Real Estate

A Canadian Real Estate Industry Primer

Real estate companies in Canada are predominantly Real Estate Investment Trusts (REITs). REITs are unique securities similar to S-Corps in the USA where income is passed directly to investors without corporate taxation (which means income is only taxed once at the personal level instead of double taxation for most publicly traded companies) provided certain rules are followed – primarily the rule that almost all income has to be passed on to unitholders/shareholders. These payouts tend to be in the form of dividends, making them very attractive for retail investors looking for a steady and strong dividend yield.

Prominent Canadian REITs include

DREAM [TSE:DRG.UN] (previously Dundee – has a few REITs based on property class)
Choice Properties [TSE:CHP.UN] (Loblaw’s real estate spin-off)
Boardwalk REIT [TSE:BEI.UN]
H&R REIT [TSE:HR.UN]
Crombie REIT [TSE:CRR.UN]
SMART REIT [TSE:SRU.UN]

Prominent Global REITs inclue

Public Storage [NYSE:PSA]
Welltower [NYSE:WELL]
Equity Residential [NYSE:EQR]

Many large retailers have spun off their real estate assets (but remain tenants in sale-leaseback transactions) to unlock value given the premium investors assign to real estate given the stability of cash flow. Real estate as a sector is also popular with Canadian investors commonly choosing iShares S&P/TSX Capped REIT Index [TSE:XRE] as an investment vehicle.

Understanding Commercial Real Estate

Real Estate is one of the easiest industries to understand but one of the most difficult to understand well. Although there are differences in real estate investing in different jurisdictions due to legal, geopolitical and regulatory structures, the business model of renting out property or developing property for sale is the same anywhere around the globe.

It is important to distinguish between commercial real estate and residential real estate. Commercial real estate is property that generates income for the owner through rent. Residential real estate is for owning to live in. These are the definitions for the purposes of this site, and there will be no discussion on semantics. This site covers real estate as a business, so coverage will be focused on commercial real estate.

Fundamentally, the business of real estate boils down to generating income in two ways – rental yield and price appreciation.

We explore the two elements here through the income statement and the balance sheet – the income statement walkthrough illustrates the quality of the property’s cash flows; the balance sheet shows what value can be realized through a sale (real estate can be recorded at fair value as an operating asset).

When there is dissonance between the two, action is taken. When the income statement output is more attractive than the balance sheet value, the property should be bought (or kept and milked forever), whereas when the opposite is true, the property should be sold with proceeds being reinvested in a vehicle with superior returns on invested capital.

We will describe these two at an asset level for the simplest explanation. For a real estate corporate, the valuation of the company will be based on the total real estate portfolio of the company – where this exercise can be repeated ad naseum to get to an appropriate figure.

Income Statement Walkthrough

The business of real estate revolves around rent (an entity will pay the owner for use of the property), usually for a fixed term (although owners can certainly be pragmatic around vacancies).

Accordingly, rental revenue can be identified by looking at a rent roll – which will sum up the income from leases of all tenants. With retail outlets, sometimes a percentage rent is also charged – or a percentage of all store sales. This is harder to predict than the firm lease.

Depending on the lease structure negotiated with tenants (where common practice varies between usage types in retail, office and industrial), the landlord will be reimbursed a certain amount of expenses (which show up further down in the income statement). This will fall under rental revenue as reimbursement income.

As most buildings will have some structural vacancies throughout the year (a lease expires and is not automatically renewed), an allowance is made for vacancies. For the estimated revenue, a certain percentage is netted out in case tenancies end.

The net revenue will often have ancillary revenues tacked on (parking, storage, laundry for multifamily).

Expenses for real estate include maintenance, HVAC, electricity, hydro, insurance, and property management.

After taking these factors into consideration, the net operating income can be calculated.

There are other factors that may affect cash flow that are unique to the relationship between the owner and the tenant. Often, the leasing aspect is outsourced to a commercial real estate agent or brokerage (CBRE, Colliers/FirstService, Avison Young, Jones Lang Lasalle) so leasing commissions must be paid on the rent every year.

Also, landlords may incentivise tenants to sign on through tenant or leasehold improvements (TI) – for example $40,000 that is to be allocated to a store facelift or renovation.

