H&R REIT
Annual Report 2011

Plain-text annual report

H&R Real Estate Investment Trust and H&R Finance Trust 2011 Annual Report Including Combined MD&A and Financial Statements        The Bow, Calgary            Two Gotham Center, NYC    Hess Tower, Houston           Atrium on Bay, Toronto                  H&R Profile H&R Real Estate Investment Trust (“H&R REIT”) is an open-ended real estate investment trust, which owns and manages a North American portfolio of 289 office, industrial and retail properties comprising over 43 million square feet, and three development projects, with a total net book value of $7.6 billion at December 31, 2011. H&R Finance Trust is an unincorporated investment trust, which primarily invests in notes issued by a subsidiary of H&R REIT. The units of H&R REIT trade together with the units of H&R Finance Trust as “stapled units” on the Toronto Stock Exchange listed under the symbol HR.UN. In this annual report, we refer to the combination of these two trusts as “H&R” or “the Trusts”. Additional information regarding H&R REIT and H&R Finance Trust is available at www.hr-reit.com and on www.sedar.com. Property Operating Income * by Geographic Region Other 8% Quebec 7% Alberta 15% Ontario, 47% United States 23% Property Operating Income * by Type of Asset Retail 25% Industrial 29% Office 46% * Property operating income is before interest, depreciation and amortization for the year ended December 31, 2011. Primary Objectives H&R strives to achieve two primary objectives: to provide unitholders with stable and growing cash distributions generated by revenues derived from a diversified portfolio of income properties, and to maximize the value of units through active management of H&R’s assets, acquisition of additional properties, and development of new projects which are pre-leased to creditworthy tenants. We are committed to maximizing returns to unitholders while maintaining prudent risk management and conservative use of financial leverage. Stability and Growth through Discipline Since inception in 1996, H&R has executed a disciplined and proven strategy that has provided stable cash flow and adjusted funds from operations. We achieve our primary objectives and mitigate risks through long-term property leasing and financing, combined with conservative management of assets and liabilities.     2011 Highlights • Maintained portfolio occupancy rate at virtually 100% for the 15th consecutive year • Invested $1.4 billion in the acquisition of 11 properties, which were partially funded with mortgages totalling $831 million with a weighted average term to maturity of 9.6 years and a weighted average interest rate of 4.8% per annum. Three of these acquisitions were full ownership interests in Atrium on Bay in Toronto ($345M), Two Gotham Center in New York City (US $416M) and Hess Tower in Houston (US $443M). Invested $349 million in properties under development, including $329 million for construction of The Bow office complex in Calgary • • Raised $867 million of funding, primarily by issuing 23 million units ($512M) and debentures ($355M) • Increased distributions per stapled unit by 24%, while H&R’s unit price rose 20% Average term to maturity of leases (years) Average term to maturity of mortgages payable (years) Gross leasable area (millions of sq.ft.) Portfolio occupancy rate Rentals from investment properties (millions) Net income/(loss) (millions) Funds from operations (millions) (2) FFO per Stapled Unit (basic) Adjusted funds from operations (millions) (2) AFFO per Stapled Unit (basic) Cash provided by operations (millions) Cash distributions paid (millions) (3) Distributions per Stapled Unit Payout ratio per Stapled Unit (distributions/AFFO) Assets (billions) Debt as percent of gross book value of assets (4) Equity market capitalization (billions) 2011 11.0 7.7 43.1 99.1% $657 ($25) $272 $1.70 $237 $1.49 $405 $119 $0.98 66% $7.6 51% $4.0 2010 (1) 11.1 8.0 39.1 98.9% $617 $497 $215 $1.43 $217 $1.45 $400 $104 $0.79 55% $6.0 48% $2.8 (1) 2010 numbers have been adjusted to reflect International Financial Reporting Standards (2) Readers are encouraged to review, in H&R’s MD&A, reconciliations of: net income (loss) to FFO; FFO to AFFO; and AFFO to cash provided by operations. (3) Cash distributions paid exclude distributions reinvested in units pursuant to H&R’s unitholder distribution reinvestment plan and include the distributions paid to the Class B Limited Partnership unitholders who can exchange their units for Stapled Units. (4) Calculated in accordance with the REIT's Declaration of Trust First Quarter 2012 Highlights • Received a non-recourse U.S. mortgage for US $250 million for Hess Tower in Houston, bearing interest at a rate of 4.5% per annum for an 8-year term; refinanced three U.S. mortgages totalling US $73 million with new non-recourse U.S. mortgages totalling $61 million, each bearing interest at a rate of 4.5% per annum for a 10-year term; and refinanced ten Canadian mortgages totalling $29 million in total with new mortgages totalling $63 million, each bearing interest at a rate of 4.0% per annum for a 10-year term • Purchased a 485,000 square foot, state-of-the-art office building located in Toronto for $186 million before transaction costs and leased for 20 years to Corus Entertainment Inc.; secured a non-recourse $60-million, interest-only mortgage with an interest rate at a spread of 2.3% over the 20-year Government of Canada bond, for a term of 20 years, and secured a $37-million, non-recourse, first mortgage on a pari passu basis for a term and rate to be determined President’s Message to Unitholders Over the past 12 months, commercial property owners in Canada have enjoyed continuing high occupancy rates and steady rental rates, in addition to increased availability of low-cost debt capital throughout North America. This allowed H&R REIT to produce solid financial results and to significantly grow its property portfolio. We foresee a continuation of these favourable market conditions boding well for the REIT in 2012 and beyond. 2011 Financial Results For the 15th year since inception, H&R executed its conservative strategy of pursuing stability and growth through discipline. Cash distributions to unitholders increased 24%. As equity and debt market conditions further improved, we continued to acquire and develop high-quality properties on an accretive basis and reduced the REIT’s financing costs. Our capital investments were partly financed by issuing 23 million stapled units at a weighted average price of $22.36 and $355 million of convertible and senior debentures at a weighted average interest rate of 4.75%. The price of H&R’s Stapled Unit closed at $23.26 in 2011, increasing 20% compared to 15% for the S&P/TSX Capped Real Estate Index and a decline of 11% for the Composite Index. Including capital gain and distributions, the overall return on investment to our unitholders was 25% last year and a compound average annual return of approximately 15% since inception in 1996. Strategic Investments Over the past 12 months, we have invested approximately $1.2 billion in three acquisitions that have become hallmarks of H&R’s property portfolio and will bolster our stable and growing income stream for decades to come. These investments significantly increased our first-class office holdings in thriving urban markets. They also signalled to the North American real estate industry that the REIT is a resourceful and competitive buyer and developer of top-quality commercial properties. The two U.S. acquisitions also increased the geographic diversification of H&R’s sources of income. Atrium on Bay, Toronto Atrium on Bay comprises approximately 915,000 square feet of Class A office space and 136,000 square feet of prime retail premises. Our acquisition of this prestigious downtown complex for $345 million represented Canada’s single largest commercial property transaction in 2011. We assumed a $190- million mortgage maturing in 2017. The property has direct underground access to the subway and to the underground pedestrian PATH. The premises are 99% occupied, and we are projecting a substantial increase in net operating income as tenant leases roll over. The property also has excess density and structural capacity for potential expansion of the office space by an additional 200,000 square feet. Two Gotham Center, New York City This new 22-storey, Class A office tower is located in the borough of Queens, across the East River from mid-town Manhattan. It comprises approximately 661,000 rentable square feet of office space, which is 100% leased to the highly creditworthy New York City Department of Health and Mental Hygiene. The lease has an initial term of 20 years, and includes contracted rental escalations of approximately 10% every five years. Last year, the tenant began enjoying awesome views of America’s largest city, and working only minutes from a major transportation hub with six subway lines, excellent bus service and easy access to the nearby Queensboro Bridge, the Long Island Expressway, and the Long Island Railroad Station. The building’s green technology will provide low operating costs and has obtained a LEED Gold certification for Core and Shell. We purchased the property for US$415.5 million and partly financed it with a US$250-million mortgage at 4.25% for 10 years. The new tower is the first building of Gotham Center – a two-block development which, once completed, will comprise about 3.5 million square feet of new office, retail, parking and residential development. Hess Tower, Houston Completed in June 2011, this property comprises a 29-storey tower offering approximately 845,000 rentable square feet of superior office space connected by a sky bridge to its adjacent 1,430-space parking garage. Hess Tower is fully leased on a triple-net basis to Hess Corporation, a global, Fortune 100, integrated energy company listed on the NYSE. The tower is part of Houston’s Pedestrian Tunnel System that connects 77 major downtown office buildings to an abundance of upscale restaurants, retail stores, and world-class hotels, sports and entertainment destinations. Overlooking the recently completed Discovery Green Park, the Hess Tower is one of the downtown’s most energy efficient office buildings, having achieved the LEED Platinum certification for Core and Shell – the U.S. Green Building Council’s highest rating. We purchased this state-of-the-art office tower for US $442.5 million and partly financed it with a US $250-million mortgage at 4.5% for eight years. The Bow, Calgary The Bow is a world-class, approximately two-million square foot downtown office complex, fully leased to EnCana Corporation on a triple-net basis for a term of 25 years. EnCana is a leading North American natural gas producer and one of Canada’s largest public companies. With our development substantially finished, tenants will begin taking occupancy in the second quarter of this year and we expect the new premises to be fully occupied by the fourth quarter. The Class AAA skyscraper is an iconic landmark in Calgary’s financial district. The Bow – the largest Canadian office tower west of Toronto, with a striking design that crowns Calgary’s skyline – will be the keystone of our property portfolio. In addition to featuring three sky gardens and an energy-efficient design, the tower is integrated with the city’s elevated pedestrian walkway and rail and bus transit system. At December 31, 2011, H&R REIT had invested approximately $1.5 billion in the 58-storey project (excluding capitalized interest costs). The annualized year-one net income from The Bow is expected to be approximately $93.5 million, and rental rates will increase 0.75% per annum on the office space and 1.5% per annum on the parking space during the lease. We have also made an application to the City of Calgary to amend the approved development permit on the South Block to allow additional office and ancillary retail uses. Outlook There continues to be strong demand from investors for REITs with potential for rising distributions and capital gains. Commercial real estate experts have a fairly good outlook for office, industrial and retail property markets in 2012. Steady economic growth and historically-low interest rates are forecast for both Canada and United States. However, occupancy rates are projected to remain higher in Canada, whereas U.S. property prices continue to be significantly lower than they were before the financial crisis in 2008. The availability of high-quality commercial assets for sale is expected to remain relatively limited, but our competitive position to bid for them is now stronger. We have a well capitalized balance sheet, attractive borrowing costs, and both significant experience and a vast presence in North American real estate markets. However, we will continue to acquire properties only in a very selective and disciplined manner – when we have in place long-term leases with highly creditworthy tenants and cost-effective, long-term, fixed-rate financing. This year, we expect to see H&R’s strong, diversified portfolio perform well and continuing growth in profitability from both contractual rental escalations and accretive acquisitions. We are therefore very optimistic about our opportunities for growth and ability to prosper. With highly predictable cash flow, we intend to increase annualized distributions this year, from $1.15 per stapled unit in the second quarter to $1.25 in the fourth quarter. Our management team wishes to thank H&R’s investors, trustees and employees for their trust and commitment to our success over the past year. With your continued support, we look forward to further achieving stability and growth through discipline. President and Chief Executive Officer March 28, 2012 COMBINED MANAGEMENT’S DISCUSSION AND ANALYSIS OF H&R REAL ESTATE INVESTMENT TRUST AND H&R FINANCE TRUST For the Year ended December 31, 2011 Dated: March 12, 2012 TABLE OF CONTENTS SECTION I Basis of Presentation Forward-Looking Disclaimer Non-GAAP Financial Measures Overview Financial Highlights Key Performance Drivers Portfolio Overview Outlook Adoption of International Financial Reporting Standards SECTION II Selected Annual Information Discussion of Operations Segmented Information Assets Liabilities Equity 1 1 2 2 4 4 5 7 8 10 11 18 19 23 25 Funds from Operations Adjusted Funds from Operations Liquidity and Capital Resources Off-Balance Sheet Items Financial Instruments and Other Instruments SECTION III Summary of Quarterly Results SECTION IV Critical Accounting Estimates Disclosure Controls and Procedures Internal Control over Financial Reporting SECTION V Risks and Uncertainties Outstanding Unit Data Subsequent Events Additional Information 26 29 32 34 35 36 36 38 38 38 43 43 43 H&R REIT AND H&R FINANCE TRUST - MD&A – December 31, 2011 SECTION I BASIS OF PRESENTATION Financial data included in this Management’s Discussion and Analysis (“MD&A”) of combined results of operations and combined financial position of H&R Real Estate Investment Trust (the “REIT”) and H&R Finance Trust (“Finance Trust” and together with the REIT, the “Trusts”) for the year ended December 31, 2011 includes material information up to March 12, 2012. Financial data provided has been prepared in accordance with International Financial Reporting Standards (“IFRS”) as issued by the International Accounting Standards Board (“IASB”). The MD&A should be read in conjunction with the Combined Financial Statements and appended notes for the years ended December 31, 2011 and 2010. All amounts in this MD&A are in thousands of Canadian dollars, except where otherwise stated. Historical results, including trends which might appear, should not be taken as indicative of future operations or results. Certain prior period items have been reclassified to conform with the presentation adopted in the current period. FORWARD-LOOKING DISCLAIMER Certain information in this MD&A contains forward-looking information within the meaning of applicable securities laws (also known as forward-looking statements) including, among others, statements made or implied under the headings “Discussion of Operations”, “Liquidity and Capital Resources”, “Outlook” and “Risks and Uncertainties” relating to the Trusts’ objectives, strategies to achieve those objectives, the Trusts’ beliefs, plans, estimates, projections and intentions, and similar statements concerning anticipated future events, results, circumstances, performance or expectations that are not historical facts including, in particular, the Trusts’ expectation regarding future development in connection with the Bow. Forward-looking statements generally can be identified by words such as “outlook”, “objective”, “may”, “will”, “expect”, “intend”, “estimate”, “anticipate”, “believe”, “should”, “plans”, “project”, “budget” or “continue” or similar expressions suggesting future outcomes or events. Such forward-looking statements reflect the Trusts’ current beliefs and are based on information currently available to management. Forward-looking statements are provided for the purpose of presenting information about management’s current expectations and plans relating to the future and readers are cautioned that such statements may not be appropriate for other purposes. These statements are not guarantees of future performance and are based on the Trusts’ estimates and assumptions that are subject to risks and uncertainties, including those described below under “Risks and Uncertainties” and those discussed in the Trusts’ materials filed with the Canadian securities regulatory authorities from time to time, which could cause the actual results and performance of the Trusts to differ materially from the forward-looking statements contained in this MD&A. Those risks and uncertainties include, among other things, risks related to: credit risk and tenant concentration; lease rollover risk; interest and financing risk; financing credit risk; currency risk; tax risk; environmental risk; development and financing risk relating to the Bow development; construction risks; debentures; availability of cash for distributions; unit prices, ability to access capital markets, dilution; redemption right; and risks relating to unitholder liability. Material factors or assumptions that were applied in drawing a conclusion or making an estimate set out in the forward-looking statements include that the general economy is stable; local real estate conditions are stable; interest rates are relatively stable; and equity and debt markets continue to provide access to capital. The Trusts caution that this list of factors is not exhaustive. Although the forward-looking statements contained in this MD&A are based upon what the Trusts believe are reasonable assumptions, there can be no assurance that actual results will be consistent with these forward-looking statements. Readers are also urged to examine the REIT and Finance Trust’s materials filed with the Canadian securities regulatory authorities from time to time as they may contain discussions on risks and uncertainties which could cause the actual results and performance of the REIT and Finance Trust to differ materially from the forward-looking statements contained in this MD&A. Neither Finance Trust nor any of its trustees or officers, assumes any responsibility for the completeness of the information contained in the REIT’s materials filed with the Canadian securities regulatory authorities or for any failure of the REIT or its trustees or officers to disclose events or facts which may have occurred or which may affect the significance or accuracy of any such information. Neither the REIT nor any of its trustees or officers, assumes any responsibility for the completeness of the information contained in Finance Trust’s materials filed with the Canadian securities regulatory authorities or for any failure of Finance Trust or its trustees