On this page Rideau Towers 2, Toronto, Ontario

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1 Morguard NORTH AMERICAN residential REAL ESTATE INVESTMENT TRUST THE POTENTIAL OF NORTH AMERICA. REALIZED ANNUAL REPORT

2 On our cover The Forestwoods, Mississauga, Ontario On this page Rideau Towers 2, Toronto, Ontario

3 A YEAR OF ACHIEVEMENT A STRATEGIC focus on North America Morguard North American Residential REIT was created to realize on the income potential of residential properties in prime locations in Canada and the U.S. Two successful Public Offerings Raised a total of more than $233 million in $778 million in acquisitions in 2012 Creating a high-quality portfolio of 6,376 residential suites. $544 million in acquisitions in early 2013 Under contract and expected to add an additional 18 U.S. properties with a total of 4,784 multi-family residential suites in six states. Strong financial performance Generating funds from operations of $19.7 million in 2012 and providing a total return to unitholders of 16.2%.

4 CHAIRMAN S MESSAGE Our high-quality portfolio of revenue-producing multi-unit residential properties realized a dependable stream of income for investors. Morguard North American Residential REIT began operations in the spring of 2012, and this first Annual Report is a testament to the business strategy that is driving results. The REIT s mandate is to hold a well-diversified portfolio of revenue-producing residential properties in both Canada and the U.S. The REIT has several key objectives. The first is to generate stable and growing cash distributions for unitholders, on a tax-efficient basis, from its portfolio of North American multi-unit residential properties. The second key objective is to maximize long-term value for unitholders through property acquisitions, as well as active asset and property management. Providing exceptional strength in these activities is the experienced multi-unit residential team from Morguard Corporation, which externally administers and operates the REIT s properties. Morguard North American Residential REIT was created following the completion of a successful offering of trust units in April 2012, which raised gross proceeds of $75.0 million initially and a further $7.5 million when underwriters exercised their option to purchase additional units. All units in the initial public offering were issued at $10.00 per unit. In September 2012, the REIT successfully completed a second public offering of trust units, which raised gross proceeds of $150.7 million from the sale of 12.7 million trust units at a price of $11.85 per unit. For the year ended December 31, 2012, the REIT had achieved net operating income of $40.4 million and net income of $188 million. The unit value of the REIT grew from $10.00 at the time of the initial public offering in April to $11.20 at year end an increase of 12%. When combined with 2012 distributions, the REIT delivered a total return of 16.2% to unitholders. Acquiring a high-quality portfolio of properties was the first priority of the management of Morguard North American Residential REIT. Over the course of 2012, management began the acquisition and expansion of this portfolio. Once the initial public offering closed, the new REIT used the proceeds to purchase 14 Canadian and three U.S. multi-unit residential properties from Morguard Corporation. 2 Morguard NORTH AMERICAN residential REIT

5 Chairman s Message These properties are located in Ontario, Alberta and Louisiana and include a total of more than 5,400 residential suites. Later in the year, the REIT purchased additional properties in Florida. They included Village Crossing Apartments, purchased from Morguard Corporation on July 16 for US$16.3 million, a two-storey garden-style multi-unit residential property with 189 suites on 11 acres of land; Woodbine Apartments, purchased on July 31 for US$42.1 million, a three-storey garden-style multi-unit residential property with 408 suites on 19 acres of land; and Blue Isle Apartments, purchased on August 29 for US$40 million, a two-storey garden-style multi-unit residential property with 340 suites on 18 acres of land. At the December 31, 2012 year end, the REIT s portfolio included a total of 6,376 residential suites in two Canadian provinces and two U.S. states, valued at approximately $903 million. At year end, 84.8% of the REIT s long-term debt was on a fixed-rate basis at a weighted average interest rate of 4.3%, and total leverage stood at 42.3% of gross book value of the REIT s total assets. In early 2013, the REIT completed one portfolio acquisition and entered into a binding agreement to acquire an additional portfolio of 12 properties. Combined, these two significant acquisitions comprise 4,784 residential suites in the U.S. for a total of US$544 million. These purchases expand the REIT s portfolio with properties that have a known operational history, solid yield and high-quality physical structures. The purchase agreement for 12 multi-family residential apartment and townhome complexes with a total of 3,752 suites are located in Dallas, Texas; Denver, Colorado; Tampa, Florida; Raleigh, North Carolina; and Atlanta, Georgia. The 12 properties are best-in-class low-rise, enclave, garden-style walk-ups with surface and covered parking, modern leasing centres and amenity packages. The acquisition that closed on February 19, 2013, comprises six multi-unit residential properties, with a total of 1,032 suites, purchased from Morguard Corporation. They are located in Pensacola, Florida and southwest Louisiana. The properties are enclave three-storey garden-style walk-ups with upgraded suites, surface and covered parking, leasing centres and amenity packages. the REIT completed a further public offering that raised $95 million from the issuance of 8.3 million trust units; plus an additional $60 million was raised by issuing convertible unsecured subordinated debentures with a term of five years. After closing both transactions in 2013, the REIT will own interests in a total of 11,160 suites in Canada and the U.S., valued at approximately $1.5 billion. The REIT s mandate is to hold a well-diversified portfolio of revenueproducing residential properties in Canada and the U.S. In the year ahead, we will continue to seek out opportunities to expand our high-quality portfolio of revenue-producing residential properties and to strategically deploy capital for improvements to existing properties. Because we expect interest rates to remain relatively low for the foreseeable future, we expect to finance future additions to the REIT s portfolio at favourable terms, as necessary, and to refinance whenever conditions warrant. We are committed to maintaining a strong balance sheet for the REIT and to reduce risk whenever possible. We expect to find opportunities in Canada as well as in the U.S., although our initial focus will be to take advantage of opportunistic pricing in the U.S. We are confident that this approach will allow the new Morguard North American Residential REIT to deliver consistent results to unitholders. K. (Rai) Sahi Chairman and Chief Executive Officer The two portfolios are financed through the assumption of mortgages in the principal amount of approximately US$338 million (with a weighted average interest rate of 4.3% and a weighted average maturity of 3.7 years) and other available sources of funds. On March 15, 2013, 2012 Annual Report 3

6 A STRATEGIC FOCUS ON NORTH AMERICA Behind the creation of Morguard North American Residential REIT lies a strategic vision: A strong belief in the investment potential of revenue-producing residential properties in both Canada and the United States. Rideau Towers, Toronto, Ontario For management, the key was to start building a highquality portfolio of properties giving priority to proven, revenue-producing residential suites in prime locations in both countries. With such a portfolio in place, the REIT s objectives are to generate stable and growing cash distributions, and, over time, to maximize the value of the REIT s units, and to increase funds from operations (FFO) per unit. The REIT is administered by a team of residential real estate professionals from Morguard Corporation. These professionals are experienced in the acquisition, divestment, development, financing and operation of multi-unit residential real estate in both Canada and the U.S. 4 Morguard NORTH AMERICAN residential REIT

7 A STRATEGIC focus on North America Tomken Place, Mississauga, Ontario Steeplechase, Lafayette, Louisiana 2012 Annual Report 5

8 TWO SUCCESSFUL PUBLIC OFFERINGS Through these two substantial offerings, the REIT had attracted more than $233 million in investment capital with which to begin building its portfolio of properties. The Valleywoods, Mississauga, Ontario $233 Million RAISED Public Offering Spring 2012 $82.5 million raised Morguard North American Residential REIT was launched in the spring of 2012 through an initial public offering of trust units. Completion of the IPO which raised a total of $75 million from the sale of 7.5 million trust units was announced on April 18, Shortly afterwards, the IPO s underwriters exercised their option to purchase 750,000 additional trust units at $10 per unit bringing the total raised to $82.5 million. Public Offering September 2012 $150.7 million raised In September 2012, the REIT completed an additional public offering of trust units on a bought-deal basis, raising a total of $150.7 million from the sale of 12.7 million trust units. 6 Morguard NORTH AMERICAN residential REIT

9 $778 MILLION IN ACQUISITIONS IN 2012 Morguard North American Residential REIT made multiple acquisitions in 2012 ultimately creating a portfolio of 6,376 residential suites in Ontario, Alberta, Louisiana and Florida. Immediately following the success of the initial public offering, management of the REIT began the process of acquiring high-quality, income producing properties for the REIT s portfolio. Rideau Towers 3, Toronto, Ontario Square 104, Edmonton, Alberta Through a calculated acquisition strategy, the REIT purchased interests in 14 Canadian and three U.S. multi-unit residential properties, including a total of 123 low-rise, mid-rise and high-rise buildings immediately following the IPO from the portfolio of Morguard Corporation. The Canadian properties are located in southern Ontario (Toronto, Mississauga and Kitchener) and Edmonton, Alberta. The Louisiana properties are in Shreveport in the northwest and New Iberia and Lafayette in the south-central area of the state. In total, the properties account for 5,439 residential suites and were purchased for approximately $680 million. Magnolia Place, New Iberia, Louisiana 2012 Annual Report 7

10 $778 million in acquisitions IN 2012 The REIT s 14 Canadian properties are high-quality assets, with a record of solid financial performance. These include 12 high-rise buildings, three mid-rise buildings and 56 low-rise buildings, with a total of 4,905 suites. Of them, the majority are in southern Ontario with 2,219 suites in Mississauga, 1,937 in Toronto and 472 in Kitchener. The remaining 277 suites are in Edmonton, Alberta. Rouge Valley Residence, Scarborough, Ontario The Arista, Mississauga, Ontario 8 Morguard NORTH AMERICAN residential REIT

11 $778 million in acquisitions IN 2012 Village Crossing Apartments, West Palm Beach, Florida Woodbine Apartments, West Palm Beach, Florida Blue Isle Apartments, Coconut Creek, Florida Later in the year, the REIT purchased three additional properties all in Florida, for US$98.4 million. The Florida acquisitions are low-rise garden-style residential properties in the West Palm Beach and Fort Lauderdale areas and include a total of 937 suites Annual Report 9

12 $544 MILLION IN ACQUISITIONS IN EARLY 2013 In January 2013, Morguard North American Residential REIT acquired or entered into binding agreements for additional purchases to further strengthen its portfolio. The agreements are for 18 properties with a total of 4,784 residential units in six southern and western U.S. states Colorado, Florida, Georgia, Louisiana, North Carolina, and Texas further expanding the REIT s growth in the U.S. The Georgian Apartments, New Orleans, Louisiana Governors Gate, Pensacola, Florida Greenbrier Estates, Slidell, Louisiana 56% U.S. Once these acquisitions are completed, the REIT s portfolio will include 11,160 residential suites. In terms of geographic distribution, 56% of the REIT s suites will be in the U.S., while 44% will be in Canada. GEOGRAPHIC DIVERSIFICATION EARLY 2013 These purchases will increase the value of the REIT s portfolio to approximately $1.5 billion. 44% Canada 10 Morguard NORTH AMERICAN residential REIT

13 STRONG FINANCIAL PERFORMANCE For Morguard North American Residential REIT, operations began immediately with the completion of the IPO in April 2012 and the purchase of an initial portfolio of properties. Because the properties are all proven performers and well known by management the REIT was able to generate positive financial results from its inception. The Estates at Lafayette Square, Mobile, Alabama $78.6 Million Total Revenue in 2012 $40.4 Million Net Operating Income in 2012 $19.7 Million Funds from Operations in % TOtal RETURN To Unitholders 2012 Annual Report 11

14 PORTFOLIO SUMMARY With Morguard North American Residential REIT s strategic focus on North America, its portfolio of multi-unit residential properties includes prime locations in both Canada and the U.S. The properties in the REIT s portfolio meet established criteria, have been chosen carefully for their quality, their attractiveness to tenants and their ongoing income potential. Multi-Unit Residential Property region No. of Suites Canada Square 104 ab 277 The Arista on 458 The Elmwoods on 321 The Forestwoods on 300 The Maplewoods on 300 Margaret Place on 472 Meadowvale Gardens on 325 Rideau Towers 1 on 287 Rideau Towers 2 on 380 Rideau Towers 3 on 474 Rideau Towers 4 on 400 Rouge Valley Residence on 396 Tomken Place on 142 The Valleywoods on 373 Subtotal 4,905 United States Blue Isle FL 340 Village Crossing FL 189 Woodbine FL 408 Magnolia Place la 148 Steeplechase la 192 Villages of Williamsburg la 194 Subtotal 1,471 Total Multi-Unit Residential Suites 6, Properties 6,376 SUITES 12 Morguard NORTH AMERICAN residential REIT

15 FINANCIALS Financial Highlights 14 Management s Discussion and Analysis 15 Independent Auditors Report 40 Consolidated Balance Sheets 41 Consolidated Statements of Income and Comprehensive Income 42 Consolidated Statements of Unitholders Equity 43 Consolidated Statements of Cash Flows 44 Notes to Consolidated Financial Statements 45 Corporate Information 68 The Elmwoods, Mississauga, Ontario 2012 Annual Report 13

16 FINANCIAL HIGHLIGHTS Statement of Income Financial Highlights Years ended December 31 (In thousands of Canadian dollars, except per unit amounts) Revenue from real estate properties $ 78,610 $ 71,923 Interest income and other revenue 726 Total revenue 79,336 71,923 Net operating income 40,380 36,446 General and administrative (2,061) Fair value gains on real estate properties 121,756 82,585 Fair value loss on Class B LP Units (20,668) EBITDA 38,319 36,446 Interest expense (18,535) (17,095) Distributions on Class B Units (7,261) Weighted average units outstanding 13,726 8,250 Diluted weighted average units outstanding 30,949 25,473 Net income for the period 187,779 86,803 Net income per unit basic Net income per unit diluted Funds from operations (FFO) 19,747 18,298 FFO per unit diluted Adjusted funds from operations (AFFO) 18,803 17,457 AFFO per unit diluted Balance Sheet Financial Highlights As at December 31, December 31, (In thousands of Canadian dollars, except per unit amounts) Real estate properties $ 903,007 $ 676,944 Morguard Facility 77,880 Total Assets 1,000, ,867 Mortgages payable and Class C LP Units 417, ,629 Class B LP Units 192,899 Debt to total assets % 42% 53% Unitholders equity 375, ,093 Book value per unit Unitholders equity including Class B LP Units 547, ,323 Diluted book value per unit Number of units outstanding 20,983 8,250 Diluted number of units outstanding 38,206 25, Morguard NORTH AMERICAN residential REIT

17 MANAGEMENT S DISCUSSION AND ANALYSIS For the year ended December 31, 2012 (All amounts are stated in thousands of Canadian dollars except per share amounts) Chairman s Report to Unitholders The REIT is pleased to provide this review of operations and update on our financial performance for the year ended December 31, All amounts are stated in thousands of Canadian dollars, unless otherwise noted and except number of units and per unit amounts. Management s Discussion and Analysis ( MD&A ) sets out Morguard North American Residential Real Estate Investment Trust s ( Morguard Residential REIT or the REIT ) strategies and provides an analysis of the financial performance for the year ended December 31, 2012, and significant risks facing the business and management s outlook for Historical results, including trends that might appear, should not be taken as indicative of future operations or results. This MD&A should be read in conjunction with the REIT s audited consolidated financial statements and accompanying notes for the years ended December 31, 2012 and This MD&A is based on financial statements prepared in accordance with International Financial Reporting Standards ( IFRS ) and is dated February 19, Disclosure contained in this document is current to that date, unless otherwise noted. Additional information relating to Morguard Residential REIT, including the prospectus, can be found at and FORWARD-LOOKING STATEMENTS DISCLAIMER Statements contained herein that are not based on historical or current fact, including without limitation statements containing the words anticipates, believes, may, continue, estimate, expects and will and words of similar expression constitute forward-looking statements. Such forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause the actual results, events or developments to be materially different from any future results, events or developments expressed or implied by such forward-looking statements. Such factors include, among others, the following: general economic and business conditions, both nationally and in the regions in which Morguard Residential REIT operates; changes in business strategy or development/acquisition plans; environmental exposures; financing risk; existing governmental regulations and changes in, or the failure to comply with, governmental regulations; liability and other claims asserted against Morguard Residential REIT; and other factors referred to in Morguard Residential REIT s filings with Canadian securities regulators. Given these uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements. Morguard Residential REIT does not assume the obligation to update or revise any forward-looking statements. NON-IFRS FINANCIAL MEASURES Morguard Residential REIT reports its financial results in accordance with IFRS. However, in this MD&A we also use certain non-ifrs financial measures, including income before fair value changes, funds from operations ( FFO ) and adjusted funds from operations ( AFFO ). These measures are commonly used by entities in the real estate industry as useful metrics for measuring performance. However, they do not have any standardized meaning prescribed by IFRS and are not necessarily comparable to similar measures presented by other real estate entities. These measures should be considered as supplemental in nature and not a substitute for related financial information prepared in accordance with IFRS. Income before fair value changes is used by management to measure the operating results of the properties, inclusive of the impact of interest expense, amortization of capital assets and other income. This measure provides income of the properties prior to the impact of fair value gains/losses that may be significantly impacted by external market conditions and also represent non-cash items. The measure is not defined by IFRS and, accordingly, the term does not necessarily have a standardized meaning and may not be comparable to similarly titled measures presented by other publicly traded entities Annual Report 15

18 Management s Discussion AND Analysis FFO is a non-ifrs industry standard for evaluating operating performance but is not indicative of funds available to meet the REIT s cash requirements. FFO is computed by the REIT in accordance with the current definitions of the Real Property Association of Canada ( REALpac ) and is defined as net income before fair value gains/losses on real estate properties, fair value gains/losses on the redeemable Class B LP Units classified as liabilities, distributions on the Class B LP Units, gains/losses on the disposition of real estate properties and deferred income taxes on the U.S. properties. AFFO is a non-ifrs financial measure used by most Canadian real estate investment trusts but should not be considered as an alternative to net income, cash flow from operations or any other measure prescribed under IFRS. The Trustees consider AFFO to be a useful measure of cash available for distributions. AFFO is a supplemental measure to net income that is used in the real estate industry to assess the sustainability of future cash distributions paid to the REIT s unitholders. AFFO should not be interpreted as an indicator of cash generated from operating activities as it does not consider changes in working capital. AFFO is defined as FFO adjusted by (i) adding amortization of deferred financing costs assumed by the REIT on the 17 properties that were acquired concurrent with the completion of the IPO, amortization of free rent and amortization of cash flow hedges, (ii) deducting reserves for maintenance capital expenditures and (iii) making such other adjustments as may be determined by the Trustees in their discretion. Maintenance capital expenditures are estimated by management and represent capital expenditures that are required to maintain the existing earning potential of a property. Significant judgment is required to classify capital investments. INITIAL PUBLIC OFFERING The REIT completed its initial public offering ( IPO or the Offering ) on April 18, Concurrent with the IPO, the REIT indirectly acquired from Morguard Corporation ( Morguard ) interests in a portfolio of 14 Canadian multi-unit residential rental properties comprising an aggregate of 12 high-rise, three mid-rise and 56 low-rise buildings (collectively, the Initial Canadian Properties ) and three U.S. multi-unit residential low-rise properties comprising an aggregate of 52 two-storey buildings (collectively, the Initial U.S. Properties and, together with the Initial Canadian Properties, the Initial Properties ). The Initial Properties consist of interests in 5,439 residential suites that are located in Ontario, Alberta and Louisiana. The REIT s IPO raised gross proceeds of $75,000. A total of 7.5 million units of the REIT ( Units ) were sold at a price of $10.00 per trust unit. On April 24, 2012, the underwriters exercised in full their over-allotment option to purchase 750,000 additional trust units at a price of $10.00 per unit, which increased the total gross proceeds of the Offering to $82,500. The total proceeds received, net of underwriters commission, was $77,550. Upon completion of the Offering, the REIT used the net proceeds of the IPO to acquire a direct interest in 8.25 million Class A LP Units of Morguard North American Canada Limited Partnership ( CAN LP or the Partnership ). Morguard acquired 17,223,090 Class B LP Units as partial consideration for the Initial Properties that were sold to the REIT. The Class B LP Units are exchangeable, on a one-for-one basis, at the option of Morguard, into Units of Morguard Residential REIT and are entitled to the same distributions as the Units of Morguard Residential REIT. Immediately after the Offering, Morguard Residential REIT held all of the Class A LP Units, representing a 32.4% interest in CAN LP, and Morguard held all of the Class B LP Units, representing a 67.6% interest in CAN LP. Upon Completion of the Offering, CAN LP and its subsidiaries used the net proceeds of the Offering to acquire from Morguard the Initial Properties with a total IFRS net book value of $680,289. CAN LP and its subsidiaries assumed mortgages on 13 of the Initial Properties and the financing costs relating to these mortgages totalling $253,242 at April 17, Morguard retained the debt on the four remaining Initial Properties (the Retained Debt ) and the deferred financing costs associated with the Retained Debt totalling $104,658 at April 17, In consideration of the Retained Debt and its associated deferred financing costs, Morguard received Class C LP Units of CAN LP on which distribution payments will be made in an amount expected to be sufficient to permit Morguard to satisfy amounts payable with respect to (i) principal and interest under the Retained Debt and (ii) the amount of tax that is due and payable that is reasonably attributable to any distributions on the Class C LP Units. In addition, CAN LP entered into an unsecured, revolving credit facility with Morguard (the Morguard Facility ) that consisted of a $50,000 facility available for acquisitions and for general business purposes, which can be drawn either in Canadian dollars or an equivalent amount in United States dollars. If CAN LP draws upon the credit facility in Canadian dollars, interest will be calculated either at the Canadian prime lending rate or at the bankers acceptance ( BA ) rate plus 1.8%. 16 Morguard NORTH AMERICAN residential REIT

