MORGUARD CORPORATION
FOURTH QUARTER RESULTS 2017
MANAGEMENT’S DISCUSSION AND ANALYSIS AND CONSOLIDATED FINANCIAL STATEMENTS
4 MORGUARD CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS | DECEMBER 31, 2017
MANAGEMENT’S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION
TABLE OF CONTENTS
Part I Part VI Forward-Looking Statements Disclaimer 3 Transactions with Related Parties 34 Non-IFRS Financial Measures 3 Part VII Part II Summary of Significant Accounting Policies Business Overview 6 and Estimates 35 Business Strategy 6 Critical Accounting Policies and Estimates 35 Significant Event 7 Financial Instruments 37 Financial and Operational Highlights 7 Adoption of Accounting Standards 38 Property Profile 8 Risks and Uncertainties 39 Controls and Procedures Concerning Part III Financial Information 43 Review of Operational Results 10 Funds From Operations 17 Part VIII Selected Annual and Quarterly Information 44 Part IV Subsequent Events 46 Balance Sheet Analysis 19 Part IX Part V Outlook 48 Liquidity 33
MORGUARD.COM 2 MORGUARD CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS | DECEMBER 31, 2017
PART I
Morguard Corporation (“Morguard” or the “Company”) is pleased to provide this review of operations and update on our financial performance for the year ended December 31, 2017. Unless otherwise noted, dollar amounts are stated in thousands of Canadian dollars, except per common share amounts.
The following Management’s Discussion and Analysis (“MD&A”) sets out the Company’s strategies and provides an analysis of the financial performance for the year ended December 31, 2017, and significant risks facing the business. Historical results, including trends that might appear, should not be taken as indicative of future operations or results.
This MD&A should be read in conjunction with the Company’s audited consolidated financial statements and accompanying notes for the years ended December 31, 2017 and 2016. This MD&A is based on financial information prepared in accordance with International Financial Reporting Standards (“IFRS”) and is dated February 22, 2018. Disclosure contained in this document is current to that date unless otherwise noted.
Additional information relating to Morguard Corporation, including the Company’s Annual Information Form, can be found at www.sedar.com and www.morguard.com.
FORWARD-LOOKING STATEMENTS DISCLAIMER Statements contained herein that are not based on historical or current fact, including without limitation, statements containing the words “anticipates”, “believes”, “may”, “continue”, “estimate”, “expects” and “will” and words of similar expression, constitute “forward-looking statements”. Such forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause the actual results, events or developments to be materially different from any future results, events or developments expressed or implied by such forward-looking statements. Such factors include, among others, the following: general economic and business conditions, both nationally and in the regions in which the Company operates; changes in business strategy or development/acquisition plans; environmental exposures; financing risk; existing governmental regulations and changes in, or the failure to comply with, governmental regulations; liability and other claims asserted against the Company; and other factors referred to in the Company’s filings with Canadian securities regulators. Given these uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements. The Company does not assume the obligation to update or revise any forward-looking statements.
NON-IFRS FINANCIAL MEASURES The Company reports its financial results in accordance with IFRS. However, this MD&A also uses certain financial measures that are not defined by IFRS. These measures do not have any standardized meaning prescribed by IFRS and are not necessarily comparable to similar measures presented by other reporting issuers in similar or different industries. These measures should be considered as supplemental in nature and not as substitutes for related financial information prepared in accordance with IFRS. The Company’s management uses these measures to aid in assessing the Company’s underlying core performance and provides these additional measures so that investors may do the same. Management believes that the non-IFRS measures described below, which supplement the IFRS measures, provide readers with a more comprehensive understanding of management’s perspective on the Company’s operating results and performance.
The following discussion describes the non-IFRS measures the Company uses in evaluating its operating results.
NET OPERATING INCOME (“NOI”) AND ADJUSTED NET OPERATING INCOME (“ADJUSTED NOI”) NOI is defined by the Company as revenue from real estate properties and revenue from hotel properties less property operating costs, utilities, realty taxes and hotel operating expenses as presented in the consolidated statements of income. NOI is an important measure in evaluating the operating performance of the Company’s real estate properties and is a key input in determining the fair value of the Company’s income producing properties.
MORGUARD.COM 3 MORGUARD CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS | DECEMBER 31, 2017
NOI includes the impact of realty tax expense accounted for under the International Financial Reporting Interpretations Committee (“IFRIC”) Interpretation 21, “Levies” (“IFRIC 21”). IFRIC 21 states that an entity recognizes a levy liability in accordance with the relevant legislation. The obligating event for realty taxes for the U.S. municipalities in which the Company operates is ownership of the property on January 1 of each year for which the tax is imposed and, as a result, the Company records the entire annual realty tax expense for its U.S. properties on January 1, except for U.S. properties acquired during the year, in which case the realty taxes are not recorded in the year of acquisition.
Adjusted NOI represents NOI adjusted to exclude the impact of realty taxes accounted for under IFRIC 21, noted above. Adjusted NOI records realty taxes for all properties on a pro rata basis over the entire fiscal year.
A reconciliation of NOI and Adjusted NOI from the IFRS financial statement presentation of revenue from real estate properties and revenue from hotel properties less property operating costs, utilities, realty taxes and hotel operating expenses is provided in “Part III, Review of Operational Results.”
COMPARATIVE NOI Comparative NOI is used by the Company to evaluate the period-over-period performance of those properties that are stabilized and owned by the Company continuously for the current and comparable reporting period. The Company believes it is useful to provide an analysis of Comparative NOI, which eliminates non-recurring and non-cash items. Comparative NOI represents NOI from properties that have been adjusted for: (i) acquisitions, (ii) dispositions and (iii) properties subject to significant change as a result of recently completed development. Comparative NOI also excludes the impact of straight-line rents, realty taxes accounted for under IFRIC 21, lease cancellation fees and other non-cash and non-recurring items.
A reconciliation of Comparative NOI from the IFRS financial statement presentation of revenue from real estate properties and revenue from hotel properties less property operating costs, utilities, realty taxes and hotel operating expenses is provided in “Part III, Review of Operational Results.”
FUNDS FROM OPERATIONS (“FFO”) AND NORMALIZED FFO FFO is a non-IFRS measure widely used as a real estate industry standard that supplements net income and evaluates operating performance but is not indicative of funds available to meet the Company’s cash requirements. FFO can assist with comparisons of the operating performance of the Company’s real estate between periods and relative to other real estate entities. FFO is computed in accordance with the current definition of the Real Property Association of Canada (“REALpac”), with the exception of the deduction of the non-controlling interest of Morguard North American Residential Real Estate Investment Trust (“Morguard Residential REIT”), and is defined as net income attributable to common shareholders adjusted for: (i) deferred income taxes, (ii) unrealized changes in the fair value of real estate properties, (iii) realty taxes accounted for under IFRIC 21, (iv) internal leasing costs, (v) gains/losses from the sale of real estate property (including income taxes on the sale of real estate property), (vi) transaction costs expensed as a result of a business combination, (vii) gains/losses on business combination, (viii) the non-controlling interest of Morguard Residential REIT, (ix) amortization of depreciable real estate assets, (x) amortization of intangible assets, (xi) adjustments for equity-accounted investments, (xii) other fair value adjustments and non-cash items. The Company believes that the analysis of FFO is more clearly presented when the non-controlling interest attributable to Morguard Residential REIT is eliminated. The Company considers FFO to be a useful measure for reviewing its comparative operating and financial performance.
Normalized FFO is computed as FFO excluding non-recurring items on a net of tax basis.
A reconciliation of net income attributable to common shareholders (an IFRS measure) to FFO and Normalized FFO is presented in the section “Part III, Funds From Operations.”
MORGUARD.COM 4 MORGUARD CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS | DECEMBER 31, 2017
NON-CONSOLIDATED MEASURES The Company’s senior unsecured debentures (“Unsecured Debentures”) are subject to the following definitions and covenants pursuant to the Trust Indenture, the First Supplemental Indenture dated as of December 10, 2013 and Third Supplement Indenture dated as of September 15, 2017, that are calculated based on the Company’s financial results, prepared in accordance with IFRS, adjusted to account for the Company’s public entity investments in Morguard Real Estate Investment Trust (“Morguard REIT”), Morguard Residential REIT and Temple Hotels Inc. (“Temple”) using the equity method of accounting (“Non-Consolidated Basis” or “Morguard Non-Consolidated Basis”).
The Company computes an interest coverage ratio, an indebtedness to aggregate assets ratio and an adjusted shareholders’ equity covenant on a Non-Consolidated Basis. Reconciliations of the Non-Consolidated Basis inputs (discussed below) used in calculating the covenants from their IFRS financial statement presentation are provided in the section “Part IV, Balance Sheet Analysis.”
Non-consolidated measures that are calculated on a Non-Consolidated Basis are as follows:
NON-CONSOLIDATED INTEREST COVERAGE RATIO Interest coverage ratio measures the amount of cash flow available to meet annual interest payments on the Company’s indebtedness on a Non-Consolidated Basis and is defined as Non-Consolidated EBITDA divided by Non- Consolidated Interest Expense. Generally, the higher the interest coverage ratio, the lower the credit risk. Non- Consolidated interest coverage ratio is presented in this MD&A because management considers this non-IFRS measure to be an important compliance measure of the Company’s operating performance.
NON-CONSOLIDATED EBITDA Non-Consolidated EBITDA is defined as net income on a Non-Consolidated Basis before interest expense, income taxes, amortization, fair value adjustments to real estate properties, acquisition-related costs, debt settlement or other costs, any gain or loss attributed to the sale or disposition of any asset or liability, other non-cash items and non- recurring items, plus the distributions received from Morguard REIT and Morguard Residential REIT.
NON-CONSOLIDATED INTEREST EXPENSE Non-Consolidated Interest Expense is defined as interest expense and interest capitalized to development properties on a Non-Consolidated Basis.
NON-CONSOLIDATED INDEBTEDNESS TO AGGREGATE ASSETS RATIO Indebtedness to aggregate assets ratio is a compliance measure and establishes the limit for financial leverage of the Company on a Non-Consolidated Basis. Indebtedness to aggregate assets ratio is presented in this MD&A because management considers this non-IFRS measure to be an important compliance measure of the Company’s financial position.
NON-CONSOLIDATED INDEBTEDNESS Indebtedness is a measure of the amount of debt financing utilized by the Company on a Non-Consolidated Basis.
NON-CONSOLIDATED AGGREGATE ASSETS Aggregate assets is a measure of the value of the Company’s assets on a Non-Consolidated Basis, excluding goodwill and deferred income tax assets and adding back accumulated amortization of hotel properties.
NON-CONSOLIDATED ADJUSTED SHAREHOLDERS’ EQUITY Adjusted shareholders’ equity is defined as the aggregate shareholders’ equity computed on a Non-Consolidated Basis adjusted to exclude deferred tax assets and liabilities and to add back accumulated amortization of hotel properties. Adjusted shareholders’ equity is a compliance measure and establishes a minimum requirement of equity of the Company.
MORGUARD.COM 5 MORGUARD CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS | DECEMBER 31, 2017
PART II
BUSINESS OVERVIEW Morguard Corporation is a real estate investment company whose principal activities include the acquisition, development and ownership of multi-suite residential, commercial and hotel properties. Morguard is also one of Canada’s premier real estate investment advisors and management companies, representing major institutional and private investors. Morguard’s total assets under management (including both owned and managed assets) were valued at $21.2 billion as at December 31, 2017. The Company’s common shares are publicly traded and listed on the Toronto Stock Exchange (“TSX”) under the symbol “MRC.” The Company’s primary goal is to accumulate a portfolio of high-quality real estate assets and then deliver the benefits of such real estate ownership to shareholders.
MANAGEMENT AND ADVISORY SERVICES The Company, through its wholly owned subsidiary, Morguard Investments Limited (“MIL”), provides real estate management services to Canadian institutional investors. Services include acquisitions, development, dispositions, leasing, performance measurement and asset and property management. For over 40 years, MIL has positioned itself as one of Canada’s leading providers of real estate portfolio and asset and property management services. In addition, Morguard through its 60% ownership interest in Lincluden Investment Management Limited (“Lincluden”) offers institutional clients and private investors a broad range of global investment products across equity, fixed-income and balanced portfolios.
As of December 31, 2017, MIL together with Lincluden manage a portfolio (excluding Morguard’s corporately owned assets and assets owned by Morguard REIT, Morguard Residential REIT and Temple) of assets having an estimated value of $11.8 billion.
BUSINESS STRATEGY Morguard’s strategy is to acquire a diversified portfolio of commercial and multi-suite residential real estate assets both for its own accounts and for its institutional clients. The Company’s cash flows are well diversified given the revenue stream earned from its management and advisory services platform, the Company’s corporately owned assets and the distributions received from its investment in Morguard REIT and Morguard Residential REIT. Diversification of the portfolio, by both asset type and location, serves to reduce investment risk. The Company will divest itself of non-core assets when proceeds can be reinvested to improve returns. A primary element of the Company’s business strategy is to generate stable and increasing cash flow and asset value by improving the performance of its real estate investment portfolio and by acquiring or developing real estate properties in sound economic markets.
MORGUARD.COM 6 MORGUARD CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS | DECEMBER 31, 2017
The Company’s business strategy consists of the following elements:
• Increase property values and cash flow through aggressive leasing of available space and of space becoming available; • Take advantage of long-standing relationships with national and regional tenants; • Increase the portfolio of third-party assets under management; • Target and execute redevelopment and expansion projects that will generate substantial returns; • Pursue opportunities to acquire or develop strategically located properties; • Minimize operating costs by utilizing internalized functions, including property and asset management, leasing, finance, accounting, legal and information technology services; and • Dispose of properties where the cash flows and values have been maximized.
SIGNIFICANT EVENT BUSINESS COMBINATION On December 14, 2016, the Company acquired 54,578,187 common shares of Temple, increasing its ownership in Temple from 38.9% to 55.9%. This acquisition of control has been reflected as a business combination occurring on December 31, 2016.
As a result of the acquisition of control, the Company converted the method of accounting for its investment in Temple from the equity method to the consolidation method effective December 31, 2016. The impact of this change was significant on the Company’s December 31, 2016 balance sheet because of the requirement to fully consolidate Temple’s assets and liabilities. Commencing January 1, 2017, the impact of consolidating Temple was significant on the Company’s statements of income since Temple’s revenue and expenses are fully consolidated in the Company’s operating results. There is no impact on FFO as a result of the change from the equity to consolidation method.
FINANCIAL AND OPERATIONAL HIGHLIGHTS
As at December 31 2017 2016 2015 Real estate properties $8,655,651 $7,919,671 $7,816,302 Hotel properties 669,026 705,663 115,560 Equity-accounted and other fund investments 280,853 380,808 329,320 Total assets 10,111,986 9,588,078 8,602,132 Indebtedness(1) $4,935,454 $4,778,750 $4,183,810 Indebtedness to total assets (%) 48.8 49.8 48.6 Total equity $3,934,369 $3,671,131 $3,481,997 Shareholders’ equity per common share 260.32 239.98 224.94 Exchange rates - U.S. dollar to Canadian dollar $1.25 $1.34 $1.38
(1) Total indebtedness is defined as the sum of the current and non-current portion of: (i) mortgages payable, (ii) Unsecured Debentures, (iii) convertible debentures, (iv) finance lease obligation, (v) bank indebtedness, (vi) loans payable, (vii) construction financing and (viii) letters of credit.
Total assets as at December 31, 2017, were $10,111,986, compared to $9,588,078 as at December 31, 2016. Total assets increased by $523,908 primarily due to the following:
• An increase in real estate properties of $735,980 mainly due to acquisition of real estate properties of $656,962, capital and development expenditures of $109,875, tenant incentives and leasing commissions of $22,159 and a fair value gain of $190,078, partially offset by the disposition of real estate properties of $88,685 and a change in foreign exchange rate amounting to $154,257; • An increase in other assets and prepaid expense of $50,449; • An increase in amounts receivable of $18,433; • A decrease in cash of $107,072; • A decrease in mortgages and loans receivable of $37,290; • A decrease in equity-accounted and other fund investments of $99,955; and • A decrease in hotel properties of $36,637.
MORGUARD.COM 7 MORGUARD CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS | DECEMBER 31, 2017
FINANCIAL AND OPERATIONAL HIGHLIGHTS (CONTINUED)
For the years ended December 31 2017 2016 2015 Revenue from real estate properties $790,535 $775,746 $762,033 Revenue from hotel properties 237,116 66,567 46,562 Management and advisory fees 71,786 67,895 59,536 Total revenue 1,113,774 921,976 883,559 Net operating income 513,867 453,398 435,899 Fair value gain (loss), net 139,898 (51,794) (87,301) Net income attributable to common shareholders 310,120 172,745 80,542 Per common share - basic and diluted 26.10 14.46 6.58 Funds from operations 225,072 213,282 183,139 Per common share - basic and diluted 18.94 17.86 14.96 Normalized FFO 222,442 198,299 194,476 Per common share - basic and diluted 18.72 16.60 15.89 Distributions received from Morguard REIT 31,178 30,151 28,371 Distributions received from Morguard Residential REIT 15,375 13,752 13,601 Dividends declared/paid (7,127) (7,163) (7,305) Average exchange rates - U.S. dollar to Canadian dollar 1.30 1.32 1.28
Total revenues increased during the year ended December 31, 2017 by $191,798 to $1,113,774, compared to $921,976 in 2016. The increase was primarily due to the following:
• An increase in revenue from real estate properties in the amount of $14,789; • An increase in hotel revenue in the amount of $170,549 of which $165,612 is due to the consolidation of Temple commencing January 1, 2017; and • An increase in management and advisory fees of $3,891.
PROPERTY PROFILE As at December 31, 2017, the Company and its subsidiaries, including Morguard REIT, Morguard Residential REIT and Temple, own a diversified portfolio of 208 multi-suite residential, retail, office, industrial and hotel properties located in Canada and in the United States.
PORTFOLIO COMPOSITION BY ASSET TYPE The composition of the Company’s real estate properties by asset type as at December 31, 2017 was as follows:
GLA Apartment Number of Square Feet Suites/Hotels Real Estate Asset Type Properties (000s)(1) Rooms(2) Properties Multi-suite residential 58 — 18,129 $4,063,555 Retail 41 8,668 — 2,536,063 Office 45 6,483 — 1,999,962 Industrial 26 1,196 — 113,857 Hotel 38 — 5,557 657,057 Properties and land held for and under development — — — 119,632 Total (3) 208 16,347 23,686 $9,490,126 (1) Total GLA is shown on a proportionate basis; on a 100% basis, total GLA of the Company’s commercial properties is 20.4 million square feet. (2) Total suites/hotel rooms include equity-accounted investments and non-controlling interest. The Company on a proportionate basis has ownership of 17,128 suites and 5,387 hotel rooms. (3) Includes two multi-suite residential, two office properties and two hotel properties classified as equity-accounted investments.
MORGUARD.COM 8 MORGUARD CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS | DECEMBER 31, 2017
The Company’s multi-suite residential portfolio comprises 24 Canadian properties (21 high-rise buildings, two low-rise buildings and one mid-rise building located primarily throughout the Greater Toronto Area (“GTA”)) and 34 U.S. properties (25 low-rise and five mid-rise garden-style communities located in Colorado, Texas, Louisiana, Georgia, Florida, North Carolina, Virginia and Maryland and four high-rise buildings located in Chicago, Illinois and Los Angeles, California). The combined multi-suite residential portfolio represents 18,129 suites.
The Company’s retail portfolio includes two broad categories of income producing properties: (i) enclosed full-scale, regional shopping centres that are dominant in their respective markets; and (ii) neighbourhood and community shopping centres that are primarily anchored by food retailers, discount department stores and banking institutions. The retail portfolio comprises 29 properties located in Canada and 12 properties located in Florida and Louisiana. The combined retail portfolio represents 8.7 million square feet of gross leasable area (“GLA”).
The Company’s office portfolio is focused on well-located, high-quality office buildings in major Canadian urban centres primarily located throughout the GTA, downtown Ottawa, Montréal, Calgary and Edmonton. The portfolio is balanced between single-tenant buildings under long-term lease to government and large national tenants and multi- tenant properties with well-distributed lease expiries that allow the Company to benefit from increased rent on lease renewals. The office portfolio represents 6.5 million square feet of GLA.
The Company’s industrial portfolio comprises 26 industrial properties located throughout Ontario, Québec and British Columbia. The Industrial portfolio represents 1.2 million square feet of GLA.
The Company’s hotel portfolio comprises 22 branded and 16 unbranded hotel properties located in six Canadian provinces and the Northwest Territories. Branded hotels include Hilton, Marriott, Holiday Inn and Wyndham and consist of full and select services. The hotel portfolio represents 5,557 rooms. The Company also owns a hotel property in Ottawa, Ontario, that is currently under development.
AVERAGE OCCUPANCY LEVELS COMPARATIVE AVERAGE OCCUPANCY LEVELS
Suites/GLA Dec. Sep. Jun. Mar. Dec. Square Feet 2017 2017 2017 2016 2016 Multi-suite residential 17,139 (1) 94.1% 94.5% 95.8% 95.8% 95.5% Retail 8,183,000 (2) 91.0% 90.3% 91.4% 92.3% 93.0% Office 6,483,500 92.9% 92.5% 93.2% 95.0% 94.6% Industrial 1,196,500 88.8% 88.8% 88.8% 88.5% 94.2% (1) Excludes two properties located in Los Angeles, California and Chicago, Illinois accounted for under equity investments. (2) Retail occupancy has been adjusted to exclude development space (485,130 square feet of GLA) affected by either disclaimed or acquired Target and Sears leases.
The retail occupancy levels were adjusted to exclude development space (485,130 square feet of GLA) affected by either disclaimed or acquired Target and Sears leases. As at December 31, 2017, this adjustment increased retail occupancy from 87.1% to 91.0%.
Occupancy excludes an equity-accounted development project, a 34-storey, 691 luxury suite residential tower (“Marquee at Block 37”). Leasing began in March 2016 and the project is currently 84.2% occupied.
MORGUARD.COM 9 MORGUARD CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS | DECEMBER 31, 2017
PART III
REVIEW OF OPERATIONAL RESULTS The Company’s operational results for the years ended December 31, 2017 and 2016 are summarized below:
For the years ended December 31 2017 2016 Revenue from real estate properties $790,535 $775,746 Revenue from hotel properties 237,116 66,567 Property operating expenses Property operating costs (174,440) (169,045) Utilities (52,986) (53,475) Realty taxes (110,644) (114,788) Hotel operating expenses (175,714) (51,607) Net operating income 513,867 453,398 OTHER REVENUE Management and advisory fees 71,786 67,895 Interest and other income 8,907 6,349 Sales of product and land 5,430 5,419 86,123 79,663 EXPENSES Interest 191,965 152,926 Property management and corporate 82,862 86,592 Cost of sales of product and land 3,524 3,466 Amortization of hotel properties 26,640 4,936 Amortization of capital assets and other 4,228 4,148 Provision for impairment 24,590 — 333,809 252,068 OTHER INCOME (EXPENSE) Fair value gain (loss), net 139,898 (51,794) Equity income (loss) from investments (10,227) 54,904 Gain on business combination — 3,778 Other income 3,885 29,448 133,556 36,336 Income before income taxes 399,737 317,329 Provision for income taxes Current 21,187 27,718 Deferred 34,183 79,687 55,370 107,405 Net income for the year $344,367 $209,924 Net income attributable to: Common shareholders $310,120 $172,745 Non-controlling interest 34,247 37,179 $344,367 $209,924 Net income per common share attributable to: Common shareholders - basic and diluted $26.10 $14.46
MORGUARD.COM 10 MORGUARD CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS | DECEMBER 31, 2017
NET INCOME Net income for the year ended December 31, 2017, was $344,367, compared to net income of $209,924 in 2016. The increase in net income of $134,443 for the year ended December 31, 2017, was primarily due to the following:
• An increase in net operating income of $60,469, primarily due to the consolidation of Temple and from acquisitions completed during and subsequent to the year ended December 31, 2017; • An increase in management and advisory fees of $3,891; • An increase in interest expense of $39,039, primarily due to the consolidation of Temple; • A decrease in property management and corporate expense of $3,730; • An increase in amortization of hotel properties of $21,704, primarily due to the consolidation of Temple; • An increase in impairment provision of $24,590 at four hotel properties located in Western Canada; • An increase in non-cash net fair value gain of $191,692, primarily due to a higher fair value gain on real estate properties from a decrease in capitalization rates for Canadian multi-suite residential properties and a lower fair value loss on MRG Units; • A decrease in non-cash equity income of $65,131, primarily due to a fair value gain recognized in 2016 at the Marquee at Block 37; • A decrease in other income of $25,563 primarily due to settlement proceeds received from Target Corporation during 2016; and • An decrease in income taxes (current and deferred) of $52,035 resulting from a one time deferred tax recovery due to the U.S. federal tax rate reduction enacted on December 22, 2017.
NET OPERATING INCOME Net operating income increased by $60,469, or 13.3%, during the year ended December 31, 2017, to $513,867, compared to $453,398 generated in 2016, and is further analyzed by asset type below.
ADJUSTED NOI BY ASSET TYPE
For the years ended December 31 2017 2016 Multi-suite residential $184,548 $169,436 Retail 137,021 141,606 Office 123,176 120,947 Industrial 6,292 7,020 Hotel 61,402 14,472 Adjusted NOI 512,439 453,481 IFRIC 21 adjustment - multi-suite residential 1,428 — IFRIC 21 adjustment - retail — (83) NOI $513,867 $453,398
NOI from the multi-suite residential portfolio for the year ended December 31, 2017, increased by $16,540 or 9.8% to $185,976, compared to $169,436 in 2016. The increase in NOI is due to an increase in the IFRIC 21 adjustment of $1,428 and the change in Adjusted NOI described below.
Adjusted NOI from the multi-suite residential portfolio for the year ended December 31, 2017, increased by $15,112 or 8.9% to $184,548, compared to $169,436 in 2016. The increase in Adjusted NOI is primarily due to the following:
• An increase of $5,768 primarily from rental rate growth, improved occupancy and lower operating expenses at properties located in Canada. The average rental rate increased by 2.3% when compared to the same period in 2016. Lower operating expenses were primarily due to a decrease in hydro rates at Ontario properties as a result of new legislation in Ontario, the Fair Hydro Act, 2017, which came into effect on June 1, 2017; • An increase of $723 due to the acquisitions of 160 Chapel located in Ottawa, Ontario, on February 1, 2016 and the Downsview Townhomes in May 2017; • Additional NOI of $3,472 generated from The Heathview in Toronto, Ontario. During 2016, The Heathview was under initial lease-up; • An increase of US$675 primarily from rental rate growth, partially offset by an increase in operating expenses at properties located in the U.S. The rental rate increased by 3.3% when compared to 2016;
MORGUARD.COM 11 MORGUARD CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS | DECEMBER 31, 2017
• An increase of US$6,910 due to the acquisition of three properties during the third quarter of 2017; • A decrease of US$2,247 due to the sale of four properties located in Mobile, Alabama, during the third quarter of 2017; and • A decrease of $189 due to the change in the U.S. dollar foreign exchange rate.
NOI from the retail portfolio for the year ended December 31, 2017, decreased by $4,502, or 3.2%, to $137,021, compared to $141,523 in 2016. The decrease in NOI is due to a decrease in the IFRIC 21 adjustment of $83 and the change in Adjusted NOI described below.
Adjusted NOI from the retail portfolio for the year ended December 31, 2017, decreased by $4,585, or 3.2%, to $137,021, compared to $141,606 in 2016. The decrease in Adjusted NOI is primarily due to the following:
• A decrease in Canadian retail properties of $3 primarily resulting from: - A decrease of $3,608 due to increased vacancy, lower base rent, higher non-recoverable operating expenses and lower recoveries primarily at three properties; - An increase of $1,072 in lease cancellation fees primarily due to a cancellation payment at a property located in Saint-Laurent, Québec; and - An increase of $2,533 due to realty tax refunds received at a property located in Toronto, Ontario, offset by increased vacancy. The vacancy is temporary as the space has been re-leased and will be occupied at various dates in 2018. The rental rates achieved on the new leases are 48% higher than rents paid by previous tenants; • A decrease in U.S. retail properties of US$2,981 primarily resulting from: - A decrease of US$298 due to the sale of one U.S. retail property during first quarter in 2016; - A decrease at two U.S. retail properties of US$2,783 due to loss of tenants at enclosed shopping centres in Louisiana; and • A decrease of $1,601 due to the change in the U.S. dollar foreign exchange rate.
NOI from the office portfolio for the year ended December 31, 2017, increased by $2,229, or 1.8%, to $123,176, compared to $120,947 in 2016 due primarily to the following: • An increase of $2,109 due to the acquisition of four properties during the year; • An increase in lease cancellation fees of $856 primarily due to two cancellation payments in the amount of $1,356 at properties in Saint-Laurent, Québec and in Toronto, Ontario during the year, offset by $500 received from a tenant that surrendered a portion of their space in the first quarter of 2016; • An increase of $915 at Performance Court, a 21-storey office building in Ottawa, Ontario, due to staggered lease commencement dates for the building’s anchor tenant with approximately 22,000 square feet of space beginning to pay rent on January 1, 2017; • An increase of $1,018 due to a single tenant property located in Calgary, Alberta, that had been vacant in the previous year has now been fully leased; • A decrease of $641 due to the sale of a property during the second quarter of 2016; and • A decrease of $2,028 due to increased vacancy and lower recoveries.
NOI from the industrial portfolio for the year ended December 31, 2017, decreased by $728, or 10.4%, to $6,292, compared to $7,020 in 2016. The decrease is due to increased vacancy at two industrial properties.
NOI from the hotel portfolio for the year ended December 31, 2017, increased by $46,930, to $61,402, compared to $14,472 in 2016. The increase is primarily due to the consolidation of Temple that contributed $42,885 of NOI and the acquisition of three hotels near Toronto’s Pearson International Airport in February 2016 that contributed an additional $486 of NOI. In addition, the remainder of the portfolio generated higher NOI of $3,559 due to stronger average room rates, improved occupancy and reduced costs.
MORGUARD.COM 12 MORGUARD CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS | DECEMBER 31, 2017
COMPARATIVE NET OPERATING INCOME
For the years ended December 31 2017 2016 Multi-suite residential (in local currency) $137,894 $131,169 Retail (in local currency) 126,604 134,308 Office 117,269 118,512 Industrial 6,156 6,851 Hotel 14,758 11,117 Exchange amount to Canadian dollars 25,972 29,047 Comparative NOI 428,653 431,004 Consolidation of Temple 42,885 — Acquired properties 18,925 6,619 Dispositions 3,720 7,826 Realty tax expense accounted for under IFRIC 21 1,428 (83) Canadian retail - lease cancellation/settlement 1,336 434 Canadian office - lease cancellation fees 1,608 500 Canadian residential - The Heathview transferred from development 10,085 6,613 Canadian hotel and office - development (513) (519) Realty tax refund/reassessment 5,305 — Other 435 1,004 NOI $513,867 $453,398
The Company believes it is useful to provide an analysis of Comparative NOI, which eliminates non-recurring and non-cash items.
Comparative NOI for the year ended December 31, 2017, decreased by $2,351, to $428,653 compared to $431,004 in 2016 due to the following:
• Multi-suite residential increase of $6,725 as a result of an increase in Canadian and U.S. rental rate growth and improved operating efficiencies; • Retail decrease of $7,704 due to increased vacancy, lower base rent, higher non-recoverable operating expenses and lower recoveries at certain Canadian properties and higher vacancy at two U.S. properties; • Office decreased by $1,243 mainly due to increased vacancy at certain properties; • Industrial decreased by $695 due to increased vacancy at two industrial properties; • Hotel increased by $3,641 due to an increase in average room rates, improved occupancy and reduced costs; and • The change in the foreign exchange rate decreased Comparative NOI for the U.S. properties by $3,075.
MANAGEMENT AND ADVISORY FEES AND OTHER OPERATIONS Morguard’s management and advisory fee revenue for the year ended December 31, 2017, increased by $3,891, or 5.7%, to $71,786, compared to $67,895 in 2016, primarily due to higher asset management fees earned by Lincluden as a result of an increase in assets under management and higher disposition fees earned, partially offset by lower leasing fees and asset management fees earned compared to 2016.
The Company also generated a net profit from the sale of product and land of $1,906 during the year ended December 31, 2017 (2016 - $1,953).
INTEREST AND OTHER INCOME Interest and other income for the year ended December 31, 2017, increased by $2,558, or 40.3%, to $8,907, compared to $6,349 in 2016. The increase was primarily due to higher income earned on investments and from loans receivable.
