Open Annual Report InStorage Real Estate Investment Trust

Transcription

1 Open 2006 Annual Report InStorage Real Estate Investment Trust

2 ifc2 InStorage 2006 Annual Report

3 BUILDING the most recognized self-storage brand name in Canada InStorage is the first Canadian REIT focused exclusively on the ownership and management of self-storage facilities. InStorage indirectly owns 46 storage facilities across Canada. InStorage s mission is to deliver service excellence to its customers while developing the most recognized self-storage brand in the industry. InStorage is also committed to delivering stable returns to its unitholders. InStorage is focused on generating stable cash distributions on a tax efficient basis for its unitholders over the long term. Edmonton Vancouver Calgary Saskatoon Regina Winnipeg Ottawa Laval Quebec City Montreal Halifax St. John s Toronto InStorage REIT 2006 Annual Report 1

4 Our focus is on the convenience and visibility of our self-storage buildings, excellent customer service, and building the most recognized self-storage brand name in Canada. MESSAGE FROM THE CHIEF EXECUTIVE OFFICER Welcome to InStorage REIT s first Annual Report. It is a pleasure to be able to discuss the REIT s performance in 2006 our first year of existence and a year characterized by rapid growth and exciting results. InStorage REIT began life as SCOSS Capital Corp., a Capital Pool Company (CPC) listed on the TSX-Venture Exchange. With just $2 million in equity in March of 2006, we had grown to over $109 million in equity by year end. We moved through the CPC process and graduated to full listed issuer status in record time, and reorganized SCOSS Capital Inc. into InStorage REIT on August 4th. All in all, it was a remarkable story of lightning-speed growth - from early identification of the opportunity to conception, formation, listing, reorganization, capitalization and growth in assets. Our objective was to grow the REIT as quickly as possible in order to take first mover advantage in the consolidation of the self-storage market in Canada. As a business characterized by steady cash flows and long-term steady growth in revenues, coupled with highly fragmented 2 InStorage REIT 2006 Annual Report

5 private ownership and relatively attractive trading multiples, we viewed the Canadian self-storage market as ripe for consolidation. Our ability to provide diversified, reliable and growing cash flows to our investors has captured the imagination of Canada s leading money managers and entrepreneurs, who have supported InStorage in its drive to become the largest owner/operator of self-storage in the country. From humble beginnings owning only two properties in Scarborough, Ontario, through a series of acquisitions InStorage grew to own and operate 20 locations by year end 2006, while providing its development company partner InScotia Developments LP with mezzanine financing for the development of four additional locations which are planned to be sold to the REIT. By May of 2007, the number of locations owned by InStorage had swollen to 46, while InScotia Developments had 12 development properties underway. Assets grew from $2 million to over $187 million during the year, enabling the REIT to initiate distributions to Unitholders. Commencing in October, a monthly distribution of $ per unit was paid to our unitholders. The operation of the business also grew dramatically, as we grew from just three initial employees to over 75 by year end, and over 180 today. Energized by our success, all of our employees are proud to be part of the InStorage Family growth story. InStorage is fortunate to be led by a strong and involved Board of Trustees, whose members have all been with the REIT since inception, and who work closely with management in providing influential oversight and vision. InStorage REIT 2006 Annual Report 3

6 MESSAGE FROM THE CHIEF EXECUTIVE OFFICER We believe that Canada s self-storage market fundamentals are strong. There is room for growth in rental rates, occupancies, and total inventory supply in Canada, as the country currently only uses approximately 2.2 square feet of self storage space per capita, versus 6.4 square feet per capita in the U.S.A. The Canadian market is less mature and product acceptance is not as deep yet, but as the Canadian market matures we believe there is considerable room for growth. To capitalize on that opportunity, InScotia Developments has already become the largest developer of self-storage facilities in Canada, and will continue to grow as it builds a network of development partners and opportunities across the country. The mezzanine lending relationship between InStorage and InScotia will be a significant cash flow growth engine for the REIT, as developed properties will be sold to the REIT once stabilized. Our relationship with InScotia also mitigates unitholder risk associated with the development and lease-up phase of properties. This development pipeline, coupled with our aggressive acquisition program, should lead to continued asset and cash flow growth in the years ahead. Our acquisition pipeline was very strong during 2006 and remains so today. With the purchase of Access Self Storage and Self Storage Plus in early September, we captured two of the top 10 portfolios of self-storage properties in Canada. We completed a number of smaller portfolio and individual asset purchases, and by year end had grown to approximately 1.0 million square feet in size. By year end, we had put the Calgary based Stor edge portfolio under contract, and were negotiating to purchase the 11 property, $110 million StorageNow portfolio as well as the 10 property, $112 million Apple Self Storage portfolio. All three of these portfolio acquisitions have subsequently been completed, bringing 25 more properties valued at over $249 million into the REIT, and growing our total portfolio to over 2.6 million square feet. We remain confident that further portfolios, large and small, as well as individual asset purchases will remain available to us for purchase at accretive capitalization rates. These purchases, together with our mezzanine lending program and internal organic growth of revenues will fuel earnings growth in 2007 and beyond. InStorage was an active participant in the equity capital markets in 2006, and we were well received by institutional and retail investors across Canada and in the U.S.A. Our CPC IPO of $750,000 was completed in March, followed by a $4,500,000 private placement in May and a further $75 million private placement at $1.00 per unit in August. We achieved our first bought deal financing in December - a $30 million private placement at $1.30 per unit. This was a real milestone for InStorage as it indicated a high degree of confidence in our firm by our investment bankers. We have subsequently closed a $105,000,000 equity offering at $1.45 per unit in our first syndicated bought deal financing, completed in early April of InStorage REIT 2006 Annual Report

7 Our balance sheet was built and remains clean and strong, with a conservative Debt to Gross Book Value ratio of approximately 38% as of December 31st, no convertible debentures or other derivative securities outstanding, and significant acquisition liquidity available. Our strong balance sheet, outstanding growth, quality assets and dedicated people worked in concert to generate impressive total returns to our unitholders in 2006, and we are proud of our accomplishments. For 2007, we will continue with our acquisition and development lending programs with added focus on small portfolio and individual asset acquisitions, and will look to keep our overall Debt to GBV ratio conservative. We will farm our portfolio for opportunities to increase revenues and achieve operating synergies to reduce expenses as we integrate all of our acquisitions into one platform. Indeed, operations and reporting systems integration will be a key focus of our entire organization in We further look forward to rolling out the InStorage Self Storage brand across the portfolio, and this will commence in mid We believe that brand awareness will be an important driver of revenue growth, as the InStorage name becomes visible and recognized across Canada. Certainly all of the new developments that InScotia is bringing to market are being branded InStorage Self Storage from the outset, and we anticipate having the best collection of self-storage assets in the nation by year end In summary, I d like to thank our unitholders for their support, the Board for its leadership and guidance, senior management for its tireless efforts, and the entire InStorage team for making 2006 so very successful. We are well positioned to take advantage of the opportunities presented by this market. We have leapt to the forefront of the industry in Canada in one short year, and will do our best to continue to deliver positive results to our unitholders. Sincerely, T. James Tadeson, CFA Chief Executive Officer InStorage REIT 2006 Annual Report 5

8 MANAGEMENT S DISCUSSION AND ANALYSIS Quarter and Year-to-Date Period Ended December 31, 2006 The following management s discussion and analysis ("MD&A") provides a review of activities, results of operations and financial condition of InStorage Real Estate Investment Trust ("we", "InStorage" or the "REIT"; and where the context requires, including subsidiaries) for the three months ended December 31, 2006 and for the period from January 12, 2006 to December 31, This discussion should be read in conjunction with the accompanying audited consolidated financial statements, which are prepared in accordance with Canadian generally accepted accounting principles ("GAAP"). All dollar amounts are expressed in Canadian dollars unless otherwise indicated. The information in this document is provided as of April 27, 2007 based on information available to management of the REIT as of that date. Additional information relating to InStorage can be found on our website at and on SEDAR at FORWARD-LOOKING INFORMATION This MD&A contains forward-looking statements. Often, but not always, forward-looking statements can be identified by the use of words such as "plans", "proposes", "expects" or "does not expect", "is expected", "estimates", "intends", "anticipates" or "does not anticipate", or "believes", or variations of such words and phrases or statements that certain actions, events or results "may", "could", "would", "might" or "will" be taken, occur or be achieved. Forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of InStorage to be materially different from any future results, performance or achievements expressed or implied by the forward-looking statements. Examples of such statements include: the intention to complete the transactions mentioned in this MD&A, as disclosed or at all; the implementation and effectiveness of the REIT s acquisition and growth strategies; InStorage s plans to be Canada s largest provider and leading manager of self-storage properties; the REIT s development intentions with respect to self-storage properties; objectives with respect to operating and financial indicators, including but not limited to average rent levels and leverage ratio; access to debt and equity financing; and any indications as to expected future performance of the REIT. Such forward-looking statements are based on a number of assumptions which may prove to be incorrect, including, but not limited to: the ability and desire of the REIT and the vendors to complete the Apple Self Storage acquisition described in this MD&A; the ability of InStorage and its subsidiaries to obtain necessary debt or equity financing, satisfy conditions under applicable transaction agreements; the availability of acquisition opportunities; the level of activity in the underlying self-storage business of InStorage, the self-storage industry and the economy generally; consumer interest in the services and products of InStorage's subsidiaries; competition; and anticipated and unanticipated costs. While InStorage anticipates that subsequent events and developments may cause its views to change, the REIT specifically disclaims any obligation to update these forward-looking statements. These forward-looking statements should not be relied upon as representing InStorage s views as of any date subsequent to the date of this MD&A. Although InStorage has attempted to identify important factors that could cause actual actions, events or results to differ materially from those described in forward-looking statements, there may be other factors that cause actions, events or results not to be as anticipated, estimated or intended. There can be no assurance that forward-looking statements will prove to be accurate, as actual results and future events could differ materially from those anticipated in such statements. Accordingly, readers should not place undue reliance on forward-looking statements. The factors identified above are not intended to represent a complete list of the factors that could affect InStorage. Additional factors are noted under "Risks and Uncertainties" in this MD&A. NON-GAAP FINANCIAL MEASURES Net operating income ("NOI") and funds from operations ("FFO") are widely used as supplemental measures of a Canadian real estate investment trust s performance and are not defined under Canadian generally accepted accounting principles ("GAAP"). We use these measures to assess the operating performance of our income-producing properties. This MD&A contains a description of NOI and FFO and reconciliation of FFO to net income. NOI and FFO should not be considered alternatives to net income or cash flow from operating activities or other measures that have been calculated in accordance with GAAP. They do not have a standardized meaning prescribed by GAAP and may not be comparable to similar measures presented by other issuers. OVERVIEW InStorage is an open-ended real estate investment trust formed under the laws of the Province of Ontario pursuant to a Declaration of Trust dated June 20, The REIT commenced commercial operations on August 4, 2006, when it completed a plan of arrangement that effectively resulted in the conversion of its public company predecessor, SCOSS Capital Corp. ("SCOSS"), into the REIT. Pursuant to this conversion, InStorage became the owner and operator of the two self-storage facilities previously owned by SCOSS. The REIT is considered to be a continuation of SCOSS following the continuity of interest method of accounting. The consolidated financial statements for 2006 reflect the results of operations of SCOSS from January 12, 2006 to August 4, 2006 and the REIT from that date forward. The REIT had no activity between June 20, 2006 and August 4, InStorage REIT 2006 Annual Report

9 InStorage is focused on investing in the self-storage segment of the real estate industry and is the first and only self-storage real estate investment trust in Canada. As a result of a number of acquisitions completed after the plan of arrangement, by December 31, 2006 InStorage had grown its property portfolio to 20 self-storage properties totalling 1.0 million square feet of gross rentable area, with a gross book value of $130.6 million. Since year-end, InStorage has announced further acquisitions, the completion of which will grow the property portfolio to 46 self-storage facilities located in Alberta, Saskatchewan, Ontario and Quebec, totalling 2.6 million square feet of gross rentable area. Going forward, the REIT intends to continue to grow its underlying business through acquisitions and internal growth initiatives. INSTORAGE S BUSINESS, VISION AND STRATEGY InStorage s Business InStorage is focused on investments in the self-storage sector of the real estate industry in Canada. Self-storage facilities are designed to offer accessible storage space for personal and business use at a relatively low cost. These facilities generally consist of one or more buildings with an interior height of approximately 8 to 12 feet and house secure self-storage units of varying sizes and features. The features offered in or associated with self-storage units vary widely from one facility to another and can include climate control, video surveillance, keypad entry, sales of merchandise, mailbox rental service, electrical power, and telephone lines. Users of space in self-storage facilities include individuals and both large and small businesses. Individuals usually obtain this space for storage of furniture, household appliances, personal belongings, seasonal equipment, motor vehicles, boats, recreational vehicles, motorcycles and other household goods. Businesses normally employ this space for storage of inventory, business records, seasonal goods, equipment, fixtures and merchandising materials. Typical lease agreements for self-storage space have a one-month term with automatic renewals at each period end. Incentives are often provided for tenants to continue leasing space for longer periods. The short lease terms provide flexibility to the business to adjust rent in response to market conditions such as competition, inflation, and demand for self-storage space and occupancy rates. This flexibility in adjusting rental rates helps to optimize occupancy rates and to earn superior income returns. According to the 2007 Self- Storage Almanac, the average term of rental of self-storage space by tenants in the United States ranges from 12 months for individuals to 22 months for commercial tenants. Though no equivalent third party statistic exists for the Canadian self-storage market, we believe the average Canadian rental term is comparable. Private individuals represent approximately 75% of InStorage s customer base. Business customers looking for space to store inventory on a more cost effective basis than renting commercial warehousing space, space to securely store tools and job materials, and storage space during and following expansion or transition generally make up the balance, although this ratio may vary from one self-storage facility to another. The broad diversity of the REIT s customer base reduces business risk and generally provides a relatively predictable and consistent cash flow. InStorage s Vision and Strategy InStorage s mission is to deliver service excellence as Canada s leader in the self-storage industry. InStorage is also committed to delivering stable returns to its unitholders. InStorage is focused on generating stable cash distributions on a tax efficient basis for its unitholders over the long term. The REIT intends to achieve this through effective property management, realizing efficiencies from scale of operations, accretive acquisitions and optimization of financing costs. To achieve this vision, InStorage has developed the following key objectives and supporting strategies: 1. To generate stable cash distributions and superior returns for its unitholders in the long term. InStorage will meet this objective through the implementation of its acquisitions and asset management strategies. Acquisitions InStorage intends to continue to acquire self-storage properties that are immediately, or in the short term will become, accretive to cash distributions to unitholders. InStorage s relationship with InScotia Developments Limited Partnership ("InScotia") is also an important feature of the REIT s acquisition strategy. Under the terms of a development agreement with InScotia, InStorage has the right of first offer to provide mezzanine financing in respect of, and, where such financing is provided, a first right to acquire (in accordance with the terms of the development agreement), self-storage properties owned or acquired by InScotia. This relationship provides InStorage with preferred access to acquisition opportunities without directly exposing the REIT to the risks associated with the development or lease-up of new self-storage facilities owned by InScotia. See "Related Party Transactions" for details of InStorage s relationship with InScotia. InStorage REIT 2006 Annual Report 7

