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Investing in Global Real Estate: A Market Update and Focus on U.S. Real Estate Including Tax Structuring Issues for Canadian Investors

November 17, 2011Investment Innovations Conference Fairmont Southampton Bermuda ResortSouthampton, Bermuda

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1

Real Estate Investing

One can invest in real estate in a number of ways: direct investments, through unlisted private funds, via publically listed companies or trusts on a stock exchange or through other avenues such as derivatives or debt. Returns vary depending on the investment strategy

Direct

Private

Public

Other

Joint Venture, Direct Ownership

Private Fund, Club Funds, Co-Investment

Real Estate Investment Trust, Real Estate Operating Company, Exchange-Traded Fund (ETFs)

Derivatives, Debt, Commercial Mortgage -Backed Securities (CMBS), Residential-Mortgage Backed Securities (RMBS)

2

Real Estate Returns =

Cash Flow + Capital Value Appreciation

Real Estate Investing (continued)

Core Core‐Plus Value‐Add Opportunistic

6% Expected Return >15%

Passive Asset Renovation / Restructuring Development

Lower riskMore stable cash flowsLower growthHigher dividend yieldsHigher dividend payout ratiosLower expected returns

Higher riskLess stable cash flowsHigher growthLower dividend yieldsLow dividend payout ratiosHigher expected returns

3

Market Update: Canada

5

Key Investment Drivers and Trends

• Availability of attractive debt continues to be the catalyst for the market’s resurgence

• Canada’s unique stable economic and political climate are making the property market highly attractive to both domestic and international investors

• International investors are looking for stability and diversification and if possible combined with high component of low-risk current yield

• Domestic buyers, specifically mid-sized to smaller pension funds are looking to increase their investments in inflation-protecting, lower volatility asset classes ie. Direct / private real estate funds

• Office market: ‘AA’ sector dominated by limited group of large pension funds and a few large asset managers; occupancy has remained strong, Calgary coming back; strong net absorption in 2Q11 at over 2.9 msf; liquidity and pricing have improved for high quality assets, now at 5 - 6.5% cap rates

• Industrial market: strong fundamentals in Western Canada, GTA seeing stable positive absorption and restrained supply resulting in 600 bps vacancy rate compression from 2002 to present, pressure on rental rates into 2012 unless economy falters

Market Update: Europe

• Hundreds of billions of dollars in commercial property debt expected to mature across the UK and Europe over the next few years

• Europe holds the largest share of the global debt funding gap (the difference between existing debt balance as it matures and debt available to replace it) for commercial real estate, from 2011‐2013

• Forced divestitures by banks under government ownership; this includes both direct holdings and loans, may exceed several hundred billion dollars in the UK, Germany, Spain and Ireland alone

• New bank and insurance firm regulations could impact lending and direct holdings

• Sovereign debt shocks likely to restrain bank lending to commercial real estate. Impact compounded by concentration of debt in bank lenders, as opposed to CMBS or insurance companies

• Several major private equity players have scaled back operations or withdrawn from the market

7


European Union represents 28% of world GDP

Painful retrenchment is resulting in a slow and tiered recovery. Consensus average growth rates of 1.5% (2009-2015) are 1% below historic recovery periods and even below historic long-term average of 1.8%

Sovereign debt of the weakest peripheral Eurozone countries will likely need to be restructured in order to restore solvency; debt yields and other pressures continue to rise, but timing of expected restructuring remains uncertain

Governments of the major EU countries have only announced 25% of the spending cuts relative to their stated targets

Unemployment rates have (largely) surprised positively and remained lower than in previous recessions. Employment growth rates are expected to be in-line with broader GDP growth rates

Hawkish European Central Bank, limited GDP growth and surplus capacity have resulted in a low inflation outlook for most Eurozone nations (Germany being the significant exception), while UK forecasts remain stubbornly high

8

Europe – Economic Overview

Vacancy rates are lower than unemployment figures would imply (relative to previous recessions); occupiers have returned less space to landlords, increasing floor space per worker, and thus vacancy rates are expected to remain +/- 10%

Net new supply is expected to fall to 25-year lows as development financing remains scarce

Ongoing sovereign debt concerns will constrain bank lending. Balance sheets are weaker than US peers, limiting transaction volumes and equity returns

Capital markets also expected to show muted transaction volumes and equity returns due to turmoil related to the European market debt crisis