MORGUARD.COM 13 MORGUARD CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS | DECEMBER 31, 2017
INTEREST EXPENSE Interest expense consists of the following:
For the years ended December 31 2017 2016 Mortgages payable $155,893 $137,787 Bank indebtedness 2,614 3,849 Construction loans 1,249 5,033 Unsecured Debentures 16,124 6,499 Convertible debentures, net of accretion 21,417 7,030 Loans payable and other 696 182 Amortization of mark-to-market adjustments on mortgages, net (10,640) (12,464) Amortization of deferred financing costs 6,390 5,089 Amortization of cash flow hedge — 189 193,743 153,194 Less: Interest capitalized to properties under development (1,778) (268) $191,965 $152,926
Interest expense for the year ended December 31, 2017, increased by $39,039, or 25.5%, to $191,965, compared to $152,926 in 2016, mainly due to higher interest on mortgages payable and convertible debentures largely attributable to the consolidation of Temple, mortgage financing on acquisitions and higher interest on Unsecured Debentures resulting from the issuance of the Series B and C debentures in November 2016 and September 2017, respectively, partially offset by lower interest on construction loans and bank indebtedness.
PROPERTY MANAGEMENT AND CORPORATE Property management and corporate expenses for the year ended December 31, 2017, decreased by $3,730, or 4.3%, to $82,862, compared to $86,592 in 2016, primarily due to a decrease in non-cash compensation expense related to the Company’s Stock Appreciation Rights (“SARs”) plan of $3,595.
AMORTIZATION OF HOTEL PROPERTIES Amortization of hotel properties for the year ended December 31, 2017, increased by $21,704 to $26,640, compared to $4,936 in 2016, primarily due to the consolidation of Temple.
FAIR VALUE GAIN (LOSS) ON REAL ESTATE PROPERTIES Fair value adjustments are determined based on the movement of various valuation parameters on a quarterly basis, including changes in projected cash flows as a result of leasing, capitalization rates, discount rates and terminal capitalization rates. During the year ended December 31, 2017, the Company recognized a net fair value gain of $189,121, compared to a net fair value gain of $25,960 in 2016.
Fair value gain (loss) on real estate properties consists of the following:
For the years ended December 31 2017 2016 Multi-suite residential $226,247 $67,414 Retail (24,118) (15,308) Office (13,499) (29,508) Industrial 1,776 2,538 Properties under development (55) (1,350) Land held for development (1,230) 2,174 $189,121 $25,960
For the year ended December 31, 2017, the Company recognized a net fair value gain of $226,247 in the residential portfolio. The fair value gain consists of $172,584 at the Canadian properties as a result of a 25 to 75 basis point decrease in capitalization rates at the Company’s GTA properties and $53,663 at the U.S. properties, which was predominantly due to an increase in stabilized NOI.
MORGUARD.COM 14 MORGUARD CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS | DECEMBER 31, 2017
For the year ended December 31, 2017, the Company recognized a net fair value loss of $24,118 in the retail portfolio. The fair value loss comprises a loss of $30,508 at the Canadian properties mainly as the result of the announcement that Sears Canada Inc. will be vacating the Company’s four locations offset by an increase at one property located in British Columbia that was valued at its highest and best use based on recent comparable land sales, and a fair value increase of $6,390 at the U.S. properties due to a decrease of 25 to 50 basis points in the capitalization rates.
For the year ended December 31, 2017, the Company recognized a net fair value loss of $13,499 in the office portfolio. The fair value loss is mainly due to the continued economic downturn in the Alberta office market.
FAIR VALUE LOSS ON MORGUARD RESIDENTIAL REIT UNITS For the year ended December 31, 2017, the Company recorded a fair value loss on the Morguard Residential REIT Units of $49,066, which includes a mark-to-market loss of $31,697 on the Units and the distributions made to external Unitholders of $17,369.
EQUITY INCOME (LOSS) FROM INVESTMENTS Equity income (loss) from investments consists of the following:
For the years ended December 31 2017 2016 Joint ventures $2,903 ($1,352) Associates (13,130) 56,256 ($10,227) $54,904
Equity income (loss) from investments for the year ended December 31, 2017, decreased by $65,131 to a loss of $10,227, compared to income of $54,904 in 2016. The increase in equity loss during the year ended December 31, 2017, compared to the same period in 2016 is predominantly due to a $85,236 fair value gain recognized during 2016 at the Company’s investment in the Marquee at Block 37 compared to a $2,475 fair value gain in the same period in 2017.
PROVISION FOR IMPAIRMENT In accordance with IFRS, management assesses all hotel properties at the end of each reporting period to determine if there is any indication that an asset may be impaired. A recoverability analysis was completed in accordance with the procedures specified by IFRS which included all hotel properties.
For the purpose of the recoverability analysis, IFRS provides that the recoverable amount of an asset is the higher of its fair value less cost of disposal and its value in use and that it is not necessary to determine both as asset's fair value less costs of disposal and its value in use. If either of these amounts exceeds the asset's carrying amount, the asset is not impaired.
Lower occupancy, future projected capital requirements and intended change in the use of one asset at the end of the lease term affected the recoverable value of four hotel properties resulting in the recognition of an impairment provision for the year ended December 31, 2017 of $24,590 (2016 - $nil).
OTHER INCOME Other income for the year ended December 31, 2017, decreased by $25,563, or 86.8%, to $3,885, compared to $29,448 in 2016, primarily due to $22,490 in settlement proceeds from Target Corporation received during 2016 relating to the five leases that were disclaimed by Target Canada Corporation and a decrease in foreign exchange gain of $2,595 as compared to 2016. IFRS requires monetary assets and liabilities denominated in foreign currencies to be translated into Canadian dollars at the exchange rate in effect at the reporting date, and any gain or loss is recognized in the consolidated statement of income.
MORGUARD.COM 15 MORGUARD CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS | DECEMBER 31, 2017
INCOME TAXES For the year ended December 31, 2017, the Company recorded total income tax expense of $55,370, compared to $107,405 in 2016. The decrease of $52,035 comprises a decrease of $6,531 in current tax and a decrease of $45,504 in deferred tax. The decrease in current tax is primarily due to settlement proceeds received from Target Corporation during 2016 and current year tax deductions from the Company’s newly developed enterprise resource planning and financial system, partly offset by current tax of $720 resulting from the non-recurring Alabama net state tax liability incurred on the disposition of properties in 2017. The non-recurring current tax is with respect to the taxable gain on disposition of the four Alabama properties, which was partly sheltered by available state tax losses in Alabama and fully sheltered by tax losses available for federal purposes.
The decrease of deferred tax is predominantly due to the decrease of $78,219 resulting from a U.S. federal tax rate reduction from 35% to 21% enacted on December 22, 2017 by the Tax Cuts and Jobs Act of 2017 (the “Act”), partially offset by increase of deferred income tax due to the fair value increases related to the U.S. properties compared to the same period in 2016.
In addition to the U.S. income tax rate reduction mentioned above, the other changes enacted by the Act having the most significant impact on the Company’s U.S. subsidiaries include, but are not limited to, the accelerated depreciation of residential real properties and the limitation of interest expense deduction. The Company has calculated its best estimate of the impact of the Act in its year-end income tax provision in accordance with its understanding of the Act and guidance available as of the date of the consolidated financial statements. The provisional amount attributable to the accelerated depreciation for certain assets placed into services after September 27, 2017 resulted in a reduction of deferred tax asset of $439. The income tax effects of limitation of interest expense deduction commencing in 2018 requires further analysis due to the volume of data required to complete the calculations. The Company expects to complete the analysis in the second half of 2018.
PENSION PLANS The Company’s accounting policy under IFRS is to recognize actuarial gains/losses in the period in which they occur, and these gains/losses are reflected in the consolidated statements of comprehensive income (loss). During the year ended December 31, 2017, an actuarial loss of $2,174 was recorded in the consolidated statements of comprehensive income (loss), compared to an actuarial gain of $25,693 for the year ended December 31, 2016.
MORGUARD.COM 16 MORGUARD CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS | DECEMBER 31, 2017
FUNDS FROM OPERATIONS The following table provides an analysis of the Company’s FFO by component:
For the years ended December 31 2017 2016 Multi-suite residential $184,548 $169,436 Retail 137,021 141,606 Office 123,176 120,947 Industrial 6,292 7,020 Hotel 61,402 14,472 Adjusted NOI 512,439 453,481 Other Revenue Management and advisory fees 71,786 67,895 Interest and other income 8,907 6,349 Sale of product and land, net of costs 1,906 1,953 Equity-accounted FFO - other investments(1) 1,343 (2,088) Equity-accounted FFO - Temple — 4,517 83,942 78,626 Expenses and Other Interest (191,965) (152,926) Property management and corporate (82,862) (86,592) Internal leasing costs 4,671 5,905 Amortization of capital assets (2,404) (1,936) Current income taxes (20,467) (27,718) Non-controlling interest’s share of FFO (57,605) (60,388) Non-controlling interest - Morguard Residential REIT (21,769) (19,323) Target settlement — 22,490 Other 1,092 1,663 FFO $225,072 $213,282 FFO per common share amounts – basic and diluted $18.94 $17.86 Weighted average number of common shares outstanding (in thousands): Basic and diluted 11,883 11,943 (1) Equity-accounted FFO - other investments, exclude fair value adjustments on real estate properties and amortization of hotel properties.
For the year ended December 31, 2017, the Company recorded FFO of $225,072 ($18.94 per common share), compared to $213,282 ($17.86 per common share) in 2016. The increase in FFO of $11,790 is mainly due to the following:
• Higher Adjusted NOI of $58,958, primarily due to the consolidation of Temple and from the acquisition of properties; • An increase in management and advisory fees of $3,891; • An increase in interest and other income of $2,558; • A decrease in equity-accounted FFO of $1,086; • An increase in interest expense of $39,039, primarily due to the consolidation of Temple and from mortgage financing on acquisitions as well as higher interest on Unsecured Debentures; • Lower property management and corporate expense of $3,730; • A decrease in internal leasing cost of $1,234; • A decrease in current taxes of $7,251; • Lower share of non-controlling interest’s share of FFO of $2,783; • An increase in non-controlling interest share of Morguard Residential REIT of $2,446; and • A decrease as a result of Target settlement proceeds of $22,490 recognized in 2016.
The change in foreign exchange rates had a negative impact on FFO of $1,236 ($0.10 per common share).
MORGUARD.COM 17 MORGUARD CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS | DECEMBER 31, 2017
Normalized FFO
For the years ended December 31 2017 2016 FFO (from above) $225,072 $213,282 Add/(deduct): Target settlement, net of non-controlling interest — (16,999) Unrealized loss (gain) from investment in convertible debentures — (601) Insurance proceeds - property damage (Temple) (1,166) — Lease cancellation fee (1,593) (500) 222,313 195,182 Tax effect 129 3,117 Normalized FFO $222,442 $198,299 Per common share amounts – basic and diluted $18.72 $16.60
Normalized FFO for the year ended December 31, 2017, was $222,442, or $18.72 per common share, versus $198,299, or $16.60 per common share, for the same period in 2016, which represents an increase of $24,143, or 12.2%.
The following table provides the Company’s net income attributable to common shareholders reconciled to FFO:
For the years ended December 31 2017 2016 Net income attributable to common shareholders $310,120 $172,745 Add/(deduct): Fair value gain on real estate properties, net(1) (178,328) (96,695) Non-controlling interests’ share of fair value gain on real estate properties, net (3,443) (23,209) Fair value loss on Morguard Residential REIT Units 31,697 63,296 Distribution to Morguard Residential REIT’s external Unitholders 17,369 14,459 Non-controlling interest - Morguard Residential REIT (21,769) (19,323) Fair value loss on conversion option of MRG convertible debentures 157 600 Amortization of intangible asset 1,720 2,108 Amortization of hotel and owner-occupied properties(2) 27,521 5,040 Non-controlling interests’ share of amortization of hotel properties (8,898) — Foreign exchange gain (2,793) (5,388) Deferred income taxes 34,183 79,687 Current tax on disposition of properties 720 — Non-controlling interests’ share of deferred income taxes (173) — Internal leasing costs 4,671 5,905 Realty taxes accounted for under IFRIC 21(3) (1,428) 83 Transaction costs incurred on business combination — 1,180 Equity loss from Temple — 13,743 Equity-accounted FFO - Temple — 4,517 Gain on sale of real estate property — (1,688) Provision for impairment 24,590 — Non-controlling interests’ share of provision for impairment (10,844) — Gain on business combination — (3,778) FFO $225,072 $213,282 FFO per common share – basic and diluted $18.94 $17.86 Weighted average number of common shares outstanding (in thousands): Basic and diluted 11,883 11,943 (1) Includes fair value adjustments on real estate properties for equity-accounted investments. (2) Includes amortization of hotel properties for equity-accounted investments. (3) Realty taxes accounted for under IFRIC 21 exclude non-controlling interests’ share.
MORGUARD.COM 18 MORGUARD CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS | DECEMBER 31, 2017
PART IV
BALANCE SHEET ANALYSIS REAL ESTATE PROPERTIES The Company’s real estate properties, together with hotel properties and equity-accounted investments, represent approximately 95% of Morguard’s total assets. Real estate properties include multi-suite residential, retail, office and industrial properties held to earn rental income and for capital appreciation. Real estate properties also include properties or land that is being constructed or developed for future use as income producing properties.
The following table details the Company’s real estate assets:
As at December 31 2017 2016 Real estate properties Multi-suite residential $3,947,660 $3,365,080 Retail 2,536,063 2,526,276 Office 1,965,704 1,818,449 Industrial 113,857 110,576 8,563,284 7,820,381 Properties under development 29,729 35,155 Land held for development 62,638 64,135 Real estate properties $8,655,651 $7,919,671
Real estate properties increased by $735,980 at December 31, 2017, to $8,655,651, compared to $7,919,671 at December 31, 2016. The increase is primarily the result of the following:
• Acquisitions of real estate properties totalling $656,962 from the following;
Property Date of Acquisition Asset Type Location Purchase Price Coast at Lakeshore East(1) July 10, 2017 Residential Chicago, IL $291,686 The Fenestra August 17, 2017 Residential Rockville, MD 166,506 123 Commerce Valley East August 3, 2017 Office Markham, ON 67,947 Northgate at Falls Church(2) July 6, 2017 Residential Falls Church, VA 65,404 Camelot Business Centre September 21, 2017 Office Ottawa, ON 21,987 Argus Corporate Centre August 17, 2017 Office Oakville, ON 18,958 Downsview Townhomes May 15, 2017 Residential Toronto, ON 16,749 South Sheridan April 6, 2017 Office Oakville, ON 7,148 Rainbow Square September 26, 2017 Retail (Land) Dunnellon, FL 319 Emerald Lake Townhomes March 24, 2017 Residential Lakeworth, FL 258 $656,962 (1) On October 2, 2017, the Company sold a 49% interest in the property for $63,410 to an institutional partner. (2) The property is subject to a long-term land lease, with a fixed price land purchase option available in September 2029. Income producing properties include $9,256 (US$7,150) relating to the land lease in connection with the finance lease obligation recognized.
• Capitalization of property enhancements, including capital expenditures and tenant improvements totalling $72,459; • Development expenditures of $59,575; • Fair value gains on real estate properties of $190,078; • A decrease of $154,257 due to the change in the U.S. dollar foreign exchange rate; and • The disposition of four U.S. properties located in Mobile, Alabama, comprising 1,329 suites, for net proceeds of $88,685 (US$69,318).
MORGUARD.COM 19 MORGUARD CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS | DECEMBER 31, 2017
Coast at Lakeshore East is a recently built, 46-storey Class A property prominently located in the Lakeshore East master planned community, part of Chicago's famed Loop district. The 515-suite rental building offers unencumbered views of the Chicago River, Navy Pier and Lake Michigan and best-in-class fundamentals including nine-foot ceilings, above-average suite sizes and floor-to-ceiling windows. The property features 18,000 square feet of ground floor retail and a focus on green living: the LEED® Silver Certified building offers a smoke-free environment, world-class fitness centre, heated outdoor pool and access to the Chicago Pedway.
The Fenestra is a property comprising 492 suites located in Rockville, Maryland. Development of the property was completed in 2008. The Fenestra at Rockville Town Square (“The Fenestra”) is prominently located on Rockville Town Square, the social and cultural hub of Rockville. Residents of The Fenestra can walk to numerous restaurants, nightclubs and boutique stores, or easily commute to Washington via the nearby Washington Metro. The Fenestra comprises three six-storey buildings, featuring condo-quality amenities located in an urban growth market located within commuting distance of Washington D.C.
123 Commerce Valley East is an eight-storey Class A suburban office building with 203,500 square feet on 10.6 acres of land in Markham, Ontario. The building is highly visible from the Highway 407/404 interchange, providing exceptional signage opportunity for anchor tenants. The acquisition provides the Company with future growth. In- place zoning, surplus density and abundant existing parking give the Company the potential for an additional 270,000 square feet of office space on the property.
Northgate at Falls Church is a newly built, 104-suite mid-rise apartment building located in the Greater Washington D.C. suburb of Falls Church, Virginia. The property includes 33,000 square feet of high street commercial space and modern amenity space, including community courtyards with patio fireplace and grill, fitness centre, clubroom and garage parking.
Camelot Business Centre is a 106,500 square foot institutional quality suburban office property with 409 surface parking stalls located in Ottawa, Ontario. The property is strategically located in the Merivale and Hunt Club area of South Ottawa and in very close proximity to an abundance of retail amenities. Hunt Club Road serves as a main east- west artery in the city of Ottawa making this a highly accessible location for commuters and employees. The building is 100% leased, 99% of which is leased to the Federal Government of Canada on a long-term basis.
Argus Corporate Centre is a five-storey Class A suburban office building located in Oakville, Ontario. The 74,500 square foot building is currently 100% occupied. The property is located in the heart of Midtown Oakville, a designated urban growth centre under the development plan of the Province of Ontario. The City of Oakville is targeting residential and commercial intensification as well as significant transit and infrastructure investment in the neighbourhood immediately surrounding the property. Under the plan, the property will be re-zoned to have the highest commercial density within the development area. The property is also conveniently located within close proximity to Oakville GO and VIA Rail transit hub and easy access to highways and also provides excellent signage and promotional opportunities for tenants.
Downsview Townhomes is a newly constructed residential property comprising 60 rental townhomes, located in Toronto, Ontario. The property was acquired before leasing had commenced and the lease-up of suites was completed in early 2018. The property is comprised of two- and three-bedroom rental townhomes that have open concept floor plans and modern finishes and is set in an ideal location on the edge of Downsview Park.
MORGUARD.COM 20 MORGUARD CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS | DECEMBER 31, 2017
APPRAISAL CAPITALIZATION AND DISCOUNT RATES The Company’s internal valuation team consists of Appraisal Institute of Canada (“AIC”) designated Accredited Appraiser Canadian Institute (“AACI”) members who are qualified to offer valuation and consulting services and expertise for all types of real property, all of whom are knowledgeable and have recent experience in the fair value techniques for investment properties. AACI designated members must adhere to AIC’s Canadian Uniform Standards of Professional Appraisal Practice (“CUSPAP”) and undertake ongoing professional development. The Company’s valuation team is responsible for determining the fair value of investment properties every quarter, which include co- owned properties and properties classified as equity-accounted investments. The team reports to a senior executive, and the internal valuation team's valuation processes and results are reviewed by senior management at least once every quarter, in line with the Company’s quarterly reporting dates.
Using the direct capitalization approach, the multi-suite residential, retail, office and industrial properties were valued using capitalization rates in the range of 3.8% to 11.5% (December 31, 2016 - 4.3% to 10.0%), resulting in an overall weighted average capitalization rate of 5.7% (December 31, 2016 - 5.8%).
The stabilized capitalization rates by product type are set out in the following table:
December 31, 2017 December 31, 2016 Occupancy Capitalization Occupancy Capitalization As at Rates Rates Rates Rates Weighted Weighted Max. Min. Max. Min. Average Max. Min. Max. Min. Average Multi-suite residential 98.0% 90.0% 8.0% 3.8% 4.7% 98.0% 91.0% 8.0% 4.3% 4.9% Retail 100.0% 80.0% 11.5% 5.0% 6.6% 100.0% 80.0% 10.0% 5.0% 6.6% Office 100.0% 90.0% 9.0% 4.5% 6.2% 100.0% 90.0% 9.0% 4.8% 6.2% Industrial 100.0% 95.0% 7.3% 5.0% 6.4% 100.0% 95.0% 7.0% 5.3% 6.7%
The key valuation metrics used in the discounted cash flow method for the retail, office and industrial properties are set out in the following table:
December 31, 2017 December 31, 2016 Weighted Weighted Maximum Minimum Average Maximum Minimum Average Retail Discount rate 10.3% 6.0% 7.0% 10.3% 5.5% 6.9% Terminal cap rate 9.5% 5.3% 6.1% 9.5% 5.3% 6.2% Office Discount rate 9.3% 5.5% 6.6% 9.3% 5.8% 6.7% Terminal cap rate 8.5% 4.5% 5.9% 8.5% 4.8% 6.0% Industrial Discount rate 7.5% 6.0% 6.9% 7.5% 6.3% 7.1% Terminal cap rate 7.0% 5.0% 6.3% 7.0% 5.3% 6.5%
Fair values are most sensitive to changes in discount rates, capitalization rates and stabilized or forecast net operating income. Generally, an increase in net operating income will result in an increase in the fair value of the income producing properties, and an increase in capitalization rates will result in a decrease in the fair value of the properties. The capitalization rate magnifies the effect of a change in net operating income, with a lower capitalization rate resulting in a greater impact on the fair value of the property than a higher capitalization rate.
MORGUARD.COM 21 MORGUARD CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS | DECEMBER 31, 2017
The sensitivity of the fair values of the Company’s income producing properties as at December 31, 2017 and 2016, is set out in the table below:
As at December 31, 2017 December 31, 2016 Change in capitalization rate: 0.25% (0.25%) 0.25% (0.25%) Multi-suite residential ($192,310) $213,190 ($161,023) $178,134 Retail (87,742) 94,632 (89,778) 96,843 Office (77,025) 83,518 (71,937) 77,792 Industrial (3,791) 4,099 (3,609) 3,899 ($360,868) $395,439 ($326,347) $356,668
HOTEL PROPERTIES Hotel properties consist of the following:
As at December 31 2017 2016 Cost $709,085 $701,618 Accumulated impairment provision (24,590) — Accumulated amortization (42,734) (16,094) Net book value 641,761 685,524 Hotel property under development 27,265 20,139 Hotel properties $669,026 $705,663
Hotel properties include the redevelopment of a hotel property in downtown Ottawa, Ontario. The redevelopment is the first dual brand conversion, of an existing building, under the Hilton banner in Canada and is set to be the first Hilton property in downtown Ottawa. The $30,000 plan calls for the redevelopment of two existing towers that will be transformed into a 17-storey Hilton Homewood Suites and a 10-storey Hilton Garden Inn. The project is expected to be completed in Spring 2018.
On September 15, 2017, the Company sold the Holiday Inn Express, Sherwood Park, Alberta, for gross proceeds of $9,690 (including working capital adjustments of $80), resulting in aggregate net cash proceeds of $278 after deducting the repayment of first mortgage loan of $9,102, interest payable of $19 and sale costs of $291.
In 2017, impairment indicators were identified including decreases in occupancy at hotel properties. A recoverability analysis was completed in accordance with the procedures specified by IFRS which indicated that an impairment of $24,590 should be recorded for certain hotel properties.
Wingate by Wyndham Saskatoon Hilton Cortona As at December 31, 2017 Regina Inn Garden Inn Residence Net book value $16,932 $39,514 $21,469 $11,125 Recoverable amount 13,000 22,300 19,300 9,850 Provision for impairment 3,932 17,214 2,169 1,275 Cumulative impairment provision 3,932 17,214 2,169 1,275 Projected first year NOI 822 1,861 987 747 Discount rate 9.0% 10.0% 8.5% 10.5%
IFRS permits an impairment provision to be reversed in the subsequent accounting periods if recoverability analysis at that time supports reversal.
MORGUARD.COM 22 MORGUARD CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS | DECEMBER 31, 2017
EQUITY-ACCOUNTED AND OTHER FUND INVESTMENTS Equity-accounted and other real estate fund investments consist of the following:
As at December 31 2017 2016 Joint ventures $55,051 $50,782 Associates 132,314 230,198 Equity-accounted investments 187,365 280,980 Other real estate fund investments 93,488 99,828 Equity-accounted and other fund investments $280,853 $380,808
The following are the Company’s significant equity-accounted investments as at December 31, 2017 and 2016:
Company’s Ownership Carrying Value Principal Place Investment Asset December 31, December 31, December 31, December 31, Property/Investment of Business Type Type 2017 2016 2017 2016 Petroleum Plaza Edmonton, AB Joint Venture Office 50.0% 50.0% $27,080 $28,201 Quinte Courthouse Belleville, ON Joint Venture Office 50.0% 50.0% 7,178 7,267 Greypoint Capital L.P. Toronto, ON Joint Venture Other 36.4% 36.4% 5,497 50 Courtyard by Marriott Ottawa, ON Joint Venture Hotel 50.0% 50.0% 10,883 10,821 Marriott Residence Inn London, ON Joint Venture Hotel 50.0% 50.0% 4,413 4,443 Sunset & Gordon Los Angeles, CA Associate Residential 59.1% 59.1% 47,733 63,359 Marquee at Block 37 Chicago, IL Associate Residential 49.0% 49.0% 68,162 150,972 MIL Industrial Fund II LP(1) Various Associate Industrial 18.8% 18.8% 16,419 15,867 $187,365 $280,980 (1) The Company accounts for its investment using the equity method since the Company has the ability to exercise significant influence as a result of its role as general partner; however, it does not control the fund.
The Company’s largest equity investment is in a U.S. multi-suite residential development property project in Chicago, Illinois, in which the Company has a 49.0% interest. The development project, known as the Marquee at Block 37, a 34-storey, 691 luxury suite residential tower is complete and is currently 84.2% occupied.
The following table presents the change in the balance of equity-accounted investments:
As at December 31 2017 2016 Balance, beginning of year $280,980 $233,469 Additions, net of disposals 10,400 1,490 Reclassification of Temple — (17,993) Acquisitions through business combination — 15,264 Share of net income (loss) (10,227) 54,904 Distributions received (79,961) (4,446) Foreign exchange (13,827) (1,708) Balance, end of year $187,365 $280,980
During the year ended December 31, 2017, distributions from equity-accounted investments amounted to $79,961, of which $74,992 (2016 - $nil) was from the Company’s investment in Marquee at Block 37 that represented the Company’s share of net proceeds from a mortgage refinancing.
MORGUARD.COM 23 MORGUARD CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS | DECEMBER 31, 2017
MORTGAGES AND LOANS RECEIVABLE Mortgages and loans receivable consist of the following:
As at December 31 2017 2016 Mortgages receivable $13,914 $15,149 Loan receivable - Paros Enterprises Limited (“Paros”) — 2,314 Loan receivable - TWC Enterprises Limited (“TWC”) 11,767 47,084 Loan receivable - other 1,576 — Total mortgages and loans receivable $27,257 $64,547
During 2016, mortgages receivable were advanced in the amount of $14,081 with a financial institution. The mortgages receivable mature on June 15, 2018, and bear interest at the bankers’ acceptance rate plus 4.0%.
MORTGAGES PAYABLE Mortgages payable totalled $4,056,028 at December 31, 2017, compared to $3,940,109 at December 31, 2016, representing an increase of $115,919 predominantly due to net proceeds from new financing of $711,961, partially offset by the repayment of mortgages discharged and matured of $388,307, scheduled principal repayments of $112,212 and the change in the foreign exchange rate of $79,824.
MORTGAGE CONTINUITY SCHEDULE
As at December 31 2017 2016 Opening mortgage balance $3,940,109 $3,599,554 New mortgage financing 711,961 289,447 New mortgage financing costs (9,463) (5,886) Mortgages discharged and matured (388,307) (200,682) Scheduled principal repayments (112,212) (95,395) Change in foreign exchange rate (79,824) (34,373) Mortgages mark-to-market adjustment, net (10,640) (12,464) Deferred financing costs 4,404 4,500 Consolidation of Temple — 395,408 Closing mortgage balance $4,056,028 $3,940,109
MORTGAGE REPAYMENT SCHEDULE
Weighted Principal Average Instalment Balance Contractual As at December 31, 2017 Repayments Maturing Total Interest Rate 2018 $96,577 $515,414 $611,991 4.76% 2019 87,663 341,228 428,891 3.77% 2020 87,564 164,293 251,857 4.76% 2021 81,139 339,296 420,435 4.23% 2022 75,102 389,778 464,880 3.70% Thereafter 171,371 1,707,248 1,878,619 3.57% $599,416 $3,457,257 4,056,673 3.86% Mark-to-market adjustment, net 24,931 Deferred financing costs (25,576) $4,056,028
MORGUARD.COM 24 MORGUARD CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS | DECEMBER 31, 2017
The Company’s first mortgages are registered against specific real estate assets. As at December 31, 2017, mortgages payable bear interest at rates ranging between 2.25% and 8.20% per annum with a weighted average interest rate of 3.86% (December 31, 2016 - 3.91%) and mature between 2018 and 2039 with a weighted average term to maturity of 5.1 years (December 31, 2016 - 4.7 years). Approximately 94.1% of the Company’s mortgages have fixed interest rates. Some of Temple’s mortgages payable require it to maintain annual debt service coverage ratios and/or debt to equity ratios and/or debt to appraised value ratios, arrange for capital expenditures in accordance with predetermined limits and maintain ongoing liquidity ratios. As at December 31, 2017, Temple was not in compliance with seven (December 31, 2016 - nine) debt service covenants affecting seven (December 31, 2016 - nine) mortgage loans amounting to $109,339 (December 31, 2016 - $139,187). None of the lenders have demanded payment of the mortgage loans. As at December 31, 2017, Temple was not in compliance with a corporate 1.1 to 1.0 working capital ratio requirement affecting three mortgage loans schedules to mature in June 2018, with an aggregate principal balance of $37,106. Temple has received a waiver from the lender subsequent to December 31, 2017. However, IFRS requires that the loan balance of mortgages payable in breach of debt covenants be included in the current portion of mortgages payable. All mortgages payable in breach of debt covenants have contractual maturities due within 12 months of December 31, 2017. Short-term fluctuations in working capital are funded through pre-established operating lines of credit. The Company anticipates meeting all future obligations. The Company has no off balance sheet financing arrangements.
MORTGAGE MATURITY SCHEDULE The following table details the Company’s mortgages contractual maturities over the next two years.
2018 2019 Weighted Weighted Average Average Number of Principal Interest Number of Principal Interest Asset Type Properties Maturing Rate Properties Maturing Rate Multi-suite residential 2 $66,051 4.68% 3 $96,195 3.21% Retail 5 129,080 3.64% 2 145,869 3.63% Office 3 64,161 3.72% 1 16,253 3.61% Hotels(1) 18 254,827 5.59% 7 82,911 4.69% 28 $514,119 4.75% 13 $341,228 3.77% (1) Temple mortgages payable in breach of debt covenants required under IFRS to be included in the current portion of mortgages payable have been presented in the above table based on their contractual maturity.
On January 16, 2017, the Company completed the financing of a multi-suite residential property located in Toronto, Ontario, in the amount of $168,350. The proceeds of the financing were used to repay the remaining construction financing facility balance of $93,000.
On February 1, 2017, the Company repaid on maturity, four mortgages in the amount of $59,326 (US$45,325) secured by four multi-suite residential properties in Mobile, Alabama.
During the three months ended March 31, 2017, the Company repaid $10,713 of mortgages payable secured by two hotel properties located in Yellowknife, Northwest Territories.
On May 1, 2017, the Company fully repaid, without penalty, three mortgages secured by three U.S. retail properties totalling $12,724 (US$9,805).
On June 1, 2017, the Company completed the refinancing of a multi-suite residential property located in Atlanta, Georgia, in the amount of $29,063 (US$21,528) at an interest rate of 3.84% for a term of 10 years.
On June 1, 2017, the Company completed the refinancing of a multi-suite residential property located in Aurora, Colorado, in the amount of $28,823 (US$21,350) at an interest rate of 3.84% for a term of 10 years.
MORGUARD.COM 25 MORGUARD CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS | DECEMBER 31, 2017
On June 27, 2017, the Company completed the financing of two hotel properties in the amount of $15,588. The loan bears interest at either prime plus 2.50% or bankers’ acceptance plus 3.50% for a term of two years.
On June 28, 2017, the Company completed the refinancing of a retail property located in Ottawa, Ontario, for $15,000 at an interest rate of 2.73% for a term of five years.
On June 30, 2017, the Company completed the refinancing of a multi-suite residential property located in Bradenton, Florida, in the amount of $23,374 (US$18,012) at an interest rate of 3.83% for a term of 10 years.
On July 6, 2017, the Company completed the financing of a multi-suite residential property located in Falls Church, Virginia, in the amount of $30,617 (US$23,650) at an interest rate of 4.05% for a term of 12.25 years.
On July 10, 2017, the Company completed the financing of a multi-suite residential property in Chicago, Illinois, in the amount of $157,878 (US$122,500) at an interest rate of 3.49% for a term of eight years.
On August 14, 2017, the Company completed the refinancing of three hotel properties in the amount of $36,337 at an interest rate of 5.20% for a term of five years.