10 MANAGEMENT S DISCUSSION AND ANALYSIS INSTORAGE S BUSINESS, VISION AND STRATEGY (continued) Active Asset Management InStorage intends to deliver internal growth through increased occupancy, operational effectiveness and efficiency improvements, and the addition of revenue producing services to tenants. We believe that economies of scale can yield positive internal growth through enhanced efficiencies in administration, cost control and the sharing of key managers and professionals as well as coordinated marketing campaigns. Certain properties may also be renovated or expanded to include additional storage units if market conditions warrant. 2. To be the largest self-storage provider in Canada with a 10% to 20% share of the market. InStorage will aggressively pursue its strategy to expand through acquisitions and through development of new self-storage facilities in conjunction with its partnership with InScotia. We believe that the Canadian self-storage industry is characterized by highly fragmented ownership and a limited number of national consolidators. We further believe that this fragmentation favours consolidation within the industry and we intend to capitalize on this opportunity to grow InStorage s self-storage portfolio through acquisitions. InStorage has established itself as the leading consolidator in the market and, as a result, is regularly presented with acquisition opportunities by sellers of self-storage properties. We believe that through our strong relationships with lenders and with our access to capital markets, we can raise sufficient capital to meet InStorage s growth objectives over the long term. 3. To be the leading manager of self-storage properties in Canada. InStorage plans to establish its reputation for service excellence through adoption of property management programs which focus on providing tenants with quality, dependable and friendly service. InStorage s safe and secure locations will offer convenient, clean, and affordable storage space for its customers. InStorage intends to adopt common branding of its self-storage facilities to increase awareness of the InStorage name and assist in the development of InStorage s reputation as the leading provider of high quality self-storage space and ancillary services. We expect to roll out the branding strategy across various markets in which we operate in phases over the second half of INVESTMENT ACTIVITIES IN 2006 Over the first several months of operations, InStorage made a series of property acquisitions, and, by year end, had grown its portfolio to 20 properties, with a gross rentable area of 1.0 million square feet and gross book value of $130.6 million. These acquisitions have provided InStorage with a leading presence in the Greater Toronto Area ("GTA") in Ontario and significant scale in Alberta, two very important markets due to their size and economic growth. The following section provides further particulars about the acquisitions completed in InStorage s predecessor corporation, SCOSS, acquired two properties in Toronto, Ontario on May 29, 2006 for a purchase price of $8.1 million. This acquisition constituted SCOSS "qualifying transaction" under the rules of the TSX Venture Exchange. On August 25, 2006, InStorage purchased three self-storage properties located in Aylmer and St. Thomas, Ontario. The properties are known as the Box-N-Lock portfolio and were acquired for a purchase price of $4.6 million. The three facilities have a combined rentable storage space of 58,067 square feet. The acquisition was funded by first mortgage financing of $3.5 million, with the balance paid in cash. On September 1, 2006, InStorage purchased six self-storage properties located in the Greater Toronto Area and known as the Access Self Storage portfolio ("Access"). The properties were acquired for a total purchase price of $59.2 million. The six facilities house a total of 4,250 storage units and have combined rentable storage space of 419,425 square feet. The acquisition was funded by first mortgage financing in the amount of $5.3 million and bridge financing of $16.7 million, the assumption of debt in the amount of $8.6 million, the issuance of 7.0 million Class C exchangeable limited partnership units ("Class C LP Units") of InStorage Limited Partnership ("InStorage LP") for $7.0 million, with the balance paid in cash. On September 5, 2006, InStorage purchased four self-storage properties known as the Self Storage Plus ("Storage Plus") portfolio. The properties were acquired for a total purchase price of $34.0 million. Two of the properties are located in London, Ontario while the other two are in Toronto, Ontario. The four facilities house a total of 2,790 storage units and have combined rentable storage space of 272,384 square feet. The acquisition was funded by first mortgage financing in the amount of $8.4 million, a draw on the bridge facility in the amount of $8.6 million, the assumption of debt in the amount of $8.3 million and the issuance of 2.4 million Class C LP Units for $2.4 million, with the balance paid in cash. On September 21, 2006, InStorage purchased a self-storage property located in Belleville, Ontario for a total purchase price of approximately $2.2 million. The facility is operated under the name "Leslie Self Storage", houses 230 storage units and has total gross 8 InStorage REIT 2006 Annual Report

11 rentable area of approximately 50,000 square feet. The acquisition was funded entirely with cash. On October 13, 2006, InStorage purchased a self-storage facility located in Calgary, Alberta. The acquired facility is comprised of nine buildings that are partitioned into approximately 400 storage units and is operated under the name "Southside Self Storage". The gross rentable area of this facility is approximately 48,500 square feet. The purchase price for the property was $8.5 million, which was paid in cash. On October 17, 2006, InStorage acquired a 50% joint venture interest in a self-storage property in Woodbridge, Ontario at a purchase price of approximately $4.0 million. This facility operates under the name "MiniWarehousing", houses approximately 540 storage units and has a gross rentable area of approximately 56,000 square feet. The acquisition of the joint venture interest was funded through the assumption of a proportionate share of the mortgage debt of $3.7 million and with the balance paid in cash. On November 15, 2006 InStorage funded InStorage (42nd Ave.) Limited, a joint venture corporation owned as to 50% each by InScotia and Talus Capital Corp. (an unrelated real estate development company), with an initial mezzanine loan in the principal amount of approximately $2.5 million. InStorage (42nd Ave.) Limited used and will use the proceeds of this loan to acquire and develop an approximately 81,000 square foot self-storage facility in Calgary, Alberta. InStorage is committed to provide InStorage (42nd Ave.) Limited with additional mezzanine financing of $3.0 million. On November 15, 2006, InStorage acquired two self-storage properties located in Edmonton, Alberta and operated under the name "Sentinel Self Storage". The two facilities have, in aggregate, gross rentable area of approximately 98,000 square feet and approximately 720 storage units. The purchase price for these properties was $5.5 million, which was financed with a first mortgage of $4.0 million and the balance paid in cash. Below is a chart summarizing the properties owned by InStorage as at December 31, 2006: Gross Rentable Province and Address City Date Built (1) Area (Sq. Ft) Units Occupancy (%) (2) Alberta th Street SW Calgary , Street Edmonton , Street Edmonton , Ontario 85 Westney Road South Ajax , John Street Aylmer , Herchimer Avenue Belleville , Kipling Avenue Toronto , Adelaide Street North London , Commissioners Road London , Farewell Avenue Oshawa , Alliance Road Pickering , Edward Road St. Thomas , South Edgeware Road St. Thomas , Danforth Road Toronto , Evans Avenue Toronto , Kennedy Road Toronto , Middlefield Road Toronto , O Connor Drive Toronto , Sheppard Avenue East Toronto , Weston Road (3) Woodbridge , Totals 999,340 9, (4) Notes: (1) A range of years indicates that portions of the property were built, expanded or redeveloped at various times during the period. (2) Occupancy information is an estimate and is provided as at December 31, (3) Joint venture interest. Gross rentable area and number of storage units represent InStorage s 50% interest in the property. (4) Represents the weighted average occupancy rate of the self-storage facilities listed in the table. InStorage REIT 2006 Annual Report 9

12 MANAGEMENT S DISCUSSION AND ANALYSIS SUBSEQUENT AND PROPOSED TRANSACTIONS On February 15, 2007, together with InScotia, the REIT made investments in seven of the 10 Stor edge Self Storage portfolio properties located in Western Canada. InStorage purchased four of the Stor edge properties for an aggregate purchase price of approximately $27.3 million and InScotia acquired three of the Stor edge properties for an aggregate purchase price of $11.1 million. The REIT funded InScotia with mezzanine loan financing in the principal amount of $5.3 million for the acquisition. Collectively the Stor edge properties acquired by InStorage represent approximately 250,000 square feet of net rentable area and approximately 1,800 self-storage units. Investments with respect to the three remaining Stor edge properties are pending, with one expected to be acquired by InScotia by May 31, 2007, and the other two expected to be acquired by InScotia before December 1, 2007, when certain outstanding title-related approvals are obtained. The aggregate purchase price for the remaining three Stor edge properties will be approximately $5.5 million and InScotia expects that the development costs associated with these three properties will be an additional amount of approximately $11.1 million. InStorage LP has committed to provide InScotia with additional mezzanine loan financing in the aggregate principal amount of approximately $6.7 million at the closings for the acquisition of the remaining three Stor edge properties. The following table provides information about the Stor edge properties we acquired: Province and Address City Date Built Gross Rentable Area (Sq. Ft) Units Occupancy % (1) Alberta 4687 Barlow Trail SE Calgary , th Street SE Calgary , Range Road 34 Okotoks , Saskatchewan 2750 Sandra Schmirler Way Regina , Totals 223,038 1, (2) Notes: (1) Occupancy information is an estimate and is provided as at the date of the acquisition (2) Represents the weighted average occupancy rate of the self-storage facilities listed in the table. On April 5, 2007, InStorage acquired 11 self-storage properties located in Alberta, Saskatchewan and Ontario. The properties operate under the names "Storage Maxx" in Western Canada and "StorageNOW" and "StorageONE" in Ontario. Collectively, the properties have a gross rentable area of approximately 660,000 square feet and house approximately 6,300 storage units. The total purchase price for these properties was $110.0 million which was financed with fixed rate mortgage loans in the amount of $57.1 million and variable rate mortgage loans in the amount of $14.4 million, with the balance paid in cash, adjusted for working capital amounts. The purchase price includes an income guarantee of $2.9 million which will be held in escrow. The amount in escrow can be drawn by InStorage on a monthly basis over a period of 21 months from closing of the acquisition, to the extent of any shortfall between the actual net operating income and the expected net operating income of three of the acquired properties. The holdback will be accounted for as a purchase price reduction, and any payments to the vendor from the escrow amounts will be accounted as an increase in purchase price. This income guarantee arrangement provides the REIT with cash inflow during the lease-up of these properties. With the acquisition of StorageNOW, InStorage has acquired a stated consolidator in the industry and we believe we now own some of the best properties in the Greater Toronto Area. 10 InStorage REIT 2006 Annual Report

13 Particulars of the self-storage properties acquired under the StorageNOW portfolio are as follows: Gross Rentable Province and Address City Operating Name Date Built (1) Area (Sq. Ft) Units Occupancy (%) (2) Alberta Fort Road Edmonton Storage Maxx 1988/ , nd Street SE Calgary Storage Maxx , Saskatchewan th Street West Saskatoon Storage Maxx 1997/ , First Avenue North Saskatoon Storage Maxx 1955/ , Maxwell Crescent Regina Storage Maxx 1997/ , Ontario 110 Bell Farm Road Barrie Storage One 1986/ , Syscon Road Burlington (GTA) Storage Maxx , Alden Road (3) Markham (GTA) StorageNOW , Guided Court Etobicoke (GTA) Storage Maxx 1990/ , Norseman Street (3) Etobicoke (GTA) StorageNOW , Wicksteed Avenue Toronto (GTA) StorageNOW 2003/2005/ ,230 (3) Totals 660,652 6, (4) Notes: (1) Years separated by / indicates the initial year of construction, followed by the year in which additional portions of the property were built, expanded, or redeveloped. Ranges of years separated by a dash indicates that portions of the property were built, expanded or redeveloped at various times during the year. (2) Occupancy information is based on information provided by the vendors of the StorageNOW properties and represents estimated occupancy as at December 31, (3) This property is presently in lease-up. (4) Includes 15,000 square feet of storage space that is presently under development. (5) Represents the weighted average occupancy rate of the self-storage facilities listed in the table. On April 2, 2007, InStorage acquired a self-storage facility located in Milton, Ontario. This facility operates under the name "Milton Mini Storage" and houses approximately 210 storage units and has a gross rentable area of approximately 24,000 square feet. The purchase price for this facility was $2.9 million, which was paid in cash, adjusted for working capital amounts. On March 16, 2007, InStorage announced that it had agreed to purchase the Apple Self Storage ("Apple") portfolio of 10 selfstorage properties located in Ontario and Quebec for an aggregate purchase price of approximately $111.6 million (subject to customary adjustments). One of the 10 acquisition properties, 875 Don Mills Road, Toronto, closed on April 25, 2007, with the remaining 9 properties of the Apple acquisition scheduled to close on May 4, The REIT will finance this acquisition with first mortgages on these properties of approximately $56.8 million, with the balance paid in cash, adjusted for working capital amounts. In connection with the Apple acquisition, InScotia will also acquire land located at Walkley Road, Ottawa. InStorage has agreed to provide InScotia with mezzanine financing of $1.5 million to finance the acquisition and development of this property. The acquisition of the Apple portfolio will establish InStorage as the leading provider of self-storage facilities in the Greater Toronto Area and will give InStorage a presence in the two largest cities in the Province of Quebec. InStorage REIT 2006 Annual Report 11

