Two major REIT spin-offs have come to market this year, and one more is on the way. But they’re not your typical IPOs, so advisors need to pay careful attention to seller motivation.
There are different approaches to financial engineering, which essentially means the steps companies take to increase share price. The most basic is selling off assets that aren’t getting the valuations they deserve from the market.
SNC-Lavalin Group is currently considering selling or spinning off several of its investments in assets it helped build. Those businesses include partial ownership in Highway 407 (a toll road just north of Toronto), and Altalink (a power transmission company in Alberta).
Companies can maximize their shareholder return by selling desirable infrastructure to a pension fund or similar entity looking for long-term cash-flow-generating assets to match their long-term cash-flow-draining liabilities. Unlike the market, a pension fund will pay top dollar for these assets. Crystallizing the value through a transaction allows the assets to be valued separately from SNC’s regular engineering and construction business, and removes any conglomerate discount.
Another option is to spin out assets directly to existing equityholders by setting up an entity to hold the assets, and issuing shares in the new entity as a dividend to current investors. The appeal of this option is that the process does not trigger a taxable gain at either the company or investor level, but still allows the value to be separated from the core business.
To maximize the value created, new shares are usually listed on an exchange to provide liquidity and a transaction value. Encana is currently contemplating such a move, announcing a strategy recently to complete an IPO involving more than 5 million acres of land in the Clearwater region in
When Encana spun off Cenovus in 2009, all shares in the new company were given to existing shareholders. But it seems Encana has different plans for the Clearwater IPO. On its recent conference call, the company said it would retain a significant stake in the new entity post-IPO. This usually means the parent company will sell a number of shares in the new entity and retain the cash for internal purposes, such as paying off debt. Existing shareholders do not receive anything.
In these situations, advisors must examine the structure of the IPO offering, question the motives of management, and probe for potential conflicts of interest if they are considering buying shares in the new entity.
Beware minority status
In two notable REIT IPOs this year, both Loblaw Companies Ltd. and Canadian Tire placed most of their real estate assets into separate companies, but maintained control of the new entities post-IPO by only selling a minority amount of shares to the public and keeping the raised cash for internal purposes. Existing shareholders in the companies did not receive any of the proceeds.
As a result, new investors in both REITs became minority shareholders, which is a risky proposition at the best of times in Canada. At minimum, advisors should scrutinize the deals’ details before taking positions for clients.
Loblaw launched its REIT in July, selling 18.3% of the shares for gross proceeds of $460 million. It sold 425 properties into the REIT, representing 35.3 million square feet of gross leasable area (GLA), which was 75% of Loblaw’s total GLA pre-transaction.
Canadian Tire came to market in October, and sold 16.9% of its new REIT, raising gross proceeds of $303 million. It sold 256 properties to the REIT, representing 19 million square feet of GLA, which accounted for 72% of Canadian Tire’s owned real estate pre-IPO.
In both cases, the majority owner of the REIT is also the majority lessee. Therefore, landlord and tenant made a deal with themselves, and the public was invited in to be minority shareholders after the fact. In the case of Choice Properties REIT, Loblaw accounts for 91% of the base minimum rent. Likewise, Canadian Tire accounts for 97% of the base minimum rent for CT REIT. So, it’s crucial to investigate what rent escalations these companies have negotiated with themselves, because one of the primary drivers of REIT valuation is organic growth derived from rent step-ups. Based on our coverage of the Canadian REIT market, we believe investors should be looking for, on average, 2% organic growth from rent escalations. Canadian Tire negotiated (with itself) rent increases of 1.5% annually, which is just below expectations. The only caveat is those step-ups won’t kick in until 2015.
By contrast, Loblaw self-bartered rent increases of just 0.3% on average for the next five years, which is well below market rates.
Worse, Loblaw also saddled minority shareholders with something we’ve not seen before in the Canadian REIT market. Choice is required to make a future payment to Loblaw if, at any time over the next 20 years, the REIT adds any gross leasable space to any of the initial properties sold into the IPO.
We can’t recall a situation where a buyer has paid a seller fair market value for assets, but has also taken on an obligation to pay the seller again in the future in order for the buyer to improve those assets. The fact that this obligation runs for the next 20 years on properties that are clearly intended for intensification represents, in our opinion, a deeply hidden and material cost for Choice’s minority shareholders.
Hudson’s Bay REIT will happen
The management of HBC has plans to create a retail REIT on par with Choice and CT now that the acquisition of Saks has closed. After appraisals are complete, the company will be clear to create a REIT with roughly 32 million square feet, encompassing properties used by the Saks, Lord & Taylor, and Hudson’s Bay banners.
In the new year, investors will have several new REIT options. Help them make the right choices.
Dr. Al Rosen, FCA, FCMA, FCPA, CFE, CIP and Mark Rosen, MBA, CFA, CFE run Accountability Research Corp., providing independent equity research to investment advisors across Canada.