Valuation of Real Estate Stocks and Standalone Property

There are differences between valuing a real estate stock, which usually will have a portfolio of real estate, and an individual real estate property (a standalone investment property).

Capitalization Rate

For individual properties, investors commonly ask for the capitalization rate (or “cap rate”), which is the net operating income over the purchase price of the property. This gives a pre-leverage yield on the property before considering how the property is financed (the debt to equity mix).

The characteristics of the property will drive the capitalization rate. This will consider factors such as:

The duration of lease contracts – the longer the leases, the more stable the cash flows. Leases can be very long term (10-year office leases) or day-by-day (a hotel room for the night). To compensate for the larger risk, if all else is equal the hotel must have a higher cap rate.
The quality of the property – Old and dilapidated buildings are going to get a less creditworthy tenant base and will cost more for repairs, as well as require repair on a more regular basis.
The regional economic factors – If the property is in an area that is undergoing a commercial boom and is seeing rising rents (and leases expire soon), the forecasted rise in net operating income will induce a lower cap rate. Conversely, if the region is suffering (Calgary after the oil bust), cap rates will rocket as investors need to be compensated for the risk of default and difficulties in filling vacancy.
Ancillary revenue – If parking and services are cross-sold to tenants or parties outside of the tenancy agreement, this will be reflected in the building cost.

Price to Net Asset Value (P/NAV)

On a portfolio or corporate basis, REITs tend to trade close to net asset value (the flows to the investor are reflected well in net asset value, as in buying similar individual properties, given the tax rules around pass-through units such as REITs). Price is measured by market capitalization and net asset value is a good representation of equity. Keep in mind that NAV is liquidation value, so price should never go too far below net asset value otherwise there is an inefficiency.

Price to Funds from Operations (P/FFO)

This is an inverse of a cash flow yield. Funds from operations is a very good measure of the long-term cash flows of a company and comes without the noise of earnings. Premium P/FFO multiples therefore signal the market’s feelings on management and underlying quality of assets.

Price to Adjusted Funds from Operations (P/AFFO)

Similar to P/FFO but with the effect of smoothing out earnings and docking off recurring or maintenance capex, this is the preferred metric for many equity analysts. This is less reflective of current year factors and takes on a longer-term view than P/FFO – however it also includes factors that are very dependent on negotiations that may not necessarily reflect the property itself.

Price to Earnings (P/E)

The ubiquitous PE ratio applies to real estate – it is widely-used but not the primary multiple considered (the former three are much more popular in being valuation anchors) due to the effect of one-time accounting items (impairment, restructuring, non-operating factors) of earnings.

Notably, depreciation is not a source of major variance from true cash flow because real estate is usually measured at fair market value on the balance sheet (which comes from capitalization rates approved by appraisers). PE is still relevant in real estate, given the long-term nature of real estate assets and the relative stability of earnings.

Dividend Yield

Real estate as an asset class has bond-like or fixed income cash flow streams. Dividend stocks are commonly contrasted with bonds, and real estate stocks are ideal dividend stocks, so the relative attractiveness of yield is always a consideration. If interest rates on bonds rise, cap rates and real estate dividends must rise or the spread tightens. If cap rates and dividend yields rise in turn, price falls – so movements in 10 year bonds will lead to valuation moves for real estate equities.

Real Estate Metrics, Ratios and Terms

Rent Roll

List of tenancies with key information such as square footage, rent per square foot, and monthly rent. For mixed use buildings, this can also include the type of use the unit is for.

Net Operating Income (NOI)

This is the most important measure for real estate and its use is ubiquitous in the field. Net operating income is net income before the effects of interest and taxation – this allows a potential purchaser or investor to evaluate property at an asset level. Depending on how much debt is layered on to property, the interest will distort the taxation and the return to the equity holder.

Gross Leasable Area (GLA) – Square footage that can be leased out commercially (do not include hallways or communal toilets).

Net Asset Value (NAV)

Net asset value is the value of the portfolio – to get to NAV, the claims on the assets are netted from the fair value of the assets.