14 MANAGEMENT S DISCUSSION AND ANALYSIS SUBSEQUENT AND PROPOSED TRANSACTIONS (continued) Below is a listing of the Apple portfolio self-storage properties to be acquired. Gross Rentable Province and Address City Operating Name Date Built (1) Area (Sq. Ft) Units Occupancy (%) (2) Ontario 140 Armstrong Avenue Georgetown (GTA) Apple Self Storage 1989/ , Arrow Road (2) Toronto (GTA) Apple Self Storage , Commerce Park Drive (3) Innisfil Apple Self Storage , Crouse Road Toronto (GTA) Apple Self Storage , Don Mills Road Toronto (GTA) Apple Self Storage , Trethewey Drive Toronto (GTA) Apple Self Storage ,035 1, Keele Street Maple (GTA) Apple Self Storage , Quebec 2249 Leon-Harmel Street Quebec City SecureMax , Pascal-Gagnon Blvd Montreal Forteresse , St. Martin Ouest Blvd Laval Forteresse , Totals 724,767 6, (4) Note: (1) Years separated by / indicates the initial year of construction followed by the year in which additional portions of the property were built, expanded or redeveloped. Ranges of years separated by a dash indicates that portions of the property were built, expanded or redeveloped at various times during the period. (2) Occupancy information is based on information provided by the vendors of the Apple Self Storage portfolio and represents estimated occupancy as at December 31, (3) Presently in lease-up. (4) Represents the weighted average occupancy rate of the self-storage facilities listed in the table. On April 3, 2007, InStorage closed a bought deal financing with a syndicate of underwriters for gross proceeds of $105.0 million. The short form prospectus offering was made in each of the provinces of Canada. The offering price for the units was $1.45 per unit. The proceeds of the offering were used to satisfy the cash portion of the purchase price for the StorageNOW portfolio and will be used to finance the upcoming Apple portfolio acquisition. Any remaining proceeds from the offering will be used to fund mezzanine loans for self-storage developments, to finance future acquisitions and for general corporate purposes. KEY PERFORMANCE INDICATORS InStorage measures the long term success of its strategies through a number of key financial and operating performance metrics as described below: Financial Indicators 1. Funds From Operations per Unit Management considers funds from operations ("FFO") to be a useful measure of operating performance as it focuses on cash flow from operating activities. InStorage calculates FFO in accordance with the definitions of the Real Property Association of Canada ("REALpac"). REALpac defines FFO as net income (computed in accordance with GAAP), excluding gains (or losses) from sales of depreciated real estate and extraordinary items, plus depreciation and amortization, plus future income taxes and after adjustments for equity-accounted-for entities and non-controlling interests. It is InStorage s objective to generate long term growth in FFO per unit. FFO is not intended to represent operating profits for a period or from the REIT s properties nor should it be viewed as an alternative to net income, cash flow from operating activities or other measures of financial performance calculated in accordance with GAAP. 2. Cash Distributions per Unit InStorage is focused on generating stable and growing distributions to its unitholders over the long term. Management intends to accomplish this goal by increasing net cash flow from InStorage s real estate assets over the long term. 12 InStorage REIT 2006 Annual Report

15 3. Debt Leverage Ratio A conservative leverage ratio mitigates unitholder risk. InStorage calculates its debt leverage as the sum of all debt payable divided by the book value of total assets plus accumulated amortization of income-producing properties. The maximum permitted debt leverage ratio under the REIT s declaration of trust is 75%. While expanding its portfolio, InStorage intends to maintain a leverage ratio of less than 65%. At December 31, 2006, the REIT s Debt Leverage Ratio was 38%. See "Liquidity and Capital Resources". 4. Debt Portfolio Management InStorage aims to reduce unitholder risk by minimizing its exposure to variable interest rate debt. InStorage plans to finance acquisitions primarily through fixed interest rate term mortgages, and as opportunities arise, through other fixed interest rate debt instruments. InStorage may finance certain acquisitions through short-term bridge financing, and for properties which are not leased up to stabilized occupancy levels, through short-term variable interest rate debt. When properties reach stabilized occupancy levels, InStorage will seek to replace such floating rate debt with fixed interest rate term debt. Operating Indicators 1. Occupancy InStorage aims to generate superior income returns and cash flows from its properties by maintaining consistently high occupancy over the long-term. Through its proactive property management and sales and marketing initiatives, management anticipates maintaining occupancy levels at or above stabilized levels. We believe that, in the self-storage industry, stabilized levels are achieved at occupancy levels of approximately 85%. At occupancy levels above that rate, opportunities may arise to increase rental rates and generate superior returns. 2. Average Rent Per Square Foot The average rental rate per square foot is another important indicator of the ability of the REIT to generate cash flows from its properties. InStorage aims to maintain average rent at levels which can generate attractive cash flow and superior returns for its unitholders. The ability to increase rental rates is largely dependent on the quality of InStorage s self-storage facilities and the services offered to tenants. InStorage owns a portfolio of high quality self-storage properties and through its asset management and branding program will strive to maintain occupancy levels and increase rental rates when appropriate. 3. Net Operating Income NOI is used by InStorage as a measure of the operating performance of its income producing properties. Growth in NOI will indicate the impact of InStorage s asset management strategies to increase the cash flows from the operations of the properties. NOI is defined by InStorage as rental property income less property operating expenses. InStorage will report on these indicators and will develop other relevant indicators in the future, as the business grows. RESULTS OF OPERATIONS InStorage had no commercial operations until the plan of arrangement with SCOSS was completed on August 4, However, the REIT is considered to be a continuation of SCOSS pursuant to the continuity of interest method of accounting. As a result, the financial statements of the REIT reflect the operations of InStorage as a continuation of SCOSS and include the results of operations of SCOSS for the period from January 12, 2006 to August 4, 2006 and the consolidated operations of the REIT from that date forward. InStorage REIT 2006 Annual Report 13

16 MANAGEMENT S DISCUSSION AND ANALYSIS RESULTS OF OPERATIONS (continued) Financial Highlights Three months ended Period from January 12 (dollars in thousands, except per unit amounts) December 31, 2006 to December 31, 2006 Rental property income $ 3,155 $ 4,369 Property operating expenses (1,047) (1,497) Net Operating Income ("NOI")* $ 2,108 $ 2,872 Interest income on mezzanine loans Interest expense, net (1,096) (1,518) General and administrative expenses (679) (1,234) Asset management fees (96) (143) Unit-based compensation (373) Amortization of income-producing properties (1,631) (2,205) Net loss $ (1,052) $ (2,074) Basic and diluted net loss per unit $ (0.01) $ (0.05) Funds From Operations ("FFO")* $ 579 $ 131 Basic and diluted FFO* per unit $ 0.01 $ Weighted average number of units (thousands) 107,004 46,031 * See "Non-GAAP Financial Measures" Total revenues for the fourth quarter of 2006 were $3.5 million, including rental property income of $3.2 million and interest income on mezzanine loans of $0.3 million. Rental property income is made up of rental income from the properties, sales of ancillary packaging materials and the sale of contents insurance to tenants. Sales of ancillary items are not material and account for less than 3% of total revenue. The weighted average rent per square foot at December 31, 2006 was approximately $17 per square foot with a weighted average occupancy of 82%. Both the average rental rate and occupancy are consistent with management s expectations. Total revenues for the period from January 12 to December 31, 2006 were $4.9 million including rental property income of $4.4 million and interest income on mezzanine loans of $0.5 million. See "Related Party Transactions" for details concerning the mezzanine lending program. Given that substantially all the properties were purchased in late August and early September 2006, there are no trends which can be observed at this time. Direct property operating expenses for the quarter were $1.0 million, or 33% of rental revenue. These expenses consist primarily of realty taxes, wages paid to staff operating the facilities, utilities, advertising, insurance, repairs and maintenance and other administrative and operating costs. On a year-to-date basis, property operating expenses were $1.5 million, or 34% of rental revenue. Property operating costs are in line with management estimates. NOI (see "Non-GAAP Financial Measures") for the three months ended December 31, 2006 was $2.1 million or 67% of rental property income. For the year-to-date period, NOI was $2.9 million, or 66% of rental property income. As this is the first reporting year for InStorage, there are no comparative same-store NOI amounts to report. InStorage incurred mortgage interest and bridge financing interest expense for the quarter of $1.1 million. This includes $0.3 million in amortization of deferred financing costs. These costs are directly attributable to debt financing for the acquisitions completed during the year. In addition to first mortgage financing, InStorage utilized a short-term bridge facility of $25.3 to complete the acquisition of certain properties. During the fourth quarter of 2006, the bridge loans were repaid and replaced with term mortgage financing. Amortization of deferred financing costs includes the write-off of $0.2 million in financing costs related to the bridge facility. Interest costs on a year-to-date basis were $1.5 million. InStorage recorded amortization expense of $1.6 million for the fourth quarter of 2006, and $2.2 million for the year-to-date period. This expense is comprised of the amortization of buildings and the value of in-place leases associated with the acquired properties. The value of in-place leases is amortized over a period of one year from the date of the acquisition, the average expected term of a tenant. For the year-to-date period, amortization of the value of in-place leases was $0.8 million. 14 InStorage REIT 2006 Annual Report

17 The REIT incurred general and administration expenses during the quarter of $0.7 million. The majority of these expenses relate to salaries, rent, professional fees and public company costs. The fourth quarter general and administrative expenses include audit fees for the year and legal fees associated with some of the REIT s corporate governance initiatives. On a year-to-date basis, general and administration expenses were $1.2 million. The year-to-date amounts include costs incurred before the commencement of significant operations of the REIT and are high in relation to revenues due to formation and reorganization expenses incurred during the period. During the fourth quarter, asset management fees of $0.1 million were paid to Carttera Management Inc. ("Carttera"), the external manager of InStorage. See "Related Party Transactions" for further details. On a year-to-date basis, the REIT paid Carttera $0.14 million in respect of asset management fees. SUMMARY OF QUARTERLY RESULTS The self-storage business is subject to seasonal fluctuations because individuals often look for storage space when change occurs in their personal lives such as change of residence or home renovations, which events tend to show significant seasonal patterns. Generally, proportionately higher revenues and profits are realized from April through to August while the lowest level of occupancy is typically in February and March (dollars in thousands, except per unit amounts) Q4 Q3 Q2 Q1 Revenues Rental property income $ 3,155 $1,128 $ 86 $ Mezzanine Interest income ,497 1, Property operating expenses (1,047) (420) (30) Interest expense (1,096) (394) (28) General and administrative expenses (679) (430) (108) (17) Asset management fee (96) (47) Stock based compensation (317) (56) Amortization (1,631) (541) (33) Net loss $ (1,052) $ (519) $ (430) $ (73) Basic and diluted loss per unit $ (0.01) $ (0.01) $ (0.03) $ Quarterly fluctuations shown above are a result of the REIT s (and its predecessor s) inception and acquisitive growth throughout the period from January 12, 2006 to December 31, Quarterly and annual fluctuations are expected to continue going forward, as InStorage continues to implement its growth strategies. InStorage REIT 2006 Annual Report 15

18 MANAGEMENT S DISCUSSION AND ANALYSIS FUNDS FROM OPERATIONS AND CASH DISTRIBUTIONS Funds from Operations The following table presents a reconciliation of GAAP net loss to FFO. FFO and FFO per unit are non-gaap measures widely used by Canadian real estate investment trusts as a measure of operating performance. See "Non-GAAP Financial Measures". The financial results used to calculate FFO include the historical results of SCOSS prior to the conversion and prior to its acquisition of any operating assets. Consequently, the FFO calculations below may not be indicative of the future financial performance of the REIT. Three months ended Period from January 12 (dollars in thousands, except per unit amounts) December 31, 2006 to December 31, 2006 Net loss per financial statements ($1,052) ($2,074) Amortization of income-producing properties 1,631 2,205 FFO* $ 579 $ 131 FFO Per unit: Weighted average number of units 107,004 46,031 FFO per weighted average number of units outstanding $ 0.01 $ 0.00 * See "Non-GAAP Financial Measures" Distributions In determining the amount of distributions to be made to unitholders, the board of trustees of the REIT considers many factors, including the provisions of its declaration of trust, overall health of the business, its expected need for capital, and taxable income. The declaration of trust of the REIT provides that a sufficient amount of the REIT s net income and net realized capital gains will be distributed each year to unitholders or otherwise in order to eliminate the REIT s liability for tax under Part I of the Income Tax Act (Canada). InStorage announced on September 20, 2006 that it would commence paying a monthly cash distribution to unitholders. From September to December 2006, the REIT declared monthly distributions of $ per unit to unitholders, representing a total of $2.6 million of distributions declared during the year. These distributions were payable to the unitholders of the REIT as well as to the holders of Class B LP Units and Class C LP Units. A unitholder is required to include, in computing income for tax purposes each year, the portion of the amount of net income of InStorage paid or payable to the unitholder each year. Distributions in excess of InStorage s taxable income, if any, allocated to the unitholders for the year will not be included in computing the taxable income of the unitholders. However, the adjusted cost base of the units held by the unitholder will be reduced by the amount of distributions not included in income. All distributions paid by the REIT in respect of 2006 were returns of capital, and would not be included in the income of a unitholder for tax purposes. Until such time as the net proceeds from the financing activities are fully invested in additional properties which are accretive to unitholders, InStorage intends to make cash distributions in excess of its FFO in order to provide unitholders with stable cash flow. Distributions in excess of FFO will be funded from the REIT s cash on hand. LIQUIDITY AND CAPITAL RESOURCES InStorage has financed its growth through the issuance of equity, conventional mortgage debt secured by income-producing properties and short-term financing through bridge facilities. The maximum debt leverage permitted by InStorage s declaration of trust is 75%. However, it is the goal of InStorage to maintain a more conservative leverage ratio of less than 65% in the long term. At December 31, 2006, InStorage s debt leverage ratio was 38%. The low leverage ratio at year end was mainly due the December 31, 2006 cash balance of $37.3 million resulting primarily from the equity issuance completed on December 29, In addition, certain income-producing properties had been acquired without use of debt financing. The total assets of the REIT include outstanding mezzanine loans in the aggregate principal amount of $13.7 million, which amount has been financed by the REIT with equity. 16 InStorage REIT 2006 Annual Report