19 Management s Discussion AND Analysis If CAN LP draws upon the credit facility in United States dollars, interest will be calculated either at the U.S. prime lending rate or at the United States dollar London Interbank Offered Rate ( LIBOR ) plus 1.7%. Upon Completion of the Offering, $25,000 was drawn from the Morguard Facility to fund a portion of the purchase of the Initial Properties. Subsidiaries of Morguard have been appointed property and asset manager for the Initial Properties. BUSINESS OVERVIEW AND STRATEGY The REIT is a newly created, unincorporated open-ended real estate investment trust governed by the laws of the Province of Ontario. Units of the REIT trade on the Toronto Stock Exchange under the symbol MRG.UN. The REIT has been formed to own multi-unit residential rental properties across Canada and the United States. The objectives of the REIT are to (i) generate stable and growing cash distributions on a tax-efficient basis; (ii) enhance the value of the REIT s assets and maximize long-term value of the Units through active asset and property management; and (iii) expand the asset base of the REIT and increase AFFO per Unit primarily through acquisitions and improvement of its properties, including the Initial Properties, through targeted and strategically deployed capital expenditures. The REIT s external growth strategy will initially be focused on opportunities to acquire additional multi-unit residential properties located in urban centres and major suburban regions in Canada and in the United States that satisfy the REIT s investment criteria, as well as generating greater cash flow from its properties. The REIT will seek to leverage its relationship with Morguard to access acquisition opportunities that satisfy the REIT s investment criteria. Morguard has advised the REIT that its current intention is to offer to sell to the REIT additional multi-unit residential properties that it manages and in which it has an ownership interest in one or more transactions subject to market conditions. Subject to limited exceptions, the REIT has the right of first opportunity to acquire the existing interests of Morguard s residential properties prior to any disposition by Morguard to a third party. The REIT s internal growth strategy will focus on maximizing cash flow from its portfolio. The REIT intends to build upon the stable cash flows currently generated by the Initial Properties by maximizing occupancy and average monthly rent, taking into account local conditions in each of its geographic markets, managing its operating costs as a percentage of revenues and strengthening its asset base through its building infrastructure improvement and capital expenditure programs. SIGNIFICANT EVENTS During the year ended December 31, 2012, the REIT completed the acquisition of three U.S. multi-unit residential low-rise properties in Florida for US$98,447. Details of the transactions are as follows: On July 16, 2012, Village Crossing Apartments was acquired from Morguard for a purchase price of US$16,347 funded by mortgage financing of US$11,400 at an interest rate of 3.96% for a term of 10 years and an advance on the Morguard Facility of approximately US$5,000. Village Crossing Apartments is a residential walk-up garden community comprising 189 suites in eight buildings situated on 11 acres of land. On July 31, 2012, the REIT acquired Woodbine Apartments from a third party vendor for a purchase price of US$42,100. The acquisition was predominantly satisfied by an advance on the Morguard Facility. Woodbine Apartments is a three-storey residential walk-up garden community comprising 408 suites in 17 buildings situated on 19 acres of land. On September 4, 2012, the REIT completed the financing of Woodbine Apartments in the amount of US$29,470 at an interest rate of 3.78% for a term of 10 years. On August 29, 2012, the REIT acquired Blue Isle Apartments from a third party vendor for a purchase price of US$40,000 funded by an advance on the Morguard Facility. Blue Isle Apartments is a two-storey residential walk-up garden community comprising 340 suites in 23 buildings situated on 18 acres of land. On October 19, 2012, the REIT completed the financing of Blue Isle Apartments in the amount of approximately US$26,000 at an interest rate of 3.66% for a term of 10 years Annual Report 17

20 Management s Discussion AND Analysis During the third quarter of 2012, the REIT altered the Morguard Facility to allow for both borrowings or advances on the same terms. The approved limit was increased from $50,000 to $105,609 to fund the acquisitions of Woodbine Apartments and Blue Isle Apartments and subsequently reduced such that by October 31, 2012, the maximum allowable to be borrowed or advanced under the Morguard Facility is $100,000. On September 12, 2012, the REIT completed the offering of $150,732 for 12,720,000 trust units sold at a price of $11.85 per trust unit. The proceeds of the offering, after underwriters commission, were $146,703. The REIT used the net proceeds of the offering to acquire a direct interest in 12,720,000 Class A LP Units of the Partnership. The Partnership used the proceeds to repay all the amounts owing under the Morguard Facility, and the excess cash was advanced to Morguard under the same facility. Morguard acquired 4,220,000 of the trust units issued on September 12, During the three months ended December 31, 2012, Morguard acquired an additional of 355,166 trust units in an open market transaction. At December 31, 2012, Morguard owned a 57.1% effective interest in the REIT through its ownership of 4,575,166 trust units and 17,223,090 Class B LP Units. DECLARATION OF TRUST The investment guidelines of the REIT are outlined in the Declaration of Trust ( DOT ) dated March 1, 2012, and as amended on April 18, 2012, in the Amended and Restated DOT, a copy of which can be found at and is available on request to all unitholders. At the date hereof, the REIT was in compliance with all investment guidelines and operating policies stipulated in the DOT. FINANCIAL REPORTING REVIEW As the REIT is a newly formed entity and Morguard has retained control over the REIT, the IPO and the acquisition of the Initial Properties represent a common control transaction that falls outside the scope of IFRS 3, Business Combinations ( IFRS 3 ), and the REIT accounts for such transactions in a manner similar to a pooling of interests, which requires the presentation of pre-acquisition financial information. This common control transaction has been accounted for as a reorganization and recapitalization. As such the consolidated balance sheet reflects the IPO at the assumed proceeds net of offering costs, the Initial Properties and mortgages were transferred from Morguard at Morguard s book values, and the cash and various limited partnership unit liabilities were issued to Morguard as a distribution. The excess of the Morguard book values over the distribution to Morguard is reflected as a contribution by Morguard to the REIT. Deferred income tax liabilities that were recorded in the combined balance sheets of the Initial Properties at December 31, 2011, were eliminated as a result of the reorganization and recapitalization. Under IFRS, the Class B LP Units are considered financial liabilities and, as a result of this classification, their corresponding distribution amounts are considered interest expense. The REIT believes these distribution payments do not truly represent financing charges, as these amounts are payable only if the REIT declares distributions and only for the amount of any distributions declared, both of which are at the discretion of the Board of Trustees as outlined in the DOT. Therefore, these distributions are excluded from the calculation of FFO and AFFO, consistent with the treatment of distributions paid to holders of the Units. Similarly the Class B LP Units are not considered in the calculation of the interest coverage ratio or the debt coverage ratio. 18 Morguard NORTH AMERICAN residential REIT

21 Management s Discussion AND Analysis Financial and operational highlights For the years ended December Operational information Number of properties Total suites 6,376 5,439 Occupancy percentage 96.7% 98.3% Weighted average in-place rent $ 1,131 $ 1,119 Financial information For the years ended December 31 (In thousands of dollars, except per unit amounts and years) Total gross book value 1 $ 1,000,191 $ 679,867 Debt 2 $ 422,976 $ 360,605 Debt to gross book value 3 42% 53% Weighted average mortgage interest rate 4.3% 4.4% Weighted average term to maturity Interest coverage Revenue $ 78,610 $ 71,923 Net operating income $ 40,380 $ 36,446 Income before fair value changes $ 13,237 $ 19,317 Funds from operations (FFO) $ 19,747 $ 18,298 FFO per unit diluted 5 $0.64 $0.72 Adjusted funds from operations (AFFO) $ 18,803 $ 17,457 AFFO per unit diluted 5 $0.61 $0.69 Distributions per unit (annualized) 5 $0.60 $0.60 FFO payout ratio % 83.33% AFFO payout ratio % 84.51% Weighted average number of units outstanding during the year (in thousands) 5 30,949 25,473 1 Gross book value as defined in the DOT. 2 Represents outstanding principal amount of mortgages payable and Class C LP Units. 3 Calculated as indebtedness as defined in the DOT, divided by gross book value. 4 Interest coverage ratio is defined as income before interest expense, income taxes, non-recurring gains or losses, amortization and interest income over interest expense excluding interest on Class B LP Units. 5 Units are defined to include the Class B LP Units. The 25,473 units issued through the IPO have been considered outstanding through the entire operating period. Property profile The following table details the geographic distribution of the portfolio at December 31, 2012: Net Operating Income for the % of the Year ended Portfolio real Estate december 31, Number of Total (based on Properties 2012 Geographic Region Properties suites suites) (000s) (000s) Ontario Toronto 5 1, % $ 250,745 $ 10,576 Mississauga 7 2, % 401,071 19,050 Kitchener % 72,350 3,532 Alberta Edmonton % 58,000 2,805 United States Louisiana % 26,325 2,255 Florida % 94,516 2,162 Total 20 6, % $ 903,007 $ 40, Annual Report 19

22 Management s Discussion AND Analysis The REIT s property portfolio consists of 14 Canadian multi-unit residential properties comprising an aggregate of 12 high-rise, three mid-rise and 56 low-rise buildings and six U.S. multi-unit residential low-rise properties comprising an aggregate of 74 two-storey buildings and 24 three-storey buildings. The properties are primarily located in urban centres and major suburban regions in Ontario, Alberta, Louisiana and Florida. Approximately 85% of the suites of the Canadian properties are located in Toronto and Mississauga, both of which form part of the Greater Toronto Area ( GTA ). The GTA is Canada s most significant economic cluster and contains the largest concentration of people. The geographic distribution of the remaining suites in the portfolio serves to add stability to the REIT s cash flows as it reduces the REIT s vulnerability to economic fluctuations affecting any particular region. On February 19, 2013, the REIT acquired 1,032 suites in five multi-unit low-rise residential properties located in Louisiana and Florida and one multi-unit mid-rise property located in Louisiana from Morguard bringing the total number of properties owned by the REIT to 26 and the total number of suites to 7,408. As a result of these transactions, the REIT holds 15% of the portfolio (1,122 suites) in Louisiana and 19% of the portfolio (1,381 suites) in Florida. WEIGHTED AVERAGE MONTHLY RENT ( AMR ) AND OCCUPANCY BY REGION The following table details AMR, market rent and occupancy of the portfolio for the following years: Weighted Weighted Average Average Weighted Weighted Monthly Monthly Average Average Rent/Suite Rent/Suite Occupancy Occupancy at December 31, at December 31, at December 31, at December 31, Geographic Region Ontario Toronto $ 1,105 $ 1, % 97.5% Mississauga 1,294 1, % 99.7% Kitchener 1,113 1, % 99.6% Alberta Edmonton 1,270 1, % 99.5% United States Louisiana % 94.7% Florida 1,035 n/a 92.5% n/a Total $ 1,131 $ 1, % 98.3% Approximately 72% of the suites in the portfolio have rental rates that are in excess of $1,000 per month. The rental rates being achieved are an indication of the high quality and attractiveness of the portfolio to existing and potential tenants. Management believes that the attractiveness of the portfolio will assist in maintaining high occupancy rates and stable demand for the rental of suites in the portfolio. Markets remain strong, and we continue to rent without incentives. Market rents are constantly monitored and increased where appropriate with the objective of maximizing revenue while reducing overall rental rates decreases. Management continues its focus on leasing, specifically in the major urban centres and suburban regions. Rental rates are constantly monitored, and leasing incentives are implemented where appropriate with the objective of maximizing revenue while reducing overall rental rate decreases. REVIEW OF OPERATIONAL RESULTS As discussed above in the Financial Reporting Review section, the review of operational results includes discussion of financial information for the years ended December 31, 2012 and The financial information, discussion and analysis for the year ended December 31, 2012, reflect the activities of Morguard with respect to the Initial Properties for the period from January 1, 2012, to April 17, 2012, combined with the activities of the REIT for the period from April 18, 2012, to December 31, The comparative figures represent the activities of Morguard with respect to the Initial Properties. 20 Morguard NORTH AMERICAN residential REIT

23 Management s Discussion AND Analysis REVENUE FROM REAL ESTATE PROPERTIES Revenue from real estate properties totalled $78,610 for the year ended December 31, 2012, compared to $71,923 during the same period in The increase for the year ended December 31, 2012, is primarily due to the acquisition of three properties in Florida ($4,677) and an increase in rental rates in the Canadian properties due to a higher guideline increase from 0.7% in 2011 to 3.1% in 2012 ($1,210). NET OPERATING INCOME Net operating income ( NOI ) is an additional IFRS measure that is used by industry analysts, investors and management to measure operating performance of the REIT s properties. NOI represents income from real estate properties less property operating costs, utilities and realty tax expense as presented in the consolidated statement of operations. Accordingly, NOI excludes certain expenses included in the determination of net income such as trust expenses, interest expense, fair market value adjustments and other indirect operating expenses. NOI is not a recognized measure under IFRS and, accordingly, the term does not necessarily have a standardized meaning and may not be comparable to similarly titled measures presented by other publicly traded entities. The following table provides the geographic allocation of net operating income: For the years ended December 31 (In thousands of dollars) Net operating income Canadian properties Ontario $ 33,158 $ 31,604 Alberta 2,805 2,676 Total Canadian properties 35,963 34,280 Net operating income U.S. properties in U.S. dollars Louisiana US$2,277 us$2,189 Florida US$2,178 US$ Total U.S. properties in U.S. dollars US$4,455 us$2,189 Exchange amount to Canadian dollars (38) (23) Net operating income U.S. properties in Canadian dollars 4,417 2,166 Total $ 40,380 $ 36,446 Net operating income increased by $3,934, or 10.8%, during the year ended December 31, 2012, to $40,380, compared to $36,446 in The increase for the Canadian properties mainly relates to higher rental rates achieved in 2012 for the larger Canadian properties. The increase for the U.S. properties is mainly due to the acquisition of three properties in Florida during the year. Property taxes decreased for the Canadian properties as a result of a reassessment associated with prior years Annual Report 21

24 Management s Discussion AND Analysis Interest Expense For the years ended December 31 (In thousands of dollars) Interest on mortgages $ 13,516 $ 15,547 Distributions on Class C LP Units to interest component 2,635 16,151 15,547 Distributions on Class C LP Units income tax component 288 Interest on Morguard Facility 453 Interest on loans payable and other 1 2 Amortization of deferred financing costs Initial Properties 1,410 1,348 Amortization of deferred financing costs other properties 29 Amortization of cash flow hedge Interest expense before distributions on Class B LP Units 18,535 17,095 Distributions on Class B LP Units 7,261 $ 25,796 $ 17,095 Total interest expense amounted to $25,796 for the year ended December 31, 2012 (2011 $17,095). The increase in interest expense is primarily attributable to the distributions of $7,261 on Class B LP Units that were issued as part of the REIT s IPO and interest on the Morguard Facility of $453 for the year ended December 31, In obtaining debt financing on its Canadian properties, the REIT is eligible to obtain government-backed insurance through the Canada Mortgage Housing Corporation ( CMHC ), an agency of the Government of Canada that provides residential mortgage insurance that protects lenders against the risk of borrower default. The benefits of purchasing this insurance are (i) the REIT can normally obtain lower interest rates on its property financing as compared to other conventional mortgage financing alternatives and (ii) renewal risk is mitigated since the insurance is transferable and follows the mortgage for the complete amortization period, which is typically between 25 and 40 years. With insurance being transferable between approved lenders, it lowers the overall risk of the REIT not being able to refinance an asset on maturity. As at December 31, 2012, 100% of the mortgages on the Canadian properties are CMHC-insured. As part of the IPO, Morguard retained debt on four Canadian properties that is secured by a charge on the properties. Morguard remains responsible for the interest and principal payments on the Retained Debt. In consideration of the Retained Debt, Morguard received Class C LP Units on which distribution payments are made in an amount sufficient to permit Morguard to satisfy amounts payable with respect to principal and interest of the Retained Debt and the tax payment that is attributable to any distributions on the Class C LP Units. The portion of the distributions that represents the interest and tax components associated with the Retained Debt has been classified as interest expense and amounted to $2,923 for the year ended December 31, Total interest payments on the mortgages and Retained Debt amounted to $16,151 for the year ended December 31, 2012 (2011 $15,547). The weighted average interest rate on the mortgages and Retained Debt decreased to 4.3% at December 31, 2012, compared to 4.4% at December 31, The REIT entered into an unsecured revolving credit facility with Morguard (the Morguard Facility ) that provides for borrowings or advances that can be drawn or advanced either in Canadian dollars or an equivalent amount in United States dollars. During the year the approved limit of the Morguard Facility increased from $50,000 to $105,609 to fund the acquisitions of Woodbine Apartments and Blue Isle Apartments and subsequently reduced such that by October 31, 2012, the maximum allowable to be borrowed or advanced under the Morguard Facility was $100,000. The balance of the Morguard Facility was repaid on September 12, During the year ended December 31, 2012, the REIT incurred interest of $453 by drawing from the Morguard Facility. Subsequent to September 12, 2012, the REIT advanced $77,880 to Morguard and received interest income of $719 during the year ended December 31, Under IFRS the Class B LP Units are classified as financial liabilities, and the corresponding distributions paid to the unitholders are classified as interest expense under IFRS. The REIT believes these distribution payments do not represent 22 Morguard NORTH AMERICAN residential REIT

