Ask the Spud: Adding a New REIT to the Index

Loblaw recently announced it will be creating a new real estate investment trust (REIT). Once it goes public, how would it be added to existing real estate ETFs? And considering how large the proposed REIT will be, what effect might it have on ETF shareholders? – Joel H.

On December 6, Loblaw Companies announced it would be turning its vast property holdings into a REIT in the new year. Units in this new trust will be listed on the Toronto Stock Exchange and sold during an initial public offering (IPO) in mid-2013.

Any time a new company is listed on the TSX, it may be considered for inclusion in any number of indexes. For example, stocks in the S&P/TSX Composite Index must meet certain criteria (mainly size and liquidity). The index is reviewed every quarter, and if a company no longer meets these criteria it can be removed. By the same token, any newly listed company that does fit the criteria can be added to the index.

The new Loblaw REIT will be one of the largest in Canada, so it will likely qualify for inclusion in the Composite index. If that’s the case, it would also be added to the S&P/TSX Capped REIT Index, which is a “subindex” of all the real estate investment trusts in the Composite.

This benchmark is tracked by the iShares S&P/TSX Capped REIT (XRE), so I asked Steven Leong, vice-president of product development at BlackRock, how this ETF would be affected if the Loblaw REIT were added to its index. “As XRE is a fund that fully replicates its index, it would also be added to XRE’s portfolio,” he says, “and generally the fund would need to sell some of its existing holdings in order to finance that purchase.”

Potential problems

Index changes occur all the time, and if the companies are small the effects are usually trivial. But the Loblaw REIT raises a couple of issues because of its size relative to the sector: XRE has just 14 holdings, so the addition of a large company to its index could force the ETF to make a significant purchase and an equally large sale.

If an index is widely followed (and XRE is a $1.37-billion fund) large transactions can have a market impact: an index fund’s purchase of the newly added company can drive up its price, and a sale can have the opposite effect. What’s more, savvy traders can front-run the index: that means they can buy the stock before it is officially added to the index, wait for the price to be driven higher, and then dump it. That’s the theory, anyway. But in practice, index providers have become good at preventing this. “Additions to the Composite index do usually take place at the quarterly review,” Leong explains, “although S&P reserves some discretionary power to add securities at other times as well.”

The second potential problem is taxes. REITs have risen dramatically in price over the last three years or so, and if a fund has to make a significant sale, it is likely to realize some capital gains. If you hold the fund in a taxable account, you’ll get T3 slip at the end of the year and you’d have to report those gains on your return. “The financial statements of the funds disclose both the average cost base and current market value of the fund’s portfolio, thereby providing some additional transparency to investors around potential capital gains,” Leong says.

Leong also points out that while Loblaw REIT may be large, only a portion of the shares will be publicly traded: “Loblaw did note in its press release that it ‘intends to maintain a significant majority interest’ in the REIT.” S&P indexes are based on float-adjusted market capitalization, which includes only shares traded on the exchange. For example, if a company has a $10 billion market cap, but $6 billion of those shares are held privately, its weight in the index would be the same as if it were a $4 billion company.

Bottom line, the impact of the new Loblaw REIT on real estate ETFs is likely to be modest. There may be a small tax hit for investors who hold their fund in a non-registered account, but in a tax-sheltered account, any changes in the index aren’t likely to have any meaningful impact.

26 Responses to Ask the Spud: Adding a New REIT to the Index

  1. J A H December 13, 2012 at 10:44 am #

    Thanks for taking my question and sourcing a great answer.

    May I ask for a small clarification on what Steven Long means by avoiding the effects of a front-run? Is it that the fund will make a purchase at an undisclosed time rather than set quarterly date that other traders can anticipate; or does it mean something else?

    Great writing as always,

    Joel H

  2. Canadian Couch Potato December 13, 2012 at 10:47 am #

    @JAH: I should clarify that Steven didn’t specifically mention front-running in his reply to me. He simply stated that not all index changes are made on those specific quarterly dates. My understanding is the reason index providers do this is to discourage front-running, which no longer seems to be a significant problem for index funds.