or officers to disclose events or facts which may have occurred or which may affect the significance or accuracy of any such information. All forward-looking statements in this MD&A are qualified by these cautionary statements. These forward-looking statements are made as of March 12, 2012 and the Trusts, except as required by applicable law, assume no obligation to update or revise them to reflect new information or the occurrence of future events or circumstances. Page 1 of 43 H&R REIT AND H&R FINANCE TRUST - MD&A – December 31, 2011 NON-GAAP FINANCIAL MEASURES Property operating income, same-asset property operating income, funds from operations (“FFO”), adjusted funds from operations (“AFFO”) and gross book value (“GBV”) are all supplemental financial measures used by management to track the Trusts’ performance. Such measures are not recognized under GAAP and therefore do not have standardized meanings prescribed by GAAP. Management believes that these non-GAAP financial measures are a meaningful measure of operating performance as they reject the assumption that the value of real estate investments diminishes predictably over time. These non-GAAP financial measures should not be construed as alternatives to comparable financial measures calculated in accordance with GAAP. Further, the Trusts’ method of calculating such supplemental financial measures may differ from the methods of other real estate investment trusts or other issuers and accordingly, such supplemental financial measures used by management may not be comparable to similar measures presented by other real estate investment trusts or other issuers. See “Funds from Operations” and “Adjusted Funds from Operations” for a reconciliation of GAAP measures to non-GAAP measures. OVERVIEW The REIT is an unincorporated open-ended trust created by a Declaration of Trust and governed by the laws of the Province of Ontario. Unitholders are entitled to have their REIT units comprising part of the Stapled Units redeemed at any time on demand payable in cash (subject to monthly limits) and/or in specie, provided that the corresponding Finance Trust units are being contemporaneously redeemed. Finance Trust is an unincorporated investment trust. Finance Trust was established pursuant to a Plan of Arrangement (the “Plan of Arrangement”) on October 1, 2008, as described in the REIT’s information circular dated August 20, 2008, as an open-ended limited purpose unit trust pursuant to its Declaration of Trust. Each issued and outstanding Finance Trust unit is “stapled” to a unit of the REIT on a one-for-one basis such that Finance Trust units and the REIT units trade together as stapled units (“Stapled Units”), and such Stapled Units are listed and posted for trading on the Toronto Stock Exchange (“TSX”). Apart from provisions necessary to achieve such stapling, each REIT unit and Finance Trust unit retains its own separate identity and is separately listed (but not posted for trading) on the TSX (unless there is an event of uncoupling, in which case Finance Trust units will cease to be listed on the TSX). The REIT has two primary objectives: (cid:131) to provide unitholders with stable and growing cash distributions, generated by the revenue it derives from investments in income producing real estate properties; and (cid:131) to maximize unit value through ongoing active management of the REIT’s assets, acquisition of additional properties and the development and construction of projects which are pre-leased to creditworthy tenants. The REIT’s strategy to accomplish these two objectives is to accumulate a diversified portfolio of high quality income producing properties in Canada and the United States occupied by creditworthy tenants on a long-term basis. The REIT does not have any specific allocation targets as to property type, but rather focuses on creditworthy tenants with long-term leases. The primary purpose of Finance Trust is to be a flow-through vehicle to allow the REIT to indirectly access the capital markets in a tax-efficient manner by indirectly borrowing money from the REIT’s unitholders. Finance Trust’s primary activity is to hold debt issued by H&R REIT (U.S.) Holdings Inc. (“U.S. Holdco”), a wholly owned U.S. subsidiary of the REIT. As at December 31, 2011, Finance Trust holds U.S. $142.8 million of aggregate principal amount of notes payable by U.S. Holdco (“U.S. Holdco Notes”). Subject to cash flow requirements, Finance Trust intends to distribute to its unitholders, who are also unitholders of the REIT, all of its cash flow, consisting primarily of interest paid by U.S. Holdco, less administrative and other expenses and amounts to satisfy liabilities. Mechanics of “Stapling” the Units of Finance Trust and the REIT Pursuant to the provisions of the Declarations of Trust for Finance Trust and the REIT at all times each REIT unit must be ‘‘stapled’’ to a Finance Trust unit (and each Finance Trust unit must be ‘‘stapled’’ to a REIT unit) unless there is an “event of uncoupling” (as described below). As part of the Plan of Arrangement, the REIT and Finance Trust entered into a support agreement (the “Support Agreement”) which provided, among other things, for the co-ordination of the declaration and payment of all distributions so as to provide for simultaneous record dates and payment dates; for co-ordination so as to permit the REIT to perform its obligations pursuant to the REIT’s Declaration of Trust, Unit Option Plan, Distribution Reinvestment Plan and Unit Purchase Plan (“DRIP”) and Unitholder Rights Plan; for Finance Trust to take all such actions and do all such things as are necessary or desirable to enable and permit the REIT to perform its obligations arising under any security issued by the REIT (including securities convertible, exercisable Page 2 of 43 H&R REIT AND H&R FINANCE TRUST - MD&A – December 31, 2011 or exchangeable into Stapled Units); for Finance Trust to take all such actions and do all such things as are necessary or desirable to enable the REIT to perform its obligations or exercise its rights under its convertible debentures; and for Finance Trust to take all such actions and do all such things as are necessary or desirable to issue Finance Trust units simultaneously (or as close to simultaneously as possible) with the issue of REIT units and to otherwise ensure at all times that each holder of a particular number of REIT units holds an equal number of Finance Trust units, including participating in and cooperating with any public or private distribution of Stapled Units by, among other things, executing prospectuses or other offering documents. In the event that the REIT issues additional REIT units, pursuant to the Support Agreement, the REIT and Finance Trust will coordinate so as to ensure that each subscriber receives both REIT units and Finance Trust units, which shall trade together as Stapled Units. Prior to such event, the REIT shall provide notice to Finance Trust to cause Finance Trust to issue and deliver the requisite number of Finance Trust units to be received by and issued to, or to the order of, each subscriber as the REIT directs. In consideration of the issuance and delivery of each such Finance Trust unit, the REIT (solely as agent for and on behalf of the purchaser) or the purchaser, as the case may be, shall pay (or arrange for the payment of) a purchase price equal to the fair market value (as determined by Finance Trust in consultation with the REIT) of each such Finance Trust unit at the time of such issuance. The remainder of the subscription price for Stapled Units shall be allocated to the issuance of REIT units by the REIT. The proceeds received by Finance Trust from any such issuance shall be invested in additional notes of the same series as the U.S. Holdco Notes or distributed to unitholders of Finance Trust. An event of uncoupling (“Event of Uncoupling”) shall occur only: (a) in the event that unitholders of the REIT vote in favour of the uncoupling of units of Finance Trust and units of the REIT such that the two securities will trade separately; or (b) at the sole discretion of the trustees, but only in the event of the bankruptcy, insolvency, winding-up or reorganization (under an applicable law relating to insolvency) of the REIT or U.S. Holdco or the taking of corporate action by the REIT or U.S. Holdco in furtherance of any such action or the admitting in writing by the REIT or U.S. Holdco of its inability to pay its debts generally as they become due. Investment Restrictions Under Finance Trust’s Declaration of Trust, the assets of Finance Trust may be invested only in: (a) U.S. Holdco Notes; and (b) temporary investments in cash, term deposits with a Canadian chartered bank or trust company registered under the laws of a province of Canada, short-term government debt securities, or money market instruments (including banker’s acceptances) of, or guaranteed by, a Schedule 1 Canadian bank (“Cash Equivalents”), but only if each of the following conditions are satisfied: (a) if the Cash Equivalents have a maturity date, the trustees hold them until maturity; (b) the Cash Equivalents are required to fund expenses of Finance Trust, a redemption of units, or distributions to unitholders, in each case before the next distribution date; and (c) the purpose of holding the Cash Equivalents is to prevent funds from being non-productive, and not to take advantage of market fluctuations. Finance Trust’s Declaration of Trust provides that Finance Trust shall not make any investment, take any action or omit to take any action which would result in the units of Finance Trust not being considered units of a ‘‘mutual fund trust’’ for purposes of the Income Tax Act (Canada) (the “Tax Act”) or that would disqualify Finance Trust as a “fixed investment trust” under the Internal Revenue Code of 1986 as amended (the “Code”) and the applicable regulations. In order to qualify as a ‘‘fixed investment trust’’ under the Code, Finance Trust generally may not acquire assets other than the U.S. Holdco Notes or certain investments in cash or cash equivalents. Page 3 of 43 H&R REIT AND H&R FINANCE TRUST - MD&A – December 31, 2011 FINANCIAL HIGHLIGHTS (in thousands of Canadian dollars except per unit amounts) Total assets Debt to gross book value of assets (per the REIT’s Declaration of Trust) Debt to gross book value of assets (per the combined financial statements) Debt to fair market value of assets (per the combined financial statements) Stapled Units outstanding Exchangeable units of H&R Limited Partnership outstanding * The 2010 ratios have been restated for IFRS Property rental revenue Property operating income Adjusted funds from operations (“AFFO”) Weighted average number of basic Stapled Units for AFFO AFFO per basic Stapled Unit Distributions paid per Stapled Unit Payout ratio per unit as a % of basic AFFO December 31, 2011 December 31, 2010* $7,637,801 50.5% 57.6% 53.6% 172,554 5,438 $5,998,640 47.8% 56.0% 52.7% 146,121 5,438 Three months ended December 31, 2011 Three months ended December 31, 2010 $178,174 118,203 60,192 167,691 0.36 0.26 72.2% $160,700 105,038 55,361 150,624 0.37 0.22 59.5% Net income (loss) is reconciled to FFO which is reconciled to AFFO. AFFO is reconciled to cash provided by operations, being the most comparable GAAP measure to these non-GAAP financial measures. See pages 26-31. KEY PERFORMANCE DRIVERS OPERATIONS Occupancy as at December 31(1) Occupancy – same asset as at December 31(2) Average contractual rent per square foot for the three months ended December 31(3) Office Industrial Retail 2011 2010 2011 2010 2011 2010 99.1% 99.2% 99.0% 99.3% $21.74 $19.66 98.9% 98.3% 98.9% 98.5% $5.73 $5.70 99.9% 100.0% 99.9% 99.9% $13.15 $12.82 Total* 99.1% 98.9% 99.1% 98.9% $11.24 $10.17 * (1) (2) (3) weighted average total Excluding properties where tenants have filed for protection under Chapter 11 of the United States Bankruptcy Code and where the REIT has subsequently handed over control of the subject properties to the non-recourse mortgage lenders. Same asset refers to those properties owned by the REIT for the entire 2-year period ended December 31, 2011 and excludes properties sold and assets where tenants have filed for protection under Chapter 11 of the United States Bankruptcy Code, and where the REIT has subsequently handed over control of the subject properties to the non-recourse mortgage lender. For all properties excluding those properties that are held for sale or sold and where tenants have filed for protection under Chapter 11 of the United States Bankruptcy Code, and where the REIT has subsequently handed over control of the subject properties to the non-recourse mortgage lender. Average remaining term to maturity of leases (years) Average remaining term to maturity of mortgages payable (years) December 31, 2011 December 31, 2010 11.0 7.7 11.1 8.0 Page 4 of 43 H&R REIT AND H&R FINANCE TRUST - MD&A – December 31, 2011 PORTFOLIO OVERVIEW The geographic diversification of the REIT’s portfolio (excluding properties where tenants have filed for protection under Chapter 11 of the United States Bankruptcy Code and where the REIT has subsequently handed over control of the property to the non-recourse mortgage lenders) as at December 31, 2011 is outlined in the charts below: NUMBER OF PROPERTIES Office Industrial Retail Total Ontario 23 49 32 104 United States 7 17 88 112 Alberta 4 19 5 28 Quebec 1 12 5 18 Square Feet (in thousands) Ontario United States Alberta Quebec Office Industrial Retail Total 6,124 9,252 1,895 17,271 2,024 7,352 5,128 14,504 1,406 2,810 515 4,731 452 2,978 498 3,928 Other 4 20 3 27 Other 884 1,280 524 2,688 Total 39 117 133 289 Total 10,890 23,672 8,560 43,122 PROPERTIES UNDER DEVELOPMENT (in thousands of Canadian dollars) Project The Bow Heart Lake Airport Road Address 5th Ave. at Centre Street, Calgary, AB Mayfield West Business Park, Caledon, ON 7900 Airport Rd., Brampton, ON December 31, 2011 $1,479,117 87,954 49,986 $1,617,057 December 31, 2010 $1,150,094 80,195 38,042 $1,268,331 MORTGAGES PAYABLE 2012 Periodic Amortized Principal ($000’s) $112,778 Principal on Maturity ($000’s) $266,290 Total Principal ($000’s) $379,068 % of Total Principal 12.1% Weighted Average Interest Rate on Maturity 6.7% 2013 2014 2015 2016 Thereafter 110,077 113,398 113,200 110,610 108,147 182,632 235,938 291,260 Mortgages payable due on demand (net of financing cost of $152)(1) Financing cost and mark-to-market adjustment arising on acquisitions(2) Total 7.4% 6.2% 5.3% 5.4% 7.0% 9.4% 11.1% 12.8% 47.6% 100% 218,224 296,030 349,138 401,870 1,493,401 3,137,731 20,675 5,187 $3,163,593 (1) Relates to the two non-recourse mortgages to the REIT for investment properties in which the tenant (Great Atlantic & Pacific Tea Company) has filed for protection under Chapter 11 of the United States Bankruptcy Code. The REIT expects to be released from any further obligations under these non-recourse mortgages upon the transfer of title to the lenders. (2) Mark-to-market adjustment represents the difference between the actual mortgages assumed on property acquisitions and the fair value of the mortgages at the date of purchase and is recognized in finance cost over the life of the applicable mortgage using the effective interest rate method. Financing costs are deducted from the REIT’s mortgages payable balances and are recognized in finance cost over the life of the applicable mortgage. Page 5 of 43 H&R REIT AND H&R FINANCE TRUST - MD&A – December 31, 2011 TOP TWENTY SOURCES OF REVENUE BY TENANT Tenant Bell Canada TransCanada Pipelines Limited Telus Communications Hess Corporation Bell Mobility New York City Department of Health Rona Inc. Canadian Tire Corp. Versacold Logistics Canada Inc. Royal Bank of Canada Canadian Imperial Bank of Commerce Lowes Companies Inc. Ontario Realty Corporation and other Ontario Agencies(2) Nestle USA Nestle Canada Inc. Public Works of Canada Shell Oil Products Purolator Courier Finning International Marsh Supermarkets Total % of rentals from income properties(1) Number of locations REIT owned sq.ft. (in 000’s) Average lease term to maturity (in years) 9.7 6.0 4.8 4.5 4.4 3.9 3.1 2.7 2.7 2.6 2.3 1.8 1.7 1.6 1.5 1.5 1.4 1.4 1.3 1.2 4 2 2 1 2 1 14 4 12 4 7 11 1 3 1 3 18 12 16 9 1,734 950 943 845 775 670 2,151 2,189 1,733 477 512 1,435 347 2,168 170 300 249 1,071 893 548 60.1% 127 20,160 13.8 9.3 11.4 (3) 13.9 18.9 8.1 14.3 15.4 4.7 3.1 7.2 4.6 5.9 7.7 4.9 10.5 10.4 10.3 14.9 The percentage of rentals from investment properties is based on estimated annualized gross revenue excluding the straight-lining of contractual rent and investment properties held for sale. Other Ontario agencies include: Legal Aid Ontario, Ontario Lottery and Gaming Corporation, Liquor Control Board of Ontario, and Hydro One Networks. Due to the confidentiality under the tenant lease, the term is not disclosed. 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. (1) (2) (3) Office Industrial Retail Total LEASE EXPIRIES % of sq.ft. Rent per sq.ft. ($) on expiry Rent per sq.ft. ($) on expiry % of sq.ft. Rent per sq.ft. ($) on expiry % of sq.ft. Rent per sq.ft. ($) on expiry % of sq.ft. 2012 2013 2014 2015 2016 0.6 1.3 1.6 1.0 2.2 6.7 18.22 17.60 16.80 22.31 18.58 18.49 1.3 3.5 3.2 1.6 5.1 14.7 5.63 5.35 4.52 6.35 3.93 4.81 0.1 0.4 0.4 0.3 0.3 1.5 32.70 11.80 15.00 27.10 19.60 18.67 2.0 5.2 5.2 2.9 7.6 22.9 10.76 8.91 9.10 14.00 8.79 9.72 Page 6 of 43 H&R REIT AND H&R FINANCE TRUST - MD&A – December 31, 2011 OUTLOOK With limited new construction underway, shrinking vacancies and rising rents, the fundamentals for Canadian real estate are promising. These factors together with the low interest rate environment and easy access to capital markets continue to compress capitalization rates lower. In the United States, the recovery in the commercial real estate and capital markets has been much slower, resulting in higher capitalization rates as compared to equivalent Canadian properties. During 2011, the REIT acquired 11 properties in Canada and the United States for a total of $1.40 billion at an average capitalization rate of 6.4%. The three largest properties purchased were: (i) a multi-tenant office retail complex in downtown Toronto known as Atrium on Bay for $344.8 million at a capitalization rate of 6.48%; (ii) a recently completed Class A LEED Gold office tower in Long Island City, New York, for U.S. $415.5 million at a capitalization rate of 5.9%, fully leased to the City of New York for a term of 20 years; (iii) a recently completed LEED Platinum office tower in Houston, Texas for U.S. $442.5 million at a capitalization rate of 6.6%, fully leased to Hess Corporation on a long term lease. The REIT partially funded the 2011 acquisitions with mortgages totalling $830.8 million. The weighted average term of these mortgages is 9.6 years and the weighted average interest rate is 4.8% per annum. To date in 2012, the REIT has purchased a 485,000 square foot state-of-the-art LEED Gold office building in downtown Toronto for $186.0 million at a capitalization rate of 6.4% leased for 20 years to Corus Entertainment Inc. The REIT expects to continue making acquisitions on a very select and disciplined basis. The low interest rate environment is expected to benefit the REIT which has $266.3 million of mortgages maturing in 2012 at a weighted average interest rate of 6.7% per annum. Subsequent to year end, the REIT has refinanced mortgages due in 2012 totalling $101.1 million which had an average interest rate of 6.5% per annum with new 10-year mortgages totalling $123.9 million at an average interest rate of 4.2% per annum. In addition, in July 2012 the REIT intends to redeem the 2013 convertible debentures and the 2014 convertible debentures which bear interest at 6.65% and 6.75%, respectively. As these convertible debentures are currently in the money, the REIT expects to convert them into equity thereby improving the REIT’s overall leverage ratios. EnCana Corporation is expected to take occupancy of floors 3 to 22 in the Bow on April 2, 2012. Occupancy of further tranches will occur throughout 2012. Once full occupancy is reached, the building will be generating $93.5 million of net operating income on an annualized basis. Management remains very optimistic and excited about the REIT’s ability to continue to grow and prosper in the coming year. Consistent with this positive outlook, the Trusts’ trustees have adopted the following distribution policy: Distribution Period Q1 2012 (January, February and March) Q2 2012 (April, May and June) Q3 2012 (July, August and September) Q4 2012 (October, November and December) Intended Monthly Distribution Per Stapled Unit Intended Annualized Distribution Per Stapled Unit $0.09167 $0.09583 $0.10000 $0.10417 $1.10 $1.15 $1.20 $1.25 The Trusts’ trustees retain the right to re-evaluate the distribution policy from time to time as they consider appropriate. As all distributions remain subject to approval and declaration by the Trusts’ trustees, there is no assurance that the actual distributions declared will be as provided in the distribution policy. 