25 Management s Discussion AND Analysis financing charges as these amounts are payable only if the REIT declares distributions and only for the amount of any distributions declared, both of which are at the discretion of the Board of Trustees as outlined in the DOT. The total distributions paid and accrued to Class B LP unitholders amounted to $7,261 for the year ended December 31, These amounts have been added back in the calculation of FFO. Trust Expenses Subsequent to April 18, 2012, the REIT began incurring costs associated with its trust structure. Trust expenses consist of the following: For the year ended December 31 (In thousands of dollars) 2012 Asset management fee $ 1,390 Public company expenses 103 Professional fees 256 Trustee fees 173 Insurance 52 Others 87 Trust expenses $ 2,061 Income Before Fair Value Changes For the years ended December 31 (In thousands of dollars) Income before fair value changes $ 13,237 $ 19,317 Income before fair value changes is used by management to measure the operating results of the properties, inclusive of the impact of interest expense, amortization of capital assets and other income. This measure provides income of the properties prior to the impact of fair value gains/losses that may be significantly affected by external market conditions and also represent non-cash items. The decrease in income before fair values of $6,080 from $19,317 in 2011 to $13,237 in 2012 is predominantly attributable to the distributions of $7,261 on the Class B LP Units that were issued as part of the REIT s IPO. As discussed in the Interest Expense section, the REIT believes these distribution payments do not represent financing charges. Excluding the distributions on the Class B LP Units, the income before fair value changes would have amounted to $20,498 in 2012, which represents an increase of 6.1% from Fair Value Gain on Real Estate Properties The REIT elected to adopt the fair value model to account for its real estate properties, and changes in fair value each period have been recognized as fair value gain/loss in the consolidated statement of operations. During the year ended December 31, 2012, the REIT recognized a fair value gain of $121,756 (2011 $82,585). Fair value adjustments are determined based on the movement of various parameters on a quarterly basis, including stabilized NOI and capitalization rates. Fair Value Loss on Class B LP Units The Class B LP Units are classified as financial liabilities in accordance with IFRS standards and as a result are recorded at their fair value at each reporting date. As at December 31, 2012, the REIT used a fair value of $11.20 based on the closing price of the trust s units to determine the financial liabilities at that date. The total fair value of these units recorded on the consolidated balance sheet was $192,899, and a corresponding fair value loss of $20,668 was recorded on the consolidated statement of operations for the year ended December 31, Funds From Operations and Adjusted Funds From Operations The real estate industry has adopted a measure of FFO to supplement net income as an operating performance measurement. The REIT considers FFO to be a useful measure for reviewing its comparative operating and financial performance. FFO can assist with comparisons of the operating performance of the REIT s real estate between periods and relative to other companies in the industry Annual Report 23

26 Management s Discussion AND Analysis The following table provides a reconciliation of FFO and AFFO, non-ifrs measures, to their closely related financial statement measurement for the following years: For the years ended December 31 (In thousands of dollars, except per unit amounts) Net income for the year $ 187,779 $ 86,803 Items not affecting cash: Fair value gain on real estate properties (121,756) (82,585) Fair value loss on Class B LP Units 20,668 Distributions on Class B LP Units recorded as interest expense 1 7,261 Deferred income taxes (74,205) 14,080 Funds from operations $ 19,747 $ 18,298 Amortization of deferred financing costs assumed on Initial Properties 1,410 1,348 Maintenance capital expenditures 2 (2,557) (2,387) Amortization of cash flow hedge Adjusted funds from operations $ 18,803 $ 17,457 FFO per unit diluted 3 $0.64 $0.72 AFFO per unit diluted 3 $0.61 $0.69 Weighted average units outstanding 3 (in thousands) 30,949 25,473 1 under IFRS, the Class B LP Units are considered financial liabilities and, as a result of this classification, their corresponding distribution amounts are considered interest expense. The REIT believes these distribution payments do not truly represent financing charges as these amounts are payable only if the REIT declares distributions and only for the amount of any distributions declared, both of which are at the discretion of the Board of Trustees as outlined in the DOT. Therefore, these distributions are excluded from the calculation of FFO. 2 Based on management s estimate of $0.45 (in thousands of dollars) per suite annually multiplied by the number of residential suites owned during the period. 3 Units are defined to include the Class B LP Units. The 25,473 units issued through the IPO have been considered outstanding through the entire operating period. Property Capital Investments The REIT has a continuous capital improvement program with respect to its investment properties. The program is designed to maintain and improve the operating performance of the properties and has enhanced the value of the properties by allowing the REIT to charge higher rents or by enabling it to lower operating costs. The capital investments have also increased resident retention by ensuring that the properties retain their attractiveness to both existing and prospective tenants. In accordance with IFRS, the REIT capitalizes all capital improvement expenditures on its properties, which enhances the service potential of the property and extends the useful lives of the assets. The REIT allocates capital expenditures to maintenance capital expenditures and value-enhancing expenditures. Maintenance capital expenditures are funded from operating cash flows and are deducted from FFO in order to estimate a sustainable amount that can be distributed to unitholders (AFFO). Maintenance capital expenditures are characterized as items that are required to maintain the existing earning potential of a property, and the REIT s estimate of the annual maintenance capital expenditures is $450 per suite. Value-enhancing expenditures are characterized as expenditures that generate growth in the property s NOI either by allowing the REIT to charge higher rents or by enabling it to lower operating costs. Distributions The REIT currently pays monthly distributions to unitholders of $0.05 per Unit or $0.60 on an annual basis. The Trustees have discretion with respect to the timing and amounts of distributions. Distributions for the year ended December 31, 2012, totalled $13,285. Class A LP Class B LP For the year ended December 31, 2012 Units Units Total Distributions paid during the year $ 4,825 $ 6,400 $ 11,225 Distributions DRIP Distributions payable at December 31, , ,910 Total $ 6,024 $ 7,261 $ 13, Morguard NORTH AMERICAN residential REIT

27 Management s Discussion AND Analysis FINANCIAL STATEMENT ANALYSIS REAL ESTATE PROPERTIES As a result of the REIT electing to use the fair value model to account for its real estate properties, real estate properties are carried at their fair value at the reporting date. The following table provides the geographical allocation of the real estate properties for the following periods: For the years ended December 31 (In thousands of dollars) Canadian properties Ontario $ 724,166 $ 599,837 Alberta 58,000 51,000 Total Canadian properties 782, ,837 U.S. properties in U.S. dollars Louisiana US$26,460 us$25,670 Florida US$95,000 us$ Total U.S. properties in U.S. dollars US$121,460 us$25,670 Exchange amount to Canadian dollars (619) 437 Total U.S. properties in Canadian dollars 120,841 26,107 Total real estate properties $ 903,007 $ 676,944 Real estate properties increased by $226,063 at December 31, 2012, to $903,007 compared to $676,944 at December 31, The increase is mainly the result of the following: A fair value increase in the income producing properties of $121,756; Acquisition of real estate properties totalling $99,042; and Capitalization of property enhancements of $5,984. On July 16, 2012, the REIT acquired Village Crossing Apartments from Morguard for a purchase price of US$16,347. Village Crossing Apartments is a residential walk-up garden community comprising 189 suites in eight buildings situated on 11 acres of land located in Florida. On July 31, 2012, the REIT acquired Woodbine Apartments from a third party vendor for a purchase price of US$42,100. Woodbine Apartments is a three-storey residential walk-up garden community comprising 408 suites in 17 buildings situated on 19 acres of land located in Florida. On August 29, 2012, the REIT acquired Blue Isle Apartments from a third party vendor for a purchase price of US$40,000. Blue Isle Apartments is a two-storey residential walk-up garden community comprising 340 suites in 23 buildings situated on 18 acres of land located in Florida. Appraisal Capitalization Rates The REIT utilizes the direct capitalization income approach method. This method requires that rental income from current leases and key assumptions about rental income, vacancies and inflation rates among other factors are used to determine a one-year income forecast for each individual property within the REIT s portfolio and also considers any capital expenditures anticipated within the year. A capitalization rate was also determined for each property based on market information related to the external sale of similar properties within a similar geographic location. These factors were used to determine the fair value of investment properties at each reporting period. Using the direct capitalization income approach, the properties were valued using capitalization rates in the range of 5.0% to 8.5% applied to a stabilized net operating income (December 31, % to 8.5%), resulting in an overall weighted average capitalization rate of 5.1% (December 31, %). The average capitalization rates by geographic location are set out in the following table: 2012 Annual Report 25

28 Management s Discussion AND Analysis December 31, 2012 december 31, 2011 Weighted weighted Maximum Minimum Average Maximum Minimum Average Canada 5.0% 4.8% 4.9% 5.8% 5.5% 5.6% United States Louisiana 8.5% 8.3% 8.3% 8.5% 8.3% 8.3% Florida 6.0% 5.3% 5.8% n/a n/a n/a LIQUIDITY AND CAPITAL RESOURCES Liquidity Net cash flows from operating activities represent the primary source of liquidity to fund distributions and maintenance capital expenditures. The REIT s net cash flows from operating activities are dependent upon the occupancy level of its rental properties, rental rates on its leases, collectibility of rent from its tenants, level of operating expenses and other factors. Material changes in these factors may adversely affect the REIT s cash flows from operating activities and liquidity. A more detailed discussion of these risks is found in the Risks and Uncertainties section. The REIT expects to be able to meet all of its obligations, including distributions to unitholders, maintenance and property capital expenditure commitments as they become due and to provide for the future growth of the business. The REIT expects to have sufficient liquidity as a result of cash flows from operating activities and financing available through the credit facility with Morguard. Accordingly, the REIT does not intend to repay maturing debt from cash flow but rather with proceeds from refinancing such debt, subject to certain conditions as outlined in the Capital Structure and Debt Profile sections. Cash Flows The following table details the changes in cash for the following periods: For the years ended December 31 (In thousands of dollars) Cash provided by operating activities $ 4,113 $ 21,125 Cash used in investing activities (172,776) (8,113) Cash provided by (used in) financing activities 172,799 (13,039) Net increase (decrease) in cash 4,136 (27) Net effect of foreign currency translation on cash (224) 12 Cash, beginning of year Cash, end of year $ 4,822 $ 910 Cash Provided by Operating Activities Cash flows from operating activities during the year ended December 31, 2012, was $4,113, compared to $21,125 in The change in 2012 relates to an increase in interest expense of $8,701 mainly relating to the distribution of Class B LP Units, trust expenses of $2,061 and an increase in working capital of $11,596, which primarily represents the deposit for an acquisition expected to close during the first quarter of 2013, offset by the increase in net operating income of $3,934 mainly due to the acquisition of three new properties in Florida and higher rental rates for the Canadian properties. Cash Used in Investing Activities Cash used in investing activities during the year ended December 31, 2012, totalled $172,776, compared to cash used in investing activities of $8,113 in The cash was used to purchase Morguard s interest in the Initial Properties ($67,750), to acquire three new properties in Florida ($99,042) and capitalization of property enhancements of $5,984 to real estate properties. Cash Provided by Financing Activities Cash flow from financing activities during the year ended December 31, 2012, provided cash of $172,799, compared to $13,039 of cash used in financing activities in The change in 2012 was largely due to the net proceeds received from the issue of Units of $218,636 and net proceeds of new mortgages of $66,382 offset by a change in the Morguard Facility of $102,880. During 2012 the properties were supported by a cash injection from the predecessor entity of $7, Morguard NORTH AMERICAN residential REIT

29 Management s Discussion AND Analysis CAPITAL STRUCTURE AND DEBT PROFILE The REIT defines its capital as the aggregate of unitholders equity and indebtedness. The REIT s capital management is designed to maintain a level of capital that allows it to implement its business strategy while complying with investment and debt restrictions pursuant to the DOT, as well as existing debt covenants, while continuing to build long-term unitholder value and maintaining sufficient capital contingencies. As at December 31, 2012, the total capital of the REIT was as follows: December 31, As at 2012 Indebtedness Mortgages payable $ 313,930 Class C LP Units 103,482 Total indebtedness 417,412 Class B LP Units 192,899 Unitholders equity 375,392 Total capitalization $ 985,703 Debt Profile As at December 31, 2012, the overall leverage, as represented by the ratio of total debt to gross book value, defined as acquisition cost of the REIT s assets plus (i) fair value adjustments and (ii) accumulated amortization on property, plant, and equipment was 42%. The maximum allowable ratio under the DOT is 70%. The following table summarizes the key liquidity metrics: For the years ended December Debt to gross book value 42% 53% Weighted average interest rate on mortgages and retained debt 4.3% 4.4% Weighted average term to maturity on mortgages and retained debt Interest coverage ratio Debt coverage ratio The interest coverage ratio and the indebtedness coverage ratio are calculated based on obligations associated with mortgages payable, Class C LP Units only and the Morguard Facility. Mortgage and Retained Debt Repayment Schedule The following table reflects principal repayment schedule for the mortgages and the Class C LP Units. weighted Principal average As at December 21, 2012 Installment balance Contractual (In thousands of dollars) repayments Maturing Total rate 2013 $ 10,984 $ 85,299 $ 96, % ,887 94, , % ,423 17,191 23, % ,156 10,634 15, % ,828 17,955 22, % Thereafter 154, % $ 416, % Deferred direct financing costs (5,564) Present value of tax payment on Class C LP Units 6,897 Mortgage and retained debt payable $ 417, Annual Report 27

30 Management s Discussion AND Analysis As part of the acquisition of the Initial Properties, Morguard retained the mortgages on four of the Initial Properties ( Retained Debt ) and the deferred financing costs associated with the Retained Debt. In consideration of the Retained Debt, Morguard received Class C LP Units of the Partnership on which distribution payments will be made in an amount expected to be sufficient to permit Morguard to satisfy amounts payable with respect to (i) principal and interest under the Retained Debt and (ii) the amount of tax that is due and payable that is reasonably attributable to any distributions on the Class C LP Units. The present value of the tax payment has been estimated to amount to $6,897 on December 31, 2012, and has been included in the carrying value of the Class C LP Units. At December 31, 2012, the principal balance on the mortgages payable and the Retained Debt totalled $416,079 (December 31, 2011 $360,605). The deferred financing costs associated with the mortgages and the Retained Debt amounted to $5,564, at December 31, 2012 (December 31, 2011 $5,976). The increase in mortgages payable and Retained Debt of $62,783 is mainly due to the following: On July 16, 2012, the REIT completed the financing of Village Crossing Apartments in the amount of $11,433 (US$11,400) at an interest rate of 3.96% for a term of 10 years. On September 4, 2012, the REIT completed the financing of Woodbine Apartments in the amount of $28,975 (US$29,470) at an interest rate of 3.78% for a term of 10 years. On October 19, 2012, the REIT completed the financing of Blue Isle Apartments in the amount of $25,974 (US$26,000) at an interest rate of 3.66% for a term of 10 years. Deferred financing costs associated with the new loans totalled $981 (US$986). The REIT s first mortgages are registered against specific real estate assets. The mortgages and Retained Debt bear interest at rates ranging between 3.7% and 6.0% per annum with a weighted average interest rate of 4.3% (December 31, %) and mature between 2013 and 2022 with a weighted average term to maturity of 4.7 years. Short-term fluctuations in working capital are funded through the Morguard Facility. The REIT anticipates meeting all future obligations and has no off-balance sheet financing arrangements. Significant changes in financial condition are reviewed below. Floating rate mortgages in the amount of $64,163 as at December 31, 2012 (December 31, 2011 $66,053) are subject to interest rate swap agreements to acquire a fixed interest rate over the floating rate in order to mitigate the REIT s interest rate risk. Mortgage and Retained Debt Maturity Schedule The following table details the REIT s mortgages and Retained Debt that are scheduled to mature in the next two years weighted weighted average average Number of Principal Interest Number of Principal Interest Asset Type Properties Maturing Rate Properties Maturing Rate Canada multi-unit residential 3 $ 85, % 4 $ 94, % 3 $ 85, % 4 $ 94, % Morguard Facility The REIT entered into an unsecured revolving credit facility with Morguard (the Morguard Facility ) that provides for borrowings or advances that can be drawn or advanced either in Canadian dollars or an equivalent amount in United States dollars. If in Canadian dollars, interest will be calculated either at the Canadian prime lending rate or at the bankers acceptance ( BA ) rate plus 1.8%. If the borrowing or advance is in United States dollars, interest will be calculated either at the U.S. prime lending rate or at the United States dollar London Interbank Offered Rate ( LIBOR ) plus 1.7%. 28 Morguard NORTH AMERICAN residential REIT

31 Management s Discussion AND Analysis During the third quarter of 2012, the approved limit of the Morguard Facility increased from $50,000 to $105,609 to fund the acquisitions of Woodbine Apartments and Blue Isle Apartments and subsequently reduced such that by October 31, 2012, the maximum allowable to be borrowed or advanced under the Morguard Facility was $100,000. The balance of the Morguard Facility was repaid on September 12, During the year ended December 31, 2012, the REIT incurred interest of $453. Subsequent to September 12, 2012, the REIT advanced $77,880 to Morguard and received interest income of $719 during the year ended December 31, Unitholders Equity The REIT is authorized to issue an unlimited number of Units and has one class of publicly traded voting securities known as REIT Units. On April 18, 2012, the REIT completed its IPO and issued 8,250,000 REIT Units. In addition, there were 17,223,090 special voting units issued to holders of Class B LP Units of CAN LP, each of which also has a special voting unit in the REIT. Each Class B LP Unit is exchangeable for a REIT Unit on a one-for-one basis at the option of the holder. Each Class B LP Unit through the special voting unit entitles the holder to one vote at any meeting of unitholders. Under IFRS the Class B LP Units are classified as fair value through profit and loss financial liabilities and are recorded at their fair value as liabilities on the consolidated balance sheet, and the distributions paid on the Class B LP Units are accounted for as interest expense on the consolidated statement of operation. On September 12, 2012, the REIT completed an offering of $150,732 for 12,720,000 Units sold at a price of $11.85 per Unit. Morguard acquired 4,220,000 of the Units issued. As at December 31, 2012, there were 20,982,963 Units issued and outstanding and 17,223,090 exchangeable Class B LP Units. Accordingly, if all of the Class B LP Units were exchanged for Units, the total issued and outstanding Units would be 38,206,053. The REIT has an equity market capitalization of approximately $235,009 based on the REIT Unit closing price of $11.20 on the Toronto Stock Exchange on December 31, The following table summarizes the changes in Units for the period from April 18, 2012, to December 31, 2012: Issued and fully paid units (in thousands) units amount Balance, April 18, ,250,000 $ 72,883 Additional issuance of Units, net of cost of $4,979 12,720, ,753 Distribution reinvestment plan 12, Balance, December 31, ,982,963 $ 218,786 Related Party Transactions Agreements with Morguard Affiliates On completion of the IPO on April 18, 2012, the REIT, the Partnership and its subsidiaries and certain Morguard affiliates entered into a series of agreements ( Agreements ) whereby the following services are provided by Morguard s affiliates under the direction of the REIT: Property Management Services Pursuant to the Agreements, Morguard s affiliates administer the day-to-day operations of the Canadian and U.S. real estate properties, for which Morguard s affiliates receive partnership distributions equal to 3.5% of gross property revenue of the real estate properties, payable monthly. Distributions amounting to $1,990 for the year ended December 31, 2012, are included in property operating costs. Of this amount, $203 is included in accounts payable and accrued liabilities Annual Report 29