  3. Tasty Crumb December 13, 2012 at 11:24 am #

    I noticed that in the model portfolio page of this site, you recommend ZRE for REIT allocations. Why did you pick ZRE over XRE?

  4. Canadian Couch Potato December 13, 2012 at 11:56 am #

    @Tasty: I like the equal-weight stratgey of ZRE, which I think makes sense in a sector fund with a small number of holdings. Otherwise a small number of companies dominate the index.
    http://canadiancouchpotato.com/2010/06/17/new-kid-on-the-real-estate-block/

  5. AndrewB December 13, 2012 at 1:19 pm #

    There is also talk that the Bay is going to spin off a REIT as well next year. This may further complicate the tax implications and re-balancing of XRE.

  6. jason December 13, 2012 at 3:41 pm #

    i have been looking for the holdings of VRE but i can not seem to find the info any were. do you have a link with this info?

  7. Derek @ Freeat33 December 13, 2012 at 3:50 pm #

    What do you suppose the fall of Zellars is going to do to REITs?

  8. Canadian Couch Potato December 13, 2012 at 3:51 pm #

    @Jason: The Vanguard site says the holdings will be published in mid-December. In the meantime, here’s the index fact sheet, which includes the top 10 holdings:
    http://www.ftse.com/Indices/FTSE_Canada_All_Cap_Sectors_Capped_Index_Series/Downloads/GPVAN022.pdf

    @Derek: Probably nothing significant.

  9. Russ December 13, 2012 at 11:26 pm #

    My question has to do with the impact on Loblaw (symbol: L) shareholders. If I have a correct understanding of these sorts of corporate reorganizations, the price of L will decline in proportion to the amount that is spun off and the shareholders will receive the corresponding value of shares of the new REIT in their accounts that currently hold L. I haven’t followed the news too closely on this, however. Has there been an official announcement on this matter?

  10. Student December 14, 2012 at 9:07 am #

    Dan: I assume, given your analysis, that this won’t impact the BMO REIT etf any more than the iShares version.

  11. Andrew F December 14, 2012 at 10:38 am #

    The way it will work is (based on my understanding):

    Loblaw (L) will create a new corporate structure ‘Loblaw REIT’, and vend into it about $7 billion worth of real estate. In return for the real estate, L will receive an intercompany note for ~$3 billion (initial financing for the REIT), and all of the equity of the REIT. L will then sell ~15% of the units of the REIT in an IPO, in exchange for cash. Because L retains 85% of the REIT, the REIT will be consolidated on L’s financial statements as their real estate division. Existing shareholders of L will not receive REIT units, and the book value of L won’t be affected. If anything, if the REIT receives more favourable valuation as a separate entity than as part of L, the value of L shares might rise (as we saw after the announcement). An interesting thing is that I imagine the REIT units will be marked to market on L’s balance sheet, whereas the real estate is currently listed at book value, which might be substantially less than the market value of the real estate. All else equal, this would tend to cause the price/book value to fall. This might just be financial engineering, I’m not sure what impact this will have.

    So this is not a full spin off like Encana/Cenovus or Bell/Nortel.

  12. Canadian Couch Potato December 14, 2012 at 11:52 am #

    @Student: I’d guess the impact on ZRE would be even less because of the equal weight structure. Right now there are 18 REITs in that fund, so the average target would be 5.56%. If you added one more, the target weight for each would be 5.26%, so any transactions necessary to rebalance the fund would be really minimal.

  13. Andrew F December 14, 2012 at 3:06 pm #

    If the XRE holding is float adjusted market cap, and REIT has a market cap of $5 billion, a float of 15%, and thus a float adjusted market cap of $750 million, its weight in XRE should be around 1.4%. So adding it to XRE will generate ~1.4% portfolio turnover, while adding it to ZRE will generate 5.26% turnover.