2011’s total return (including distributions) to unitholders was 25%. Page 7 of 43 H&R REIT AND H&R FINANCE TRUST - MD&A – December 31, 2011 ADOPTION OF INTERNATIONAL FINANCIAL REPORTING STANDARDS The Canadian Accounting Standards Board (“AcSB”) has mandated the adoption of IFRS effective for interim and annual periods beginning on or after January 1, 2011 for Canadian publicly accountable profit-oriented enterprises. As a result, the Trusts have adopted IFRS effective January 1, 2010 (the “transition date”) and have prepared the current combined financial statements in accordance with IFRS accounting policies. Furthermore, these are the first annual combined financial statements that comply with IFRS. The Trusts’ combined financial performance and financial position as disclosed under IFRS use a framework similar to the one applied under previous Canadian generally accepted accounting principles (”Canadian GAAP”), however, there are significant differences relating to measurement, recognition and disclosure. Refer to the December 31, 2011 combined financial statements for the effect of the REIT’s transition to IFRS for the January 1, 2010 and December 31, 2010 periods. Key changes between previous Canadian GAAP and IFRS: For the actual quantitative effect of the changes below, please refer to note 3 of the financial statements. The significant IFRS differences that had an impact on the Trusts’ financial statements include the following: (a) Investment properties The REIT has elected to apply the fair value as deemed cost for certain properties as at January 1, 2010 and the cost model for subsequent accounting for its investment properties. The carrying values of these selected properties were adjusted to their fair market value at the transition date. Any adjustment to the carrying value at the transition date is reflected as an adjustment in investment properties and an offsetting adjustment to retained earnings. (b) Foreign currency translation election In accordance with IFRS 1, First-time Adoption of International Finance Reporting Standards (“IFRS 1”), the REIT has elected to deem all foreign currency translation differences that arose prior to the date of transition in respect of all foreign operations to be nil at January 1, 2010, with the balance reclassified to retained earnings. The only effect of this is a restatement within the accounts of the unitholders’ equity. (c) Business combination election In accordance with IFRS 1, the REIT has elected to apply the business combination accounting standard prospectively to all business combinations subsequent to the January 1, 2010 transition date. (d) Impairment of investment properties Previous Canadian GAAP generally uses a two-step approach to impairment testing: first comparing asset carrying values with undiscounted future cash flows to determine whether impairment exists, and then measuring impairment by comparing asset carrying values to their fair value (which is calculated using discounted cash flows). IAS 36, Impairment of Assets uses a one-step approach for testing and measuring impairment, with asset carrying values compared directly with the higher of fair value less costs to sell and value in use (which uses discounted cash flows). This resulted in write-downs where the carrying value of assets were previously supported under previous Canadian GAAP on an undiscounted cash flow basis, but could not be supported on a discounted cash flow basis. Unlike previous Canadian GAAP, which does not permit reversals, IFRS allow for the reversal of an impairment loss in prior periods for an asset if there has been a change in the estimates used to determine the assets recoverable amounts since the last impairment loss was recognized. (e) Accrued rent receivable Under IFRS and previous Canadian GAAP, rental revenue is recognized on a straight-line basis over the term of the lease, resulting in accruals for rents that are not billable or due until future years. Under IFRS, the accrued rent receivable amount resulting from straight-lining rent is determined from the inception of each lease or the date the REIT assumed the lease. Under previous Canadian GAAP only leases in place from January 1, 2004 were straight-lined. Page 8 of 43 H&R REIT AND H&R FINANCE TRUST - MD&A – December 31, 2011 (f) Convertible debentures Under IFRS, the REIT has elected to measure its outstanding convertible debentures at fair value. At each period end, the fair value of these convertible debentures is measured based on the ask price of each series of convertible debentures. The fluctuation in the fair value between each period, is charged to gain (loss) in changes in fair values in comprehensive income. Under previous Canadian GAAP, convertible debentures were bifurcated into a liability component, net of issue costs, and an equity component, which represents the holders’ option to convert the convertible debentures into Stapled Units. Interest expense was recorded as a charge to income using an effective rate representing the coupon rate and the effective rate being credited to the debt component of the convertible debentures such that, at maturity, the debt component was equal to the face value of the then outstanding convertible debentures. (g) Unit-based compensation Under IFRS, the REIT is required to measure its cash-settled unit-based option plan at fair value and record a liability. The fluctuation in the fair value between each period is charged to trust expenses in comprehensive income over the relevant vesting period. Under previous Canadian GAAP, the REIT expensed and charged to equity the cost of unit-based compensation over the weighted average vesting period. (h) Class B LP Units (previously non-controlling interest) Under IAS 32, Financial Instruments: Presentation (“IAS 32”), the Class B LP Units of H&R Portfolio Limited Partnership (“HRLP”) are considered puttable instruments and are classified as financial liabilities in the combined financial statements. At each period end, the fair value of these units is measured based on the ask price of Stapled Units. The fluctuation in the fair value is charged to comprehensive income and distributions on the Class B LP Units of HRLP are reflected as a component of finance costs in earnings. Under previous Canadian GAAP, non-controlling interest was presented as a separate item between liabilities and unitholders’ equity in the statement of financial position, and the non-controlling interest’s share of income and other comprehensive income was deducted in calculating net income and comprehensive income of the REIT. (i) Discontinued operations The definition of discontinued operations under IFRS is more restrictive than under previous Canadian GAAP. Only disposals of significant operations, such as a major line of business or geographical area of operation, meet the IFRS requirements to present the results as discontinued operations. Discontinued operations in the financial statements as presented pursuant to previous Canadian GAAP have been reclassified to continuing operations on the IFRS financial statements, as they do not meet the IFRS definition of discontinued operations. This did not affect unitholders’ equity on transition. (j) Net loss on foreign exchange The foreign exchange gain (loss) recorded in net income as a result of exchanging Finance Trust’s U.S. dollar note receivable from U.S. Holdco is not eliminated on combination as U.S. Holdco is a U.S. denominated foreign operation of the REIT, which results in the foreign exchange on the note payable being reported in accumulated other comprehensive income. Under IFRS, the extension option embedded in the note receivable between the REIT and Finance Trust meets the definition of a loan commitment and is no longer treated as a derivative. (k) Rent amortization of above- and below-market rents Under previous Canadian GAAP, the purchase price of an acquired property was recorded in several components, including an intangible assets and liabilities for above- and below-market leases. These assets/liabilities were amortized against revenue over the life of the underlying leases. Under IFRS, these assets/liabilities are amortized and recognized in amortization and impairment expense. (l) Deferred tax Under both IFRS and previous Canadian GAAP, deferred income taxes are recorded for the temporary differences arising in respect of assets and liabilities for the periods when the REIT did not meet the REIT conditions. This is determined at the tax rates that are expected to apply to the period when the asset is realized or the liability is settled. Under previous Page 9 of 43 H&R REIT AND H&R FINANCE TRUST - MD&A – December 31, 2011 Canadian GAAP, future distributions were factored into the tax rate applied. Under IFRS, the tax rate applied to determine the deferred income liability on January 1, 2010 and December 31, 2010 was 46.41%, the applicable tax rate excluding future distributions. The deferred income tax liability was reversed during the quarter ended June 30, 2010 when the REIT met the REIT conditions. (m) Income earned and property operating costs incurred during construction of the Bow Approximately $30.1 million of rental income is expected to be received from EnCana Corporation prior to practical completion of the building. Under previous Canadian GAAP, this rental income was recorded as a reduction to the cost of the project. Under IFRS, income earned during the construction of the property will not reduce the cost to construct the Bow, but will rather be included in rentals from income properties which will cause a corresponding increase to the cost of the project. These figures assume all occupancies occur on time. (n) REIT units Under IAS 32, puttable instruments such as the REIT units, are generally classified as financial liabilities unless, the exemption criteria are met for equity classification. As a result of the REIT receiving consent of its unitholders to modify the REIT’s Declaration of Trust to eliminate the mandatory distribution and leave distributions to the discretion of the trustees and the ability of the trustees to fund its distributions by way of issuing additional units prior to the amendment, the REIT met the exemption criteria under IAS 32 for equity classification. Nevertheless, the REIT units are not considered ordinary units under IAS 33, Earnings Per Share, and therefore an income (loss) per unit calculation is not presented. SECTION II SELECTED ANNUAL INFORMATION The following table summarizes certain financial information of the Trusts for the years indicated below: (in thousands of Canadian dollars except per unit amounts) Year Ended December 31, 2011(1) Year Ended December 31, 2010(1) Year Ended December 31, 2009(1) Rentals from investment properties $656,911 $617,427 $605,165 Finance income Net income (loss) Comprehensive income (loss) Total assets Mortgages payable Debentures payable Cash distributions per unit 1,051 (25,277) (22,681) 7,637,801 3,163,593 1,370,917 $0.98 2,589 496,600 490,438 5,998,640 2,706,707 965,828 $0.79 6,222 86,525 75,348 5,351,123 2,818,476 565,758 $0.72 (1) 2009 figures are based on previous Canadian GAAP, prior to change over to IFRS. The 2010 and 2011 figures are based on IFRS. For a discussion on the above changes between the 2011 and 2010 figures, please see pages 11 to 25. For a discussion of the changes between 2010 and 2009, please see the 2010 MD&A. Page 10 of 43 H&R REIT AND H&R FINANCE TRUST - MD&A – December 31, 2011 DISCUSSION OF OPERATIONS Three months ended December 31 Year ended December 31 (in thousands of Canadian dollars) Property operating income: 2011 2010 % Change 2011 2010 % Change Rentals from investment properties $178,174 $160,700 11 $656,911 $617,427 Property operating costs (59,971) (55,662) 8 (219,997) (204,386) Finance costs: Finance income 118,203 105,038 13 436,914 413,041 239 265 (10) 1,051 2,589 Finance cost - operations (49,551) (42,686) 16 (181,012) (174,120) 6 8 6 (59) 4 Gain (loss) on extinguishment of debt 158 (332) (148) 19,726 (21,538) (192) Gain (loss) on change in fair value (69,191) 10,617 (752) (108,378) (83,282) (118,345) (32,136) 268 (268,613) (276,351) Amortization and impairment (48,940) (5,356) 814 (181,757) (77,429) Trust expenses (5,463) (2,344) 133 (15,366) (14,554) Gain (loss) on sale of investment properties Transaction costs on issuance of convertible debentures (26) (2,813) (40) - (35) 3,260 3,576 - (2,813) (4,535) Net gain (loss) on foreign exchange (3,881) (4,469) (13) 3,383 (6,828) Net income (loss) before income taxes (61,265) 60,693 (201) (24,992) 36,920 Income tax recovery (expense) (73) (45) (285) 459,680 Net income (loss) (61,338) 60,648 (25,277) 496,600 30 (3) 135 6 (9) (38) (150) (168) Other comprehensive income (loss): Unrealized gain (loss) on translation of U.S. denominated foreign operations Transfer of realized loss on cash flow hedges to net income Deferred income taxes (7,153) (4,955) 2,211 (7,449) 98 - 94 - 385 - 372 915 (7,055) (4,861) 2,596 (6,162) Total comprehensive income (loss) attributable to unitholders ($68,393) $55,787 ($22,681) $490,438 The change in net income (loss) for both the three months and year ended December 31, 2011 as compared to the respective 2010 periods is mainly due to the income tax recovery in 2010, the gain (loss) on extinguishment of debt, the gain (loss) on change in fair value and the change in amortization and impairment expense. Rentals from Investment Properties Rentals from investment properties (“rentals”) include all amounts earned from tenants related to lease agreements, including basic rent, parking income, operating cost recoveries and realty tax recoveries. Page 11 of 43 H&R REIT AND H&R FINANCE TRUST - MD&A – December 31, 2011 Rentals from Investment Properties Three months ended December 31 Year ended December 31 (in thousands of Canadian dollars) 2011 2010 Change 2011 2010 Same-asset – current rentals $152,972 $153,057 ($85) $600,039 $598,195 Change $1,844 Same-asset – straight-lining of contractual rent (1,942) 4,157 (6,099) (2,572) 8,959 (11,531) Same-asset rent amortization of tenant inducements Acquisitions – current rentals, rent amortization of tenant inducements Acquisitions - straight-lining of contractual rent Terminated leases due to U.S. bankruptcies Properties sold Total rentals (278) (236) (42) (1,028) (938) (90) 26,027 2,762 23,265 56,370 1,398 37 (40) 12 77 871 1,386 (40) (911) 2,535 144 1,423 6,266 41 2,193 2,711 50,104 2,494 (2,049) (1,288) $178,174 $160,700 $17,474 $656,911 $617,427 $39,484 The decrease in same-asset current rentals of $0.1 million for Q4 2011 as compared to Q4 2010 is primarily due to the following items: (cid:131) (cid:131) (cid:131) (cid:131) (cid:131) a net increase of $2.3 million in rentals; a decrease of $1.1 million due to one-time rent blend and extend adjustments; lower tenant recoveries of $3.9 million which resulted from lower regular property operating expenses; an increase of $2.3 million in additional rent recoverable from tenants in accordance with their leases for items which were capitalized to building improvements; and an increase of $0.6 million due to the strengthening of the U.S. dollar, offset by the cash settlement of the forward exchange contracts. The average exchange rate for the three months ended December 31, 2011 was Canadian $1.02 for each U.S. $1.00 (Q4 2010 - $1.00). The increase in same-asset current rentals of $1.8 million for the year ended December 31, 2011 as compared to the same 2010 period is primarily due to the following items: (cid:131) (cid:131) (cid:131) (cid:131) (cid:131) (cid:131) a net increase of $8.1 million in rentals; a decrease of $1.6 million due to one-time rent blend and extend adjustments; a decrease of $0.8 million due to $1.5 million of sundry income and lease termination payments in 2011 compared to $2.3 million occurring in 2010; higher tenant recoveries of $1.4 million which resulted from higher regular property operating expenses; a decrease of $3.1 million in additional rent recoverable from tenants in accordance with their leases for items which were capitalized to building improvements; and a decrease of $2.2 million due to the weakening of the U.S. dollar, offset by the cash settlement of the forward exchange contracts. The average exchange rate for the year ended December 31, 2011 was Canadian $0.99 for each U.S. $1.00 (December 31, 2010 - $1.03). The decrease of $6.1 million in the same-asset straight-lining of contractual rent for Q4 2011 as compared to Q4 2010 includes a one-time smoothing adjustment to a Canadian property of $0.9 million in Q4 2011 and a one-time smoothing adjustment to a U.S. property of $2.4 million in Q4 2010. Without these one-time adjustments, straight-lining of contractual rent for the three months ended December 31, 2011 and 2010 would have been ($1.0 million) and $1.7 million, respectively, and ($1.7 million) and $6.6 million for the year ended December 31, 2011 and 2010. Page 12 of 43 H&R REIT AND H&R FINANCE TRUST - MD&A – December 31, 2011 Rentals from acquisitions including current rentals, rent amortization and straight-lining of contractual rent increased by $24.7 million in Q4 2011 compared to Q4 2010 and $52.6 million for the year ended December 31, 2011 as compared to the respective 2010 period. The increase is primarily due to the 27 property acquisitions between January 1, 2010 and December 31, 2011. Property Operating Costs For Q4 2011, realty taxes, maintenance, utilities and property management fees represented 48.9%, 31.3%, 9.1% and 6.1%, respectively, of total property operating costs (Q4 2010 - 46.9%, 31.2%, 11.3% and 6.0%). For the year ended December 31, 2011, these costs represented 51.2% 26.9%, 12.3%, and 5.7%, respectively, of total property operating costs (December 31, 2010 - 51.6%, 25.8%, 12.3% and 6.0%). Maintenance includes costs relating to such items as cleaning, interior and exterior building repairs and maintenance, elevator, HVAC, security and wages and benefits. Property Operating Costs (in thousands of Canadian dollars) Same-asset property operating costs Acquisitions Terminated leases due to U.S. bankruptcies Properties sold Three months ended December 31 Year ended December 31 2011 2010 $51,171 $55,254 Change ($4,083) 2011 2010 Change $201,018 $201,090 ($72) 8,778 29 (7) 489 (235) 154 8,289 264 (161) 18,350 1,050 17,300 141 488 1,222 (1,081) 1,024 (536) Total property operating costs $59,971 $55,662 $4,309 $219,997 $204,386 $15,611 The decrease in same-asset property operating costs of $4.1 million for Q4 2011 as compared to Q4 2010 is due primarily to the following reasons: (cid:131) (cid:131) (cid:131) (cid:131) lower regular property operating expenses of $3.9 million; higher management fees of $0.1 million due