NAV = Fair Value of Properties – Debt – Preferred Shares + Cash + Investments + Shares of JV + Land Value + Developments

The fair value of the properties is easy to get to – the individual valuations of the properties in the portfolio are determined by capitalization rates assigned by real estate appraisers or valuators (including the Altus Group). If an example company has a hotel in Calgary and an apartment complex in Vancouver, the respective net operating income of each property will be divided by an appropriate cap rate for that location given the property class and the quality of the property. The net operating income will be disclosed, as well as the breakdown of property revenue and expenses in getting to NOI.

After the total value of the properties is established, debt on the properties (mortgages) and debt at the corporate level (bonds) are subtracted. If there are any preferred shares in the capital structure, these are subtracted as well.

Excess cash at the company level, passive investments and equity value of joint ventures are added to get to Net Asset Value. Land and buildings in development are also added. Land is marked at fair value and developments may be at cost or a discounted value of the sale price.

Funds from Operations (FFO)

FFO is a good proxy for actual cash flow for the year.

FFO = Net Income + Depreciation (if there is depreciation) +/- Losses/Gains on Sale + other Non-Cash Charges

Depreciation does not necessarily show up as an income statement line item because real estate can be (and usually is) valued on a fair market value basis instead of a depreciating property such as a factory. Usually the underlying rationale behind this is that the land value is appreciating. However, if depreciation is a line item on the income statement, it will be added back to calculate FFO.

The benefits of gains and losses for the year are reversed, as these one-time items are not seen to be sustainable in helping the REIT with its ability to pay cash distributions or dividends.

Adjusted Funds from Operations (AFFO)

AFFO is seen as a more normalized measure compared to FFO and also considers other recurring costs that are not necessarily related to the operation of the buildings. As such, AFFO may be the most informative metric.

AFFO = FFO – recurring maintenance capital expenditures – recurring charges +/- straight line rent adjustment

Capitalized maintenance (repairs) that are likely to recur without any positive consequence on revenue (but negative ramifications if repairs are not done) are taken off from FFO as this cash is not available to investors.

Recurring charges include tenant improvements and leasing commissions. Tenant improvements are allowances offered to tenants who renew or move in (possibly a free month of rent or cash allocated for renovations and making the place look a certain way). These incentives are a cash outflow or lack of cash inflow, so they are removed from FFO.

Leasing commissions are paid to commercial real estate brokers and constitute a portion of rent each month – again, cash flow that is not available to the investor.

Straight-line rent means the smoothing out of rental cash flows throughout the term of the lease. Usually, lease contracts will involve step-ups in rent after a certain time. For example, at a retail outlet in Pacific Centre, Vancouver, may have a lease agreement that stipulates $55 per square foot for years 1 and 2 before being stepped up to $65 per square foot for years 3 to 5. AFFO averages out the rent over the lease term.

Types of Real Estate Properties

Industrial
Office
Retail
Multifamily
Hotel
Gaming/Casino
Healthcare
Storage

Industrial

Industrial operations for a variety of specialized tenant needs

Industrial buildings tend to be in suburban areas with open space
Industrial real estate tends to be bespoke for a single tenant but can be grouped into industrial/technology parks
- Due to the bespoke nature of industrial buildings, tenant improvements or allowances from the landlord may be substantial
Types include:
Heavy manufacturing (a manufacturing plant)
Assembly plants
Bulk warehousing and distribution centres
Flex industrial: a mix of both industrial and office space

Office

Office buildings are segmented by geography (urban vs suburban) and quality (Class AA, A, B, C). Urban properties are located in city centres with high traffic – generally, barring a large oversupply situation (as we saw in Calgary post-2015 oil bust), properties will be easier to rent out as there will be higher demand and city centers have strong clustering effects (it is good to have your banker, lawyer, accountant and business partners in a convenient location).

Suburban offices tend to be tenanted by less creditworthy or affluent companies and will thus demand a higher cap rate. Buildings tend to be smaller in stature/lower density and sometimes grouped in office parks, which increases vacancy risk.

Even though there is no international standard for classifying office buildings. Office buildings are generally classified as Class A, Class B, or Class C (which commercial real estate brokers will aggressively market to the high end).

