say that in just two short years as a public company we have become the premier small-box retail property owner in Canada and are well on the way to doubling our asset base. We are truly gaining critical mass. Our business model, which focuses on acquiring small box retail properties, is unique and we are proving that it works. While staying true to our prudent acquisition criteria and strategy, we have increased our rate of acquisitions, further diversified our tenant base, and dramatically increased gross leasable area. Together, these accomplishments have led to a dramatic increase in our revenue and net operating income. In fact, we achieved a 22.3% increase in revenue and as a result increased net operating income by 17.6%. We continue to be a lean and prudent operation and to pay careful attention to operating costs. In the past year, we successfully completed nine acquisitions, a 50% increase over our first full year in 2006, including the largest acquisition in our history. These acquisitions produced a 30% increase in gross leasable area as well as a substantial improvement in tenant base diversification, one of our key objectives. The Canadian market is a major untapped source of small-box property opportunities and we are well equipped to continue identifying them. Our position as the premier player in this niche has us fast becoming the go to group when such properties become available. We continue to seek out properties that fit our model and are leased to strong, recession resistant, national and regional name brand tenants. Our expanding asset base covers seven provinces and many major centres within them. At our first AGM in 2006 we set a goal to double our assets within five years. We have made consistent and substantial progress toward this goal and at our second AGM last April we revised our timeframe down to three years. In terms of our outlook for 2008, we are going to continue to do what we do best: grow the company. The financial sector gave us a vote of confidence early last fall when we raised $20 million through a convertible debenture offering. With the proceeds from this offering, together with our acquisition line, we believe we can comfortably fund our growth in Scott s REIT is truly unique. Our niche business model, quadruple net leases, quality properties and tenants, and outstanding growth set us apart. And while our value is not reflected in our current unit price, we strongly believe in our strategy and are confident in our ability to execute. So confident in fact that we recently announced a normal course issuer bid to support our unit price during these turbulent markets. We are really excited about the opportunities we are seeing in the marketplace and look forward to the upcoming year. With the continued support of our board of directors, trustees, and unitholders, we look forward to delivering further proof that small-box means big returns. JOHN BITOVE Chairman and Chief Executive Officer On behalf of the board of trustees of Scott s REIT SCOTT S REIT AR 07 3

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7 FINANCIAL REVIEW Management s Discussion & Analysis 6 Management s Statement of Responsibility 21 Auditors Report 22 Financial Statements 23 Corporate Information 40

8 MD&A Management s Discussion and Analysis For the three months ended December 31, 2007 (the fourth quarter ) and twelve months ended December 31, 2007 ( year-to-date ) (In thousands of dollars, except Unit and Per Unit amounts) Management s discussion and analysis ( MD&A ) discusses the significant factors affecting the results of operations and financial position of Scott s Real Estate Investment Trust ( Scott s REIT or the REIT ) for the quarter and year ended December 31, The MD&A should be read in conjunction with the audited consolidated financial statements of Scott s REIT prepared as at and for the year ended December 31, The MD&A is based on financial statements prepared in accordance with Canadian Generally Accepted Accounting Principles (GAAP). All dollar amounts are in thousands of dollars unless otherwise noted. Forward Looking Disclaimer This MD&A contains certain information that may constitute forward-looking information within the meaning of securities laws. In some cases, forward-looking information can be identified by the use of terms such as may, will, should, expect, plan, anticipate, believe, intend, estimate, predict, potential, continue or other similar expressions concerning matters that are not historical facts. Forwardlooking information may relate to management s future outlook and anticipated events or results, and may include statements or information regarding future growth opportunities and potential and expected cash distributions or cash distribution levels. Particularly, information regarding the REIT s monthly cash distributions as well as information relating to the impact of the REIT s recent acquisitions on annual revenues and interest expense is forward-looking information. Forward-looking information is based on certain factors and assumptions regarding, among other things, occupancy rates, property expense and capital expenditures. While the REIT considers these assumptions to be reasonable based on information currently available to it, they may prove to be incorrect. Forward looking-information is subject to certain factors, including risks and uncertainties, which could cause actual results to differ materially from what is currently expected. These factors include risks relating to the REIT s reliance on Priszm LP, the REIT s largest tenant, risks associated with investment in real property, competition, reliance on key personnel, financing risks, environmental matters and tenant risks. You should not place undue importance on forward-looking information and should not rely upon this information as of any other date. While the REIT may elect to, the REIT is under no obligation and does not undertake to update this information at any particular time. OVERVIEW The REIT holds a 70.6% interest in Scott s Real Estate Limited Partnership and an indirect 100% interest in its general partner Scott s GP Trust. Obelysk Inc. ( Obelysk ) holds the remaining interest in Scott s Real Estate Limited Partnership through its ownership of Exchangeable Units. The REIT s securities are listed on the Toronto Stock Exchange (the TSX ). The REIT s trust units trade under the symbol SRQ.UN, and its convertible debentures trade under the symbol SRQ.DB. 6 SCOTT S REIT AR 07