32 Management s Discussion AND Analysis Asset Management Services Pursuant to the Agreements, Morguard s affiliates have certain duties and responsibilities for the strategic management and administration of the Partnership and its subsidiaries, for which they receive partnership distributions equal to 0.25% of the Partnership s gross book value defined as acquisition cost of the REIT s assets plus (i) fair value adjustments and (ii) accumulated amortization on property, plant and equipment. Distributions amounting to $1,390 for the year ended December 31, 2012, are included in trust expenses. Of this amount, $163 is included in accounts payable and accrued liabilities. In addition, an annual distribution is calculated in arrears, based on funds from operations exceeding a predetermined threshold of $0.66 per unit. For the year ended December 31, 2012, $nil was payable with respect to the annual distribution. Acquisition Services Pursuant to the Agreements, Morguard s affiliates are entitled to receive partnership distributions with respect to properties acquired, directly or indirectly, by the REIT from third parties, and the fees are to be paid upon the closing of the purchase of each such property. The fees range from 0% of the purchase price paid for properties acquired directly or indirectly from Morguard, including entities controlled by Morguard, up to 0.75% of the purchase price paid for properties acquired from third parties. Distributions amounting to $610 for the year ended December 31, 2012, have been capitalized to real estate properties and are included in accounts payable and accrued liabilities as of December 31, Financing Services Pursuant to the Agreements, with respect to arranging for financing services, Morguard s affiliates are entitled to receive partnership distributions equal to 0.15% of the principal amount and associated costs of any debt financing or refinancing. Distributions amounting to $84 for the year ended December 31, 2012, have been capitalized to deferred financing costs and are included in accounts payable and accrued liabilities as of December 31, All agreements have an initial term of 10 years and are renewable for further terms of five years each, subject to certain notice provisions or upon the occurrence of an event of default as stipulated in the provisions of the Agreements. Head Lease with Morguard On completion of the Offering, the REIT entered into a head lease (the Head Lease ) with Morguard, as head tenant, with respect to 90 furnished suites at 3665 Arista Way, Mississauga, Ontario (the Arista ). The Head Lease will terminate upon the earlier of (i) the date on which the Arista ceases to be owned by the REIT or (ii) 30 days following the date on which the REIT notifies Morguard in writing that it intends to terminate the Head Lease. Under the Head Lease, Morguard will pay the REIT rent in an amount equal to 85% of gross revenue allocable to the 90 suites subject to the Head Lease, payable quarterly in advance, subject to adjustment at year end based on the actual rent received on such suites. The payment under the Head Lease for the year ended December 31, 2012, amounted to $1,178. SUMMARY OF QUARTERLY RESULTS The following table provides a summary of operating results for the last eight quarters in accordance with IFRS. (In thousands of dollars, Total Net Per Unit except per unit amounts) revenue Income Basic 1 December 31, 2012 $ 21,545 $ 53,039 $1.39 September 30, ,316 37, June 30, ,517 91, March 31, ,232 5, December 31, ,306 54, September 30, ,160 4, June 30, ,748 5, March 31, ,709 21, Units are defined to include the Class B LP Units. The 25,473 units issued through the IPO have been considered outstanding through the entire operating period. 30 Morguard NORTH AMERICAN residential REIT

33 Management s Discussion AND Analysis SIGNIFICANT ACCOUNTING POLICIES A summary of the significant accounting policies is included in Note 2 to the audited consolidated financial statements. The preparation of the financial statements in conformity with IFRS requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and contingent assets and liabilities at each financial statement date and of revenue and expenses for the periods indicated. Actual results could differ from those estimates. Critical Accounting Policies and Estimates The REIT s critical accounting policies are those that management believes are the most important in portraying the REIT s financial condition and results and that require the most subjective judgment and estimates on the part of management. Real Estate Properties Real estate properties are recorded at fair value, determined based on available market evidence, at the balance sheet date. The critical assumptions and estimates used when determining the fair value of real estate properties are the amount of rental income from future leases reflecting current market conditions adjusted for assumption of future cash flows with respect to current and future leases, capitalization rates and expected occupancy rates. The properties are appraised using the direct capitalization income method and judgment is applied in determining the extent and frequency of independent appraisals. To assist with the evaluation of fair value, the REIT has its Canadian properties appraised by Morguard s appraisal division and has its U.S. portfolio appraised by an independent national U.S. real estate appraisal firm. Morguard s appraisal division is staffed with six accredited members of the Appraisal Institute of Canada, who collectively in 2012 valued over $12 billion of real estate properties in Canada for institutional and corporate clients. Fair Value of Financial Instruments Management reports on a quarterly basis the fair value of financial instruments. The fair value of financial instruments approximates amounts at which these instruments could be exchanged between knowledgeable and willing parties. The estimated fair value may differ in amount from that which could be realized on an immediate settlement of the instruments. Management estimates the fair value of mortgages payable by discounting the cash flows of these financial obligations using December 31, 2012, market rates for debts of similar terms. RISKS AND UNCERTAINTIES All real estate properties are subject to a degree of risk and uncertainty. Income from real estate assets is affected by various factors, including general economic conditions and local market circumstances. Local business conditions such as oversupply of space or a reduction in demand particularly affect income property investments. The following are business risks the REIT expects to face in the normal course of its operations and management s strategy to reduce the potential impact. Operating Risk Real estate has a high fixed cost associated with ownership, and income lost due to vacancies cannot easily be minimized through cost reduction. Tenant retention and leasing vacant suites are critical to maintaining occupancy levels. Through well-located and professionally managed properties, management seeks to increase tenant loyalty and become the landlord of choice. For the year ended December 31, 2012, the portfolio diversification as a percentage of net operating income is as follows: BY REGION Ontario 82% Alberta 7% Louisiana 6% Florida 5% BY LOCATION Canada 89% U.S. 11% 2012 Annual Report 31

34 Management s Discussion AND Analysis Financing Risk The REIT is subject to the risks associated with debt financing, including the risk that mortgages and credit facilities secured by the REIT s properties will not be able to be refinanced or that the terms of such refinancing will not be as favourable as the terms of existing indebtedness. To minimize this risk, the REIT has structured its debt maturities over a number of years and has negotiated fixed interest rates on all of its mortgages payable, with the exception of two mortgages with a floating rate. To mitigate the interest rate risk on the refinancing of these mortgages, the REIT assumed from Morguard interest rate swap transactions on two properties to acquire a fixed rate over the floating rate. United States Financing Renewal Risk Condition of Fannie Mae or Freddie Mac In the future, the REIT will seek to manage its financing risk with respect to its U.S. properties by maintaining a balanced maturity profile with no significant amounts coming due in any particular period. Management believes that the use of Fannie Mae or Freddie Mac insured mortgages will assist the REIT in managing its renewal risk. Given the increased credit quality of such debt, the probability of the REIT being unable to renew the maturing debt or transfer this debt to another accredited lending institution is significantly reduced. However, there can be no assurance that the renewal of debt will be on as favourable terms as the REIT s existing debt. The ongoing financial and real estate market disruptions that began in 2007 could adversely affect the multi-unit residential property sector s ability to obtain financing from Freddie Mac and Fannie Mae, which could materially adversely affect the REIT s U.S. operations. Fannie Mae and Freddie Mac are major sources of financing for the U.S. multi-unit residential sector, and both Freddie Mac and Fannie Mae have experienced significant losses during the last three years due to credit-related expenses, securities impairments and fair value losses. If new U.S. government regulations (i) heighten the underwriting standards of Freddie Mac or Fannie Mae, (ii) adversely affect interest rates or (iii) reduce the amount of capital that either Freddie Mac or Fannie Mae can make available to the multi-unit residential sector, such regulations could reduce or remove entirely a vital resource of multi-unit residential financing. Any potential reduction in loans, guarantees and credit enhancement arrangements from Freddie Mac or Fannie Mae could limit the availability of financing, increase the cost of financing or otherwise decrease the amount of liquidity and credit available to the multi-unit residential sector generally and the REIT specifically. On September 7, 2008, the Federal Housing Finance Agency, or the FHFA, placed Fannie Mae and Freddie Mac into conservatorship and, together with the U.S. Treasury, established a program designed to boost investor confidence in Fannie Mae s and Freddie Mac s debt and mortgage-related securities. Although the U.S. Treasury has committed capital to Fannie Mae and Freddie Mac, there can be no assurance that these actions will be adequate for their needs. If these actions are inadequate, Fannie Mae and Freddie Mac could continue to suffer losses and could fail to honour their guarantees and other obligations. The future roles of Fannie Mae and Freddie Mac could be significantly reduced, and the nature of their guarantees could be considerably limited relative to historical measurements. Any changes to the nature of the guarantees provided by Fannie Mae and Freddie Mac could redefine what constitutes a U.S. government agency mortgage-backed security and could have broad adverse market implications. Such market implications could negatively affect the performance and market value of the REIT s U.S. portfolio. Credit Risk The REIT s primary business is the ownership and operation of multi-unit residential properties. The income stream, generated by tenants paying rent, can be affected by general and local economic conditions and by a change in the credit and financial stability of tenants. Examples of other local conditions that could adversely affect income include oversupply of space or reduced demand for rental space, the attractiveness of the REIT s properties compared to other residential properties and fluctuation in real estate taxes, insurance and other operating costs. The REIT may be adversely affected if tenants become unable to meet their financial obligations under their leases. Environmental Risk As an owner and manager of real property, the REIT is subject to various laws relating to environmental matters. These laws impose liability for the cost of removal and remediation of certain hazardous materials released or deposited on properties owned or managed by the REIT or on adjacent properties. As a result, Phase 1 assessments are completed prior to the acquisition of any property. Once the property is acquired, environmental assessment programs ensure continued compliance with all laws and regulations governing environmental and related matters. The REIT s management is responsible for 32 Morguard NORTH AMERICAN residential REIT

35 Management s Discussion AND Analysis ensuring compliance with environmental legislation and is required to report quarterly to the REIT s Trustees. The REIT has certain properties that contain hazardous substances, and management has concluded that the necessary remediation costs will not have a material impact on its operations. The REIT has obtained environmental insurance on certain assets to further manage risk. Foreign Exchange Risk A portion of the REIT s real estate properties are located in the United States. As a result, the REIT is exposed to foreign currency exchange rate risk with respect to future cash flows derived from the properties located in the U.S. The REIT s exposure to exchange rate risk could increase if the proportion of income from properties located in the United States increases as a result of future property acquisitions in the United States. The REIT mitigates its foreign currency exposure by offsetting certain revenues earned in United States dollars from its U.S. properties against expenses and liabilities undertaken by the REIT in United States dollars. At December 31, 2012, the Canadian dollar value was US$ compared to US$ a year earlier. The average exchange rate for the year ended December 31, 2012, was US$ compared to US$ in The strengthening of the Canadian dollar during 2012 resulted in an unrealized foreign currency translation loss of approximately $440 for the year ended December 31, 2012, recognized in other comprehensive income. Risk of Natural Disasters While the REIT has insurance to cover a substantial portion of the cost of events such as natural disasters, the insurance includes deductible amounts, and certain items may not be covered by insurance. The REIT s operations and properties may be significantly affected by future natural disasters. Future natural disasters may cause the REIT to lose rent and incur additional storm cleanup costs. Any of these events might have a materially adverse impact on the REIT s results of operations and financial condition. Risk of Loss Not Covered by Insurance The REIT generally maintains insurance policies related to its business, including casualty, general liability and other policies covering the REIT s business operations and assets; however, the REIT would be required to bear all losses that are not adequately covered by insurance, as well as any insurance deductibles. In the event of a substantial property loss, the insurance coverage may not be sufficient to pay the full current market value or current replacement cost of the property. In the event of an uninsured loss, the REIT could lose some or all of its capital investment, cash flow and anticipated profits related to one or more properties. Although the REIT believes that its insurance programs are adequate, assurance cannot be provided that the REIT will not incur losses in excess of insurance coverage or that insurance can be obtained in the future at acceptable levels and reasonable cost. Risk Related to Insurance Renewals Certain events could make it more difficult and expensive to obtain property and casualty insurance, including coverage for terrorism. When the REIT s current insurance policies expire, the REIT may encounter difficulty in obtaining or renewing property or casualty insurance on its properties at the same levels of coverage and under similar terms. Such insurance may be more limited and, for catastrophic risks (e.g., earthquake, hurricane, flood and terrorism), may not be generally available to fully cover potential losses. Even if the REIT is able to renew its policies at levels and with limitations consistent with its current policies, the REIT cannot be sure that it will be able to obtain such insurance at premium rates that are commercially reasonable. If the REIT were unable to obtain adequate insurance on its properties for certain risks, it could cause the REIT to be in default under specific covenants on certain of its indebtedness or other contractual commitments it has that require the REIT to maintain adequate insurance on its properties to protect against the risk of loss. If this were to occur or if the REIT were unable to obtain adequate insurance and its properties experienced damages that would otherwise have been covered by insurance, it could adversely affect the REIT s financial condition and the operations of its properties. Risk Related to Government Regulations Certain provinces and territories of Canada have enacted residential tenancy legislation that, among other things, imposes rent control guidelines that limit the REIT s ability to raise rental rates at its properties. Limits on the REIT s ability to raise rental rates at its properties may materially adversely affect the REIT s ability to increase income from its properties Annual Report 33

36 Management s Discussion AND Analysis In addition to limiting the REIT s ability to raise rental rates, provincial and territorial residential tenancy legislation provides certain rights to tenants, while imposing obligations upon the landlord. Residential tenancy legislation in the provinces of Alberta and Ontario prescribes certain procedures that must be followed by a landlord in order to terminate a residential tenancy. As certain proceedings may need to be brought before the respective administrative body governing residential tenancies as appointed under a province s residential tenancy legislation, it may take several months to terminate a residential lease, even where the tenant s rent is in arrears. Under Ontario s rent control legislation, a landlord is entitled to increase the rent for existing tenants once every 12 months by no more than the guideline amount established by regulation. For the calendar year 2012, the guideline amount was established at 3.1% (0.7% for 2011). This adjustment is meant to take into account the income of the building and the municipal and school taxes, the insurance bills, the energy costs, maintenance and service costs. Landlords may apply to the Ontario Rental Housing Tribunal for an increase above the guideline amounts if annual costs for heat, hydro, water or municipal taxes have increased significantly or if building security, maintenance and service costs have increased. When a suite is vacated, however, the landlord is entitled to lease the suite to a new tenant at any rental amount, after which annual increases are limited to the applicable guideline amount. The landlord may also be entitled to a greater increase in rent for a suite under certain circumstances, including, for example, where extra expenses have been incurred as a result of a renovation of that suite. Further, residential tenancy legislation in certain provinces and territories provides the tenant with the right to bring certain claims to the respective administrative body seeking an order to, among other things, compel the landlord to comply with health, safety, housing and maintenance standards. As a result, the REIT may, in the future, incur capital expenditures that may not be fully recoverable from tenants. The inability to fully recover substantial capital expenditures from tenants may have a material adverse effect on the REIT s business, cash flows, financial condition and results of operations and ability to make distributions to holders of Units. Residential tenancy legislation may be subject to further regulations or may be amended, repealed or enforced, or new legislation may be enacted, in a manner that will materially adversely affect the ability of the REIT to maintain the historical level of earnings of its properties. Relative Liquidity of Real Estate Real estate is not considered to be a liquid investment as it requires a reasonable sales period and normal market conditions to generate multiple bids to complete the sales process. The characteristics of the property being sold and general and local economic conditions can affect the time required to complete the sales process. Significant competition exists that may decrease the rental rates and occupancy rates of the REIT s properties. The REIT competes with many other real estate entities, and some of these entities develop their own properties that compete for tenants. New multi-unit residential properties with more convenient locations or lower rental rates may cause tenants to leave the REIT s properties or may give cause for tenants to renew their leases on terms less favourable to the REIT. Competition The multi-unit residential real estate sector is highly competitive. The REIT faces competition from many sources, including other multi-unit residential buildings in the immediate vicinity of the various Initial Properties and the broader geographic areas where the REIT s residential properties are and will be located. In addition, overbuilding in the multi-unit residential sector, particularly in the United States, may increase the supply of multi-unit residential properties, further increasing the level of competition in certain markets. Such competition may reduce occupancy rates and rental revenues of the REIT and could have a material adverse effect on the REIT s business, cash flows, financial condition and results of operations and ability to make distributions to holders of Units. Furthermore, the multi-unit residential properties that the REIT owns or may acquire compete with numerous housing alternatives in attracting tenants, including owner-occupied single and multi-family homes available to rent or purchase. The relative demand for such alternatives may be increased by declining mortgage interest rates, government programs that promote home ownership or other events or initiatives that increase the affordability of such alternatives to multi-unit residential rental properties and could materially adversely affect the REIT s ability to retain tenants, lease suites and 34 Morguard NORTH AMERICAN residential REIT

37 Management s Discussion AND Analysis increase or maintain rental rates. Such competition may reduce occupancy rates and rental revenues of the REIT and could have a material adverse effect on the REIT s business, cash flows, financial condition and results of operations and ability to make distributions to holders of Units. The competition for multi-unit residential properties available for sale may significantly increase the cost of acquiring such assets and may result in such assets being acquired by the REIT at prices, or on terms, that are comparatively less favourable to the REIT or may result in such assets being acquired by competitors of the REIT. In addition, the number of entities seeking to acquire multi-unit residential properties and/or the amount of funds competing for such acquisitions may increase. In addition, single-property acquisitions from tax motivated individual sellers may be available for sale only at a higher cost to the REIT relative to portfolio acquisitions. Increases in the cost to the REIT of acquiring multi-unit residential properties may materially adversely affect the ability of the REIT to acquire such properties on favourable terms and may otherwise have a material adverse effect on the REIT s business, cash flows, financial condition and results of operations and ability to make distributions to holders of Units. Dependence on the Partnership The REIT is an unincorporated, open-ended real estate investment trust that will be entirely dependent on the operations and assets of the Partnership through the REIT s ownership of a 54.9% limited partnership interest in the Partnership. Cash distributions to holders of Units will be dependent on, among other things, the ability of the Partnership to make cash distributions with respect to the Class A LP Units. See Plan of Distribution. The Partnership and its subsidiaries are separate and distinct legal entities. The ability of the Partnership to make cash distributions or other payments or advances will depend on the Partnership s results of operations and may be restricted by, among other things, applicable corporate, tax and other laws and regulations and contractual restrictions contained in the instruments governing any indebtedness of the Partnership (including the Retained Debt), any priority distributions contained in the Limited Partnership Agreement and other agreements governing the Partnership and restrictions contained in the agreements governing the arrangement with the co-owners of certain properties. Acquisitions The REIT s strategy includes growth through identifying suitable acquisition opportunities, pursuing such opportunities, consummating acquisitions and effectively operating and leasing such properties. If the REIT is unable to manage its growth effectively, it could have a material adverse effect on the REIT s business, cash flows, financial condition and results of operations and ability to make distributions to holders of Units. There can be no assurance as to the pace of growth through property acquisitions or that the REIT will be able to acquire assets on an accretive basis, and, as such, there can be no assurance that distributions to holders of Units will increase in the future. The REIT will rely on Morguard s expertise in identifying acquisition opportunities, underwriting potential transactions, transaction execution and asset management capabilities. Morguard also provides similar services to its other clients and will concurrently present acquisition opportunities to the REIT and to its other clients. The provision by Morguard of similar services to its other clients may increase the cost of acquiring properties that are of interest to the REIT, increase competition for those acquisitions generally or inhibit their acquisition altogether. Taxation Matters Legislation relating to the federal income taxation of a specified investment flow-through ( SIFT ) trust or partnership was enacted on June 22, 2007 (the SIFT Rules ). A SIFT includes a publicly listed or traded partnership or trust such as an income trust. Under the SIFT Rules, certain distributions attributable to a SIFT will not be deductible in computing the SIFT s taxable income and the SIFT will be subject to tax on such distributions at a rate that is substantially equivalent to the general tax rate applicable to Canadian corporations. However, distributions paid by a SIFT as returns of capital should generally not be subject to the tax. Under the SIFT rules, the new taxation regime will not apply to a trust that meets prescribed conditions relating to the nature of its income and investments ( the REIT Exception ). The REIT intends to comply with the requirements under the Tax Act at all relevant times such that it maintains its status as a unit trust and a mutual fund trust for purposes of the Tax Act. Under current law, a trust may lose its status under the Tax Act as a mutual fund trust if it can reasonably be considered that the trust was established or is maintained primarily for the benefit of non-residents, except in limited circumstances. Accordingly, non-residents may not be the beneficial 2012 Annual Report 35