to an increase of $0.3 million in the incentive fee payable to H&R Property Management Ltd. offset by higher management fees being capitalized to leasing expenses; lower major repair expenditures of $0.4 million; and higher U.S. dollar operating costs of $0.1 million due to the strengthening of the U.S. dollar when converted into Canadian dollars. The average exchange rate for the three months ended December 31, 2011 was Canadian $1.02 for each U.S. $1.00 (Q4 2010 - $1.00). The decrease in same-asset property operating costs of $0.1 million for the year ended December 31, 2011 compared to the year ended December 31, 2010 is due primarily to the following reasons: (cid:131) (cid:131) (cid:131) (cid:131) higher regular property operating expenses of $1.4 million; lower management fees of $0.7 million primarily due to a higher portion of management fees being capitalized to leasing expenses, offset by an increase of $1.0 million in the incentive fee payable to H&R Property Management Ltd.; lower major repair expenditures of $0.2 million; and lower U.S. dollar operating costs of $0.6 million due to the weakening of the U.S. dollar when converted into Canadian dollars. The average exchange rate for the year ended December 31, 2011 was Canadian $0.99 for each U.S. $1.00 (December 31, 2010 - $1.03). Page 13 of 43 H&R REIT AND H&R FINANCE TRUST - MD&A – December 31, 2011 Same-Asset Property Operating Income* Three months ended December 31 Year ended December 31 (in thousands of Canadian dollars) 2011 2010 Change 2011 2010 Change Same-asset current rentals and straight-lining of contractual rent $151,030 $157,214 ($6,184) $597,467 $607,154 ($9,687) Same-asset - property operating costs 51,171 55,254 (4,083) 201,018 201,090 (72) Total same-asset - property operating income 99,859 101,960 (2,101) 396,449 406,064 (9,615) Total same-asset - property operating income excluding straight-lining of contractual rent $101,801 $97,803 $3,998 $399,021 $397,105 $1,916 * Same-asset property operating income excludes the properties where the tenants have terminated their leases due to U.S. bankruptcies and the REIT has subsequently handed over control of the subject properties to the non-recourse mortgage lenders. Total same-asset property operating income, excluding straight-lining of contractual rent, has increased by $4.0 million for the three months ended December 31, 2011 as compared to December 31, 2010, of which a $3.0 million increase is from Canadian operations and a $1.0 million increase is from U.S. operations. For the year ended December 31, 2011 as compared to December 31, 2010, the increase of $1.9 million resulted from a $0.8 million increase in Canadian operations and a $1.1 million increase in U.S. operations. See the table below for further details: Three months ended December 31 Year ended December 31 Canada (in thousands of Canadian dollars) 2011 2010 Change 2011 2010 Change Same-asset current rentals $129,963 $131,085 ($1,122) $508,904 $507,476 $1,428 Same-asset property operating costs 47,659 51,802 (4,143) 186,806 186,154 Same-asset property operating income excluding straight-lining of contractual rent 82,304 79,283 3,021 322,098 321,322 652 776 United States (in thousands of Canadian dollars) Same-asset current rentals 23,009 21,972 1,037 Same-asset property operating costs 3,512 3,452 60 91,135 14,212 90,719 14,936 416 (724) Same-asset property operating income excluding straight-lining of contractual rent 19,497 18,520 977 76,923 75,783 1,140 Total same-asset property operating income* $101,801 $97,803 $3,998 $399,021 $397,105 $1,916 * Same-asset property operating income excludes the properties where the tenants have terminated their leases due to U.S. bankruptcies where the REIT has subsequently handed over control of the subject properties to the non-recourse mortgage lenders. Had the same-asset property operating income excluding the straight-lining of contractual rent for properties located in the United States been shown in U.S. dollars, the adjusted property operating income would have been $19.1 million for the three months ended December 31, 2011 as compared to income of $18.5 million for the three months ended December 31, 2010 and the adjusted property operating income would have been $77.7 million for the year ended December 31, 2010 as compared to $73.6 million for the year ended December 31, 2010. Finance Income (in thousands of Canadian dollars) Finance income Three months ended December 31 Year ended December 31 2011 $239 2010 $265 Change 2011 2010 Change ($26) $1,051 $2,589 ($1,538) Page 14 of 43 H&R REIT AND H&R FINANCE TRUST - MD&A – December 31, 2011 Finance income decreased during the year ended December 31, 2011 as compared to the year ended December 31, 2010, primarily due to the collection of a $58 million mortgage receivable in April 2010. Finance Cost-Operations (in thousands of Canadian dollars) Three months ended December 31 Year ended December 31 2011 2010 Change 2011 2010 Change Contractual interest on mortgages payable $45,646 $41,532 $4,114 $171,193 $170,293 $900 Contractual interest on debentures payable 16,468 13,326 Interest on construction loans Effective interest rate accretion Bank interest and charges Exchangeable unit distributions 2,536 1,276 121 486 1,680 1,721 1,428 67,879 1,183 59,524 3,142 1,260 (365) (41) 245 61,262 46,400 14,862 7,235 908 4,389 5,302 7,369 1,772 3,573 4,282 (134) (864) 816 1,020 16,600 8,355 250,289 233,689 Capitalized interest (18,328) (16,838) (1,490) (69,277) (59,569) (9,708) Finance cost - operations $49,551 $42,686 $6,865 $181,012 $174,120 $6,892 The increase in contractual interest on mortgages payable for the three months and year ended December 31, 2011 compared to the respective 2010 periods is primarily due to an increase in mortgage interest from the REIT entering into and assuming mortgages in 2010 and 2011, which is partially offset by a decrease in foreign exchange rates, regular mortgage amortization payments, and releases from five properties with bankrupt tenants in 2011. Debenture interest increased for the three months and year ended December 31, 2011 by $3.1 million and $14.9 million compared to the respective 2010 periods primarily due the following: (i) an increase of $3.1 million and $16.9 million for the three and twelve month periods ended December 31, 2011, respectively, compared to December 31, 2010 in debenture interest due primarily to the REIT issuing $100 million of convertible debentures in July 2010, $125 million of non-convertible debentures in September 2010, $180 million of non-convertible debentures in January 2011, $100 million of non-convertible debentures in October 2011, $75 million convertible debentures in November 2011 and (ii) for the year ended December 31, 2011 compared to December 31, 2010, there was an additional decrease of $2.1 million in debenture interest due to the repayment of the debentures issued to Fairfax Financial Holdings Limited or its affiliates (the “Fairfax Debentures”). The amount of capitalized interest will continue to increase as the REIT continues to fund its development projects. The majority of this increase is due to the Bow development. Finance Cost - Gain (Loss) on Extinguishment of Debt (in thousands of Canadian dollars) Gain (loss) on extinguishment of debt Three months ended December 31 Year ended December 31 2011 $158 2010 Change 2011 2010 Change ($332) $490 $19,726 ($21,538) $41,264 In March 2011, the REIT was legally released from its mortgages on two Bruno’s Supermarkets LLC properties and two Boscov’s Department Stores properties upon the lender accepting title to the properties. In July 2011, the REIT was legally released from its mortgage on the final Boscov Department Store property upon the lender accepting title to the property. As a result, the investment properties, the mortgages and the accrued interest on the mortgages were all derecognized resulting in a gain on extinguishment of debt of $0.2 million for the three months and $19.7 million for the year ended December 31, 2011. In February 2010, the REIT repaid the outstanding Fairfax Debentures having an aggregate face value of $200 million for a total repurchase price of $230 million. The repurchase price included accrued interest of approximately $2.2 million. The REIT recognized a one-time non-recurring charge to net income, included in the gain (loss) on extinguishment of debt of approximately ($38.8 million) in the twelve months ended December 31, 2010, representing the difference between the repurchase price, excluding accrued interest expense, and the carrying value of the Fairfax Debentures of $189 million. In May 2010, the REIT was legally released from its mortgage on the Circuit City Distribution Warehouse upon the lender accepting title to the property. In September 2010, the REIT was legally released from its mortgages on four of the Boscov Department Stores upon the lender accepting title to the property. This released the REIT from the debt owing with respect to the mortgages on these properties. As a result, the Page 15 of 43 H&R REIT AND H&R FINANCE TRUST - MD&A – December 31, 2011 investment properties, the mortgages and the accrued interest on the mortgages were all derecognized resulting in a gain (loss) on extinguishment of debt of ($0.3 million) for the three months and $17.3 million for the year ended December 31, 2010. Finance Cost - Gain (Loss) on Change in Fair Value Three months ended December 31 Year ended December 31 (in thousands of Canadian dollars) 2011 2010 Change 2011 2010 Change Gain (loss) on fair value of convertible debentures ($58,608) $6,229 ($64,837) ($84,670) ($56,119) ($28,551) Gain (loss) on fair value of exchangeable units (12,180) 1,740 (13,920) (21,043) (21,642) 599 Unrealized gain (loss) on derivative instruments 1,597 2,648 (1,051) (2,665) (5,521) 2,856 Finance cost - gain (loss) on change in fair value ($69,191) $10,617 ($79,808) ($108,378) ($83,282) ($25,096) Under IFRS, the REIT has elected to measure the outstanding convertible debentures at fair value. At each period end, the fair value of these convertible debentures is measured based on the ask price of each series of convertible debentures. The fluctuation in the fair value between each period is charged to gain (loss) in changes in fair values in comprehensive income. At the end of each quarter, the fair value of each exchangeable unit is measured based on the ask price of Stapled Units which was $23.30 on December 31, 2011 (December 31, 2010 - $19.43). The unrealized gain (loss) on derivative instruments resulted from: (i) (ii) the REIT entering into an interest rate swap which effectively locked the interest rate on the Bow construction facility at 4.65%. The interest expense on this facility is capitalized to properties under development during the eligible period. At the end of each reporting period, the interest rate swap is marked-to-market, resulting in an unrealized gain or loss recorded in net income. Upon completion of the development of the Bow and cessation of capitalizing interest, the difference between the hedged rate and the actual rate will be recorded as a realized gain or loss in net earnings; the REIT entering into foreign exchange forward contracts and swaps with a Canadian chartered bank which effectively locked the REIT’s rate to exchange U.S. dollars in order to lock in a portion of the REIT’s projected USD FFO and AFFO at a fixed Canadian dollar amount. The foreign exchange forward contracts are marked-to-market through earnings each reporting period. As each month’s contract is realized, any gain or loss is recorded into earnings at that time; (iii) the REIT securing a floating rate mortgage on a U.S. property in June 2010. In order to fix the interest rate, the REIT entered into an interest rate swap, which is marked-to-market through earnings each reporting period; and (iv) the REIT entering into two foreign exchange swaps with Canadian chartered banks which effectively locked the REIT’s rate to exchange U.S. dollars for the acquisition of Hess Tower as the USD mortgage on this acquisition closed subsequent to year end. These swaps are marked-to-market through earnings and any gain or loss is reported at the end of each reporting period. Amortization and Impairment Three months ended December 31 Year ended December 31 (in thousands of Canadian dollars) 2011 2010 Change 2011 2010 Change Depreciation of investment properties $29,456 $25,463 $3,993 $107,240 $98,943 $8,297 Amortization of intangible assets on acquisitions 12,794 Amortization of above- and below- market rents Amortization of leasing expenses Impairment loss on investment properties 5,581 1,016 1,693 9,841 5,256 991 2,953 46,398 40,052 6,346 325 25 19,634 21,052 (1,418) 4,445 6,892 3,685 760 14,862 (7,970) 14,862 (13,169) Impairment reversal on investment properties (1,600) (51,057) 49,457 (2,852) (101,165) 98,313 Amortization and impairment $48,940 $5,356 $43,584 $181,757 $77,429 $104,328 All Canadian and U.S. properties were tested for impairment at January 1, 2010 in accordance with IAS 36 Impairment of Assets and a write-down of $126.3 million was taken on January 1, 2010. However, there were impairment charges reversed due to changing economic conditions of $51.1 million in Q4 2010 and $101.2 million for the year ended December 31, 2011. In Q4 2011, there was Page 16 of 43 H&R REIT AND H&R FINANCE TRUST - MD&A – December 31, 2011 one property written down as its carrying amount continued to exceed its recoverable amount, and there was one Canadian impaired property where a portion of the impairment loss was reversed due to an improvement in market rents and discount rates. For the year ended December 31, 2011, there were six properties written down as their carrying amount exceeded their recoverable amounts. There were also two Canadian impaired properties where their losses were reversed based on an improvement in market rents and discount rates. Trust Expenses (in thousands of Canadian dollars) Unit-based compensation Other expenses Trust expenses Three months ended December 31 Year ended December 31 2011 $3,346 2010 $862 Change 2011 2010 Change $2,484 $7,600 $6,882 2,117 1,482 635 7,766 7,672 $5,463 $2,344 $3,119 $15,366 $14,554 Other expenses are primarily comprised of salaries, professional fees, trustee fees and overhead expenses. The REIT’s Unit Option Plan is considered to be cash-settled under IFRS 2, Share-based Payments and as a result, is measured at each reporting period and settlement date at its fair value. The impact of the transition to IFRS from previous Canadian GAAP on unit-based compensation is as follows: Unit-based Compensation (in thousands of Canadian dollars) Unit-based compensation Fair value adjustment to unit-based compensation Three months ended December 31 Year ended December 31 Change 2011 2010 Change 2011 $537 2,809 2010 $310 552 $227 $2,034 $1,225 2,257 5,566 5,657 As reported under IFRS $3,346 $862 $2,484 $7,600 $6,882 $718 94 $812 $809 (91) $718 Net Gain (loss) on Foreign Exchange (in thousands of Canadian dollars) Three months ended December 31 Year ended December 31 2011 2010 Change 2011 2010 Change Gain (loss) on sale on foreign exchange ($3,881) ($4,469) $588 $3,383 ($6,828) $10,211 The net gain (loss) on foreign exchange, which was recorded in the financial statements of Finance Trust, is due to a difference in exchange rates as the U.S. Holdco Notes receivable by Finance Trust are denominated in U.S. dollars while the financial statements of Finance Trust are expressed in Canadian dollars. The notes are eliminated upon combination however, the foreign exchange difference is not eliminated on combination as U.S. Holdco has a different functional currency than that of the REIT. Gain (loss) on Sale of Investment Properties (in thousands of Canadian dollars) Gain (loss) on sale of investment properties 2011 ($26) 2010 ($40) Change 2011 2010 Change $14 $3,260 $3,576 ($316) Three months ended December 31 Year ended December 31 In July and August 2011, the REIT sold the following four industrial properties in Ontario: 880 Milner, 5230 Orbitor, 51 Kelfield and 738 Polymoore. For the twelve months ended December 31, 2010, the gain on sale of investment properties was from the sale of the 110 Sheppard office building and the 2390 Argentia Road industrial building both located in Ontario. Income Tax Recovery (Expense) (in thousands of Canadian dollars) Current income tax expense Deferred income tax recovery Three months ended December 31 Year ended December 31 2011 ($73) - 2010 ($45) - Change 2011 2010 Change ($28) ($285) ($458) $173 - - 460,138 ($460,138) Income tax recovery (expense) ($73) ($45) ($28) ($285) $459,680 $459,965 Page 17 of 43 H&R REIT AND H&R FINANCE TRUST - MD&A – December 31, 2011 The REIT is generally subject to tax in Canada under the Tax Act with respect to its taxable income each year, except to the extent such taxable income is paid or made payable to unitholders and deducted by the REIT for tax purposes. During the second quarter of 2010, the REIT completed the necessary restructuring to qualify for the REIT Exemption (as defined herein) under the SIFT Rules (as defined herein). See the “Tax Risk” section for further discussion. Accordingly, the net deferred income tax liability was reversed into earnings in the second quarter of 2010. SEGMENTED INFORMATION The REIT invests in investment producing properties in both Canada and the United States with creditworthy tenants on long-term leases. The REIT is not required to report in its financial statements on the performance of each class of assets separately due to management’s assessment that all assets effectively adhere to the same investment policy of being leased on a long-term basis to creditworthy tenants and the fact that the REIT manages all assets on a similar basis. Segmented disclosure is provided in the financial statements by net property operating income on a geographic basis as the property operations in the United States are considered to be a geographic segment. This segmented information on net property operating income is as follows: Property operating income for the three months ended December 31, 2011 (in thousands of Canadian dollars) Rentals from investment properties Property operating costs Property operating income Property operating income for the three months ended December 31, 2010 (in thousands of Canadian dollars) Rentals from investment properties Property operating costs Property operating income Property operating income for the year ended December 31, 2011 (in thousands of Canadian dollars) Rentals from investment properties Property operating costs Property operating income Property operating income for the year ended December 31, 2010 (in thousands of Canadian dollars) Rentals from investment properties Property operating costs Property operating income Canada United States Total $140,150 $38,024 $178,174 (53,501) (6,470) (59,971) $86,649 $31,554 $118,203 Canada United States Total $132,499 $28,201 $160,700 (51,956) (3,706) (55,662) $80,543 $24,495 $105,038 Canada United States Total $534,681 $122,230 $656,911 (199,799) (20,198) (219,997) $334,882 $102,032 $436,914 Canada United States Total $513,562 $103,865 $617,427 (187,177) (17,209) (204,386) $326,385 $86,656 $413,041 The increase in U.S. property operating income of $7.1 million and $15.4 million for the three months and year ended December 31, 2011, as compared to the respective 2010 period, is primarily due to an increase in rentals from acquisitions as the REIT has acquired 24 properties in the United States between January 1, 2010 and December 31, 2011. See page 14 for the effect of the change in foreign exchange rates on the U.S. same-store property operating income. Page 18 of 43 H&R REIT AND H&R FINANCE TRUST - MD&A – December 31, 2011 ASSETS Investment Properties The REIT acquired eleven properties during the year ended December 31, 2011. The cost of these acquisitions less mortgages assumed were funded from the REIT’s general operating facility, funds from debenture issuances and proceeds from units issued during 2011. There were 16 properties acquired during the year ended December 31, 2010. 