On August 17, 2017, the Company completed the financing of a multi-suite residential property in Rockville, Maryland, in the amount of $88,546 (US$70,950) at an interest rate of 3.55% for a term of 10 years.
On August 30, 2017, the Company completed the refinancing of an office property located in Victoria, British Columbia, for $38,000 at an interest rate of 3.68% for a term of 10 years.
On September 29, 2017, the Company fully repaid, without penalty, three mortgages secured by three U.S. retail properties totalling $83,696 (US$67,064).
On November 1, 2017, the Company fully repaid on maturity, a mortgage secured by an industrial property located in Salaberry-de-Valleyfield, Québec, in the amount of $9,761.
On December 29, 2017, the Company completed the refinancing of a multi-suite residential property located in Tampa, Florida, in the amount of $40,144 (US$32,000) at an interest rate of 3.58% for a term of 10 years.
UNSECURED DEBENTURES The Company’s Unsecured Debentures consist of the following:
Coupon As at December 31 Maturity Date Interest Rate 2017 2016 Series A senior unsecured debentures December 10, 2018 4.099% $135,000 $135,000 Series B senior unsecured debentures November 18, 2020 4.013% 200,000 200,000 Series C senior unsecured debentures September 15, 2022 4.333% 200,000 — Unamortized financing costs (2,093) (1,362) $532,907 $333,638
On December 10, 2013, the Company issued $135,000 (net proceeds including issuance costs - $134,315) of the Series A senior unsecured debentures due on December 10, 2018. Interest on the Series A unsecured debentures is payable semi-annually, not in advance, on June 10 and December 10 of each year. Paros, a related party, acquired $10,000 aggregate principal amount of the Series A unsecured debentures.
The Company has the option to redeem the Series A unsecured debentures at a redemption price equal to the greater of the Canada Yield Price or par plus any accrued and unpaid interest. The Canada Yield Price is defined as the amount that would return a yield on investment for the remaining term to maturity equal to the Canada Bond Yield with an equal term to maturity plus a spread of 0.56%.
MORGUARD.COM 26 MORGUARD CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS | DECEMBER 31, 2017
On November 18, 2016, the Company issued $200,000 (net proceeds including issuance costs - $199,198) of Series B senior unsecured debentures due on November 18, 2020. Interest on the Series B unsecured debentures is payable semi-annually, not in advance, on May 18 and November 18 of each year commencing on May 18, 2017.
The Company has the option to redeem the Series B unsecured debentures at a redemption price equal to the greater of the Canada Yield Price or par plus any accrued and unpaid interest. The Canada Yield Price is defined as the amount that would return a yield on investment for the remaining term to maturity equal to the Canada Bond Yield with an equal term to maturity plus a spread of 0.785%.
On September 15, 2017, the Company issued $200,000 (net proceeds including issuance costs - $198,800) of Series C senior unsecured debentures due on September 15, 2022. Interest on the Series C unsecured debentures is payable semi-annually, not in advance, on March 15 and September 15 of each year commencing on March 15, 2018.
The Company has the option to redeem the Series C unsecured debentures at a redemption price equal to the greater of the Canada Yield Price or par plus any accrued and unpaid interest. The Canada Yield Price is defined as the amount that would return a yield on investment for the remaining term to maturity equal to the Canada Bond Yield with an equal term to maturity plus a spread of 0.635%.
For the year ended December 31, 2017, interest on Unsecured Debentures of $16,124 (2016 - $6,499) is included in interest expense.
The covenants that govern the Unsecured Debentures are calculated using the Company’s published results prepared in accordance with IFRS adjusted as required to account for the Company’s public entity investments in Morguard REIT, Morguard Residential REIT and Temple using the equity method of accounting. The Company must maintain an interest coverage ratio computed on a Non-Consolidated Basis above 1.65 times, an indebtedness to aggregate assets ratio computed on a Non-Consolidated Basis not to exceed 65% and a minimum equity requirement computed on a Non-Consolidated Basis of at least $300,000. If the Company does not meet these covenants, the Unsecured Debentures will become immediately due and payable unless the Company is able to remedy the default or obtain a waiver from lenders. The covenants computed on a Non-Consolidated Basis are as follows:
Covenant Requirements December 31, 2017 December 31, 2016 Interest coverage ratio 1.65 3.66 3.56 Indebtedness to aggregate assets ratio(1) Less than or equal to 65% 37.6% 37.9% Adjusted shareholders’ equity(2) Not less than $300,000 $3,160,753 $3,081,695
(1) As defined in the Trust Indenture and the First Supplemental Indenture, adjusted to exclude goodwill and deferred income tax assets and to add back accumulated amortization of hotel properties. (2) As defined in the Trust Indenture and the First Supplemental Indenture, adjusted to exclude deferred tax assets and liabilities and to add back accumulated amortization of hotel properties. The Company’s unencumbered properties on a Non-Consolidated Basis as at December 31, 2017, are $436,211 (December 31, 2016 - $174,406).
MORGUARD.COM 27 MORGUARD CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS | DECEMBER 31, 2017
The Company’s financial results on a Non-Consolidated Basis are as follows:
MORGUARD NON-CONSOLIDATED FINANCIAL STATEMENTS BALANCE SHEET
Morguard Morguard Non- Morguard Morguard Residential Consolidated As at December 31, 2017 Consolidated REIT REIT Temple Adjustments Basis
ASSETS Real estate properties $8,655,651 ($2,861,816) ($2,570,589) $— ($78,817) $3,144,429 Hotel properties 669,026 — — (442,187) (43,260) 183,579 Equity-accounted and other fund investments 280,853 (27,080) (37,295) (10,498) 1,160,302 1,366,282 Investment in Class C LP Units — — — — 92,577 92,577 Other assets 506,456 (32,195) (43,213) (29,519) 86,521 488,050 Total assets $10,111,986 ($2,921,091) ($2,651,097) ($482,204) $1,217,323 $5,274,917
LIABILITIES Mortgage payable and Class C LP Units $4,056,028 ($1,080,258) ($1,257,049) ($367,614) $23,413 $1,374,520 Construction financing, loans and bank indebtedness 86,126 (52,861) (21,799) (13,500) 70,299 68,265 Class B LP Units — — (258,863) — 258,863 — Unsecured Debentures 532,907 — — — — 532,907 Convertible debentures 236,375 (166,983) (60,466) (74,737) 65,811 — Morguard Residential REIT Units 365,438 — — — (365,438) — Deferred income tax liabilities 646,884 — (82,482) (2,311) (562,091) — Accounts payable and accrued liabilities 253,859 (55,398) (52,732) (18,173) 10,916 138,472 Total liabilities 6,177,617 (1,355,500) (1,733,391) (476,335) (498,227) 2,114,164 Adjusted shareholders’ equity 3,934,369 (1,565,591) (917,706) (5,869) 1,715,550 3,160,753 Total liabilities and equity $10,111,986 ($2,921,091) ($2,651,097) ($482,204) $1,217,323 $5,274,917
COMPUTATION FOR INTEREST COVERAGE RATIO Morguard Morguard Non- Morguard Morguard Residential Consolidated Year ended December 31, 2017 Consolidated REIT REIT Temple Adjustments Basis Revenue from real estate properties $790,535 ($278,754) ($226,495) $— ($2,431) $282,855 Revenue from hotel properties 237,116 — — (165,612) — 71,504 Property operating expenses (338,070) 121,729 103,759 — (11,786) (124,368) Hotel operating expenses (175,714) — — 122,727 — (52,987) Net operating income 513,867 (157,025) (122,736) (42,885) (14,217) 177,004 Management and advisory fees and distributions 71,786 — — — 44,488 116,274 Interest and other income 8,907 (179) 529 (380) 1,404 10,281 Sales of product and land, net of costs 1,906 — — — — 1,906 Property management and corporate(1) (82,862) 4,517 12,618 3,410 (15,357) (77,674) Other income (expense)(2) 296 — — — — 296 Distributions from Morguard REIT and Morguard Residential REIT — — — — 46,553 46,553 EBITDA $513,900 ($152,687) ($109,589) ($39,855) $62,871 $274,640 Interest expense $191,965 ($55,087) ($58,497) ($28,609) $24,248 $74,020 Interest capitalized to development projects 1,778 (662) — — — 1,116 Interest expense for interest coverage ratio $193,743 ($55,749) ($58,497) ($28,609) $24,248 $75,136 (1) Morguard consolidated property management and corporate expense for the year ended December 31, 2017, includes a non-cash fair value adjustment relating to the Company’s SARs liability and has been adjusted to add back the increase in SARs expense of $3,012. (2) Excludes acquisition-related costs, debt settlement or other costs, any gain or loss attributed to the sale or disposition of any asset or liability, other non-cash items and non-recurring items.
MORGUARD.COM 28 MORGUARD CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS | DECEMBER 31, 2017
CONVERTIBLE DEBENTURES Convertible debentures consist of the following:
Principal Coupon Owned by Conversion Interest Principal the December 31, December 31, As at Maturity Date Price Rate Balance Company 2017 2016 Morguard REIT (1) — — — — $— $100,336 Morguard REIT December 31, 2021 $20.40 4.50% $175,000 $60,000 108,335 116,625 Morguard Residential REIT (2) March 30, 2018 $15.50 4.65% $60,000 $5,000 55,466 54,779 Temple - Series C (3) — — — — — 21,922 Temple - Series D (4) — — — — — 31,450 Temple - Series E (5) September 30, 2020 $9.75 7.25% $42,905 $1,067 39,366 41,877 Temple - Series F March 31, 2018 $39.12 7.00% $34,419 $600 33,208 30,763 $236,375 $397,752 (1) On January 9, 2017, the remaining convertible debenture balance of $99,957 was fully redeemed by the Company. (2) The liability includes the fair value of the conversion option of $798 (December 31, 2016 - $641). (3) The Series C convertible debentures had a December 31, 2016 due date but since December 31, 2016 fell on a weekend, the Company repaid the convertible debentures on January 3, 2017, the first business day after December 31, 2016. (4) On June 30, 2017, the Company repaid the remaining Series D convertible debentures on maturity. (5) The Series E convertible debentures had a September 30, 2017 due date but since September 30, 2017 fell on a weekend, the convertible debentures had a maturity date on October 2, 2017, the first business day after September 30, 2017. On October 2, 2017, the terms of the Series E convertible debentures were amended, which included extending the maturity date to September 30, 2020 and reducing the conversion price to $9.75 (see below).
MORGUARD REIT On October 31, 2012, Morguard REIT issued $150,000 principal amount of 4.85% convertible unsecured subordinated debentures and incurred issue costs of $4,228 for net proceeds of $145,772. On January 6, 2017, $18 of the convertible debentures were converted into 731 Units and on January 9, 2017, the remaining $149,957 ($99,957 excluding principal owned by the Company) convertible debentures were redeemed in advance of their October 31, 2017 maturity date.
On December 30, 2016, Morguard REIT issued $175,000 principal amount of 4.50% convertible unsecured subordinated debentures and incurred issue costs of $5,137 for net proceeds of $169,863. Interest is payable semi- annually, not in advance, on June 30 and December 31 of each year. The convertible debentures, with the exception of $3,242, the value assigned to the holder’s conversion option, have been recorded as debt on the consolidated balance sheets. On January 12, 2017, the Company purchased an additional $10,000 principal amount of the 4.50% convertible unsecured subordinated debentures.
MORGUARD RESIDENTIAL REIT On March 15, 2013, Morguard Residential REIT issued $60,000 principal amount of 4.65% convertible unsecured subordinated debentures and incurred issue costs of $2,062, which have been capitalized and are being amortized over their term to maturity. Interest is payable semi-annually, not in advance, on March 31 and September 30 of each year (see “Part VIII, Subsequent Events”).
TEMPLE HOTELS INC. On January 3, 2017, Temple redeemed the remaining $22,773 ($21,922 excluding principal owned by the Company) Series C convertible debentures on maturity.
On June 30, 2017, Temple redeemed the remaining $34,282 ($33,137 excluding principal owned by the Company) Series D convertible debentures on maturity.
As at December 31, 2017, the 7.25% Series E convertible debentures have a principal balance of $42,905. The Series E convertible debentures are redeemable at the option of Temple at their principal amount. Interest is payable semi-annually, not in advance, on March 31 and September 30 of each year.
MORGUARD.COM 29 MORGUARD CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS | DECEMBER 31, 2017
On September 28, 2017, holders of the Series E convertible redeemable unsecured debentures approved the following proposed amendments to the Series E debentures, effective October 2, 2017: i) Decreasing the conversion price from $40.08 to $9.75 per common share of Temple; ii) Extending the maturity date from September 30, 2017 to September 30, 2020; iii) Permitting Temple to redeem the Series E debentures, in whole or in part, at any time up to September 30, 2020, at a price equal to the principal amount thereof plus accrued and unpaid interest to, but excluding the date of the redemption; and iv) Permitting Temple to complete the Initial Partial Redemption (as defined below) without further notice or communication to holders of Series E debentures and to complete the Additional Partial Redemptions (as defined below). On October 2, 2017, Temple redeemed $2,259 ($2,202 excluding principal owned by the Company) of the principal amount of the Series E debentures outstanding, which represents approximately 5% of the issued and outstanding Series E debentures (the “Initial Partial Redemption”). Temple has also committed to redeem an additional 5% of the currently issued and outstanding principal amount of Series E debentures on each of September 30, 2018 and September 30, 2019 (the “Additional Partial Redemptions”). Each of the Initial Partial Redemption and the Additional Partial Redemptions will be for a cash payment equal to the principal amount of such redemption plus accrued and unpaid interest to, but excluding the date of redemption. On October 2, 2017, the convertible debentures, with the exception of $2,120, the value assigned to the holder’s conversion option, have been recorded as debt on the consolidated balance sheets.
As at December 31, 2017, the 7% Series F convertible debentures have a principal balance of $34,419. The Series F convertible debentures are redeemable at the option of Temple at the principal amount. Interest is payable semi- annually, not in advance, on March 31 and September 30 of each year.
For the year ended December 31, 2017, interest on convertible debentures net of accretion of $21,417 (2016 - $7,030), is included in interest expense.
MORGUARD RESIDENTIAL REIT UNITS As at December 31, 2017, the Company owned a 46.9% (December 31, 2016 - 48.7%) effective interest in Morguard Residential REIT through its ownership of 6,675,166 Units and 17,223,090 Class B LP Units. Although the Company owns less than 50% of Morguard Residential REIT, it continues to consolidate its investment on the basis of de facto control.
The non-controlling interest in Morguard Residential REIT Units has been presented as a liability. Morguard Residential REIT Units are redeemable at any time, in whole or in part, on demand by the holders. Upon receipt of the redemption notice by Morguard Residential REIT, all rights to and under the Units tendered for redemption shall be surrendered, and the holder shall be entitled to receive a price per Unit equal to the lesser of: (i) 90% of the market price of the Units on the principal exchange market on which the Units are listed or quoted for trading during the 10 consecutive trading days ending immediately prior to the date on which the Units were surrendered for redemption; or (ii) 100% of the closing market price on the principal exchange market on which the Units are listed or quoted for trading on the redemption date.
On January 9, 2017, Morguard Residential REIT completed an offering for 4,370,000 Units sold for a price of $13.75 per Unit for aggregate gross proceeds of $60,088. The net proceeds of the offering, after underwriters’ commission and other closing costs totalling $2,402, was $57,686. The Company purchased 1,230,000 of the Units offered amounting to $16,688.
As at December 31, 2017, the Company valued the non-controlling interest in Morguard Residential REIT Units at $365,438 (December 31, 2016 - $292,304) and classified the Units as a liability on the consolidated balance sheets. Due to the change in the market value of the Units and the distributions paid to external Unitholders, the Company recorded a fair value loss for the year ended December 31, 2017 of $49,066 (2016 - $77,755) in the consolidated statements of income.
MORGUARD.COM 30 MORGUARD CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS | DECEMBER 31, 2017
CONSTRUCTION FINANCING PAYABLE As at December 31, 2017, the Company has a construction financing facility with maximum available borrowings totalling $39,255 (December 31, 2016 - $184,255) collateralized by a development property. The construction financing facility bears interest at either prime rate plus 1.5% or the bankers’ acceptance rate plus 2.5%, maturing on April 30, 2018. As at December 31, 2017, the Company had borrowed $36,476 (December 31, 2016 - $93,000) in construction financing.
BANK INDEBTEDNESS As at December 31, 2017 and 2016, the Company has credit facilities and operating lines of credit totalling $349,000, the majority of which can be borrowed in either Canadian or U.S. dollars and are subject to floating interest rates based on bankers’ acceptance or LIBOR rates. The Company’s investments in Morguard REIT and Morguard Residential REIT, marketable securities, amounts receivable, inventory, capital assets and a fixed-charge security on specific properties have been pledged as collateral on these credit facilities and operating lines of credit. As at December 31, 2017, the Company had borrowed $49,650 (December 31, 2016 - $nil) and issued letters of credit in the amount of $15,048 (December 31, 2016 - $14,251) related to these facilities.
The bank credit agreements include certain restrictive undertakings by the Company. As at December 31, 2017, the Company is in compliance with all undertakings.
FINANCE LEASE OBLIGATION The Company acquired a land lease in connection with the acquisition of a residential property. The Company has the option to purchase the land in September 2029 for US$7,150. The Company has classified the land lease as a finance lease under the assumption that substantially all the risks and rewards incidental to ownership have been transferred.
Future minimum lease payments under the finance lease are as follows:
As at December 31 2017 2016 Within 12 months $377 $— 2 to 5 years 1,677 — Over 5 years 12,205 — Total minimum lease payments 14,259 — Less: future interest costs (5,289) — Present value of minimum lease payments $8,970 $—
CONTRACTUAL MATURITIES The contractual maturities and repayment obligations of the Company’s financial liabilities for upcoming periods as at December 31, 2017, are as follows:
As at December 31, 2017 2018 2019 2020 2021 2022 Thereafter Total Mortgages payable $611,991 $428,891 $251,857 $420,435 $464,880 $1,878,619 $4,056,673 Mortgage interest 140,413 119,820 108,126 92,065 77,978 140,197 678,599 Convertible debentures 90,911 1,987 37,759 115,000 — — 245,657 Interest on convertible debentures 9,442 8,020 7,229 5,175 — — 29,866 Unsecured Debentures 135,000 — 200,000 — 200,000 — 535,000 Interest on Unsecured Debentures 21,906 16,692 15,746 8,666 6,119 — 69,129 Construction financing payable 36,476 — — — — — 36,476 Bank Indebtedness 49,650 — — — — — 49,650 Accounts payable and accrued liabilities 244,889 — — — — — 244,889 Finance lease obligation 377 390 429 429 429 12,205 14,259 $1,341,055 $575,800 $621,146 $641,770 $749,406 $2,031,021 $5,960,198
MORGUARD.COM 31 MORGUARD CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS | DECEMBER 31, 2017
EQUITY Total equity increased by $263,238 to $3,934,369 at December 31, 2017, compared to $3,671,131 at December 31, 2016.
The increase in equity was primarily the result of: • Net income for the year ended December 31, 2017 of $344,367; and • A decrease in subsidiary ownership interest of $63,410.
These items were partially offset by: • Unrealized foreign currency translation loss of $81,432; • A change in ownership of Morguard REIT of $16,779; • Repurchase of common shares through the Company’s normal course issuer bid amounting to $15,834; • Non-controlling interest distributions of $27,032; and • Dividends paid of $7,127.
During the year ended December 31, 2017, 88,309 common shares were repurchased through the Company’s normal course issuer (“NCIB”) for cash consideration of $15,834. At December 31, 2017, 11,841,732 common shares were outstanding. As at February 22, 2018, 11,477,489 common shares were outstanding.
MORGUARD.COM 32 MORGUARD CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS | DECEMBER 31, 2017
PART V
LIQUIDITY Morguard uses a combination of existing cash, cash generated from operations, mortgages, bank indebtedness, project-specific financing and equity to finance its activities. For the year ended December 31, 2017, Morguard received approximately $51,522 in recurring distributions and dividends from subsidiaries and affiliated entities.
Net cash flows provided by operating activities represent the primary source of liquidity to fund dividends and maintenance capital expenditures (excluding new acquisition and development spending) on the Company’s real estate properties. The Company’s net cash flows provided by operating activities are dependent upon the occupancy level of its rental properties, rental rates on its leases, collectibility of rent from its tenants, level of operating expenses and other factors. Material changes in these factors may adversely affect the Company’s cash flows provided by operating activities and liquidity. The Company’s cash dividend policy reflects a strategy of maintaining a relatively constant debt level as a percentage of total gross assets. Accordingly, the Company does not repay maturing debt from cash flow but rather with proceeds from refinancing such debt or financing unencumbered properties.
Cash Provided by Operating Activities Cash provided by operating activities during the year ended December 31, 2017, was $315,528, compared to $285,058 in 2016. The cash provided by operating activities has been used to meet the Company’s liquidity requirements, which consisted primarily of property re-leasing costs, maintenance costs and dividends to shareholders.
Cash Used in Investing Activities Cash used in investing activities during the year ended December 31, 2017, totalled $689,853, compared to cash used in investing activities of $180,750 in 2016. The cash used in investing activities reflects:
• Additions to real estate properties and tenant improvements of $713,279; • Additions to hotel properties of $16,786; • Additions to capital assets and intangibles of $18,107; • Proceeds from sale of real estate properties of $88,685; • Proceeds from sale of hotel properties of $9,399; • An investment in properties under development of $66,701; • Investment in equity-accounted and other fund investment, net of $10,400; and • The net decrease from mortgages and loans receivable of $37,336.
Cash Provided by Financing Activities Cash provided by financing activities during the year ended December 31, 2017, totalled $264,000, compared to cash provided by financing activities of $44,992 in 2016. The cash provided by financing activities reflects:
• Proceeds from new mortgages, net financing cost of $705,619; • Repayment of mortgages on maturity of $388,307; • Mortgage principal repayments of $112,212; • Net proceeds from bank indebtedness of $45,008; • Net proceeds from the issuance of Units of $40,998; • Proceeds from issuance of Unsecured Debentures, net of costs of $198,800; • Redemption of convertible debentures of $157,218; • Net repayment of construction financing of $56,524; • Dividends paid of $6,979; • Contribution from non-controlling interest of $63,410; • Distributions to non-controlling interests of $26,742; • Common shares repurchased for cancellation of $15,834; • An investment in Morguard REIT of $26,797; and • A decrease in restricted cash of $778.
MORGUARD.COM 33 MORGUARD CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS | DECEMBER 31, 2017
PART VI
TRANSACTIONS WITH RELATED PARTIES Related party transactions that are in the normal course of operations are subject to the same processes and controls as other transactions; that is, they are subject to standard approval procedures and management oversight, but are also considered by management for reasonability against fair value. Related party transactions that are found to be material are subject to review and approval by the Company’s Audit Committee, which comprises Independent Directors.
PAROS ENTERPRISES LIMITED Paros is the majority shareholder and ultimate parent of the Company. Paros is owned by the Company’s Chairman and Chief Executive Officer, Mr. K. Rai Sahi. On December 10, 2013, Paros acquired $10,000 aggregate principal amount of the Company’s Series A unsecured debentures.
The Company entered into a demand loan agreement with Paros that provides for the Company to borrow up to $22,000. The total loan payable outstanding from Paros as at December 31, 2017 was $nil (December 31, 2016 - receivable of $2,314). During the year ended December 31, 2017, the Company incurred interest expense of $62 (2016 - earned interest of $16).
TWC ENTERPRISES LIMITED The Company provides TWC with managerial and consulting services for its business and the business of its subsidiaries. Mr. K. Rai Sahi is Chairman and Chief Executive Officer and the majority shareholder of TWC through his personal holding companies, which include Paros. Pursuant to contractual agreements between the Company and TWC, for the year ended December 31, 2017, the Company received a management fee of $836 (2016 - $1,105), and paid rent and operating expenses of $710 (2016 - $978).
The Company has a revolving demand loan agreement with TWC that provides for either party to borrow up to $50,000 at either the prime rate or the bankers' acceptance rate plus applicable stamping fees. The total loan receivable outstanding as at December 31, 2017 was $11,767 (December 31, 2016 - $47,084). During the year ended December 31, 2017, the Company earned interest of $403 (2016 - $174).
SHARE/UNIT PURCHASE AND OTHER LOANS As at December 31, 2017, share/Unit purchase and other loans to officers and employees of the Company and its subsidiaries of $5,519 (December 31, 2016 - $5,550) are outstanding. The share/Unit purchase loans are collateralized by their common shares of the Company, Units of Morguard REIT and Units of Morguard Residential REIT and are interest-bearing computed at the Canadian prime interest rate and are due on January 8, 2019. Other loans are secured against the underlying asset. The loans are classified as amounts receivable on the consolidated balance sheets. As at December 31, 2017, the fair market value of the common shares/Units held as collateral is $90,804.
KEY MANAGEMENT COMPENSATION Key management personnel are those having authority and responsibility for planning, directing and controlling the activities of the Company, directly or indirectly. The Company’s key management personnel include the Chairman and Chief Executive Officer, President (MIL), Chief Financial Officer, Executive Vice President, Retail Asset Management (MIL), and Executive Vice President, Office/Industrial Asset Management (MIL).
The compensation paid or payable to key management for employee services is shown below:
For the years ended December 31 2017 2016 Salaries and other short-term employee benefits $4,335 $3,954 SARs 1,074 2,591 $5,409 $6,545
MORGUARD.COM 34 MORGUARD CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS | DECEMBER 31, 2017
PART VII
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND ESTIMATES The Company's consolidated financial statements for the years ended December 31, 2017 and 2016, have been prepared in accordance with IFRS. A summary of the significant accounting policies are described in Note 2 to the audited consolidated financial statements for the year ended December 31, 2017.
The preparation of the consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and reported amounts of revenue and expenses during the reporting periods.
In determining estimates of fair market value for the Company’s income producing properties, the assumptions underlying estimated values are limited by the availability of comparable data and the uncertainty of predictions concerning future events. Significant estimates used in determining fair value of the Company’s income producing properties include capitalization rates and stabilized net operating income (which is influenced by vacancy rates, inflation rates and operating costs). Should any of these underlying assumptions change, actual results could differ from the estimated amounts.
Property and equipment and investments in joint arrangements are assessed for impairment. Significant assumptions are used in the assessment of fair value and impairment including estimates of future operating cash flows, the time period over which they will occur, an appropriate discount rate, appropriate growth rates (revenues and costs) and changes in market valuation parameters. Management considers various factors in its assessment including the historical performance of property and equipment and investments in joint arrangements, expected trends in each specific market as well as local and macroeconomic conditions.
The estimated useful lives and related amortization method are determined for each component of hotel properties. The selected amortization method and estimate of useful life impact the amount of amortization expense recognized. In establishing useful lives and related amortization method management considers its capital maintenance plans.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES The Company’s critical accounting policies are those that management believes are the most important in portraying the Company’s financial condition and results and that require the most subjective judgment and estimates on the part of management.
De Facto Control IFRS 10, Consolidated Financial Statements, (“IFRS 10”) prescribes that the Company may have control over an investment even if the Company holds less than a majority of the investee’s voting rights (de facto control). In accordance with IFRS 10, the following are the criteria that the Company uses to determine if de facto control exists: (i) the Company holds a significant voting interest (but less than half of the voting rights); (ii) there is wide diversity of public holdings of the remaining voting rights; (iii) the Company has the majority of the voting quorum according to historical participants in the general meetings of the Unitholders; and (iv) the Company has the ability to establish policies and guide operations by appointing the investee’s senior management. Judgment is applied by management in determining the existence of de facto control.
Real Estate Properties Real estate properties include multi-suite residential, retail, office, industrial and hotel properties held to earn rental income (income producing properties) and properties or land that are being constructed or developed for future use as income producing properties. Real estate properties, with the exception of hotel properties, are recorded at fair value, determined based on available market evidence, at the balance sheet date. The Company determined the fair value of each real estate property based upon, among other things, rental income from current leases and assumptions about rental income from future leases, reflecting market conditions at the applicable balance sheet dates, less future cash outflow pertaining to the respective leases. The residential properties are appraised using the direct capitalization income method. The retail, office and industrial properties are appraised using a number of approaches
MORGUARD.COM 35 MORGUARD CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS | DECEMBER 31, 2017
that typically include a discounted cash flow analysis and a direct comparison approach. The discounted cash flow analysis is primarily based on discounting the expected future cash flows, generally over a term of 10 years, including a terminal value based on the application of a capitalization rate to estimated year 11 cash flows. To assist with the evaluation of fair value, the Company has its Canadian properties appraised by Morguard’s appraisal division. Morguard’s appraisal division is staffed with accredited members of the AIC who, collectively, in 2017 valued approximately $15 billion of real estate properties in Canada and the U.S. for institutional and corporate clients.
In applying the accounting policies to the Company’s real estate properties, judgment is required in determining whether certain costs are additions to the carrying amount of the property, in distinguishing between tenant incentives and tenant improvements, and, for properties under development, in identifying the point at which practical completion of the property occurs and identifying the directly attributable borrowing costs to be included in the carrying value of the development property. Judgment is also applied in determining the extent and frequency of independent appraisals.
IFRS 3, Business Combinations (“IFRS 3”) Accounting for business combinations under IFRS 3 applies only if it is considered that a business has been acquired. Under IFRS 3, a business is defined as an integrated set of activities and assets conducted and managed for the purposes of providing a return to investors or lower costs or other economic benefits directly and proportionately to the Company. A business generally consists of inputs, processes applied to those inputs and resulting outputs that are or will be used to generate revenue. Judgment is used by management in determining if the acquisition of an individual property qualifies as a business combination in accordance with IFRS 3 or as an asset acquisition.
When determining whether the acquisition of a real estate or hotel property or a portfolio of properties is a business combination or an asset acquisition, the Company applies judgment when considering whether the property or properties are acquired with significant processes.
Joint Arrangements The Company reviews its interests in joint arrangements and accounts for those joint arrangements in which the Company is entitled only to the net assets of the arrangement as joint ventures using the equity method of accounting and for those joint arrangements in which the Company is entitled to its share of the assets and liabilities as joint operations and recognizes its rights to and obligations of the assets, liabilities, revenue and expenses of the joint operation.
The Company applies judgment to determine whether the joint arrangements provided it with joint control, significant influence or no influence and whether the arrangements are joint operations or joint ventures.
Leases The Company applies judgment in determining whether certain leases, in particular those tenant leases with long contractual terms and long-term ground leases where the Company is the lessor, are operating or finance leases.
Income Taxes Current income tax assets and liabilities are measured at the amount expected to be paid to tax authorities, net of recoveries, based on the tax rates and laws enacted or substantively enacted at the balance sheet date.
In accordance with IFRS, the Company uses the liability method of accounting for income taxes. Under the liability method of tax allocation, current income tax assets and liabilities are based on the amount expected to be paid to tax authorities, net of recoveries, based on the tax rates and laws enacted or substantively enacted at the balance sheet date. Deferred income tax assets and liabilities are determined based on differences between the financial reporting and tax bases of assets and liabilities and are measured using substantively enacted tax rates and laws that will be in effect when the differences are expected to reverse. Deferred tax assets are recognized for all deductible temporary differences, carryforward of unused tax credits and unused tax losses to the extent that it is probable that deductions, tax credits and tax losses can be utilized. The carrying amounts of deferred income tax assets are reviewed at each balance sheet date and reduced to the extent it is no longer probable that the income tax asset will be recovered.
MORGUARD.COM 36 MORGUARD CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS | DECEMBER 31, 2017
Revenue Recognition The computation of cost reimbursements from tenants for realty taxes, insurance and common area maintenance charges is complex and involves a number of judgments, including the interpretation of terms and other tenant lease provisions. Tenant leases are not consistent in dealing with such cost reimbursements, and variations in computations can exist. Adjustments are made throughout the year to these cost-recovery revenues based upon the Company’s best estimate of the final amounts to be billed and collected.
Fair Value of Financial Instruments Management reports on a quarterly basis the fair value of financial instruments. The fair value of financial instruments approximates amounts at which these instruments could be exchanged between knowledgeable and willing parties. The estimated fair value may differ in amount from that which could be realized on an immediate settlement of the instruments. Management estimates the fair value of mortgages payable by discounting the cash flows of these financial obligations using December 31, 2017, market rates for debts of similar terms.
FINANCIAL INSTRUMENTS Financial instruments must be classified into one of the following specified categories: at fair value through profit or loss, held-to-maturity investments, available-for-sale financial assets, loans and receivables and other financial liabilities.
The Company’s financial assets and financial liabilities comprise cash, restricted cash, amounts receivable, mortgages and loans receivable, accounts payable and accrued liabilities, bank indebtedness, construction financing payable, mortgages payable, loans payable, finance lease obligation, Unsecured Debentures and convertible debentures (excluding any conversion option). Fair values of financial assets and financial liabilities and a discussion of risks associated with financial assets and liabilities are presented as follows.