9

Europe – Real Estate Markets

Europe has the highest expected funding gap from 2011-2013 globally, at 58%. This gap is much more concentrated among bank lenders than in the US (75% vs. 55%)Pressure on lenders to actively seek solutions will gradually increase towards 2013. After adjusting for loan extensions, 42% of all EU loans originated between 2005 and 2009 are likely to mature in 2013Consensual restructuring will be lender’s preferred path due to structural and legal factorsStructural: Lenders will defer enforcement until swap liabilities, which are how most loans are issued and are out of the money, amortize and interest rates increase Legal: Enforcement and administration in European jurisdictions, with the exception of the UK, is a much longer and riskier process than in the US

Source: DTZ Research

Debt Funding Gap by Country (EU)

10

Europe – Real Estate Markets (continued)


Many banks under government ownership have targeted 2013 for achieving specific reductions in total commercial real estate exposure

Consensual restructuring will be lender’s preferred path due to structural and legal factors

Legal consideration: enforcement and administration in European jurisdictions, with the exception of the UK, is a much longer and riskier process than in the US

11

Europe – Investment Opportunities

2%

21%

22%

55%

18%

6%

75%

4%

96%

Outstanding Debt by Lender Type Year End 2010


Market Update: United States

• Large accumulation of distressed assets requiring recapitalization and improving valuations: resulting in increased volume and velocity of transactions

• Well‐known larger scale distressed real estate situations consummated at the peak are approaching the next phase of resolution: need to roll over debt or equity haircut

• Debt capital markets have improved, with accelerating origination volumes, including some CMBS issuance; significant debt maturities through 2017

• Challenging IPO market may force capital‐starved companies to seek alternative capital sources

• Real estate asset divestitures by banks may accelerate as their balance sheets improve and can withstand write‐downs

• Poor residential markets continue weighed down by high unemployment: knock-on effect on retail market

• Continued tale of two cities: gateway cities doing well, secondary cities suffering

• Multi-family: strongest prospects

• Limited new supply across real estate sectors should lead to accelerated fundamental improvement once economic recovery fully takes hold

13


United States – Economic Overview

Continuing but uneven signs of economic improvement. Consensus GDP estimates of ~2% over next two years with moderate inflation. Risk of double dip recession appears low but not out of realm of possibilityU.S. employment picture remains mixed with unemployment rate at approximately 9%. Initial weekly unemployment claims remain very high at around 400k and new job growth is still anemicHousing prices continue to slide backwards. 28% of mortgages already or nearly under water. Economists pushing back estimates of housing bottomLong term federal, state and municipal government deficits remain unresolved. Toxic political environment negatively impacting fiscal policy formationS&P downgraded U.S. credit rating to AA+ for the first time in historyRecent economic deceleration has prompted Fed officials to leave open possibility for additional stimulus

Retail Sales Growth and Case‐Shiller Home Price Index

Source: U.S. Census Bureau, Standard and Poor’s

Source: Bureau of Economic Analysis and Morgan Stanley Forecasts

GDP Growth and Unemployment

14 Source: Bureau of Economic Analysis and Morgan Stanley Forecasts

There are $181 billion in known distressed assets, with nearly 24% in office and 21% in multi-family, according to Real Capital AnalyticsBanks are beginning to more aggressively review their portfolios with the rebound in pricing. Larger well-known distressed real estate situations (e.g. Calwest, Archstone, Stuy Town) are approaching next phase of resolutionLenders favoring short sales, sales of defaulted notes, and court-ordered auctions to taking title; however, REO inventories still total $40 billionTransactional volumes were up 104% year over year in 1H11 with cap rates declining Delinquency rates are highest among lodging, multifamily and industrial assets

Source: Real Capital Analytics

Debt Maturity Schedule

Distressed Assets Accumulating

Source: Trepp, Foresight Analytics

15

United States – Real Estate Market

CMBS market recently weakening, with spreads blowing out for across all tranches of pre-crisis vintages and a doubling of spreads for post-December 2009 AAA vintages. CMBS origination volumes slowingWho’s going to fill the gap?

CMBS Issuance

Source: Commercial Mortgage AlertNote: Excludes agency deals and CRE CDOs

16

United States – Real Estate Market (continued)

Office fundamentals still in the early stages of recovery and the pace of recovery is slowLack of new construction will help speed recovery – almost no new speculative projects underwayPrime markets for rent growth include the San Francisco Bay Area, as well as other tech-exposed marketsTransaction volumes have nearly doubled, with New York, San Francisco, D.C./Northern Virginia posting the most impressive sales volumes

Cap rates near 5% for trophy assets in gateway markets such as New York and D.C., and 8%-plus in most suburbs

Source: Jones Lang LaSalle

17

United States – Office Sector Status

Energy and tech-related markets truly driving majority of gains

YTD 2011 net absorption percent of inventory

Silic

on V

alle

y

San

Fra

ncis

co

Pen

insu

la Aus

tin

Sea

ttle

Hou

ston

San

Fra

ncis

co

Den

ver

Dal

las

U.S

.