2011 Acquisitions: Property Year Built Property Type Date Acquired Square Footage 665 American Legion Dr., Teaneck, NJ 3773-3841 S. Hamilton Rd., Columbus, OH 1961 2009 Retail Feb 15, 2011 42,047 Retail Feb 18, 2011 118,066 2480 Rock House Rd., Lithia Springs, GA 2009 Office May 6, 2011 79,570 1670 Rue Eiffel, Boucherville, QC 1999 Industrial May 26, 2011 127,776 Cash Purchase Price ($ Millions) $10.2 21.5 58.3 11.1 Anchor Tenants Stop & Shop Giant Eagle Pricewaterhouse Coopers LLP Carquest Canada 550 McAllister Dr., St. John, NB 2003 Industrial May 26, 2011 104,094 8.7 Carquest Canada 595 Bay St., 20 & 40 Dundas St. & 306 Yonge St., Toronto, ON (Atrium on Bay) 1979- 2002 Office & Retail June 1, 2011 1,051,307 1 Academy Dr., Jeffersonville, GA 2008 Industrial June 15, 2011 1,038,183 3642 Savannah Highway (U.S. 17), Charleston, SC 150 New Jersey State, Hwy Route 73, Voorhees, NJ 42-01 28th St., Long Island City, NY (Gotham Tower) 1501 McKinney St., Houston, TX (Hess Tower) Total 2007 Retail Sep 12, 2011 58,851 2004 Retail Oct 6, 2011 115,396 2011 Office Oct 26, 2011 670,000 415.5 City of New York 2011 Office Dec 22, 2011 844,763 451.4 Hess Corporation 4,250,053 $1,403.5 344.8 54.2 11.3 16.5 CIBC, Ontario Realty Corporation Academy, Ltd. Publix Supermarkets Inc. BJ’s Wholesale Club, Inc. Average Remaining Lease Term (years) 7 17 20 20 20 5 20 16 13 20 * * Due to the confidentiality under the tenant lease, the term is not disclosed. The dollar figures shown above for U.S. acquisitions are in Canadian dollars and are based on the exchange rates at the date of such acquisitions. The REIT secured a mortgage commitment on the acquisition of Hess Tower for U.S. $250.0 million. This mortgage closed in January 2012. Including this mortgage, the REIT partially funded the acquisition of the above properties with mortgages totalling $830.8 million bearing interest at an average contractual rate of 4.8% per annum. These mortgages have an average remaining term of 9.6 years and only $5.0 million is recourse to the REIT. The REIT sold four properties during the year ended December 31, 2011. There were two properties sold during the year ended December 31, 2010. Page 19 of 43 H&R REIT AND H&R FINANCE TRUST - MD&A – December 31, 2011 2011 Dispositions: Property 880 Milner Ave., Toronto, ON 5230 Orbitor Dr., Mississauga, ON 738 Polymoore Dr., Corunna, ON 51 Kelfield St., Toronto, ON Total Property Type Industrial Industrial Industrial Industrial Date Sold Square Footage Gross Proceeds ($ Millions) Ownership Interest Disposed July 4, 2011 July 6, 2011 Aug 4, 2011 Aug 16, 2011 60,028 22,000 76,136 57,976 216,140 $2.9 2.3 4.6 7.3 $17.1 70% 100% 100% 100% The portfolio continues to remain in good condition. The average age of the total portfolio from the date built or renovated is 17.2 years at December 31, 2011 (December 31, 2010 - 16.9 years) and the average age of properties by type of asset is as follows: Average Age by Type of Asset Office Industrial Retail Total December 31, 2011 (years) December 31, 2010 (years) 18.6 17.9 13.3 17.2 19.5 17.6 12.1 16.9 Legal title to each of the United States properties is held by a separate legal entity which is 100% owned, directly or indirectly, by H&R REIT (U.S.) Holdings Inc. (“U.S. Holdco”), a subsidiary of the REIT. The assets of each such separate entity are not available to satisfy the debts or obligations of any other person or entity; each such separate entity maintains separate books and records. The identity of the owner of a particular U.S. property is available from U.S. Holdco. This structure does not prevent distributions to U.S. Holdco provided there are no conditions of default. The composition of the fair value and the net book value of investment properties expressed by type of asset and by region is as follows: Type of Asset (millions) Office Industrial Retail Total Fair Value December 31, 2011(1) Net Book Value December 31, 2011(2) Net Book Value December 31, 2010(2) $3,963 1,794 1,454 $7,211 $3,387 1,354 1,210 $5,951 $2,146 1,328 1,208 $4,682 Page 20 of 43 H&R REIT AND H&R FINANCE TRUST - MD&A – December 31, 2011 Fair Value Net Book Value Net book Value December 31, 2011(1) December 31, 2011(2) December 31, 2010(2) $3,076 1,042 376 510 5,004 2,207 $7,211 $2,441 $2,156 774 273 394 3,882 2,069 $5,951 803 270 396 3,625 1,057 $4,682 Region (millions) Ontario Alberta Quebec Other Canada United States Total (1) (2) Please refer to note 4 of the financial statements for the assumptions and methods in determining the fair value of the portfolio. Net book value includes investment properties and accrued rent receivable (including investment properties and accrued rent receivable included in assets held for sale). Significant costs associated with income properties are either capitalized and depreciated or expensed in the year incurred. The REIT expects to incur the following costs: Total Amount Expected to be Incurred Amount Expected to be Capitalized Amount Expected to be Expensed to Property Operating Costs Total Expected Recovery $25 million $14 million $15 million $10 million $10 million $20 million $4 million $12 million Amount Expected to be Recovered in the Year Incurred $11 million $9 million Amount Expected to be Recovered thereafter $9 million $3 million Year 2012 2013 The information contained in the table above is based on current tenancies in place and management’s estimates of these costs being recovered through tenant’s leases. Properties Under Development The REIT is currently developing the Bow in Calgary, AB. The Bow is a 2-million square foot head office complex pre-leased, on a triple net basis, to EnCana Corporation for a term of 25 years. The total annualized year one projected income from the Bow is expected to be approximately $93.5 million. Rent escalations will be 0.75% per annum on the office space and 1.5% per annum on the parking income for the full 25-year term. Occupancy is currently expected to occur in tranches commencing on April 2, 2012 with full occupancy expected by the fourth quarter of 2012. The North Block budget has been revised to $1.63 billion to reflect IFRS changes and the revised expected tranche delivery dates. Under previous Canadian GAAP the original budget included, as a reduction to costs, net rent paid by EnCana Corporation during the initial tranches until the building was fully occupied. Under IFRS, this net rent will be recorded in the income statement as revenue and not as a reduction of budgeted costs. Excluding capitalized interest, these IFRS changes resulted in an increase to the budget of $30.1 million. Any delay in the delivery of the tranches will result in a delay cost of $1.67 per square foot per month. The estimated delay cost of approximately $24.1 million has not been included in the budget below as it will be payable by way of a credit against EnCana Corporation’s rent due. In addition, the budget has increased due to labour and trade costs associated with the revised occupancy schedule. The presentation of the updated budget also shows a reallocation of the costs incurred to date for the South Block. The REIT has made an application to the City of Calgary to amend the approved Development Permit on the South Block to allow office and ancillary retail uses. Discussions are underway with EnCana Corporation and the City of Calgary with respect to cultural uses in the South Block and with EnCana Corporation’s cost sharing obligations and right to approve future development. Page 21 of 43 H&R REIT AND H&R FINANCE TRUST - MD&A – December 31, 2011 The following table shows the previously reported budget, the updated budget and the costs to complete: (in thousands of Canadian dollars) Land Financing costs Capitalized interest on the REIT’s costs as incurred Soft costs Hard costs Recoveries and other income Contingency Cost incurred to date/remaining costs/budget Less capitalized interest on the REIT’s costs incurred Total costs incurred to date/remaining costs/budget less capitalized interest Original Budget North Block Budget South Block Budget Costs Incurred to Date $60,804 41,721 215,722 192,644 1,131,211 (116,937) 21,557 1,546,722 (215,722) $42,804 35,290 223,722 176,389 1,189,122 (69,328) 27,717 1,625,716 (223,722) $18,000 - - - 10,087 - - 28,087 - $60,804 32,414 186,033 157,231 1,099,630 (56,995) - 1,479,117 (186,033) Costs to Complete $ - 2,876 37,689 19,158 99,579 (12,333) 27,717 174,686 (37,689) $1,331,000 $1,401,994 $28,087 $1,293,084 $136,997 The estimated fair value of the Bow on completion is approximately $1.7 billion, determined as at December 31, 2011 by using a 5.50% capitalization rate on the first full year’s operating income. Accrued Rent Receivable Certain leases call for rental payments that increase over the lease term. To comply with IFRS, the rental revenue from these leases are recorded on a straight-line basis, resulting in accruals for rents that are not billable or due until future periods. Accrued rent receivable has decreased by 0.3% or $0.4 million from $156.9 million at December 31, 2010 to $156.5 million at December 31, 2011. The chart below lists contractual rental step ups greater than $0.1 million for the REIT occurring over the next 12 months: Property 160 Elgin St., Ottawa, ON 19100-94th Ave., Surrey, BC 6735-11th St. N.E., Calgary, AB 5099 Creekbank Rd., Mississauga, ON 2928-16th St., Calgary, AB Sq.ft. 469,105 112,819 163,899 525,921 163,280 Rent increase ($ psf) Effective date of increase Annualized rental increases (in thousands of dollars) 2.00 1.40 1.08 2.77 1.25 Feb 2012 Feb 2012 Feb 2012 Mar 2012 Mar 2012 $1,055 158 177 1,457 204 Other Assets (in thousands of Canadian dollars) December 31, 2011 December 31, 2010 Current: Restricted cash Accounts receivable Prepaid expenses and sundry assets Derivative instruments Other Assets $22,110 12,711 12,959 1,273 $49,053 $22,802 7,420 6,932 1,225 $38,379 Restricted cash decreased from $22.8 million at December 31, 2010 to $22.1 million at December 31, 2011 due primarily to a decrease in funds being held in escrow relating to rent paid in advance and costs to complete Bell Phase III. Accounts receivable has increased from $7.4 million at December 31, 2010 to $12.7 million at December 31, 2011 primarily due to the billing of large capital expenditures to a few large tenants at the end of the year. Prepaid expenses and sundry assets have increased from $6.9 million at December 31, 2010 to $13.0 million at December 31, 2011 primarily due to mortgage application fee deposits on several properties. Page 22 of 43 H&R REIT AND H&R FINANCE TRUST - MD&A – December 31, 2011 The REIT also entered into two foreign exchange swaps with Canadian chartered banks which effectively locked the REIT’s rate to exchange U.S. dollars for the acquisition of Hess Tower as the USD mortgage on this acquisition closed subsequent to year end. The fair value of these swaps as at December 31, 2011 was an asset of $1.3 million and a liability of $1.1 million (December 31, 2010 - nil). LIABILITIES The REIT’s Declaration of Trust limits the indebtedness of the REIT (subject to certain exceptions) to a maximum of 65% of the GBV of the REIT. Total debt to GBV per the REIT’s Declaration of Trust(1) Total debt to GBV per the combined financial statements Total debt to fair market value of total assets (per the combined financial statements) Non-recourse mortgages as a percentage of total mortgages Floating rate debt as a percentage of total debt Canadian properties total debt to GBV U.S. properties total debt to GBV December 31, 2011 December 31, 2010(2) 50.5% 57.6% 53.6% 59.8% 9.1% 61.5% 47.7% 47.8% 56.0% 52.7% 53.3% 2.4% 53.9% 65.2% (1) (2) Total debt per the REIT’s Declaration of Trust excludes all convertible debentures and the U.S. Holdco Notes payable to Finance Trust. The REIT’s calculation of total debt to GBV is not recognized under IFRS and therefore does not have a standardized meaning prescribed by IFRS. The 2010 ratios have been restated for IFRS. The non-recourse mortgages as a percentage of total mortgages. This ratio increased due to non-recourse mortgages acquired or assumed from 2011 acquisitions. The U.S. properties total debt to GBV ratio decreased as the REIT acquired Hess Tower at an acquisition price of U.S. $442.5 million in 2011 and the mortgage of U.S. $250.0 million was not received until January 2012. Mortgages Payable (in thousands of Canadian dollars) Opening balance - December 31, 2010 Principal payments Mortgage repaid upon maturity New mortgages Mortgages released upon lender taking title to properties Mortgages released from sale of investment properties Foreign exchange difference Closing balance – December 31, 2011 $2,706,707 (104,658) (70,543) 667,709 (59,056) (4,071) 27,505 $3,163,593 The mortgages outstanding as at December 31, 2011 bear interest at a weighted average rate of 5.9% (December 31, 2010 – 6.2%) and mature between 2012 and 2035. The weighted average term to maturity of the REIT’s mortgages is 7.7 years (December 31, 2010 - 8.0 years). Of the total mortgages (excluding mortgages due on demand), 12.1% will mature in 2012 and 7.0% will mature in 2013. The mortgages maturing during 2012 bear interest at a weighted average rate on maturity of 6.7% while mortgages maturing during 2013 bear interest at a weighted average rate on maturity of 7.4%. For a further discussion of liquidity please see “Funding of future commitments”. For a further discussion of interest rate risk, please see “Risks and Uncertainties”. Debt related to certain Canadian properties is held by separate legal entities, where the rent received from each property is first used to satisfy the related debt obligations with any balance then available to satisfy the cash flow requirements of the REIT. Page 23 of 43 H&R REIT AND H&R FINANCE TRUST - MD&A – December 31, 2011 Segmented disclosure by geographic location is provided as follows: (in thousands of Canadian dollars) Mortgages payable - Canada Mortgages payable - United States Total Debentures Payable December 31, 2011 December 31, 2010 $2,015,424 1,148,169 $3,163,593 $1,890,881 815,826 $2,706,707 December 31, 2011 December 31, 2010 Contractual Interest Rate Effective Interest Rate Conversion Price Face Value (in millions) Carrying Value (in millions) Carrying Value (in millions) Maturity Convertible Debentures 2013 Convertible Debentures (HR.DB) Jun 30, 2013 2014 Convertible Debentures (HR.DB.B) Dec 31, 2014 2017 Convertible Debentures (HR.DB.C) Jun 30, 2017 2020 Convertible Debentures (HR.DB.D) Jun 30, 2020 2016 Convertible Debentures (HR.DB.E) Dec 31, 2016 Senior Debentures Series A Senior Debentures Series B Senior Debentures Series C Senior Debentures Series D Senior Debentures Series E Senior Debentures Feb 3, 2015 Feb 3, 2017 Dec 1, 2018 Jul 27, 2016 Feb 2, 2018 6.65% 6.75% 6.00% 5.90% 4.50% 5.20% 5.90% 5.00% 4.78% 4.90% 6.65% 6.75% 6.00% 5.90% 4.50% 5.40% 6.06% 5.30% 4.96% 5.22% $23.11 $114.9 $126.2 $121.3 14.00 19.00 23.50 25.70 n/a n/a n/a n/a n/a 127.9 169.9 100.0 75.0 587.7 115.0 115.0 125.0 180.0 100.0 635.0 214.4 210.6 113.0 78.0 742.2 114.3 114.2 122.9 178.7 98.6 628.7 203.0 188.1 102.6 - 615.0 114.1 114.1 122.6 - - 350.8 Total $1,222.7 $1,370.9 $965.8 Debentures payable increased by $405.1 million from $965.8 million at December 31, 2010 to $1.37 billion at December 31, 2011. Convertible debentures increased by $127.2 million mainly due to the increase in fair value of the convertible debentures and the issuance of the 2016 convertible debentures with a face value of $75.0 million. The senior debentures increased by $277.9 million mainly due to the issuance of the series D senior debentures with a carrying value of $178.7 million and the Series E senior debentures with a carrying value of $98.6 million. See the combined financial statements of the Trusts for detailed information regarding the various debentures payable. Derivative Instruments Derivative instruments include the fair value of the interest rate swap on the Bow construction facility. At December 31, 2011, the fair value of the interest rate swap on the Bow construction facility was a liability of $3.5 million (December 31, 2010 - liability of $2.9 million). The REIT also entered into an interest rate swap on one mortgage. The fair value of this interest rate swap as at December 31, 2011 was a liability of $0.7 million (December 31, 2010 - liability of $0.4 million). The REIT also entered into foreign exchange forward contracts and swaps with a Canadian chartered bank effectively locking the REIT’s rate to exchange U.S. dollars into Canadian dollars. The fair value of these forward exchange contracts as at December 31, 2011 was a liability of $0.7 million (December 31, 2010 - asset of $1.2 million). Page 24 of 43 H&R REIT AND H&R FINANCE TRUST - MD&A – December 31, 2011 Accounts Payable and Accrued Liabilities Accounts payable and accrued liabilities increased by $5.3 million from $170.5 million at December 31, 2010 to $175.8 million at December 31, 2011. Most of the change was due to an increase of $21.2 million in interest accrued on all of the debentures which resulted from interest for 2011 that was paid on January 3, 2012 compared to interest for 2010 that was paid on December 31, 2010. Accruals relating to properties under development totalled $54.3 million at December 31, 2011 compared to $66.9 million at December 31, 2010. Included in accrued liabilities is an amount relating to interest accrued to date on the non-recourse mortgages under default which decreased by $6.6 million from $8.1 million at December 31, 2010 to $1.5 million at December 31, 2011 due to the lenders of five properties with bankrupt tenants accepting title during 2011. The remaining balance of accounts payable and accruals increased as a result of routine transactions with tenants occurring in the normal course of business operations. USE OF PROCEEDS FROM FINANCING ISSUED DURING 2011 Financing Disclosed Use of Proceeds Actual Use of Proceeds Public offering of $180 million of unsecured senior debentures on January 27, 2011. To fund future property acquisitions, including to the extent necessary, Atrium on Bay and for general trust purposes. The net proceeds were used to fund the Bow and for general trust purposes. Public offering of Stapled Units of $200 million on May 31, 2011. To fund development projects, property acquisitions and for general trust purposes. Public offering of $100 million of unsecured senior debentures on October 27, 2011. To repay bank indebtedness, to fund future property acquisitions, and for general trust purposes. Public offering of Stapled Units of $187 million and of convertible debentures of $75 million on November 22, 2011. Public offering of Stapled Units of $125 million on December 22, 2011. To repay bank indebtedness which was incurred to finance acquisitions and development activity, to fund future property acquisitions and for general trust purposes The REIT intends to use its portion of such net proceeds to repay, in part, the bank indebtedness expected to be incurred to finance the Hess Tower acquisition. The net proceeds were used to fund a portion of the acquisition of Atrium on Bay, to repay bank indebtedness and for general trust purposes. The net proceeds were used to fund a portion of the acquisition of Gotham Tower and for general trust purposes. The net proceeds were used to repay bank indebtedness and for general trust purposes. The net proceeds were used to fund a portion of the acquisition of Hess Tower. EQUITY Unitholders’ Equity Unitholders’ equity increased by $391.7 million between December 31, 2010 and December 31, 2011. The increase is primarily due to the REIT and Finance Trust completing three public