19 The leverage ratio at December 31, 2006 is calculated as presented in the following table: (dollars in thousands) December 31, 2006 Total assets as per consolidated balance sheet $ 187,016 Add: accumulated amortization of income-producing properties 2,205 Total assets $ 189,221 Total debt as per balance sheet $ 71,841 Leverage ratio 38.0% At December 31, 2006, InStorage had $60.9 million of fixed rate term mortgage debt outstanding. The outstanding mortgages bear interest at rates ranging between 5.32% and 6.35% per annum, with a weighted average rate of 5.53% at December 31, The weighted average term to maturity of the term mortgages at December 31, 2006 was 6.8 years. These mortgage loans are secured by first charges over specific income-producing properties. At December 31, 2006, the REIT had the following variable interest rate mortgages: a loan of $7.3 million bearing variable interest at prime plus 1.00%, secured by a first registered mortgage over one incomeproducing property and a first in priority assignment of rents and/or leases of the property. The debt matures on December 31, 2008 and it can be prepaid at any time in whole or in part during its term without penalty. a demand non-revolving loan in the amount of $3.7 million bearing variable interest at prime plus 0.85%, secured by a first charge on a co-ownership property. The debt is repayable on demand, subject to annual review, but in no case later than August 31, The amount drawn against the facility can be increased to $4.9 million with additional amounts drawn for construction of an expansion on the same property. These amounts represent InStorage s 50% share in the co-ownership of the property. The REIT s mortgage loans are subject to certain covenants related to maintenance of debt service coverage ratios and reporting requirements. As at December 31, 2006, the REIT is in compliance with these covenants. The main sources of acquisition funds for InStorage will be cash on hand remaining from the recent equity financings as well as additional mortgage financing on acquired properties. On April 3, 2007, InStorage closed an offering of 72.4 million units for estimated net proceeds of $99.3 million after payment of issuance costs of approximately $5.7 million. These funds have been, and will be used primarily to fund the acquisition of the StorageNOW and Apple portfolios, respectively. InStorage s ongoing capital expenditures will be mainly in the nature of maintenance capital expenditure on its income-producing properties. While we do expect some maintenance capital expenditures to be incurred every year, we do not expect significant spending in the next 5 to 10 years because most of the REIT s properties are relatively newly constructed. Debt repayment obligations InStorage s most significant contractual obligations relate to mortgages payable. The following table presents the future principal repayment obligations on fixed rate term mortgage debt. (dollars in thousands) 2007 $ 1, , , , ,086 Thereafter 39,730 $ 60,929 In addition, InStorage has two variable rate loans with $7.3 million maturing in 2008 and $3.7 million maturing in InStorage REIT 2006 Annual Report 17

20 MANAGEMENT S DISCUSSION AND ANALYSIS CASH FLOWS Financing Activities Equity On January 12, 2006, SCOSS was incorporated with 1 common share issued for gross proceeds of one dollar. On February 10, 2006, SCOSS completed a private placement offering of 4,999,999 shares at a price of $0.10 per share for gross proceeds of $0.5 million. Also on February 10, 2006, SCOSS completed a private placement offering of 3,750,000 shares at a price of $0.20 per share for gross proceeds of $0.8 million. On March 22, 2006 SCOSS completed its initial public offering of 3,750,000 shares at a price of $0.20 per share for gross proceeds of $0.8 million. On May 29, 2006, SCOSS completed a private placement of 9,000,000 shares at a price of $0.50 per share for gross proceeds of $4.5 million. Net of total issuance costs of $1.1 million, SCOSS raised total net proceeds of $5.4 million in the offerings listed above. On August 31, 2006, InStorage completed a private placement of 75.0 million trust units at a price of $1.00 per unit for net proceeds of $70.6 million after deducting the expenses of the offering. On December 29, 2006, the REIT completed an additional private placement of 23.1 units at a price of $1.30 per unit for net proceeds of $28.3 million after deducting the expenses of the offering. The proceeds of this offering were partially used to satisfy the cash portion of the purchase price of the Stor edge properties acquired in February During the period ended December 31, 2006, InStorage received $0.2 million from the exercise of options by trustees and officers to acquire 0.8 million units of the trust. In 2006, the REIT declared $2.6 million in distributions, with $1.9 million paid to its unitholders in the period ended December 31, 2006 and with the December distribution of $0.7 million paid in January Debt During the year, InStorage obtained $76.8 million in debt financing of which $51.5 million was in the form of fixed and variable interest rate mortgage financing and $25.3 was in the form of bridge financing. Loan repayments during the year included the repayment of the bridge loan of $25.3 million and scheduled principal repayments on mortgages of $0.3 million. InStorage incurred $0.7 million in deferred financing costs associated with various debt financing arrangements. Investing Activities During the year InStorage used $99.9 million for various acquisitions discussed in the "Investment Activities in 2006" section. In addition, InStorage advanced $12.5 million in mezzanine financing of development properties to InScotia and a co-ownership in which InScotia has a 50% interest. InStorage held back $1.3 million on mezzanine loans to cover interest payments for a period over which the development properties are not expected to generate positive cash flows. Hence, the amount advanced for mezzanine loans is $12.5 million, compared to the principal repayment obligation of the borrowers of $13.7 million. See "Related Party Transactions" for more details. The following table presents InStorage s mezzanine financing projects in Canada at December 31, 2006: Summary of the Development Properties (dollars in thousands) Estimated Gross Rentable Principal Amount Province and address Location Status Area (Sq. Ft.) Committed Advanced Alberta nd Avenue SE Calgary Land 81,000 $ 5,564 $ 2,516 Ontario 221 Todd Baylis Boulevard Toronto Lease-up 72,000 $ 3,494 $ 3, Warden Avenue Toronto Lease-up 70,000 $ 4,394 $ 4, Wonderland Road South London Lease-up 56,811 $ 3,324 $ 3, ,811 $ 16,776 $ 13,728 The interest rate charged on the mezzanine loan for the Calgary property is 10% and the rate is 14% for the other loans in the table. 18 InStorage REIT 2006 Annual Report

21 RELATED PARTY TRANSACTIONS In August 2006, InStorage and its subsidiaries IS Operating Trust and InStorage LP entered into a five-year agreement with Carttera whereby Carttera has been engaged as the exclusive provider of management services to these entities. These management services include the provision of the services of three executive officers and other staff. Two of the officers provided by Carttera to the REIT and its subsidiaries are shareholders of Carttera and also hold units of the REIT. i) During 2006, the REIT incurred advisory fees of $0.14 million, which have been accrued in the accounts. The annual advisory fee is calculated at 0.25% of the gross book value of the REIT s assets as defined in the management agreement. ii) During 2006, SCOSS was charged $0.14 million for the management of the operations of SCOSS and the conversion of SCOSS into the REIT. This amount is included in general and administrative expenses. iii) The REIT incurred and paid $0.6 million in acquisition fees to Carttera for The acquisition fee is calculated on the date of closing of a purchase or acquisition, as 0.50% of the total cost of acquisition. This amount is included in the cost of acquisitions. On November 1, 2006, InStorage entered into an amended and restated development agreement with InScotia, a related party of the REIT, by virtue of common management and an ownership interest in InScotia by certain members of Carttera. Pursuant to the development agreement, InStorage has the right of first offer to provide mezzanine financing in respect of, and, where such financing is provided, a first right to acquire, self-storage properties owned and/or under development by InScotia. Under the terms of the development agreement, InStorage can exercise its right of first refusal to acquire, at a price based on 95% of the fair market value, the properties developed by InScotia for which mezzanine financing has been provided by InStorage. The development agreement includes a process to determine the fair market value of the properties to be acquired by InStorage from InScotia. This process includes obtaining two independent appraisals of the property and approval by the independent members of the boards of InStorage and InScotia. The loans advanced under this agreement are secured by a second charge on the property in favour of InStorage. The mezzanine loans provided under the development agreement mature at the earlier of the following: five years from the date of initial advance of funds under the loan; the sale of the project to InStorage or to a third party in compliance with the terms of the development agreement; and the second anniversary of the date on which stabilization of the project has occurred. A project is considered to be stabilized when it has been occupied by tenants, in possession and paying full rent, at an average occupancy rate of 85% or greater over a period of three consecutive months. As at December 31, 2006, InStorage had funded mezzanine loans that are open for prepayment without penalty to InScotia with a total principal amount of $12.4 million and to a non-related party in the principal amount of $1.3 million, with a weighted average interest rate of 13.6%. Interest income for the period ended December 31, 2006 in the amount of $0.5 million has been accrued. This includes a proportionate share of the interest income on the mezzanine loan to a co-ownership in which InScotia has a 50% interest. OUTSTANDING SECURITIES As of December 31, 2006, InStorage had 107,418,620 units outstanding. In addition, as of the same date, InStorage LP had 12,946,056 Class B LP units and 9,400,000 Class C LP units outstanding. Both Class B LP Units and Class C LP Units are exchangeable into trust units of InStorage on a one-for-one basis and are entitled to receive monthly distributions that are economically equivalent to distributions made in respect of REIT units. The Class B LP Units and Class C LP Units do not entitle holders to vote on matters to be considered by the limited partners of the InStorage LP. However, holders of Class B LP units are also holders of special voting units of the REIT, which entitles them to vote at meetings of the unitholders of the REIT. InStorage REIT 2006 Annual Report 19

22 MANAGEMENT S DISCUSSION AND ANALYSIS OUTLOOK In 2007 we will continue to steer InStorage towards achieving its short term and long term objectives. We believe that the Canadian self-storage industry offers strong potential for growth through consolidation. We have announced and closed several acquisitions in early 2007 and will continue to look for other acquisitions, both from an opportunistic and strategic perspective. We will focus on integrating the acquired properties and realizing economies of scale as we build our property portfolio. We have commenced activities towards building our administrative and field infrastructure as well as standardised information systems at our properties to help us manage in a more efficient and cost effective manner. In the second half of 2007, we will roll out our branding strategy and expect to have a common and recognizable brand under which all our properties will operate. In conjunction with branding, we will look for opportunities to increase revenues through sales and marketing programs, which will benefit from our strong presence in Ontario and Alberta as well as our presence in other markets which are strategic to our growth. We will also look for opportunities to optimize average rental rates and occupancy levels to achieve the financial objectives of the REIT. We will make decisions regarding the REIT s capital structure in order to maintain the debt leverage ratio and cost of borrowing at levels which optimize returns on investments while managing risks so as to generate stable cash flows for our unitholders. OFF BALANCE SHEET ARRANGEMENTS Our off balance sheet arrangements are restricted to an operating lease of office space with lease commitments of $0.1 million in each of 2007, 2008 and In addition, InStorage has committed to the following contingent payment arrangements: i) Under the terms of the purchase and sale agreement dated June 30, 2006 between Access Self Storage Inc., Ontario Inc. and InStorage LP, InStorage LP agreed to a post-closing purchase price adjustment on three properties known as 1776 O Connor Drive, 542 Evans Avenue and 3429 Kennedy Road. Based on the operating income for the period commencing 12 months after closing and ending 24 months after closing, an adjustment would be made to the purchase price if operating income exceeds certain specified levels. The maximum contingent amount of the increase in the purchase price for these properties, if all conditions were to be satisfied, would be $8.5 million. ii) Under the terms of the purchase and sale agreement dated June 30, 2006 between Access Self Storage Inc., Ontario Inc. and InStorage LP, it was agreed that if at any time prior to the second anniversary of the closing date, the purchaser sells the properties located at 1776 O Connor Drive, 542 Evans Avenue or 3429 Kennedy Road, InStorage LP would pay to the vendor an adjustment to the purchase price in the amount of $3.4 million, $2.1 million, and $1.9 million, respectively. CRITICAL ACCOUNTING ESTIMATES InStorage prepares its financial statements in Canadian dollars in accordance with Canadian GAAP. The preparation of financial statements requires InStorage to make judgements, assumptions and estimates that affect the reported amounts of assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses and cash flows during the reporting period. InStorage s significant accounting policies are summarized in Note 2 to its financial statements for the period ended December 31, We believe the following are critical accounting policies, the application of which has a material impact on InStorage s financial results. Acquisition of Income-Producing Properties InStorage allocates the purchase price of income-producing properties to land, building and intangibles such as the value of in-place leases. We use estimates in the assignment of purchase price as follows: i) the value of land is based on appraisal reports from accredited appraisers; ii) the value of building is estimated on an "as if vacant" basis; iii) the value of in-place leases is calculated based on the present value of the difference between the cash flows from estimated lease-up of a vacant property and the estimated cash flows of the property on a "as is" basis; Our estimates of fair value could vary in different circumstances and result in another determination that could affect reported financial results. 20 InStorage REIT 2006 Annual Report

23 Amortization of Income-Producing Properties Substantially all the assets of InStorage consist of depreciable buildings. InStorage records amortization expense with respect to these assets based upon their estimated useful lives which have been estimated to be 25 years. Any changes in the estimated useful lives of buildings, caused by functional or economic obsolescence or other factors, could have a material impact on InStorage s financial condition or results of operation. Variable Interest Entities As detailed in "Related Party Transactions", InStorage provides mezzanine financing to InScotia under the terms of a development agreement. CICA Accounting Guideline 15, "Consolidation of Variable Interest Entities" ("AcG-15"), provides guidance for applying the principles in Section 1590, "Subsidiaries", to those entities defined as Variable Interest Entities ("VIEs"). The application of this guidance requires estimates to be made by InStorage regarding the potential range of cash flows of entities to which it provides mezzanine financing, an estimation of the potential losses of the borrower and the obligations to absorb residual losses of the borrower. InStorage has reviewed its interests, specifically its relationship with InScotia, and has determined that the results of InScotia are not required to be included in the consolidated financial statements of the REIT. Any changes in the estimated cash flows of InScotia or any other entities to which InStorage provides mezzanine financing could have an impact on the VIE conclusions and may require consolidation of such entities which could have a material impact on InStorage s financial statements. Income Tax Expense InStorage has been organized and operated, and intends to continue to operate, as a qualifying real estate investment trust. A qualifying real estate investment trust does not pay income taxes on its taxable income that is distributed to its unitholders, and accordingly, InStorage does not pay income tax on the taxable income, if any, that is distributed to its unitholders. Hence we do not accrue any income tax expense. This estimate could be incorrect. Due to the complex nature of the tax requirements, the ongoing importance of factual determinations and the possibility of future changes in the REIT s circumstances, there can be no assurance that InStorage has satisfied and will satisfy in future the requirements for taxation status as a real estate investment trust for any taxable year. See the section "Risks and Uncertainties Proposed New Taxation Regime" for more details concerning the uncertainty related to this estimate. FUTURE CHANGES TO ACCOUNTING POLICIES Management monitors accounting pronouncements from the Canadian Institute of Chartered Accountants ("CICA") and assesses the applicability and impact, if any, thereof on InStorage s consolidated financial statements. The CICA issued handbook section 1530, Comprehensive Income, which is applicable to InStorage commencing January 1, This standard provides for a new statement, comprehensive income, to be included in the consolidated financial statements. The major components of this statement will include unrealized gains and losses on financial assets classified as available-for-sale, deferred gains and losses arising from settlement of any hedging transactions and changes in fair value of effective position of cash flow hedging instruments. We do not expect any significant amounts to appear on the statement of comprehensive income for InStorage. The CICA issued handbook section 3855, Financial Instruments Recognition and Measurement, which is applicable to InStorage commencing January 1, This standard provides more comprehensive guidance on how to recognize financial instruments on the balance sheet, how to measure them, and how to account for gains and losses. The standard also specifies how financial instrument gains and losses are presented. Under this standard all financial instruments will be classified as one of: held-to-maturity, loans and receivables, held-for-trading or available-for-sale. We do not expect this accounting standard to have any significant impact on InStorage s financial statements. The CICA also issued Section 3865, Hedges, which is applicable to InStorage commencing January 1, In a fair value hedge, the change in fair value of the hedging derivative will be offset in the consolidated statement of income against the change in the fair value of the hedged item relating to the hedged risk. In a cash flow hedge, the change in fair value of the derivative, to the extent effective, will be recorded in other comprehensive income until the asset or liability being hedged affects the consolidated statement of income, at which time the related change in the fair value of the derivative will also be recorded in the consolidated statements of income. Any hedge ineffectiveness will be recorded in the consolidated statement of income. We do not expect this accounting standard to have any significant impact on InStorage s financial statements. InStorage REIT 2006 Annual Report 21

