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Heavyweight fund manager scorns Loblaw REIT

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Loblaw Cos. waited a long time before launching a real estate investment trust of most of its properties. Maybe too long: its Choice Properties REIT is about to go public as interest rates threaten to make yield-oriented investments less attractive. But there are two other knocks against Choice and they are enough to convince one of Canada's most prominent REIT investors, Dennis Mitchell, to take a pass altogether for the $1.4-billion Sentry REIT fund he oversees. Prospective investors would be wise to take note.

On the surface, there is much to like about Choice REIT. It will pay a 6.5 per cent yield and has a solid balance sheet, experienced management and 35 million square feet of gross leasable area, including most Loblaw stores across Canada. The quality of the real estate in the REIT, says Mr. Mitchell, Sentry's chief investment officer, is "better than expected."

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But investors need to ask how Loblaw and Choice have managed their inherent conflict of interests. As controlling shareholder, Loblaw is both the landlord and key tenant. It wants to extract good return from its real estate, but not pay too much rent. Meanwhile, Choice's minority shareholders are strictly landlords.

Unfortunately, two things suggest the offering is "slanted to favour Loblaw," says Mr. Mitchell.

For starters, rents are growing very slowly. It will take the REIT fully five years to reach a level of 1.5 per cent annual growth in rents across the portfolio. At a time when REITs are being closely watched for their ability to grow cash flows, this is no time to bet on the turtle in the race.

"Why would I buy a name that won't even get to 1.5 per cent in five years," Mr. Mitchell asks, "especially on the cusp of a recovery where you would expect GDP, interest rates and inflation to go up? If you expect all those things, I don't see why I would buy a name [where] your chances of getting distribution growth are minimal."

The other thing that bugs him is the "strategic alliance agreement" governing the relationship between Choice and Loblaw. There are some things one would expect including the REIT's first right to buy other properties from Loblaw, and Loblaw's right to block a competing supermarket from moving into an unoccupied property purchased by the REIT.

But there are also strings attached to undeveloped properties Loblaw has transferred into the REIT and which could potentially be developed into another 3.5 million square feet of leasable area. If Choice builds on any of it in the next 20 years, it must pay Loblaw a fee at that time determined by several factors, including the region, class of space and use.

"It's to the advantage of the REIT," says Kim Lee, Choice REIT's vice president, investor relations and financial planning and analysis. "Loblaw is basically giving us the land now, and saying you pay for it when you develop it." Though Ms. Lee declined to comment directly on Mr. Mitchell's assertions, she said, "We think it's a strength to have a strategic alliance with a tenant of this profile."

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But Mr. Mitchell doesn't like the structure. Either Choice is buying the real estate outright, he argues, and all the rights attached, or it isn't – that's the way it usually works. "I've never seen that in a REIT before," he says. "If I'm buying an asset, I'm buying it as is. Once I buy it, it's mine. If I choose to do something with it years later and take on the development risk, why should I have to pay an additional fee? I don't see why I should give the original owner a riskless return."

Choice REIT is by no means a terrible investment – far from it. But it's not the most compelling investment opportunity in Canada, either.

Sean Silcoff is a contributor to ROB Insight, the business commentary service available to Globe Unlimited subscribers. Click here for more of his Insights , and follow Sean on Twitter at @seansilcoff .

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About the Author

Sean Silcoff joined The Globe and Mail in January, 2012, following an 18-year-career in journalism and communications. He previously worked as a columnist and Montreal correspondent for the National Post and as a staff writer at Canadian Business Magazine, where he was project co-ordinator of the magazine's inaugural Rich 100 list. More

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