9 Objectives The objectives of Scott s REIT are: 1. to provide Unitholders with stable monthly cash distributions that are, to the maximum extent possible, tax deferred, through the ownership of a geographically diversified portfolio of small box retail properties and income-producing quick service restaurants ( QSR ) across Canada and elsewhere; Portfolio Summary As at December 31, 2007, the REIT owned 205 commercial small-box retail properties located in British Columbia, Alberta, Manitoba, Ontario, Quebec, New Brunswick and Nova Scotia with an aggregate of approximately 661,499 square feet of gross leasable area ( GLA ). GLA GROWTH SINCE IPO (in thousands) 2. to maximize cash flow and Unit value, while minimizing 700 Unitholder risk; 3. to expand the asset base of Scott s REIT through the acquisition of additional small box retail properties and QSR retail properties; and % Increase 4. to increase the distributable income of Scott s REIT through ongoing active management of the assets. The REIT s Declaration of Trust, provides that Scott s REIT make monthly cash distributions to its Unitholders. The Trustees set out on an annual basis the targeted amount of distributable income to be distributed to Unitholders for that year (currently $0.85 per unit on an annualized basis) IPO 6-Oct Dec-07 Geographic Distribution As at December 31, 2007, the portfolio of the GLA by province was as follows: Number of GLA Percentage Province Properties (sq.ft.) of GLA British Columbia 6 10, % Alberta 12 27, % Manitoba 8 20, % Ontario , % Quebec , % New Brunswick 9 16, % Nova Scotia 15 32, % Total , % SCOTT S REIT AR 07 7

10 Approximately 83% of the REIT s rental revenue is derived from properties in Ontario and Quebec. Annual Minimum Rent, the minimum rent provided by all the REIT s leases, is broken out geographically in the table below: Lease Maturities As at December 31, 2007, the REIT had a total of 205 properties with termination dates ranging from December 31, 2007 to October 14, The weighted average remaining lease term is approximately 8.9 years. MINIMUM RENT BY PROVINCE LEASE MATURITIES NB 3% NS 4% ON 53% MB 3% BC 2% AB 5% QC 30% Approximately 83% of the GLA of the properties are in desirable primary and secondary markets. 55% of the GLA of the REIT s properties are in primary markets which generate approximately 60% of the REIT s minimum rent. PROPERTIES BY MARKET TYPE YEAR Number of Units % of Minimum Rent Expiring % of GLA Expiring Historical Weighted Average Portfolio Occupancy Q Q Q Q % 99.3% 98.4% 98.8% During the fourth quarter Scott s REIT had one lease expire which was not renewed. Scott s REIT anticipates that this space will be leased within the next twelve months. In total, there are two property units which are vacant as at December 31, Tenant Base One of the goals of Scott s REIT is to broaden its tenant base primarily through its acquisition strategy, as well as through land intensification. When the REIT was formed, it had a 0 Primary Secondary Tertiary 0 Number of Properties % of Minimum Rent % of GLA 8 SCOTT S REIT AR 07

11 tenant base that was comprised of 83% KFC standalone stores. As of the most recent quarter ended, the REIT s tenant base has been greatly diversified, as the percentage of KFC standalone stores has been reduced to 52%, with the remaining balance of 48% made up of several tenants such as KFC/Taco Bell, KFC/Pizza Hut, Pharma Plus, Shopper s Drug Mart, Staples, Laurentian Bank and Prime Restaurants. The charts below illustrate a breakdown of the REIT s tenant base. In addition, upon formation, Scott s REIT had 99% of its tenants as QSRs by GLA. As of December 31, 2007, Scott s REIT has 69% QSR tenants and 31% other commercial retail. The charts below illustrate the split between QSR and other commercial retail tenants. Throughout Scott s REIT s ongoing acquisitions and diversification process, it has concentrated on maintaining a high quality national tenant base. Currently the REIT generates over 92% of its revenue from high quality tenants representing national retail brands. TENANT MIX BY GLA At IPO TENANT BASE BY GLA QSR VERSUS OTHER COMMERCIAL RETAIL At IPO KFC- Taco Bell 9% Other 2% Other 1% KFC- Pizza Hut 6% KFC Standalone 83% QSR 99% TENANT MIX BY GLA As at December 31, 2007 TENANT BASE BY GLA QSR VERSUS OTHER COMMERCIAL RETAIL As at December 31, 2007 Staples 4% Shopper s Drug Mart 5% Prime Restaurants 2% KFC Standalone 52% Other 31% Pharma Plus 9% Other QSR 2% Other 13% Laurentian Bank 1% KFC-Pizza Hut 4% KFC-Taco Bell 8% QSR 69% SCOTT S REIT AR 07 9

