A Tale of Two Markets
Excerpts from the Toronto Outreach
Conference
From afar, the US and Canadian markets
may look identical, but the closer you get, the more the
differences appear. How do these two markets that are so
intertwined differ and how are they the same? Can you do
business the same way in both countries? Is it worth the
hassle? These questions were put to panelists in the session
titled "A Tale of Two Markets" at AFIRE's recent
Outreach Conference held in Toronto, Canada.
Amy Erixon,
LaSalle Investment Management
Amy Erixon, international director at LaSalle Investment
Management, moderated the session. She started off by comparing
the characteristics of the two markets, through such indicators
as returns, cyclicality and timing, regional correlations
and other factors. The greatest similarities between Canada
and the US, Erixon noted, are in their levels of risk and
return over time. Their differences, she said, arise from
differences in the characteristics of the real estate markets
(for example, Canadian leases tend to be longer and the
properties in Canada tend to be concentrated in downtown
areas).
Private real estate markets in both countries
have been very strong in the last quarter century, Erixon
said, with only two years of recession. Canada's business
cycle, she noted, "is slightly more volatile, but
it is more volatile to the upside," with its recoveries
having been sharper than those in the United States.
Real estate securities, however, differ
much more between Canada and the US than do the overall
real estate markets, Erixon said, with tax and legal structures
contributing to the difference. Monetary policy is another
important factor, she held, noting that US and Canadian
monetary policies are independent of each other. On this
theory, she offered the opinion that North American securities
offer diversification benefits. The statistical correlation
between real estate investments in the US and Canada is
half that between the UK and continental Europe, she stressed,
attributing the difference to the fact that monetary policy
across Europe is linked, as opposed to the independent monetary
policies of the US and Canada.
Other differences between the markets
include more flexible financing options in Canada but more
flexibility in investment structure in the US In Canada,
real estate securities trade like an income product, she
said, whereas in the US they are more like equity. In those
differences, she said, "you can make some money."
LaSalle, Erixon said, has been selling
properties in the US "at just absolutely breathtaking
cap rates" of late. In both Canada and the US, however,
the problem is "where to take those proceeds,"
she said.
Asking the audience for a show of hands,
Erixon asked whether members believed the recent wide fluctuation
in currencies is an anomaly or a new reality. Opinion was
about evenly split. For herself, however, Erixon said she
sees the increase in European interest in North America
in part related to currency fluctuations." Up to this
point, she said, the role of the Europeans has not affected
capital flows between Canada and the US, but it may do so
in the future.
Describing Canada in closing as a very
friendly and transparent market, Erixon had one pointer
for newcomers. "I warn you, there are very competitive
and sophisticated insiders here and it is hard to make a
deal."
As to whether investing in Canada is
worthwhile, Erixon was unequivocal. "At LaSalle Investment
Management we think it is worth bothering. Canada is a large,
safe, transparent market that offers diversification benefits
to global investors. The investment structures that we use
for direct investors do create some tax drag for foreigners,
but if you are safety oriented, we think it's well worth
it." The undertaking does require a heavy investment
in research and administration, she noted.
Finally, Erixon stated, Canada offers
investor benefits because the Canadian economy, although
closely linked to that of the US, is not synchronized with
it. The two countries operate independent fiscal and monetary
policies and there are timing differences in their business
cycles. In fact, she argued, in Mexico a number of economic
activities, such as office and industrial leases, construction
activities and tourism, are explicitly linked to the US
dollar, and Mexico's monetary policy includes "tracking"
the US dollar. These links make Mexico's economy more closely
correlated to the US than Canada's. Among the NAFTA economies
Canada is the outsider, Erixon argued, based on distinctions
such as deficit spending, trade balances and the Canadian
government's greater influence in stabilizing the economy.
John Flavin,
Grosvenor Americas
In his comparison of the two markets, John Flavin, fund
management director for Grosvenor Americas, an international
real estate management and investment firm, first mentioned
a variety of cultural differences. He offered examples including
support for the war in Iraq, legalization of marijuana and
gay marriage as depicting the cultural divide between the
US and Canada.
He showed demographic maps, noting in
Canada clustering toward the southern extremes and noting
in the US clustering toward the northeast and the coastal
areas.
Legal structures for doing business are
similar, however, Flavin said, citing the origins of both
Canadian and US systems in English law. He offered as areas
demonstrating the similarities, property titles, leases,
zoning processes and property taxation. Income tax is less
clearly similar between the countries, Flavin said, noting
the plethora of special structures and rules in the United
States. Posing to himself the general question of whether
income tax is similar between Canada and the US, he characterized
the answer as "yes, no and maybe. But even under
the no there's a lot of maybe," he said, due to constant
flux in US law.
In discussing whether it's worth the
hassle to do business in both countries, Flavin described
Grosvenor's consideration of whether there is a distinction
between investing in the US and Canada. The group came to
a split conclusion, he said. Using charts depicting NCREIF
and RCPI indexes for office, industrial and retail space,
he portrayed what he called "a very strong correlation
in the office market," industrial sectors "basically
overlapping each other," and retail markets of "very
much a similar character."
In these markets, he said, the US and Canada have just recently
begun to move together. Based on that portrait, Flavin said,
Grosvenor decided to focus on the investment markets, without
so much concern about location. The company plans to open
an office in Toronto shortly, he concluded.