Fair Value of Financial Assets and Financial Liabilities The fair values of cash, restricted cash, amounts receivable, accounts payable and accrued liabilities and bank indebtedness approximate their carrying values due to the short-term maturity of those instruments. The fair value of construction financing payable and mortgages and loans receivable are based on the current market conditions for financing loans with similar terms and risks. The loans payable are reflected at fair value since they are based on a floating interest rate and reflect the terms of current market conditions.
Mortgages payable, Unsecured Debentures, convertible debentures and finance lease obligation are carried at amortized cost using the effective interest method of amortization. The estimated fair values of long-term borrowings have been determined based on market information, where available, or by discounting future payments of interest and principal at estimated interest rates expected to be available to the Company.
The fair value of the mortgages payable has been determined by discounting the cash flows of these financial obligations using December 31, 2017, market rates for debts of similar terms. Based on these assumptions, the fair value as at December 31, 2017, of the mortgages payable before deferred financing costs and mark-to-market adjustments is estimated at $4,177,548 (December 31, 2016 - $4,063,448), compared with the carrying value of $4,056,673 (December 31, 2016 - $3,925,657). The fair value of the mortgages payable varies from the carrying value due to fluctuations in interest rates since their issue.
The fair value of the Unsecured Debentures liability is based on its closing bid price. As at December 31, 2017, the fair value of the Unsecured Debentures has been estimated at $542,453 (December 31, 2016 - $341,099) compared with the carrying value of $535,000 (December 31, 2016 - $335,000).
The fair value of the convertible debentures liability is based on their market trading prices. As at December 31, 2017, the fair value of the convertible debentures before deferred financing costs has been estimated at $248,710 (December 31, 2016 - $406,655), compared with the carrying value of $245,657 (December 31, 2016 - $412,893).
The fair value of the finance lease obligation is determined by discounting the cash flows of the financial obligation using December 31, 2017, market rates for debt on similar terms. Based on these assumptions, as at December 31, 2017, the fair value of the finance lease obligation has been estimated at $8,970 (December 31, 2016 - $nil), compared with the carrying value of $8,970 (December 31, 2016 - $nil).
MORGUARD.COM 37 MORGUARD CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS | DECEMBER 31, 2017
ADOPTION OF ACCOUNTING STANDARDS Current Accounting Policy Changes Amendments to IAS 7, “Statement of Cash Flows” (“IAS 7”) The amendments require disclosure of information enabling users of financial statements to evaluate changes in liabilities arising from financing activities. The amendments do not define financing activities, instead they clarify that financing activities are based on the existing definition used in IAS 7. The amendments are to be applied prospectively effective for annual periods beginning January 1, 2017.
The amendments did not have a material impact on the Company’s consolidated financial statements.
Future Accounting Policy Changes IFRS 15, Revenue from Contracts with Customers (“IFRS 15”) In May 2014, the IASB issued IFRS 15, a single comprehensive model to account for revenue arising from contracts with customers. The objective of IFRS 15 is to establish the principles that an entity shall apply to report useful information to users of financial statements about the nature, amount, timing and uncertainty of revenue and cash flows arising from a contract with a customer. The core principle of the standard is that an entity will recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects consideration to which the entity expects to be entitled in exchange for those goods and services. The standard has a mandatory effective date for annual periods beginning on or after January 1, 2018.
The Company is in its final stages of its assessment of the impact of this standard on its consolidated financial statements. The assessment included a review of contracts for the scoped-in streams including rents from tenants under leases, percentage participation rents, property tax and operating cost recoveries, lease cancellation fees, leasing concessions, parking income, incidental income, revenue from hotel services and product sold as well as management and advisory fees. For rental revenue and related recoveries, management has determined that the pattern of revenue recognition will remain unchanged upon adoption of the standard and the impact will be limited to additional note disclosure on the disaggregation of some of the Company’s revenue streams. The Company will complete its review of all contracts and will adopt the new standard on the required effective date.
IFRS 9 (2014), Financial Instruments (“IFRS 9”) The final version of IFRS 9 was issued by the IASB in July 2014 and will replace IAS 39, “Financial Instruments: Recognition and Measurement” (“IAS 39”). IFRS 9 addresses the classification and measurement of all financial assets and liabilities within the scope of the current IAS 39 and a new expected loss impairment model that will require more timely recognition of expected credit losses and a substantially reformed model for hedge accounting. Also included are the requirements to measure debt-based financial assets at either amortized cost or fair value through profit or loss and to measure equity-based financial assets either as held-for-trading or as fair value through other comprehensive income (“FVTOCI”). No amounts are reclassified out of other comprehensive income if the FVTOCI option is elected. Additionally, embedded derivatives in financial assets would no longer be bifurcated and accounted for separately under IFRS 9. The standard has a mandatory effective date for annual periods beginning on or after January 1, 2018.
The Company is performing an assessment of key areas within the scope of IFRS 9 which includes, but not limited to, the change in classification and measurement of: (i) mortgages and loans receivable measured at amortized cost to FVTPL and (ii) available-for-sale securities measured at FVTOCI to FVTPL. The Company intends to adopt the new standard on the required effective date of January 1, 2018 and will not restate comparative information.
IAS 40, Investment Property (“IAS 40”) During December 2016, the IASB issued an amendment to IAS 40 clarifying certain existing IAS 40 requirements. The amendment requires that an asset be transferred to or from investment property when, and only when, there is a change in use. A change in use occurs when the property meets or ceases to meet the definition of investment property and there is evidence of the change in use. In isolation, a change in management’s intentions for the use of a property does not provide evidence of a change in use. These amendments are effective for annual periods beginning on or after January 1, 2018.
The amendment is not expected to have a material impact on the Company’s consolidated financial statements.
MORGUARD.COM 38 MORGUARD CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS | DECEMBER 31, 2017
IFRS 16, Leases (“IFRS 16”) In January 2016, the IASB issued IFRS 16. The new standard requires that for most leases, lessees must initially recognize a lease liability for the obligation to make lease payments and a corresponding right-of-use asset for the right to use the underlying asset for the lease term. Lessor accounting, however, remains largely unchanged, and the distinction between operating and finance leases is retained. This standard will be effective for annual periods beginning on or after January 1, 2019, with early adoption permitted so long as IFRS 15 has been adopted.
The Company is currently assessing the impact this new standard will have on its consolidated financial statements.
RISKS AND UNCERTAINTIES An investment in securities of the Company involves significant risks. Investors should consider carefully the risks described below, the other information described elsewhere in this MD&A (as updated by any subsequent interim MD&A) and those risks set out in the Company’s Annual Information Form (“AIF”) for the year ended December 31, 2017, dated February 22, 2018, before making a decision to buy securities of the Company. If any of the following or other risks occur, the Company’s business, prospects, financial condition, financial performance and cash flows could be materially adversely affected. In that case, the trading price of securities of the Company could decline, and investors could lose all or part of their investment in such securities. There is no assurance that risk management steps taken will avoid future loss due to the occurrence of the risks described below or other unforeseen risks.
There are certain risks inherent in an investment in the securities of the Company and in the activities of the Company, including those set out in the Company’s publicly filed disclosure available on SEDAR.
The following are business risks the Company expects to face in the normal course of its operations and management’s strategy to reduce the potential impact.
OPERATING RISK Real estate has a high fixed cost associated with ownership, and income lost due to vacancies cannot easily be minimized through cost reduction. Tenant retention is critical to maintaining occupancy levels. Through well-located and professionally managed properties, management seeks to increase tenant loyalty and become the landlord of choice. Morguard reduces operating risk through diversification. The Company diversifies its portfolio by tenants, lease maturities, product and location.
Certain significant expenditures, including property taxes, maintenance costs, mortgage payments, insurance costs and related charges, must be made throughout the period of ownership of real property regardless of whether a property is producing any income. If the Company is unable to meet mortgage payments on any property, losses could be sustained as a result of the mortgagee’s exercise of its rights of foreclosure or of sale.
The Company is also subject to utility and property tax risk relating to increased costs that the Company may experience as a result of higher resource prices, as well as its exposure to significant increases in property taxes. There is a risk that property taxes may be raised as a result of revaluations of municipal properties and their adherent tax rates. In some instances, enhancements to properties may result in a significant increase in property assessments following a revaluation. Additionally, utility expenses, consisting mainly of natural gas and electricity service charges, have been subject to considerable price fluctuations over the past several years. Unlike commercial leases, which generally are “net” leases and allow a landlord to recover expenditures, residential leases are generally “gross” leases, and the landlord is not able to pass on costs to its tenants.
In connection with the prudent management of its properties, the Company makes significant property capital investments (for example, to upgrade and maintain building structure, balconies, parking garages, roofing, and electrical and mechanical systems). The Company commissioned building condition reports in connection with the acquisition of each of the properties and has committed to a multi-year property capital investment plan based on the findings of such reports. The Company continually monitors its properties to ensure appropriate and timely capital repairs and replacements are carried out in accordance with its property capital investment programs. The Company requires sufficient capital to carry out its planned property capital investment and repair and refurbishment programs to upgrade its properties or it could be exposed to operating business risks arising from structural failure, electrical or mechanical breakdowns, fire or water damage, etc., which may result in significant loss of earnings to the Company.
MORGUARD.COM 39 MORGUARD CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS | DECEMBER 31, 2017
The portfolio diversification is shown by percentage of NOI for the year ended December 31, 2017:
REPORTING INVESTMENT PROPERTY AT FAIR VALUE The Company holds investment property to earn rental income or for capital appreciation or both. All investment properties are measured using the fair value model under IFRS, whereby changes in fair value are recognized for each reporting period in the consolidated statements of income and comprehensive income. Management values each investment property based on the most probable price that a property could be sold for in a competitive and open market as of the specified date under all conditions requisite to a fair sale, such as the buyer and seller each acting prudently and knowledgeably and assuming the price is not affected by undue stimulus. Each investment property has been valued on a highest-and-best-use basis.
There is a risk that general declines in real estate markets or sales of assets by the Company under financial or other hardship would have an impact on the fair values reported or on the cash flows associated with owning or disposing of such properties. Market assumptions applied for valuation purposes do not necessarily reflect the Company’s specific history or experience, and the conditions for realizing the fair values through a sale may change or may not be realized. Consequently, there is a risk that the actual fair values may differ, and the differences may be material. In addition, there is an inherent risk related to the reliance on and use of a single appraiser as this approach may not adequately capture the range of fair values that market participants would assign to the investment properties. Certain ratios and covenants could be negatively affected by downturns in the real estate market and could have significant impact on the Company’s operating revenues and cash flows, as well as the fair values of the investment properties.
FINANCING RISK The Company is subject to the risks associated with debt financing, including the risk that mortgages and credit facilities secured by the Company’s properties will not be able to be refinanced or that the terms of such refinancing will not be as favourable as the terms of existing indebtedness. To minimize this risk, Morguard has structured its debt maturities over a number of years and has negotiated fixed interest rates on approximately 94% of its mortgages payable.
CREDIT RISK The Company’s primary business is the ownership and operation of multi-suite residential, retail, office and hotel properties. The income stream generated by tenants paying rent can be affected by general and local economic conditions and by a change in the credit and financial stability of tenants. Examples of local conditions that could adversely affect income include oversupply of space or reduced demand for rental space, the attractiveness of the Company’s properties compared to other space, and fluctuation in real estate taxes, insurance and other operating costs. The Company may be adversely affected if tenants become unable to meet their financial obligations under their leases.
MORGUARD.COM 40 MORGUARD CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS | DECEMBER 31, 2017
Retail shopping centres traditionally rely on anchor tenants (department stores, junior department stores or grocery stores) as a source of significant revenue and in terms of generating traffic for the centre. Accordingly, the risk is present that an anchor tenant will move out or experience a failure, which would have a negative impact on the subject property.
The Company’s five largest tenants account for 26.8% of the Company’s annualized commercial rental revenue as follows:
Annualized Rental Tenants as at December 31, 2017 Revenue GLA (000s) % of Total GLA Federal and provincial government 12.0% 1,499 9.5% Penn West Petroleum Ltd. 7.2% 619 3.9% TD Canada Trust 3.1% 443 2.8% Bombardier Inc. 3.0% 556 3.5% Loblaw Companies Limited 1.5% 266 1.7% 26.8% 3,383 21.4%
COMMERCIAL LEASE ROLLOVER RISK Lease rollover risk results from the possibility that the Company may experience difficulty in renewing leases as they expire or in re-leasing space vacated by a tenant upon expiry. Management attempts to stagger the lease expiry profile so that the Company is not exposed to disproportionate amounts of space expiring in any one year, as set out in the table below. Management further mitigates this risk by maintaining a diversified portfolio mix by both asset type and location.
Lease Expiries
Summary of Lease Expiries as at 2018 2019 2020 December 31, 2017 Total Sq. Ft. Sq. Ft. % Sq. Ft. % Sq. Ft. % Retail 8,183 1,069 13% 588 7% 1,082 13% Office 6,483 316 5% 249 4% 611 9% Industrial 1,196 151 13% 189 16% 9 1% Total 15,862 1,536 10% 1,026 6% 1,702 11%
FOREIGN EXCHANGE RISK A portion of the Company’s real estate properties are located in the United States. As a result, the Company is exposed to foreign currency exchange rate risk with respect to future cash flows derived from the properties located in the United States. The Company’s exposure to exchange rate risk could increase if the proportion of income from properties located in the United States increases as a result of future property acquisitions. The Company mitigates its foreign currency exposure by offsetting certain revenues earned in United States dollars from its U.S. properties against expenses and liabilities undertaken by the Company in United States dollars.
At December 31, 2017, the Canadian dollar value was US$0.80 compared to US$0.74 a year earlier. The average exchange rate for the year ended December 31, 2017, was US$0.77 compared to US$0.76 during 2016. The strengthening of the Canadian dollar during 2017 resulted in an unrealized foreign currency translation loss of approximately $81,432 recognized in other comprehensive income.
MORGUARD.COM 41 MORGUARD CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS | DECEMBER 31, 2017
MORGUARD REIT AND MORGUARD RESIDENTIAL REIT UNITHOLDER TAXATION At December 31, 2017, the Company owned 32,878,348 Units of Morguard REIT and 6,675,166 Units of Morguard Residential REIT and 17,223,090 Class B LP Units of Morguard NAR Canada Limited Partnership. The Class B LP Units are exchangeable, on a one-for-one basis, at the option of the Company, into Units of Morguard Residential REIT.
Legislation relating to the federal income taxation of a specified investment flow-through (“SIFT”) trust or partnership was enacted on June 22, 2007 (the “SIFT Rules”). A SIFT includes a publicly listed or traded partnership or trust such as an income trust. Under the SIFT Rules, certain distributions attributable to a SIFT will not be deductible in computing the SIFT’s taxable income, and the SIFT will be subject to tax on such distributions at a rate that is substantially equivalent to the general tax rate applicable to Canadian corporations. However, distributions paid by a SIFT as returns of capital should generally not be subject to the tax. Under the SIFT Rules, the new taxation regime will not apply to a trust that meets prescribed conditions relating to the nature of its income and investments (“the REIT Exception”).
The Company believes that Morguard REIT and Morguard Residential REIT (the “REITs”) intend to comply with the requirements under Part 1 of the Income Tax Act (Canada) (the “Tax Act”) at all relevant times such that they maintain their status as “unit trusts” and “mutual fund trusts” for purposes of the Tax Act. Under current law, a trust may lose its status under the Tax Act as a mutual fund trust if it can reasonably be considered that the trust was established or is maintained primarily for the benefit of non-residents, except in limited circumstances. Accordingly, non-residents may not be the beneficial owners of more than 49% of the Units (determined on a basic or a fully diluted basis). The Trustees of Morguard REIT and Morguard Residential REIT also have various powers that can be used for the purpose of monitoring and controlling the extent of non-resident ownership of the Units. The restrictions on the issuance of Units by the REITs to non-residents may negatively affect the REITs’ ability to raise financing for future acquisitions or operations. In addition, the non-resident ownership restrictions could have a negative impact on the liquidity of the Units and the market price at which Units can be sold.
There can be no assurance that Canadian federal income tax laws and the administrative policies and assessing practices of the Canada Revenue Agency with respect to mutual fund trusts will not be changed in a manner that adversely affects Unitholders.
Although, as of the date hereof, management believes that Morguard REIT and Morguard Residential REIT will be able to meet the requirements of the REIT Exception throughout 2018 and beyond, there can be no assurance that the REITs will be able to qualify for the REIT Exception such that the REITs and the Unitholders will not be subject to the SIFT Rules in 2018 or in future years.
VOLATILE MARKET PRICE FOR THE COMPANY’S SECURITIES The market price for the Company’s securities may be volatile and subject to wide fluctuations in response to numerous factors, many of which are beyond the Company’s control, including the following: (i) actual or anticipated fluctuations in the Company’s financial performance and future prospects; (ii) recommendations by securities research analysts; (iii) changes in the economic performance or market valuations of other issuers that investors deem comparable to the Company; (iv) an addition to or departure of the Company’s executive officers; (v) release or expiration of lock-up or other transfer restrictions on outstanding shares; (vi) sales or perceived sales of additional shares; (vii) significant acquisitions or business combinations, strategic partnerships, joint ventures or capital commitments by or involving the Company or its competitors; (viii) news reports relating to trends, concerns, technological or competitive developments, regulatory changes and other related issues in the Company’s industry or target markets; (ix) liquidity of the Company’s securities; (x) prevailing interest rates; (xi) the market price of other Company securities; (xii) a decrease in the amount of dividends declared and paid by the Company; and (xiii) general economic conditions.
Financial markets have, in recent years, experienced significant price and volume fluctuations that have particularly affected the market prices of securities of issuers and that have, in many cases, been unrelated to the operating performance, underlying asset values or prospects of such issuers. Accordingly, the market price of the Company’s securities may decline even if the Company’s financial performance, underlying asset values or prospects have not
MORGUARD.COM 42 MORGUARD CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS | DECEMBER 31, 2017
changed. Additionally, these factors, as well as other related factors, may cause decreases in asset values that are deemed to be other than temporary, which may result in impairment losses. As well, certain institutional investors may base their investment decisions on consideration of the Company’s environmental, governance and social practices and performance according to such institutions’ respective investment guidelines and criteria, and failure to meet such criteria may result in a limited investment or no investment in the Company’s securities by those institutions. There can be no assurance that continuing fluctuations in price and volume will not occur. If such increased levels of volatility and market turmoil exist for a protracted period of time, the Company’s operations could be adversely affected and the trading price of the securities may be adversely affected.
DILUTION The number of common shares and the principal amount of Unsecured Debentures under the Trust Indenture that the Company is authorized to issue are unlimited. The Company may, in its sole discretion, issue additional common shares and/or Unsecured Debentures from time to time subject to the rules of any applicable stock exchange on which the common shares are then listed and applicable securities law. The issuance of any additional common shares and/or Unsecured Debentures may have a dilutive effect on the interests of holders of common shares and/or Unsecured Debentures.
CONTROLS AND PROCEDURES CONCERNING FINANCIAL INFORMATION The financial certification process project team has documented and assessed the design and effectiveness of the internal controls in order to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with IFRS. This undertaking has enabled the Chief Executive Officer and Chief Financial Officer to attest that the design and effectiveness of the internal controls with regard to financial information are effective using the Committee of Sponsoring Organizations of the Treadway Commission (COSO) Internal Control - Integrated Framework (2013). In order to ensure that the consolidated financial statements and MD&A present fairly, in all material respects, the financial position of the Company and the results of its operations, management is responsible for establishing and maintaining disclosure controls and procedures, as well as internal control over financial reporting.
The Company’s management has evaluated the effectiveness of the Company’s disclosure controls and procedures and, based on such evaluation, has concluded that their design and operation are adequate and effective as of and for the year ended December 31, 2017. The Company’s management has also evaluated the effectiveness of the internal controls over financial reporting and has concluded that their design and operation are effective as of and for the year ended December 31, 2017.
An information disclosure policy constitutes the framework for the information disclosure process with regard to the annual and interim filings, as well as to other reports filed or submitted under securities legislation. This policy aims in particular at identifying material information and validating the related reporting. The Disclosure Committee, established in 2005, is responsible for ensuring compliance with this policy. Senior management acts as the Disclosure Committee, ensuring compliance with this policy and reviewing main documents to be filed with regulatory authorities to ensure that all significant information regarding operations is communicated in a timely manner.
During the year ended December 31, 2017, Morguard completed the conversion to a new enterprise resource planning (ERP) system, and financial reporting application. The ERP and financial reporting system conversion has not resulted in any significant changes in internal controls during the year ended December 31, 2017. Management employed appropriate procedures to ensure internal controls over financial reporting were in place during and after the conversion.
MORGUARD.COM 43 MORGUARD CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS | DECEMBER 31, 2017
PART VIII
SELECTED ANNUAL AND QUARTERLY INFORMATION The following table shows information for revenue from income producing properties, revenue from hotel properties, NOI, net income attributable to common shareholders, FFO, dividends declared, total assets, non-current financial liabilities, and per common share amounts for the periods noted.
For the years ended December 31 (In thousands of dollars, except per common share amounts) 2017 2016 2015 Revenue from income producing properties $790,535 $775,746 $762,033 Revenue from hotel properties 237,116 66,567 46,562 NOI 513,867 453,398 435,899 NOI per common share - basic and diluted 43.24 37.96 35.61 Net income attributable to common shareholders 310,120 172,745 80,542 Net income attributable to common shareholders per common share - basic and diluted 26.10 14.46 6.58 FFO 225,072 213,282 183,139 FFO per common share - basic and diluted 18.94 17.86 14.96 Dividends declared 7,127 7,163 7,305 Dividends per common share 0.60 0.60 0.60 Total assets 10,111,986 9,588,078 8,602,132 Non-current portion of financial liabilities: Mortgages payable 3,440,069 3,187,957 3,367,638 Unsecured Debentures 398,152 333,638 134,228 Convertible debentures 147,701 202,167 154,440 Morguard Residential REIT Units 365,438 292,304 229,416
Fourth Quarter Results 2017 The Company’s net income for the three months ended December 31, 2017, increased by $74,935 to $109,084, compared to $34,149 in the fourth quarter of 2016. The increase in net income was primarily due to the following: • An increase in NOI of $16,605 primarily due to the consolidation of Temple and acquisitions completed subsequent to the three months ended December 31, 2016. In addition, higher rental rates and lower operating expenses at the Company’s residential properties increased NOI; • A fair value gain of $18,648 on income producing properties mainly due to an increase in stabilized NOI; • An increase in the fair value gain on MRG Units of $34,211 due to the change in market value of the Units; and • A decrease in deferred income tax of $41,588, mainly resulting from a U.S. federal tax rate decrease from 35% to 21% enacted on December 22, 2017.
These items were partially offset by the following:
• A provision for impairment of $24,590 recorded during the three months ended December 31, 2017; and • An increase in interest expense of $11,943 primarily due to the consolidation of Temple.
MORGUARD.COM 44 MORGUARD CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS | DECEMBER 31, 2017
SUMMARY OF QUARTERLY INFORMATION The following table provides a summary of operating results for the last eight quarters.
Net Income Net Income (Loss) (Loss) to Attributable Common to Shareholders (In thousands of dollars, except Total Adjusted Net Common per share - per common share amounts) Revenue NOI NOI FFO Income Shareholders basic/diluted December 31, 2017 $287,523 $139,663 $131,934 $68,596 $109,084 $115,300 $9.73 September 30, 2017 279,612 138,374 131,440 55,448 23,264 27,552 2.33 June 30, 2017 275,700 134,737 128,508 53,427 179,567 151,526 12.72 March 31, 2017 270,939 101,093 120,557 47,601 32,452 15,742 1.32 December 31, 2016 231,842 123,058 116,200 53,067 34,149 34,694 2.89 September 30, 2016 230,337 119,862 113,957 53,545 70,505 63,403 5.31 June 30, 2016 227,679 117,675 111,830 58,992 93,197 81,754 6.85 March 31, 2016 232,118 92,803 111,494 47,678 12,073 (7,106) (0.59)
SUMMARY OF QUARTERLY RESULTS h A significant portion of the Company’s real estate properties are located in the United States. As a result, the Company is exposed to foreign currency exchange rate fluctuations with respect to its quarterly results derived from its properties located in the U.S.
Quarterly results fluctuate due to acquisitions and dispositions, the impact of foreign exchange rate fluctuations and new mortgage financing as well as mortgage refinancing. In addition, net income includes a number of non-cash components, such as, fair value gain/loss on Morguard Residential REIT Units, fair value gain/loss on real estate properties, an IFRIC 21 adjustment to realty taxes, equity income (loss) from investment, provision for impairment and deferred taxes.
On December 14, 2016, the Company increased its ownership in Temple from 38.9% to 55.9%. As a result of the acquisition of control, the Company converted the method of accounting for its investment in Temple from the equity method to the consolidation method effective December 31, 2016. Commencing January 1, 2017, the impact of consolidating Temple was significant on the Company’s statements of income since Temple’s revenue and expenses are fully consolidated in the Company’s operating results.
During the second quarter of 2016, the Company received $22,490 in settlement proceeds from Target Corporation relating to the five leases that were disclaimed by Target Canada Corporation. The settlement proceeds were recorded to other income (expense) recognized in net income.
Significant real estate property transactions during the year ended December 31, 2017 During the third quarter of 2017, the Company acquired three multi-suite residential properties comprising 1,111 suites and three office properties consisting of approximately 384,500 square feet of commercial area. The Company also disposed of four multi-suite residential properties comprising 1,329 suites and one hotel property comprising 90 rooms during the third quarter of 2017.
During the second quarter of 2017, the Company acquired a multi-suite residential property comprising 60 rental townhomes and an office property consisting of approximately 36,500 square feet of commercial area.
Significant real estate property transactions during the year ended December 31, 2016 During the second quarter of 2016, the Company disposed of one office property comprising approximately 127,000 square feet of commercial area.
During the first quarter of 2016, the Company acquired a multi-suite residential property comprising 370 suites and three hotels comprising 417 rooms and disposed of one retail property comprising approximately 109,000 square feet of commercial area.
MORGUARD.COM 45 MORGUARD CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS | DECEMBER 31, 2017
Revenue and Net Operating Income The regional distribution of the Company’s properties serves to add stability to the Company’s cash flows because it reduces the Company’s vulnerability to economic fluctuations affecting any particular region. In addition, the Company’s tenant mix is diversified therefore limiting its exposure to any one tenant.
The Company has seen steady revenue growth during the last eight quarters with the exception of an increase during the first quarter of 2017 due to the consolidation of Temple. In addition, the change in foreign exchange rates and the impact of acquisition net of disposal of properties (described above) and the completed development of The Heathview during 2016 also contributed to the increase in revenue.
Similar to the reasons described above, NOI has profiled steady growth over the last eight quarters resulting from an increase in revenue and the Company’s ability to control expenses as a percentage of revenue as well as from the contribution of NOI from Temple. The impact of foreign exchange rates and of acquisitions and dispositions also factor into the variance from quarter to quarter. The first quarter results (three months ended March 31) are impacted by IFRIC 21, whereby the Company records the entire annual realty tax expense for its U.S. properties on January 1, except for U.S. properties acquired during the year in which the realty taxes are not recorded in the year of acquisition. As a result, the second, third and fourth quarters typically have no realty tax expense which results in higher NOI and NOI margins. Adjusted NOI which excludes IFRIC 21, is presented in the table above to illustrate a more comparable quarter to quarter analysis.
Net Income (Loss) Attributable to Common Shareholders Taking into account the above factors for revenue, NOI variations and the consolidation of Temple, the change in net income (loss) is predominantly due to a change in non-cash components described below:
• The Company valued the Morguard Residential Units (presented as a liability under IFRS) based on the market value of the TSX-listed Units, over the last eight quarters there has been an upward trend in the trading price of the Morguard Residential Units resulting in a fair value loss recorded to net income; • The Company has recorded a fair value gain on real estate properties for the years ended December 31, 2017 and 2016, due to an overall increase in stabilized NOI and compression in capitalization rates; • During the second quarter of 2016, the Company recorded a fair value gain on its equity-accounted investment Marquee at Block 37 in connection with the completed development; • The Company has recorded deferred tax expense coinciding with the fair value gains on the company’s income producing properties. In addition, during the fourth quarter of 2017, the Company recorded a deferred tax recovery of $78,219 resulting from a U.S. federal tax rate decrease from 35% to 21% enacted on December 22, 2017; • The consolidation of Temple resulted in higher amortization of hotel properties subsequent to the fourth quarter 2016; • An impairment provision of $24,590 recorded during the fourth quarter of 2017.
SUBSEQUENT EVENTS Subsequent to December 31, 2017, the Company acquired 1,119,660 units of Morguard REIT for cash consideration of $15,773.
Subsequent to December 31, 2017, the Company acquired 364,243 shares under NCIB for cash consideration of $65,659.
On January 9, 2018, the Company purchased a Class A industrial property located in Ottawa, Ontario, for a purchase price of $42,500, excluding closing costs.
On February 5, 2018, the Company purchased an office property located in Mississauga, Ontario, for a purchase price of $50,600, excluding closing costs.
MORGUARD.COM 46 MORGUARD CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS | DECEMBER 31, 2017
On February 13, 2018, Morguard Residential REIT completed a public offering of convertible unsecured subordinated debentures on a bought deal basis, of $85,500 (including an over-allotment, $81,500 excluding principal owned by the Company) aggregate principal amount of 4.50% convertible unsecured subordinated debentures due March 31, 2023 (the “4.50% Debentures”). The 4.50% Debentures are convertible, at the option of the holder, into Units at $20.20 per Unit.
The Company will use the net proceeds from the offering to fund the redemption of all of the Company’s outstanding 4.65% convertible unsecured subordinated debentures on February 26, 2018, which mature on March 30, 2018 and which have a par call date of April 1, 2017. The Company intends to use the remainder of the net proceeds, if any, to fund future acquisitions, for debt repayment and for general trust purposes.
MORGUARD.COM 47 MORGUARD CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS | DECEMBER 31, 2017
PART IX
OUTLOOK Generally speaking 2017 was a year of positives for real estate markets in Canada and the U.S., driven by an above- average economic performance. Investors were able to achieve healthy income growth across much of the market except for those who continued to suffer the effects of the recent resource sector malaise. Healthy rental demand patterns were observed in the office, industrial and multi-suite residential sectors overall, resulting in vacancy levels that generally ranged near the cycle low. Rental demand softness however continued to characterize resource-driven regions. In the retail sector, the discount and luxury market segments continued to expand. However the transformation of the sector driven by demographic and technological change resulted in store closures and downsizing activity. The most noteworthy casualty was the closure of all Sears Canada stores. Against this rental market backdrop, investment market performance was largely stable and healthy. The relative stability of our economy and commercial property market remained a draw for investment capital in a number of forms. Low cost debt continued to be a catalyst for investment along with strong overall performance characteristics. Capital availability surpassed the supply of core quality assets offered for sale. The pressure on the part of investors to place capital resulted in modest increases in value for the highest quality assets. Canadian property yields remained higher than long-term bond yields which added to the rationale for investing. The resulting sector liquidity was an additional element of what was a largely positive overall sector performance during the past year.
Looking to 2018, the real estate sector is expected to generate largely positive metrics, while investors monitor risks that may have an impact on performance. The national economies in Canada and the U.S. were forecast to expand by healthy margins. Stronger business investment activity and construction output are seen as drivers of economic output in the coming year. The 2018 economic performance should continue to support rental demand and income growth for owners in most market segments. The volume of available investment capital will result in a highly competitive investment market given ongoing access to low cost capital. While the outlook is broadly positive, investors will monitor performance risks that could affect values and performance. The main areas of sector risk include the potential for sharp increases in borrowing costs, the possibility of instituted protectionist trade measures in the U.S. related to the North American Free Trade Agreement and any interruption in the global economic recovery.
In 2018, the environment for acquisitions should continue to be extremely competitive. The Company remains disciplined in exploring new investment opportunities. Management will continue to seek acquisition opportunities, focusing on properties that are accretive in the long term. In addition to acquisitions, the Company also expects growth to come organically from within the existing portfolio and from intensification opportunities.
The Company’s strength stems from conservative financial leverage, significant cash retention and our highly diversified cash flow streams.
MORGUARD.COM 48 MORGUARD CORPORATION CONSOLIDATED FINANCIAL STATEMENTS | DECEMBER 31, 2017
CONSOLIDATED FINANCIAL STATEMENTS
TABLE OF CONTENTS
Management’s Report to Shareholders 50 Independent Auditors’ Report 51 Consolidated Balance Sheets 52 Consolidated Statements of Income 53 Consolidated Statements of Comprehensive Income 54 Consolidated Statements of Changes in Shareholders’ Equity 55 Consolidated Statements of Cash Flow 56 Notes to the Consolidated Financial Statements 57
MORGUARD.COM 49 MANAGEMENT’S REPORT TO SHAREHOLDERS
The consolidated financial statements of Morguard Corporation (the “Company” or “Morguard”) have been prepared by management in accordance with International Financial Reporting Standards (“IFRS”). Management is responsible for the information in these consolidated financial statements and other sections of this annual report.
