NIC on Financing

NIC ON financing
BY ANTHONY J. MULLEN

U.S. versus Canadian REITs: A comparison

Avery: There are more than 25 REITs in Canada with a combined market capitalization of over $23 billion (Canadian), roughly $20 billion (U.S.). By comparison, U.S. REITs have a total market capitalization of $350 billion, making them about 17+ times as large as the Canadian REIT industry.

Within that universe, there are three Canadian seniors housing REITs, with a combined market capitalization of about $2.2 billion (Canadian). That compares to almost $20 billion in the U.S. for healthcare REITs. The Canadian seniors housing REITs yield from 7.1% to 9%, or about 7.8% on average. The largest is Retirement REIT, with a market capitalization of about $860 million. They have a more than 24,000-resident capacity, with about 90% of their properties located in Canada. Second largest is Chartwell, with a market capitalization of about $830 million and a resident capacity of almost 20,000. Again, most of these properties are located in Canada. The third is Sunrise Senior Living REIT, with a market capitalization of about $570 million, and a capacity of about 4,000, with about 80% located in the U.S.

How large is the public market for Canadian REITs? How many companies are represented? Who invests in them? And how are they perceived as an investment class?

Avery: The Canadian seniors housing industry in general is about one-tenth the size of the U.S. industry, in line with the general population comparison. Like the U.S. industry, the Canadian industry is highly fragmented in terms of ownership. As to who invests in Canadian REITs, the Canadian investor base is more retail-oriented. This is due in part to the trust structure, which makes it available to virtually all businesses, including those without any real estate holdings. This wide variety of available investments has made trust investing in Canada popular among retail investors. We’re starting to see, however, increased interest from Canadian, U.S., and other international institutional investors in the sector.

In the United States, seniors housing and care has always been viewed as a riskier asset class, compared to apartments, office, industrial, and retail. How does that match up in Canada?

Avery: The seniors housing industry has been viewed as a less risky asset by Canadian investors, largely due to structural differences. That’s because our seniors housing industry has been focused on a narrower level of service offering than available in the U.S., that traditionally being retirement homes and long-term care. Retirement homes in Canada are somewhat equivalent to the light-care assisted living sector in the U.S., and the long-term care sector in Canada is similar to the U.S. skilled nursing sector, being largely government funded and, traditionally, less involved with subacute care segments.

What are some of the key differences between Canadian and U.S. REITs?

Pincus: About eight or nine years ago, we came up with this concept of a senior care transaction in which we could have the properties held in the trust and lease those properties to an operating subsidiary that would carry on the business of managing the facilities. That was a fundamental change in the Canadian trust sector. So I would say the primary difference between Canadian REITs and those in the United States is this ability to operate a business and, in the senior care sector, to manage and operate nursing homes, assisted living, and so on.

Another difference is that the REIT itself, which is the public entity, the trust, cannot engage in an operating business. But any subsidiary-a corporation, an LLC, a limited partnership, and so on-can engage in operations, and that obviously gives the Canadian REITs a lot of flexibility.

What are other rules and requirements to qualify as a Canadian REIT? Must you own any property in Canada or can all of your real estate be in the United States?

Pincus: There’s no requirement to own anything in Canada. You could structure a Canadian REIT with operations and properties only in the United States. However, you need to at least have a head office in Canada. You also need to have a board here, because the REIT is in the form of a trust, and you have to have at least a majority of the trustees in Canada. But you can have some non-Canadians, some U.S. resident trustees, as well. Another requirement is that a REIT’s senior management would have to go to Canada for board meetings about four to six times a year.

Pincus: The ideal size for an IPO these days is somewhere between $150 million and $250 or $300 million (Canadian). Certainly, one of the interesting things about the Canadian market is the ability to absorb smaller size deals than in the U.S. You’ve got some IPOs that are quite a bit smaller than that, and you’ve got others that are a lot bigger-for example, there have been trust IPOs that have been in the billion-dollar range. But there are no hard-and-fast rules about what the sponsor needs to retain. I think a typical structure in the example you’ve given would be for the IPO to be about 50%. So you’d do an IPO at about $250 million, with the balance to be retained.

One technical rule is that a majority of the ownership of the REIT has to be based in Canada. So typically you’ll look for at least 50% plus one to be held by Canadian residents. There are structures for U.S. private equity sponsors to have more than 50%, but that’s typically held down at the U.S. subsidiary level, and then ultimately they cash out through a liquidity mechanism through the Canadian markets over time as the enterprise grows. But on the basis of the 50% limit for nonresidents below 50%, you need to consider that in structuring the capital.

The Canadian regulatory environment tends to be more balanced than the United States. It’s a lot less litigious. The regulatory system is not quite as complex, but we do have governance rules and requirements that are similar to those in the United States, such as the Sarbanes-Oxley rules.

What’s the difference in valuation between Canadian and U.S. REITs? Can I get a higher valuation in Canada?

Avery: If you look on a general basis at the valuation of Canadian REITs and U.S. REITs that focus on seniors housing, they are relatively comparable, with both trading at about 13 times 2006 FFO. On the surface, it doesn’t appear that there is a strong valuation motive for choosing a Canadian REIT structure.

That being said, I think the motives for choosing a Canadian REIT structure have more to do with the structural differences between them, notably the ability to own and operate the business of the seniors housing. But, again, there are also drawbacks to the Canadian REIT structure, including currency risk management and having to deal with the cross-border tax structure. And for Canadian REITs looking to buy in the U.S., they have the challenge of achieving economies of scale for management of these properties, given the magnitude of the U.S. market.

Let’s talk about Chartwell’s specific U.S. strategy. How much do you expect to invest over the next two years here in the United States? What types of properties are you going to target?

Ezer: We have aligned ourselves with a capital partner, ING Real Estate Group out of Australia. They’re our joint venture partner exclusively on assets in the United States. Together we acquired just under $300 million in eight properties last year. It’s our goal to do at least in the $300 to $400 million range in 2006 and in 2007. Our target is independent living and private-pay assisted living. We prefer not to be exposed to any kind of funding fluctuation. Everything that we’ve bought today that has a component of care has been private pay with no Medicaid or Medicare.

On the development front, we are looking to develop in the U.S., but are going to start with internal growth projects in our Meridian portfolio, with about 6,800 units under development in Canada.

What about your relationship with Horizon Bay Senior Communities? Does that give you any advantage?

Ezer: I think it certainly does in terms of the speed at which we would like to operate in the U.S., considering a lot of Canadian companies came down to the United States and got clobbered. We always felt that we needed to operate with someone who understands the business, the industry; has the contacts; and knows the legislation and licensing requirements, so we weren’t operating in a vacuum from a distance.

So we set up a management company called Horizon Bay Chartwell, owned 50% by Horizon Bay and 50% by Chartwell, to manage the properties in the United States. And that gives both companies the ability to even look at cross-border synergies as we continue to grow our businesses. We felt much more comfortable with a management partner in the United States, as opposed to going it alone. Over time, as we learn the business and get a better comfort from operating, that may change.