24 MANAGEMENT S DISCUSSION AND ANALYSIS RISKS AND UNCERTAINTIES InStorage s overall performance and results of operations are subject to the risks associated with the ownership and operation of real property and, in particular, self-storage facilities. Income properties are affected by general economic and local real estate market conditions, supply and demand for leased premises, competition from other available premises and various other factors. Certain of the most significant risks InStorage faces in conducting its business are set forth below. Proposed New Taxation Regime The REIT currently qualifies as a Mutual Fund Trust for Canadian income tax purposes and does not record a provision for income taxes on income earned by the REIT and its flow-through entities. On October 31, 2006, the Canadian Minister of Finance announced proposals to amend the Income Tax Act (Canada) to change the taxation regime applicable to "specified investment flow-through" trusts or partnerships (a "SIFT"), including certain income trusts, and their investors. On March 29, 2007, Bill C-52 was tabled in Parliament proposing draft legislation to implement the SIFT Proposals (the "2007 Amendments"). The REIT will be a SIFT for the purposes of the 2007 Amendments unless it qualifies for the exception for certain real estate investment trusts (the "REIT Exception"). Under the 2007 Amendments, certain distributions from a SIFT will no longer be deductible in computing a SIFT's taxable income, and a SIFT will be subject to tax on such distributions at a rate that is substantially equivalent to the general tax rate applicable to a Canadian corporation. However, the 2007 Amendments provide that distributions paid by a SIFT as returns of capital are not subject to the tax. The 2007 Amendments will apply to income trusts for taxation years that end after 2006, except that if a trust would have been a SIFT trust on October 31, 2006 (an "Existing Trust") had the definition been in force and applied to the trust as of that date, the 2007 Amendments will apply to a trust for its taxation year that ends before the earlier of 2011 and the first day after December 15, 2006 on which the trust exceeds normal growth as determined by reference to the normal growth guidelines issued by the Department of Finance on December 15, 2006, as amended from time to time. In the case of the REIT, its subsequent offerings have exceeded the guidelines on the amount of normal growth allowed. Accordingly, in the event that the REIT was a SIFT as finally enacted, the 2007 Amendments would be expected to apply commencing on January 1, Under the 2007 Amendments, the new taxation regime will not apply to a Real Estate Investment Trust (a "Trust") that continues to meet prescribed conditions relating to the nature of its income and investments (the "Trust Conditions"). Unless an Existing Trust, that was a Trust at the time of the 2007 Amendments, is able to continuously meet all Trust Conditions, the 2007 Amendments, if enacted, would immediately subject an Existing Trust to tax, which may adversely impact the level of cash otherwise available for distribution. As the 2007 Amendments are currently drafted, the REIT would not satisfy the conditions to qualify for the REIT Exception and therefore would be a SIFT for 2007 and for each year in which the technical tests are not met. If the 2007 Amendments are enacted as currently drafted, the REIT would become subject to tax on certain income and, at the date of substantive enactment, the REIT would record future income tax assets and liabilities in respect of accounting and tax basis differences that are expected to reverse in future periods, with a corresponding credit or charge to consolidated earnings for the period. To the extent InStorage does not qualify for the REIT Exception under the specific legislation as finally enacted, InStorage will consider alternative measures, including restructuring, assuming that they are in the best interests of its unitholders, in order to qualify for the REIT Exception in 2008 and subsequent years. There can be no assurances, however, that changes will be made to the 2007 Amendments, or that the REIT would be able to restructure such that the REIT would not be subject to the tax contemplated by the 2007 Amendments. Completion of the Apple Self Storage Acquisition In the event that the Apple Self Storage acquisition identified in this MD&A is not completed, InStorage intends to use the remaining proceeds of its recent short form prospectus offering that were expected to be used to complete this acquisition to acquire other properties the quality and nature of which may differ from the Apple Self Storage properties, to fund mezzanine loans for self-storage developments and/or for general corporate purposes. To the extent that suitable acquisitions with appropriate investment returns are not made using the REIT s available funds, dilution of NOI, FFO and the amount of cash available for distribution per unit may occur. There is no assurance that alternative suitable acquisition or investment opportunities will be available to InStorage in the near future or at all. 22 InStorage REIT 2006 Annual Report

25 Competition Increased competition has affected the self-storage industry and has led to pricing pressure. Management believes that this may have had and may continue to have an adverse effect on the profitability of self-storage facilities in certain markets. Many markets have been able to absorb the increase in self-storage property development due to superior demographics and density. However, select markets, including certain areas within the GTA, have not been able to absorb the new facilities and have not performed as well as others. The REIT also faces competition on acquisitions, especially with brokered portfolios. Bidding wars could develop between both public and private entities, and this competition may hinder the REIT s ability to grow. In addition, due to the relatively low development cost of each individual self-storage facility, other developers, owners and operators have the capability to build additional facilities that may compete with the REIT s facilities. If the REIT's competitors build new facilities that compete with the REIT's facilities or offer space at rental rates below current market rates or below the rental rates the REIT charges its customers, the REIT may lose existing and potential customers and, in order to retain customers, it may be pressured to discount its rental rates below those it would otherwise charge. As a result, the REIT's rental revenue may decrease, which could impair the REIT's ability to satisfy its debt service obligations and to pay distributions to unitholders. In addition, increased competition for customers may require the REIT to make capital improvements to facilities that it would not have otherwise made. Any unbudgeted capital improvements the REIT undertakes may reduce cash available for distributions to unitholders. The loss of revenues or increased expenses that may result from competitive pressures could have a materially adverse affect on the financial condition and results of operations of the REIT, the amount of cash available for distribution to unitholders and the REIT s ability to satisfy its debt service obligations. Occupancy and Rental Rates Virtually all of the REIT s leases are on a month-to-month basis. Delays in re-letting units as vacancies arise would reduce the REIT s revenues and could adversely affect its operating performance. The REIT currently owns, and expects in the future to own, certain properties that are in the "lease-up" stage and that have occupancy rates that are below stabilized levels. Should the number of properties owned by the REIT operating below stabilized levels exceed expected or budgeted levels and timeframes, the REIT s financial condition, results of operations and amount of cash available for distribution to unitholders could be materially adversely affected. In addition, lower than expected rental rates could adversely affect the REIT s rental revenues and impede its growth. Integration of Additional Properties The REIT cannot assure unitholders that it will be able to adapt its management, administrative, accounting and operational systems or hire and retain sufficient operational staff to integrate any of its acquired properties into its portfolio without operating disruptions or unanticipated costs. In addition, the recent and proposed acquisitions may cause disruptions in the REIT s operations and divert management s attention away from day-to-day operations. The REIT s failure to successfully integrate any of the recently acquired and proposed acquisitions could have a material adverse effect on the REIT s operations and financial performance and, as a result, on its ability to make cash distributions to unitholders. Earn-Out Purchase Price Adjustments Three of the properties acquired as part of the Access Self Storage portfolio are subject to earn-out purchase price adjustments, up to a cumulative maximum of $8.5 million, the purpose of which is to compensate the vendors of such properties for near-term expected growth in NOI at the subject properties. These adjustments would be equal to the excess of NOI for the period from August 31, 2007 to August 31, 2008 over certain specified amounts. Additionally, the vendors are entitled to a purchase price adjustment up to a cumulative maximum of $7.4 million in the event any of the properties subject to earn-out purchase price adjustments are sold by the REIT before August 31, As such, the REIT may have obligations to make additional cash payments to the vendors of the Access Self Storage portfolio pursuant to the above obligations. In order to satisfy these obligations, the REIT may be required to incur additional indebtedness or issue additional units. Any one of these events to satisfy the REIT s payment obligations could have an adverse effect on the REIT s financial condition, results of operations and amount of available cash for distribution. InStorage REIT 2006 Annual Report 23

26 MANAGEMENT S DISCUSSION AND ANALYSIS RISKS AND UNCERTAINTIES (continued) Investment Concentration and Unfavourable Conditions in Key Geographic Markets The REIT s investments consist solely of self-storage interests. As a result, it is subject to risks inherent in investments in a single industry. A decrease in the demand for self-storage space would have a greater adverse effect on the REIT s financial condition and results of operation than if it owned a more diversified portfolio of assets. Moreover, the REIT's performance is, and will be, subject to local economic, competitive and other conditions prevailing in the particular geographic areas where it owns properties. Assuming the completion of the Apple Self Storage acquisition, 68.0% of the gross rentable area of the REIT's properties will be located in Ontario with 57.9% in the Greater Toronto Area. Because of the geographic concentration of the REIT's properties, the REIT's performance may, in particular, be subject to economic, competitive and other conditions prevailing in Ontario and the Greater Toronto Area which could have a material adverse effect on the REIT's financial condition and results of operations and the amount of cash available for distribution to unitholders. Government Regulation and Environmental Matters The REIT is subject to federal, provincial and local environmental regulations that apply generally to the ownership of real property and the operation of self-storage facilities. If it fails to comply with those laws, the REIT could be subject to significant fines or other governmental sanctions. Under various federal, provincial and local laws, ordinances and regulations, an owner or operator of real estate may be required to investigate and clean up hazardous or toxic substances or petroleum product released at a facility and may be held liable to a governmental entity or to third parties for property damage and for investigation and clean-up costs incurred by such parties in connection with contamination. Such liability may be imposed whether or not the owner or operator knew of, or was responsible for, the presence of these hazardous or toxic substances. The cost of investigation, remediation or removal of such substances may be substantial, and the presence of such substances, or the failure to properly remediate such substances, may adversely affect the owner's ability to sell or rent such facility or to borrow using such facility as collateral. Further, the REIT cannot assure unitholders that the REIT's tenants have not stored, do not store or will not in the future store property at the REIT's facilities which could cause a material environmental condition or contamination. Cash Flow and Cash Distributions Are Not Guaranteed and May Fluctuate with the REIT s Performance Although the REIT intends, to the extent possible, to make equal monthly cash distributions to unitholders, such cash distributions are not guaranteed and may fluctuate with its performance. The REIT depends on revenue generated from its properties to make such distributions. There can be no assurance regarding the amount of revenue that will be generated by such properties. The amount of distributions depends upon numerous factors, including the profitability of the REIT s properties from time to time, resources used to fund the REIT s growth initiatives, fluctuations in working capital, interest rates, capital expenditures, and other factors which may be beyond the control of the REIT. If the Trustees determine that it would be in the best interests of the REIT, they may reduce, for any period, the cash distributions to be made to unitholders. Cash distributions made to holders of units and holders of exchangeable units of InStorage LP may exceed actual cash available to the REIT from time to time because of items such as uninvested cash, principal repayments, capital expenditures, seasonal fluctuations in operating results and redemption of units, if any. The REIT may be required to borrow funds or reduce distributions in order to accommodate such items. The REIT may temporarily fund such items, if necessary, through an operating credit facility, to the extent that it is available. Additionally, during the REIT s growth phase, the REIT is likely to hold excess funds to be invested in additional self-storage properties. During such period, InStorage may make cash distributions in excess of its FFO in order to provide unitholders with stable cash distributions. This excess cash required to fund distributions will be funded from the REIT s cash on hand. CONTROLS AND PROCEDURES InStorage s management, with the participation of the Chief Executive Officer and Chief Financial Officer, is responsible for establishing and maintaining disclosure controls and procedures and internal control over financial reporting as defined in the Canadian Securities Administrators Multilateral Instrument In addition, InStorage s Audit Committee and Board of Trustees provide an oversight role with respect to the REIT s public disclosure of financial information, and have reviewed and approved this MD&A and the consolidated financial statements for the period ended December 31, InStorage REIT 2006 Annual Report

27 Disclosure controls and procedures InStorage has established and maintains disclosure controls and procedures ("DC"). The Chief Executive Officer and Chief Financial Officer ("certifying officers") have evaluated the effectiveness of the REIT s DC as of December 31, 2006, and have concluded that such procedures are adequate and effective to provide reasonable assurance that the material information relating to the REIT and its consolidated subsidiaries and proportionately consolidated entities would be made known to them by others within those entities to allow for accurate and complete disclosures in annual filings. Internal controls over financial reporting Internal controls over financial reporting ("ICFR") are designed to provide reasonable assurance regarding the reliability of InStorage s financial reporting and its preparation of financial statements for external purposes in accordance with GAAP. As of the date of this MD&A, the REIT has ICFR in place that have been designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with GAAP. However, management s documentation and assessment of the design of the REIT s ICFR are underway as of the date of this MD&A, with a focus on processes and controls in areas identified as being key risk areas. Management has identified certain areas where it can enhance process controls and intends to incorporate such enhancements into ICFR over the next twelve months. InStorage employs entity level controls to compensate for any deficiencies that may exist. InStorage REIT 2006 Annual Report 25