3.0%

2.5%

2.0%

1.5%

1.0%

0.5%

0.0%

Operating fundamentals are gradually strengthening as retail sales, manufacturing output and trade continue to trend positivelyLeasing being driven by retailers and third-party logistics firms and focused on large, modern Class A product: velocity remains strong though still tenants’ marketVacancies declined for the fifth consecutive quarter to 11.7%, but meaningful rent growth still a year awayLow new supply with exception of select “build to suit” opportunities for developersTransaction volumes increased to $3.6B in 2Q11, a 50% increase from the prior yearCoastal Class A assets trading in 5-6% range, versus 7-8% for most U.S. markets

18

United States – Industrial Sector Status

Another solid quarter of positive net absorption— Net Absorption (SF in millions) — Vacancy Rate

Q32007

Q42007

Q12006

Q22006

Q32006

Q42006

Q12009

Q22009

Q32009

Q42009

Q12010

Q22010

Q32010

Q42010

Q12011

Q22011


Public company same store NOI growth expectations are ~7% in 2011 with several years of strong fundamentals expected Vacancy rate declined 30 basis points in 2Q11 to 6.9% and is expected to reach 6.4% over the next year. Rents expected to increase 3.7% in 2011 and 4% per annum through 2015New supply is very low, but apartment companies are restarting development pipelinesAsset values are now only 5% off peak with some trophy assets below 4%. Median cap rate is 6.3% Financing environment very attractive for multi-family sector

19

United States – Multi-family Sector Status

Operating fundamentals remain mildly positive with occupancy and rent levels modestly improving due to growing sales and limited new supply High productivity malls have materially outpaced lower-end malls due to the resilience of high-end consumers. A-quality malls are better positioned from a fundamental and asset value perspectiveNew mall supply almost non-existent; outlet supply is somewhat higher but still lowShopping center sector continues to suffer from subdued demand from small shop tenants. Retail chain bankruptcies continue to cause leasing challenges to centers. Leasing spreads remain weakResidential housing markets remain particularly challenged – negative knock on effect on retailCap rates range from 5-6.5% for A assets to 7-9% for B malls, and 6-8% for strip shopping centers

20

United States – Retail Sector Status

Total United StatesType Total stock

(s.f.)Total

vacancyQ2 2011 Net

absorptionQ2 2011

average rentQ-Q change Y-Y Change

Total Retail 12,151,360,981 7.1% 11,112,629 $14.74 0.7% 2.4%

Malls 1,186,282,925 5.6% 2,155,975 $18.26 -4.4% -3.4%

Power centers 723,926,871 6.8% 2,233,143 $17.09 -3.7% -2.9%

Shopping center 4,093,035,380 10.8% 3,012,174 $14.43 -0.6% -3.6%

General Retail 6,047,800,029 4.8% 13,163,475 $14.54 -0.3% -2.9%


Potential opportunities include:

– Debt and debt vehicles remain a targeted entry point (banks, regional banks, mezz funds, etc.)

– Cash-strapped companies who have postponed or shelved IPOs due to poor market conditions

– Unlisted funds, investment sponsors

– Unstable or broken capital structures

– Entities or assets with impending debt maturities without access to debt or equity markets to recapitalize

21

United States – Investment Opportunities

Tax Structuring Issues for Investing in U.S. Real Estate

Withholding Tax

Hybrid Entity Rules- Article IV (6)- Article IV (7)

Article XXI

Limitation on Benefits

Foreign Accrual Property Income (“FAPI”)

Non – Resident Trust (NRT) and Offshore Investment Fund Property

23

Canada – U.S. Tax Treaty Highlights

What is the investment (debt or equity)? Can the asset be held in a REIT?What is the existing or proposed legal structure?What are the U.S. tax profiles of the investors?What are the taxable income/cash projections for the investment?Will interim cash distributions from the investment (e.g., interest or dividends) be subject to U.S. withholding tax (“WHT”)?What is the expected exit strategy? Will there be U.S. tax on exit?Will Canada provide credit for U.S. taxes?Will the investment cause the investor to have a U.S. tax filing requirement?Will the hybrid entity rules under the Canada-U.S. Tax Treaty impact the WHT analysis?Will the offshore investment property rules or the non-resident trust rules apply?Will the Canadian controlled foreign affiliate (“CFA”) and foreign accrual property income (“FAPI”) rules be applicable?