12 SELECTED FINANCIAL PERFORMANCE The following is a summary of selected financial information: Year ended December 31, (1) Revenue $ 14,750 $ 12,058 $ 2,681 Net Earnings before non-controlling interest (2) 635 1, Net Earnings per Unit Basic $ $ $ 0.06 Diluted $ $ $ 0.06 Total Assets 174, , ,310 Total Liabilities 114,084 78,234 66,739 Funds from Operations ( FFO) (3) 7,097 6,705 1,557 FFO Per Unit $ 0.93 $ 0.92 $ 0.21 Total Distributions to Unitholders 6,455 6,168 1,458 Total Distributions per Unit $ 0.85 $ 0.85 $ 0.21 Notes: (1) Based on the audited financial statements as at December 31, 2005 and for the 87 day period then ended. (2) Refer to this MD&A for a discussion and analysis relating to the two years ended December 31, 2007 and Refer to the MD&A for the two years ended December 31, 2006 and 2005 for discussion and analysis relating to those periods. (3) A non GAAP measure defined in our Declaration of Trust for which a reconciliation to net earnings can be found in our discussion under FFO FOURTH QUARTER HIGHLIGHTS Portfolio Growth In the fourth quarter, Scott s REIT acquired six properties in Ontario and Quebec, adding approximately 60,000 square feet of GLA area to its portfolio. These transactions are described below. Number of Properties Square Feet Portfolio properties as at December 31, ,447* First Quarter 2007 Acquisitions 4 53,275 Second Quarter 2007 Acquisitions 0 0 Third Quarter 2007 Acquisitions 3 79,818 Fourth Quarter 2007 Acquisitions 6 59,959 Total properties as at December 31, ,499 *GLA of 117 which was deemed unusable has been reclaimed to be available for rent. 10 SCOTT S REIT AR 07

13 On October 1, 2007, Scott s REIT completed the acquisition of two income-producing properties in Quebec. The properties are both single-tenant retail centres leased exclusively to Laurentian Bank. The first property is 6,478 sq. ft. and is located at a major intersection in Longueuil, Quebec while the second property is 2,989 sq. ft. and is located in a high-traffic retail district in Lachine, Quebec. At the time of purchase, the two properties hold a weighted average lease term of approximately eight years and the aggregate purchase price was $2,150. The acquisition was financed through the use of proceeds from the REIT s convertible debentures offering and were acquired at healthy cap rate of approximately 8%. On December 13, 2007, a subsidiary of Scott s Real Estate LP, Ontario Inc. acquired three companies whose primary assets included three properties located in Windsor and Renfew Ontario. The companies were purchased for a total price of $14,200 plus acquisition related costs of $347 for a total purchase price of $14,547. All of these properties are all leased to Rexall Pharma Plus and have an average lease term of just over 18 years. The cap rate to acquire these properties was 7.1%. The purchase was financed through an assumption of a mortgage for $2,500, the use of proceeds from the REIT s convertible debenture offering and the REIT s revolving credit facility. On December 17, 2007, Scott s REIT acquired a property located in Hanover Ontario for a purchase price of $1,380 plus $65 acquisition related costs totaling $1,445. Scott s REIT financed the acquisition through the REIT s revolving credit facility. The property was acquired at a cap rate of 8% and is leased to Rexall Pharma Plus with an average lease term of 8.4 years. RISKS AND UNCERTAINTIES The results of operations, business prospects and financial condition of the REIT are subject to a number of risks and uncertainties, and are affected by a number of factors outside of the control of management. In addition to the significant risk factors discussed in this MD&A, readers are advised to review risk factors discussed by the REIT in its Annual Information Form for the year ended December 31, 2007, available at for a complete discussion of the risks affecting the REIT s business. Reliance on Priszm LP Priszm LP currently is a tenant at all but fifteen of the REIT s 205 properties and operates KFC restaurants (standalone or multi-branded) at these properties. As a result, the cash flow of Scott s REIT may be negatively affected if Priszm LP s business or financial condition is materially adversely affected. The business of Priszm LP is subject to a number of risks and uncertainties outside of the control of the REIT. For a description of recent events concerning Priszm LP, please refer to the Priszm LP s management s discussion and analysis for the twelve months ended December 30, For information concerning Priszm LP s restructuring, investors are directed to Priszm Income Fund s publicly filed materials which are available at Real Property Ownership Real property equity investments are relatively illiquid. This illiquidity will tend to limit the ability of Scott s REIT to respond to changing economic or investment conditions. By specializing in a particular type of real estate, being quick service restaurants (QSR) and retail properties, Scott s REIT is exposed to adverse effects on that segment of the real estate market, and does not benefit from a diversification of its portfolio by property type. All real property investments are subject to elements of risk. Such investments are affected by general economic conditions, local real estate markets, changing demographics, supply and demand for leased premises, and competition from other available premises and various other factors. SCOTT S REIT AR 07 11

14 ANALYSIS OF OPERATING RESULTS Fourth Quarter and Year-To-Date Financial Results with Comparison to the Previous Fourth Quarter and Year-To-Date Financial Results Three month period ended Twelve month period ended Variance Variance to prior to prior December 31, quarter period Revenue $ 4,075 $ 3,197 $ 878 $ 14,750 $ 12,058 $ 2,692 Operating expenses (204) 1, (714) Net operating income 3,539 2, ,232 11,254 1,978 Amortization 1,728 1,357 (371) 6,263 5,018 (1,245) Interest expense 1, (494) 4,881 3,571 (1,310) General and administrative (88) 1, (275) Guarantee fee (57) 3,567 2,756 (811) 12,597 9,710 (2,887) Net earnings before income taxes and non-controlling interest (28) 109 (137) 635 1,544 (909) Income tax expense (recovery) (1,608) 0 1, Net (loss) earnings before non-controlling interest 1, , ,544 (909) Basic earnings (loss) per Unit $ $ $ $ $ $ (0.129) Diluted earnings (loss) per Unit $ $ $ $ $ $ (0.089) Units outstanding, end of period (1) 7,665,436 7,254, ,527 7,665,436 7,254, ,527 Notes: (1) Assumes the exchange of all Class B LP Units of Priszm LP for Units of the REIT. The operating results of Scott s REIT for the quarter ended and the year ended December 31, 2007 have changed from the previous year s results due primarily to the thirteen acquisitions which took place over the course of the last twelve months and two acquisitions which took place mid way through the third quarter in Revenues and Net Operating Income ( NOI ) Revenues from income producing properties include all amounts earned from tenants related to lease agreements, including basic rent, operating cost and realty tax recovery as well as adjustments for the straight-lining of rents. Property operating expenses include realty taxes as well as other costs related to interior and exterior maintenance, HVAC, insurance, utilities and managements fee. 12 SCOTT S REIT AR 07