38 Management s Discussion AND Analysis owners of more than 49% of the Units (determined on a basic or a fully diluted basis). The Trustees will also have various powers that can be used for the purpose of monitoring and controlling the extent of non-resident ownership of the Units. See Description of Trust Units and Declaration of Trust Limitation on Non-Resident Ownership. The restrictions on the issuance of Units by the REIT to non-residents may negatively affect the REIT s ability to raise financing for future acquisitions or operations. In addition, the non-resident ownership restrictions could negatively impact the liquidity of the Units and the market price at which Units can be sold. There can be no assurance that Canadian federal income tax laws and the administrative policies and assessing practices of the Canada Revenue Agency ( CRA ) respecting mutual fund trusts will not be changed in a manner that adversely affects unitholders. Although, as of the date hereof, management believes that the REIT will be able to meet the requirements of the REIT Exception throughout 2013 and beyond, there can be no assurance that the REIT will be able to qualify for the REIT Exception such that the REIT and the unitholders will not be subject to the SIFT Rules in 2013 or in future years. In the event that the SIFT Rules apply to the REIT, the impact to unitholders will depend on the status of the holder and, in part, on the amount of income distributed, which would not be deductible by the REIT in computing its income in a particular year, and what portions of the REIT s distributions constitute non-portfolio earnings, other income and returns of capital. The likely effect of the SIFT Rules on the market for Units, and on the REIT s ability to finance future acquisitions through the issue of Units or other securities, is unclear. If the SIFT Rules apply to the REIT, they may adversely affect the marketability of the Units, the amount of cash available for distributions and the after-tax return to investors. The Tax Act may impose additional withholding or other taxes on distributions made by the REIT to unitholders who are non-residents. These taxes and any reduction thereof under a tax treaty between Canada and another country may change from time to time. Prospective purchasers who are non-residents should consult their own tax advisers. The CRA has expressed a view that, in certain circumstances, the deductibility of interest on money borrowed to invest in an income trust (including a real estate investment trust such as the REIT) may be reduced on a pro rata basis with respect to distributions from the income trust that are a return of capital and that are not reinvested for an income earning purpose. If the CRA s view were to apply to a unitholder who borrowed money to invest in Units of the REIT, part of the interest payable by such unitholder in connection with money borrowed to acquire such Units could be non-deductible. Litigation Risks In the normal course of the REIT s operations, whether directly or indirectly, it may become involved in, named as a party to or the subject of various legal proceedings, including regulatory proceedings, tax proceedings and legal actions relating to personal injuries, property damage, property taxes, land rights, the environment and contract disputes. The outcome with respect to outstanding, pending or future proceedings cannot be predicted with certainty and may be determined in a manner adverse to the REIT and, as a result, could have a material adverse effect on the REIT s assets, liabilities, business, financial condition and results of operations. Even if the REIT prevails in any such legal proceeding, the proceedings could be costly and time-consuming and may divert the attention of management and key personnel from the REIT s business operations, which could have a material adverse effect on the REIT s business, cash flows, financial condition and results of operations and ability to make distributions to holders of Units. Internal Controls Effective internal controls are necessary for the REIT to provide reliable financial reports and to help prevent fraud. Although the REIT will undertake a number of procedures and Morguard GP, the U.S. Manager and Morguard will implement a number of safeguards, in each case, in order to help ensure the reliability of their respective financial reports, including those imposed on the REIT under Canadian securities law, the REIT cannot be certain that such measures will ensure that the REIT will maintain adequate control over financial processes and reporting. Failure to implement required new or improved controls, or difficulties encountered in their implementation, could harm the REIT s results of operations or cause it to fail to meet its reporting obligations. If the REIT or its auditors discover a material weakness, the disclosure of that fact, even if quickly remedied, could reduce the market s confidence in the REIT s consolidated financial statements and materially adversely affect the trading price of the Units. 36 Morguard NORTH AMERICAN residential REIT

39 Management s Discussion AND Analysis Potential Conflicts of Interest with Trustees The Trustees will from time to time in their individual capacities deal with parties with whom the REIT may be dealing, or may be seeking investments similar to those desired by the REIT. The interests of these individuals could conflict with those of the REIT. The Declaration of the Trust contains conflict of interest provisions requiring the Trustees to disclose their interests in certain contracts and transactions and to refrain from voting on those matters. In addition, certain decisions regarding matters that may give rise to a conflict of interest must be made by a majority of Independent Trustees only. Conflicts may also exist due to the fact that certain Trustees of the REIT will be affiliated with Morguard and will be nominated by Morguard. Potential Conflicts of Interest with Morguard Morguard s continuing businesses may lead to conflicts of interest between Morguard and the REIT. The REIT may not be able to resolve any such conflicts, and, even if it does, the resolution may be less favourable to the REIT than if it were dealing with a party that was not a holder of a significant interest in the REIT. The agreements that the REIT entered into with Morguard may be amended upon agreement between the parties, subject to applicable law and approval of the Independent Trustees. Because of Morguard s significant holdings in the REIT, the REIT may not have the leverage to negotiate any required amendments to these agreements on terms as favourable to the REIT as those the REIT could secure with a party that was not a significant holders of Units. Future Accounting Policy Changes Each of the standards below is effective for annual periods beginning on or after January 1, 2013, with the exception of IFRS 9, which requires adoption effective January 1, 2015, and the amended version of IAS 1, which is effective for annual periods beginning on or after July 1, Earlier adoption is permitted for each standard. Consolidated Financial Statements ( IFRS 10 ) IFRS 10, Consolidated Financial Statements, will replace IAS 27, Consolidated and Separate Financial Statements, and SIC-12, Consolidation Special Purpose Entities, and provides a single model for consolidation based on a revised definition of control that states that an entity has control over another entity if it has the ability to direct the activities of that entity, even if the investor holds less than 50% of the voting rights of the investee. The REIT does not expect that this standard will result in a material impact to the consolidated financial statements. Joint Arrangements ( IFRS 11 ) IFRS 11, Joint Arrangements, will replace IAS 31, Interests in Joint Ventures. IFRS 11 requires that reporting issuers consider whether a joint arrangement is structured through a separate vehicle, as well as the terms of the contractual arrangement and other relevant facts and circumstances, to assess whether the venture is entitled to only the net assets of the joint arrangement ( joint venture ) or to its share of the assets and liabilities of the joint arrangement ( a joint operation ). The standard is required to be applied retrospectively to prior periods presented. The REIT does not expect that this standard will result in a material impact to the consolidated financial statements. Disclosure of Interests in Other Entities ( IFRS 12 ) IFRS 12, Disclosure of Interests in Other Entities, applies to entities that have an interest in a subsidiary, a joint arrangement, an associate or an unconsolidated structured entity. The standard requires the REIT to disclose information that enables users of the financial statements to evaluate (i) the nature of, and risks associated with, the REIT s interests in other entities and (ii) the effects of those interests on the REIT s financial position, financial performance and cash flows. Adoption of this standard will not materially impact the consolidated financial statements. Fair Value Measurement ( IFRS 13 ) IFRS 13, Fair Value Measurement, replaces the current guidance on fair value measurement in existing IFRSs with a single standard. The standard defines fair value, provides guidance on its determination and requires disclosures about fair value measurements but does not change the requirements about the items that should be measured and disclosed at fair value. The REIT does not expect that this standard will result in a material impact to the consolidated financial statements Annual Report 37

40 Management s Discussion AND Analysis Presentation of Financial Statements ( IAS 1 ) IAS 1, Presentation of Financial Statements, will require companies to group items presented in other comprehensive income on the basis of whether they will or will not subsequently be reclassified to profit or loss. The REIT has adopted IAS 1. Financial Instruments ( IFRS 9 ) IFRS 9, Financial Instruments, will replace IAS 39, Financial Instruments: Recognition and Measurement, and applies to the classification and measurement of financial assets and financial liabilities as defined in IAS 39. The approach in IFRS 9 is based on how an entity manages its financial instruments in the context of its business model and the contractual cash flow characteristics of its financial assets. The REIT has not yet determined the impact of IFRS 9 on its consolidated financial statements. CONTROLS AND PROCEDURES CONCERNING FINANCIAL INFORMATION The REIT s management has evaluated the effectiveness of the REIT s disclosure controls and procedures and based on such evaluation has concluded that their design and operation are adequate and effective as of and for the year ended December 31, The financial certification process has been documented and has assessed the design and effectiveness of the internal controls in order to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with IFRS. This undertaking has enabled the Chief Executive Officer and Chief Financial Officer to attest that the design and effectiveness of the internal controls with regard to financial information are effective. In order to ensure that the consolidated financial statements and MD&A present fairly, in all material respects, the financial position of the REIT and the results of its operations management is responsible for establishing and maintaining disclosure controls and procedures, as well as internal control over financial reporting. An information disclosure policy constitutes the framework for the information disclosure process with regard to the annual and interim filings, as well as to other reports filed or submitted under securities legislation. This policy aims in particular at identifying material information and validating the related reporting. Morguard s Disclosure Committee, established in 2005, is responsible for ensuring compliance with this policy for both Morguard and the REIT. Morguard s senior management acts as the Disclosure Committee, ensuring compliance with this policy and reviewing main documents to be filed with regulatory authorities to ensure that all significant information regarding operations is communicated in a timely manner. SUBSEQUENT EVENTS On February 19, 2013, the REIT acquired 1,032 suites in five multi-unit low-rise residential properties located in Louisiana and Florida and one multi-unit mid-rise property located in Louisiana from Morguard (collectively, the Morguard Properties ) for an aggregate purchase price of approximately US$94,800 (approximately $95,900), including estimated transaction costs of $800. The purchase price for the Morguard Properties was satisfied by the assumption of certain Fannie Mae insured mortgages in the aggregate amount of approximately US$61,900 (approximately $62,600) as at December 31, 2012, (the Assumed Fannie Mae Mortgages ) and a reduction of the balance owing by Morguard to the REIT under the Morguard Facility by US$32,900 (approximately $33,300). The transaction has an adjustment date of January 1, The Assumed Fannie Mae Mortgages have an effective weighted average interest rate of 5.7% and a weighted average term to maturity of 3.7 years. In connection with the acquisition of the Morguard Properties, Morguard has agreed to provide instalment payments during the remaining terms of the Assumed Fannie Mae Mortgages to the REIT in order to achieve an effective annual interest rate of 4.7% on the Assumed Fannie Mae Mortgages. All costs and expenses relating to the assumption by the REIT of the Assumed Fannie Mae Mortgages were paid for by the REIT. The previously announced agreements to purchase an additional six properties from Morguard were terminated. The REIT may resume negotiations with Morguard Corporation with respect to these properties as market conditions permit. 38 Morguard NORTH AMERICAN residential REIT

41 Management s Discussion AND Analysis OUTLOOK The multi-unit residential sector enjoyed a successful year in 2012 given the strong fundamentals. Tenant demand for quality rental suites continued to be solid, and low interest rates provided owners with increased cash flow and a significant source of capital. We believe our strong balance sheet, access to capital and strong reputation in markets where we operate will allow the REIT to fund debt maturities and take advantage of opportunities in the future. In Canada, demographic trends are expected to support the overall health of the rental market. In particular, immigration levels and an aging population will continue to be important drivers of demand. Positive economic and labour market trends will also help keep rental sector demand high. Property values are at historical highs in many markets, and the lack of new construction will, generally, permit owners to achieve moderate increases in rental rates. From an investment perspective, access to relatively inexpensive CMHC financing will continue to provide stability to the sector and attract investment. In the U.S., while the economic and political landscape contains some uncertainties, management continues to believe in the long-term positive fundamentals for the multi-unit residential sector. During the ongoing economic recovery, rental apartments have benefited from the housing market shifting, in general, toward renting and away from home ownership. The U.S. recession was particularly difficult on young workers, and those who have found employment will continue to seek rental accommodation. These factors will continue to provide apartment owners with an environment conducive to rent increases. In addition, tight lending standards for homeowners and down payment requirements for those seeking mortgages will continue to favour multi-unit residential fundamentals Annual Report 39

42 INDEPENDENT AUDITORS REPORT To the Unitholders of Morguard North American Residential Real Estate Investment Trust We have audited the accompanying consolidated financial statements of Morguard North American Residential Real Estate Investment Trust, which comprise the consolidated balance sheets as at December 31, 2012 and 2011, and the consolidated statements of income and comprehensive income, changes in unitholders equity and cash flows for the years ended December 31, 2012 and 2011, and a summary of significant accounting policies and other explanatory information. Management s Responsibility for the Consolidated Financial Statements Management is responsible for the preparation and fair presentation of these consolidated financial statements in accordance with International Financial Reporting Standards, and for such internal control as management determines is necessary to enable the preparation of consolidated financial statements that are free from material misstatement, whether due to fraud or error. Auditors Responsibility Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with Canadian generally accepted auditing standards. Those standards require that we comply with ethical requirements and plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free from material misstatement. An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the consolidated financial statements. The procedures selected depend on the auditors judgment, including the assessment of the risks of material misstatement of the consolidated financial statements, whether due to fraud or error. In making those risk assessments, the auditors consider internal control relevant to the entity s preparation and fair presentation of the consolidated financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the entity s internal control. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of accounting estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that the audit evidence we have obtained in our audits is sufficient and appropriate to provide a basis for our audit opinion. Opinion In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of Morguard North American Residential Real Estate Investment Trust as at December 31, 2012 and 2011, and its financial performance and its cash flows for the years ended December 31, 2012 and 2011 in accordance with International Financial Reporting Standards. Chartered Accountants Licensed Public Accountants Toronto, Canada February 19, Morguard NORTH AMERICAN residential REIT

43 CONSOLIDATED BALANCE SHEETS As at December 31 (in thousands of Canadian dollars) Note ASSETS Non-current assets Real estate properties 5 $ 903,007 $ 676,944 Other assets , ,957 Current assets Morguard Facility 6 77,880 Amounts receivable 1, Prepaid expenses 12, Restricted cash Cash 4, ,184 2,910 $ 1,000,191 $ 679,867 LIABILITIES AND UNITHOLDERS EQUITY Non-current liabilities Mortgages payable and Class C LP Units 7 $ 322,646 $ 322,760 Class B LP Units 8 192,899 Deferred income tax liabilities 13 73, , ,233 Current liabilities Mortgages payable and Class C LP Units 7 94,766 31,869 Accounts payable and accrued liabilities 9 14,488 12, ,254 44,541 Total liabilities 624, ,774 UNITHOLDERS EQUITY 375, ,093 $ 1,000,191 $ 679,867 Commitments and contingencies 16 See accompanying notes to the consolidated financial statements. On behalf of the Trustees: K. (Rai) Sahi, bruce K. Robertson, Trustee Trustee 2012 Annual Report 41

44 CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME For the years ended December 31 (in thousands of Canadian dollars) Note Revenue from income producing properties $ 78,610 $ 71,923 Property operating costs 19,957 17,948 Utilities 9,308 8,663 Realty taxes 8,965 8,866 Net operating income 40,380 36,446 Interest expense 11 25,796 17,095 Trust expenses 2,061 Amortization of capital assets Other income (726) Income before fair value changes 13,237 19,317 Fair value gain on real estate properties 5 121,756 82,585 Fair value loss on Class B LP Units 8 (20,668) Net income before income taxes 114, ,902 Provision for (recovery of) income taxes 13 Current 751 1,019 Deferred (74,205) 14,080 (73,454) 15,099 Net income for the year 187,779 86,803 OTHER COMPREHENSIVE INCOME (LOSS) Items that may be reclassified subsequently to net earnings: Gain (loss) on interest rate swap agreement 1,139 (753) Amortization of cash flow hedge Unrealized foreign currency translation (loss) gain (440) 98 Other comprehensive income (loss) 902 (457) Deferred income tax (provision) recovery 13 (154) 139 Deferred income taxes due to reorganization/recapitalization 13 (623) Other comprehensive income (loss) after tax provision 125 (318) Total comprehensive income for the year $ 187,904 $ 86,485 See accompanying notes to the consolidated financial statements. 42 Morguard NORTH AMERICAN residential REIT

45 CONSOLIDATED STATEMENTS OF UNITHOLDERS EQUITY accumulated other Total Number of Trust Contributed Divisional Retained Comprehensive Unitholders (in thousands of Canadian dollars, except Units) Units units Surplus Surplus Earnings (Loss) Income Equity Balance as at December 31, 2010 $ $ $ 200,796 $ $ (2,204) $ 198,592 Changes during the year: Net income 86,803 86,803 Other comprehensive loss (318) (318) Distributions (45,984) (45,984) Balance as at December 31, 2011 $ $ $ 241,615 $ $ (2,522) $ 239,093 Changes during the period: Net income for the period January 1, 2012 to April 17, ,703 80,703 Net contributions from Morguard 7,298 7,298 Other comprehensive loss for the period January 1, 2012 to April 17, 2012 (233) (233) Balance as at April 17, ,250,000 $ $ $ 329,616 $ $ (2,755) $ 326,861 Reorganization and recapitalization 1 72,883 57,951 (329,616) (198,782) Issuance of Units 12,720, , ,753 Issue of Units Distribution Reinvestment Plan 12, (150) Net income for the period April 18, 2012 to December 31, , ,076 Other comprehensive income for the period April 18, 2012 to December 31, Distributions (5,874) (5,874) Unitholders equity, December 31, ,982,963 $ 218,786 $ 57,951 $ $ 101,052 $ (2,397) $ 375,392 1 To reflect the reorganization and recapitalization of Morguard North American Residential Real Estate Investment Trust. See Note 2 Basis of Presentation, for further details. See accompanying notes to the consolidated financial statements Annual Report 43

46 CONSOLIDATED STATEMENTS OF CASH FLOWS For the years ended December 31 (in thousands of Canadian dollars) Note OPERATING ACTIVITIES Net income for the year $ 187,779 $ 86,803 Items not affecting cash 15(a) (173,317) (66,925) Net change in operating assets and liabilities 15(b) (10,349) 1,247 Cash provided by operating activities 4,113 21,125 INVESTING ACTIVITIES Purchase of Morguard s interest in the Initial Properties (67,750) Acquisition of real estate assets (99,042) Additions to real estate properties (5,984) (8,105) Additions to capital assets (8) Cash used in investing activities (172,776) (8,113) FINANCING ACTIVITIES Proceeds from issuance of Units, net of costs 218,636 Change to Morguard Facility 6 (102,880) Proceeds from new mortgages 7 66, ,569 Financing cost on new mortgages (986) (2,959) Repayment of mortgages Repayments on maturity (57,038) Principal instalment repayments (10,586) (9,602) Net contributions from (distributions to) Morguard 7,298 (45,984) Distributions to REIT unitholders (4,825) Increase in restricted cash (240) (25) Cash provided by (used in) financing activities 172,799 (13,039) Net increase (decrease) in cash during the year 4,136 (27) Net effect of foreign currency translation on cash balance (224) 12 Cash, beginning of year Cash, end of year $ 4,822 $ 910 See accompanying notes to the consolidated financial statements. 44 Morguard NORTH AMERICAN residential REIT