Management maintains a system of internal controls to provide reasonable assurance that the Company’s assets are safeguarded and to facilitate the preparation of relevant, reliable and timely financial information. Where necessary, management uses its judgment to make estimates required to ensure fair and consistent presentation of this information. Management recognizes its responsibility for conducting the Company’s affairs in compliance with applicable laws and proper standards of conduct.
As at December 31, 2017, the Chief Executive Officer and Chief Financial Officer evaluated, or caused the evaluation of under their direct supervision, the disclosure controls and procedures and the internal controls over financial reporting (as defined in Multilateral Instrument 52-109, Certification of Disclosure in Issuers’ Annual and Interim Filings) and, based on that assessment, determined that the disclosure controls and procedures were designed and operating effectively and the internal controls over financial reporting were designed and operating effectively.
The Audit Committee of the Board of Directors of the Company, consisting solely of independent directors, has reviewed the consolidated financial statements, the report to shareholders of the external auditors, Ernst & Young LLP, and the management’s discussion and analysis with management and recommended their approval to the Board of Directors. The Board of Directors has approved the consolidated financial statements.
Ernst & Young LLP, as independent auditors, have conducted the audits in accordance with Canadian generally accepted auditing standards and have had full access to the Audit Committee, with and without management being present.
(Signed) “K. Rai Sahi” (Signed) “Paul Miatello”
K. Rai Sahi Paul Miatello Chief Executive Officer Chief Financial Officer
MORGUARD.COM 50 INDEPENDENT AUDITORS’ REPORT
To the Shareholders of Morguard Corporation We have audited the accompanying consolidated financial statements of Morguard Corporation, which comprise the consolidated balance sheets as at December 31, 2017 and 2016, and the consolidated statements of income, comprehensive income, changes in shareholders’ equity and cash flows for the years then ended, and a summary of significant accounting policies and other explanatory information.
Management’s Responsibility for the Consolidated Financial Statements Management is responsible for the preparation and fair presentation of these consolidated financial statements in accordance with International Financial Reporting Standards, and for such internal control as management determines is necessary to enable the preparation of consolidated financial statements that are free from material misstatement, whether due to fraud or error.
Auditors’ Responsibility Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with Canadian generally accepted auditing standards. Those standards require that we comply with ethical requirements and plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free from material misstatement.
An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the consolidated financial statements. The procedures selected depend on the auditors’ judgment, including the assessment of the risks of material misstatement of the consolidated financial statements, whether due to fraud or error. In making those risk assessments, the auditors consider internal control relevant to the entity’s preparation and fair presentation of the consolidated financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the entity’s internal control. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of accounting estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements.
We believe that the audit evidence we have obtained in our audits is sufficient and appropriate to provide a basis for our audit opinion.
Opinion In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of Morguard Corporation as at December 31, 2017 and 2016, and its financial performance and its cash flows for the years then ended, in accordance with International Financial Reporting Standards.
Chartered Professional Accountants Licensed Public Accountants Toronto, Canada February 22, 2018 MORGUARD CORPORATION CONSOLIDATED FINANCIAL STATEMENTS | DECEMBER 31, 2017
BALANCE SHEETS In thousands of Canadian dollars
As at December 31 Note 2017 2016 ASSETS Non-current assets Real estate properties 6 $8,655,651 $7,919,671 Hotel properties 7 669,026 705,663 Equity-accounted and other fund investments 9 280,853 380,808 Other assets 10 246,440 199,466 9,851,970 9,205,608 Current assets Mortgages and loans receivable 11 27,257 64,547 Amounts receivable 77,227 58,794 Prepaid expenses and other 21,082 17,607 Cash 134,450 241,522 260,016 382,470 $10,111,986 $9,588,078 LIABILITIES AND EQUITY Non-current liabilities Mortgages payable 12 $3,440,069 $3,187,957 Unsecured debentures 13 398,152 333,638 Convertible debentures 14 147,701 202,167 Morguard Residential REIT Units 15 365,438 292,304 Deferred income tax liabilities 24 646,884 629,914 4,998,244 4,645,980 Current liabilities Mortgages payable 12 615,959 752,152 Unsecured debentures 13 134,755 — Convertible debentures 14 88,674 195,585 Construction financing payable 16 36,476 93,000 Accounts payable and accrued liabilities 17 253,859 230,230 Bank indebtedness 18 49,650 — 1,179,373 1,270,967 Total liabilities 6,177,617 5,916,947 EQUITY Shareholders’ equity 3,082,673 2,862,812 Non-controlling interest 851,696 808,319 Total equity 3,934,369 3,671,131 $10,111,986 $9,588,078
Commitments and contingencies 28
See accompanying notes to the consolidated financial statements.
On behalf of the Board:
(Signed) “K. Rai Sahi” (Signed) “Bruce K. Robertson”
K. Rai Sahi, Bruce K. Robertson, Director Director
MORGUARD.COM 52 MORGUARD CORPORATION CONSOLIDATED FINANCIAL STATEMENTS | DECEMBER 31, 2017
STATEMENTS OF INCOME In thousands of Canadian dollars, except per common share amounts
For the years ended December 31 Note 2017 2016 Revenue from real estate properties $790,535 $775,746 Revenue from hotel properties 237,116 66,567 Property operating expenses Property operating costs (174,440) (169,045) Utilities (52,986) (53,475) Realty taxes (110,644) (114,788) Hotel operating expenses (175,714) (51,607) Net operating income 513,867 453,398
OTHER REVENUE Management and advisory fees 71,786 67,895 Interest and other income 8,907 6,349 Sales of product and land 5,430 5,419 86,123 79,663
EXPENSES Interest 20 191,965 152,926 Property management and corporate 82,862 86,592 Cost of sales of product and land 3,524 3,466 Amortization of hotel properties 7 26,640 4,936 Amortization of capital assets and other 4,228 4,148 Provision for impairment 7 24,590 — 333,809 252,068
OTHER INCOME (EXPENSE) Fair value gain (loss), net 21 139,898 (51,794) Equity income (loss) from investments 9 (10,227) 54,904 Gain on business combination 5 — 3,778 Other income 22 3,885 29,448 133,556 36,336 Income before income taxes 399,737 317,329
Provision for income taxes 24 Current 21,187 27,718 Deferred 34,183 79,687 55,370 107,405 Net income for the year $344,367 $209,924
Net income attributable to: Common shareholders $310,120 $172,745 Non-controlling interest 34,247 37,179 $344,367 $209,924
Net income per common share attributable to: Common shareholders - basic and diluted 25 $26.10 $14.46
See accompanying notes to the consolidated financial statements.
MORGUARD.COM 53 MORGUARD CORPORATION CONSOLIDATED FINANCIAL STATEMENTS | DECEMBER 31, 2017
STATEMENTS OF COMPREHENSIVE INCOME In thousands of Canadian dollars
For the years ended December 31 Note 2017 2016 Net income for the year $344,367 $209,924
OTHER COMPREHENSIVE INCOME (LOSS) Items that may be reclassified subsequently to net income: Unrealized gain on investments in real estate funds 194 11,660 Unrealized foreign currency translation loss (81,432) (30,523) Gain on interest rate swap agreement 665 734 Amortization of cash flow hedge — 189 (80,573) (17,940) Deferred income tax recovery (provision) 2,429 (5,588) (78,144) (23,528)
Items that will not be reclassified subsequently to net income: Actuarial gain (loss) on defined benefit pension plans 27 (2,174) 25,693 Deferred income tax recovery (provision) 283 (6,652) (1,891) 19,041 Other comprehensive loss (80,035) (4,487) Total comprehensive income for the year $264,332 $205,437
Total comprehensive income attributable to: Common shareholders $232,383 $167,497 Non-controlling interest 31,949 37,940 $264,332 $205,437
See accompanying notes to the consolidated financial statements.
MORGUARD.COM 54 MORGUARD CORPORATION CONSOLIDATED FINANCIAL STATEMENTS | DECEMBER 31, 2017
STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY In thousands of Canadian dollars
Accumulated Other Total Non- Retained Comprehensive Share Shareholders’ Controlling Note Earnings Income Capital Equity Interest Total
Shareholders’ equity, January 1, 2016 $2,316,660 $272,967 $108,097 $2,697,724 $784,273 $3,481,997
Changes during the year: Net income 172,745 — — 172,745 37,179 209,924 Other comprehensive income (loss) — (5,248) — (5,248) 761 (4,487) Dividends (7,163) — — (7,163) — (7,163) Distributions — — — — (27,906) (27,906) Issuance of common shares — — 83 83 — 83 Repurchase of common shares (8,240) — (579) (8,819) — (8,819) Change in ownership of Morguard REIT 13,490 — — 13,490 (35,476) (21,986) Equity component of convertible debentures — — — — 3,242 3,242 Business combination — — — — 46,246 46,246
Shareholders’ equity, December 31, 2016 2,487,492 267,719 107,601 2,862,812 808,319 3,671,131
Changes during the year: Net income 310,120 — — 310,120 34,247 344,367 Other comprehensive loss — (77,737) — (77,737) (2,298) (80,035) Dividends 19(a) (7,127) — — (7,127) — (7,127) Distributions — — — — (27,032) (27,032) Equity component of convertible debentures 14 — — — — 2,120 2,120 Decrease in subsidiary ownership interest 6 — — — — 63,410 63,410 Issuance of common shares 19(a) — — 148 148 — 148 Repurchase of common shares 19(a) (15,037) — (797) (15,834) — (15,834) Change in ownership of Morguard REIT 19(b) 10,291 — — 10,291 (27,070) (16,779)
Shareholders' equity, December 31, 2017 $2,785,739 $189,982 $106,952 $3,082,673 $851,696 $3,934,369
See accompanying notes to the consolidated financial statements.
MORGUARD.COM 55 MORGUARD CORPORATION CONSOLIDATED FINANCIAL STATEMENTS | DECEMBER 31, 2017
STATEMENTS OF CASH FLOWS In thousands of Canadian dollars
For the years ended December 31 Note 2017 2016 OPERATING ACTIVITIES Net income for the year $344,367 $209,924 Add (deduct) items not affecting cash 26(a) (56,321) 56,709 Distributions from equity-accounted investments 9 79,961 4,446 Land held for residential development and sale (310) 38 Additions to development property - inventory 10 (36,073) — Additions to tenant incentives and leasing commissions 6 (6,886) (10,036) Net change in operating assets and liabilities 26(b) (9,210) 23,977 Cash provided by operating activities 315,528 285,058
INVESTING ACTIVITIES Additions to real estate properties and tenant improvements 6 (713,279) (138,809) Additions to hotel properties 7 (16,786) (2,187) Additions to capital and intangible assets (18,107) (8,647) Proceeds from sale of real estate properties 6 88,685 41,201 Proceeds from the sale of hotel properties 7 9,399 — Investment in properties under development 6, 7 (66,701) (35,416) Investment in equity-accounted and other fund investments, net 9 (10,400) 3,520 Increase in mortgages and loans receivable (41,070) (63,479) Decrease in mortgages and loans receivable 78,406 25,589 Business combination — (70,444) Cash assumed on business combination — 67,922 Cash used in investing activities (689,853) (180,750)
FINANCING ACTIVITIES Proceeds from new mortgages 711,961 289,447 Financing costs on new mortgages (6,342) (5,886) Repayment of mortgages Repayments on maturity (388,307) (92,538) Repayments due to mortgage extinguishments — (108,144) Principal instalment repayments (112,212) (95,396) Proceeds from bank indebtedness 464,765 162,040 Repayment of bank indebtedness (419,757) (293,648) Proceeds from issuance of Morguard Residential REIT Units, net of cost 15 40,998 — Proceeds from issuance of unsecured debentures, net of costs 13 198,800 199,198 Proceeds from issuance of convertible debentures, net of costs — 119,863 Redemption of convertible debentures 14 (157,218) — Proceeds from construction financing 36,476 343 Repayment of construction financing (93,000) (50,832) Proceeds from (repayment of) loans payable, net — (9,718) Dividends paid 19(a) (6,979) (7,080) Contribution from non-controlling interest 6 63,410 — Distributions to non-controlling interest (26,742) (27,810) Common shares repurchased for cancellation 19(a) (15,834) (8,819) Investment in Morguard REIT (26,797) (21,986) Morguard Residential REIT Units repurchased for cancellation — (734) Decrease (increase) in restricted cash 778 (3,308) Cash provided by financing activities 264,000 44,992
Net increase (decrease) in cash during the year (110,325) 149,300 Net effect of foreign currency translation on cash balance 3,253 (1,282) Cash, beginning of year 241,522 93,504 Cash, end of year $134,450 $241,522
See accompanying notes to the consolidated financial statements.
MORGUARD.COM 56 MORGUARD CORPORATION CONSOLIDATED FINANCIAL STATEMENTS | DECEMBER 31, 2017
NOTES For the years ended December 31, 2017 and 2016 In thousands of Canadian dollars, except per common share and unit amounts and unless otherwise noted
NOTE 1 NATURE AND DESCRIPTION OF COMPANY Morguard Corporation (the “Company” or “Morguard”) is a real estate investment and management corporation formed under the laws of Canada. Morguard’s principal activities include property ownership, development and investment advisory services. Property ownership encompasses interests in multi-suite residential, commercial and hotel properties. The common shares of the Company trade on the Toronto Stock Exchange (“TSX”) under the symbol “MRC.” The Company owns a diverse portfolio of properties in Canada and the United States. The Company’s head office is located at 55 City Centre Drive, Suite 1000, Mississauga, Ontario, L5B 1M3.
NOTE 2 STATEMENT OF COMPLIANCE AND SIGNIFICANT ACCOUNTING POLICIES These consolidated financial statements have been prepared in accordance with International Financial Reporting Standards (“IFRS”) as issued by the International Accounting Standards Board (“IASB”).
The consolidated financial statements were approved and authorized for issue by the Board of Directors on February 22, 2018.
Basis of Presentation The Company’s consolidated financial statements are prepared on a going concern basis and have been presented in Canadian dollars rounded to the nearest thousand unless otherwise indicated. The consolidated financial statements are prepared on a historical cost basis, except for real estate properties and certain financial instruments that are measured at fair value. The accounting policies set out below have been applied consistently to all periods presented in these consolidated financial statements unless otherwise indicated.
Basis of Consolidation The consolidated financial statements include the financial statements of the Company, as well as the entities that are controlled by the Company (“subsidiaries”). The Company controls an entity when the Company is exposed to, or has rights to, variable returns from its involvement with the entity and has the ability to affect those returns through its power over the entity. Subsidiaries are fully consolidated from the date of acquisition or the date on which the Company obtains control and are deconsolidated from the date that control ceases. Intercompany transactions, balances, unrealized losses and unrealized gains on transactions between the Company and its subsidiaries are eliminated.
Non-Controlling Interests and Convertible Debentures Non-controlling interests represent equity interests in subsidiaries that are not attributable to the Company. For all of the Company’s subsidiaries, with the exception of Morguard North American Residential Real Estate Investment Trust (“Morguard Residential REIT” or “MRG”), the share of the net assets of the subsidiaries that is attributable to non- controlling interest is presented as a component of equity.
The Units of Morguard Residential REIT are redeemable at the option of the holder and therefore are considered puttable instruments that meet the definition of a financial liability under International Accounting Standards 32, Financial Instruments - Presentation (“IAS 32”). Whereas certain exceptions in IAS 32 allow Morguard Residential REIT to classify the Units as equity in its own balance sheet, this exception is not available to the Company, and therefore the non-controlling interest that these Units represent is classified as a liability in the consolidated financial statements of the Company and is measured at fair value, which is based on the Units’ redemption amount, with changes in the redemption amount recorded in the consolidated statements of income in the period of the change.
MORGUARD.COM 57 MORGUARD CORPORATION CONSOLIDATED FINANCIAL STATEMENTS | DECEMBER 31, 2017
Similarly, the conversion feature component of the convertible debentures issued by Morguard Residential REIT also meets the definition of a financial liability and is recorded in the consolidated balance sheets as a liability, measured at fair value based on the Black-Scholes option pricing model, with changes in fair value recognized in the consolidated statements of income. Any directly attributable transaction costs were allocated to the debt and conversion components of the convertible debentures in proportion to their initial carrying amounts, with the portion allocated to the conversion component expensed immediately.
Investments in Associates Associates are entities over which the Company has significant influence but not control or joint control, generally accompanying an ownership of between 20% and 50% of the voting rights. However, determining significant influence is a matter of judgment and specific circumstances and, from time to time, the Company may hold an interest of less than 20% and exert significant influence through representation on the board of directors, through direction of management or through contractual agreements.
Investments in associates are accounted for using the equity method, whereby the investment is initially recognized at cost, and the carrying amount is increased or decreased to recognize the investor’s share of the profit or loss of the investee. The Company determines at each reporting date whether there is any objective evidence that the investment in the associate is impaired. If this is the case, the Company calculates the amount of impairment as the difference between the recoverable amount of the associate and its carrying value, and recognizes the amount in the consolidated statements of income and comprehensive income.
Interests in Joint Arrangements The Company reviews its interests in joint arrangements and accounts for those joint arrangements in which the Company is entitled only to the net assets of the arrangement as joint ventures using the equity method of accounting, and for those joint arrangements in which the Company is entitled to its share of the assets and liabilities as joint operations and recognizes its rights to and obligations of the assets, liabilities, revenue and expenses of the joint operation.
Real Estate Properties Real estate properties include residential, retail, office and industrial properties held to earn rental income and for capital appreciation (income producing properties) and properties or land that are being constructed or developed for future use as income producing properties.
Income Producing Properties Income producing property that is acquired as an asset purchase and not as a business combination is recorded initially at cost, including transaction costs. Transaction costs include transfer taxes, professional fees for legal and other services and initial leasing commissions, of which transfer tax and professional fees represent the majority of the costs.
Subsequent to initial recognition, income producing properties are recorded at fair value. The changes in fair value for each reporting period will be recorded in the consolidated statements of income. In order to avoid double counting, the carrying value of income producing properties includes straight-line rent receivable, tenant improvements, tenant incentives, capital expenditures and direct leasing costs since these amounts are incorporated in the appraised values of the real estate properties. Fair value is based on external and internal valuations using recognized valuation techniques, including the direct capitalization of income and discounted cash flow methods. Recent real estate transactions with characteristics and location similar to the Company’s assets are also considered.
Tenant improvements include costs incurred to meet the Company’s lease obligations and are classified as either tenant improvements owned by the landlord or tenant incentives. When the obligation is determined to be an improvement that benefits the landlord and is owned by the landlord, the improvement is accounted for as a capital expenditure and included in the carrying amount of income producing properties in the consolidated balance sheets.
Leasing costs include incremental costs associated with leasing activities such as external leasing commissions. These costs are included in the carrying amount of income producing properties in the consolidated balance sheets.
MORGUARD.COM 58 MORGUARD CORPORATION CONSOLIDATED FINANCIAL STATEMENTS | DECEMBER 31, 2017
Hotel Properties Hotel properties comprise land, building, furniture, fixtures and equipment, and other (paving, signage, computer equipment and vehicle) and are stated at cost less accumulated amortization and any impairment losses. The application of this policy requires an estimate of the useful life of the asset and its residual value. The revenue and operating expenses of the hotel properties are included within net operating income in the consolidated statements of income.
The Company provides for amortization of hotel properties so as to apply the cost of the assets over the estimated useful lives as follows:
Method Rate Buildings Straight-line 40 years Furniture, fixture and equipment Straight-line 5 to 10 years Other Straight-line 5 to 10 years
Properties Under Development The cost of properties under development includes all expenditures incurred in connection with the acquisition, including all direct development costs, realty taxes and other costs to prepare it for its productive use and borrowing costs directly attributable to the development. Borrowing costs associated with direct expenditures on properties under development or redevelopment are capitalized. Borrowing costs are also capitalized on the purchase cost of a site or property acquired specifically for redevelopment in the short term if the activities necessary to prepare the asset for development or redevelopment are in progress. Borrowing costs are capitalized from the commencement of the development until the date of practical completion. The capitalization of borrowing costs is suspended if there are prolonged periods when development activity is interrupted. The Company considers practical completion to have occurred when the property is capable of operating in the manner intended by management. Generally, this consideration occurs on completion of construction and receipt of all necessary occupancy and other material permits. Where the Company has pre-leased space as of or prior to the start of the development and the lease requires the Company to construct tenant improvements that enhance the value of the property, practical completion is considered to occur on completion of such improvements.
Real estate properties under development are measured at fair value, with changes in fair value being recognized in the consolidated statements of income when fair value can be reliably determined.
Financial Instruments Recognition and Measurement of Financial Instruments Financial instruments must be classified into one of the following specified categories: at fair value through profit or loss (“FVTPL”), held-to-maturity investments, available-for-sale (“AFS”) financial assets, loans and receivables and other financial liabilities. Initially, all financial assets and financial liabilities are recorded in the consolidated balance sheets at fair value. After initial recognition, financial instruments are measured at their fair values, except for held-to- maturity investments, loans and receivables and other financial liabilities, which are measured at amortized cost. The effective interest related to financial assets and liabilities measured at amortized cost and the gain or loss arising from the change in the fair value of financial assets or liabilities classified as FVTPL are included in net income for the year in which they arise. AFS financial instruments are measured at fair value through other comprehensive income (“FVTOCI”) until the financial asset is derecognized or it becomes impaired. All cumulative gains or losses are then recognized in net income.
MORGUARD.COM 59 MORGUARD CORPORATION CONSOLIDATED FINANCIAL STATEMENTS | DECEMBER 31, 2017
The following summarizes the Company’s classification and measurement of financial assets and liabilities:
Classification Measurement Financial Assets Investment in real estate funds AFS FVTOCI Investment in publicly traded securities AFS FVTOCI Investment in convertible debentures FVTPL FVTPL Mortgages and loans receivable Loans and receivables Amortized cost Amounts receivable Loans and receivables Amortized cost Restricted cash Loans and receivables Amortized cost Cash Loans and receivables Amortized cost
Financial Liabilities Mortgages payable Other financial liabilities Amortized cost Unsecured debentures Other financial liabilities Amortized cost Convertible debentures, excluding conversion option Other financial liabilities Amortized cost Construction financing payable Other financial liabilities Amortized cost Loans payable Other financial liabilities Amortized cost Accounts payable and accrued liabilities Other financial liabilities Amortized cost Finance lease obligation Other financial liabilities Amortized cost Bank indebtedness Other financial liabilities Amortized cost Conversion option of MRG convertible debentures FVTPL FVTPL Morguard Residential REIT Units FVTPL FVTPL
Transaction Costs Transaction costs are incremental costs directly related to the acquisition of a financial asset or the issuance of a financial liability.
Direct and indirect financing costs that are attributable to the issue of other financial liabilities measured at amortized cost are presented as a reduction from the carrying amount of the related debt and are amortized using the effective interest rate method over the term of the related debt. These costs include interest, amortization of discounts or premiums relating to borrowings, fees and commissions paid to lenders, agents, brokers and advisers, and transfer taxes and duties that are incurred in connection with the arrangement of borrowings.
Derivatives and Embedded Derivatives All derivative instruments, including embedded derivatives, are recorded in the consolidated balance sheets at fair value unless exempted from derivative treatment as a normal purchase and sale.
The Company enters into interest rate swaps to hedge its risk associated with interest rates. Derivatives are carried as assets when the fair value is positive and as liabilities when the fair value is negative. Hedge accounting is discontinued prospectively when the hedging relationship is terminated, when the instrument no longer qualifies as a hedge or when the hedging item is sold or terminated. In cash flow hedging relationships, the portion of the change in the fair value of the hedging derivative that is considered to be effective is recognized in other comprehensive income (“OCI”), while the portion considered to be ineffective is recognized in net income. Unrealized hedging gains and losses in accumulated other comprehensive income are reclassified to net income in the years when the hedged item affects net income. Gains and losses on derivatives are immediately reclassified to net income when the hedged item is sold or terminated.
Fair Value The fair value of a financial instrument is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The fair value measurement is based on the presumption that the transaction to sell the asset or transfer the liability takes place either: (i) in the principal market for the asset or liability; or (ii) in the absence of a principal market, in the most advantageous market for the asset or liability.
MORGUARD.COM 60 MORGUARD CORPORATION CONSOLIDATED FINANCIAL STATEMENTS | DECEMBER 31, 2017
Fair value measurements recognized in the consolidated balance sheets are categorized using a fair value hierarchy that reflects the significance of inputs used in determining the fair values:
Level 1: Quoted prices in active markets for identical assets or liabilities. Level 2: Quoted prices in active markets for similar assets or liabilities or valuation techniques where significant inputs are based on observable market data. Level 3: Valuation techniques for which any significant input is not based on observable market data.
Each type of fair value measurement is categorized based on the lowest level input that is significant to the fair value measurement in its entirety.
Cash and Cash Equivalents Cash and cash equivalents include cash on hand, balances with banks, and short-term deposits with remaining maturities at the time of acquisition of three months or less. Bank borrowings are considered to be financing activities.
Goodwill On acquisition of a business, the underlying fair value of net identifiable tangible and intangible assets is determined, and goodwill is recognized as the excess of the purchase price over this amount. Goodwill is not amortized.
Capital Assets Capital assets include the following assets, which are stated at cost and amortized over their estimated useful lives using the following rates and methods:
Building (owner-occupied property) Straight-line over 40 years Leasehold improvements Straight-line over the term of the lease Furniture, fixtures, office and computer equipment Straight-line ranging from 5 to 10 years
Intangible Assets The Company’s intangible assets comprise: (i) the value assigned to an acquired investment advisory contract, amortized over an estimated 10-year useful life on a straight-line basis; and (ii) the cost of self-built management information systems and computer application software that is initially recognized at cost and amortized over an estimated 5 to 10 year useful life on straight-line basis.
Inventory - Land Held for Residential Development Land for residential development properties that is acquired or improved for sale in the ordinary course of business is recorded at the lower of cost or estimated net realizable value and is classified in the consolidated balance sheets as residential inventory properties, which are included as part of “other assets” (Note 10). Costs are allocated to the saleable acreage of each project or subdivision in proportion to the anticipated revenue and include borrowing costs directly attributable to projects under active development. Residential developments are reviewed for impairment whenever events or changes in circumstances indicate the carrying value may exceed net realizable value. An impairment loss is recognized in income when the carrying value of the land exceeds its net realizable value. Net realizable value represents the amount of estimated net sales proceeds, taking into account management’s assumptions and projections for the development of the property and market conditions.
Business Combinations The purchase method of accounting is used for acquisitions meeting the definition of a business combination. A business combination is an acquisition where an integrated set of activities is acquired. The consideration transferred in a business combination is measured at fair value, which is calculated as the sum of the acquisition date fair values of the assets transferred to the acquirer and the liabilities incurred by the acquirer. For each business combination, the Company elects whether to measure the non-controlling interest in the acquiree at fair value or at the proportionate share of the acquiree’s identifiable net assets. Any transaction costs incurred with respect to the business combination are expensed in the period incurred.
Impairment of Non-financial Assets The Company assesses at the end of each reporting period whether there is any indication that an asset may be impaired. Property and equipment and investments in joint arrangements are reviewed for impairment when events or changes in circumstances indicate that the carrying value may not be recoverable. Assets, including goodwill, that do
MORGUARD.COM 61 MORGUARD CORPORATION CONSOLIDATED FINANCIAL STATEMENTS | DECEMBER 31, 2017
not generate largely independent cash inflows are combined into cash-generating units. Cash-generating units to which goodwill has been allocated are tested for impairment at least annually and whenever there is an indication that the cash-generating unit may be impaired. If the carrying values exceed the estimated recoverable amount, the assets or cash-generating units are written down to their recoverable amount. Recoverable amount is the greater of fair value less costs to sell or value in use. Value in use is assessed based on estimated future cash flows discounted to their present value using a pre-tax discount rate that reflects current market assessments of the time value of money and the risks specific to the asset. An impairment loss is recognized for the amount by which the asset’s carrying amount exceeds its recoverable amount and is recorded as an expense.
Assets or cash-generating units that have been impaired in prior periods are tested for possible reversal of impairment whenever events or changes in circumstances indicate that the impairment has reversed. If the impairment has reversed, the carrying amount of the asset or cash-generating unit (excluding goodwill) is increased to its recoverable amount but not beyond the carrying amount that would have been determined had no impairment loss been recognized for the asset in the prior periods. A reversal of an impairment loss is recognized in net income. Impairment losses for goodwill are not revalued.
Provisions A provision is a liability of uncertain timing or amount. Provisions are recognized when the Company has a present legal or constructive obligation as a result of past events, it is probable that an outflow of resources will be required to settle the obligation and the amount can be reliably estimated. Provisions are measured at the present value for the expenditures expected to be required to settle the obligation using a discount rate that reflects current market assessment of the time value of money and the risks specific to the obligation. Provisions are remeasured at each consolidated balance sheet date using the current discount rate. The increase in the provision due to the passage of time is recognized as interest expense.
Revenue Recognition Revenue from properties include rents from tenants under leases, percentage participation rents, property tax and operating cost recoveries, lease cancellation fees, leasing concessions, parking income and incidental income. Percentage participation rents are accrued based on sales estimates submitted by tenants if the tenant anticipates attaining the minimum sales level stipulated in the tenant lease. All other rental revenue is recognized in accordance with each lease. The Company has not transferred substantially all of the risks and benefits of ownership of its real estate properties and therefore accounts for leases with its tenants as operating leases.
Revenue from real estate properties recorded in the consolidated statements of income during free rent periods represents future cash receipts and is reflected in the consolidated balance sheets in the carrying value of real estate properties and recognized in the consolidated statements of income on a straight-line basis over the initial term of the lease. The Company accounts for stepped rents on a straight-line basis. Rents recorded in advance of cash received are included in amounts receivable. Tenant incentives are deducted from rental revenue on a straight-line basis over the term of the tenant’s lease.
Revenue from hotel services provided and products sold is recognized at the time the service is provided and the products are delivered to the customer.
Management and advisory fees and sales of product are recognized when the service is performed or goods are shipped and ownership is legally transferred.
Income Taxes The Company uses the liability method of accounting for income taxes. Under the liability method of tax allocation, current income tax assets and liabilities are based on the amount expected to be paid to tax authorities, net of recoveries, based on the tax rates and laws enacted or substantively enacted at the consolidated balance sheet dates. Deferred income tax assets and liabilities are determined based on differences between the financial reporting and tax bases of assets and liabilities and are measured using enacted or substantively enacted tax rates and laws that will be in effect when the differences are expected to reverse. Deferred income tax assets are recognized for all deductible temporary differences, carryforward of unused tax credits and unused tax losses to the extent that it is probable that deductions, tax credits and tax losses can be utilized. The carrying amount of deferred income tax
MORGUARD.COM 62 MORGUARD CORPORATION CONSOLIDATED FINANCIAL STATEMENTS | DECEMBER 31, 2017
assets is reviewed at each consolidated balance sheet date and reduced to the extent it is no longer probable that the income tax asset will be recovered.
In accordance with IAS 12, Income Taxes, the Company measures deferred tax assets and liabilities on its real estate and hotel properties based on the rebuttable presumption that the carrying amount of the property is recovered through sale, as opposed to presuming that the economic benefits of the property will be substantially consumed through use over time. This presumption is rebutted if the property is held within a business model whose objective is to consume substantially all of the economic benefits embodied in the property over time, rather than through sale, which is not the case for the Company.
Employee Future Benefits The Company provides pensions to certain of its employees under two defined benefit arrangements and recognizes the cost of the defined benefit plans in the period in which the employee has rendered services. The cost of benefits earned by employees is actuarially determined using the projected benefit method pro-rated on service, compensation increases, retirement ages of employees and future termination levels. No past service costs have been incurred under these plans. Actuarial gains and losses are recognized in full in the period in which they occur and are presented in the consolidated statements of comprehensive income. The current service cost and gains and losses on settlement and curtailments are charged to operating income. The discount rate used to calculate net pension obligations or assets is determined on the basis of current market rates for high-quality corporate bonds and is re- evaluated at each year-end.
Stock-Based Compensation The Company has a stock appreciation rights (“SARs”) plan, which entitles specified officers and directors of Morguard to receive a cash payment equal to the excess of the market price of Morguard's common shares at the time of exercise over the grant-date price of the right. The Company accounts for the SARs plan using the fair value method. Under this method, compensation expense for the SARs plan is measured at the fair value of the vested portion using the Black-Scholes option pricing model at each balance sheet date. The liability is measured at each reporting date at fair value, with changes in the liability recorded in the consolidated statements of income.
Foreign Exchange The operations of the Company’s U.S.-based subsidiaries are in United States dollars, which are the functional currency of the foreign subsidiaries. Accordingly, the assets and liabilities of these foreign subsidiaries are translated into Canadian dollars at the exchange rate on the consolidated balance sheet dates. Revenue and expenses are translated at the average rate of exchange for the year. The resulting gains and losses are recorded in OCI. Monetary assets and liabilities denominated in foreign currencies are translated into Canadian dollars at the exchange rate in effect at the reporting date. Exchange differences are recognized in profit or loss except for exchange differences arising from a monetary item receivable from or payable to a foreign subsidiary, the settlement of which is neither planned nor likely to occur in the foreseeable future and which in substance is considered to form part of the net investment in the foreign subsidiary. These exchange differences are recognized in OCI until the disposal of the net investment, at which time they are reclassified to profit or loss.