24

General Considerations for U.S. Real Estate Structuring

The Foreign Investment in Real Property Tax Act (“FIRPTA”) was enacted by the U.S. Congress in 1980 and currently covers all forms of U.S. real estate

Generally, non-U.S. investors do not incur U.S. tax liability from income and gains realized from investing in various types of U.S. assets including stocks and bonds. However, non-U.S. investors are generally subject to FIRPTA on gains realized on the sale of a U.S. corporation that owns U.S. real estate (this includes regular corporations and REITs), or on a capital gain distribution from a REIT

The applicable tax rate ranges from 35 to 54.5%, depending on the tax profile of the investor. The general FIRPTA tax rate is 35%; however, non-U.S. corporate investors without treaty relief are also subject to the U.S. “branch profits tax” on asset sale gains (e.g., REIT capital gain distributions) that can cause the effective tax rate to be as high as 54.5% (for Canadian taxable entities that can obtain treaty benefits, the combined rate is typically 38.25%)

Under current law there are limited exceptions to the application of FIRPTA:– Where an investor holds less than 5% of a publicly traded REIT; or– Where an investor holds shares in a “domestically controlled REIT” (i.e., > 50% U.S. owners by

value)

TBD – impact of the FATCA withholding legislation (live date: January 1, 2013)

25

Taxation of U.S. Real Estate for non-U.S. Investors –General Overview

In addition to the current statutory exceptions from FIRPTA, the following are general strategies that may be employed to eliminate or mitigate the impact of FIRPTA:

Eliminate

−Structuring the investment via a non-U.S. blocker - a non-U.S. blocker corporation is not considered a U.S. real property interest and, therefore, is not subject to FIRPTA. Thus, a non-U.S. blocker may be sold free of FIRPTA; and

−Acquisition of debt at a discount

• To the extent non-U.S. investors are paid back at the face amount, any resulting gain would not be subject to FIRPTA

• To the extent a fund restructures its debt investment (e.g., via a foreclosure), any realized gain on the debt would not be subject to FIRPTA for non-U.S. investors and a tax basis increase (equal to the gain) in the underlying property would be obtained

26

U.S. Real Estate – FIRPTA Planning

Mitigate

Investment Level− Earnings Stripping – FIRPTA impact can be mitigated by maximizing interest and dividend

income paid out of a U.S. REIT or corporation at the investment level (which is generally subject to a lower or zero effective U.S. withholding tax rate, depending on the relevant treaty), prior to exit in order to minimize the gain subject to FIRPTA

Shareholder Level− Standard Blocker – a non-U.S. investor invests through an existing U.S. subsidiary or newly

created U.S corporate entity (which may be a part of such investor’s U.S. consolidated group) so that future income/gains from its investment in the Fund may be reduced by available net operating losses and depreciation deductions; and

− Leveraged Blocker – a non-U.S. investor invests through an existing U.S. subsidiary or newly created U.S. corporate entity that is capitalized with both debt and equity, so that future income/gains may also be reduced by interest expense, in addition to the benefits of the standard blocker

27

U.S. Real Estate – FIRPTA Planning (continued)

Fund

Investors

REIT

100 s/h

U.S. Real Estate

GP

Flow through structure for tax purposes (no entity level tax at the Fund)

Treaty hybrid rules should not have an adverse impact

REIT acts as a blocker against U.S. “effectively connected income”(“ECI”) or “commercial activity income” (“CAI”)

REIT is not subject to entity level tax, but REIT must distribute 100% of its taxable income annually

Interest and depreciation deductions at the REIT level may create tax losses

Exit via a share sale or asset sale typically subject to FIRPTA

REIT NOLs cannot be used to offset REIT capital gains from asset sales

Receipt of a REIT capital gain dividend or sale of US REIT shares creates an “informational filing” for U.S. tax purposes

– Non-U.S. investors who wish to avoid this administrative issue may consider a blocker structure to hold its Fund units

28

Sample Structure – Real Estate Investment Trust (“REIT”)

Fund

Investors

REIT

100 s/h

U.S. Real Estate

GP

REIT income subject to entity level tax at the blocker level

Taxable entity – typical effective tax rate can approximate 40% depending on state tax profile