28 MANAGEMENT S RESPONSIBILITY FOR FINANCIAL STATEMENTS The accompanying consolidated financial statements of InStorage Real Estate Investment Trust (the REIT ) were prepared by management, which is responsible for the integrity and fairness of the information presented therein. These consolidated financial statements have been prepared in accordance with Canadian generally accepted accounting principles and necessarily include some amounts that are based on management s best estimate and judgment. Financial information appearing throughout this annual report is consistent with these consolidated financial statements. In discharging its responsibility for the integrity and fairness of the consolidated financial statements and for the accounting systems from which they are derived, management maintains the necessary system of internal controls designed to ensure that transactions are authorized, assets are safe-guarded and proper records are maintained. The Board of Trustees oversees management s responsibility for financial reporting through an Audit Committee, which is composed entirely of independent Trustees. The consolidated financial statements have been reviewed and approved by the Board of Trustees on the recommendation of its Audit Committee. PricewaterhouseCoopers LLP, the independent auditors, have performed an independent audit of the consolidated financial statements and their report follows. The auditors have full and unrestricted access to the Audit Committee to discuss their audit and related findings. T. James Tadeson, CFA John Bartkiw Chief Executive Officer Chief Financial Officer April 27, 2007 April 27, InStorage REIT 2006 Annual Report

29 AUDITORS REPORT To the Unitholders of InStorage Real Estate Investment Trust We have audited the consolidated balance sheet of InStorage Real Estate Investment Trust ( REIT ) as at December 31, 2006 and the consolidated statements of operations, unitholders equity and cash flows for the period from January 12, 2006 to December 31, These consolidated financial statements are the responsibility of the REIT s management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit 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 the REIT as at December 31, 2006 and the results of its operations and its cash flows for the period from January 12, 2006 to December 31, 2006 in accordance with Canadian generally accepted accounting principles. PricewaterhouseCoopers LLP Chartered Accountants, Licensed Public Accountants April 27, 2007 InStorage REIT 2006 Annual Report 27

30 CONSOLIDATED BALANCE SHEET As at December 31, 2006 (dollars in thousands) Assets Real estate assets Income-producing properties (note 4) Tangible assets $ 126,239 Intangible assets 2,162 Mezzanine loans receivable (note 12) 13, ,130 Deferred financing costs (note 5) 415 Prepaid expenses and deposits (note 6(a)) 5,477 Amounts receivable 1,679 Cash and cash equivalents 37,315 Liabilities $ 187,016 Debt (note 7) $ 71,841 Accounts payable and accrued liabilities (note 6(b)) 5,618 77,459 Unitholders equity 109,557 $ 187,016 Commitments and Contingencies (note 16) Subsequent events (note 17) The accompanying notes are an integral part of these consolidated financial statements. On behalf of the Board: Louis J. Maroun Trustee James C. Lawley Trustee 28 InStorage REIT 2006 Annual Report

31 CONSOLIDATED STATEMENT OF OPERATIONS For the period from January 12, 2006 to December 31, 2006 (dollars in thousands, except per unit amounts) Revenues Rental property income $ 4,369 Interest income on mezzanine loans 527 4,896 Expenses Property operating costs 1,497 Interest (note 7(d)) 1,518 General and administrative 1,234 Asset management fees (note 12(a)) 143 Unit-based compensation (note 9) 373 Amortization of income-producing properties (note 10) 2,205 6,970 Net loss for the period $ (2,074) Basic and diluted loss per unit $ (0.05) Weighted average number of units in thousands 46,031 The accompanying notes are an integral part of these consolidated financial statements. CONSOLIDATED STATEMENT OF UNITHOLDERS EQUITY For the period from January 12, 2006 to December 31, 2006 Unit Contributed Cumulative Cumulative (dollars in thousands) equity surplus net loss distributions Total (note 8) Trust units issued on establishment of the REIT (note 1) $ $ $ $ $ SCOSS Capital Corp. offerings - net of issuance costs (note 1, note 8) 5,439 5,439 Issuance of units, net of costs 98,841 98,841 Issuance of Class C units of InStorage Limited Partnership 9,400 9,400 Option compensation expense (note 9) Exercise of options Net loss for the period (2,074) (2,074) Distributions (2,575) (2,575) Unitholders equity - December 31, 2006 $ 113,833 $ 373 $ (2,074) $ (2,575) $109,557 The accompanying notes are an integral part of these consolidated financial statements. InStorage REIT 2006 Annual Report 29

32 CONSOLIDATED STATEMENT OF CASH FLOWS For the period from January 12, 2006 to December 31, 2006 (dollars in thousands) Cash provided by (used in) Operating activities Net loss for the period $ (2,074) Add: Items not affecting cash Amortization of income-producing properties 2,205 Amortization of deferred financing costs 281 Unit-based compensation expense Changes in other non-cash operating items (note 11(a)) 1,242 2,027 Financing activities Proceeds from mortgages and other debt 76,837 Mortgages and other debt repayments (25,577) Proceeds from exercise of unit options 153 Proceeds from issuance of units - net of issuance costs 104,280 Distributions paid (1,931) Deferred financing costs incurred (696) 153,066 Investing activities Acquisitions of income-producing properties (note 3) (99,894) Capital expenditures (157) Advances of mezzanine debt (12,427) Deposits (5,300) (117,778) Increase in cash and cash equivalents during the period 37,315 Cash and cash equivalents - beginning of period Cash and cash equivalents - end of period $ 37,315 Supplemental cash flow information (note 11) The accompanying notes are an integral part of these consolidated financial statements. 30 InStorage REIT 2006 Annual Report

33 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Tabular dollars amounts in thousands, except per unit amounts unless otherwise stated) December 31, ORGANIZATION InStorage Real Estate Investment Trust ( InStorage or the REIT ) is an open-ended real estate investment trust formed under the laws of the Province of Ontario pursuant to the declaration of trust dated June 20, 2006 when ten trust units were issued for cash consideration of one hundred and thirty dollars. The trust units trade on the TSX Venture Exchange under the symbol IS.UN. The REIT was created to invest in income-producing self-storage properties within Canada. The REIT entered into a plan of arrangement (the Arrangement ) on August 4, 2006, whereby SCOSS Capital Corp. ( SCOSS ) was continued as the REIT and all of SCOSS s common shares were exchanged for a similar number of REIT units. SCOSS was incorporated on January 12, 2006 and its common shares were listed for trading on the TSX Venture Exchange on March 27, 2006 as a capital pool corporation. SCOSS completed its qualifying transaction on May 29, 2006 and was approved as a real estate issuer on the TSX Venture Exchange. 2 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of presentation The REIT is considered to be a continuation of SCOSS following the continuity of interest method of accounting. These consolidated financial statements reflect the results of operations of SCOSS from January 12, 2006 to August 4, 2006 and the REIT from that date forward. The REIT had no activity between June 20, 2006 and August 4, The REIT s accounting policies and its standards of financial disclosure are in accordance with Canadian generally accepted accounting principles ( GAAP ). The preparation of consolidated financial statements in accordance with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. The consolidated financial statements include the accounts of the REIT and its subsidiaries, including InStorage Limited Partnership (the LP ), together with its proportionate share of the assets, liabilities, revenue and expenses of all co-ownerships in which it participates. Real estate assets a) Income-producing properties Income-producing properties are carried at cost less accumulated amortization, less impairment loss, if any. Cost includes all amounts relating to the acquisition and improvement of the properties. All costs associated with upgrading the existing facilities, other than ordinary repairs and maintenance, are capitalized as property improvements and amortized over their expected useful lives. In accordance with The Canadian Institute of Chartered Accountants ( CICA ) Emerging Issues Committee Abstract ( EIC ) No. 137, Recognition of Customer Relationship Intangible Assets Acquired in a Business Combination, and, EIC-140 Accounting for Operating Leases Acquired in Either an Asset Acquisition or a Business Combination, the cost of incomeproducing property acquisitions is allocated to tangible and intangible assets based on their respective fair market values. Tangible assets include land, buildings, furniture and equipment. Intangible assets mainly include the value of in-place leases. The REIT records amortization expense on a straight-line basis over the assets estimated useful lives as follows: Buildings Furniture and equipment Value of in-place leases 25 years 5 years 1 year b) Impairment of income-producing properties The REIT uses a two-step process for determining when an impairment of income-producing properties should be recognized in the consolidated financial statements. If events or circumstances indicate that the carrying value of a property may be impaired, a recoverability analysis is performed based on estimated undiscounted future cash flows to be generated from property operations and its projected disposition. If the analysis indicates that the carrying value is not recoverable from future cash flows, the property is written down to estimated fair value and an impairment loss is recognized in the consolidated statement of operations. No impairment losses were recorded by the REIT during InStorage REIT 2006 Annual Report 31

34 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 2 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued) c) Impairment of mezzanine loans receivable Mezzanine loans receivable are classified as impaired when, in the opinion of management, there is reasonable doubt as to the timely collection of principal and interest. The carrying amount of mezzanine loans that are classified as impaired are reduced to their estimated fair value. Revenue recognition Rental property income, which is generally earned pursuant to month-to-month leases for self-storage space, is recognized as services are provided. Amounts billed in advance of providing services are recorded as deferred revenue. Late charges and administrative fees are recognized as income when collected. Revenue from merchandise sales is recognized when earned on delivery of products to the customer and ultimate collection is reasonably assured. Unit-based compensation The REIT has a unit option plan for trustees, officers and employees. The REIT recognizes compensation expense based on the fair value of the options at the date of grant, using a Black-Scholes option pricing model, over the vesting period. A summary of the plan is included in note 9. Deferred financing costs Deferred financing costs include commitment fees, underwriting costs and legal costs associated with new debt and the renewal of existing debt of the REIT. Financing costs for term mortgages are deferred and amortized over the term of the respective indebtedness. Financing costs for non-term debt are deferred and amortized over the expected term of the debt. In the event any debt is terminated, any associated unamortized financing costs are expensed immediately. Income (loss) per unit calculations Basic and diluted income (loss) per unit is calculated by dividing net income (loss) for the period by the weighted average number of units outstanding during the period. Diluted income (loss) per unit is calculated by dividing net income (loss) for the period by the weighted average number of units outstanding during the period plus the effect of dilutive unit equivalents such as unit options. The diluted amounts are calculated using the treasury method as if all the unit equivalents in respect of which average market prices exceed issue price, have been exercised at the beginning of the reporting period or the date of issue, as the case may be, and that the funds obtained thereby were used to purchase units of InStorage at the average trading price of units during the period. Unit options are not included in the calculation of diluted net loss for December 31, 2006 because they are anti-dilutive. Cash and cash equivalents Cash and cash equivalents are comprised of cash and include short-term investments with original maturities of three months or less. Fair value of financial instruments The REIT s amounts receivable, cash and cash equivalents, and accounts payable and accrued liabilities are carried at cost, which approximates their fair values because of the short period to receipt or payment of cash. The fair values of other financial instruments are disclosed in notes 7 and 12, with fair values estimated based on discounted future cash flows using discount rates that reflect current market conditions for instruments with similar terms and risks. Such fair value estimates are not necessarily indicative of the amounts the REIT might pay or receive in actual market transactions. Variable interest entities CICA Accounting Guideline 15, Consolidation of Variable Interest Entities ( AcG-15 ), provides guidance for applying the principles in Section 1590, Subsidiaries, to those entities defined as Variable Interest Entities ( VIEs ). This standard considers a VIE to be an entity in which either the equity at risk is not sufficient to permit it to finance its activities without additional subordinated financial support from other parties, or equity investors lack either voting control, or an obligation to absorb expected losses or the right to receive expected residual returns. AcG-15 requires consolidation of VIE s by the Primary Beneficiary. The Primary Beneficiary is defined as the party who has exposure to the majority of a VIE s expected losses and/or expected residual returns. InStorage has reviewed its interests, specifically its relationship with InScotia Developments Limited Partnership ( InScotia ), and has determined that the results of InScotia are not required to be included in the consolidated financial statements of the REIT. Further details about the relationship with InScotia are included in note InStorage REIT 2006 Annual Report

35 3 ACQUISITIONS Acquisitions during the period ended December 31, 2006 On May 29, 2006, SCOSS purchased two self-storage facilities in Toronto, Ontario for a total purchase price of $8.1 million. The acquisition was funded by a first mortgage loan of $6.0 million, with the balance paid in cash, adjusted for working capital amounts. On August 25, 2006, InStorage purchased three self-storage properties. The properties were acquired for a total purchase price of $4.6 million and are located in Aylmer, Ontario and St. Thomas, Ontario. The acquisition was funded by first mortgage financing of $3.5 million, with the balance paid in cash, adjusted for working capital amounts. On September 1, 2006, InStorage purchased six self-storage properties. The properties were acquired for a total purchase price of $59.2 million plus transaction costs of $1.7 million and are located in the Toronto, Ontario area. The acquisition was funded by first mortgage financing in the amount of $5.3 million, bridge facility financing in the amount of $16.7 million, the assumption of debt in the amount of $8.6 million and by issuance of 7.0 million Class C LP units of the LP for $7.0 million, with the balance paid in cash, adjusted for working capital amounts. The Class C LP units were valued at their estimated fair value of $1.00 per unit, which is equal to the unit price at which 75 million units were issued in a private placement completed on August 31, An additional amount of up to approximately $8.5 million may be payable as an increased purchase price in connection with this acquisition, contingent upon certain acquired properties generating specified operating income during the period commencing 12 months after closing and ending 24 months after closing. As the outcome of this contingency cannot be determined beyond reasonable doubt at this time, no amount has been recognized as part of the cost of acquisition. This purchase price adjustment consideration, if and when due, would be payable in the form of Class C LP units issuable at a price of $1.00 per unit, which would be measured at the estimated fair value of these units and recognized when issued. On September 5, 2006, InStorage purchased four self-storage properties. The properties were acquired for a total purchase price of $34.0 million plus transaction costs of $1.2 million. Two of the properties are located in London, Ontario, while the other two are located in Toronto, Ontario. The acquisition was funded by first mortgage financing in the amount of $8.4 million, a bridge facility draw in the amount of $8.6 million, the assumption of debt in the amount of $8.3 million and the issuance of 2.4 million Class C LP units of the LP for $2.4 million, with the balance paid in cash, adjusted for working capital amounts. The Class C LP units were valued at their estimated fair value of $1.00 per unit as described above. On September 20, 2006, InStorage purchased a self-storage property located in Belleville, Ontario. The total purchase price was $2.2 million, which was paid in cash, adjusted for working capital amounts. On October 13, 2006, InStorage purchased a self-storage facility located in Calgary, Alberta. The total purchase price for the property was $8.5 million, which was paid in cash, adjusted for working capital amounts. On October 17, 2006, InStorage acquired a 50% co-ownership interest in a self-storage property in Toronto, Ontario at a purchase price of approximately $4.0 million. The acquisition was funded through the assumption of a proportionate share of the first mortgage debt of $3.7 million, with the balance paid in cash, adjusted for working capital amounts. On November 15, 2006, InStorage acquired two self-storage properties located in Edmonton, Alberta. The total purchase price for these properties was $5.5 million, which was financed with a first mortgage of $4.0 million, with the balance paid in cash, adjusted for working capital amounts. Consideration paid for the assets acquired during the period ended December 31, 2006 is summarized as follows: September 1, 2006 September 5, 2006 Others Total Cash $ 45,263 $ 24,446 $ 30,185 $ 99,894 Issuance of Class C LP units 7,000 2,400 9,400 Mortgages assumed on acquisition 8,588 8,331 3,662 20,581 $ 60,851 $ 35,177 $ 33,847 $ 129,875 InStorage REIT 2006 Annual Report 33