The foreign exchange rates for the current and prior reporting years are as follows:
2017 2016
Canadian dollar to United States dollar exchange rates: - As at December 31 $0.7971 $0.7448 - Average during the year ended December 31 0.7701 0.7550
United States dollar to Canadian dollar exchange rates: - As at December 31 1.2545 1.3427 - Average during the year ended December 31 1.2986 1.3245
MORGUARD.COM 63 MORGUARD CORPORATION CONSOLIDATED FINANCIAL STATEMENTS | DECEMBER 31, 2017
Income Per Common Share Basic income per common share is calculated by dividing net income attributable to common shareholders by the weighted average number of common shares outstanding in each respective period. Diluted income per common share is calculated by dividing net income attributable to common shareholders, adjusted for the effect of dilutive securities, by the weighted average number of diluted shares outstanding.
Reportable Operating Segments Reportable operating segments are reported in a manner consistent with the internal reporting provided to the chief operating decision-maker. The chief operating decision-maker is the person or group that allocates resources to and assesses the performance of the operating segments of an entity. The Company has determined that its chief operating decision-maker is the Chairman and Chief Executive Officer.
Critical Judgments in Applying Accounting Policies The following are the critical judgments that have been made in applying the Company’s accounting policies and that have the most significant effect on the amounts in the consolidated financial statements:
De Facto Control The Company’s basis of consolidation is described above in the “Basis of Consolidation” section. Judgment is applied in determining when the Company controls an investment even if the Company holds less than a majority of the investee’s voting rights (the existence of de facto control). The key assumptions are further defined in Note 4.
Real Estate Properties The Company’s accounting policies relating to real estate properties are described above. In applying these policies, judgment has been applied in determining whether certain costs are additions to the carrying amount of the property, in distinguishing between tenant incentives and tenant improvements, and, for properties under development, identifying the point at which practical completion of the property occurs and identifying the directly attributable borrowing costs to be included in the carrying value of the development property. The key assumptions are further defined in Note 6.
Business Combinations Accounting for business combinations under IFRS 3, Business Combinations, (“IFRS 3”) applies only if it is considered that a business has been acquired. Under IFRS 3, a business is defined as an integrated set of activities and assets conducted and managed for the purposes of providing a return to investors or lower costs or other economic benefits directly and proportionately to the Company. A business generally consists of inputs, processes applied to those inputs and resulting outputs that are or will be used to generate revenue. Judgment is used by management in determining if the acquisition of an individual property qualifies as a business combination in accordance with IFRS 3 or as an asset acquisition.
When determining whether the acquisition of a real estate or hotel property or a portfolio of properties is a business combination or an asset acquisition, the Company applies judgment when considering whether the property or properties are acquired with significant processes.
Joint Arrangements The Company applies judgment to determine whether the joint arrangements provided it with joint control, significant influence or no influence and whether the arrangements are joint operations or joint ventures.
Leases The Company applies judgment in determining whether certain leases, in particular those tenant leases with long contractual terms and long-term ground leases where the Company is the lessor, are operating or finance leases.
Critical Accounting Estimates and Assumptions The preparation of the consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and reported amounts of revenue and expenses during the reporting periods.
MORGUARD.COM 64 MORGUARD CORPORATION CONSOLIDATED FINANCIAL STATEMENTS | DECEMBER 31, 2017
In determining estimates of fair market value and net realizable values for the Company’s real estate properties, the assumptions underlying estimated values are limited by the availability of comparable data and the uncertainty of predictions concerning future events. Should the underlying assumptions change, actual results could differ from the estimated amounts. The critical estimates and assumptions underlying the valuation of real estate properties are outlined in Note 6.
Property and equipment and investments in joint arrangements are assessed for impairment. Significant assumptions are used in the assessment of fair value and impairment including estimates of future operating cash flows, the time period over which they will occur, an appropriate discount rate, appropriate growth rates (revenues and costs) and changes in market valuation parameters. Management considers various factors in its assessment including the historical performance of property and equipment and investments in joint arrangements, expected trends in each specific market as well as local and macroeconomic conditions. The critical estimates and assumptions underlying the valuation of hotel properties are outlined in Note 7.
The estimated useful lives and related amortization method are determined for each component of hotel properties. The selected amortization method and estimate of useful life impact the amount of amortization expense recognized. In establishing useful lives and related amortization method management considers its capital maintenance plans.
The fair value of financial instruments approximates amounts at which these instruments could be exchanged between market participants at the measurement date. The estimated fair value may differ in amount from that which could be realized on an immediate settlement of the instruments. The Company estimates the fair value of mortgages payable by discounting the cash flows of these financial obligations using market rates for debts of similar terms.
NOTE 3 ADOPTION OF ACCOUNTING STANDARDS Current Accounting Policy Changes Amendments to IAS 7, “Statement of Cash Flows” (“IAS 7”) The amendments require disclosure of information enabling users of financial statements to evaluate changes in liabilities arising from financing activities. The amendments do not define financing activities, instead they clarify that financing activities are based on the existing definition used in IAS 7. The amendments are to be applied prospectively effective for annual periods beginning January 1, 2017.
The amendments did not have a material impact on the Company’s consolidated financial statements.
Future Accounting Policy Changes IFRS 15, “Revenue from Contracts with Customers” (“IFRS 15”) In May 2014, the IASB issued IFRS 15, a single comprehensive model to account for revenue arising from contracts with customers. The objective of IFRS 15 is to establish the principles that an entity shall apply to report useful information to users of financial statements about the nature, amount, timing and uncertainty of revenue and cash flows arising from a contract with a customer. The core principle of the standard is that an entity will recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects consideration to which the entity expects to be entitled in exchange for those goods and services. The standard has a mandatory effective date for annual periods beginning on or after January 1, 2018.
The Company is in the final stages of its assessment of the impact of this standard on its consolidated financial statements. The assessment included a review of contracts for the scoped-in streams including rents from tenants under leases, percentage participation rents, property tax and operating cost recoveries, lease cancellation fees, leasing concessions, parking income, incidental income, revenue from hotel services and product sold as well as management and advisory fees. For rental revenue and related recoveries, management has determined that the pattern of revenue recognition will remain unchanged upon adoption of the standard and the impact will be limited to additional note disclosure on the disaggregation of some of the Company’s revenue streams. The Company will complete its review of all contracts and will adopt the new standard on the required effective date.
MORGUARD.COM 65 MORGUARD CORPORATION CONSOLIDATED FINANCIAL STATEMENTS | DECEMBER 31, 2017
IFRS 9 (2014), “Financial Instruments” (“IFRS 9”) The final version of IFRS 9 was issued by the IASB in July 2014 and will replace IAS 39, “Financial Instruments: Recognition and Measurement” (“IAS 39”). IFRS 9 addresses the classification and measurement of all financial assets and liabilities within the scope of the current IAS 39 and a new expected loss impairment model that will require more timely recognition of expected credit losses and a substantially reformed model for hedge accounting. Also included are the requirements to measure debt-based financial assets at either amortized cost or fair value through profit or loss and to measure equity-based financial assets either as held-for-trading or as FVTOCI. No amounts are reclassified out of OCI if the FVTOCI option is elected. Additionally, embedded derivatives in financial assets would no longer be bifurcated and accounted for separately under IFRS 9. The standard has a mandatory effective date for annual periods beginning on or after January 1, 2018.
The Company is performing an assessment of key areas within the scope of IFRS 9 which includes, but not limited to, the change in classification and measurement of: (i) mortgages and loans receivable measured at amortized cost to FVTPL and (ii) available-for-sale securities measured at FVTOCI to FVTPL. The Company intends to adopt the new standard on the required effective date of January 1, 2018 and will not restate comparative information.
IAS 40, “Investment Property” (“IAS 40”) During December 2016, the IASB issued an amendment to IAS 40 clarifying certain existing IAS 40 requirements. The amendment requires that an asset be transferred to or from investment property when, and only when, there is a change in use. A change in use occurs when the property meets or ceases to meet the definition of investment property and there is evidence of the change in use. In isolation, a change in management’s intentions for the use of a property does not provide evidence of a change in use. These amendments are effective for annual periods beginning on or after January 1, 2018.
The amendment is not expected to have a material impact on the Company’s consolidated financial statements.
IFRS 16, “Leases” (“IFRS 16”) In January 2016, the IASB issued IFRS 16. The new standard requires that for most leases, lessees must initially recognize a lease liability for the obligation to make lease payments and a corresponding right-of-use asset for the right to use the underlying asset for the lease term. Lessor accounting, however, remains largely unchanged, and the distinction between operating and finance leases is retained. This standard will be effective for annual periods beginning on or after January 1, 2019, with early adoption permitted so long as IFRS 15 has been adopted.
The Company is currently assessing the impact this new standard will have on its consolidated financial statements.
NOTE 4 SUBSIDIARIES WITH NON-CONTROLLING INTEREST Morguard North American Residential Real Estate Investment Trust (“Morguard Residential REIT” or “MRG”) As at December 31, 2017, the Company owned a 46.9% (December 31, 2016 - 48.7%) effective interest in Morguard Residential REIT through its ownership of 6,675,166 Units and 17,223,090 Class B LP Units. The Company continues to consolidate its investment in Morguard Residential REIT on the basis of de facto control in accordance with IFRS 10, Consolidated Financial Statements, (“IFRS 10”). The basis for concluding that the Company continues to control Morguard Residential REIT is as follows: (i) the Company holds a significant interest in Morguard Residential REIT’s voting rights as at December 31, 2017; (ii) there is a wide dispersion of the public holdings of Morguard Residential REIT’s remaining Units; (iii) the Company has the ability to nominate a minimum number of Morguard Residential REIT’s trustees based on the Company's ownership interest; (iv) all of Morguard Residential REIT’s senior management are employees of the Company; and (v) Morguard Residential REIT is significantly dependent on the Company as a result of existing service agreements that cover property management, asset management, debt financing and acquisitions.
During the year ended December 31, 2017, Morguard Residential REIT recorded distributions of $21,663 or $0.64 per Unit (2016 - $17,763 or $0.61 per Unit), of which $4,294 was paid to the Company (2016 - $3,304) and $17,369 was paid to the remaining Unitholders (2016 - $14,459). In addition, during the year ended December 31, 2017, Morguard Residential REIT paid distributions to the Company on the Class B LP Units of $11,081 (2016 - $10,448).
MORGUARD.COM 66 MORGUARD CORPORATION CONSOLIDATED FINANCIAL STATEMENTS | DECEMBER 31, 2017
Morguard Real Estate Investment Trust (“Morguard REIT” or “MRT”) As at December 31, 2017, the Company owned 32,878,348 Units (December 31, 2016 - 31,813,982 Units) of Morguard REIT, which represents a 54.2% (December 31, 2016 - 52.5%) ownership.
During the year ended December 31, 2017, Morguard REIT recorded distributions of $58,203 or $0.96 per Unit (2016 - $58,306 or $0.96 per Unit), of which $31,178 was paid to the Company (2016 - $30,151) and $27,025 was paid to the remaining Unitholders (2016 - $28,155).
Temple Hotels Inc. (“Temple”) The Company commenced consolidating its investment in Temple effective December 31, 2016. Prior to December 31, 2016, the Company was accounting for its investment in Temple using the equity method. As at December 31, 2017, the Company owned 14,136,012 common shares (December 31, 2016 - 84,816,076 common shares) of Temple, which represents a 55.9% (December 31, 2016 - 55.9%) ownership.
The following summarizes the results of Morguard REIT, Morguard Residential REIT and Temple before any intercompany eliminations and the corresponding non-controlling interest in the equity of Morguard REIT, Morguard Residential REIT and Temple. The Units issued by Morguard Residential REIT that are not held by the Company are presented as equity on Morguard Residential REIT's balance sheet but are classified as a liability on the Company's consolidated balance sheets (Note 15).
As at December 31, 2017 December 31, 2016 MRT MRG Temple MRT MRG Temple Non-current assets $2,887,473 $2,607,884 $535,220 $2,852,876 $2,224,670 $576,585 Current assets 32,113 43,213 20,397 179,809 61,057 75,164 Total assets $2,919,586 $2,651,097 $555,617 $3,032,685 $2,285,727 $651,749 Non-current liabilities $1,178,640 $1,523,364 $194,519 $1,222,099 $1,431,797 $142,300 Current liabilities 202,607 210,027 281,527 292,427 169,904 404,488 Total liabilities $1,381,247 $1,733,391 $476,046 $1,514,526 $1,601,701 $546,788 Equity $1,538,339 $917,706 $79,571 $1,518,159 $684,026 $104,961 Non-controlling interest $706,093 $486,944 $32,429 $722,323 $350,673 $46,246
The following summarizes the results of the operations and cash flows for the following periods as presented in Morguard REIT’s, Morguard Residential REIT’s and Temple’s financial statements before any intercompany eliminations and the corresponding non-controlling interest in their net income (loss):
For the years ended December 31 2017 2016 MRT MRG Temple MRT MRG Revenue $278,754 $226,495 $165,612 $280,726 $218,472 Expenses (170,451) (158,622) (193,099) (158,463) (203,956) Fair value gain (loss) on real estate properties, net (31,225) 129,543 — (51,643) 68,270 Fair value loss on Class B LP Units — (24,285) — — (50,808) Net income (loss) for the year $77,078 $173,131 ($27,487) $70,620 $31,978 Non-controlling interest $35,812 $91,865 ($15,937) 33,874 16,394
For the years ended December 31 2017 2016 MRT MRG Temple MRT MRG Cash provided by operating activities $100,817 $59,476 $13,298 $115,148 $52,602 Cash provided by (used in) investing activities (61,831) (338,962) 3,777 (25,090) (87,801) Cash provided by (used in) financing activities (136,930) 298,706 (73,627) (3,644) 33,553 Net increase (decrease) in cash during the year ($97,944) $19,220 ($56,552) $86,414 ($1,646)
MORGUARD.COM 67 MORGUARD CORPORATION CONSOLIDATED FINANCIAL STATEMENTS | DECEMBER 31, 2017
NOTE 5 BUSINESS COMBINATION On December 14, 2016, the Company acquired 54,578,187 common shares of Temple, increasing its ownership in Temple from 38.9% to 55.9%. This acquisition of control has been reflected as a business combination occurring on December 31, 2016. The Company’s acquisition of control of Temple on December 31, 2016, was recorded as follows:
1. The Company’s previously held equity interest in Temple of $17,993 (Note 9) was remeasured to its fair market value based on the TSX closing price of Temple common shares on December 14, 2016. This resulted in a revalued equity investment in Temple of $21,771. The remeasurement of the investment resulted in the Company recording a non-cash gain of $3,778 in the consolidated statements of income.
2. On December 14, 2016, the Company purchased 54,578,187 common shares of Temple for cash consideration of $36,944.
The following table details the recognized amounts of the identifiable assets acquired and liabilities assumed, measured at their respective fair values on December 31, 2016 (“net assets”).
Hotel properties $556,468 Equity-accounted investments 15,264 Cash 67,922 Mortgages payable (395,408) Convertible debentures (129,617) Deferred income tax liabilities (2,358) Net working capital (7,310) Non-controlling interest (46,246) Fair value of net assets acquired $58,715 Purchase consideration (58,715) $—
The following table details the purchase consideration of Temple:
Purchase of Temple common shares $36,944 Remeasurement of equity interest 21,771 $58,715
The non-controlling interest in Temple has been measured at its proportionate share of Temple’s net identifiable assets. As at December 31, 2016, the Company had a $3,720 principal investment in Temple’s convertible debentures and upon consolidation of Temple, the investment was required to be eliminated.
As at December 31, 2016, Temple had Canadian tax loss carryforwards of approximately $119,553 that expire in various years commencing in 2030, and other deductible temporary differences of approximately $50,468 that have no expiration date. The benefit of the tax loss carryforwards and other deductible temporary differences have not been recognized.
MORGUARD.COM 68 MORGUARD CORPORATION CONSOLIDATED FINANCIAL STATEMENTS | DECEMBER 31, 2017
NOTE 6 REAL ESTATE PROPERTIES Real estate properties consist of the following:
As at December 31 2017 2016 Income producing properties $8,563,284 $7,820,381 Properties under development 29,729 35,155 Land held for development 62,638 64,135 $8,655,651 $7,919,671
Reconciliation of the carrying amounts for real estate properties at the beginning and end of the current financial year are set out below:
Income Properties Land Producing Under Held for Properties Development Development Total Balance as at December 31, 2016 $7,820,381 $35,155 $64,135 $7,919,671 Additions: Acquisitions and investments 656,962 — — 656,962 Capital expenditures 50,300 — — 50,300 Development expenditures — 58,658 917 59,575 Tenant improvements, incentives and leasing commissions 22,159 — — 22,159 Transfers 64,029 (64,029) — — Dispositions (88,685) — — (88,685) Fair value gain (loss), net 191,313 (55) (1,180) 190,078 Foreign currency translation (153,023) — (1,234) (154,257) Other (152) — — (152) Balance as at December 31, 2017 $8,563,284 $29,729 $62,638 $8,655,651
Transactions Completed During the Year Ended December 31, 2017 Acquisitions The following table presents a summary of the Company’s acquisitions and their purchase price, including transaction costs.
Apartment Commercial Date of Acquisition Ownership Asset Type Location Suites Square Feet Purchase Price July 10, 2017 51%(1) Residential Chicago, IL 515 20,000 $291,686 August 17, 2017 100% Residential Rockville, MD 492 — 166,506 August 3, 2017 100% Office Markham, ON — 203,500 67,947 July 6, 2017(2) 100% Residential Falls Church, VA 104 33,000 65,404 September 21, 2017 100% Office Ottawa, ON — 106,500 21,987 August 17, 2017 100% Office Oakville, ON — 74,500 18,958 May 15, 2017 100% Residential Toronto, ON 60 — 16,749 April 6, 2017 100% Office Oakville, ON — 36,500 7,148 September 26, 2017 100% Retail (Land) Dunnellon, FL — — 319 March 24, 2017 100% Residential Lakeworth, FL 1 — 258 1,172 474,000 $656,962 (1) On October 2, 2017, the Company sold a 49% interest in the property for $63,410 to an institutional partner. (2) The property is subject to a long-term land lease, with a fixed price land purchase option available in September 2029. Income producing properties include $9,256 (US$7,150) relating to the land lease in connection with the finance lease obligation recognized.
MORGUARD.COM 69 MORGUARD CORPORATION CONSOLIDATED FINANCIAL STATEMENTS | DECEMBER 31, 2017
Dispositions On July 12, 2017, the Company sold four U.S. properties located in Mobile, Alabama, comprising 1,329 suites, for net proceeds of $88,685 (US$69,318).
Reconciliation of the carrying amounts for real estate properties for the year ended December 31, 2016, is set out below:
Income Properties Land Producing Under Held for Properties Development Development Total Balance as at December 31, 2015 $7,752,919 $9,373 $54,010 $7,816,302 Additions: Acquisitions and investments 68,243 — 8,341 76,584 Capital expenditures 43,807 — — 43,807 Development expenditures — 32,374 158 32,532 Tenant improvements, incentives and leasing commissions 28,454 — — 28,454 Transfers 5,242 (5,242) — — Dispositions (39,513) — — (39,513) Fair value gain (loss), net 25,136 (1,350) 2,174 25,960 Foreign currency translation (65,488) — (548) (66,036) Other 1,581 — — 1,581 Balance as at December 31, 2016 $7,820,381 $35,155 $64,135 $7,919,671
Transactions Completed During the Year Ended December 31, 2016 Acquisitions On February 1, 2016, the Company acquired a multi-suite residential property comprising 370 suites located in Ottawa, Ontario, for a gross purchase price of $67,000. The acquisition was partially financed by a new mortgage of $38,589 at an interest rate of 2.88% for a term of 10 years.
Dispositions On March 18, 2016, the Company sold a retail property consisting of 109,097 square feet located in Kenner, Louisiana, for net proceeds of $17,525 (US$13,494).
On June 10, 2016, the Company sold an office property consisting of 127,366 square feet located in Montréal, Québec, for net proceeds of $22,350.
On October 17, 2016, the Company sold an industrial property located in Sudbury, Ontario, for net proceeds of $1,290.
During the three months ended December 31, 2016, the Company sold two parcels of land for $36.
Capitalization Rates As at December 31, 2017 and 2016, the Company had its portfolio appraised by Morguard’s appraisal division. In addition, the Company’s U.S. portfolio is appraised by independent U.S. real estate appraisal firms on a three-year cycle.
The Company determined the fair value of each income producing property based upon, among other things, rental income from current leases and assumptions about rental income from future leases reflecting market conditions at the applicable consolidated balance sheet dates, less future cash outflow pertaining to the respective leases. The Company’s multi-suite residential properties are appraised using the direct capitalization of income method. The retail, office and industrial properties are appraised using a number of approaches that typically include a discounted cash flow analysis, a direct capitalization of income method and a direct comparison approach. The discounted cash flow analysis is primarily based on discounting the expected future cash flows, generally over a term of 10 years, including a terminal value based on the application of a capitalization rate to estimated year 11 cash flows.
MORGUARD.COM 70 MORGUARD CORPORATION CONSOLIDATED FINANCIAL STATEMENTS | DECEMBER 31, 2017
Using the direct capitalization approach, the multi-suite residential, retail, office and industrial properties were valued using capitalization rates in the range of 3.8% to 11.5% (December 31, 2016 - 4.3% to 10.0%), resulting in an overall weighted average capitalization rate of 5.7% (December 31, 2016 - 5.8%).
The stabilized capitalization rates by asset type are set out in the following table:
December 31, 2017 December 31, 2016 Occupancy Capitalization Occupancy Capitalization As at Rates Rates Rates Rates Weighted Weighted Max. Min. Max. Min. Average Max. Min. Max. Min. Average Multi-suite residential 98.0% 90.0% 8.0% 3.8% 4.7% 98.0% 91.0% 8.0% 4.3% 4.9% Retail 100.0% 80.0% 11.5% 5.0% 6.6% 100.0% 80.0% 10.0% 5.0% 6.6% Office 100.0% 90.0% 9.0% 4.5% 6.2% 100.0% 90.0% 9.0% 4.8% 6.2% Industrial 100.0% 95.0% 7.3% 5.0% 6.4% 100.0% 95.0% 7.0% 5.3% 6.7%
The key valuation metrics used in the discounted cash flow method for the retail, office and industrial properties are set out in the following table:
As at December 31, 2017 December 31, 2016 Weighted Weighted Maximum Minimum Average Maximum Minimum Average Retail Discount rate 10.3% 6.0% 7.0% 10.3% 5.5% 6.9% Terminal cap rate 9.5% 5.3% 6.1% 9.5% 5.3% 6.2% Office Discount rate 9.3% 5.5% 6.6% 9.3% 5.8% 6.7% Terminal cap rate 8.5% 4.5% 5.9% 8.5% 4.8% 6.0% Industrial Discount rate 7.5% 6.0% 6.9% 7.5% 6.3% 7.1% Terminal cap rate 7.0% 5.0% 6.3% 7.0% 5.3% 6.5%
Fair values are most sensitive to changes in discount rates, capitalization rates and stabilized or forecast net operating income. Generally, an increase in stabilized net operating income will result in an increase in the fair value of the income producing properties, and an increase in capitalization rates will result in a decrease in the fair value of the properties. The capitalization rate magnifies the effect of a change in stabilized net operating income, with a lower capitalization rate resulting in a greater impact on the fair value of the property than a higher capitalization rate. If the weighted average stabilized capitalization rates were to increase or decrease by 25 basis points (assuming no change in stabilized net operating income), the value of the income producing properties as at December 31, 2017, would decrease by $360,868 and increase by $395,439, respectively.
The sensitivity of the fair values of the Company’s income producing properties as at December 31, 2017 and 2016, is set out in the table below:
As at December 31, 2017 December 31, 2016 Change in capitalization rate: 0.25% (0.25%) 0.25% (0.25%) Multi-suite residential ($192,310) $213,190 ($161,023) $178,134 Retail (87,742) 94,632 (89,778) 96,843 Office (77,025) 83,518 (71,937) 77,792 Industrial (3,791) 4,099 (3,609) 3,899 ($360,868) $395,439 ($326,347) $356,668
MORGUARD.COM 71 MORGUARD CORPORATION CONSOLIDATED FINANCIAL STATEMENTS | DECEMBER 31, 2017
NOTE 7 HOTEL PROPERTIES Hotel properties consist of the following:
Accumulated Impairment Accumulated Net Book As at December 31, 2017 Cost Provision Amortization Value Land $91,984 ($2,407) $— $89,577 Buildings 533,313 (19,483) (21,462) 492,368 Furniture, fixtures, equipment and other 83,788 (2,700) (21,272) 59,816 $709,085 ($24,590) ($42,734) $641,761 Hotel property under development 27,265 — — 27,265 $736,350 ($24,590) ($42,734) $669,026
Accumulated Net Book As at December 31, 2016 Cost Amortization Value Land $93,334 $— $93,334 Buildings 530,146 (7,957) 522,189 Furniture, fixtures, equipment and other 78,138 (8,137) 70,001 $701,618 ($16,094) $685,524 Hotel property under development 20,139 — 20,139 $721,757 ($16,094) $705,663
Transactions in hotel properties for the year ended December 31, 2017, are summarized as follows:
Opening Closing Net Book Impairment Net Book As at December 31, 2017 Value Additions Provision Disposals Amortization Value Land $93,334 $— ($2,407) ($1,350) $— $89,577 Buildings 522,189 10,412 (19,483) (7,245) (13,505) 492,368 Furniture, fixtures, equipment and other 70,001 6,374 (2,700) (724) (13,135) 59,816 $685,524 $16,786 ($24,590) ($9,319) ($26,640) $641,761 Hotel property under development 20,139 7,126 — — — 27,265 $705,663 $23,912 ($24,590) ($9,319) ($26,640) $669,026
Transactions in hotel properties for the year ended December 31, 2016, are summarized as follows:
Opening Closing Net Book Consolidation Net Book As at December 31, 2016 Value Acquisitions Additions Amortization of Temple Value Land $17,006 $3,733 $— $— $72,595 $93,334 Buildings 75,082 27,462 848 (2,406) 421,203 522,189 Furniture, fixtures, equipment and other 6,217 2,305 1,339 (2,530) 62,670 70,001 $98,305 $33,500 $2,187 ($4,936) $556,468 $685,524 Hotel property under development 17,255 — 2,884 — — 20,139 $115,560 $33,500 $5,071 ($4,936) $556,468 $705,663
In accordance with IFRS, management completed an assessment of all hotel properties at the end of each reporting period to determine if there is any indication that an asset may be impaired.
The Company identified each hotel property as a cash generating unit for impairment purposes. The recoverable amounts of the hotel properties have been estimated using the value-in-use method. Value-in-use is established using a discounted cash flow calculation method. Under this calculation, discount rates are applied to the forecasted cash flows reflecting the assumptions for hotel activity. The key assumptions are the normalized first year net operating income and the discount rate applied over the useful life of the hotel property. The table below provides details of normalized first year net operating income and the discount rates used for valuing the hotel properties.
MORGUARD.COM 72 MORGUARD CORPORATION CONSOLIDATED FINANCIAL STATEMENTS | DECEMBER 31, 2017
IFRS permits an impairment provision to be reversed in the subsequent accounting periods if recoverability analysis at that time supports reversal.
In 2017, impairment indicators were identified including decreases in occupancy at hotel properties. A recoverability analysis was completed in accordance with the procedures specified by IFRS which indicated that an impairment provision of $24,590 should be recorded for certain hotel properties.
Wingate by Wyndham Saskatoon Hilton Cortona As at December 31, 2017 Regina Inn Garden Inn Residence Net book value $16,932 $39,514 $21,469 $11,125 Recoverable amount 13,000 22,300 19,300 9,850 Provision for impairment 3,932 17,214 2,169 1,275 Cumulative impairment provision 3,932 17,214 2,169 1,275 Projected first year NOI 822 1,861 987 747 Discount rate 9.0% 10.0% 8.5% 10.5%
Transactions Completed During the Year Ended December 31, 2017 Dispositions On September 15, 2017, the Company sold the Holiday Inn Express, Sherwood Park, Alberta, for gross proceeds of $9,690 (including working capital adjustments of $80), resulting in aggregate net cash proceeds of $278 after deducting the repayment of first mortgage loan of $9,102, interest payable of $19 and sale costs of $291.
Transactions Completed During the Year Ended December 31, 2016 Acquisitions On February 1, 2016, the Company acquired three hotels comprising 417 rooms located in Toronto, Ontario, for a gross purchase price of $33,500. The purchase price was allocated to land $3,733, building $27,462 and the remaining $2,305 was allocated to furniture, fixtures, equipment and other. Acquisition costs of $1,180 have been recorded in other income (expense) because the acquisition represents a business combination. The acquisition was financed by cash on hand and a $20,000 credit facility having a term of three years.
NOTE 8 CO-OWNERSHIP INTERESTS The Company is a co-owner in several properties that are subject to joint control based on the Company’s decision-making authority with regards to the relevant activities of the properties. These co-ownerships have been classified as joint operations and, accordingly, the Company recognizes its rights to and obligation for these assets, liabilities, revenue and expenses of these co-ownerships in the respective lines in the consolidated financial statements.
MORGUARD.COM 73 MORGUARD CORPORATION CONSOLIDATED FINANCIAL STATEMENTS | DECEMBER 31, 2017
The following are the Company’s significant co-ownerships as at December 31, 2017 and 2016:
Company’s Ownership Jointly Controlled Asset Location Asset Type December 31, 2017 December 31, 2016
Bramalea City Centre Brampton, ON Retail 20.7% 20.7% Woodbridge Square Woodbridge, ON Retail 50.0% 50.0% Performance Court Ottawa, ON Office 50.0% 50.0% 77 Bloor Street West Toronto, ON Office 50.0% 50.0% Mississauga City Centre Mississauga, ON Office 50.0% 50.0% Standard Life Centre Ottawa, ON Office 50.0% 50.0% 65 Overlea Boulevard Toronto, ON Office 95.0% 95.0% Heritage Place Ottawa, ON Office 50.0% 50.0% Scotia Place Edmonton, AB Office 20.0% 20.0% 505 Third Street Calgary, AB Office 50.0% 50.0% 2920 Matheson Boulevard Mississauga, ON Office 50.0% 50.0% 7474 McLean Road Puslinch, ON Industrial 50.0% 50.0% 825 Des Érables Salaberry-de-Valleyfield, QC Industrial 50.0% 50.0% Toronto Airport Marriott Toronto, ON Hotel 94.8% 94.8%
The following amounts, included in these consolidated financial statements, represent the Company’s proportionate share of the assets and liabilities of the Company’s co-ownership interests as at December 31, 2017 and 2016, and the results of operations for the years ended December 31, 2017 and 2016:
As at December 31 2017 2016 Assets $911,369 $885,293 Liabilities $249,840 $273,898
For the years ended December 31 2017 2016 Revenues $106,131 $105,330 Expenses 67,894 67,220 Income before fair value adjustments 38,237 38,110 Fair value gain (loss) on real estate properties 16,993 (4,421) Net income $55,230 $33,689
NOTE 9 EQUITY-ACCOUNTED AND OTHER FUND INVESTMENTS
(a) Equity-accounted and other real estate fund investments consist of the following:
As at December 31 2017 2016 Joint ventures $55,051 $50,782 Associates 132,314 230,198 Equity-accounted investments 187,365 280,980 Other real estate fund investments 93,488 99,828 Equity-accounted and other fund investments $280,853 $380,808
MORGUARD.COM 74 MORGUARD CORPORATION CONSOLIDATED FINANCIAL STATEMENTS | DECEMBER 31, 2017
Equity-accounted investments The following are the Company’s significant equity-accounted investments as at December 31, 2017 and 2016:
Company’s Ownership Carrying Value Principal Place Investment Asset December 31, December 31, December 31, December 31, Property/Investment of Business Type Type 2017 2016 2017 2016 Petroleum Plaza Edmonton, AB Joint Venture Office 50.0% 50.0% $27,080 $28,201 Quinte Courthouse Belleville, ON Joint Venture Office 50.0% 50.0% 7,178 7,267 Greypoint Capital L.P. Toronto, ON Joint Venture Other 36.4% 36.4% 5,497 50 Courtyard by Marriott Ottawa, ON Joint Venture Hotel 50.0% 50.0% 10,883 10,821 Marriott Residence Inn London, ON Joint Venture Hotel 50.0% 50.0% 4,413 4,443 Sunset & Gordon Los Angeles, CA Associate Residential 59.1% 59.1% 47,733 63,359 Marquee at Block 37 Chicago, IL Associate Residential 49.0% 49.0% 68,162 150,972 MIL Industrial Fund II LP(1) Various Associate Industrial 18.8% 18.8% 16,419 15,867 $187,365 $280,980 (1) The Company accounts for its investment using the equity method since the Company has the ability to exercise significant influence as a result of its role as general partner; however, it does not control the fund.