15 As indicated below, acquisitions have contributed substantially to Revenues and NOI in both 2007 and Same Asset (1) Acquisitions Same Asset (1) Acquisitions Revenue 11,432 3,318 11, Operating expenses NOI 10,906 2,326 10, Share of NOI 82% 18% 96% 4% Notes (1) Same Asset includes income producing properties owned on the first day of the reporting period. In accordance with GAAP, Scott s REIT accounts for rent stepups by straight-lining the incremental increases over the noncancelable lease term. In the fourth quarter, straight-line rent of $193 (year-to-date $721) increased compared to last year s fourth quarter of $172 (year-to-date $637) due to the acquisitions. On the acquisition of properties, Scott s REIT records intangible assets and liabilities resulting from above-below market rent leases. These intangible assets and liabilities are amortized over the term of the related leases. In 2007 and 2006, Scott s REIT acquired a number of properties which have leases in place at rental rates below market. As a result, in 2007, the market rent adjustments were $36 and $6 respectively. During the fourth quarter, the market rent adjustment was $11 versus last year at $4. Revenues of $4,075 for the fourth quarter were favourable by $878 (year-to-date $14,750 and favourable by $2,692) compared to the same quarter last year. This was due to the thirteen properties acquired over the last twelve months. Operating Costs Operating expenses of $536 for the fourth quarter were higher than last year by $204 (year-to-date $1,518 and higher by $714). This was due to the nature of the leases in the acquisitions of fifteen properties over the last two years as previously discussed. Eight of the acquired properties are triple net leases and thus the REIT incurs and recovers common area maintenance costs from the tenants. The remaining seven are quadruple net leases for which the tenant pays all common area maintenance costs and capital maintenance expenditures directly. Amortization At the time of acquisition, Scott s REIT allocated a portion of the purchase price of the properties to income producing properties and a portion to intangible assets. Incomeproducing properties are amortized on a straight-line basis over their estimated useful lives. Intangible assets, such as the value of in-place operating leases and customer relationships are amortized on a straight-line basis over the term of the underlying lease agreements and the expected customer relationship respectively. For the quarter ended December 31, 2007, amortization of $1,728 was higher by $371 to the same quarter last year (year-to-date $6,263 and higher by $1,245) due to the thirteen properties acquired. Interest Expense Net interest expense consists of interest paid on first mortgages on income producing properties, the vendor note that was repaid on June 11, 2007, the revolving credit facility, the amortization of deferred financing fees, net of interest earned on term deposits and interest accretion on convertible debentures. Interest expense of $1,491 in the fourth quarter was higher than the same quarter last year by $494 (year-to date $4,881 and higher by $1,310) as a result of new debt assumed and the convertible debentures raised to finance the thirteen acquisitions. General and Administrative Expenses General and administrative expenses of $348 in the fourth quarter were higher than the same quarter last year by $88 (year-to-date $1,254 and higher by $275). Approximately $47 (year-to-date $48) can be attributed to higher quarterly and SCOTT S REIT AR 07 13

16 annual reporting fees as a result of raising the convertible debenture and other public company costs. In addition the asset management fee and incentive fees increased by $49 (year-todate $95). Both of these increases can be attributed to the acquisitions which have taken place over the last twelve months. Distributable Income Distributable Income is not a measure recognized under GAAP and does not have a standardized meaning prescribed by GAAP. Distributable Income is presented in this MD&A because management of Scott s REIT believes this non-gaap measure is a relevant measure of the ability of Scott s REIT to earn and distribute cash returns to Unitholders. Distributable Income as computed by Scott s REIT may differ from similar computations as reported by other similar organizations and, accordingly, may not be comparable to distributable income as reported by such organizations. Distributable Income in this MD&A represents income before non-controlling interest of Scott s REIT on a consolidated basis as determined in accordance with GAAP, plus amortization expense, the guarantee fee, less the straight-line revenue accrual, future income taxes and interest accretion. The following table outlines the reconciliation of distributable income to cash provided by operating activities: Three months ended Twelve months ended December 31, (1) Cash provided by operating activities $ 1,673 $ 1,615 $ 7,136 $ 6,130 $ 2,094 Net change in non-cash working capital (107) 645 Distributable income 1,609 1,477 6,609 6,237 1,449 Distributions declared 1,628 1,541 6,455 6,168 1,458 Distributable income per Unit Distributions per Unit Distributable Income Payout Ratio 101.2% 104.1% 97.7% 98.8% 100.7% Note (1) Based on the audited financial statements as at December 31, 2005 and for the 87 day period then ended. 14 SCOTT S REIT AR 07

