TrizecHahn finds the key to unlocking shareholder value in converting to a REIT

Sears Tower, Chicago

The end justifies the means. At least that’s what TrizecHahn Corporation hopes as it undergoes a complex restructuring to extract its U.S. assets from a Canadian-domiciled corporation and spin them off into a U.S. REIT. Propelling the reorganization is a single clear-cut goal: to unlock and enhance shareholder value previously constrained by a C-corporation structure and Canadian headquarters, says president and chief executive officer Christopher Mackenzie, who was hired specifically to guide the company through its restructuring.

The company has struggled to gain the respect of investors under its current structure but expects its transformation to change all that. TrizecHahn executives see numerous advantages for the company and its shareholders by divesting itself of non-core holdings and focusing on its core U.S. office business, which represents approximately 92 percent of the company’s rental income. The restructuring will simplify the ownership framework, decrease operating expenses, bring its corporate structure in line with U.S. peers and enhance market recognition of the value of its core U.S. office business.

Allen Center, Huston

Renaissance Tower, Dallas

Mackenzie says that over the past decade TrizecHahn has accumulated one of the most attractive office portfolios in the U.S., and is now positioned as one of the largest owner/operators of U.S. office properties. “It makes absolute sense for us to become a REIT, in parallel with our peers in this industry,” asserts Mackenzie. “From a strategic as well as tax efficiency perspective, this reorganization is the right thing to do.”

TrizecHahn’s portfolio consists of 76 U.S. office properties totaling 49 million square feet concentrated in the central business districts of seven major cities. TrizecHahn’s U.S. ownership and management interests include the Sears Tower, Watergate Office Building, The Grace Building, One New York Plaza, Allen Center, Ernst & Young Plaza and Renaissance Tower. The company also owns several retail/entertainment properties in the U.S. and Europe, a global technology center business and several Canadian properties. The company’s FFO for the nine months ended Sept. 30, 2001, were $246.9 million or $1.64 per diluted share and rental income for the same period totaled $154.6 million on total revenues of $277.7 million. FFO per diluted share for the quarter ended Sept. 30, 2001, was $0.58 on a GAAP basis and $0.53 excluding straight-line rents. In 2001, the company adopted the straight-line method of rental revenue recognition and straight-line building depreciation on a retroactive basis, with restatement of prior periods.

Financial Implications of Spin-off Plan

A summation of TrizecHahn’s restructuring plan is as follows: Most, if not all, of its U.S. shareholders (about 60 percent of TrizecHahn, or roughly 90 million shares) will have direct ownership in the new REIT. Most, if not all, other shareholders (about 40 percent, or 60 million shares, held primarily by Canadian investors) will own shares in a publicly traded Canadian company called Canco, which will trade on the Toronto Stock Exchange. U.S. shareholders will exchange their TrizecHahn shares for shares of the REIT, which will trade on the New York Stock Exchange. All other shareholders will exchange their existing TrizecHahn shares for shares of Canco, on a 1:1 basis. The REIT and Canco intend to pay equal dividends. Proceeds from the monetization of other assets—including TrizecHahn’s equity stake in Global Switch, a carrier-neutral, tele-housing and facilities management company with properties around the world—will be held by Canco and split equally between Canco and the REIT shareholders.

TrizecHahn’s U.S. retail/entertainment properties will also be rolled into the new REIT, but each would be divested at an optimal time.

Lee Schalop, a real estate analyst with Banc of America Securities, explains that only about 60 percent of the new REIT will be spun off initially so that a special kind of capital gains tax related to non-U.S. holders payable under the Foreign Investment in Real Estate Property Tax Act (FIRPTA) is not triggered. As a result, the amount the REIT distributes directly to U.S. shareholders will not be subject to withholding tax.

Through the use of international treaties and structures, though subject to periodic review, TrizecHahn has managed the withholding tax rate down to an unusually low 10 percent rate.

“The one downside is that the exchange of existing TrizecHahn stock for the new REIT shares is considered a sale and purchase for tax purposes,” Schalop notes. “As a result, taxable shareholders with an unrealized gain will be subject to capital gains tax on the difference between the value of TrizecHahn REIT shares and their basis in their current holdings of TrizecHahn.”

Schalop says that because TrizecHahn currently is structured as a C-corporation, not a REIT, its dividend yield is lower than those of comparable real estate companies, since the company historically has opted to reinvest most of its cash flow. However, when TrizecHahn’s dividend policy changes to conform with REIT rules, which mandate at least 90 percent of taxable income be paid out as dividends, the company expects to increase its dividend to $1.75 per share in 2003, up from a current annual dividend of $0.35 per share, which will remain unchanged until 2003, the first full year of REIT operation.

The Right Move

Grace Building, New York

Watergate, Washington, D.C.

In general, the analyst community seems to be responding favorably to TrizecHahn’s decision. Schalop says he is impressed with TrizecHahn’s commitment to focus on its core office portfolio and with management activities over recent months. “As a result, Banc of America Securities rates TrizecHahn a ‘buy,’ based on the stock’s attractive valuation and the anticipated short and long-term benefits of the company’s restructuring,” he says. “In addition, we believe TrizecHahn will be able to mitigate the costs involved in spinning off the U.S. REIT. Our 12-month target price of $21 is based on our 2002 FAD estimate of $1.99 per share and a target multiple of 10.6x, in line with the current average for the company’s peer group of large-cap office stocks.”