  14. Andrew F December 14, 2012 at 3:09 pm #

    $5 billion is my best guess of what the REIT will list at, by the way. It’s just back of the napkin using: (Loblaw REIT Assets/Riocan Assets) * Riocan market cap. I’m not sure how fair that is. It could well be worth less than my guess.

  15. André December 15, 2012 at 6:41 am #

    Hello Dan,
    I started to invest in index funds some time ago and since I usually invest regularly, I am looking at ways to reduce transaction costs. I saw on your web-site that TD has some index funds that I could buy throught my discount broker at no cost. Looking at performance I was quite surprise, however, to see that TD US index funds had a relatively poor annual performance for the 10-year period ending nov.30 (TD: 0.8% vs SPY: 6.3%). I understand MER are higher with TD but it doesn’t explain the huge difference. Does exchange rate the main reason for this? (I understand that my question has nothing to do with the article you just wrote but would appreciate your help).
    Thanks

  16. André December 15, 2012 at 7:07 am #

    I was looking at TDB661.

  17. Russ December 15, 2012 at 8:21 am #

    @André TDB661 is an index fund, but it is not the e-series fund. Rather this one is available through “normal” TD Canada Trust mutual fund accounts, and perhaps through other non-TD brokerages. The e-series funds are only available through an online-only TD e-series account or through a TD Waterhouse discount brokerage account.
    The unhedged US equity fund in C$ is TDB902, the US$ version is TDB952, and the hedged (currency neutral) C$ version is TDB904.
    If you go to the TD Asset Management website (www.tdassetmanagement.com), click on TD Mutual Funds in the right column, then click on e-series, again on the right, you can see a listing of e-series funds. If you click on the TD U.S. Index fund, you’ll get an overview. There is also a path to “price and performance,” and the opportunity there to select “Advanced Graph Growth.” There you can select the currency neutral version to compare against the unhedged version, and you will see that the currency neutral version has performed much better over 10 years, an indication that the depreciation of the US$ against the C$ has been a significant factor in the relatively poor performance of the S&P 500 in C$ terms.

  18. Canadian Couch Potato December 15, 2012 at 8:36 am #

    @Andre: Russ is correct (thanks, Russ). This post may help you sort out this confusing issue:
    http://canadiancouchpotato.com/2010/08/11/will-the-real-sp-500-please-stand-up/

  19. André December 15, 2012 at 9:15 pm #

    Russ and Dan, thanks both of you!

  20. patrck s December 24, 2012 at 1:40 am #

    Im planning to incorporaten commodities in my asset allocated portfolio. Whats a good low mer commodities fund?

  21. Rick March 6, 2013 at 8:44 am #

    I have been reading a lot and attempting to get some retirement funds set up to do the best I can and not over pay on fees.I appreciate this input so I can gain a bit more comfort in my plans to do better.I spent years working in Alberta and just assumed that a managed Mutual fund in the bank was looked after because it was managed. After years of just thinking the funds were growing I decided to pull the history on paper out of a box and take a look.At present its not a pretty site and it appears when it comes to taking out these funds everything will be at a loss. When you lose money on funds that have been there since the 80s can they be written off as a loss.
    rick

  22. Andrew F March 6, 2013 at 9:39 am #

    Rick, it would take some doing to lose money on an investment held since the 1980s. You might want to double check…

    If the investment is not held in an RRSP, you need to figure out the Adjusted Cost Base of the assets. This is the amount you deduct from the sale proceeds when calculating your capital gain (or loss). If the investment is held in an RRSP, you’re in luck–you don’t have to figure out the ACB. On the downside, if you have a loss you will not be able to use that to offset other capital gains.

  23. J A H May 9, 2013 at 10:16 am #

    And now Canadian Tire plans to join in on the fun…

    http://business.financialpost.com/2013/05/09/canadian-tire-reveals-plan-to-launch-3-5-billion-reit-this-year/

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