17 Funds from Operations (FFO) and Adjusted Fund from Operations (AFFO) Net Income Reconciliation: Three months ended Twelve months ended December 31, (1) Earnings before non-controlling interest $ 1,580 $ 109 $ 635 $ 1,544 $ 437 Add (deduct): Amortization of income producing properties and intangible assets 1,728 1,357 6,263 5,018 1,120 Income taxes (1,608) Guarantee fee FFO $ 1,700 $ 1,608 $ 7,097 $ 6,704 $ 1,557 Add (deduct): Straight-line revenue accrual (193) (172) (721) (637) (148) Amortization of deferred financing fees Interest accretion Amortization of Below Market Rents (11) (4) (36) (6) 0 AFFO $ 1,609 $ 1,478 $ 6,609 $ 6,237 $ 1,449 Note (1) Based on the audited financial statements as at December 31, 2005 and for the 87 day period then ended. Funds from operations increased by 6% over last year s fourth quarter, as a result of the six acquisitions which took place at various times during the fourth quarter of ANALYSIS OF FINANCIAL POSITIONS Total Assets and Liabilities As at December 31, Total assets $ 174,721 $ 140,522 $ 133,310 Total liabilities 114,084 78,234 66,739 Assets Income Producing Properties and Related Intangibles Assets: The REIT s income producing properties and related intangible assets increased significantly, reflecting the acquisition of six income producing properties during the fourth quarter as follows: Property Location Acquisition Date Laurentian Bank 4 St. Charles Street, Longueuil, QC October 1, 2007 Laurentian Bank 1675 Notre-Dame Street, Lachine, QC October 1, 2007 Rexall 1727 Huron Church Rd, Windsor, ON December 13, 2007 Rexall 1215 Ouellette Avenue, Windsor, ON December 13, 2007 Rexall 339 Raglan Street South, Renfrew, ON December 13, 2007 Hanover th Street, Hanover, ON December 17, 2007 SCOTT S REIT AR 07 15

18 The results of operations for the acquired properties are included in the REIT s accounts from the dates of acquisition. Scott s REIT funded these acquisitions from proceeds of an assumed mortgage, the proceeds from a convertible debenture offering completed in September 2007 and through the use of the demand loan acquisition facility. The acquisitions have been accounted for under the as if vacant method, with a portion of the purchase price allocated to income-producing properties and a portion allocated to intangible assets and liabilities. Cash and Cash Equivalents: At December 31, 2007, Scott s REIT had $705 of cash and cash equivalents on hand (compared to $1,280 as at December 31, 2006). Cash equivalents are guaranteed by the financial institutions. The cash balance is anticipated to be used for general corporate purposes including monthly distributions paid to unitholders. Liabilities Long-term debt is comprised of mortgages and other loans related to properties as well as the carrying value of convertible debentures issued by the REIT. In accordance with GAAP, Scott s REIT s convertible debentures on issue are separated into a liability and an equity component; with the liability component, or carrying value included in long-term debt of the REIT. Under the terms of Scott s REIT s Declaration of Trust, the total indebtedness of the REIT (including indebtedness related to the convertible debentures) is limited to 65% of gross book value ( GBV ). GBV is calculated as the consolidated net book value of the consolidated assets of the REIT, adding back the amount of accumulated amortization of the income-producing properties and other assets (including intangibles). The consolidated debt to gross book value ratio of the REIT was 60.0% as at December 31, Management expects to finance future growth through the use of a combination of conventional mortgage debt secured by income-producing properties and the issuance of additional units. Mortgages The REIT s contractual debt obligations at December 31, 2007 were limited to: (i) a first mortgage for $65,000 maturing in October 2010; (ii) a first mortgage for $7,950 maturing in August 2016; (iii) a first mortgage for $6,983 maturing in August 2016; (iv) a first mortgage for $6,060 maturing in July 2017; and (v) a first mortgage for $2,500 maturing in December MORTGAGES PAYABLE (in thousands of dollars) YEAR The weighted average interest rate on all debt obligations was 5.1% as at December 31, During the quarter Scott s REIT assumed a mortgage for $2,500 due in December 2022 to finance the Raglan Street property in Renfrew, Ontario. Convertible Debentures On September 27, 2007, Scott s REIT completed the offering of $20,000 convertible unsecured subordinated debentures (the Convertible Debentures ), bearing interest at an annual rate of 7.15% payable semi-annually in arrears on June 30 and December 31, with a conversion price of $10.50 per unit and due June 30, On redemption or on the maturity date the debentures may, at the option of the Fund, be repaid in cash or in units of the Fund SCOTT S REIT AR 07