Yvon Tessier,
SITQ
Last to speak on the topic was Yvon Tessier, senior vice
president for investments with SITQ. Tessier spoke as a
Canadian investor with holdings in the United States. SITQ
is a subsidiary of Caisse de Depot (CDP) and manages about
CAN $8.5 billion of the CDP's $22 billion in assets. A decade
ago, Tessier said, 100 percent of CDP's investment was in
Canada, but the company has needed to diversify since then,
and now has about 22 percent of its holdings in the US,
16 percent in Europe and 8 percent in Asia.
Tessier gave an extensive listing of
the advantages for SITQ of investing in Canada, ranging
from taxes, familiarity with the markets and market dominance
to the liquidity, transparency and advantageous interest
rates on corporate financing. (Transparency was a widely-noted
characteristic of the real estate markets in Canada throughout
the session.)
Providing a bit more detail on some of
these advantages Tessier explained, for example, that SITQ,
as a governmental institution in Canada and a pension fund
as well, can invest tax-free in its homeland. With lively
interest in the Canadian markets from European, Israeli
and US investors in the last three years or so, liquidity
has been similar to that in the US, he said. The company
has advantages in financing in Canada because it is precluded
from defaulting on properties, he said. This restriction
allows it to access corporate financing rates that are 30
or 40 basis points over bond rates, rather than the 140
basis points typical for debt financing. Finally, the absence
of taxes provides the company flexibility in ownership,
Tessier said, another advantage of its Canadian investing.
The disadvantages Tessier cited to investing
in Canada are generally the things that led the company
to look outside the country. The size of the market was
a limitation, he said, as SITQ is a fairly dominant player.
With rising real estate allocations, he said, it became
increasingly difficult to build the real estate portfolio
enough domestically. Although the company's portfolio is
well diversified as to product, he said, further geographic
diversity also became desireable. Increasing competition
from investors, too, played a role. "We have been
meeting a lot of competitors. The returns have gone down
because of the competition. É So either we reduce
our expectations or we have to go and invest elsewhere."
Finally, the lack of turnover in Canadian markets prompted
SITQ's look abroad, he said. The REITs and pension funds,
as well as foreign investors, have been holding what they
own, "so there is not much available."
The challenges Tessier cited in diversifying
internationally included, most importantly, taxes, as well
as maintaining Canadian-style yields, currency issues and
financing. The company, not surprisingly, wanted to minimize
taxes, even to eliminate them if possible, he said.
With these objectives in mind, Tessier
reported, the company went "treaty shopping"
in 1993, in the US and Europe, looking for favorable conditions.
In the US, limited partnerships are the typical basis of
investor ownership of real estate, but the tax burden on
them made the format unattractive to SITQ. The company settled
on an approach that involved investing with local partners
in REITs. The attraction of REITs, Tessier said, was the
tax provisions: there are no taxes on the sale of shares,
providing tax efficiency on disposition of the asset, and
there are no taxes on dividends under certain treaties and
articles, making the vehicle tax efficient on current activity
as well.
In undertaking this type of arrangement,
SITQ had specific objectives for its partner relationships,
Tessier advised. He noted that successful pairings would
involve partners with aligned interests (the partner should
be interested in more than just the property and its revenue
stream) and similar business plans.
In addition to being tax efficientÑin
the interest of maintaining returnsÑTessier said,
the vehicle would have to be flexible enough to allow an
exit. Furthermore, it had to be marketable, hedging it would
have to be possible, at least to the extent that local financing
was less than 70 percent.
In light of these considerations, most
of the company's investments outside Canada were eventually
done through private REITs, Tessier said, and he presented
a chart detailing the relevant tax provisions that produced
the tax efficiency sought.
There were other considerations in making
effective use of the REIT structure, Tessier said, many
arising from the US requirements on the entities. In order
to reap the desired benefits, Tessier said, the REITs would
have to be US-controlled, so the two main partners would
each take 49.5 percent ownership, recruiting additional
investors in the remaining one percent to satisfy requirements
as to a minimum number of investors. A guaranteed return
served to attract those non-voting investors, but the two
main partners retain control.
Another of the restrictions on REITs
was not a concern for SITQ's REITs, he clarified. Because
of the company's pension status and "look through"
provisions, the restriction that five or fewer individuals
may not own more than 50 percent of a REIT's stock does
not hinder SITQ, Tessier said. But he advised that the "five
or fewer" limitation could pose a problem for other
investors.
Another issue would be requirements about
how long a REIT must hold on to an asset. This standard
makes the investors' intent a key consideration in deciding
to adopt the REIT structure, according to Tessier. The REIT
approach would not be attractive to investors focused on
developing and selling the properties or otherwise achieving
a shorter turnaround, but two- to four-year holds suit the
REIT arrangement, he said. Finally, the partners must have
agreed on an exit strategy, Tessier offered, before the
partnership is undertaken, since the sale of a property
would be a taxable event. The structure should allow liquidation
of the REIT as sales are made. Options include selling the
shares, refinancing or restructuring. SITQ has sold shares
in a few cases, Tessier said, but the market is somewhat
limited, due to the greater popularity of limited partnerships.
Additionally, the investment structure must not be so complicated
that successors would "not be able to live with it
once you decide to sell."
Final considerations, Tessier said, are
that dependency on the partner may be a drawback for some
investors and if the entity fails to maintain its domestic
control, there is a two-year wait to reestablish it.
Because it is probably the largest
and deepest market in the world, Tessier said, his company
sees the US as a good market for SITQ. Additionally, the
US has good treaties with Canada and monitoring is easy
between the close neighbors, he said (much easier than it
would be for Europe). The US is open to foreign investors,
who all live under the same rules and regulations, he said,
except for taxes, "and it is always possible to work
out tax efficient structures."