47 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS For the year ended December 31, 2012 (Amounts in thousands of Canadian dollars, except unit and per unit amounts) Note 1 Nature and Formation of Trust Morguard North American Residential Real Estate Investment Trust ( Morguard Residential REIT or the REIT ) is an unincorporated open-ended real estate investment trust established pursuant to a Declaration of Trust ( DOT ) dated March 1, 2012, and as amended on April 18, 2012, in the Amended and Restated DOT, under and governed by the laws of the Province of Ontario. The units of the REIT ( Units ) trade on the Toronto Stock Exchange under the symbol MRG.UN. The REIT invests in multi-unit residential rental properties in Canada and the southeast United States. The REIT s head office is located at 55 City Centre Drive, Suite 1000, Mississauga, Ontario, L5B 1M3. The REIT commenced operations on April 18, 2012, when it issued Units for cash pursuant to an initial public offering ( IPO or the Offering ). The Offering raised gross proceeds of $75,000. A total of 7,500,000 trust units were sold at a price of $10.00 per trust unit. On April 24, 2012, the underwriters exercised in full their over-allotment option to purchase 750,000 additional trust units at a price of $10.00 per trust unit, which increased the total gross proceeds of the Offering to $82,500. The total proceeds received, net of underwriters commission, was $77,550. Morguard Residential REIT used the net proceeds of the Offering to acquire a direct interest in 8,250,000 Class A LP Units of Morguard North American Canada Limited Partnership ( CAN LP or the Partnership ). Upon completion of the Offering, CAN LP and its subsidiaries used the net proceeds of the Offering to acquire from Morguard Corporation ( Morguard ) 14 multi-unit residential rental properties located in Canada and three multi-unit residential properties located in the United States (the Initial Properties ). In connection with this acquisition, Morguard was issued 17,223,090 Class B LP Units of the Partnership. Immediately after the Offering and the above-mentioned acquisition, the unitholders of Morguard Residential REIT held all of the Class A LP Units, representing a 32.4% interest in the Partnership, and Morguard held all of the Class B LP Units, representing a 67.6% interest in the Partnership. The Class B LP Units are exchangeable, on a one-for-one basis, at the option of Morguard, into Units of Morguard Residential REIT and are entitled to the same distributions as the Units of Morguard Residential REIT. Note 2 Significant Accounting Policies Statement of Compliance These consolidated financial statements have been prepared in accordance with International Financial Reporting Standards ( IFRS ) as issued by the International Accounting Standards Board ( IASB ). The consolidated financial statements were approved and authorized for issue by the Board of Trustees on February 19, Basis of Presentation The REIT holds its interest in the real estate properties and other assets and liabilities related to these properties directly and indirectly in the Partnership. The consolidated financial statements include the accounts of the REIT, the Partnership and their subsidiaries, all of which are controlled by the REIT. Control exists when the REIT has the power, directly or indirectly, to govern the financial and operating policies of an entity so as to obtain benefits from its activities. In accordance with Interpretation SIC-12, Consolidation Special Purpose Entities ( SIC-12 ), an entity can exercise control on a basis other than ownership of voting interests. The consolidated financial statements include the accounts of the REIT, 2012 Annual Report 45

48 notes to consolidated financial statements the Partnership and their subsidiaries, including the REIT s proportionate share of the accounts of its co-ownership interests in unincorporated joint ventures. The consolidated financial statements are prepared on a historical basis, except for real estate property and certain financial instruments that are measured at fair value, as explained in the accounting policies below. As the REIT was a newly formed entity in 2012 and Morguard has retained control over the REIT, the IPO and the acquisition of the Initial Properties represent a common control transaction that has been accounted for as a reorganization and recapitalization in a manner similar to a pooling of interests, which requires the presentation of pre-acquisition financial information. As such, the consolidated balance sheets reflect the IPO at the assumed proceeds net of offering costs, the Initial Properties and mortgages were transferred from Morguard at Morguard s book values and the cash and various limited partnership unit liabilities were issued to Morguard as a distribution. The excess of the Morguard book values over the distribution to Morguard is reflected as a contribution by Morguard to the REIT. Deferred income tax liabilities that were recorded in the combined balance sheets of the Initial Properties prior to the reorganization and recapitalization were reversed as a result of the reorganization and recapitalization. Co-Ownerships A special purpose entity ( SPE ) is an entity created to accomplish a narrow and well-defined objective and may take the form of a corporation, trust, partnership or unincorporated entity. The primary beneficiary is the enterprise that will absorb or receive the majority of the SPE s expected losses, expected residual returns or both. IFRS requires the consolidation of SPEs by the primary beneficiary. The REIT has concluded that its co-ownerships are not SPEs and represent interests in jointly controlled assets that will be accounted for using the proportionate consolidation method. Real Estate Properties Real estate properties include multi-unit residential properties held to earn rental income (income producing properties). Income producing property that is acquired as an asset purchase and not as a business combination is recorded initially at cost, including transaction costs. Transaction costs include transfer taxes and professional fees for legal services. Subsequent to initial recognition, income producing properties are recorded at fair value. The changes in fair value each reporting period will be recorded in the consolidated statements of income and comprehensive income. In order to avoid double counting, the carrying value of income producing properties includes straight-line rent receivable, all capital expenditures associated with upgrading and extending the economic life of the existing properties, and direct leasing costs since these amounts are incorporated in the appraised values of the real estate properties. Fair value is based upon valuations using the direct capitalization income method. Recent real estate transactions with characteristics and location similar to the REIT s assets are also considered. The direct capitalization income method applies a capitalization rate to the property s stabilized net operating income, which incorporates allowances for vacancy, management fees and structural reserves for capital expenditures for the property. The resulting appraised value is further adjusted, where appropriate, for non-recurring costs to stabilize the income and non-recoverable capital expenditures. Cash Cash includes cash on hand and balances with banks. Bank borrowings are considered to be financing activities. Revenue Recognition The Trust has retained substantially all of the risks and benefits of ownership of its real estate properties and therefore accounts for leases with its tenants as operating leases. Revenue from income producing properties includes rents from tenants under leases, parking income, laundry income and other miscellaneous income paid by the tenants under the terms of their existing leases. Revenue recognition under a lease commences when a tenant has a right to use the leased asset, and revenue is recognized pursuant to the terms of the lease agreement. Revenue is recognized systematically over the term of the lease, which is generally not more than 12 months. Any suite specific incentives offered or initial direct costs incurred in negotiating and arranging an operating lease are reflected in the consolidated balance sheets in the carrying value of real estate properties and are amortized over the term of the operating lease and recognized in the consolidated statements of income and comprehensive income on a straight-line basis. 46 Morguard NORTH AMERICAN residential REIT

49 notes to consolidated financial statements Class B LP Units The REIT has issued Class B LP Units of the Partnership as partial consideration for the acquisition of the Initial Properties. The Class B LP Units are exchangeable into Units at the option of the holder. The Units are puttable and, therefore, the Class B LP Units meet the definition of a financial liability under International Accounting Standards 32, Financial Instruments Presentation ( IAS 32 ). Further, the Class B LP Units are designated as fair value through profit or loss ( FVTPL ) financial liabilities and are measured at fair value based on the trading price of the underlying Units at each reporting period with any changes in fair value recognized in the consolidated statements of income and comprehensive income. The distributions paid on the Class B LP Units are accounted for as interest expense on the consolidated statements of income and comprehensive income. Unit Capital The Units are redeemable at the option of the holder and, therefore, are considered puttable instruments in accordance with IAS 32. Puttable instruments are required to be accounted for as financial liabilities, except where certain conditions are met in accordance with IAS 32, in which case the puttable instruments may be presented as equity. The Units meet these conditions of IAS 32 and are, therefore, presented as equity. Income Taxes The REIT is a mutual fund trust and a real estate investment trust pursuant to the Income Tax Act (Canada). Under current tax legislation, a real estate investment trust is entitled to deduct distributions of taxable income such that it is not liable to pay income taxes provided that its taxable income is fully distributed to unitholders. The REIT intends to continue to qualify as a real estate investment trust and to make distributions of not less than the amount necessary to ensure that the REIT will not be liable to pay income taxes in Canada. Accordingly, no current or deferred income taxes have been recorded in the consolidated financial statements for the REIT s Canadian properties. However, the REIT s U.S. properties are held by U.S. subsidiaries that are taxable legal entities. The REIT will use the liability method of accounting for the U.S. income taxes. Under the liability method of tax allocation, current income tax assets and liabilities are based on the amount expected to be paid to tax authorities, net of recoveries, based on the tax rates and laws enacted or substantively enacted at the consolidated balance sheet dates. Deferred income tax assets and liabilities are determined based on differences between the financial reporting and tax bases of assets and liabilities and are measured using substantively enacted tax rates and laws that will be in effect when the differences are expected to reverse. Deferred income tax assets are recognized for all deductible temporary differences, carryforward of unused tax credits and unused tax losses, to the extent that it is probable that deductions, tax credits and tax losses can be utilized. The carrying amounts of deferred income tax assets are reviewed at each consolidated balance sheet date and reduced to the extent it is no longer probable that the income tax asset will be recovered. In December 2010, the IASB made amendments to IAS 12, Income Taxes ( IAS 12 ), that are applicable to the measurement of deferred tax assets and liabilities where investment property is measured using the fair value model in IAS 40, Investment Property. The amendments introduce a rebuttable presumption that, for purposes of determining deferred tax consequences associated with temporary differences relating to investment properties, the carrying amount of the investment property is recovered entirely through the sale of the property. This presumption is rebutted if the investment property is held within a business model whose objective is to consume substantially all of the economic benefits embodied in the investment property over time, rather than through sale. The amendments to IAS 12 were effective for annual periods beginning on or after January 1, 2012, and the REIT has applied this approach in calculating deferred income taxes on its U.S. properties under IFRS. The amendments had minimal impact on the financial statements since the REIT had been applying this approach in calculating deferred income taxes under IFRS. Foreign Exchange The operations of the REIT s U.S.-based subsidiaries are in U.S. dollars, which represent the functional currency of the subsidiaries. Accordingly, the assets and liabilities of foreign subsidiaries are translated into Canadian dollars at the rates on the consolidated balance sheet dates. Revenues and expenses are translated at the average rate of exchange for the period. The resulting gains and losses are recorded in accumulated other comprehensive income ( AOCI ) Annual Report 47

50 notes to consolidated financial statements Canadian dollar to United States dollar exchange rates: December 31 $ $ Average during the period $ $ United States dollar to Canadian dollar exchange rates: December 31 $ $ Average during the period $ $ Comprehensive Income Comprehensive income is defined as the change in equity from transactions and other events from non-owner sources. Other comprehensive income ( OCI ) refers to items recognized in comprehensive income that are excluded from net income. Accordingly, the REIT prepares consolidated statements of comprehensive income and includes AOCI as a component of unitholders equity within the consolidated balance sheets. OCI generally would include changes in the fair value of the effective portion of cash flow hedging instruments and unrealized foreign currency translation adjustments net of hedging arising from foreign operations. Net Income per Unit Basic net income per unit is calculated by dividing net income by the weighted average number of units outstanding in each respective period. Diluted net income per unit is calculated by dividing net income, adjusted for the effect of dilutive securities, by the weighted average number of diluted units outstanding. Financial Instruments Recognition and Measurement of Financial Instruments Financial assets are classified into one of the following categories: held for trading, loans and receivables or available-forsale assets. Financial liabilities are classified as other financial liabilities. The REIT designated its cash as held for trading and its amounts receivable and Morguard Facility as loans and receivables, which are measured at amortized cost. Accounts payable and accrued liabilities, mortgage obligations and Class C LP Units are classified as other financial liabilities, which are measured at amortized cost. Class B LP Units are classified as FVTPL and are measured at fair value. Derivatives and Embedded Derivatives All derivative instruments, including embedded derivatives, are recorded in the consolidated balance sheets at fair value unless exempted from derivative treatment as a normal purchase and sale. All changes in their fair value are recorded in income unless cash flow hedge accounting is used, in which case changes in fair value are recorded in OCI to the extent of hedge effectiveness. Financial guarantees are recorded at their inception date fair value and reversed as the REIT is relieved of its guarantee obligations. Hedges Derivative financial instruments are utilized to reduce interest rate risk on the REIT s debt. Interest rate swap agreements are used to manage the fixed and floating interest rate mix of the REIT s total debt portfolio and related overall cost of borrowing. Such instruments are designated, and are effective, as hedges of certain of the REIT s interest rate risk exposures. The interest rate swap agreements involve the periodic exchange of payments without the exchange of the notional principal amount upon which the payments are based. The net receipt or payment of interest will be recorded as an adjustment to interest expense in each period. Gains and losses on termination of interest rate swap agreements that were designated, and were effective, as hedges of certain interest rate risk exposures are included in AOCI and are amortized in interest expense over the remaining term of the original contract life of the terminated swap agreement. Interest expense on the related debt obligation together with this deferred financing cost amortization reflects the overall costs of such borrowing. 48 Morguard NORTH AMERICAN residential REIT

51 notes to consolidated financial statements Transaction Costs Direct and indirect financing costs that are attributable to the issue of financial liabilities are presented as a reduction from the carrying amount of the related debt and are amortized using the effective interest rate method over the terms of the related debt. These costs include interest, amortization of discounts or premiums relating to borrowings, fees and commissions paid to agents, brokers and advisers and transfer taxes and duties that are incurred in connection with the arrangement of borrowings. Fair Value The fair value of a financial instrument is the amount of consideration that could be agreed upon in an arm s-length transaction between knowledgeable, willing parties who are under no compulsion to act. In certain circumstances, however, the initial fair value may be based on other observable current market transactions in the same instrument, without modification or on a valuation technique using market-based inputs. The REIT s financial assets include cash and restricted cash, amounts receivable and the Morguard Facility. The REIT s financial liabilities include accounts payable and accrued liabilities and mortgages. Except as noted below in their respective notes, the carrying values of the REIT s financial assets and financial liabilities approximate their fair values because of the short period of time until the receipt or payment of cash. The indebtedness to Morguard is reflected at fair value since the loan s interest rate is based on floating interest rates. The fair values of designated hedging derivatives included in accounts payable and accrued liabilities are estimated based on discounted future cash flows using discount rates that reflect current market conditions for instruments with similar terms and risks. Fair value measurements recognized in the consolidated balance sheets are categorized using a fair value hierarchy that reflects the significance of inputs used in determining the fair values: Level 1: Quoted prices in active markets for identical assets or liabilities. Level 2: quoted prices in active markets for similar assets or liabilities or valuation techniques where significant inputs are based on observable market data. Level 3: Valuation techniques for which any significant input is not based on observable market data. Each type of fair value is categorized based on the lowest-level input that is significant to the fair value measurement in its entirety. Critical Judgments in Applying Accounting Policies The following are the critical judgments that have been made in applying the REIT s accounting policies and that have the most significant effect on the amounts in the consolidated financial statements: Real Estate Properties The REIT s accounting policies relating to real estate properties are described above. In applying these policies, judgment has been applied in determining whether certain costs are additions to the carrying amount of the property. Judgment is also applied in determining the extent and frequency of independent appraisals. The key assumptions are further defined in Note 5. Basis of Consolidation The REIT s basis of consolidation is described above in the Basis of Presentation section. Judgment is applied in determining what is considered in substance control within the scope of SIC-12 when an entity can exercise control on a basis other than ownership of voting interests. Income Taxes Under current tax legislation, a real estate investment trust is not liable to pay Canadian income taxes provided that its taxable income is fully distributed to unitholders during the year. The REIT is a real estate investment trust if it meets prescribed conditions under the Income Tax Act (Canada) relating to the nature of its assets and revenue ( the REIT Conditions ). The REIT has reviewed the REIT Conditions and has assessed their interpretation and application to the REIT s Canadian assets and revenue, and it has determined that it qualifies as a real estate investment trust. The REIT expects to qualify as a real estate investment trust under the Income Tax Act (Canada); however, should it no longer qualify, it would not be able to flow-through its taxable income to unitholders and the REIT would, therefore, be subject to tax on its Canadian properties Annual Report 49

52 notes to consolidated financial statements Common Control Transactions Since common control business combinations fall outside the scope of IFRS 3, management has used its judgment to determine an appropriate policy to account for these transactions, considering other relevant accounting guidance that is within the framework of principles in IFRS and that reflects the economic reality of the transactions, in accordance with IAS 8, Accounting Policies, Changes in Accounting Estimates and Errors. As a result, the consolidated financial statements account for assets and liabilities acquired at the previous carrying value on the predecessor s financial statements. Differences between the consideration given and the assets and liabilities received have been recorded directly to equity. Critical Accounting Estimates and Assumptions The preparation of the consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and reported amounts of revenue and expenses during the reporting periods. In determining estimates of fair market value and net realizable values for the REIT s real estate properties, the assumptions underlying estimated values are limited by the availability of comparable data and the uncertainty of predictions concerning future events. Significant estimates used in determining fair value of the REIT s real estate properties include capitalization rates and stabilized net operating income (which is influenced by inflation rates, vacancy rates and operating costs). Should any of these underlying assumptions change, actual results could differ from the estimated amounts. The critical estimates and assumptions underlying the valuation of real estate properties are outlined in Note 5. Note 3 Future Accounting Policy Changes Each of the standards below is effective for annual periods beginning on or after January 1, 2013, with the exception of IFRS 9, which requires adoption effective January 1, 2015, and the amended version of IAS 1, which is effective for annual periods beginning on or after July 1, Earlier adoption is permitted for each standard. Consolidated Financial Statements ( IFRS 10 ) IFRS 10, Consolidated Financial Statements, will replace IAS 27, Consolidated and Separate Financial Statements, and SIC-12, Consolidation Special Purpose Entities, and provides a single model for consolidation based on a revised definition of control that states that an entity has control over another entity if it has the ability to direct the activities of that entity, even if the investor holds less than 50% of the voting rights of the investee. The REIT does not expect that this standard will result in a material impact to the consolidated financial statements. Joint Arrangements ( IFRS 11 ) IFRS 11, Joint Arrangements, will replace IAS 31, Interests in Joint Ventures. IFRS 11 requires that reporting issuers consider whether a joint arrangement is structured through a separate vehicle, as well as the terms of the contractual arrangement and other relevant facts and circumstances, to assess whether the venture is entitled to only the net assets of the joint arrangement ( joint venture ) or to its share of the assets and liabilities of the joint arrangement ( a joint operation ). The standard is required to be applied retrospectively to prior periods presented. The REIT does not expect that this standard will result in a material impact to the consolidated financial statements. Disclosure of Interests in Other Entities ( IFRS 12 ) IFRS 12, Disclosure of Interests in Other Entities, applies to entities that have an interest in a subsidiary, a joint arrangement, an associate or an unconsolidated structured entity. The standard requires the REIT to disclose information that enables users of the financial statements to evaluate (i) the nature of, and risks associated with, the REIT s interests in other entities and (ii) the effects of those interests on the REIT s financial position, financial performance and cash flows. Adoption of this standard will not materially affect the consolidated financial statements. 50 Morguard NORTH AMERICAN residential REIT