The following table presents the change in the balance of equity-accounted investments:
As at December 31 2017 2016 Balance, beginning of year $280,980 $233,469 Additions, net of disposals 10,400 1,490 Reclassification of Temple (Note 5) — (17,993) Acquisitions through business combination (Note 5) — 15,264 Share of net income (loss) (10,227) 54,904 Distributions received (79,961) (4,446) Foreign exchange (13,827) (1,708) Balance, end of year $187,365 $280,980
During the year ended December 31, 2017, distributions from equity-accounted investments amounted to $79,961, of which $74,992 (2016 - $nil) was from the Company’s investment in Marquee at Block 37 that represented the Company’s share of net proceeds from a mortgage refinancing.
The following tables present the financial results of the Company’s equity-accounted investments on a 100% basis:
As at December 31, 2017 December 31, 2016 Joint Joint Venture Associate Total Venture Associate Total Non-current assets $218,868 $762,202 $981,070 $223,946 $806,999 $1,030,945 Current assets 32,991 5,695 38,686 10,569 5,549 16,118 Total assets $251,859 $767,897 $1,019,756 $234,515 $812,548 $1,047,063 Non-current liabilities $121,322 $319,781 $441,103 $124,686 $169,667 $294,353 Current liabilities 7,683 99,566 107,249 8,063 102,085 110,148 Total liabilities $129,005 $419,347 $548,352 $132,749 $271,752 $404,501 Net assets $122,854 $348,550 $471,404 $101,766 $540,796 $642,562 Equity-accounted investment $55,051 $132,314 $187,365 $50,782 $230,198 $280,980
MORGUARD.COM 75 MORGUARD CORPORATION CONSOLIDATED FINANCIAL STATEMENTS | DECEMBER 31, 2017
For the years ended December 31 2017 2016 Joint Joint Venture Associate Total Venture Associate Total Revenues $34,877 $26,225 $61,102 $18,258 $135,795 $154,053 Expenses (23,797) (27,577) (51,374) (11,461) (207,071) (218,532) Fair value gain (loss) on real estate properties, net (4,470) (9,428) (13,898) (9,300) 199,987 190,687 Net income (loss) for the year $6,610 ($10,780) ($4,170) ($2,503) $128,711 $126,208 Income (loss) in equity-accounted investments $2,903 ($13,130) ($10,227) ($1,352) $56,256 $54,904
(b) Income recognized from other fund investments:
Other real estate fund investments For the years ended December 31 2017 2016 Distribution income $2,910 $2,728 Other comprehensive income (loss) for the year (5,031) 3,445 Total comprehensive income (loss) from other real estate fund investments ($2,121) $6,173
The Company holds investments in two U.S. real estate funds. The funds are classified as AFS financial instruments and are measured at FVTOCI. Gains or losses arise from the change in the fair value of the underlying real estate properties held by the funds (Level 3) and from foreign exchange currency translation. Distributions received from these funds are recorded in other income (expense) on the consolidated statements of income.
The Company’s two fund investments hold multi-suite residential, retail and office investment properties located in the U.S. The underlying assets are appraised using a number of approaches that principally include a discounted cash flow analysis or a direct capitalization of income method. Using the direct capitalization approach, fund properties were valued using capitalization rates in the range of 4.0% to 6.0%, resulting in an overall weighted average capitalization rate of 4.6%. Under the discounted cash flow method, fund properties were valued using discount rates in the range of 6.2% to 7.2%, resulting in an overall weighted average discount rate of 6.7% and terminal cap rates in the range of 5.0% to 5.9%, resulting in an overall weighted average terminal cap rate of 5.4%.
NOTE 10 OTHER ASSETS Other assets consist of the following:
As at December 31 2017 2016 Accrued pension benefit asset (Note 27) $80,840 $82,841 Goodwill 24,488 24,488 Capital assets, net 11,831 23,825 Intangible assets, net 39,905 13,904 Inventory 3,479 2,834 Inventory - development properties 54,923 18,850 Restricted cash 27,293 28,922 Other 3,681 3,802 $246,440 $199,466
During the three months ended June 30, 2016, Morguard was awarded a mandate for the design, construction and operation of an ancillary services office building as part of the Etobicoke General Hospital’s expansion plans. The Company entered into a 41-year ground lease agreement for a nominal consideration for the construction and operation of the development project, which is to be returned to the landlord at the end of the 41-year term. The landlord has the right to buy out the ground lease in year 20 at the fair market value of Morguard’s interest in the development as defined by the agreement. Contemporaneously, the Company entered into a sublease agreement with the same party, and has agreed to rent any unused space over the 41-year term. As at December 31, 2017, the Company has incurred $49,145 on the project’s development. The project is funded by a non-revolving construction
MORGUARD.COM 76 MORGUARD CORPORATION CONSOLIDATED FINANCIAL STATEMENTS | DECEMBER 31, 2017
financing in the amount of $39,255 (Note 16). The Company has entered into an interest rate swap transaction to mitigate the interest rate risk on the floating-rate construction loan. The swap matures on April 30, 2018. NOTE 11 MORTGAGES AND LOANS RECEIVABLE Mortgages and loans receivable consist of the following:
As at December 31 2017 2016 Mortgages receivable $13,914 $15,149 Loan receivable - Paros Enterprises Limited (Note 23(a)) — 2,314 Loan receivable - TWC Enterprises Limited (Note 23(b)) 11,767 47,084 Loan receivable - other 1,576 — Total mortgages and loans receivable $27,257 $64,547
During 2016, mortgages receivable were advanced in the amount of $14,081 with a financial institution. The mortgages receivable mature on June 15, 2018, and bear interest at the bankers’ acceptance rate plus 4.0%.
NOTE 12 MORTGAGES PAYABLE Mortgages payable consist of the following:
As at December 31 2017 2016 Mortgages payable $4,056,673 $3,925,657 Mark-to-market adjustments, net 24,931 35,671 Deferred financing costs (25,576) (21,219) $4,056,028 $3,940,109
Current $615,959 $752,152 Non-current 3,440,069 3,187,957 $4,056,028 $3,940,109
Range of interest rates 2.25-8.20% 2.25 - 7.08% Weighted average contractual interest rate 3.86% 3.91% Estimated fair value of mortgages payable $4,177,548 $4,063,448
The aggregate principal repayments and balances maturing of the mortgages payable as at December 31, 2017, together with the weighted average contractual interest rate on debt maturing in the next five years and thereafter are as follows:
Weighted Principal Average Instalment Balances Contractual Repayments Maturing Total Interest Rate 2018 $96,577 $515,414 $611,991 4.76% 2019 87,663 341,228 428,891 3.77% 2020 87,564 164,293 251,857 4.76% 2021 81,139 339,296 420,435 4.23% 2022 75,102 389,778 464,880 3.70% Thereafter 171,371 1,707,248 1,878,619 3.57% $599,416 $3,457,257 $4,056,673 3.86%
Substantially all of the Company’s properties and related rental revenue have been pledged as collateral for the mortgages payable.
MORGUARD.COM 77 MORGUARD CORPORATION CONSOLIDATED FINANCIAL STATEMENTS | DECEMBER 31, 2017
The Company’s first mortgages are registered against specific real estate assets and mature between 2018 and 2039 with a weighted average term to maturity of 5.1 years (December 31, 2016 - 4.7 years). Approximately 94.1% of the Company’s mortgages have fixed interest rates.
The Company entered into an interest rate swap transaction to mitigate the interest rate risk on the floating-rate mortgage secured by five hotel properties. The swap transaction matures on June 14, 2018, and as at December 31, 2017, the outstanding balance of the floating-rate mortgage is $42,640 (December 31, 2016 - $43,600).
Some of Temple’s mortgages payable require it to maintain annual debt service coverage ratios and/or debt to equity ratios and/or debt to appraised value ratios, arrange for capital expenditures in accordance with predetermined limits, and maintain ongoing liquidity ratios. As at December 31, 2017, Temple was not in compliance with seven (December 31, 2016 - nine) debt service covenants affecting seven (December 31, 2016 - nine) mortgage loans amounting to $109,339 (December 31, 2016 - $139,187). None of the lenders have demanded payment of the mortgage loans. As at December 31, 2017, Temple was not in compliance with a corporate 1.1 to 1.0 working capital ratio requirement affecting three mortgage loans scheduled to mature in June 2018, with an aggregate principal balance of $37,106. Temple has received a waiver from the lender subsequent to December 31, 2017. However, IFRS requires that the loan balance of mortgages payable in breach of debt covenants be included in the current portion of mortgages payable. All mortgages payable in breach of debt covenants have contractual maturities due within twelve months of December 31, 2017.
NOTE 13 UNSECURED DEBENTURES The Company’s senior unsecured debentures (“Unsecured Debentures”) consist of the following:
Coupon As at Maturity Date Interest Rate December 31, 2017 December 31, 2016 Series A senior unsecured debentures December 10, 2018 4.099% $135,000 $135,000 Series B senior unsecured debentures November 18, 2020 4.013% 200,000 200,000 Series C senior unsecured debentures September 15, 2022 4.333% 200,000 — Unamortized financing costs (2,093) (1,362) $532,907 $333,638
Current $134,755 $— Non-current 398,152 333,638 $532,907 $333,638
On December 10, 2013, the Company issued $135,000 (net proceeds including issuance costs - $134,315) of the Series A unsecured debentures due on December 10, 2018. Interest on the Series A unsecured debentures is payable semi-annually, not in advance, on June 10 and December 10 of each year. Paros Enterprises Limited (“Paros”), a related party (Note 23(a)), acquired $10,000 aggregate principal amount of the Series A unsecured debentures.
The Company has the option to redeem the Series A unsecured debentures at a redemption price equal to the greater of the Canada Yield Price or par plus any accrued and unpaid interest. The Canada Yield Price is defined as the amount that would return a yield on investment for the remaining term to maturity equal to the Canada Bond Yield with an equal term to maturity plus a spread of 0.56%.
On November 18, 2016, the Company issued $200,000 (net proceeds including issuance costs - $199,198) of Series B senior unsecured debentures due on November 18, 2020. Interest on the Series B unsecured debentures is payable semi-annually, not in advance, on May 18 and November 18 of each year commencing on May 18, 2017.
MORGUARD.COM 78 MORGUARD CORPORATION CONSOLIDATED FINANCIAL STATEMENTS | DECEMBER 31, 2017
The Company has the option to redeem the Series B unsecured debentures at a redemption price equal to the greater of the Canada Yield Price or par plus any accrued and unpaid interest. The Canada Yield Price is defined as the amount that would return a yield on investment for the remaining term to maturity equal to the Canada Bond Yield with an equal term to maturity plus a spread of 0.785%.
On September 15, 2017, the Company issued $200,000 (net proceeds including issuance costs - $198,800) of Series C senior unsecured debentures due on September 15, 2022. Interest on the Series C unsecured debentures is payable semi-annually, not in advance, on March 15 and September 15 of each year commencing on March 15, 2018.
The Company has the option to redeem the Series C unsecured debentures at a redemption price equal to the greater of the Canada Yield Price or par plus any accrued and unpaid interest. The Canada Yield Price is defined as the amount that would return a yield on investment for the remaining term to maturity equal to the Canada Bond Yield with an equal term to maturity plus a spread of 0.635%.
For the year ended December 31, 2017, interest on Unsecured Debentures of $16,124 (2016 - $6,499) is included in interest expense (Note 20).
NOTE 14 CONVERTIBLE DEBENTURES Convertible debentures consist of the following:
Principal Coupon Owned Conversion Interest Principal by the December 31, December 31, As at Maturity Date Price Rate Balance Company 2017 2016 Morguard REIT(1) — — — — $— $100,336 Morguard REIT December 31, 2021 $20.40 4.50% $175,000 $60,000 108,335 116,625 Morguard Residential REIT(2) March 30, 2018 $15.50 4.65% $60,000 $5,000 55,466 54,779 Temple - Series C(3) — — — — — 21,922 Temple - Series D(4) — — — — — 31,450 Temple - Series E(5) September 30, 2020 $9.75 7.25% $42,905 $1,067 39,366 41,877 Temple - Series F March 31, 2018 $39.12 7.00% $34,419 $600 33,208 30,763 $236,375 $397,752
Current $88,674 $195,585 Non-current 147,701 202,167 $236,375 $397,752 (1) On January 9, 2017, the remaining convertible debenture balance of $99,957 was fully redeemed by the Company. (2) The liability includes the fair value of the conversion option of $798 (December 31, 2016 - $641). (3) The Series C convertible debentures had a December 31, 2016 due date but since December 31, 2016 fell on a weekend, the Company repaid the convertible debentures on January 3, 2017, the first business day after December 31, 2016. (4) On June 30, 2017, the Company repaid the remaining Series D convertible debentures on maturity. (5) The Series E convertible debentures had a September 30, 2017 due date but since September 30, 2017 fell on a weekend, the convertible debentures had a maturity date on October 2, 2017, the first business day after September 30, 2017. On October 2, 2017, the terms of the Series E convertible debentures were amended which included extending the maturity date to September 30, 2020 and reducing the conversion price to $9.75 (see below).
Morguard REIT On October 31, 2012, Morguard REIT issued $150,000 principal amount of 4.85% convertible unsecured subordinated debentures and incurred issue costs of $4,228 for net proceeds of $145,772. On January 6, 2017, $18 of the convertible debentures were converted into 731 Units and on January 9, 2017, the remaining $149,957 ($99,957 excluding principal owned by the Company) convertible debentures were redeemed in advance of their October 31, 2017 maturity date.
On December 30, 2016, Morguard REIT issued $175,000 principal amount of 4.50% convertible unsecured subordinated debentures, and incurred issue costs of $5,137 for net proceeds of $169,863. Interest is payable semi- annually, not in advance, on June 30 and December 31 of each year. The convertible debentures, with the exception
MORGUARD.COM 79 MORGUARD CORPORATION CONSOLIDATED FINANCIAL STATEMENTS | DECEMBER 31, 2017
of $3,242, the value assigned to the holder’s conversion option, have been recorded as debt on the consolidated balance sheets. On January 12, 2017, the Company purchased an additional $10,000 principal amount of the 4.50% convertible unsecured subordinated debentures.
Morguard Residential REIT On March 15, 2013, Morguard Residential REIT issued $60,000 principal amount of 4.65% convertible unsecured subordinated debentures and incurred issue costs of $2,062, which have been capitalized and are being amortized over their term to maturity. Interest is payable semi-annually, not in advance, on March 31 and September 30 of each year.
Temple Hotels Inc. On January 3, 2017, Temple redeemed the remaining $22,773 ($21,922 excluding principal owned by the Company) Series C convertible debentures on maturity.
On June 30, 2017, Temple redeemed the remaining $34,282 ($33,137 excluding principal owned by the Company) Series D convertible debentures on maturity.
As at December 31, 2017, the 7.25% Series E convertible debentures have a principal balance of $42,905. The Series E convertible debentures are redeemable at the option of Temple at their principal amount. Interest is payable semi-annually, not in advance, on March 31 and September 30 of each year.
On September 28, 2017, holders of the Series E convertible redeemable unsecured debentures approved the following proposed amendments to the Series E debentures, effective October 2, 2017:
i) Decreasing the conversion price from $40.08 to $9.75 per common share of Temple; ii) Extending the maturity date from September 30, 2017 to September 30, 2020; iii) Permitting Temple to redeem the Series E debentures, in whole or in part, at any time up to September 30, 2020, at a price equal to the principal amount thereof plus accrued and unpaid interest to, but excluding the date of the redemption; and iv) Permitting Temple to complete the Initial Partial Redemption (as defined below) without further notice or communication to holders of Series E debentures and to complete the Additional Partial Redemptions (as defined below).
On October 2, 2017, Temple redeemed $2,259 ($2,202 excluding principal owned by the Company) of the principal amount of the Series E debentures outstanding, which represents approximately 5% of the issued and outstanding Series E debentures (the “Initial Partial Redemption”). Temple has also committed to redeem an additional 5% of the currently issued and outstanding principal amount of Series E debentures on each of September 30, 2018 and September 30, 2019 (the “Additional Partial Redemptions”). Each of the Initial Partial Redemption and the Additional Partial Redemptions will be for a cash payment equal to the principal amount of such redemption plus accrued and unpaid interest to, but excluding the date of redemption. On October 2, 2017, the convertible debentures, with the exception of $2,120, the value assigned to the holder’s conversion option, have been recorded as debt on the consolidated balance sheets.
As at December 31, 2017, the 7% Series F convertible debentures have a principal balance of $34,419. The Series F convertible debentures are redeemable at the option of Temple at the principal amount. Interest is payable semi- annually, not in advance, on March 31 and September 30 of each year.
For the year ended December 31, 2017, interest on convertible debentures net of accretion of $21,417 (2016 - $7,030), is included in interest expense (Note 20).
MORGUARD.COM 80 MORGUARD CORPORATION CONSOLIDATED FINANCIAL STATEMENTS | DECEMBER 31, 2017
NOTE 15 MORGUARD RESIDENTIAL REIT UNITS As at December 31, 2017, the Company owned a 46.9% (December 31, 2016 - 48.7%) effective interest in Morguard Residential REIT. The Units of Morguard Residential REIT trade on the TSX under the symbol “MRG.UN.” Although the Company owns less than 50% of Morguard Residential REIT, it continues to consolidate its investment in MRG on the basis of de facto control (Note 4).
The Units issued by Morguard Residential REIT that are not held by the Company are classified as equity on Morguard Residential REIT’s balance sheet but are classified as a liability on the Company’s consolidated balance sheets. Morguard Residential REIT Units are redeemable at any time, in whole or in part, on demand by the holders. Upon receipt of the redemption notice by Morguard Residential REIT, all rights to and under the units tendered for redemption shall be surrendered, and the holder shall be entitled to receive a price per Unit equal to the lesser of: (i) 90% of the market price of the Units on the principal exchange market on which the Units are listed or quoted for trading during the 10 consecutive trading days ending immediately prior to the date on which the Units were surrendered for redemption; or (ii) 100% of the closing market price on the principal exchange market on which the Units are listed or quoted for trading on the redemption date.
On January 9, 2017, Morguard Residential REIT completed an offering for 4,370,000 Units sold for a price of $13.75 per Unit for aggregate gross proceeds of $60,088. The net proceeds after underwriters’ commission and other closing costs totalling $2,402, was $57,686. The Company purchased 1,230,000 of the Units offered amounting to $16,688.
As at December 31, 2017, the Company valued the non-controlling interest in the Morguard Residential REIT Units at $365,438 (December 31, 2016 - $292,304) and classified the Units as a liability on the consolidated balance sheets. Due to the change in the market value of the Units and the distributions paid to external Unitholders, the Company recorded a fair value loss for the year ended December 31, 2017 of $49,066 (2016 - $77,755) in the consolidated statements of income (Note 21).
The components of the fair value loss on Morguard Residential REIT Units are as follows:
For the years ended December 31 2017 2016 Fair value loss on Morguard Residential REIT Units ($31,697) ($63,296) Distributions to external Unitholders (Note 4) (17,369) (14,459) Fair value loss on Morguard Residential REIT Units ($49,066) ($77,755)
NOTE 16 CONSTRUCTION FINANCING PAYABLE As at December 31, 2017, the Company has a construction financing facility with maximum available borrowings totalling $39,255 (December 31, 2016 - $184,255) collateralized by a development property. The construction financing facility bears interest at either prime rate plus 1.5% or the bankers’ acceptance rate plus 2.5%, maturing on April 30, 2018. As at December 31, 2017, the Company had borrowed $36,476 (December 31, 2016 - $93,000) in construction financing.
NOTE 17 ACCOUNTS PAYABLE AND ACCRUED LIABILITIES Accounts payable and accrued liabilities consist of the following:
As at December 31 2017 2016 Accounts payable and accrued liabilities $196,075 $176,763 Tenant deposits 22,803 23,046 SARs liability 19,709 16,697 Income taxes payable 4,046 10,694 Finance lease obligation 8,970 — Other 2,256 3,030 $253,859 $230,230
MORGUARD.COM 81 MORGUARD CORPORATION CONSOLIDATED FINANCIAL STATEMENTS | DECEMBER 31, 2017
The Company assumed a land lease in connection with the acquisition of a residential property. The Company has the option to purchase the land in September 2029 for US$7,150. The Company has classified the land lease as a finance lease under the assumption that substantially all the risks and rewards incidental to ownership have been transferred.
Future minimum lease payments under the finance lease are as follows:
As at December 31 2017 2016 Within 12 months $377 $— 2 to 5 years 1,677 — Over 5 years 12,205 — Total minimum lease payments 14,259 — Less: future interest costs (5,289) — Present value of minimum lease payments $8,970 $—
NOTE 18 BANK INDEBTEDNESS As at December 31, 2017 and 2016, the Company has credit facilities and operating lines of credit totalling $349,000, the majority of which can be borrowed in either Canadian or U.S. dollars and are subject to floating interest rates based on bankers’ acceptance or LIBOR rates. The Company’s investments in Morguard REIT and Morguard Residential REIT, marketable securities, amounts receivable, inventory, capital assets and a fixed-charge security on specific properties have been pledged as collateral on these credit facilities and operating lines of credit. As at December 31, 2017, the Company had borrowed $49,650 (December 31, 2016 - $nil) and issued letters of credit in the amount of $15,048 (December 31, 2016 - $14,251) related to these facilities.
The bank credit agreements include certain restrictive undertakings by the Company. As at December 31, 2017, the Company is in compliance with all undertakings.
NOTE 19 SHAREHOLDERS’ EQUITY (a) Share Capital Authorized Unlimited common shares, no par value. Unlimited preference shares, no par value, issuable in series.
Number Issued and Fully Paid Common Shares (000s) Amount Balance, December 31, 2015 11,993 $108,097 Common shares repurchased through the Company’s NCIB (64) (579) Dividend reinvestment plan — 83 Balance, December 31, 2016 11,929 107,601 Common shares repurchased through the Company’s NCIB (88) (797) Dividend reinvestment plan 1 148 Balance, December 31, 2017 11,842 $106,952
The Company had the approval of the TSX under its normal course issuer bid (“NCIB”) to purchase up to 596,784 common shares. The program expired on September 21, 2017. On September 19, 2017, the Company obtained the approval of the TSX under its NCIB to purchase up to 592,415 common shares, being approximately 5% of the issued and outstanding common shares, and the program expires on September 21, 2018. The daily repurchase restriction for the common shares is 1,000. During the year ended December 31, 2017, 88,309 common shares were purchased for cash consideration of $15,834 at a weighted average price of $179.30 per common share.
MORGUARD.COM 82 MORGUARD CORPORATION CONSOLIDATED FINANCIAL STATEMENTS | DECEMBER 31, 2017
Total dividends declared during the year ended December 31, 2017 amounted to $7,127 or $0.60 per common share (2016 - $7,163 or $0.60 per common share). On February 22, 2018, the Company declared a common share dividend of $0.15 per common share, to be paid in the first quarter of 2018.
(b) Contributed Surplus During the year ended December 31, 2017, the Company acquired 1,064,366 Units of Morguard REIT (2016 - 1,120,929 Units) for cash consideration of $16,031 (2016 - $16,146) increasing the Company’s ownership interest in Morguard REIT from 52.5% as at December 31, 2016, to 54.2% as at December 31, 2017.
During the year ended December 31, 2017, Morguard REIT purchased for cancellation 50,300 Units (2016 - 371,769 Units) for cash consideration of $766 (2016 - $5,840), and the amount has been recorded within retained earnings.
The difference between the cash consideration and the carrying value of the non-controlling interest acquired for the year ended December 31, 2017, amounted to $10,291 (2016 - $13,490), and the amount has been recorded within retained earnings.
(c) Stock Appreciation Rights Plan The SARs granted vest equally over 10 years subject to restrictions.
As at December 31, 2017 Date of Grant Exercise Price Issued Redeemed Cancelled Outstanding March 20, 2008 $30.74 200,000 39,000 53,500 107,500 November 2, 2010 $43.39 55,000 2,000 8,000 45,000 May 13, 2014 $137.90 25,000 2,000 8,000 15,000 May 13, 2015 $153.82 10,000 — — 10,000 January 11, 2017 $179.95 90,000 — — 90,000 Total 380,000 43,000 69,500 267,500
During the year ended December 31, 2017, the Company recorded a fair value adjustment to compensation expense of $3,012 (2016 - $6,607). The increase in expense is included in property management and corporate expenses in the consolidated statements of income, and the liability is classified as accounts payable and accrued liabilities (Note 17).
The fair value for the SARs was calculated using the Black-Scholes option pricing model. In determining the fair value of the SARs, management is required to make assumptions that could have a material impact on the valuation. The following are the assumptions that were used in determining the fair value as at December 31, 2017: a dividend yield of 0.33% (2016 - 0.34%), expected volatility of approximately 19.83% (2016 - 19.62%) and the 10-year Bank of Canada Bond Yield of 1.98% (2016 - 1.73%).
(d) Accumulated Other Comprehensive Income As at December 31, 2017 and 2016, accumulated other comprehensive income consists of the following amounts:
As at December 31 2017 2016 Actuarial gain on defined benefit pension plans $46,982 $48,873 Unrealized gain on financial instruments and other 17,315 14,076 Loss on interest rate swap agreement (118) (606) Unrealized foreign currency translation gain 125,803 205,376 $189,982 $267,719
MORGUARD.COM 83 MORGUARD CORPORATION CONSOLIDATED FINANCIAL STATEMENTS | DECEMBER 31, 2017
NOTE 20 INTEREST EXPENSE The components of interest expense are as follows:
For the years ended December 31 2017 2016 Interest on mortgages $155,893 $137,787 Interest on bank indebtedness 2,614 3,849 Interest on construction loans 1,249 5,033 Interest on Unsecured Debentures (Note 13) 16,124 6,499 Interest on convertible debentures, net of accretion (Note 14) 21,417 7,030 Interest on loans payable and other 696 182 Amortization of mark-to-market adjustments on mortgages, net (10,640) (12,464) Amortization of deferred financing costs 6,390 5,089 Amortization of cash flow hedge — 189 193,743 153,194 Less: Interest capitalized to properties under development (1,778) (268) $191,965 $152,926
NOTE 21 FAIR VALUE GAIN (LOSS), NET The components of fair value gain (loss) are as follows:
For the years ended December 31 2017 2016 Fair value gain on real estate properties, net $189,121 $25,960 Financial assets (liabilities): Fair value loss on conversion option of MRG convertible debentures (Note 14) (157) (600) Fair value loss on MRG Units (Note 15) (49,066) (77,755) Fair value gain on convertible debenture investments — 601 Total fair value gain (loss), net $139,898 ($51,794)
NOTE 22 OTHER INCOME The components of other income (expense) are as follows:
For the years ended December 31 2017 2016 Foreign exchange gain $2,793 $5,388 Other income 1,092 24,060 $3,885 $29,448
During the three months ended June 30, 2016, the Company entered into a binding agreement with Target Corporation (“Target U.S.”), concluding the terms of settlement related to the guarantees for the five leases that were disclaimed by Target Canada Corporation pursuant to the Companies’ Creditors Arrangement Act. For the year ended December 31, 2016, other income (expense) includes $22,490 in settlement proceeds relating to the release of Target U.S. from the indemnity agreements.
MORGUARD.COM 84 MORGUARD CORPORATION CONSOLIDATED FINANCIAL STATEMENTS | DECEMBER 31, 2017
NOTE 23 RELATED PARTY TRANSACTIONS In addition to the related party transactions disclosed in Notes 9, 11 and 13, related party transactions also include the following:
(a) Paros Enterprises Limited Paros is the majority shareholder and ultimate parent of the Company. Paros is owned by the Company’s Chairman and Chief Executive Officer, Mr. K. Rai Sahi.
The Company entered into a demand loan agreement with Paros that provides for the Company to borrow up to $22,000. The total loan payable outstanding from Paros as at December 31, 2017 was $nil (December 31, 2016 - receivable of $2,314). During the year ended December 31, 2017, the Company incurred interest expense of $62 (2016 - earned interest of $16).
(b) TWC Enterprises Limited (“TWC”) The Company provides TWC with managerial and consulting services for its business and the business of its subsidiaries. Mr. K. Rai Sahi is Chairman and Chief Executive Officer and the majority shareholder of TWC through his personal holding companies, which include Paros. Pursuant to contractual agreements between the Company and TWC, for the year ended December 31, 2017, the Company received a management fee of $836 (2016 - $1,105), and paid rent and operating expenses of $710 (2016 - $978).
The Company has a revolving demand loan agreement with TWC that provides for either party to borrow up to $50,000 at either the prime rate or the bankers’ acceptance rate plus applicable stamping fees. The total loan receivable outstanding as at December 31, 2017 was $11,767 (December 31, 2016 - $47,084). During the year ended December 31, 2017, the Company earned interest of $403 (2016 - $174).
(c) Share/Unit Purchase And Other Loans As at December 31, 2017, share/Unit purchase and other loans to officers and employees of the Company and its subsidiaries of $5,519 (December 31, 2016 - $5,550) are outstanding. The loans are collateralized by their common shares of the Company, Units of Morguard REIT and Units of Morguard Residential REIT and are interest-bearing computed at the Canadian prime interest rate and are due on January 8, 2019. Other loans are secured against the underlying asset. The loans are classified as amounts receivable in the consolidated balance sheets. As at December 31, 2017, the fair market value of the common shares/Units held as collateral is $90,804.
(d) Key Management Compensation Key management personnel are those having authority and responsibility for planning, directing and controlling the activities of the Company, directly or indirectly. The Company’s key management personnel include the Chairman and Chief Executive Officer, President (MIL), Chief Financial Officer, Executive Vice President, Retail Asset Management (MIL), and Executive Vice President, Office/Industrial Asset Management (MIL).
The compensation paid or payable to key management for employee services is shown below:
For the years ended December 31 2017 2016 Salaries and other short-term employee benefits $4,335 $3,954 SARs 1,074 2,591 $5,409 $6,545
MORGUARD.COM 85 MORGUARD CORPORATION CONSOLIDATED FINANCIAL STATEMENTS | DECEMBER 31, 2017
NOTE 24 INCOME TAXES (a) The following are the major components of income tax expenses:
For the years ended December 31 2017 2016 Current income tax expense Based on taxable income of the current year $20,721 $27,054 Adjustments to current income tax estimates 466 664 21,187 27,718 Deferred income tax expense (benefit) Origination and reversal of temporary differences 30,316 81,711 Adjustments to deferred income tax estimates 3,867 (2,024) 34,183 79,687 Income tax expense recorded in the statements of income 55,370 107,405 Deferred income tax expense (other comprehensive income) Actuarial loss (gain) on defined benefit pension plans (283) 6,652 Loss on interest rate swap agreement 177 197 Unrealized foreign currency translation loss (gain) 439 (158) Unrealized loss (gain) on financial instruments and other (3,045) 5,549 Income tax expense (recovery) recorded in the statements of comprehensive income (2,712) 12,240 Total provision for income taxes $52,658 $119,645
(b) The Company’s income tax expense is derived as follows:
For the years ended December 31 2017 2016 Income before income taxes $399,737 $317,329 Statutory rate (%) 26.50 26.50 Income taxes at statutory rate $105,930 $84,092 Capital losses (3,554) 13,908 Non-taxable loss (income) of MRT and MRG, net (10,677) (17,269) Impact of change in foreign tax rates (78,219) — Foreign tax rate differential 12,017 17,847 Change in MRT and MRG ownership 2,519 5,428 Non-recognition of the benefit of tax losses 23,868 2,882 Taxes recognized on business combination — 1,606 Permanent differences 470 512 Adjustments to income tax estimates 4,333 (1,360) State tax on disposition 720 — Other (2,037) (241) $55,370 $107,405
On December 22, 2017, the Tax Cuts and Jobs Act of 2017 was signed into law making significant changes to the Internal Revenue Code. The changes having the most significant impact on the Company’s U.S. subsidiaries include, but are not limited to, a federal tax rate decrease from 35% to 21% effective taxation years beginning after December 31, 2017, the accelerated depreciation of residential real properties, and the limitation of interest expense deduction. The provisional amount related to the re-measurement of certain deferred tax assets and liabilities based on the rates at which they are expected to reverse in the future resulted in a deferred tax recovery of $78,219. The provisional amount attributable to the accelerated depreciation for certain assets placed into services after September 27, 2017, resulted in a reduction of deferred tax asset of $439. The income tax effects of limitation of interest expense deductions commencing 2018 requires further analysis due to the volume of data required to complete the calculations. The Company expects to complete the analysis in the second half of 2018.