REIT still acts as a blocker against ECI or CAI

REIT distribution rules still apply

No distribution requirements out of leveraged blocker

No U.S. filing requirement at investor level as the leveraged blocker acts as a filing blocker (it is the “taxpayer” from a U.S. tax perspective)

Shareholder loans can create additional tax deductions at the blocker level and can be used to offset both ordinary and FIRPTAcapital gains income

U.S. tax impact typically same as leveraged C corporation structure

Blocker may be existing U.S. balance sheet or a NewCo, or a non-U.S. entity/structure, depending on the tax profile of the investor and relevant U.S. income tax treaty

Leveraged blocker must conform with U.S. debt/equity and interest stripping rules

U.S. withholding taxes may apply on interest and dividends paid out of the C corporation, depending on the tax profile of the investor and the relevant U.S. income tax treaty

U.S. Blocker

Feeder sInvestors

Shareholder loans

29

Sample Structure – REIT with Leverage Blocker

U.S.

Canada

Real Property/REIT

Can P’ship

US P’ship

Canadian Investor

Internal Loan

30

Sample Structure – Canadian Blocker

Tiered partnerships allow income to flow through to Canadian investors

Canadian partnership checks the box for US purpose to be taxed as a C-Corp

Treaty hybrid rules should not have an adverse impact

Canadian investors should benefit from foreign tax credits on US tax paid on US income

Structure eliminates US Estate Tax concerns for Canadian individual investors

Structure eliminates US filing requirements at investor level

Investment in domestically controlled REITsmay also provide opportunity to exit investment without U.S. tax

*Qualifying pension trusts and individuals can obtain the lower individual ECI rate of 15%.**Assumes 35% federal/5% state entity level corporate rates. NOTE: depending on the facts, it is possible to reduce the taxable income of the C Corporation by as much as 50% via interest deductions, which would give rise to a 20% effective tax rate at the entity level.

31

Comparison of U.S. Tax Leakage

Leveraged C – Corporation Investor REIT Investor

Section 892

Taxable Canadian (Treaty)

Canadian Pension

Trust

Section 892

Taxable Canadian (Treaty)

Canadian Pension

Trust

Dividend WHT 0% 15% 0% 0% 15-30% 0%

Interest WHT 0% 0% 0% 0% 0% 0%

Share Exit 0% 35% 15% 0% 35% 15%*

Asset Exit** 40% 40% 40% 35% 38.25% 15%*

Investing in U.S. Real Estate through Private Funds

Private Fund– Private Placement Memorandum (and Supplements)– Subscription Documents– Partnership Agreement– Side Letters

W-8 Tax Forms

AML/KYC Information

33

Fund Documentation

Due Diligence on Fund Manager

Review/Negotiation of Documentation

Submission of Subscription Materials (Sub Docs, W-8, KYC)

Closing

Capital Call

34

Subscription Process

How is the Fund structured?– Blocker

• Deal-by-deal blocker?• Feeder option?• Use of leverage?

– Domestically-controlled REIT

What percentage of investors are U.S./non-U.S.?

How much ECI is expected to be generated?– Nature of the investment– Income profile

Is there an ECI structuring covenant?

How are most non-U.S. investors coming in to the Fund?

35

U.S. Tax Diligence Questions

W-8 BEN– Beneficial owner– Tax treaty benefits

W-8 IMY– Intermediate entity (i.e., non-U.S. pass-through vehicle)

W-8 EXP– Foreign government, tax-exempt organization, private foundation, etc. – Claiming withholding exemption (i.e., Section 892)

W-8 ECI– Receipt of U.S. “effectively connected income”

∗ Not provided to IRS, kept with Fund Manager

36

U.S. Tax Forms

Wrap-Up

Once in a cycle investment opportunity to take advantage of distressed U.S. real estate market

Can access through public or private markets with saw-off being liquidity vs. volatility and potential for out-sized returns and whether to access through debt or equity; make sure to compare to equivalent net-of-taxes returns in Canada

Should keep in mind that ‘FIRPTA’ related tax leakage for U.S. real estate investments could in the worst case scenario result in 54.5% tax paid on income and capital gains but that there are other likely-outcome scenarios that could result in as low as zero tax paid on income and capital gains

Determine your tax status with the IRS: are you a section 892, a special trust, or just a corporate?

Get specialized advice – work with legal counsel and tax accountants with experience in dealing with Canadian investors making investments in U.S. real estate

Ask peers with known experience for advice and get references

38

Key take-aways and actions to consider