36 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 3 ACQUISITIONS (continued) The allocations of the purchase price of the acquisitions during the period ended December 31, 2006 to the assets acquired are summarized as follows: September 1, 2006 September 5, 2006 Others Total Tangible assets: Land $ 9,163 $ 7,134 $ 4,945 $ 21,242 Building 50,861 27,343 27, ,135 Furniture and equipment ,024 34,477 32, ,452 Net working capital (159) (88) (327) (574) Intangible assets: In-place leases ,223 2,997 $ 60,851 $ 35,177 $ 33,847 $ 129,875 As at December 31, 2006, the allocations of the purchase prices to the fair value of some of the assets acquired have not been finalized and may be subject to adjustment. Income from the acquired properties is included in the consolidated statement of operations from the dates of acquisition of the respective income-producing properties. 4 INCOME-PRODUCING PROPERTIES Income-producing properties consist of the following: Accumulated Cost amortization Net Tangible assets Land $ 21,242 $ $ 21,242 Buildings 106,135 1, ,795 Furniture and equipment ,609 1, ,239 Intangible assets In-place leases 2, ,162 $ 130,606 $ 2,205 $ 128,401 5 DEFERRED FINANCING COSTS Deferred financing costs consist of the following: Accumulated Cost amortization Net Deferred financing costs $ 696 $ 281 $ 415 Interest expense for 2006 includes $0.3 million of amortization of deferred financing costs. 34 InStorage REIT 2006 Annual Report

37 6 WORKING CAPITAL a) Prepaid expenses and deposits Prepaid expenses and deposits consist of the following: Deposits on acquisitions $ 2,000 Mortgage funding reserves held by lender 3,250 Prepaid expenses and other 227 $ 5,477 Mortgage funding reserves held by lender will be released to the REIT upon achieving stipulated occupancy levels and on completing required repairs. Interest is being paid to the lender on these amounts and the funds withheld have been invested by the lender in term deposits on the REIT s behalf. b) Accounts payable and accrued liabilities Accounts payable and accrued liabilities consist of the following: Accounts payable and operating expense accruals $ 2,571 Tenant prepaid rents and deposits 1,127 Prepaid interest on mezzanine loans 995 Accrued interest payable 281 Distributions payable 644 $ 5,618 7 DEBT Debt consists of the following: Fixed rate term mortgages (a) $ 60,929 Variable rate mortgages (b) 10,912 $ 71,841 a) Fixed rate term mortgages Fixed rate term mortgages payable bear interest at rates ranging between 5.32% and 6.35% per annum with a weighted average rate of 5.53% at December 31, 2006, payable in monthly principal and interest instalments and mature between 2008 and The weighted average term to maturity of the term mortgages is 6.80 years. The mortgages are secured by registered first charges over specific income properties. All interest rates are fixed for the term of the respective mortgage. Principal repayment requirements for the fixed rate term mortgages are as follows: 2007 $ 1, , , , ,086 Thereafter 39,730 $ 60,929 InStorage REIT 2006 Annual Report 35

38 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 7 DEBT (continued) b) Variable rate mortgages At December 31, 2006, the REIT had the following variable interest rate mortgages: a loan of $7.3 million bearing a variable interest rate at prime plus 1.00%, secured by a first registered mortgage over one income-producing property and an assignment of rents and/or leases of the property. The debt matures on December 31, 2008 and it can be prepaid without penalty at any time in whole or in part during its term; and a demand non-revolving loan in the amount of $3.7 million bearing a variable interest rate at prime plus 0.85%, secured by a first charge on a co-ownership property. The debt is repayable on demand, subject to annual review, but in no case later than August 31, The amount drawn against the facility can be increased to $4.9 million with additional amounts drawn for construction of an expansion on the same property. These amounts represent InStorage s 50% share in the co-ownership of the property. c) Bridge facility On September 5, 2006, InStorage arranged a three-month bridge facility with a bank in the amount of $25.3 million to finance the acquisition of certain self-storage properties. The bridge loan had an interest rate payable at prime plus 1.5% and was repayable upon one week s written notice to the bank. This loan was repaid in the fourth quarter of 2006 and new term mortgage financing was obtained. d) Interest expense Interest expense consists of the following: Interest $ 1,433 Amortization of deferred financing costs 281 1,714 Less: Interest income on short-term investments (196) $ 1,518 e) Fair values The estimated fair values of the debt balances at December 31, 2006 are approximately equal to carrying values. 8 UNIT EQUITY The following presents the number of units issued and outstanding and the related carrying value of unit equity as at December 31, 2006: Number of units issued and outstanding Carrying amount REIT Class B Class C REIT Class B Class C units LP units LP units Total units LP units LP units Total SCOSS offerings, net of issuance cost, converted into REIT units 8,553,944 12,946,056 21,500,000 $ 2,165 $ 3,274 $ $ 5,439 Units issued on establishment of REIT Private placement of units, August 31, ,000,000 75,000,000 70,553 70,553 Private placement of units, December 29, ,098,000 23,098,000 28,288 28,288 Issuance of units on acquisitions 9,400,000 9,400,000 9,400 9,400 Unit options exercised (note 9) 766, , Balance - December 31, ,418,620 12,946,056 9,400, ,764,676 $101,159 $ 3,274 $ 9,400 $ 113, InStorage REIT 2006 Annual Report

39 Pursuant to a special resolution passed by shareholders of SCOSS at a meeting held on July 25, 2006, SCOSS converted into a real estate investment trust as at August 4, The shareholders of SCOSS exchanged their common shares, on a one-for-one basis, for either units of the REIT or exchangeable Class B LP units of the LP. On January 12, 2006, SCOSS was incorporated with 1 common share issued for gross proceeds of one dollar. On February 10, 2006, SCOSS completed a private placement offering of 4,999,999 shares at a price of $0.10 per share for gross proceeds of $0.5 million. Also on February 10, 2006, SCOSS completed a private placement offering of 3,750,000 shares at a price of $0.20 per share for gross proceeds of $0.8 million. On March 22, 2006 SCOSS completed its initial public offering of 3,750,000 shares at a price of $0.20 per share for gross proceeds of $0.8 million. On May 29, 2006, SCOSS completed a private placement of 9,000,000 shares at a price of $0.50 per share for gross proceeds of $4.5 million. Net of total share issue costs of $1.1 million, SCOSS raised total net proceeds of $5.4 million in the offerings listed above. On August 31, 2006, InStorage completed a private placement offering of 75,000,000 units at a price of $1.00 per unit for net proceeds of $70.6 million after deducting the expenses of the offering. On December 29, 2006, InStorage completed a private placement offering of 23,098,000 units at a price of $1.30 per unit for net proceeds of $28.3 million after deducting the expenses of the offering. In conjunction with the acquisition of properties on September 1, 2006, the REIT issued 7,000,000 exchangeable Class C LP units at $1.00 per unit, for a value of $7.0 million. In conjunction with the acquisition of properties on September 5, 2006, the REIT issued 2,400,000 exchangeable Class C LP units at $1.00 per unit, for a value of $2.4 million. a) Authorized units i) REIT units The REIT is authorized to issue an unlimited number of voting units, each of which represents an equal undivided interest in the REIT. All REIT units outstanding from time to time shall be entitled to participate pro rata in any distributions by the REIT and, in the event of termination or winding up of the REIT, in the net assets of the REIT. All REIT units shall rank among themselves equally and rateably without discrimination, preference or priority. Unitholders are entitled to require the REIT to redeem all or any part of their REIT units at prices determined and payable in accordance with the conditions provided in the REIT s declaration of trust. A maximum amount of fifty thousand dollars may be redeemed in total in any one month unless otherwise waived by the Board of Trustees. The REIT is authorized to issue an unlimited number of special voting units that will be used to provide voting rights to holders of exchangeable securities. Special voting units are not entitled to any interest or share in the distributions or net assets of the REIT. Each special voting unit entitles the holder to the number of votes at any meeting of unitholders of the REIT which is equal to the number of REIT units into which the exchangeable security is exchangeable. Special voting units are cancelled on the issuance of REIT units on exercise, conversion or cancellation of the corresponding exchangeable securities. As at December 31, 2006, there were 12,946,056 special voting units outstanding. There is no carrying value assigned to the special voting units in these consolidated financial statements. ii) Limited partnership units InStorage Limited Partnership ( LP ) was formed on June 21, An unlimited number of Class A LP units, Class B LP units and Class C LP units and an unlimited number of limited partnership units of any class (as the same may be created from time to time by the general partner) may be issued by the LP. The Class A LP units are entitled to all distributable cash of the LP after the required distributions on the Class B LP units and Class C LP units have been paid. As at December 31, 2006, there were 107,418,620 Class A LP units outstanding. All Class A LP units are owned indirectly by the REIT and have been eliminated on consolidation. Class B LP units and Class C LP units are exchangeable into units of the REIT on a one-for-one basis and entitle holders to receive distributions that are equivalent to distributions made on units of the REIT and do not entitle holders to vote on matters to be considered by the limited partners of the LP. However, holders of Class B LP units are also holders of special voting units of the REIT, which entitles them to vote at meetings of the unitholders of the REIT. The terms of the Class B LP units and the Class C LP units are governed by the limited partnership agreement of the LP and the applicable exchange agreement in respect of such units. These units are non-transferable, except on exchange on a one-for-one basis for units of the REIT. In accordance with EIC-151, Exchangeable Securities Issued by Subsidiaries of Income Trusts, the Class B LP units and Class C LP units are presented in unitholders equity. InStorage REIT 2006 Annual Report 37

40 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 8 UNIT EQUITY (continued) iii) Unit distributions The declaration of trust of the REIT provides that a sufficient amount of the REIT s net income and net realized capital gains will be distributed each year to unitholders or otherwise in order to eliminate the REIT s liability for tax under Part I of the Income Tax Act (Canada). Unit distributions declared during the period ended December 31, 2006 are as follows: REIT units $ 2,034 Class B LP units 314 Class C LP units 227 $ 2,575 9 UNIT OPTIONS InStorage has adopted a unit option plan (the Plan ). Under the terms of the Plan, the Board of Trustees of the REIT may from time to time, in its discretion, and in accordance with TSX Venture Exchange requirements, grant trustees, officers, employees and consultants, including all persons acting in such capacity regardless of whether they are employed by the REIT or its subsidiaries or affiliates or by another person or entity, non-transferable options to purchase trust units, exercisable for a period of up to ten years from the date of grant. The maximum number of units reserved for issuance under the plan is 10% of the total number of issued and outstanding units. On March 21, 2006, SCOSS granted 1,250,000 options to its officers and directors at an exercise price of $0.20 per share, expiring on March 21, These options vested immediately upon granting. On May 29, 2006, SCOSS granted 900,000 options to its officers and directors at an exercise price of $0.94 per share, expiring on May 29, These options vested immediately upon granting. The compensation expense was determined based on the fair value of the options at the grant date as calculated using the Black- Scholes option pricing model with the following assumptions: Risk-free interest rate 4.08% Expected volatility 40.00% Distribution yield 5.00% During the period ended December 31, 2006, InStorage recognized $0.4 million of unit-based compensation expense. In conjunction with the Arrangement for the continuation of SCOSS as the REIT, the SCOSS options were converted into unit options of the REIT at a weighted exercise price of $0.51 per unit. During the period ended December 31, 2006, 766,666 options were exercised at $0.20 per unit for proceeds of $0.15 million. At December 31, 2006, 1,383,334 options were outstanding and vested, with a weighted average exercise price of $0.68. The weighted average remaining life of options was 4.4 years at December 31, InStorage REIT 2006 Annual Report

41 10 AMORTIZATION EXPENSE Amortization expense consists of the following: Income-producing properties Tangible assets $ 1,370 Intangible assets 835 $ 2, SUPPLEMENTAL CASH FLOW INFORMATION The following summarizes supplemental cash flow information and non-cash transactions: Interest paid $ 1,136 Interest received $ 192 Mortgages assumed on acquisitions $ 20,581 Units issued as consideration for acquisitions $ 9,400 Liabilities assumed on acquisitions $ 775 Distributions payable at period-end $ 644 Changes in other non-cash operating items consist of the following: Prepaid expenses and deposits $ (177) Amounts receivable (1,478) Accounts payable and accrued liabilities 2,897 $ 1, RELATED PARTY BALANCES AND TRANSACTIONS Transactions with related parties that are conducted in the normal course of operations have been recorded at the exchange amount. Monetary and non-monetary transactions with related parties that are not in the normal course of operations, that have commercial substance, but that result in a substantive change in the ownership interests of the item transferred and are supported by independent evidence are recorded at the exchange amount. a) In August 2006, InStorage entered into an exclusive five-year management agreement with Carttera Management Inc. ( Carttera ), whereby Carttera has been engaged as the exclusive provider of management services to InStorage. These services include the provision to the REIT of three executive officers and other staff. Two of the officers of the REIT are shareholders of Carttera and also hold units of the REIT. i) During 2006, the REIT incurred advisory fees of $0.14 million, which has been accrued in the accounts. The annual advisory fee is calculated at 0.25% of the gross book value of the REIT s assets as defined in the management agreement. ii) During 2006, SCOSS was charged $0.14 million for the management of the operations of SCOSS and the conversion of SCOSS into the REIT. This amount is included in general and administrative expenses. iii) The REIT incurred and paid $0.6 million in acquisition fees to Carttera for The acquisition fee is calculated on the date of closing of a purchase or acquisition, as 0.50% of the total cost of acquisition. This amount is included in the cost of acquisitions. InStorage REIT 2006 Annual Report 39