offerings in May, November and December of 2011, issuing a total of 22,900,000 units for gross proceeds of approximately $512.1 million. This increase was partially offset by net loss and distributions paid to unitholders during the year ended December 31, 2011. Other comprehensive loss consists of the unrealized gain (loss) on translation of U.S. denominated foreign operations and the transfer of realized losses on cash flow hedges to net income. Page 25 of 43 H&R REIT AND H&R FINANCE TRUST - MD&A – December 31, 2011 LIQUIDITY AND CAPITAL RESOURCES FUNDS FROM OPERATIONS Although funds from operations (“FFO”) is widely used by the real estate industry as a measure of operating performance, the Trusts’ method of calculating FFO may differ when comparing to other issuers. The Trusts present FFO calculations in accordance with the Real Estate Property Association of Canada (REALPAC) except for the adjustment to exchangeable unit distributions, transaction costs on issuance of convertible debentures and the fair value change to the unit-based compensation resulting from the adoption of IFRS. Interest on exchangeable units were previously treated as distributions under previous Canadian GAAP, however under IFRS, they are treated as finance costs and have therefore been added back to FFO. Transaction costs for non-convertible debentures are capitalized against the total amount of issued debentures, however, for convertible debentures transaction costs are expensed. To ensure FFO reflects consistent treatment of transaction costs, this has been added back. FFO is a non-GAAP measure which should not be used as an alternative to comprehensive income, or cash flow from operations. Three months ended December 31 Year ended December 31 (in thousands of Canadian dollars except per unit amounts) 2011 2010 2011 2010 ($61,338) $60,648 ($25,277) $496,600 Net income (loss) Add (deduct): (Gain) loss on fair value of convertible debentures and exchangeable units Unrealized (gain) loss on derivative instruments Exchangeable unit distributions Amortization and impairment Fair value adjustment to unit-based compensation (Gain) loss on sale of income properties Transaction costs on issuance of convertible debentures Net (gain) loss on foreign exchange Deferred income tax recovery 70,788 (1,597) 1,428 48,940 2,809 26 2,813 3,881 - (7,969) (2,648) 1,183 5,356 552 40 - 4,469 - 105,713 2,665 5,302 181,757 5,566 (3,260) 2,813 (3,383) - 77,761 5,521 4,282 77,429 5,657 (3,576) 4,535 6,828 (460,138) $214,899 FFO $67,750 $61,631 $271,896 Weighted average number of Stapled Units (in thousands of Stapled Units adjusted for conversion of non-controlling interest) Diluted weighted average number of Stapled Units (in thousands of Stapled Units) for the calculation of FFO(1)(2)(3)(4)(5) FFO per Stapled Unit (basic – adjusted for conversion of non- controlling interest) FFO per Stapled Unit (diluted) 167,691 150,624 159,607 149,786 197,699 180,391 188,652 172,136 $0.40 $0.39 $0.41 $0.39 $1.70 $1.62 $1.43 $1.38 (1) For the three months ended December 31, 2011 and 2010, 530,510 Stapled Units and 804,513 Stapled Units, respectively, are included in the determination of diluted FFO with respect to the Unit Option Plan. For the year ended December 31, 2011 and 2010, 606,556 Stapled Units and 636,044 Stapled Units, respectively, are included in the determination of diluted FFO with respect to the Unit Option Plan. (2) The 2013, 2014, 2016, 2017 and 2020 Convertible Debentures are dilutive for the three months ended December 31, 2011. Therefore, debenture interest of $8.7 million is added to FFO and 29,477,013 Stapled Units are included in the diluted weighted average number of Stapled Units outstanding for this period. (3) The 2013, 2014, 2017 and 2020 Convertible Debentures are dilutive for the three months ended December 31, 2010. Therefore, debenture interest of $8.6 million is added to FFO and 28,962,490 Stapled Units are included in the weighted average number of Stapled Units outstanding for this period. (4) The 2013, 2014, 2016, 2017 and 2020 Convertible Debentures are dilutive for the year ended December 31, 2011. Therefore, debenture interest of $33.5 million is added to FFO and 28,438,535 Stapled Units are included in the weighted average number of Stapled Units outstanding for this period. Page 26 of 43 H&R REIT AND H&R FINANCE TRUST - MD&A – December 31, 2011 (5) The 2014, 2017 and 2020 Convertible Debentures are dilutive for the year ended December 31, 2010. Therefore, debenture interest of $23.2 million is added to FFO and 21,713,768 Stapled Units are included in the weighted average number of Stapled Units outstanding for this period. The primary reasons for the increase of $6.1 million in FFO between Q4 2011 and Q4 2010 are: • • • • • • • • an increase of $16.4 million in property operating income due to acquisitions in 2010 and 2011; a decrease of $6.1 million in property operating income due to straight-lining of contractual rent. See same-asset straight- lining of contractual rent on page 12 for further details; a decrease of $0.1 million due to lower same-asset current rentals. See same-asset current rentals on page 12 for further details; an increase of $4.1 million due to lower same-asset property operating costs. See same-asset property operating costs on page 13 for further details; a decrease of $1.1 million in property operating income due to terminated leases from U.S. bankruptcies and properties sold; a decrease of $6.6 million due to higher finance cost - operations; an increase of $0.5 million from the change in the gain (loss) on extinguishment of debt; and a decrease of $0.9 million due to higher trust expenses. The primary reasons for the increase of $57.0 million in FFO for the year ended December 31, 2011 as compared to the same period in 2010 are: • • • • • • • • • • an increase of $41.3 million from the change in gain (loss) on extinguishment of debt; an increase of $35.3 million in property operating income due to acquisitions in 2010 and 2011; an increase of $1.8 million due to higher same-asset current rentals. See same-asset current rentals on page 12 for further details; a decrease of $11.5 million in property operating income due to straight-lining of contractual rent. See same-asset straight-lining of contractual rent on page 12 for further details; an increase of $0.1 million due to lower same-asset property operating costs. See same-asset property operating costs on page 13 for further details; a decrease of $1.7 million in property operating income due to terminated leases from U.S. bankruptcies and properties sold; a decrease of $1.5 million due to lower finance income; a decrease of $5.9 million due to higher finance cost - operations; a decrease of $0.9 million due to higher trust expenses; and an increase of $0.2 million due to lower income tax expenses. Page 27 of 43 H&R REIT AND H&R FINANCE TRUST - MD&A – December 31, 2011 The following table provides a reconciliation of FFO reported under previous Canadian GAAP to the FFO currently reported under IFRS for the three months and year ended December 31, 2010 together with the unrealized gain (loss) on derivative instruments as an adjustment to FFO: (in thousands of Canadian dollars) Previously reported FFO IFRS adjustments resulting from the restated December 31, 2010 income statement: Three months ended December 31, 2010 Year ended December 31, 2010 $57,046 $191,927 Change in rent amortization Change in straight-lining of contractual rent Change in effective interest rate accretion Change in net loss on foreign exchange Net loss on foreign exchange Unrealized (gain) loss on derivative instruments Revised FFO 612 (592) 2,760 (16) 4,469 (2,648) $61,631 2,974 (1,979) 9,681 (53) 6,828 5,521 $214,899 Page 28 of 43 H&R REIT AND H&R FINANCE TRUST - MD&A – December 31, 2011 ADJUSTED FUNDS FROM OPERATIONS Although adjusted funds from operations (“AFFO”) is a common measure in the real estate industry, the Trusts’ method of calculating AFFO may differ to that of other issuers. Management views AFFO as an alternate measure to cash flow generated from operations. AFFO is calculated by adjusting FFO for non-cash items such as: straight-lining of contractual rent, rent amortization of tenant inducements, effective interest rate accretion, unit-based compensation and mortgage interest accruals on non-recourse mortgage defaults which is a non-cash item that will become a (gain) loss on extinguishment of debt, once the lender of the bankrupt properties takes title. Non-recurring costs that impact operating cash flow may be adjusted and capital and tenant expenditures incurred by the Trusts and capitalized to the balance sheet are deducted from AFFO. AFFO is a non-GAAP measure which should not be used as an alternative to comprehensive income or cash flow from operations. Three months ended December 31 Year ended December 31 (in thousands of Canadian dollars except per unit amounts) FFO Add (deduct): Straight-lining of contractual rent Rent amortization of tenant inducements Effective interest rate accretion Mortgage interest accruals on non-recourse mortgage defaults (Gain) loss on extinguishment of debt Unit-based compensation Capital expenditures Tenant expenditures 2011 $67,750 544 278 121 311 (158) 537 (6,759) (2,432) 2010 2011 2010 $61,631 $271,896 $214,899 (4,150) 236 486 1,191 332 310 (3,428) (1,247) 288 1,028 908 2,199 (19,726) 2,034 (8,920) 938 1,772 6,783 21,538 1,225 (11,259) (15,371) (9,890) (5,517) AFFO $60,192 $55,361 $237,478 $217,347 Weighted average number of Stapled Units (in thousands of Stapled Units adjusted for conversion of non-controlling interest) Diluted weighted average number of Stapled Units (in thousands of Stapled Units) for the calculation of AFFO(1)(2)(3) AFFO per Stapled Unit (basic - adjusted for conversion of non- controlling interest) AFFO per Stapled Unit (diluted) Distributions per Stapled Unit Payout ratio 167,691 150,624 159,607 149,786 192,724 175,415 183,676 172,136 $0.36 $0.35 $0.26 72.2% $0.37 $0.35 $0.22 $1.49 $1.43 $0.98 $1.45 $1.40 $0.79 59.5% 65.8% 54.5% (1) (2) (3) For the three months ended December 31, 2011 and 2010, 530,510 units and 804,513 Stapled Units, respectively, are included in the determination of diluted AFFO with respect to the Unit Option Plan. For the year ended December 31, 2011 and 2010, 606,556 Stapled Units and 636,044 Stapled Units, respectively, are included in the determination of diluted AFFO with respect to the Unit Option Plan. The 2014, 2016, 2017 and 2020 Convertible Debentures are dilutive for the three months and year ended December 31, 2011. Therefore, debenture interest of $6.8 million and $25.8 million are added to AFFO and 24,502,505 Stapled Units and 23,462,761 Stapled Units, respectively, are included in the dilutive weighted average number of Stapled Units outstanding for both of these periods. The 2014, 2017 and 2020 Convertible Debentures are dilutive for the three months and year ended December 31, 2010. Therefore, debenture interest of $6.7 million and $23.2 million, respectively, are added to AFFO and 23,986,289 Stapled Units and 21,713,768 Stapled Units, respectively, are included in the dilutive weighted average number of Stapled Units outstanding for both of these periods. Page 29 of 43 H&R REIT AND H&R FINANCE TRUST - MD&A – December 31, 2011 Included in AFFO were additional recoveries for capital and maintenance expenditures in excess of items expensed in property operating costs of $4.4 million for the three months ended December 31, 2011 (December 31, 2010 - $2.3 million) and $7.1 million for the year ended December 31, 2011 (December 31, 2010 - $9.9 million). Included in AFFO were capital and tenant expenditures of $9.2 million for the three months ended December 31, 2011 (December 31, 2010 - $4.7 million) and $21.1 million for the year ended December 31, 2011 (December 31, 2010 - $20.9 million). Excluding the above items, AFFO would have been $65.0 million ($0.39 per Stapled Unit) compared to $57.8 million ($0.38 per Stapled Unit) for the three months ended December 31, 2011 and 2010, respectively, and $251.5 million ($1.58 per Stapled Unit) compared to $228.3 million ($1.52 per Stapled Unit) for the year ended December 31, 2011 and 2010, respectively. The primary reasons for the increase of $4.8 million in AFFO between Q4 2011 and Q4 2010 are: • • • • • • • an increase in property operating income of $15.0 million due to acquisitions in 2010 and 2011; a decrease of $0.1 million due to lower same-asset current rentals. See same-asset current rentals on page 12 for further details; an increase of $4.1 million due to lower same-asset property operating costs. See same-asset property operating costs on page 13 for further details; a decrease in property operating income of $1.1 million due to terminated leases from U.S. bankruptcies and properties sold; a decrease of $7.9 million due to higher finance cost - operations; a decrease of $0.6 million due to higher trust expenses; and a decrease of $4.5 million due to higher capital and tenant expenditures, The primary reasons for the increase of $20.1 million in AFFO for the year ended December 31, 2011 as compared to the same period in 2010 are: • • • • • • • • an increase in property operating income of $32.8 million due to acquisitions in 2010 and 2011; a decrease in property operating income of $1.5 million due to terminated leases from U.S. bankruptcies and properties sold; an increase of $1.8 million due to higher same-asset current rentals. See same-asset current rentals on page 12 for further details; an increase of $0.1 million due to lower same-asset property operating costs. See same-asset property operating costs on page 13 for further details; a decrease of $1.5 million due to lower finance income; a decrease of $11.3 million due to higher finance cost - operations; a decrease of $0.3 million due to higher capital and tenant expenditures; and an increase of $0.2 million due to lower income tax expenses. Page 30 of 43 H&R REIT AND H&R FINANCE TRUST - MD&A – December 31, 2011 The following table below provides a reconciliation of AFFO reported under previous Canadian GAAP to the AFFO currently reported under IFRS for the three months and year ended December 31, 2010 together with the inclusion of the Fairfax Debentures as an adjustment to AFFO: (in thousands of Canadian dollars) Previously reported AFFO Loss on repayment of Fairfax Debentures Revised AFFO Three months ended December 31, 2010 Year ended December 31, 2010 $55,361 - $55,361 $178,513 38,834 $217,347 The following is a reconciliation of the Trusts’ AFFO to cash provided by operations. (in thousands of Canadian dollars) Adjusted funds from operations Straight-lining of contractual rent Mortgage interest accruals on non-recourse mortgage defaults Exchangeable unit distributions Additions to capital expenditures and tenant expenditures Finance cost - operations Effective interest rate accretion Transaction costs on issuance of convertible debentures Change in other non-cash operating items Realized gain (loss) on foreign exchange Three months ended December 31 2010 2011 Year ended December 31 2010 2011 $60,192 $55,361 $237,478 $217,347 (544) (311) (1,428) 9,191 49,551 (121) (2,813) (9,525) (9) 4,150 (1,191) (1,183) 4,675 42,686 (486) - (288) (2,199) (5,302) 21,149 8,920 (6,783) (4,282) 20,888 181,012 174,120 (908) (2,813) 21,078 (23,394) 6 (8) (1,772) (4,535) (4,126) 4 Cash provided by operations $104,183 $125,096 $404,727 $399,781 Page 31 of 43 H&R REIT AND H&R FINANCE TRUST - MD&A – December 31, 2011 LIQUIDITY AND CAPITAL RESOURCES Cash Distributions In accordance with National Policy 41-201, the Trusts are required to provide the following additional disclosure relating to cash distributions. (in thousands of Canadian dollars) Cash provided by operating activities Net income (loss) Actual cash distributions paid or payable relating to the period Excess of cash provided by operating activities over cash distributions paid Excess (shortfall) of net income over cash distributions paid Three months ended December 31, 2011(1) Year ended December 31, 2011(1) Year ended December 31, 2010(1) Year ended December 31, 2009(1) $104,183 (61,338) $404,727 (25,277) $399,781 $238,941 496,600 86,525 30,225 114,112 99,426 97,726 73,958 290,615 300,355 141,215 (91,563) (139,389) 397,174 (11,201) (1) 2009 figures are based on previous Canadian GAAP, prior to transition to IFRS. The 2010 and 2011 figures are based on IFRS. For all of the periods noted above, cash provided by operating activities exceeded cash distributions. Management expects this trend to continue. Cash distributions paid exceeded net income (loss) for the three months and year ended December 31, 2011 as well as the year ended December 31, 2009 due to non-cash items which are deducted or added in determining net income. Non- cash items such as gain (loss) on change in fair value impairment losses, gain (loss) on extinguishment of debt, deferred income tax recoveries, depreciation and amortization, while deducted from or added to net income have no impact on cash available to pay current distributions. Net income exceeded cash distributions paid for the year ended December 31, 2010. Capital Resources Subject to market conditions, management expects to be able to meet all of the REIT’s ongoing obligations and to finance short-term development commitments through the issue of new securities, as well as by using conventional real estate debt, selling or refinancing other assets, the general operating facilities discussed below and the REIT’s cash flow from operations. As at December 31, 2011, the REIT is not in default or arrears on any of its obligations including interest or principal payments on debt and any debt covenant with the exception of the non payment of principal and interest for the two Great Atlantic and Pacific Tea Company non- recourse mortgages following the Chapter 11 filings of this tenant. The REIT’s subsidiaries have handed over control of these properties to the respective mortgage lenders and is waiting for the lenders to legally release the REIT’s subsidiaries from their debt obligations. The REIT’s general operating facility has been provided by the same chartered bank since the REIT’s inception. This general operating facility expires on December 31, 2013 and is secured by certain income properties. At December 31, 2011, approximately $63.0 million was available under this facility. The REIT also has a second general operating facility with another Canadian chartered bank. This facility expires November 21, 2013 and is secured by the Bow. At December 31, 2011, approximately $167.0 million was available under this facility. Other than the Bow development which is described in greater detail under “Properties under Development”, the following is a summary of material contractual obligations of the REIT (excluding mortgages due on demand) including payments due as at December 31, 2011 for the next 5 years and thereafter: Page 32 of 43 H&R REIT AND H&R FINANCE TRUST - MD&A – December 31, 2011 Contractual Obligations (in thousands of Canadian dollars) Mortgages payable 2013 Convertible debentures 2014 Convertible debentures 2016 Convertible debentures 2017 Convertible debentures 2020 Convertible debentures Series A Senior Debentures Series B Senior Debentures Series C Senior Debentures Series D Senior Debentures Series E Senior Debentures Bank indebtedness Property acquisitions(1) Total Contractual Obligations Payments Due by Period 2012 $379,068 - - - - - - - - - - - 126,000 $505,068 2013- 2014 2015- 2016 2017 and thereafter Total $514,254 114,900 127,935 - - - - - - - - 440,173 - $751,008 $1,493,401 $3,137,731 - - 75,000 - - 115,000 - - 180,000 - - - - - - 169,871 99,990 - 115,000 125,000 - 100,000 - - 114,900 127,935 75,000 169,871 99,990 115,000 115,000 125,000 180,000 100,000 440,173 126,000 $1,197,262 $1,121,008 $2,103,262 $4,926,600 (1) The total purchase price is approximately $186.0 million before transaction costs less the mortgage commitment of $60.0 million. DBRS Limited (“DBRS”) provides credit ratings of debt securities for commercial entities. A credit rating generally provides an indication of the risk that the borrower will not fulfill its obligations in a timely manner with respect to both interest and principal commitments. Rating categories range from highest credit quality (generally AAA) to default payment (generally D). DBRS has confirmed that the REIT has a credit rating of BBB with a Stable trend as at December 31, 2011. A credit rating of BBB by DBRS is generally an indication of adequate credit quality, where protection of interest and principal is considered acceptable. A credit rating of BBB or higher is an investment grade rating. There can be no assurance that any rating will remain in effect for any given period of time or that any rating will not be withdrawn or revised by DBRS at any time. The credit rating is reviewed periodically by DBRS. The REIT has no material capital or operating lease obligations. Funding of Future Commitments The REIT believes that as at December 31, 2011, through the amount available under its general operating facilities of $230.0 million, it has sufficient funds for the property acquisition commitments and to complete the development of the Bow. Please see “Properties under Development” for further details on the costs to complete. The REIT’s capacity to fund future acquisitions, capital expenditures and commitments was in excess of $1.78 billion as at December 31, 2011. This represents the amount by which the REIT can increase its debt, subject to market availability, before the REIT reaches its maximum debt limitation of 65% of debt to its GBV of assets under its banking covenants. Page 33 of 43 H&R REIT AND H&R FINANCE TRUST - MD&A – December 31, 2011 The following summarizes the estimated loan to value ratios that will be outstanding on properties whose mortgages mature over the next five years: Year 2012 2013 2014 2015 2016 Number of Properties Mortgage Debt due on Maturity ($000’s) Weighted Average Interest Rate on Maturity 2012 Estimated Property Operating Income ($000’s)(1) Loan to Value(2) 21 10 8 22 37 98 $266,290 108,147 182,632 217,938 291,260 $1,066,267 (3) 6.7% 7.4% 6.2% 5.3% 5.4% $48,252 22,902 26,933 29,029 39,353 $166,469 39% 33% 47% 53% 52% 45% (1) (2) (3) Converting U.S. dollars to Canadian dollars at an exchange rate of $1.02. Using a 7% capitalization rate. Excludes $18.0 million vendor takeback mortgage on land held for development. Based on the low percentage of the projected loan to values of the maturing mortgages, the REIT is confident it will be able to refinance these mortgages upon maturity should it choose to do so. In February 2012, the REIT refinanced three U.S. mortgages totalling U.S. $72.6 million, bearing interest at a rate of 5.94% per annum, with three new non-recourse U.S. mortgages totalling $61.0 million, bearing interest at a rate of 4.50% per annum for a 10-year term. The REIT also refinanced ten Canadian mortgages totalling $28.5 million, at a weighted average interest rate of 7.74% per annum, with ten new mortgages totalling $62.9 million, bearing interest at a rate of 3.99% per annum for a 10-year term. OFF-BALANCE SHEET ITEMS The REIT has co-owners and partners in various projects. As a rule the REIT does not provide guarantees or indemnities for these co-owners pursuant to property acquisitions because should such guarantees be provided, recourse would be available against the REIT in the event of a default of the borrowers, in which case the REIT would have a claim against the underlying real estate investment. However, in certain circumstances, where absolutely required but subject to compliance with the REIT’s Declaration of Trust and also, when management has determined that the fair value of the borrower’s investment in the real estate investment is greater than the mortgages payable for which the REIT has provided guarantees, such guarantees will be provided. At December 31, 2011, such guarantees amounted to $74.3 million (December 31, 2010 - $41.3 million), expiring in 2016 and no amount has been provided for in the combined financial statements of the Trusts for these items. These amounts arise where the REIT has guaranteed a co-owner’s share of the mortgage liability. The REIT, however, customarily guarantees or indemnifies the obligations of its nominee companies which hold separate title to each of its properties owned. In addition, the REIT continued to guarantee certain debt assumed by purchasers in connection with past dispositions of properties, and will remain liable thereunder until such debts are extinguished or the lenders agree to release the REIT’s covenants. At December 31, 2011, the estimated amount of debt subject to such guarantees, and therefore the maximum exposure to credit risk is approximately $113.4 million (December 31, 2010 - $116.4 million) with expiries between 2013 and 2018. There have been no defaults by the primary obligor for debts on which the REIT has provided its guarantees, and as a result, no contingent loss on these guarantees has been recognized in the combined financial statements. Related Party Transactions H&R Property Management Ltd. (the “Property Manager”), a company partially owned by family members of the Chief Executive Officer, provides property management services for substantially all properties owned by the REIT, including leasing services, for a fee of 2% of gross revenue. The Property Manager also provides support services in connection with the acquisition, disposition and development activities of the REIT and is also entitled to an incentive fee. Acquisitions and development support services are provided for a fee of 2/3 of 1% of total acquisition and development costs. The support services relating to dispositions of investment properties are provided for a fee of 10% of the gain on sale of investment properties adjusted for the add back of accumulated depreciation and amortization. Services are provided by the Property Manager pursuant to a property management agreement which expires on January 1, 2015 with one automatic five-year extension. During the three months ended December 31, 2011, the REIT recorded fees pursuant to this agreement of $9.6 million (December 31, 2010 - $3.6 million), of which $5.9 million (December 31, 2010 - $0.3 million) was capitalized to the cost of investment properties acquired, $0.4 million (December 31, 2010 - $0.4 million) was capitalized to properties under development and $0.6 million Page 34 of 43 H&R REIT AND H&R FINANCE TRUST - MD&A – December 31, 2011 (December 31, 2010 - $0.3 million) was capitalized to leasing expenses. The REIT has also reimbursed the Property Manager for certain direct property operating costs and tenant construction costs. For the three months ended December 31, 2011, a further amount of $0.9 million (December 31, 2010 - $0.6 million) has been earned by the Property Manager pursuant to the above agreement, in accordance with the annual incentive fee payable to the Property Manager. During the year ended December 31, 2011, the REIT recorded fees pursuant to this agreement of $24.0 million (December 31, 2010 - $14.7 million), of which $9.5 million (December 31, 2010 - $1.1 million) was capitalized to the cost of the investment properties acquired, $2.1 million (December 31, 2010 - $2.2 million) was capitalized to properties under development and $3.6 million (December 31, 2010 - $1.8 million) was capitalized to leasing expenses. The REIT has also reimbursed the Property Manager for certain direct property operating costs and tenant construction costs. For the year ended December 31, 2011, a further amount of $3.5 million (December 31, 2010 - $2.5 million) has been earned by the Property Manager pursuant to the above agreement, in accordance with the annual incentive fee payable to the Property Manager. Pursuant to the above agreement, as at December 31, 2011, $3.5 million (December 31, 2010 - $1.7 million) was payable to the Property Manager. The REIT leases space to companies affiliated with the Property Manager. The rental income earned for the three months ended December 31, 2011 is $0.3 million (December 31, 2010 - $0.3 million) and for the year ended December 31, 2011 is $1.4 million (December 31, 2010 - $1.3 million). These transactions are measured at the amount of consideration established and agreed to by the related parties. FINANCIAL INSTRUMENTS AND OTHER INSTRUMENTS Where appropriate, the REIT uses forward contracts to lock in lending rates on certain anticipated mortgages. This strategy provides certainty to the rate of interest on borrowings when the REIT is involved in transactions that close further into the future than during the normal timeframe of a transaction. At December 31, 2011, the REIT had no such forward contracts in place. Where appropriate, the REIT uses forward exchange contracts to lock in foreign exchange rates. This strategy provides certainty in the foreign exchange rates on transactions that will occur in the future. The REIT has entered into forward exchange contracts with a Canadian chartered bank, which effectively locks in the REIT’s rate to exchange, U.S. dollars into Canadian dollars. The REIT has entered into interest rate swaps on the Bow credit facility and on one U.S. mortgage which effectively locked the interest rate at 4.65% and 5.25%, respectively. At the end of each reporting period, the interest rate swaps are marked-to-market resulting in an unrealized gain or loss recorded in comprehensive income. The REIT has entered into two foreign exchange swaps with Canadian chartered banks which effectively locked the REIT’s rate to exchange U.S. dollars for the acquisition of Hess Tower as the USD mortgage on this acquisition closed subsequent to year end. These swaps are marked-to-market through earnings and any gain or loss is reported at the end of each reporting period. Page 35 of 43 H&R REIT AND H&R FINANCE TRUST - MD&A – December 31, 2011 SECTION III SUMMARY OF QUARTERLY RESULTS (in thousands of Canadian dollars) Rentals from investment properties Finance income Net earnings (loss) Total comprehensive income (loss) Rentals from investment properties Finance income Net earnings(loss) Total comprehensive income (loss) December 31, 2011 September 30, 2011 $178,174 239 (61,338) (68,393) $169,582 215 58,301 72,478 December 31, 2010 September 30, 2010 $160,700 265 60,648 55,787 $152,778 248 (12,107) (15,068) June 30, 2011 $155,861 231 9,074 7,586 June 30, 2010 $151,369 802 505,151 509,619 March 31, 2011 $153,294 366 (31,314) (34,352) March 31, 2010 $152,580 1,274 (57,092) (59,900) Changes to the quarterly financial information are not reflective of seasonality or cyclicality but generally from new property acquisitions, dispositions and income changes. Revenues may have significant fluctuations due to recoveries from tenants for changes to property operating costs depending on when major maintenance projects are incurred. SECTION IV CRITICAL ACCOUNTING ESTIMATES The preparation of the Trusts’ combined financial statements requires management to make estimates and judgements that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements and reported amounts of revenue and expenses during the reporting period. The Trusts’ combined financial statements have been prepared in accordance with IFRS. Management believes the policies which are most subject to estimation and judgements are outlined below. For a detailed description of these and other accounting policies refer to note 2 of the December 31, 2011 combined financial statements of the Trusts. Leases The REIT’s policy for property rental revenue recognition is described in note 2(h) of the financial statements. The REIT makes judgements in determining whether certain leases, in particular those tenant leases with long contractual terms where the lessee is the sole tenant in a property and long-term ground leases where the REIT is lessor, are operating or finance leases. The REIT has determined that all of its leases are operating leases. Impairment of Investment Properties The carrying amount of the REIT’s investment properties and properties under development is reviewed at each reporting date to determine whether there is an indication of impairment. If such indicator exists, then the asset’s recoverable amount is estimated. An asset is impaired when its carrying amount exceeds its recoverable amount. The recoverable amount of an asset is the greater of its value in use and its fair value less costs to sell. In assessing value in use, the estimated future cash flows are discounted to their present value using a pre-tax discount rate that reflects current market assessments of the time value of money and the risk specific to the asset. Impairment losses are recognized in net income (loss). Impairment losses recognized in prior periods are assessed at each reporting date for any indications that the loss has decreased or no longer exists. An impairment loss is reversed if there has been a change in the estimates used to determine the recoverable amount. An impairment loss is reversed only to the extent that the asset’s carrying amount does not exceed the carrying amount that would have been determined, net of depreciation or amortization, if an impairment loss had not been recognized. Page 36 of 43 H&R REIT AND H&R FINANCE TRUST - MD&A – December 31, 2011 Depreciation of Investment Properties Depreciation is based on the cost of an asset less its residual value. Significant components of individual assets are assessed, and if a component has a useful life that is different from the remainder of that asset, then that component is depreciated separately. Depreciation is recognized in net income (loss) on a straight-line basis over the estimated useful life of each component of an item of property, plant and equipment. Land is not amortized. Depreciation and amortization methods, useful lives and residual values are reviewed at each annual reporting date and adjusted as appropriate. Buildings are depreciated on a straight-line basis over their useful lives for a period of approximately 40 years. Building improvements are depreciated over their useful lives, which typically vary between 5 and 20 years. Improvements that do not meet the capitalization criteria are expensed in full in the period incurred. Paving and equipment are depreciated on a straight-line basis over their useful lives, which is typically 10 years. Intangibles resulting from in-place leases and above- and below-market leases are amortized over the related lease terms. Property Acquisitions Investment properties are held to earn rental income or for capital appreciation or for both, but not for sale in the ordinary course of business. All of the REIT’s commercial properties are investment properties measured at cost less accumulated depreciation and impairment losses. The cost of replacing a major component of a building is recognized in the carrying amount of the building if it is probable that the future economic benefits embodied within the component will flow to the REIT, and its cost can be measured reliably. The carrying amount of the replaced component is derecognized at the time of replacement through the statement of comprehensive income. Upon acquisition, the REIT performs an assessment of investment properties being acquired to determine whether the acquisition is to be accounted for as an asset acquisition or a business combination. A transaction is considered to be a business combination if the acquired property meets the definition of a business, being an integrated set of activities and assets that are capable of being managed for the purpose of providing a return to the unitholders. Whether the acquisition is accounted for as an asset acquisition or a business combination, the REIT determines the fair values of the assets and liabilities including land, building and intangibles such as above- and below-market leases, in-place operating leases and tenant renewal value. The REIT expenses transaction costs on business combinations and capitalizes transaction costs if it is an asset acquisition. The REIT has elected to apply the fair value method as deemed cost for certain properties as at January 1, 2010 and the cost model for subsequent accounting for its investment properties. The carrying values of these selected properties were adjusted to their fair value at the transition date. Significant judgments and estimates have been made by the REIT in order to fair value these properties. Income Tax During the second quarter of 2010, the REIT completed necessary restructuring to qualify for the REIT Exemption whereby defined as the new taxation regime under SIFT rules that will not apply to a real estate investment trust that meets prescribed conditions relating to the nature of its income and investments throughout the taxation year, commencing January 1, 2011. The REIT will not be subject to the SIFT Rules provided that the REIT qualifies for the REIT Exemption at all times after 2010. See the “Tax Risk” section for further discussion. Accordingly, the net deferred income tax liability of $465.2 million recorded as at March 31, 2010, was reversed into net income as at December 31, 2010. Prior to the SIFT Rules, income earned by the REIT and distributed annually to unitholders was not, and would not be, subject to taxation in the REIT, but was taxed at the unitholder level. For financial statement reporting purposes, the tax deductibility of the REIT's distributions was treated as an exemption from taxation as the REIT distributed and intended to continue distributing all of its income to its unitholders. Accordingly, prior to the SIFT Rules, the REIT did not record a provision for income taxes, or future income tax assets or liabilities, in respect of the REIT or its investments in its subsidiary trusts. Deferred income taxes are recognized for the temporary differences between the financial statement carrying amounts of assets and liabilities and their respective tax bases. Deferred income tax assets and liabilities are measured using enacted or substantively enacted tax rates and laws that are expected to apply to taxable income in the years in which those temporary differences are expected to be reversed or settled. The effect on deferred income tax assets and liabilities of a change in tax rate is recognized in income or unitholders’ equity, as appropriate, in the period that includes the date of enactment or substantive enactment. Page 37 of 43 H&R REIT AND H&R FINANCE TRUST - MD&A – December 31, 2011 DISCLOSURE CONTROLS AND PROCEDURES (“DC&P”) Each Trust’s Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”) has designed, or caused to be designed under their direct supervision, the applicable Trust’s DC&P (as defined in National Instrument 52-109 - Certification of Disclosure in Issuers’ Annual and Interim Filings (“NI 52-109”), adopted by the Canadian Securities Administrators) to provide reasonable assurance that: (i) material information relating to the applicable Trust, including its consolidated subsidiaries, is made known to them by others within those entities, particularly during the period in which the interim filings are being prepared; and (ii) material information required to be disclosed in the interim filings is recorded, processed, summarized and reported on a timely basis. The combined financial statements and MD&A were reviewed and approved by the Audit Committees and the Boards of Trustees of each Trust prior to this publication. INTERNAL CONTROL OVER FINANCIAL REPORTING Management of each Trust has reviewed its internal control over financial reporting as part of the conversion from previous Canadian GAAP to IFRS. The most significant change to each Trust’s control