MORGUARD.COM 86 MORGUARD CORPORATION CONSOLIDATED FINANCIAL STATEMENTS | DECEMBER 31, 2017
(c) The components of the deferred income tax liabilities are as follows:
December 31, 2017 December 31, 2016 As at Canada U.S. Total Canada U.S. Total Real estate properties $447,793 $148,476 $596,269 $391,739 $173,235 $564,974 Investments (3,083) 20,180 17,097 351 34,009 34,360 Accumulated other comprehensive income 19,097 6,874 25,971 18,252 10,602 28,854 Deferred financing costs 1,072 (107) 965 108 — 108 Pension asset 5,710 — 5,710 5,393 — 5,393 Other 1,095 (223) 872 (2,407) (1,368) (3,775) Total net deferred income tax liabilities $471,684 $175,200 $646,884 $413,436 $216,478 $629,914
(d) The following are the components of the movement in deferred income tax expense:
For the years ended December 31 2017 2016 Real estate properties $43,123 $52,947 Investments (14,640) 28,852 Deferred financing costs 861 (1,480) Pension asset 317 (704) Other 4,522 72 $34,183 $79,687
(e) Reconciliation of the deferred income tax liabilities at the beginning and end of the current financial period is as follows:
2017 2016 Balance as at January 1 $629,914 $538,197 Provision reflected in consolidated statements of income 34,183 79,687 Provision (recovery) reflected in consolidated statements of other comprehensive income (2,712) 12,240 Foreign currency translation (14,501) (2,568) Business combination — 2,358 Balance as at December 31 $646,884 $629,914
(f) The Company’s tax losses are as follows: The Company has U.S. net operating losses of approximately US$80,650 (December 31, 2016 - US$40,432) that expire in various years commencing in 2026, the benefits of which have not been recognized. The Company has other U.S. temporary differences for which no deferred tax assets are recognized of approximately US$410 (December 31, 2016 - US$nil).
As a result of the consolidation of Temple (Note 5), the Company has Canadian net operating losses of approximately $179,377 (December 31 - 2016 - $119,553) that expire in various years commencing in 2030, the benefit of which have not been recognized. The Company has other Canadian temporary differences pertaining to Temple for which no deferred tax asset is recognized for approximately $13,888 (December 31, 2016 - $50,468). These other temporary differences have no expiration date.
(g) Other temporary differences: The temporary differences associated with investments in subsidiaries and joint ventures, for which the deferred tax liability has not been recognized, amount to $209,820 (2016 - $227,111).
MORGUARD.COM 87 MORGUARD CORPORATION CONSOLIDATED FINANCIAL STATEMENTS | DECEMBER 31, 2017
(h) Other: The Company regularly assesses the status of open tax examinations and its historical tax filing positions for the potential for adverse outcomes to determine the adequacy of the provision for income and other taxes. The Company believes that it has adequately provided for any tax adjustments that are more likely than not to occur as a result of ongoing tax examinations or historical filing positions.
NOTE 25 NET INCOME PER COMMON SHARE
For the years ended December 31 2017 2016 Net income attributable to common shareholders $310,120 $172,745 Weighted average number of common shares outstanding (000s) - basic and diluted 11,883 11,943 Net income per common share - basic and diluted $26.10 $14.46
NOTE 26 CONSOLIDATED STATEMENTS OF CASH FLOWS (a) Items Not Affecting Cash
For the years ended December 31 2017 2016 Fair value gain on real estate properties, net ($190,549) ($25,877) Fair value loss on conversion option of MRG convertible debentures (Note 21) 157 600 Fair value gain on convertible debenture investments (Note 21) — (601) Fair value loss on MRG Units (Note 15) 31,697 63,296 Equity loss (income) from investments 10,227 (54,904) Amortization of hotel properties 26,640 4,936 Amortization of capital assets and other 4,228 4,148 Amortization of cash flow hedge (Note 20) — 189 Amortization of deferred financing costs (Note 20) 6,390 5,089 Amortization of mark-to-market adjustments on mortgages, net (Note 20) (10,640) (12,464) Loss on extinguishment of mortgages payable — 142 Amortization of tenant incentive 1,093 1,026 Stepped rent - adjustment for straight-line method (902) (2,606) Deferred income taxes 34,183 79,687 Gain on business combination — (3,778) Accretion of convertible debentures 6,763 (415) Gain on sale of real estate properties — (1,688) Provision for impairment 24,590 — Other (198) (71) ($56,321) $56,709
(b) Net Change in Operating Assets and Liabilities
For the years ended December 31 2017 2016 Amounts receivable ($17,998) $3,014 Prepaid expenses and other (8,061) (11,381) Accounts payable and accrued liabilities 16,849 32,344 Net change in operating assets and liabilities ($9,210) $23,977
MORGUARD.COM 88 MORGUARD CORPORATION CONSOLIDATED FINANCIAL STATEMENTS | DECEMBER 31, 2017
(c) Supplemental Cash Flow Information
For the years ended December 31 2017 2016 Interest paid $172,134 $156,735 Interest received 2,864 764 Income taxes paid 25,217 18,511
During the year ended December 31, 2017, the Company issued non-cash dividends under the distribution reinvestment plan of $148 (2016 - $83).
(d) Reconciliation of Liabilities Arising from Financing Activities The following provides a reconciliation of liabilities arising from financing activities:
Construction Mortgages Unsecured Convertible Financing Bank As at December 31, 2017 payable Debentures Debentures payable Indebtedness Total Balance, beginning of year $3,940,109 $333,638 $397,752 $93,000 $— $4,764,499 Repayments (112,212) — — (93,000) (419,757) (624,969) New financing, net 702,498 198,800 — 36,476 464,765 1,402,539 Lump sum repayments (388,307) — (157,218) — — (545,525) Non-cash changes (6,236) 469 (4,159) — — (9,926) Foreign exchange (79,824) — — — 4,642 (75,182) Balance, end of year $4,056,028 $532,907 $236,375 $36,476 $49,650 $4,911,436
NOTE 27 EMPLOYEE FUTURE BENEFITS The Company maintains a non-contributory defined benefit pension plan covering certain employees under the Morguard Corporation Employee Retirement Plan (the “Morguard Plan”). This plan provides benefits based on length of service and final average earnings. There is only one active member since the majority of members were employed in the Company’s industrial products distribution business, which was sold in 1996. The pension obligations and related assets for the former employees remain part of the Company’s defined benefit pension plan. The most recent actuarial valuation for the Morguard Plan was as at December 31, 2014.
Effective January 1, 2008, the Morguard Plan was amended and restated in its entirety to consist of the existing defined benefit provisions and new defined contribution provisions. Employees who accrued benefits under the Morguard Plan on December 31, 2007, will continue to participate in the defined benefit provisions of the Morguard Plan on and after January 1, 2008, and are not eligible to participate in the new defined contribution provisions. New employees of the Company participate under the defined contribution provisions upon completion of the applicable waiting period effective January 1, 2008.
Morguard Investments Limited Employees’ Retirement Plan (the “MIL Plan”) is a defined benefit plan that provides benefits based on years of service, years of contributions and annual earnings.
Effective January 1, 2008, all members of the MIL Plan ceased to accrue future benefits under the MIL Plan and commenced participation under the new defined contribution provisions of the Morguard Plan. No assets or liabilities will transfer from the MIL Plan to the new Morguard Plan with respect to benefits accrued to December 31, 2007, with respect to MIL Plan members. Accrued benefits under the MIL Plan will be determined using credited service and benefit entitlement as at December 31, 2007.
Membership is a requirement after a defined term of employment and age. Funding of the MIL Plan is provided by contributions from Morguard Investments Limited (“MIL”). Certain employees who commenced employment prior to January 1, 1997, elected to contribute to the MIL Plan and receive a higher benefit. The most recent actuarial valuation for the MIL Plan was as at December 31, 2016.
MORGUARD.COM 89 MORGUARD CORPORATION CONSOLIDATED FINANCIAL STATEMENTS | DECEMBER 31, 2017
The significant actuarial assumptions adopted in measuring the Company’s defined benefit pension plans for the years ended December 31, 2017 and 2016, are as follows:
For the years ended December 31 2017 2016 Morguard MIL Morguard MIL Assumptions for defined benefit pension obligation Discount rate 3.50% 3.50% 3.85% 3.85% Rate of price inflation 1.69% 1.69% 1.80% 1.80% Rate of compensation increase 2.69% 2.69% 2.80% 2.80% Rate of pension increases - pre-retirement — 1.65% — 1.55% Rate of pension increases - post-retirement — 1.65% — 1.55% Assumptions for defined benefit expense Discount rate 3.85% 3.85% 4.05% 4.05% Rate of price inflation 1.80% 1.80% 1.50% 1.50% Rate of compensation increase 2.80% 2.80% 2.50% 2.50% Rate of pension increases - pre-retirement — 1.55% — 1.85% Rate of pension increases - post-retirement — 1.55% — 1.50%
Information about the Company’s defined benefit pension plans is as follows:
As at December 31 2017 2016 Morguard MIL Total Morguard MIL Total Accrued benefit obligations Balance at beginning of year ($59,299) ($39,519) ($98,818) ($60,261) ($37,760) ($98,021) Current service cost (59) — (59) (56) — (56) Interest cost (2,204) (1,501) (3,705) (2,357) (1,508) (3,865) Benefits paid 6,178 1,372 7,550 4,461 1,156 5,617 Changes in: Financial assumptions (1,917) (2,717) (4,634) (1,093) (1,409) (2,502) Experience adjustments 40 1,268 1,308 7 2 9 Balance at end of year ($57,261) ($41,097) ($98,358) ($59,299) ($39,519) ($98,818) Plan assets Fair value at beginning of year $137,820 $43,839 $181,659 $118,849 $36,962 $155,811 Expected return on plan assets 5,173 1,663 6,836 4,674 1,473 6,147 Administration expenses (500) (286) (786) (330) (143) (473) Return on plan assets 1,085 302 1,387 21,406 6,703 28,109 Employer contributions (2,348) — (2,348) (2,318) — (2,318) Benefits paid (6,178) (1,372) (7,550) (4,461) (1,156) (5,617) Balance at end of year $135,052 $44,146 $179,198 $137,820 $43,839 $181,659 Net assets $77,791 $3,049 $80,840 $78,521 $4,320 $82,841
In 2017, Morguard contributed $2,348 to the defined contribution plan (2016 - $2,318).
MORGUARD.COM 90 MORGUARD CORPORATION CONSOLIDATED FINANCIAL STATEMENTS | DECEMBER 31, 2017
Details of the defined benefit expense (income) recorded in the consolidated statements of other comprehensive income for the years ended December 31, 2017 and 2016, are provided below:
For the years ended December 31 2017 2016 Morguard MIL Total Morguard MIL Total Components of defined benefit cost Current service cost $59 $— $59 $56 $— $56 Interest cost 2,204 1,501 3,705 2,357 1,508 3,865 Expected return on plan assets (5,173) (1,663) (6,836) (4,674) (1,473) (6,147) Administrative expenses and taxes 376 175 551 375 175 550 Net benefit plan expense (income) ($2,534) $13 ($2,521) ($1,886) $210 ($1,676)
Details of the defined benefit pension plan recorded in the consolidated statements of other comprehensive income are provided below:
For the years ended December 31 2017 2016 Morguard MIL Total Morguard MIL Total Changes in: Financial assumptions $1,917 $2,717 $4,634 $1,093 $1,409 $2,502 Experience adjustments (40) (1,268) (1,308) (7) (2) (9) Return of plan assets (961) (191) (1,152) (21,451) (6,735) (28,186) Net actuarial loss (gain) on defined benefit pension plans $916 $1,258 $2,174 ($20,365) ($5,328) ($25,693)
Reconciliation of net accrued pension assets for the years ended December 31, 2017 and 2016, is as follows:
For the years ended December 31 2017 2016 Morguard MIL Total Morguard MIL Total Net defined benefit asset, beginning of the year $78,521 $4,320 $82,841 $58,588 ($798) $57,790 Net benefit plan income (expense) 2,534 (13) 2,521 1,886 (210) 1,676 Net actuarial gain (loss) (916) (1,258) (2,174) 20,365 5,328 25,693 Employer contribution (2,348) — (2,348) (2,318) — (2,318) Net defined benefit asset, end of the year $77,791 $3,049 $80,840 $78,521 $4,320 $82,841
Details of the defined benefit obligation by participant status as at December 31, 2017 and 2016, are as follows:
For the years ended December 31 2017 2016 Morguard MIL Total Morguard MIL Total Actives, suspended and long-term disability $15,670 $25,114 $40,784 $15,967 $28,911 $44,878 Vested deferreds 4,364 2,951 7,315 4,501 2,953 7,454 Retirees 37,227 13,032 50,259 38,831 7,655 46,486 Total $57,261 $41,097 $98,358 $59,299 $39,519 $98,818
MORGUARD.COM 91 MORGUARD CORPORATION CONSOLIDATED FINANCIAL STATEMENTS | DECEMBER 31, 2017
The Morguard Plan and the MIL Plan have a sole investment in the Morguard Master Trust Fund (the “Master Trust”), and the assets of the Morguard Plan and the MIL Plan are combined in the Master Trust. The fair value of the investments in the Master Trust is as follows:
For the years ended December 31 2017 2016 Cash and cash equivalents $1,843 $1,170 Fixed-income securities 9,232 13,660 Convertible securities 11,208 16,088 Canadian equities 133,096 127,800 Canadian pooled funds 22,165 21,943 Other 1,654 998 Total investments $179,198 $181,659
The following is a quantitative sensitivity analysis of the impact on the accrued pension benefits obligation as a result of the following changes in the significant pension assumptions:
Increase (Decrease) in Pension Benefit Obligation Year ended December 31, 2017 Morguard MIL Total Discount rate Discount rate -100 basis points $6,377 $7,112 $13,489 Discount rate +100 basis points (5,086) (5,643) (10,729) Pension increase rate Pension increase rate -50 basis points — (3,075) (3,075) Pension increase rate +50 basis points — 3,406 3,406 Mortality Mortality - life expectancy for member age 65 -1 year (2,610) (1,538) (4,148) Mortality - life expectancy for member age 65 +1 year 2,563 1,512 4,075
The following are the expected benefits payments to be made in the next 10 years from the defined benefit plan obligations:
Year ended December 31, 2017 Morguard MIL Total Year 1 $4,035 $1,169 $5,204 Year 2 3,987 1,250 5,237 Year 3 4,068 1,428 5,496 Year 4 3,987 1,506 5,493 Year 5 3,816 1,668 5,484 Next 5 years 18,363 9,451 27,814
The Morguard Plan holds directly 336,618 common shares of the Company and 80,962 Units of Morguard REIT. Net benefit plan income is recorded in property management and corporate expenses.
MORGUARD.COM 92 MORGUARD CORPORATION CONSOLIDATED FINANCIAL STATEMENTS | DECEMBER 31, 2017
NOTE 28 COMMITMENTS AND CONTINGENCIES (a) Commitments Future minimum annual rental payments for land leases, office premises and equipment operating leases that expire at various dates ending in 2113 are payable over the next five years and thereafter as follows:
2018 $16,855 2019 16,084 2020 15,280 2021 14,724 2022 14,305 Thereafter $568,821
The Company is a lessee under eight ground leases that expire at various dates, the latest of which is 2113. Annual rental expenses for each of the ground leases are as follows:
Ground Lease #1 Annual rental expense From July 1, 1990 to June 30, 2010 $2,779 From July 1, 2010 to June 30, 2030 $10,962 (see Note 28(b)) From July 1, 2030 to June 30, 2050 Fair market value of land at June 2030 multiplied by 6% From July 1, 2050 to June 30, 2060 Fair market value of land at June 2050 multiplied by 6%
Ground Lease #2 Annual rental expense From March 1, 2011 to February 28, 2021 $714 From March 1, 2021 to February 28, 2065 Fair market value of land at February 2021 multiplied by 8.5%
Ground Lease #3 Annual rental expense From October 1, 2014 to September 30, 2019 US$300 From October 1, 2019 to September 30, 2024 342 From October 1, 2024 to September 30, 2029 396 The greater of: (i) 1.1 times the rent for the fifteenth lease year (2029) and the last year of each fifth year lease year increment Every 5 years thereafter thereafter until 2113; or (ii) Index Adjustment
The Company has five other ground leases that expire between March 1, 2018 and July 21, 2069. The Company is required to pay an annual base rent totalling $553. In addition, the Company has a commitment to purchase the land of one of the ground leases that expires on May 31, 2022. The purchase price of the land will be based on the market value of the land at the end of the lease term.
The Company has entered into various leasing agreements and contracts for the development of properties. As at December 31, 2017, committed leasing costs, capital and development expenditures are estimated to be $106,563.
(b) Contingencies Ground Lease #1 represents the lease associated with the land underlying a mixed-use property located in Toronto, Ontario. Since the lessor and the Company were not able to reach an agreement on the fair market value of the land on the last scheduled reset date of July 1, 2010, the matter was appointed to an arbitration tribunal (the “Arbitrators”). On June 21, 2013, a majority of the Arbitrators awarded their decision and concluded on a land value that resulted in the annual land rent increasing from $2,779 to $10,962 (the “Majority Decision”). In accordance with the Majority Decision, the Company has recorded the land rent based on the increased annual rent of $10,962.
As indicated above, the Majority Decision for Ground Lease #1 was an annual land rent of $10,962, compared to the decision delivered by the minority of the Arbitrators, which would have resulted in an annual land rent of $3,600. The Company appealed the Majority Decision, and on December 23, 2014, the appeal decision determined that the Majority Decision was to be set aside, and a new arbitration has been ordered in accordance with instructions provided by the court. A further appeal by the landlord was heard in early 2016, which concluded the matter would revert back to the Arbitrators to re-examine certain facts affecting the determination of fair market value of the land.
MORGUARD.COM 93 MORGUARD CORPORATION CONSOLIDATED FINANCIAL STATEMENTS | DECEMBER 31, 2017
The Company will continue to accrue the land rent based on the Majority Decision until the new arbitration decision is issued.
The Company has issued irrevocable letters of credit relating to normal course development activity amounting to $19,252 as at December 31, 2017 (2016 - $18,244).
In addition, the Company is contingently liable with respect to litigation, claims and environmental matters that arise from time to time, including those that could result in mandatory damages or other relief, which could result in significant expenditures. While the final outcome of these matters cannot be predicted with certainty, in the opinion of management, any uninsured liability that may arise from such contingencies would not have a material adverse effect on the financial position or results of operations of the Company. Any settlement of claims in excess of amounts recorded will be charged to operations as and when such determination is made.
(c) Franchise Agreements Under the terms of the franchise agreements expiring through January 31, 2032, annual payments for franchise fees are payable for 23 hotel properties owned by the Company. The franchise fees paid are based on a percentage of revenue and fixed annual fees.
NOTE 29 MANAGEMENT OF CAPITAL The Company defines capital that it manages as the aggregate of its shareholders’ equity, mortgages payable, Unsecured Debentures, convertible debentures, construction financing payable, loans payable, bank indebtedness and finance lease obligation. The Company’s objective when managing capital is to ensure that the Company will continue as a going concern so that it can sustain daily operations and provide adequate returns to its shareholders.
The Company is subject to risks associated with debt financing, including the possibility that existing mortgages may not be refinanced or may not be refinanced on as favourable terms or with interest rates as favourable as those of the existing debt. The Company mitigates these risks by its continued efforts to stagger the maturity profile of its long-term debt, enhance the value of its real estate properties, maintain high occupancy levels and foster excellent relations with its lenders. The Company manages its capital structure and makes adjustments to it in light of changes in economic conditions and the risk characteristics of the underlying assets.
The total managed capital for the Company as at December 31, 2017 and 2016, is summarized below:
As at December 31 2017 2016 Mortgages payable, principal balance $4,056,673 $3,925,657 Unsecured Debentures, principal balance 535,000 335,000 Convertible debentures, principal balance 245,657 412,893 Construction financing payable 36,476 93,000 Bank indebtedness 49,650 — Finance lease obligation 8,970 — Shareholders’ equity 3,082,673 2,862,812 $8,015,099 $7,629,362
The Company monitors its capital structure based on an interest coverage ratio and a debt to gross book value ratio. These ratios are used by the Company to manage an acceptable level of leverage and are calculated in accordance with the terms of the specific agreements with creditors and are not considered measures in accordance with IFRS; nor is there an equivalent IFRS measure.
The Company’s Unsecured Debentures contain covenants that are calculated on a non-consolidated basis, which represents the Company’s consolidated results prepared in accordance with IFRS as shown on the Company’s most recently published annual audited consolidated financial statements, adjusted, as required, to account for the Company’s public entity investments in Morguard Residential REIT, Morguard REIT and Temple using the equity method. The covenants that the Company must maintain are a non-consolidated interest coverage ratio above 1.65 times, a non-consolidated debt to gross book value ratio not to exceed 65% and a minimum non-consolidated equity requirement of at least $300,000. If the Company does not meet these covenants, the Unsecured Debentures will
MORGUARD.COM 94 MORGUARD CORPORATION CONSOLIDATED FINANCIAL STATEMENTS | DECEMBER 31, 2017
become immediately due and payable unless the Company is able to remedy the default or obtain a waiver from lenders. The Company is in compliance with all Unsecured Debenture covenants.
NOTE 30 FINANCIAL INSTRUMENTS AND RISK MANAGEMENT The Company’s financial assets and financial liabilities comprise cash, restricted cash, amounts receivable, mortgages and loans receivable, accounts payable and accrued liabilities, bank indebtedness, construction financing payable, mortgages payable, loans payable, finance lease obligation, Unsecured Debentures and convertible debentures (excluding any conversion option). Fair values of financial assets and financial liabilities and a discussion of risks associated with financial assets and liabilities are presented as follows.
Fair Value of Financial Assets and Financial Liabilities The fair values of cash, restricted cash, amounts receivable, accounts payable and accrued liabilities and bank indebtedness approximate their carrying values due to the short-term maturity of those instruments. The fair values of construction financing payable and mortgages and loans receivable are based on the current market conditions for financing loans with similar terms and risks. The loans payable are reflected at fair value since they are based on a floating interest rate and reflect the terms of current market conditions.
Mortgages payable, Unsecured Debentures, convertible debentures and finance lease obligation are carried at amortized cost using the effective interest method of amortization. The estimated fair values of long-term borrowings have been determined based on market information, where available, or by discounting future payments of interest and principal at estimated interest rates expected to be available to the Company.
The fair value of the mortgages payable has been determined by discounting the cash flows of these financial obligations using December 31, 2017, market rates for debts of similar terms (Level 2). Based on these assumptions, the fair value as at December 31, 2017, of the mortgages payable before deferred financing costs and mark-to-market adjustments is estimated at $4,177,548 (December 31, 2016 - $4,063,448), compared with the carrying value of $4,056,673 (December 31, 2016 - $3,925,657). The fair value of the mortgages payable varies from the carrying value due to fluctuations in interest rates since their issue.
The fair value of the Unsecured Debentures liability is based on its closing bid price (Level 1). As at December 31, 2017, the fair value of the Unsecured Debentures has been estimated at $542,453 (December 31, 2016 - $341,099) compared with the carrying value of $535,000 (December 31, 2016 - $335,000).
The fair value of the convertible debentures liability is based on their market trading prices (Level 1). As at December 31, 2017, the fair value of the convertible debentures before deferred financing costs has been estimated at $248,710 (December 31, 2016 - $406,655), compared with the carrying value of $245,657 (December 31, 2016 - $412,893).
The fair value of the finance lease obligation is determined by discounting the cash flows of the financial obligation using December 31, 2017, market rates for debt on similar terms (Level 2). Based on these assumptions, as at December 31, 2017, the fair value of the finance lease obligation has been estimated at $8,970 (December 31, 2016 - $nil), compared with the carrying value of $8,970 (December 31, 2016 - $nil).
MORGUARD.COM 95 MORGUARD CORPORATION CONSOLIDATED FINANCIAL STATEMENTS | DECEMBER 31, 2017
The fair value hierarchy of financial instruments and real estate properties measured at fair value in the consolidated balance sheets is as follows:
December 31, 2017 December 31, 2016 As at Level 1 Level 2 Level 3 Level 1 Level 2 Level 3 Assets: Real estate properties $— $— $8,655,651 $— $— $7,919,671 Investments in real estate funds — — 93,488 — — 99,828 Financial liabilities: Morguard Residential REIT Units — 365,438 — — 292,304 — Conversion option on MRG convertible debentures — 798 — — 641 — Interest rate swap liability — 161 — — 826 —
Risks Associated with Financial Assets and Financial Liabilities The Company is exposed to financial risks arising from its financial assets and financial liabilities. The financial risks include market risk relating to interest rates and foreign exchange rates, credit risk and liquidity risk. The Company’s overall risk management program focuses on establishing policies to identify and analyze the risks faced by the Company, to set appropriate risk limits and controls and to monitor risks and adherence to limits. Risk management policies and systems are reviewed regularly to reflect changes in market conditions and the Company’s activities. The Company aims to develop a disciplined control environment in which all employees understand their roles and obligations.
(a) Market Risk The risk that the fair value or future cash flows of financial assets or financial liabilities will fluctuate due to movements in market prices includes the effect of interest rate risk and foreign exchange risk.
Interest Rate Risk The Company is subject to the risks associated with debt financing, including the risk that mortgages and credit facilities will not be refinanced on terms as favourable as those of the existing indebtedness. Interest on the Company’s bank indebtedness and certain mortgages is subject to floating interest rates. For the year ended December 31, 2017, the increase or decrease in annual net income for each one percent change in interest rates on floating-rate debt amounts to $1,370.
The Company’s objective in managing interest rate risk is to minimize the volatility of the Company’s income. As at December 31, 2017, interest rate risk has been minimized because the majority of long-term debt is financed at fixed interest rates with maturities scheduled over a number of years. Mortgages payable totalling $239,783 are subject to floating interest rates; however, the Company's risk has been minimized because the Company entered into an interest rate swap transaction on $42,640 to acquire a fixed rate in substitution for the floating rate secured by five hotel properties. The swap matures on June 14, 2018.
Foreign Exchange Risk The Company is exposed to foreign exchange risk as it relates to its U.S. investments due to fluctuations in the exchange rate between the Canadian and United States dollars. Changes in the exchange rate may result in a reduction or an increase of reported earnings and other comprehensive income. For the year ended December 31, 2017, a $0.05 change in the United States to Canadian dollar exchange rate would have resulted in a $5,063 change to net income or loss and a $45,859 change to comprehensive income or loss.
The Company’s objective in managing foreign exchange risk is to mitigate the exposure from fluctuations in the exchange rate by maintaining U.S.-denominated debt against its U.S. assets. The Company currently does not hedge translation exposures.
MORGUARD.COM 96 MORGUARD CORPORATION CONSOLIDATED FINANCIAL STATEMENTS | DECEMBER 31, 2017
(b) Credit Risk Credit risk arises from the possibility that tenants and/or debtors may experience financial difficulty and be unable or unwilling to fulfill their lease commitments. The Company mitigates the risk of loss by investing in well-located properties in urban markets that attract quality tenants, by ensuring that its tenant mix is diversified and by limiting its exposure to any one tenant. A tenant’s success over the term of its lease and its ability to fulfill its obligations are subject to many factors. There can be no assurance that a tenant will be able to fulfill all of its existing commitments and leases up to the expiry date.
The Company’s commercial leases typically have lease terms between five and 10 years and may include clauses to enable periodic upward revision of the rental rates and contractual extensions at the option of the lessee.
Future minimum rentals under non-cancellable tenant operating leases are as follows:
As at December 31 2017 2016 Not later than one year $291,228 $280,394 Later than one year and not longer than five years 827,546 811,708 Later than five years 570,009 604,916 $1,688,783 $1,697,018
The objective in managing credit risk is to mitigate exposure through the use of approved credit policies governing the Company’s credit practices that limit transactions according to counterparties’ credit quality.
The carrying amount of amounts receivable is reduced through the use of an allowance account, and the amount of the loss is recognized in the consolidated statements of income within property operating expenses. When a receivable balance is considered uncollectible, it is written off against the allowance for doubtful accounts. Subsequent recoveries of amounts previously written off are credited against operating expenses in the consolidated statements of income.
The following table sets forth details of trade receivables and the related allowance for doubtful accounts:
As at December 31 2017 2016 Trade receivables $20,520 $14,782 Less: Allowance for doubtful accounts (2,560) (2,083) Trade receivables, net $17,960 $12,699
(c) Liquidity Risk Liquidity risk is the risk the Company will encounter difficulties in meeting its financial liability obligations. The Company will be subject to the risks associated with debt financing, including the risk that mortgages and credit facilities will not be able to be refinanced. The Company’s objectives in minimizing liquidity risk are to maintain appropriate levels of leverage on its real estate assets and to stagger the debt maturity profile. As at December 31, 2017, the Company was holding cash of $134,450 and had undrawn lines of credit available to it of $284,302.
The fair value of the interest rate swap for the year ended December 31, 2017, is a loss position of $161 (2016 - $826), which is included in accounts payable and accrued liabilities in the consolidated balance sheets. Included in OCI for the year ended December 31, 2017, is a loss net of deferred taxes of $508 (2016 - $537); deferred taxes amount to $157 (2016 - $197), which relates to the effective portion of the net change in fair value of the interest rate swaps.
MORGUARD.COM 97 MORGUARD CORPORATION CONSOLIDATED FINANCIAL STATEMENTS | DECEMBER 31, 2017
NOTE 31 SEGMENTED INFORMATION (a) Operating Segments The Company has the following five reportable segments after aggregation: (i) multi-suite residential, (ii) retail, (iii) office, (iv) industrial, and (v) hotel. The Company has applied judgment by aggregating its operating segments according to the nature of the property operations. Such judgment considers the nature of operations, types of customers and an expectation that operating segments within a reportable segment have similar long-term economic characteristics.
The following summary presents certain financial information regarding the Company’s operating segments:
Multi-suite For the year ended December 31, 2017 Residential Retail Office Industrial Hotel Total Revenue from real estate/hotel properties $322,128 $243,029 $215,808 $9,570 $237,116 $1,027,651 Property/hotel operating expenses 136,152 106,008 92,632 3,278 175,714 513,784 Net operating income $185,976 $137,021 $123,176 $6,292 $61,402 $513,867
Multi-suite For the year ended December 31, 2016 Residential Retail Office Industrial Hotel Total Revenue from real estate/hotel properties $305,477 $247,150 $212,571 $10,548 $66,567 $842,313 Property/hotel operating expenses 136,041 105,627 91,624 3,528 52,095 388,915 Net operating income $169,436 $141,523 $120,947 $7,020 $14,472 $453,398
Multi-suite Residential Retail Office Industrial Hotel Total As at December 31, 2017 Real estate/hotel properties $3,963,689 $2,569,501 $2,008,604 $113,857 $669,026 $9,324,677 Mortgages payable $1,932,701 $886,267 $786,527 $11,272 $439,261 $4,056,028 For the year ended December 31, 2017 Additions to real estate/hotel properties $571,899 $81,676 $133,614 $1,807 $23,912 $812,908 Fair value gain (loss) on real estate properties $225,924 ($23,868) ($13,454) $1,476 $— $190,078
Multi-suite Residential Retail Office Industrial Hotel Total As at December 31, 2016 Real estate/hotel properties $3,381,984 $2,539,394 $1,887,717 $110,576 $705,663 $8,625,334 Mortgages payable $1,620,450 $1,020,980 $808,715 $21,926 $468,038 $3,940,109 For the year ended December 31, 2016 Additions to real estate/hotel properties $104,800 $51,718 $23,983 $876 $595,039 $776,416 Fair value gain (loss) on real estate properties $67,388 ($14,608) ($30,858) $4,038 $— $25,960
MORGUARD.COM 98 MORGUARD CORPORATION CONSOLIDATED FINANCIAL STATEMENTS | DECEMBER 31, 2017
(b) Regional Segments The following summary presents financial information by the regions in which the Company operates:
As at December 31 2017 2016 Real estate and hotel properties Canada $6,790,801 $6,450,280 United States 2,533,876 2,175,054 $9,324,677 $8,625,334
For the years ended December 31 2017 2016 Revenue from real estate and hotel properties Canada $809,463 $627,732 United States 218,188 214,581 $1,027,651 $842,313
NOTE 32 SUBSEQUENT EVENTS Subsequent to December 31, 2017, the Company acquired 1,119,660 Units of Morguard REIT for cash consideration of $15,773.
Subsequent to December 31, 2017, the Company acquired 364,243 shares under NCIB for cash consideration of $65,659.
On January 9, 2018, the Company purchased a Class A industrial property located in Ottawa, Ontario, for a purchase price of $42,500, excluding closing costs.
On February 5, 2018, the Company purchased an office property located in Mississauga, Ontario, for a purchase price of $50,600, excluding closing cost.
On February 13, 2018, Morguard Residential REIT completed a public offering of convertible unsecured subordinated debentures on a bought deal basis, of $85,500 (including an over-allotment, $81,500 excluding principal owned by the Company) aggregate principal amount of 4.50% convertible unsecured subordinated debentures due March 31, 2023 (the “4.50% Debentures”). The 4.50% Debentures are convertible, at the option of the holder, into Units at $20.20 per Unit.
The Company will use the net proceeds from the offering to fund the redemption of all of the Company’s outstanding 4.65% convertible unsecured subordinated debentures on February 26, 2018, which mature on March 30, 2018 and which have a par call date of April 1, 2017. The Company intends to use the remainder of the net proceeds, if any, to fund future acquisitions, for debt repayment and for general trust purposes.
MORGUARD.COM 99