Merrill Lynch & Co. agrees, giving TrizecHahn an ‘accumulate’ rating. Merrill Lynch feels the rating verifies that the company has proposed “a very significant reorganization that should ultimately eliminate a future tax liability ($400 million, the FIRPTA tax on the sale of foreign-owned assets payable to the U.S.), increase reported results through the elimination of substantial withholding taxes, and provide an investment vehicle more similar to its peers,” according to Steve Sakwa, senior real estate analyst with Merrill Lynch’s Global Securities Research & Economics Group.

Sakwa says TrizecHahn’s challenges will relate more to its existing portfolio than to the complicated restructuring plans. He says, for example, that following the September 11 World Trade Center tragedy, there is potential for some tenants to relocate from the high-profile Sears Tower in Chicago. In addition, he notes that TrizecHahn’s Desert Passage project is attached to the Aladdin Hotel in Las Vegas, which is now in bankruptcy.

Mackenzie’s outlook on these issues is brighter. He says the Sears Tower remains 96 percent occupied, and that only 35,000 square feet of the 3 million-square foot property will be rolling over next year. “We are taking all reasonable measures to ensure the safety and well being of our customers, working to make them and their employees feel safe and comfortable, and have not had any indication from tenants that they wish to go elsewhere,” he states.

The Aladdin’s change in management is “a positive development for us,” asserts Mackenzie. “We look forward to the Aladdin being taken over by a home-grown professional and experienced casino operator from Las Vegas,” he says, adding that his company has no direct financial stake in the Aladdin, merely a physical connection. Mackenzie adds that when Desert Passage, as well as TrizecHahn’s Paseo Colorado project in Pasadena, CA, and its Hollywood & Highland project in Los Angeles, independently are completed and stable, each retail/entertainment project would be sold.

As for the core concerns prevalent in the U.S. office market following September 11, Mackenzie says, “Probably the most exciting aspect of our pending arrival on the REIT market is that TrizecHahn will be one of the few U.S. office REITs with an inherent growth capacity at a time when the real estate sector most likely will be flat. Compared to our peers, we will be creating excitement and opportunities that otherwise will be hard to find.” He says the company’s major challenge–wrestling with multi–jurisdiction tax treaties–is now behind them.

Helping to generate that shareholder excitement are three specific opportunities in which value will be unlocked under the new REIT structure, Mackenzie says. “First, our in-place rents currently are 37 percent below market rents. Even in a flat market we still have a great opportunity to grow,” he explains. “Second, share prices are trading at a 30 percent discount to net asset value, so there is a tremendous upside potential. Third, we have relatively high operating costs, but by applying Six Sigma Quality initiatives, now in progress, we will streamline processes and improve customer service while eliminating unnecessary bureaucracy and costs.”

The Six Sigma Quality business strategy is a targeted measurement for near perfect execution of a process, using reduction of variations and robust design as methods for improvement. Already adopted by companies like Motorola, General Electric and Allied Signal to reach and maintain dominant market positions, the Six Sigma Quality program at TrizecHahn focuses on providing world-class levels of excellence to its customers and delivering sustainable bottom line growth.

Looking Ahead

Over time, the portfolio held by the new TrizecHahn REIT will be repositioned to concentrate on fewer markets in order to increase the REIT’s relative market share of key submarkets. This concentration will also allow the REIT to reduce operating and G&A costs, thereby extracting further profit growth for shareholders.

Mackenzie says he expects investors to select his newly restructured company over peer real estate stocks for several reasons, including better growth prospects and better management. “We also have diversification across seven core, high-growth cities without being so diversified as to simply grow with the nationwide average,” he says. Nor is TrizecHahn so concentrated as to suffer with a downturn in any specific market, he maintains, noting that current investors have been pleased with and supportive of TrizecHahn’s strategic plans.

“In fact, our restructuring will make TrizecHahn attractive to two groups of investors not currently part of our shareholder base: One, institutions that invest purely in REITs; and two, with our significantly increased dividend, we will now be very attractive to a number of retail investors,” Mackenzie says.

Significant organizational changes accompany TrizecHahn’s forward-looking plan. To improve its focus on operations and financial performance, the company has realigned and simplified its management structure, including changes in executive responsibilities, a substantial reduction of the corporate development function and the elimination of several senior management positions. Certain functions will be centralized in TrizecHahn’s Chicago office to improve efficiency.

Peter Munk, founder and chairman of TrizecHahn Corporation, will serve as chairman of the new REIT. Munk stepped down as CEO in early 2001 and handed the reigns to Mackenzie. Mackenzie was brought in from his role as partner in Clayton, Dubilier & Rice, a leading private equity partnership in New York and London. Prior to that position, Mackenzie was the CEO and president of GE Capital Europe. Mackenzie brought in his former chief financial offer with GE Capital, Greg Hanson, to take on that role with TrizecHahn.

Where will TrizecHahn be in 10 years under its REIT structure, as opposed to remaining a Canadian-based operating company? Says Mackenzie, “We will be a highly focused U.S. office business which will have participated in and benefited from the consolidation that will have taken place in the U.S. real estate industry within 10 years.” He asserts that TrizecHahn could not have benefited from this consolidation without first restructuring itself as a REIT.