53 notes to consolidated financial statements Fair Value Measurement ( IFRS 13 ) IFRS 13, Fair Value Measurement, replaces the current guidance on fair value measurement in existing IFRSs with a single standard. The standard defines fair value, provides guidance on its determination and requires disclosures about fair value measurements but does not change the requirements about the items that should be measured and disclosed at fair value. The REIT does not expect that this standard will result in a material impact to the consolidated financial statements. Presentation of Financial Statements ( IAS 1 ) IAS 1, Presentation of Financial Statements, will require entities to group items presented in OCI on the basis of whether they will or will not subsequently be reclassified to profit or loss. The REIT has adopted IAS 1. Financial Instruments ( IFRS 9 ) IFRS 9, Financial Instruments, will replace IAS 39, Financial Instruments: Recognition and Measurement, ( IAS 39 ) and applies to the classification and measurement of financial assets and financial liabilities as defined in IAS 39. The approach in IFRS 9 is based on how an entity manages its financial instruments in the context of its business model and the contractual cash flow characteristics of its financial assets. The REIT has not yet determined the impact of IFRS 9 on its consolidated financial statements. Note 4 Acquisition of Initial Properties Concurrently with the completion of the Offering that occurred on April 18, 2012, the REIT indirectly acquired from Morguard the Initial Properties for a net purchase price of $424,835. As a result of Morguard owning 67.6% of the REIT, the sale of the Initial Properties by Morguard to the REIT did not represent a business combination under IFRS 3. Since the Initial Properties are ultimately controlled by Morguard before and after the sale to the REIT, the sale of the Initial Properties by Morguard to the REIT represents a business combination under common control, and the transaction has been accounted for using pooling of interests accounting, whereby the REIT recorded the acquisition of the Initial Properties at Morguard s carrying value at April 17, 2012 (the date of acquisition ). The allocation of the purchase price to the assets acquired and liabilities assumed based on their carrying values at the date of acquisition is as follows: A amount Real estate properties $ 680,289 Working capital items, net (2,212) Assumed mortgages, net of deferred financing costs of $2,762 (253,242) Net assets acquired 424,835 Distributions to Morguard: Class C LP Units, net of deferred financing costs of $2, ,658 Class B LP Units 172,231 Indebtedness to Morguard 25,000 Cash paid out by the REIT 67, ,639 Net contribution by Morguard (net of AOCI) $ 55, Annual Report 51

54 notes to consolidated financial statements Note 5 Real Estate Properties Reconciliations of the carrying amounts for real estate properties at the beginning and end of the current reporting year and prior financial year are set out below: December 31, December 31, Balance at beginning of year $ 676,944 $ 585,729 Additions: Acquisitions 99,042 Capital expenditures and lease incentives 5,984 8,105 Fair value gains 121,756 82,585 Foreign currency translation Others (685) 555 (34) (30) Balance at end of year $ 903,007 $ 676,944 As at December 31, 2012, and December 31, 2011, the REIT had its Canadian portfolio appraised by Morguard s appraisal division and the U.S. portfolio appraised by an independent national U.S. real estate appraisal firm. Approximately 13.4% of the REIT s portfolio was appraised by an independent national U.S. real estate appraisal firm at December 31, 2012 (December 31, %). The REIT utilizes the direct capitalization income approach method. This method requires that rental income from current leases and key assumptions about rental income, vacancies and inflation rates among other factors are used to determine a one-year income forecast for each individual property within the REIT s portfolio and also considers any capital expenditures anticipated within the year. A capitalization rate was also determined for each property based on market information related to the external sale of similar properties within a similar geographic location. These factors were used to determine the fair value of investment properties at each reporting period. Using the direct capitalization income approach, the properties were valued using capitalization rates in the range of 5.0% to 8.5% applied to a stabilized net operating income (December 31, % to 8.5%), resulting in an overall weighted average capitalization rate of 5.1% (December 31, %). The average capitalization rates by geographic location are set out in the following table: December 31, 2012 december 31, 2011 Weighted weighted Maximum Minimum Average Maximum Minimum Average Canada 5.0% 4.8% 4.9% 5.8% 5.5% 5.6% United States Louisiana 8.5% 8.3% 8.3% 8.5% 8.3% 8.3% Florida 6.0% 5.3% 5.8% n/a n/a n/a Values are most sensitive to changes in capitalization rates and timing or variability of cash flows. On July 16, 2012, Village Crossing Apartments was acquired from Morguard for a purchase price of US$16,347 funded by mortgage financing of US$11,400 at an interest rate of 3.96% for a term of 10 years and an advance on the Morguard Facility of approximately US$5,000. Village Crossing Apartments is a residential walk-up garden community comprising 189 suites in eight buildings situated on 11 acres of land located in Florida. 52 Morguard NORTH AMERICAN residential REIT

55 notes to consolidated financial statements On July 31, 2012, the REIT acquired Woodbine Apartments from a third party vendor for a purchase price of US$42,100. The acquisition was predominantly satisfied by an advance on the Morguard Facility. Woodbine Apartments is a three-storey residential walk-up garden community comprising 408 suites in 17 buildings situated on 19 acres of land located in Florida. On September 4, 2012, the REIT completed the financing of Woodbine Apartments in the amount of US$29,470 at an interest rate of 3.78% for a term of 10 years. On August 29, 2012, the REIT acquired Blue Isle Apartments from a third party vendor for a purchase price of US$40,000 funded by an advance on the Morguard Facility. Blue Isle Apartments is a two-storey residential walk-up garden community comprising 340 suites in 23 buildings situated on 18 acres of land located in Florida. On October 19, 2012, the REIT completed the financing of Blue Isle Apartments in the amount of US$26,000 at an interest rate of 3.66% for a term of 10 years. Included in real estate properties is $3 (2011 $91) of net straight-line rent and incentive receivables arising from the recognition of rental revenue net of incentives on a straight-line basis over the lease term in accordance with IAS 17, Leases. Note 6 Morguard Facility The REIT entered into an unsecured, revolving credit facility with Morguard (the Morguard Facility ) that provides for borrowings or advances that can be drawn or advanced either in Canadian dollars or an equivalent amount in United States dollars. If in Canadian dollars, interest will be calculated either at the Canadian prime lending rate or at the bankers acceptance ( BA ) rate plus 1.8%. If the borrowing or advance is in United States dollars, interest will be calculated either at the U.S. prime lending rate or at the United States dollar London Interbank Offered Rate ( LIBOR ) plus 1.7%. During the third quarter of 2012, the approved limit of the Morguard Facility increased from $50,000 to $105,609 to fund the acquisitions of Woodbine Apartments and Blue Isle Apartments and subsequently reduced such that since October 31, 2012, the maximum allowable to be borrowed or advanced under the Morguard Facility is $100,000. The balance of the Morguard Facility was repaid on September 12, 2012, and during the year ended December 31, 2012, the REIT incurred and paid interest expense of $453. Subsequent to September 12, 2012, the REIT advanced $77,880 to Morguard and received interest income of $719 during the year ended December 31, Note 7 Mortgages Payable and Class C LP Units As part of the acquisition of the Initial Properties, Morguard retained the mortgages on four of the Initial Properties ( Retained Debt ) and the deferred financing costs associated with the Retained Debt. In consideration of the Retained Debt, Morguard received Class C LP Units of the Partnership on which distribution payments will be made in an amount expected to be sufficient to permit Morguard to satisfy amounts payable with respect to (i) principal and interest under the Retained Debt and (ii) the amount of tax that is due and payable that is reasonably attributable to any distributions on the Class C LP Units. The present value of the tax payment has been estimated to amount to $6,897 on December 31, 2012, and has been included in the carrying value of the Class C LP Units Annual Report 53

56 notes to consolidated financial statements Mortgages payable and Class C LP Units, which are at fixed and floating rates, consist of the following: December 31, december 31, Mortgages Class C LP Mortgages Payable Units Total Payable Principal balance of mortgages $ 316,927 $ 99,152 $ 416,079 $ 360,605 Financing costs (2,997) (2,567) (5,564) (5,976) Present value of tax payment on Class C LP Units 6,897 6,897 $ 313,930 $ 103,482 $ 417,412 $ 354,629 Current $ 92,462 $ 2,304 $ 94,766 $ 31,869 Non-current 221, , , ,760 $ 313,930 $ 103,482 $ 417,412 $ 354,629 Range of interest rates % 4.0% % % Weighted average interest rate 4.4% 4.0% 4.3% 4.4% Estimated fair value of mortgages payable and Class C LP Units $ 331,994 $ 113,253 $ 445,247 $ 383,792 Floating rate mortgages in the amount of $64,163 as at December 31, 2012 (December 31, 2011 $66,053) are subject to interest rate swap agreements to acquire a fixed interest rate over the floating rate (see Note 19 for further details). The aggregate principal repayments and balances maturing of the mortgages payable and the Class C LP Units, in the next five years and thereafter, are as follows: W weighted Principal average Instalment balances Contractual R repayments Maturing Total rate 2013 $ 10,984 $ 85,299 $ 96, % ,887 94, , % ,423 17,191 23, % ,156 10,634 15, % ,828 17,955 22, % Thereafter 154, % $ 416, % Substantially all of the REIT s rental properties and related rental revenues have been pledged as collateral for the mortgages payable. The REIT s first mortgages are registered against specific real estate assets and the Retained Debt is secured by a charge on the four properties, and the REIT provided Morguard s creditors with a guarantee with respect to the Retained Debt to ensure the lenders are not prejudiced in their ability to collect from Morguard in the event that payments on the Class C LP Units are not made as expected. Morguard has also provided an indemnity to the REIT for any losses suffered by the REIT in the event payments on the Retained Debt are not made as required, provided such losses are not attributable to any action or failure to act on the part of the REIT. The mortgages directly held by the REIT and the Retained Debt bear interest at rates ranging between 3.7% and 6.0% per annum with a weighted average interest rate of 4.3% (December 31, %) and mature between 2013 and 2022 with a weighted average term to maturity of 4.7 years. 54 Morguard NORTH AMERICAN residential REIT

57 notes to consolidated financial statements Note 8 Class B LP Units On April 18, 2012, the REIT issued 17,223,090 Class B LP Units for $172,231 to Morguard as part of the consideration for the acquisition of the Initial Properties. The Class B LP Units, representing an aggregate fair value of $192,899 at December 31, 2012, are non-transferable, except under certain circumstances, but are exchangeable on a one-for-one basis into Morguard Residential REIT Units (the Units ) at any time at the option of the holder. Prior to such exchange, distributions will be made on the exchangeable units in an amount equivalent to the distribution that would have been made had the Units of Morguard Residential REIT been issued. Each Class B LP Unit was accompanied by a Special Voting Unit, which entitles the holder to receive notice of, attend and vote at all meetings of the unitholders. There is no value assigned to the Special Voting Units. The Class B LP Units have been classified as FVTPL financial liabilities in accordance with IAS 39. Gains or losses resulting from changes in the fair value at each reporting date are recorded in the consolidated statements of income and comprehensive income. At December 31, 2012, there were 17,223,090 Class B LP Units issued and outstanding. Note 9 Accounts Payable and Accrued Liabilities Accounts payable and accrued liabilities consist of the following: As at December Accounts payable and accrued liabilities $ 8,606 $ 7,219 Tenant deposits 5,882 5,453 $ 14,488 $ 12,672 Note 10 Unitholders Equity (a) Units The REIT is authorized to issue an unlimited number of Units. Each Unit confers the right to one vote at any meeting of unitholders and to participate pro rata in the distributions by the REIT and, in the event of termination or winding-up of the REIT, in the net assets of the REIT. The unitholders have the right to require the REIT to redeem their Units on demand subject to certain conditions. The Units have no par value. Upon receipt of the redemption notice by the REIT, all rights to and under the Units tendered for redemption will cease and the holder thereof will be entitled to receive a price per Unit ( Redemption Price ), as determined by a formula outlined in the DOT. The Redemption Price will be paid in accordance with the conditions provided for in the DOT. The Trustees have discretion with respect to the timing and amounts of distributions. Units are redeemable at any time, in whole or in part, on demand by the holders. Upon receipt of the redemption notice by the REIT, all rights to and under the Units tendered for redemption will be surrendered and the holder will be entitled to receive a price per Unit equal to the lesser of (i) 90% of the market price of the Units on the principal exchange market on which the Units are listed or quoted for trading during the 10 consecutive trading days ending immediately prior to the date on which the Units were surrendered for redemption; or (ii) 100% of the closing market price on the principal exchange market on which the Units are listed or quoted for trading on the redemption date. The total amount payable by the REIT, with respect to any Units surrendered for redemption during any calendar month, will not exceed $50 unless waived at the discretion of the Trustees and will be satisfied by way of a cash payment in Canadian dollars within 30 days after the end of the calendar month in which the Units were tendered for redemption Annual Report 55

58 notes to consolidated financial statements To the extent the Redemption Price payable with respect to Units surrendered for redemption exceeds $50 in any given month, such excess will be redeemed for cash and by a distribution in specie of assets held by the REIT on a pro rata basis. (b) Special Voting Units The REIT is authorized to issue an unlimited number of Special Voting Units. The DOT and the exchange agreement provide for the issuance of the Special Voting Units, which have no economic entitlement in the REIT or in the distribution or assets of the REIT but are used to provide voting rights proportionate to the votes of the Units to holders of securities exchangeable into Units, including the Class B LP Units. Each Special Voting Unit is not transferable separately from the Class B LP Unit to which it is attached and will be automatically redeemed and cancelled upon exchange of the attached Class B LP Unit into a Unit. (c) Units Outstanding The following table summarizes the changes in Units for the period from April 18, 2012, to December 31, 2012: Issued and fully paid Units (in thousands) units amount Balance, April 18, ,250,000 $ 72,883 Additional issuance of Units for cash, net of cost of $4,979 (Note 1) 12,720, ,753 Distribution Reinvestment Plan 12, Balance, December 31, ,982,963 $ 218,786 On September 12, 2012, the REIT completed an offering of $150,732 for 12,720,000 trust units sold at a price of $11.85 per trust unit. The net proceeds of the offering, after underwriters commission and other costs, was $145,753. The REIT used the net proceeds of the offering to acquire a direct interest in 12,720,000 Class A LP Units of the Partnership. Morguard acquired 4,220,000 of the trust units issued on September 12, During the three months ended December 31, 2012, Morguard acquired an additional 355,166 trust units in an open market transaction. At December 31, 2012, Morguard owned a 57.1% effective interest in the REIT through its ownership of 4,575,166 trust units and 17,223,090 Class B LP Units. The net proceeds were used to repay all the amounts owing under the Morguard Facility, and the excess cash was advanced to Morguard under the same facility. Total distributions recorded during the period from April 18, 2012, to December 31, 2012, amounted to $6,024. On December 14, 2012, the REIT declared a distribution of $0.05 per Unit to be paid on January 15, (d) Distribution Reinvestment Plan On June 18, 2012, the REIT adopted a Distribution Reinvestment Plan (the DRIP ). Unitholders can elect to reinvest cash distributions into additional Units at a weighted average closing price of the Units on the TSX for the five trading days immediately preceding the applicable date of distribution. For the period from April 18, 2012, to December 31, 2012, the REIT issued 12,963 Units under the DRIP. (e) Accumulated Other Comprehensive Loss As at December 31, 2012 and 2011, accumulated other comprehensive loss consists of the following amounts: As at December Unrealized foreign currency translation loss $ (631) $ (192) Loss on interest rate swap agreement (1,053) (1,644) Amortization of cash flow hedge (713) (686) Balance, end of year $ (2,397) $ (2,522) 56 Morguard NORTH AMERICAN residential REIT

59 notes to consolidated financial statements Note 11 Interest Expense The components of interest expense are as follows: For the years ended December Interest on mortgages $ 13,516 $ 15,547 Interest and tax payment on Class C LP Units 2,923 Amortization of deferred direct financing costs 1,439 1,348 Amortization of cash flow hedge Interest on indebtedness and other ,535 17,095 Distributions on Class B LP Units 7,261 $ 25,796 $ 17,095 Note 12 Related Party Transactions In addition to the related party transaction disclosed in Notes 4, 5, 6, 7 and 8, related party transactions also include the following: (a) Agreements with Morguard Affiliates On completion of the IPO on April 18, 2012, the REIT, the Partnership and its subsidiaries and certain Morguard affiliates entered into a series of agreements ( Agreements ) whereby the following services are provided by Morguard s affiliates under the direction of the REIT: Property Management Services Pursuant to the Agreements, Morguard s affiliates administer the day-to-day operations of the Canadian and U.S. real estate properties, for which Morguard s affiliates receive partnership distributions equal to 3.5% of gross property revenue of the real estate properties, payable monthly. Distributions amounting to $1,990 for the year ended December 31, 2012, are included in property operating costs. Of this amount, $203 is included in accounts payable and accrued liabilities. Asset Management Services Pursuant to the Agreements, Morguard s affiliates have certain duties and responsibilities for the strategic management and administration of the Partnership and its subsidiaries, for which they receive partnership distributions equal to 0.25% of the Partnership s gross book value defined as acquisition cost of the REIT s assets plus (i) fair value adjustments and (ii) accumulated amortization on property, plant and equipment. Distributions amounting to $1,390 for the year ended December 31, 2012, are included in trust expenses. Of this amount, $163 is included in accounts payable and accrued liabilities. In addition, an annual distribution is calculated in arrears, based on funds from operations exceeding a predetermined threshold of $0.66 per unit. For the year ended December 31, 2012, $nil was payable with respect to the annual distribution. Acquisition Services Pursuant to the Agreements, Morguard s affiliates are entitled to receive partnership distributions with respect to properties acquired, directly or indirectly, by the REIT from third parties, and the fees are to be paid upon the closing of the purchase of each such property. The fees range from 0% of the purchase paid for properties acquired, directly or indirectly from Morguard, including entities controlled by Morguard, up to 0.75% of the purchase price paid for properties acquired from third parties. Distributions amounting to $610 for the year ended December 31, 2012, have been capitalized to real estate properties and are included in accounts payable and accrued liabilities as of December 31, Annual Report 57

60 notes to consolidated financial statements Financing Services Pursuant to the Agreements, with respect to arranging for financing services, Morguard s affiliates are entitled to receive partnership distributions equal to 0.15% of the principal amount and associated costs of any debt financing or refinancing. Distributions amounting to $84 for the year ended December 31, 2012 have been capitalized to deferred financing costs and are included in accounts payable and accrued liabilities as at December 31, All agreements have an initial term of 10 years and are renewable for further terms of five years each, subject to certain notice provisions or upon the occurrence of an event of default as stipulated in the provisions of the Agreements. (b) Head Lease With Morguard On completion of the Offering, the REIT entered into a head lease (the Head Lease ) with Morguard as head tenant, with respect to 90 furnished suites at 3665 Arista Way, Mississauga, Ontario (the Arista ). The Head Lease will terminate upon the earlier of (i) the date on which the Arista ceases to be owned by the REIT or (ii) 30 days following the date on which the REIT notifies Morguard in writing that it intends to terminate the Head Lease. Under the Head Lease, Morguard will pay the REIT rent in an amount equal to 85% of gross revenue allocable to the 90 suites subject to the Head Lease, payable quarterly in advance, subject to adjustment at year end based on the actual rent received on such suites. The payment under the Head Lease for the period from April 18, 2012, to December 31, 2012, amounted to $1,178. There is no outstanding receivable from this amount as at December 31, (c) Key Management Compensation The executive officers of the REIT are employed by Morguard, and the REIT does not directly or indirectly pay any compensation to them. Any variability in compensation paid by Morguard to the executive officers of the REIT has no impact on the REIT s financial obligations, including its obligations under the various service agreements with Morguard and Morguard s affiliates. 58 Morguard NORTH AMERICAN residential REIT