42 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 12 RELATED PARTY BALANCES AND TRANSACTIONS (continued) b) As of November 1, 2006, InStorage entered into a development agreement with InScotia, a related party of the REIT by virtue of common management and an ownership interest in InScotia by certain members of management of the REIT. This agreement amended certain terms of the previous development agreement between the same parties dated August 4, Pursuant to the development agreement, InStorage has the right of first offer to provide mezzanine financing in respect of, and, where such financing is provided, a first right to acquire, self-storage properties owned and/or under development by InScotia. Under the terms of the development agreement, InStorage can exercise its right of first refusal to acquire, at a price based on 95% of the fair market value, the properties developed by InScotia for which mezzanine financing has been provided by InStorage. The development agreement includes a process to determine the fair market value of the properties to be acquired by InStorage from InScotia. This process includes obtaining two independent appraisals of the property and approval by the independent boards of InStorage and InScotia. The loans advanced under this agreement are secured by a second charge on the property in favour of InStorage. The mezzanine loans provided under the development agreement have a maturity at the earlier of the following: five years from the date of initial advance of funds under the loan; the sale of the project to InStorage or to a third party in compliance with the terms of the development agreement; or the second anniversary of the date on which stabilization of the project has occurred. A project is considered to be stabilized when it has been occupied by tenants, in possession and paying full rent, at an average occupancy rate of 85% or greater over a period of three consecutive months. InStorage had funded InScotia with a total principal amount of $12.5 million and $1.3 million to a non-related party, in mezzanine loans that are open for prepayment without penalty, with a weighted average interest rate of 13.6%. Interest income for the period ended December 31, 2006 in the amount of $0.5 million has been accrued. This includes a proportionate share of the interest income on the mezzanine loan to a co-ownership in which InScotia has a 50% interest. Accrued liabilities at December 31, 2006 include a prepaid interest amount received from InScotia of $0.7 million. The estimated fair value of the mezzanine loans receivable is approximately equal to its carrying value, based on current market rates for mortgages and loans with similar terms and risks. At December 31, 2006, $0.5 million was owing to InStorage from InScotia on account of mezzanine interest and other items, and $0.1 million was owing from InStorage to Carttera on account of asset management fees and other items. 13 SEGMENTED INFORMATION The REIT owns income-producing properties located in Canada. In measuring performance, the REIT does not distinguish or group its operations on a geographical or any other basis and, accordingly, has a single reportable segment for disclosure purposes. None of InStorage s tenants individually account for revenues in excess of 10% of the REIT s total revenues for INCOME TAXES The REIT currently qualifies as a Mutual Fund Trust for Canadian income tax purposes and does not record a provision for income taxes on income earned by the REIT and its flow-through entities. The REIT is required by its declaration of trust to distribute all of its taxable income to unitholders, which enables the REIT to deduct such distributions for income tax purposes. Accordingly, no provision for income taxes is recorded in the consolidated financial statements. In respect of assets and liabilities of the REIT, and its flow through entities, the carrying value of net assets for accounting purposes exceeds their tax basis by approximately $2.2 million at December 31, InStorage REIT 2006 Annual Report

43 New proposed tax rules for income trusts On October 31, 2006, the Canadian Minister of Finance announced proposals to amend the Income Tax Act (Canada) to change the taxation regime applicable to specified investment flow-through trusts or partnerships (a SIFT ), including certain income trusts, and their investors. On March 29, 2007, Bill C-52 was tabled in Parliament proposing draft legislation to implement the SIFT Proposals (the 2007 Amendments ). The REIT will be a SIFT for the purposes of the 2007 Amendments unless it qualifies for the exception for certain real estate investment trusts (the REIT Exception ). Under the 2007 Amendments, certain distributions from a SIFT will no longer be deductible in computing a SIFT's taxable income, and a SIFT will be subject to tax on such distributions at a rate that is substantially equivalent to the general tax rate applicable to a Canadian corporation. However, the 2007 Amendments provide that distributions paid by a SIFT as returns of capital are not subject to the tax. The 2007 Amendments will apply to income trusts for taxation years that end after 2006, except that if a trust would have been a SIFT trust on October 31, 2006 (an Existing Trust ) had the definition been in force and applied to the trust as of that date, the 2007 Amendments will apply to a trust for its taxation year that ends before the earlier of 2011 and the first day after December 15, 2006 on which the trust exceeds normal growth as determined by reference to the normal growth guidelines issued by the Department of Finance on December 15, 2006, as amended from time to time. In the case of the REIT, its subsequent offerings have exceeded the guidelines on the amount of normal growth allowed. Accordingly, in the event that the REIT was a SIFT as finally enacted, the 2007 Amendments would be expected to apply commencing on January 1, Under the 2007 Amendments, the new taxation regime will not apply to a Real Estate Investment Trust (a Trust ) that continues to meet prescribed conditions relating to the nature of its income and investments (the Trust Conditions ). Unless an Existing Trust, that was a Trust at the time of the 2007 Amendments, is able to continuously meet all Trust Conditions, the 2007 Amendments, if enacted, would immediately subject an Existing Trust to tax, which may adversely impact the level of cash otherwise available for distribution. As the 2007 Amendments are currently drafted, the REIT would not satisfy the conditions to qualify for the REIT Exception and therefore would be a SIFT for 2007 and for each year in which the technical tests are not met. If the 2007 Amendments are enacted as currently drafted, the REIT would become subject to tax on certain income and, at the date of substantive enactment, the REIT would record future income tax assets and liabilities in respect of accounting and tax basis differences that are expected to reverse in future periods, with a corresponding credit or charge to consolidated earnings for the period. To the extent InStorage does not qualify for the REIT Exception under the specific legislation as finally enacted, InStorage will consider alternative measures, including restructuring, assuming that they are in the best interests of its unitholders, in order to qualify for the REIT Exception in 2008 and subsequent years. There can be no assurances, however, that changes will be made to the 2007 Amendments, or that the REIT would be able to restructure such that the REIT would not be subject to the tax contemplated by the 2007 Amendments. 15 RISK MANAGEMENT The REIT is exposed to certain financial risks, including changes in interest rates, the credit quality of its borrowers and environmental matters. The REIT manages these risks as follows: a) Interest rate risk The majority of the REIT s debt is financed at fixed rates with maturities staggered over a number of years, thereby mitigating its exposure to changes in interest rates. The variable rate loans outstanding have a short maturity and can be prepaid without any penalties should that be necessary. b) Credit risk Risks arise in the event that borrowers default on the repayment of amounts owing to the REIT. The REIT endeavours to ensure adequate security has been provided in support of mezzanine loans receivable. InStorage REIT 2006 Annual Report 41

44 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 15 RISK MANAGEMENT (continued) c) Environmental risk As an owner of real property, the REIT is subject to various federal, provincial and municipal laws relating to environmental matters. Such laws provide a range of potential liability, including potentially significant penalties, and potential liability for the costs of removal or remediation of certain hazardous substances. The presence of such substances, if any, could adversely affect the REIT s ability to sell or redevelop such real estate or to borrow using such real estate as collateral and, potentially, could also result in civil claims against the REIT. As required by the declaration of trust, and in accordance with best management practices, Phase I Environmental Site Assessments are completed on all properties prior to acquisition. Further investigation is conducted if Phase I tests indicate a potential problem. In addition, the standard lease restricts tenants from carrying on environmentally hazardous activities or having environmentally hazardous substances on site. The trust has obtained environmental insurance on certain assets to further manage risk. 16 COMMITMENTS AND CONTINGENCIES a) Lease commitments: Future minimum lease payments under a non-cancellable lease agreement for office space amount to $0.1 million for 2007, $0.1 million for 2008 and $0.1 million for b) Under the terms of the purchase and sale agreement between Access Self Storage Inc., Ontario Inc. and InStorage LP dated June 30, 2006, InStorage LP agreed to a post-closing purchase price adjustment on the three properties known as 1776 O Connor Drive, 542 Evans Avenue and 3429 Kennedy Road. An adjustment will be made to the purchase price if operating income for the period commencing 12 months after closing and ending 24 months after closing exceeds certain specified levels. The maximum contingent amount of the increase in the purchase price for these properties if all conditions are satisfied would be $8.5 million. c) Under the terms of the purchase and sale agreement between Access Self Storage Inc., Ontario Inc., and InStorage LP dated June 30, 2006, it was agreed that if at any time prior to the second anniversary of the closing date, the purchaser sells 1776 O Connor Drive, 542 Evans Avenue or 3429 Kennedy Road, the purchaser will pay to the vendor an adjustment to the purchase price. The adjustment to the purchase price for Evans Avenue would be in the amount of $2.1 million; O Connor Drive, $3.4 million; and Kennedy Road, $1.9 million. 17 SUBSEQUENT EVENTS a) On February 15, 2007 the REIT, together with InScotia, acquired seven Stor edge Self Storage portfolio properties located in western Canada. InStorage purchased four of the Stor edge properties for an aggregate purchase price of approximately $27.3 million which was financed with a first mortgage on the property of $14.2 million, with the balance paid in cash. InScotia acquired three of the Stor edge properties for an aggregate purchase price of approximately $11.1 million. The REIT funded InScotia with mezzanine loan financing in the principal amount of approximately $5.3 million to acquire the three Stor edge properties. InScotia has also agreed to purchase three other Stor edge properties, the closing for one of which is expected to be before May 31, 2007 and the other two purchases are anticipated to close before December 1, 2007, when certain outstanding title-related approvals are expected to be obtained. The aggregate purchase price for the remaining three Stor edge properties will be approximately $5.5 million and InScotia budgets that additional development costs associated with these properties will be approximately $11.1 million. InStorage has committed to provide InScotia with additional mezzanine loan financing in the aggregate principal amount of approximately $6.7 million at the closing of InScotia s acquisition of these three Stor edge properties. b) On April 2, 2007, InStorage acquired a self-storage facility located in Milton, Ontario. This facility is operated under the name Milton Mini Storage. This facility was purchased for $2.9 million, which was paid in cash, adjusted for working capital amounts. 42 InStorage REIT 2006 Annual Report

45 c) On April 3, 2007, InStorage closed a bought deal equity offering of 72,415,000 trust units at a price of $1.45 per unit, for gross proceeds of $105 million, subject to underwriter s fees in the amount of $4.2 million ($0.058 per unit). Expenses of the offering are estimated to be $1.5 million. d) On April 5, 2007, InStorage acquired 11 self-storage properties located in Alberta, Saskatchewan and Ontario. The properties operate under the names Storage Maxx in Western Canada and StorageNOW and StorageONE in Ontario. The total purchase price for these properties was $110.0 million which was financed with a fixed rate mortgage loan in the amount of $57.1 million and a variable rate mortgage loan in the amount of $14.4 million, with the balance paid in cash, adjusted for working capital amounts. The purchase price includes an income guarantee of $2.9 million which will be held in escrow. The amount in escrow can be drawn by InStorage on a monthly basis over a period of 21 months from closing of the acquisition, to the extent of the shortfall between the actual net operating income and the expected net operating income as per the terms of the agreement. e) On March 16, 2007, InStorage announced that it had agreed to purchase the Apple Self Storage ( Apple ) portfolio of 10 self-storage properties located in Ontario and Quebec for an aggregate purchase price of approximately $111.6 million (subject to customary adjustments). One of the 10 acquisitions, 875 Don Mills Road, Toronto, closed on April 25, 2007, with the remainder of the Apple acquisition scheduled to close on May 4, The REIT will finance this acquisition with first mortgages on these properties of approximately $49.8 million, with the balance paid in cash, adjusted for working capital amounts. In connection with the Apple acquisition, InScotia will also acquire land located at Walkley Road, Ottawa. InStorage has agreed to provide InScotia with mezzanine financing of $1.5 million to finance the acquisition and development of this property. InStorage REIT 2006 Annual Report 43

46 CORPORATE DIRECTORY BOARD OF TRUSTEES TRANSFER AGENT AND REGISTRAR Louis J. Maroun Executive Chair of ING Real Estate Canada LP Mississauga, Ontario Chairman of the Board of Trustees Dr. Greg A. Burk Partner, Endodontic Associates Halifax, Nova Scotia Trustee (2) Philip D. Fraser (1) (2) President, Chief Executive Officer and a director of Killam Properties Halifax, Nova Scotia Trustee (1) (2) Investors are encouraged to contact our Transfer Agent and Registrar ComputerShare Trust Company of Canada for information regarding their security holdings. They can be reached at: ComputerShare Trust Company of Canada Upper Water Street Halifax, Nova Scotia B3J 3R (Toll free throughout North America) Facsimile: (Toll free throughout North America) Website: service@customerservice.com TSX VENTURE EXCHANGE James C. Lawley General Manager of Scotia Fuels Ltd. Halifax, Nova Scotia Trustee (1) (2) T. James Tadeson Chief Executive Officer Toronto, Ontario Trustee SENIOR MANAGEMENT T. James Tadeson Chief Executive Officer Thomas Gualtieri-Walters President and Chief Operating Officer InStorage s trust units trade under the symbol IS.UN. ANNUAL GENERAL MEETING Thursday, June 7, 2007 at 4:30pm The National Club Main Dining Room 303 Bay Street Toronto, Ontario AUDITORS PricewaterhouseCoopers LLP Royal Trust Tower, Toronto-Dominion Centre 77 King Street West, Suite 3000 Toronto, Ontario M5K 1G8 John Bartkiw Vice President and Chief Financial Officer Alay Shah Vice President, Finance and Administration (1) Member of the Audit Committee (2) Member of the Compensation, Nominating and Governance Committee 44 InStorage REIT 2006 Annual Report

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