Canadian real estate investment trusts: A review of the IPO literature and preliminary analysis of Canadian REIT IPO pricing

Canadian Journal of Administrative Sciences, Dec 2002 by Jane Londerville

Abstract

Initial Public Offerings (IPOs) of equity securities often exhibit underpricing; common stock values tend to rise significantly from the offer price on the first day of trading. The evidence for Real Estate Investment Trust (REIT) IPOs is less consistent. Early studies found evidence of overpricing; a 1990s study found underpricing. Several theories as to why this underpricing might be a rational strategy for a firm are outlined in the paper along with a discussion of their likely applicability to REITs as an asset class. The author's preliminary study examines the IPOs of the 13 Canadian REITs listed on the TSE in mid-1998, and shows evidence of underpricing of IPO units over the first 10 and 20 days of trading.

Real Estate Investment Trusts (REITs) have been an available investment in the U.S. since the 1960s. REITs are publicly traded unit funds which invest primarily in income-producing real estate assets.1 These trusts allow investors to add real estate as an asset class to their investment portfolio. Relatively small amounts of money can provide ownership in a portfolio that is diversified by geography and property type. Because the units are publicly traded, the investment is substantially more liquid than a standard real estate investment. Daily trading data are available for REITs, making them a subject of intense study in the real estate finance literature.

REITs are relatively new phenomena in Canada,2 emerging largely as a result of a change to the Canadian Income Tax Act in 1995. This change allowed REITs to qualify as closed-end trusts, benefitting from more favourable tax treatment. The income earned in the REIT is not taxed at the trust level; it is passed as taxable income to the unit holders, along with applicable CCA deductions. This avoids the double taxation inherent in dividend payments from corporations, as well as providing some tax shelter for the cash flow received. The legislation also removed the 21-year deemed disposition rule for REITs, which was a drawback to investing in open-ended real estate funds. A further attraction is that REITs now automatically qualify as eligible investments for retirement savings plans. As the implications of these changes became apparent and as the economy improved, a flurry of new REITs appeared. The most recently developed REITs are closed-end. Three are reincarnations of open-ended funds that ran into difficulty providing redemptions in the soft real estate market of the late 1980s.

As of November 1994, there were only three REITs trading in Canada, and just five by March 1997. At the time of the Initial Public Offering (IPO) pilot study reported here (May 1998), there were 13 REITs trading on the Toronto Stock Exchange (TSE), seven of which were launched in 1997. Total assets in Canadian REITs grew from Cdn$80 million in 1993 to $4 billion in 1998. While this growth is dramatic, the market is still in its infancy. REIT assets in the U.S. in 1997 were US$100 billion (Clayton & MacKinnon, 2000). Since 1998 the Canadian REIT market has been relatively quiet. Riocan acquired REALFUND and Summit acquired Avista, both on unsolicited offerings. Three new funds have issued IPOs: Cominar in September of 1998, O&Y REIT and Retirement Residences REIT (RETREIT) in 2001. RETREIT and CPL REIT announced in 2002 that they would merge.

The surge of new REIT investment in Canada occurred for various reasons. The impressive performance of the stock market recently is part of the explanation, particularly when contrasted with the low interest rate returns available on alternative investments. REITs allow those with real estate portfolios to liquidate a portion of their holdings, with the opportunity to retain some ownership and possibly management control. For small investors, REITs allow access to a liquid investment in a diversified real estate portfolio with relatively little cash.

Institutional investors have also been attracted to these aspects of REIT investment when compared to the management, diversification, and liquidity risks associated with direct investment in real estate assets. The ability to frequently and accurately assess the value of this type of real estate holding is also attractive to institutional investors. Direct real estate investments have to be valued by an appraiser to estimate the appreciation portion of portfolio returns. Since large institutional-grade real estate changes hands infrequently, these value changes are difficult to measure accurately. The fact that REITs trade daily and thus the value of an institutional real estate portfolio, consisting of REIT units, can be tracked frequently and accurately is appealing to advisors and management who are asked to report on portfolio returns.

The Canadian REIT taxation rules are similar to those in the U.S. At least 95% of each year's operating income must be distributed to unit holders and realized capital gains must be distributed annually. Tax is not paid on the REIT income at the fund or trust level, but by the individual unit holder. However, Canadian trusts can invest in shares, bonds, mortgages, marketable securities, cash and/or real property as long as at least 80% of its investments are situated in Canada. In practice, Canadian REITs invest primarily in real property and would be classed as equity REITs in the U.S. vernacular.3