19 Carrying Value Face Value Convertible Face as at as at Debenture Issued Maturity Rate December 31, 2007 December 31, 2007 $20,000 Convertible September 27, 2007 December 31, % $18,602 $20,000 Demand Loan On June 11, 2007, Scott s REIT secured a revolving credit facility. The facility bears interest at prime plus 0.75% and is due on demand. The line may be used up to a maximum of $10,000, however, once $4,000 has been drawn, Scott s REIT must repay the borrowings to $nil within six months. At December 31, 2007, $5,800 has been drawn on the facility which was used to fund certain recent acquisitions. Management expects to pay down this line within the repayment period date by placing first mortgages on the respective properties. Non Controlling Interest In accordance with GAAP, the amount of equity related to the issue of 2,254,909 Class B units of has been recorded as a non-controlling interest of the REIT. The Class B units are exchangeable on a one-for-one basis with units of the REIT, and holders of the Class B units are entitled to receive distributions at a per unit amount equal to the per unit amount payable to holders of the REIT s trust units. Unitholders Equity Class A units of Scott s REIT increased by $3,870 between December 31, 2006 and December 31, 2007, primarily as result of the completion of equity and convertible debenture offerings in the year. Scott s REIT issued 410,527 units at a price of $9.50 per unit for gross proceeds to the REIT of $3,900 less issuance related costs of $30. At the time Scott s REIT issued the Convertible Debentures, it allocated a portion of the proceeds to the liability and equity components of such financial instrument. Unitholders equity was increased $299 as a result of that issue. LIQUIDITY AND CAPITAL RESOURCES Rental revenue generated from its portfolio of incomeproducing properties is the primary source of liquidity to fund the REIT s operating, interest, and general and administrative expenses, as well as cash distributions to Unitholders. Rental revenue is affected by factors such as lease maturities, portfolio occupancy and GLA growth through property acquisitions. See Portfolio Summary for information concerning weighted average remaining lease term, historical weighted average portfolio occupancy and GLA growth. In the fourth quarter Scott s REIT generated $1,673 (year-todate $7,136) of cash flows from operating activities compared to $1,615 generated in the fourth quarter of 2006 (year-to-date $6,130). As the acquisitions made during the fourth quarter were not owned for the full three month period, management anticipates that the cash flows from operations will increase in future periods as a result of these acquisitions. Interest coverage for the REIT for the year (defined as income before non-controlling interest plus interest expense, amortization, divided by interest expense, all on a consolidated basis) was 2.3 times, which is in compliance with all the loans outstanding as at December 31, INVESTING ACTIVITIES On October 1, 2007, Scott s REIT acquired two properties located Longueuil and Lachine, Quebec for a purchase price of $2,150 plus $134 acquisition related costs totaling $2,284. The acquisition was financed through the use of proceeds from the convertible debentures. On December 13, 2007, Scott s Real Estate LP formed a number company, Ontario Inc. for the purposes of acquiring 1726 Huron Church Inc., 1215 Ouellette Avenue Inc., 339 Raglan Developments Inc. whose primary assets included three properties located in Windsor and Renfew Ontario. The companies were purchased for a total price of $14,200 plus acquisition related costs of $347 for a total purchase price of $14,547. Subsequent to the transaction, Ontario Inc and the three companies amalgamated to form Scott s Acquisition Inc. The acquisition was financed through an assumption of a mortgage for $2,500, the use of proceeds from the convertible debentures and the REIT s revolving credit facility. SCOTT S REIT AR 07 17

20 On December 17, 2007, Scott s REIT acquired a property located in Hanover Ontario for a purchase price of $1,380 plus $65 acquisition related costs totaling $1,445. Scott s REIT financed the acquisition through its revolving credit facility. During the year, Scott s REIT identified and commenced on a land intensification project on one property located in Brampton Ontario. The REIT has applied for a permit to build a single tenant pad on the existing property. During the quarter, the REIT incurred approximately $10 (year-to-date $98). The REIT anticipates that the property should be revenue producing in the next 12 months. The REIT also spent $257 during the year replacing a roof and parking lot on a property located in Brampton ON. These improvements were required by the first mortgage and had to be completed within one year of the property acquisition. Restricted funds of $250 were released upon completion of the work. FINANCING ACTIVITIES For a discussion of the REIT s financing activities (mortgages, convertible debentures and demand loans), see Analysis of Financial Position Liabilities. SUMMARIZED QUARTERLY INFORMATION: Quarter ended Mar. 31 June 30 Sept. 30 Dec. 31 Mar. 31 June 30 Sept. 30 Dec. 31 Revenue $ 2,866 $ 2,882 $ 3,114 $ 3,196 $ 3,338 $ 3,514 $ 3,823 $ 4,075 Operating costs Net operating income 2,723 2,735 2,932 2,864 3,096 3,181 3,416 3,539 Amortization 1,183 1,183 1,296 1,356 1,420 1,504 1,611 1,728 Interest expense ,097 1,076 1,217 1,491 General and administrative Guarantee fee Expenses 2,222 2,240 2,493 2,755 3,028 2,892 3,110 3,567 Net earnings before income taxes and non-controlling interest (28) Income tax expense ,633 (1,025) (1,608) Net earnings (loss) before non-controlling interest (2,344) 1,331 1,580 Basic earnings per Unit $ 0.07 $ 0.07 $ 0.06 $ 0.02 $ 0.01 $ (0.31) $ 0.17 $ 0.21 Diluted earnings per Unit $ 0.07 $ 0.07 $ 0.06 $ 0.02 $ 0.01 $ (0.31) $ 0.17 $ 0.19 Units outstanding, end of quarter (1) 7,254,909 7,254,909 7,254,909 7,254,909 7,665,436 7,665,436 7,665,436 7,665,436 Notes: (1) Assumes the exchange of all Class B LP Units for Units of the Trust. 18 SCOTT S REIT AR 07

