An appreciating US dollar and weakening Canadian economy is causing an uptick in interest in Canada for cross-border real estate investment trusts (REITs) that give US market exposure.
“A lot of investors are looking for exposure to the US markets, and one of the ways to get that – and historically one of the most attractive and stable ways to get that exposure – has been through real estate,” says Stephen Pincus, a lawyer at Goodmans. “Canadian investors have shown a strong interest in these US real estate portfolios through these cross-border structures.”
Spurred by low oil prices, the public real estate market has benefited from an injection of capital in the last few months, according to Pincus. Meanwhile, the Canadian dollar continues to fall in the face of a crippled energy sector, which has Canadians looking for exposure to US assets and currency.
The result, some experts say, may potentially contribute to the next wave of cross-border REIT offerings.
“At the time of the last IPO wave of cross-border IPOs (in 2013), there was not much of a delta between the currencies,” says Jeffrey Singer, a lawyer at Stikeman Elliott. “But now, that delta is quite significant.
“...It may be that demand by Canadian investors for exposure to both US real estate and US dollars may well be the catalyst for a future wave of cross-border REITs.”
REITs can follow three primary models: they can be traded in Canadian dollars, hedged or un-hedged; traded in US dollars; or they can be traded in both currencies. Real estate assets can be bundled from the US or around the world and can go public in Canada.
Where a REIT is earning income in US dollars but paying out its distributions (dividends) in Canadian, it may seek to purchase rolling hedges to mitigate any currency exchange risk. It is in this situation that fluctuations in exchange rates become an important part of some REIT structures, as this distribution of cash flow is tied to these market conditions.
For example, if an investor has exposure to assets denominated in US dollars but are traded in Canadian dollars and the Canadian dollar appreciates, the cost of distribution in US dollars to unitholders is higher. Conversely, if the Canadian dollar depreciates, the cost of distribution in US dollars is lower. This is assuming the REIT is hedged.
Pincus says the pay-out ratio is an important factor in how REITs are valued. “REITs tend to be valued higher if they have a lower pay-out ratio,” he says.
“Obviously if you’re paying out 100 per cent, there’s more risk in the distribution, especially in this example where the Canadian dollar appreciates – you don’t have enough US dollars to pay out. So you might end up paying out more than 100 per cent of your cash, which effectively means you’re paying out capital and the market would typically discount your stock for that.”
Singer says that a REIT that earns its income in US dollars but issues its distributions in Canadian dollars will also be subject to conversion costs when the company converts the income for those distributions. Over 12 distributions, he says, that can be a significant cost.
He adds that there is a timing element as well. “If you declare a distribution of Cdn$X, do you convert later (i.e., closer to distribution date), and risk the currency moving against you, or do you convert earlier (at the date you declare the distribution) and pay for a hedge?”
Mark Johnson, managing director and co-head of real estate investment banking at CIBC, says that a desire for US real estate and currency in this environment may drive another wave of cross-border REIT deals.
“I think it depends," Johnson says. "Canadians continue to seek yield and exposure to the US economy. However, in the current market, many of the REITs are trading below net asset value. This makes the environment for new entrants more difficult to optimize value via a new public offering in Canada versus other opportunities they may have.”
The majority of US REITs went public in Canadian dollars and trade in Canadian dollars.
“Historically, the Canadian retail investor has preferred to invest in Canadian dollars,” Pincus says. “…Generally the majority of these cross-border situations, the trading has been in Canadian, the distribution has been in Canadian, and they’ve been hedged to protect the stability of their distribution so it wouldn’t have to be reduced if the US cash flow went down relative and the Canadian dollar appreciated.”
But Singer says the bid prices of REITs are generally higher in the United States than in Canada, which, he says, may put off investors who are looking to invest in Canada.
“Convincing them to go public in Canada could be a trick,” Singer says. “But to me, what might overcome that – if the currency stays this way – is when they bridge this valuation gap or otherwise, is people that don’t just want access to real estate but they want access to Canadian-denominated real estate.”
Some REITs leave hedging up to investors. Slate Retail REIT, for example, does not hedge. It has two tickers of the same unit, one in Canadian and the other in US dollars, which gives the investor the option of betting on the currency, according to Conor McBroom, vice president at Slate Asset Management.
McBroom adds that hedging can be a worth-while strategy, but it can also be expensive. Singer says that most cross-border REITs have hedged their foreign exchange risk.
Pincus says he doesn't think currency drives the market for cross-borders, but rather it's the assets that investors are looking for.
Johnson says the consideration now is more about how investors get their dollar exposure.
“I think there’s definitely a desire for Canadians to have US dollar exposure, whether that is something that is listed in Canada, or buying US REITs for that income exposure is another way to get the US dollar exposure,” Johnson says.
“So I think it’s less about cross-border and more about where do they want US dollar exposure.”