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.