21 Variations over the quarters are due primarily to the thirteen acquisitions which took place over the course of the last twelve months and two acquisitions which took place mid way through the third quarter in CRITICAL ACCOUNTING ESTIMATES The significant accounting policies used in preparing Scott s REIT s audited consolidated financial statements for the year ending December 31, 2007 are described in Note 2 of those statements. In preparing the REIT s consolidated financial statements, management makes estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses as well as financial statements disclosures. The most significant estimates made by management include the allocation of purchase price to income producing properties and intangible assets, the useful life of depreciable assets, impairment of real estate assets and the fair value of financial instruments. Changes in these estimates and assumptions could cause actual results to differ from estimated amounts. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The Canadian Institute of Chartered Accountants has issued new recommendations for the recognition and measurement of financial instruments, and amendments to the existing presentation and disclosure standards. The new standards have applied to the REIT since January 1, Section 3855 Recognition and Measurement, establishes standards for recognizing financial assets and liabilities as well as nonfinancial derivatives. Section 1530 Comprehensive Income, establishes standards for reporting and displaying certain gains and losses, such as unrealized gains and losses related to hedges or other derivative instruments, outside of net income, in a statement of comprehensive income. Sections 3861 discuss related presentation and disclosure principles. Please refer to Note 2 to the consolidated financial statements for further detail. Income Taxes The REIT is taxed as a mutual fund trust for Canadian income tax purposes. The REIT is required by its Declaration of Trust to distribute all of its taxable income to its Unitholders, which currently enables the REIT to deduct such distributions for income tax purposes. Accordingly, prior to June 12, 2007, no provision for income taxes was recorded in the consolidated financial statements. On June 12, 2007, amendments to the Income Tax Act (Canada) were substantively enacted which modify the tax treatment of certain publicly-traded trusts and partnerships that are specified investment flow-through trusts or partnerships ( SIFTs ). Certain real estate investment trusts that satisfy certain specified conditions (the REIT Exception ) are excluded from the SIFT definition and therefore will not be subject to the SIFT rules. Since the SIFT rules have only recently been enacted it was not clear under the new legislation whether the technical REIT exception was available to Scott s REIT. Accordingly, future income tax liabilities in the amount of $2,633 were recorded as at June 30, 2007 and $1,608 as at September 30, 2007, based on the temporary differences that existed at these dates that were expected to reverse on, or after, January 1, On December 20, 2007, the Department of Finance provided a clarification of the application of the REIT exception to income from real or immovable property earned through an intermediary trust. Management believes that Scott s REIT has met the REIT exception. Consequently, the future income tax liability and expense recorded during the year has been reversed as at December 31, INTERNAL CONTROL OVER FINANCIAL REPORTING As at the financial year-ended December 31, 2007, the Chief Executive Officer and Chief Financial Officer evaluated the design of the REIT s internal control over financial reporting. Based on that evaluation, the Chief Executive Officer and the Chief Financial Officer concluded that the design of internal control financial reporting was effective as at December 31, 2007 to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with GAAP. There have been no significant changes in the REIT s internal control over financial reporting that occurred during the most SCOTT S REIT AR 07 19

22 recent interim period ended December 31, 2007 that have materially affected, or are reasonably likely to have material affect, the REIT s internal control over financial reporting. including accessing capital for expansion and development of those assets, which access might not otherwise be available to competitors and other property owners. RELATED PARTY TRANSACTIONS The related party transactions and details as required by generally accepted accounting principles are included in the consolidated financial statements of Scott s REIT for the year ended December 31, John I. Bitove, Chairman and CEO of Scott s REIT is a controlling shareholder and current Chairman of Obelysk, which holds directly and indirectly 34.8% interest in the REIT. Obelysk also holds a 39.8% interest in Priszm LP, the REIT s largest tenant. JBM Properties Inc. (JBM) is the asset and property manager for Scott s REIT. JBM is a company controlled by the principal shareholder of Obelysk. After a review of comparative REIT s, with independent Board review and independent legal advice, each of the property and asset management agreements between Scott s REIT and JBM were amended to reflect more indicative market rates. (Such agreements are publicly available at Effective September 1, 2007, such amendments include certain changes to increase the property management fee from 2.5% to 3%, the introduction of an acquisition fee ranging from 0.5% to 1% of the purchase price, and new leasing fees from $0.75 to $2.50 per square foot, each of the changes being consistent with the comparative data. TAX DEFERRAL Management of Scott s REIT estimates that a portion of the monthly cash distribution made to Unitholders in 2007 will be characterized as non-taxable amounts by reason of Scott s LP s ability to claim capital cost allowance and certain other deductions. In 2007, approximately 30.7% of the REIT s cash distributions were taxable to Unitholders as ordinary income for Canadian tax purposes and the remaining approximately 69.3 % of the cash distributions were a non-taxable return of capital. OUTSTANDING SHARE DATA AND OTHER INFORMATION The REIT is authorized to issue an unlimited number of Units. As of the date hereof, there were an aggregate of 5,410,527 Units issued and outstanding. An additional 2,254,909 Units are issuable upon exchange of the outstanding Class B LP Units of Scott s LP and up to 1,904,761 Units are issuable upon the conversion of $20,000 principal amount of convertible debentures at a conversion price of $10.50 per Unit. Additional information relating to Scott s REIT, including the Annual Information Form of Scott s REIT, is available on SEDAR at March 10, 2008 OUTLOOK The REIT s objectives for 2008 are to enhance its real estate portfolio as measured by the stability, reliability and growth of the resulting cash flows, and to achieve growth in distributable income through the acquisition and/or development of existing properties or vacant land that can be leased out, the acquisition of existing land and/or properties from established retail business, and by developing relationships with other retail businesses. The REIT s investment criteria focus primarily on return on equity, security of cash flow, potential for capital appreciation and the potential to increase value by more efficient management of the assets being acquired, 20 SCOTT S REIT AR 07