Class A: Highest quality buildings in the mark. Generally newer properties less than 15 years old with top amenities, high-income earning tenants and low vacancy rates. Class A buildings are well located in the market and typically professionally managed.

Class A demands the highest rent with little or no deferred maintenance issues and include trophy assets, which are sometimes deemed Class AA (large landmarks that generate substantial net operating income per annum, such as Scotia Tower or First Canadian Place). Leases tend to be 10+ years.

Class B: Older than Class A, but still have good quality management and tenants. Class B building should not be functionally obsolete and should be well maintained.

Class C: The lowest classification of office building and space. These are older buildings (usually more than 20 years old), and are located in less desirable areas and/or are in need of extensive renovation. Class C has the lowest rent, take the longest time to lease, and are often targeted as development opportunities.

Intuitively, cap rates are lowest for Class AA and highest for Class C.

Hotels

Hotels and hospitality includes real estate that provides accommodations, meals, and other services for travelers and tourists. Hotels are generally separated into the following categories:

Limited Service: Does not have room service, on-site restaurant, or concierge
Full Service: include room service and has on-site meal available
Boutique: Locate in an urban or resort location; has full-services amenities; but it is not part of a national chain; fewer rooms
Casino: Has a gaming component (video poker, slot machines)
Resort: Full service – large amount of land, in a typical resort location, has additional attached amenities (water park, golf course, or other amusement facility) – think Disneyworld

Logically, hotel properties have higher cap rates as earnings are much more volatile. Instead of long-term leases, leases tend to be only a few days, so there are always incentives to get travelers to stay for more than one night and to return to the hotel (rewards programs – Starwood Points).

When the economy is doing poorly, leisure and business travel cuts back, so the short-lease model that hotels use will suffer more than a multifamily property. Hotels see cap rates north of 8% to compensate for 1) volatility and 2) lower ability to get favorable leverage from banks.

Retail

Retail properties are usually occupied by retailers and restaurants

Multi-tenanted: often with an anchor, or lead tenant, that serves to drive traffic to the property). Multi-tenanted properties can be further classified into segments including national malls (West Edmonton Mal), regional malls (Oakridge Centre), power centers (a big box anchored open air retail park), anchored strip malls (with a Dollarama or a bank) or an unanchored strip mall (an assortment of convenience stores and restaurants).
Single-use: standalone buildings, like big box centers (national chain like Walmart, Canadian Tire, Superstore, Best Buy, Home depot, etc) or pad sites (single-tenanted buildings within a shopping center, often a bank, restaurant or drug store)
Leases tend to be 5-10 years

The concept of an anchor tenant is particularly important in the retail subsector. When a large mall has a Target or a Walmart (or a ritzier mall has a Saks or Neiman Marcus), customers will go to the mall for the anchor and purchase goods elsewhere during the shopping trip. Owners and anchors are cognizant of this and usually the anchor will pay a lower rent per square foot than the ancillary businesses.

Multi-Family

The multifamily group covers all types of residential properties, including apartments, condos and townhomes. Like office buildings, multifamily properties are often classified into Class A, Class B, Class C.

High-rise
Mid-rise
Garden Apartment (low-rise)

Real Estate Lease Types

Property operating expenses can include, but not limited to, property taxes, utilities, maintenance, etc.

Types of Commercial Real Estate Leases
Type of Lease	Rent Basis	Often Used In
Percentage Lease	Base Rent + Percent of Monthly Sales	Retail Businesses; Malls
Net Lease	In additional to rent, tenant pays some or all of taxes, insurance, or maintenance.	Any commercial lease; usually favours landlord’s interests.
Double Net Lease	Tenant pays rent + taxes and insurance.	Any commercial lease; usually favours landlord’s interests.
Triple Net Lease	Tenant pays rent + taxes, insurance, and maintenance.	Any commercial lease; usually favours landlord’s interests.
Fully Serviced Lease (Gross Lease)	Landlord directly pays all or most usual costs. These costs are often passed on to tenant in rent as a “Load Factor.”	Office, Some industrial and retail leases.
Modified Net or Gross Lease	Customized lease terms offer middle group for both tenant and landlord. Allows a broader range of negotiations around operating expense.	Applies to all property types