61 notes to consolidated financial statements Note 13 Income Taxes The REIT is a mutual fund trust and a real estate investment trust pursuant to the Income Tax Act (Canada) and, accordingly, is not taxable on its income earned on its Canadian properties to the extent that the income is distributed to its unitholders. However, this exemption does not extend to the REIT s U.S. properties that are held by U.S. subsidiaries that are taxable legal entities. (a) The following are the major components of income tax expense: For the years ended December Current income tax expense based on taxable income of the current year $ 751 $ 1,019 Deferred income tax expense (benefit) Origination and reversal of temporary differences ,080 Benefit arising from reversal as a result of reorganization and recapitalization (75,036) (74,205) 14,080 (Recovery of) provision for income taxes (73,454) 15,099 Deferred income tax expense (recovery) (OCI) Amortization of cash flow hedge 154 (139) Expense arising from reversal as a result of reorganization and recapitalization 623 Income tax expense (recovery) recorded in OCI $ 777 $ (139) (b) The Trust s effective income tax rate is derived as follows: For the years ended December Income taxes at Canadian statutory rate $ $ 28,723 Impact of tax rate change 1,898 (13,615) Impact of foreign tax rates (890) (58) Other Reversal of deferred taxes as a result of reorganization and recapitalization 1 (75,036) 1 See Note 2, Basis of Presentation, for further details. $ (73,454) $ 15,099 (c) The following are the major components of deferred income tax liabilities: As at December 31, 2012 december 31, 2011 Canada U.S. Total Canada U.S. Total Real estate assets $ $ $ $ 73,533 $ 1,703 $ 75,236 Others (1,763) (1,763) Total net deferred income tax liabilities $ $ $ $ 71,770 $ 1,703 $ 73, Annual Report 59

62 notes to consolidated financial statements (d) The following are the components of the movement in deferred income tax expense: For the years ended December Real estate assets $ (74,205) $ 14,080 Others 732 (102) $ (73,473) $ 13,978 (e) Reconciliation of the deferred income tax liabilities at the beginning and end of the current financial period are as follows: Balance at January 1 $ 73,473 $ 59,495 (Recovery) provision reflected in consolidated statements of income (74,205) 14,080 Provision (recovery) reflected in consolidated statements of other comprehensive income 777 (139) Foreign currency translation (45) 37 Balance at December 31 $ $ 73,473 (f) The REIT has U.S. net operating losses of approximately US$409 that have not been recognized as it is not probable that taxable profits will be available against which they can be utilized. These losses relate to activities subsequent to April 17, These losses expire in The REIT has other U.S. temporary differences for which no deferred tax asset is recognized of approximately US$408. These other temporary differences have no expiration date. (g) The REIT regularly assesses the status of open tax examinations and its historical tax filing positions for the potential for adverse outcomes to determine the adequacy of the provision for income and other taxes. The REIT believes that it has adequately provided for any tax adjustments that are more likely than not to occur as a result of ongoing tax examinations or historical filing positions. Note 14 Net Income per Unit The following table sets forth the computation of basic and diluted net income per unit: April 18, 2012, to December 31, Period from 2012 Net income attributable for the period basic $ 107,076 Impact of Class B LP Unit revaluation and distributions 27,929 Net income attributable for the period diluted $ 135,005 Weighted average units outstanding basic 13,726,000 Impact of Class B LP Unit conversion 17,223,000 Weighted average units outstanding diluted 30,949,000 Net income per unit basic $7.80 Net income per unit diluted $ Morguard NORTH AMERICAN residential REIT

63 notes to consolidated financial statements Note 15 Consolidated Statements of Cash Flows (a) Items Not Affecting Cash For the years ended December Fair value gain on real estate properties $ (121,756) $ (82,585) Fair value loss on Class B LP Units 20,668 Amortization capital assets Amortization cash flow hedge Amortization deferred financing mortgages 1,235 1,348 Amortization deferred financing Class C LP Units 204 Present value of tax liability 288 Amortization tenant incentive 34 Deferred income taxes (74,205) 14,080 $ (173,317) $ (66,925) (b) Net Change in Operating Assets and Liabilities For the years ended December Amounts receivable $ (1,118) $ 264 Prepaid expenses (11,124) 747 Tenant deposits Accounts payable and accrued liabilities 1, Net change in operating assets and liabilities $ (10,349) $ 1,247 (c) Supplemental Cash Flow Information For the years ended December Interest paid $ 16,320 $ 15,534 Note 16 Commitments and Contingencies The REIT is involved in litigation and claims in relation to real estate properties that arise from time to time in the normal course of business. In the opinion of management, none of these, individually or in aggregate, would result in a liability that would have a significant adverse effect on the final position of the REIT. The REIT has agreed to indemnify, in certain circumstances, the Trustees and officers of the REIT. (a) Commitments Future minimum annual rental receipts on non-cancellable tenant operating leases are as follows: As at December Not later than one year $ 22,100 $ 14,165 Later than one year but not longer than five years $ 22,829 $ 14,218 (b) Rent Control Regulations In the province of Ontario, the REIT is subject to, and believes it has complied with, the Residential Tenancies Act, 2006 (Ontario). Each year, the Ontario government determines the province s residential rent increase for existing tenants. In 2012, the rental guideline increase was 3.1% ( %) Annual Report 61

64 notes to consolidated financial statements Note 17 Proportionately Consolidated Co-Ownership Interests The REIT is a participant in four (December 31, 2011 four) co-ownerships that own multi-unit residential rental properties in Canada, which are proportionately consolidated in these consolidated financial statements (collectively, the joint ventures ). The REIT s participation interest in these joint ventures ranges from 89% to 91%. As at December Balance sheet Assets Non-current assets $ 197,816 $ 162,241 Current assets 965 1,018 Total assets 198, ,259 Liabilities Non-current liabilities 88,140 90,329 Current liabilities 4,261 4,202 Total liabilities 92,401 94,531 Equity $ 106,380 $ 68,728 For the years ended December Statement of operations Revenue $ 17,252 $ 16,601 Expenses 12,449 12,163 Income before fair value changes on real estate properties 4,803 4,438 Fair value gains on real estate properties 34,959 23,411 Net income for the period $ 39,762 $ 27,849 Note 18 Management of Capital The REIT defines capital that it manages as the aggregate of its unitholders equity, Class B LP Units, mortgages payable and Class C LP Units. The REIT s objective when managing capital is to ensure that the REIT will continue as a going concern so that it can sustain daily operations and provide adequate returns to its unitholders. The REIT is subject to risks associated with debt financing, including the possibility that existing mortgages may not be refinanced or may not be refinanced on as favourable terms or with interest rates as favourable as those of the existing debt. The REIT mitigates these risks by its continued efforts to stagger the maturity profile of its long-term debt, enhance the value of its real estate properties, maintain high occupancy levels and foster excellent relations with its lenders. The REIT manages its capital structure and makes adjustments to it in light of changes in economic conditions and the risk characteristics of the underlying assets. 62 Morguard NORTH AMERICAN residential REIT

65 notes to consolidated financial statements The total managed capital for the REIT as at December 31, 2012, is summarized below: As at December Mortgages payable $ 313,930 Class C LP Units 103,482 Cash (4,822) 412,590 Class B LP Units 192,899 Unitholders equity 375,392 $ 980,881 The REIT s primary objectives when managing capital are to maximize Unit value through the ongoing active management of the REIT s assets and the acquisition of additional real estate properties, which are leased to creditworthy tenants, as opportunities arise. The REIT s strategy is also driven by policies, as set out in the Amended and Restated DOT, as well as requirements from certain lenders. The requirements of the REIT s operating policies as outlined in the Amended and Restated DOT include requirements that the REIT will not: (a) Incur or assume indebtedness if, after giving effect to the incurring or assumption of the indebtedness, the total indebtedness of the REIT would be more than 70% of the gross book value (as defined in the DOT) in accordance with IFRS; and (b) Incur indebtedness aggregating more than 20% of gross book value (as defined in the DOT) in accordance with IFRS at floating interest rates or having maturities of less than one year. The REIT s debt ratios compared to its borrowing limits established in the Declaration of Trust are outlined in the table below: As at as at B borrowing December 31, December 31, L limits Fixed-rate debt to gross book value 50% 36% 43% Floating-rate debt to gross book value 20% 6% 10% Total debt to gross book value 70% 42% 53% 2012 Annual Report 63

66 notes to consolidated financial statements Note 19 Financial Instruments and Risk Management The REIT s financial assets and liabilities comprise cash, amounts receivable, accounts payable and accrued liabilities, the Morguard Facility, mortgages payable, Class C LP Units and Class B LP Units. Fair values of financial assets and liabilities and discussion of risks associated with financial assets and liabilities are presented as follows. Fair Value of Financial Assets and Liabilities The fair values of cash, amounts receivable, the Morguard Facility, accounts payable and accrued liabilities approximate their carrying values due to the short-term maturity of those instruments. Mortgages payable and Class C LP Units are carried at amortized cost using the effective interest method of amortization. The estimated fair values of long-term borrowings have been determined based on market information, where available, or by discounting future payments of interest and principal at estimated interest rates expected to be available to the REIT at period end. The fair values of the mortgages payable and Class C LP Units have been determined by discounting the cash flows of these financial obligations using December 31, 2012, market rates for debts of similar terms (category Level 2). Based on these assumptions, the fair values as at December 31, 2012, of the mortgages payable and Class C LP Units before deferred financing costs and present value of tax payment are estimated at $331,994 and $113,253, respectively (December 31, 2011 $383,792 and $nil). The fair values of the mortgages payable and Class C LP Units vary from their carrying values due to fluctuations in market interest rates since their issue. The fair value of the Class B LP Units is equal to the market trading price of the REIT s Units. To mitigate the interest rate risk on the REIT s two floating rate mortgages, interest rate swap transactions are in place that mature on December 31, The outstanding balance of the floating rate mortgages as at December 31, 2012, amounts to $64,163. The fair value hierarchy of financial instruments measured at fair value on the consolidated balance sheets is as follows: As at December 31, 2012 december 31, 2011 Level 1 Level 2 Level 3 Level 1 Level 2 Level 3 Financial liabilities: Class B LP Units $ 192,899 $ $ $ $ $ Interest rate swap liability 1,053 2,192 Risks Associated With Financial Assets and Liabilities The REIT is exposed to financial risks arising from its financial assets and liabilities. The financial risks include market risk relating to interest rates and foreign exchange rates, credit risk and liquidity risk. The REIT s overall risk management program focuses on establishing policies to identify and analyze the risks faced by the REIT, to set appropriate risk limits and controls and to monitor risks and adherence to limits. Risk management policies and systems are reviewed regularly to reflect changes in market conditions and the REIT s activities. The REIT aims to develop a disciplined control environment in which all employees understand their roles and obligations. 64 Morguard NORTH AMERICAN residential REIT

67 notes to consolidated financial statements (a) Market Risk Market risk, the risk that the fair value or future cash flows of financial assets or liabilities will fluctuate due to movements in market prices, comprises the following: Interest Rate Risk The REIT is subject to the risks associated with debt financing, including the risk that mortgages and credit facilities will not be refinanced on terms as favourable as those of the existing indebtedness. Interest on the Morguard Facility and certain mortgages is subject to floating interest rates. For the year ended December 31, 2012, the increase or decrease in net income for each one per cent change in interest rates amounts to $642 on mortgages payable. The REIT s objective of managing interest rate risk is to minimize the volatility of the REIT s income. As at December 31, 2012, interest rate risk has been minimized as the majority of long-term debt is financed at fixed interest rates with maturities scheduled over a number of years. Mortgages totalling $64,163 are subject to floating interest rates; however, the REIT s risk has been minimized as the REIT has two interest rate swap transactions in place to acquire a fixed rate in substitution for the floating rate. In addition, all the mortgages on the Canadian properties are insured by the Canada Mortgage and Housing Corporation ( CMHC ). This added level of insurance offered to lenders allows the REIT to receive advantageous interest rates while minimizing the risk of mortgage renewals or extensions and significantly reduces the potential for a lender to call a loan prematurely. Foreign Exchange Risk The REIT is exposed to foreign exchange risk as it relates to its U.S. real estate properties due to fluctuations in the exchange rate between Canadian and U.S. dollars. Changes in the exchange rate may result in a reduction or an increase of reported earnings and OCI. For the year ended December 31, 2012, a $0.05 change in the U.S. to Canadian dollar exchange rate would have resulted in a $120 change to net income or loss and a $2,061 change to comprehensive income or loss. The REIT s objective of managing foreign exchange risk is to mitigate the exposure from fluctuations in the exchange rate by maintaining U.S. denominated debt against its U.S. assets, which amounted to US$85,851 as at December 31, The REIT currently does not hedge translation exposures. (b) Credit Risk Credit risk is the risk that (i) one party to a financial instrument will cause a financial loss for the REIT by failing to discharge its obligations and (ii) the possibility that tenants may experience financial difficulty and be unable to meet their rental obligations. The REIT is exposed to credit risk on all financial assets, and its exposure is generally limited to the carrying value of the financial assets. The REIT mitigates the risk of credit loss with respect to tenants by evaluating their creditworthiness, obtaining security deposits as permitted by legislation and geographically diversifying its portfolio Annual Report 65

68 notes to consolidated financial statements The REIT monitors its collection process on a month-to-month basis to ensure that a stringent policy is adopted to provide for all past due amounts. All receivables from past tenants and tenant receivable balances exceeding 90 days are provided for as bad debt expense in the consolidated statements of income and comprehensive income within property operating costs. When a receivable balance is considered uncollectible, it is written off against the allowance for doubtful accounts. Subsequent recoveries of amounts previously written off are credited against property operating costs in the consolidated statements of income and comprehensive income. The following table sets forth details of trade receivables and the related allowance for doubtful accounts: As at December Trade receivables $ 521 $ 688 Less: Allowance for doubtful accounts (207) (312) Total trade receivables, net $ 314 $ 376 (c) Liquidity Risk Liquidity risk is the risk the REIT will encounter difficulties in meeting its financial liability obligations. The REIT will be subject to the risks associated with debt financing, including the risk that mortgages and credit facilities will not be able to be refinanced. The REIT s objectives in minimizing liquidity risk are to maintain appropriate levels of leverage on its real estate assets and to stagger the debt maturity profile. At December 31, 2012, the REIT was holding cash of $4,822, amounts receivable on the Morguard Facility of $77,880 and access to an additional $100,000 through the same facility. The fair value of the interest rate swaps for the year ended December 31, 2012, is a loss position of $1,053 (December 31, 2011 $2,192), which is included in accounts payable and accrued liabilities in the consolidated balance sheets. Included in OCI is a gain of $1,139 for the year ended December 31, 2012 (a loss of $941 for the year ended December 31, 2011) that relates to the effective portion of the net change in fair value of the interest rate swaps. Note 20 Segmented Information All of the REIT s assets and liabilities are in and their revenue derived from the Canadian and U.S. multi-unit residential real estate segment. The Canadian properties are located in the provinces of Ontario and Alberta, and the U.S. properties are located in the states of Louisiana and Florida. No single tenant accounts for 10% or more of the REIT s total revenue. The REIT is separated into two operating segments, Canada and the United States. Additional information with respect to each operating segment is outlined below: For the years ended December 31, 2012 december 31, 2011 Canada U.S. Total Canada U.S. Total Revenue from income producing properties $ 69,473 $ 9,137 $ 78,610 $ 67,568 $ 4,355 $ 71,923 Property operating costs 33,510 4,720 38,230 33,288 2,189 35,477 Net operating income $ 35,963 $ 4,417 $ 40,380 $ 34,280 $ 2,166 $ 36,446 As at December 31, 2012 december 31, 2011 Canada U.S. Total Canada U.S. Total Real estate properties $ 782,166 $ 120,841 $ 903,007 $ 650,837 $ 26,107 $ 676,944 Mortgages payable and Class C LP Units 333,118 84, , ,038 19, ,629 Additions to real estate properties and capital assets $ 5,129 $ 99,897 $ 105,026 $ 7,575 $ 538 $ 8, Morguard NORTH AMERICAN residential REIT

69 notes to consolidated financial statements Note 21 Subsequent Event On February 19, 2013, the REIT acquired 1,032 suites in five multi-unit low-rise residential properties located in Louisiana and Florida and one multi-unit mid-rise property located in Louisiana from Morguard (collectively, the Morguard Properties ), for an aggregate purchase price of approximately US$94,800 (approximately $95,900), including estimated transaction costs of $800. The purchase price for the Morguard Properties was satisfied by the assumption of certain Fannie Mae insured mortgages in the aggregate amount of approximately US$61,900 (approximately $62,600) as at December 31, 2012, (the Assumed Fannie Mae Mortgages ) and a reduction of the balance owing by Morguard to the REIT under the Morguard Facility by US$32,900 (approximately $33,300). The Assumed Fannie Mae Mortgages have an effective weighted average interest rate of 5.7% and a weighted average term to maturity of 3.7 years. In connection with the acquisition of the Morguard Properties, Morguard has agreed to provide instalment payments during the remaining terms of the Assumed Fannie Mae Mortgages to the REIT in order to achieve an effective annual interest rate of 4.7% on the Assumed Fannie Mae Mortgages. All costs and expenses relating to the assumption by the REIT of the Assumed Fannie Mae Mortgages were paid for by the REIT Annual Report 67

70 CORPORATE INFORMATION BOARD OF TRUSTEES K. Rai Sahi 3 Chairman and Chief Executive Officer Avtar T. Bains 2, 3 Real Estate Advisor and Investor Dino Chiesa 1, 3 Principal, Chiesa Group Mel Leiderman 1 Managing Partner, Lipton LLP Frank Munsters 2 Corporate Director Bruce K. Robertson 1, 3 Principal, Grandview Capital William O. Wallace 2 President, Wallace Automotive 1 Audit Committee 2 Compensation and Governance Committee 3 Investment Committee Executive Directory K. Rai Sahi Chairman and Chief Executive Officer Paul Miatello Chief Financial Officer Beverley G. Flynn General Counsel and Secretary John Talano Vice President, Operations (U.S.) Brian Athey Vice President, Operations (Canada) Investor Information Registered Office 55 City Centre Drive, Suite 1000 Mississauga, Ontario L5B 1M3 Tel: Fax: Unit Listing Toronto Stock Exchange Symbol MRG.UN MRG.DB Auditors Ernst & Young LLP Principal Bankers Royal Bank of Canada Toronto-Dominion Bank Transfer Agent Computershare Trust Company Investor Relations Visit our website at or view our filings on SEDAR at For additional information, please contact: Paul Miatello Chief Financial Officer pmiatello@morguard.com Beverley G. Flynn General Counsel and Secretary bflynn@morguard.com Tel: Fax: Annual Meeting Tuesday, May 14, 2013 at 9:00 am Rattlesnake Point Golf Club 5407 Regional Road 25 Milton, Ontario L9T 2X5 Eligilibity RRSP RRIF DPSP Design: 68 Morguard NORTH AMERICAN residential REIT

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