23 Management s Statement of Responsibility The accompanying consolidated financial statements are the responsibility of management and have been reviewed and approved by the Board of Directors and the Trustees. The consolidated financial statements have been prepared by management in accordance with Canadian generally accepted accounting principles and, where appropriate, reflect management s best estimates and judgments. Management has also prepared financial and all other information in the Annual Report and has ensured that this information is consistent with the consolidated financial statements. The Fund maintains appropriate systems of internal control, policies and procedures, which provide management with reasonable assurance that assets are safeguarded and the financial records are reliable and form a proper basis for preparation of financial statements. The Board of Directors and the Trustees ensure that management fulfills its responsibilities for financial reporting and internal control through an Audit Committee. This committee reviews the consolidated financial statements and reports to the Trustees. The auditors have full and direct access to the Audit Committee. The consolidated financial statements have been independently audited by PricewaterhouseCoopers LLP in accordance with Canadian generally accepted auditing standards. Their report below expresses their opinion on the consolidated financial statements of the Fund. JOHN BITOVE Chairman and Chief Executive Officer EVELYN SUTHERLAND Chief Financial Officer SCOTT S REIT AR 07 21

24 Auditors Report To the Unitholders of Scott s Real Estate Investment Trust We have audited the consolidated balance sheets of Scott s Real Estate Investment Trust (Scott s REIT) as at December 31, 2007 and 2006 and the consolidated statements of earnings and cumulative earnings, comprehensive income and cash flows for the years then ended. These financial statements are the responsibility of Scott s REIT s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with Canadian generally accepted auditing standards. Those standards require that we plan and perform an audit to obtain reasonable assurance whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. In our opinion, these consolidated financial statements present fairly, in all material respects, the financial position of Scott s REIT as at December 31, 2007 and 2006 and the results of its operations and its cash flows for the years then ended in accordance with Canadian generally accepted accounting principles. CHARTERED ACCOUNTANTS, LICENSED PUBLIC ACCOUNTANTS March 10, SCOTT S REIT AR 07

25 Consolidated Balance Sheets As at December 31, (in thousands of dollars) ASSETS Income-producing properties (notes 3 and 4) $ 165,071 $ 133,573 Intangible assets (notes 4 and 5) 6,937 3,358 Cash and short-term investments 705 1,280 Prepaid expenses and other assets (note 7) Straight-line revenue accrual 1, Deferred financing charges (notes 2 and 6) Guarantee fee (note 14) , ,522 LIABILITIES AND UNITHOLDERS EQUITY Mortgages payable (note 6) 87,837 73,000 Convertible debentures (note 8) 18,602 - Note payable (note 3) - 3,900 Demand loan (note 9) 5,800 - Accounts payable and accrued liabilities 1, Due to related companies (note 14) Distributions payable to Unitholders (note 10) ,084 78,234 Class B Exchangeable Units (note 11) 19,067 20,795 UNITHOLDERS EQUITY Contributed surplus (note 14) Class A Units of Scott s REIT (note 11) 48,913 45,043 Convertible debentures (note 8) Cumulative earnings 1,813 1,365 Cumulative distributions declared on Class A Units (note 10) (9,796) (5,256) 41,570 41, , ,522 Approved by the Board of Directors JOHN G. JAKOLEV LEWIS S. ALLEN DONALD M. BIBACK Director and Trustee Director and Trustee Director and Trustee SCOTT S REIT AR 07 23

26 Consolidated Statements of Earnings and Cumulative Earnings For the years ended December 31, (in thousands of dollars, except Unit amounts) REVENUE Rental revenue received $ 13,993 $ 11,415 Amortization of below market rentals 36 6 Straight-line revenue accrual ,750 12,058 EXPENSES Depreciation and amortization 6,263 5,018 Operating expenses (note 14) 1, Interest expense (note 6) 4,881 3,571 General and administrative (note 14) 1, Guarantee fee (note 14) ,115 10,514 Earnings before income taxes and non-controlling interest (note 11) 635 1,544 Income taxes (note 13) - - Earnings before non-controlling interest 635 1,544 Non-controlling interest of Class B Exchangeable Units (note 11) Net earnings for the year 448 1,064 Cumulative earnings - Beginning of year 1, Cumulative earnings - End of year 1,813 1,365 Basic and diluted earnings per Unit (note 12) Class A Units outstanding 5,410,527 5,000,000 Class B Exchangeable Units outstanding 2,254,909 2,254,909 Consolidated Statements of Comprehensive Income For the years ended December 31, (in thousands of dollars) Net earnings for the year $ 448 $ 1,064 Other comprehensive income - - Comprehensive income 448 1, SCOTT S REIT AR 07