environment is the disclosure of the fair value of investment properties in the notes to the financial statements. Management has implemented controls and processes to ensure that accurate fair values can be determined. Other than previous Canadian GAAP to IFRS, no changes were made to the design of either Trust’s internal control over financial reporting during the three and twelve months ended December 31, 2011 that have materially affected, or are reasonably likely to materially affect, the Trusts’ internal control over financial reporting Each Trust’s management, including the CEO and CFO, does not expect that the applicable Trust’s controls and procedures will prevent or detect all misstatements due to error or fraud. Due to the inherent limitations in all control systems, an evaluation of controls can provide only reasonable, not absolute assurance, that all control issues and instances of fraud or error, if any, within the Trusts have been detected. The Trusts are continually evolving and enhancing its systems of controls and procedures. SECTION V RISKS AND UNCERTAINTIES All income property investments are subject to a degree of risk and uncertainty. They are affected by various factors including general market conditions and local market circumstances. An example of general market conditions would be the availability of long-term mortgage financing whereas local conditions would relate to factors affecting specific properties such as an oversupply of space or a reduction in demand for real estate in a particular area. Management attempts to manage these risks through geographic, type of asset and tenant diversification in the REIT’s portfolio. The major risk factors are outlined below and in the REIT’s Annual Information Form. Credit Risk and Tenant Concentration The REIT is exposed to credit risk as an owner of real estate in that tenants may become unable to pay the contracted rents. Management mitigates this risk by carrying out appropriate credit checks and related due diligence on the significant tenants. Management has diversified the REIT’s holdings so that it owns several categories of properties (office, industrial and retail) and acquires properties throughout Canada and the United States. In addition, management ensures that no tenant or related group of tenants, other than investment grade tenants, account for a significant portion of the cash flow. The only tenants which individually account for more than 5% of the rentals from income properties of the REIT are Bell Canada and TransCanada PipeLines Limited. Each of these companies that have a public debt rating is rated with at least an A low rating by a recognized rating agency. Once the Bow is completed, EnCana Corporation is also expected to account for more than 5% of the rentals from income properties. EnCana Corporation’s current public debt rating is BBB high. Lease Rollover Risk Lease rollover risk arises from the possibility that the REIT may experience difficulty renewing leases as they expire. Management attempts to enter into long-term leases to mitigate this risk. The leases for 22.9% of the REIT’s total leasable area will expire in the next 5 years. Interest and Financing Risk In the low interest rate environment that the Canadian economy has experienced in recent years, leverage has enabled the REIT to enhance its return to unitholders. A reversal of this trend, however, can significantly affect the business’s ability to meet its financial Page 38 of 43 H&R REIT AND H&R FINANCE TRUST - MD&A – December 31, 2011 obligations. In order to minimize this risk, the REIT negotiates fixed rate term debt with staggered maturities on the portfolio and attempts to match average lease maturity to average debt maturity. Derivative financial instruments may be utilized by the REIT in the management of its interest rate exposure. In addition, the REIT’s Declaration of Trust restricts total indebtedness permitted on the portfolio. Financing Credit Risk The REIT is also exposed to credit risk as a lender on the security of real estate in the event that a borrower is unable to make the contracted payments. Such risk is mitigated through credit checks and related due diligence of the borrowers and through careful evaluation of the worth of the underlying assets. Risk is further mitigated by the REIT’s investment guideline of only providing construction financing after 70% of the project has been pre-leased. Currency Risk The REIT is exposed to foreign exchange fluctuations as a result of ownership of assets in the United States and the rental income earned from these properties. In order to mitigate the risk, the REIT’s debt on these properties is also held in U.S. dollars to act as a natural hedge. The REIT is exposed to foreign exchange fluctuations as a result of the U.S. Holdco Notes being denominated in U.S. dollars. Tax Risk The REIT currently qualifies as a mutual fund trust for Canadian income tax purposes. The Tax Act contains legislation (the “SIFT Rules”) affecting the tax treatment of “specified investment flow-through” (“SIFT”) trusts. A SIFT includes a publicly-traded trust. The SIFT Rules provide for a transition period until 2011 for publicly-traded trusts like the REIT which existed prior to November 1, 2006. Under the SIFT Rules, distributions of certain income by a SIFT are not deductible in computing the SIFT’s taxable income, and a SIFT is subject to tax on such income at a rate that is substantially equivalent to the general tax rate applicable to a Canadian corporation. The SIFT Rules do not apply to a publicly-traded trust that qualifies as a real estate investment trust under the Tax Act. The REIT completed the necessary tax restructuring to qualify as a real estate investment trust effective June 30, 2010. For periods before it qualified, the REIT recorded deferred tax liabilities in respect of temporary differences expected to reverse after January 1, 2011. Such deferred tax liability was reversed as an adjustment to deferred income tax expense in income and as an adjustment to other comprehensive income during the second quarter of 2010, when the REIT became a qualifying real estate investment trust. Management of the REIT intends to conduct the affairs of the REIT so that it qualifies for the REIT Exemption at all times after 2010; however, as the requirements of the REIT Exemption include complex revenue and asset tests, no assurances can be provided that the REIT will in fact so qualify at any time. The REIT operates in the United States through U.S. Holdco which is capitalized with equity provided by the REIT and debt in the form of U.S. Holdco Notes owed to Finance Trust and HRLP. As at December 31, 2011, U.S. Holdco owed $146.5 million to Finance Trust and HRLP which is eliminated upon combination in combined financial statements. U.S. Holdco intends to treat the U.S. Holdco Notes as indebtedness for U.S. federal income tax purposes. If the Internal Revenue Service (“IRS”) or a court were to determine that the U.S. Holdco Notes should be treated for U.S. federal income tax purposes as equity rather than debt, the interest on the notes could be treated as a dividend, and interest on the notes would not be deductible for U.S. federal income tax purposes. In addition, if the IRS were to determine that the interest rate on the U.S. Holdco Notes did not represent an arm’s length rate, any excess amount over arm’s length would not be deductible and could be recharacterized as a dividend payment instead of an interest payment. This would significantly increase the U.S. federal income tax liability of U.S. Holdco, potentially including the tax liability for prior years in which U.S. Holdco has claimed a deduction for interest paid on the U.S. Holdco Notes. In addition, U.S. Holdco could be subject to penalties. The increase in tax liability could materially adversely affect U.S. Holdco’s ability to make interest payments on the U.S. Holdco Notes or the REIT’s ability to make distribution on its units. Additionally, payments of interest on the U.S. Holdco Notes to non-U.S. holders of Stapled Units could be subject to withholding taxes. To the extent that the REIT or a related party provided debt financing to U.S. Holdco (e.g., by acquiring U.S. Holdco Notes), in determining income for U.S. tax purposes, U.S. Holdco is subject to possible limitations on the deductibility of interest, if any, paid to the REIT. Section 163(j) of the U.S. Internal Revenue Code (the “Code”) applies to defer U.S. Holdings’ deduction of interest paid on Page 39 of 43 H&R REIT AND H&R FINANCE TRUST - MD&A – December 31, 2011 debt to the REIT in years that (i) the debt to equity ratio of U.S. Holdings exceeded 1.5:1, and (ii) the net interest expense exceeds an amount equal to 50% of its “adjusted taxable income” (generally, earnings before interest, taxes, depreciation, and amortization). The REIT intends to take the position that, due to the treatment of Finance Trust as a grantor trust that is disregarded for U.S. federal tax purposes, the interest paid to Finance Trust is treated as having been paid to the holders of the Finance Trust units and is therefore not subject to section 163(j). If section 163(j) applied to interest paid to Finance Trust, depending on the facts and circumstances and the availability of net operating losses to U.S. Holdco (which are subject to normal assessment by the IRS), the U.S. federal income tax liability of U.S. Holdings could increase. In such case, the amount of income available for distribution by the REIT to its unitholders could be reduced. A foreign corporation will be classified as a passive foreign investment company ("PFIC") for United States federal income tax purposes if either (i) 75% or more of its gross income is passive income or (ii) on average for the taxable year, 50% or more of its assets (by value) produce or are held for the production of passive income. The properties of the REIT are managed by a third party rather than directly by its own employees. Although the REIT's officers and employees oversee the activities of the manager, it is likely that the REIT will be characterized as a PFIC for U.S. federal income tax purposes, though this conclusion is uncertain. In the absence of certain elections being made by a U.S. holder of REIT units, any distributions in respect of the REIT units which exceed 125% of the average amount of distributions in respect of such REIT units during the preceding three years, or, if shorter, during the preceding years in the U.S. holder's holding period ("excess distributions") and any gain on a sale or other disposition of the REIT units will be treated as ordinary income and will be subject to special tax rules, including an interest charge. U.S. holders should consult with their own tax advisors regarding the implications of these rules and the advisability of making one of the applicable PFIC elections, taking into account their particular circumstances. In compliance with U.S. Treasury Department Circular 230, which provides rules governing certain conduct of U.S. tax advisors giving advice with respect to U.S. tax matters, please be aware that: (i) any U.S. federal tax advice contained herein is not intended to be used and cannot be used by the reader for the purpose of avoiding penalties that may be imposed under the Code; (ii) such advice was prepared in the expectation that it may be used in connection with the promotion or marketing (within the meaning of U.S. Treasury Department Circular 230) of Stapled Units; and (iii) prospective investors should seek advice based on their particular circumstances from an independent tax advisor. On July 20, 2011, the Department of Finance announced proposed amendments to the provisions of the Tax Act concerning the income tax treatment of SIFTs, real estate investment trusts (“Real Estate Trusts”) and publicly traded corporations. The proposed amendments include changes which impact publicly traded stapled securities of SIFTs, Real Estate Trusts and corporations. The proposals include amendments which will deny a deduction for payments made by another entity to a Real Estate Trust, or to a subsidiary of a Real Estate Trust. The stapled unit structure of the Trusts (TSX: HR.UN; HR.DB; HR.DB.B; HR.DB.C; HR.DB.D, HR.DB.E) does not involve the kinds of payments that are targeted by the proposed amendments. In particular, the REIT does not receive interest or other income from Finance Trust. Finance Trust only receives interest income from a U.S. corporation which is a wholly owned subsidiary of the REIT. Based on the information available in the Department of Finance’s press release, the Trusts expect that the amendments will not affect the Stapled Unit structure. Detailed draft legislation was not released by the government as at March 12, 2012, but will be reviewed by the REIT as soon as it is released. Tax Consequences to U.S. Holders Finance Trust qualifies as an investment trust that is classified as a grantor trust for U.S. federal income tax purposes under Treasury Regulation section 301.7701-4(c) (a ‘‘Fixed Investment Trust’’) and section 671 of the Code. In general, an investment trust will qualify as a Fixed Investment Trust if: (i) the trust has a single class of ownership interests, representing undivided beneficial interests in the assets of the trust; and (ii) there is no power under the trust agreement to vary the investment of the holders. If Finance Trust is a Fixed Investment Trust, then it will generally be disregarded for U.S. federal income tax purposes, with the result that the holders of Finance Trust units will be treated as owning directly their pro rata shares of all of the Finance Trust assets (i.e. primarily the U.S. Holdco Notes). Moreover, all payments made on the U.S. Holdco Notes will be treated as payments made directly to the holders of the Finance Trust units in proportion to their interest in Finance Trust. Provided that Finance Trust qualifies as a Fixed Investment Trust and the U.S. Holdco Notes are respected as debt for U.S. federal income tax purposes, payments of principal and interest on the U.S. Holdco Notes that are attributable to U.S. holders will be treated as payments directly to the U.S. holders. Interest on the U.S. Holdco Notes will generally be taxable to U.S. holders as ordinary income at the time it is paid or accrued and will be subject to U.S. federal taxation at a maximum marginal rate of 35%. If the U.S. Holdco Notes were treated as equity rather than debt for U.S. federal income tax purposes, then the stated interest on the U.S. Holdco Notes would be treated as a distribution with respect to units. Page 40 of 43 H&R REIT AND H&R FINANCE TRUST - MD&A – December 31, 2011 Environmental Risk As an owner and manager of real property in Canada and the United States, the REIT is subject to various laws relating to environmental matters. These laws impose a liability for the cost of removal and remediation of certain hazardous materials released or deposited on properties owned by the REIT on or adjacent properties. As required by the REIT’s Declaration of Trust and in accordance with best management practices, Phase 1 audits are completed on all properties prior to acquisition. Further investigation is conducted if Phase 1 tests indicate a potential problem. The REIT has operating policies to monitor and manage risk. In addition, the standard lease requires compliance with environmental laws and regulations and restricts tenants from carrying on environmentally hazardous activities or having environmentally hazardous substances on site. Development and Financing Risk Relating to the Bow Development The REIT entered into agreements to develop the Bow an approximately 2.0 million square foot office and retail complex in Calgary. The North Block budget, of approximately $1.63 billion (including capitalized interest), is pre-leased, on a triple net basis, to EnCana Corporation for an initial term of approximately 25 years. Any delay in the delivery of the tranches will result in a delay cost of $1.67 per square foot per month. The estimated delay cost of approximately $24.1 million will be payable by way of a credit against EnCana Corporation’s rent due. The REIT is currently bearing the risk for construction overruns and project delays as the REIT does not have a fixed price contract for the entire project cost. To mitigate this, the REIT has entered into fixed price contracts amounting to approximately 97% of the hard cost budget. The REIT is also at risk for interest rate fluctuations on this project during the construction period. To mitigate this risk, the REIT entered into an interest rate swap which is intended to limit the interest rate to an effective annual rate of 4.65%. Construction Risks It is likely that, subject to compliance with the REIT’s Declaration of Trust, the REIT will be involved in various development projects. The REIT’s obligations in respect of properties under construction, or which are to be constructed, are subject to risks which include (i) the potential insolvency of a third party developer (where the REIT is not the developer); (ii) a third party developer’s failure to use advanced funds in payment of construction costs; (iii) construction or other unforeseeable delays; (iv) cost overruns; (v) the failure of tenants to occupy and pay rent in accordance with existing lease agreements, some of which are conditional; (vi) the incurring of construction costs before ensuring rental revenues will be earned from the project; and (vii) increases in interest rates during the period of the development. See also “Development and Financing Risk relating to the Bow Development” above. Management strives to mitigate these risks where possible by entering into fixed price construction contracts with general contractors (and to the extent possible, on a bonded basis) and by attempting to obtain long-term financing as early as possible during construction. Debentures The likelihood that purchasers of the 2013, 2014, 2016, 2017 and 2020 convertible debentures and the Series A, B, C, D and E senior debentures will receive payments owing to them under the terms of such debentures will depend on the financial health of the REIT and its creditworthiness. In addition, such debentures are unsecured obligations of the REIT and are subordinate in right of payment to all the REIT’s existing and future senior indebtedness as defined in each such respective trust indenture. Therefore, if the REIT becomes bankrupt, liquidates its assets, reorganizes or enters into certain other transactions, the REIT’s assets will be available to pay its obligations with respect to such debentures only after it has paid all of its senior indebtedness in full. There may be insufficient assets remaining following such payments to pay amounts due on any or all of the debentures then outstanding. The debentures are also effectively subordinate to claims of creditors (including trade creditors) of the REIT’s subsidiaries except to the extent the REIT is a creditor of such subsidiaries ranking at least pari passu with such other creditors. Finance Trust is a creditor of U.S. Holdco, a subsidiary of the REIT. A parent entity is entitled only to the residual equity of its subsidiaries after all debt obligations of its subsidiaries are discharged. In the event of bankruptcy, liquidation or reorganization of the REIT, holders of indebtedness of the REIT (including holders of the convertible debentures, may become subordinate to lenders to the subsidiaries of the REIT. The indentures governing such debentures do not prohibit or limit the ability of the REIT or its subsidiaries to incur additional debt or liabilities (including senior indebtedness), to amend and modify the ranking of any indebtedness or to make distributions, except, in respect of distributions, where an event of default has occurred and such default has not been cured or waived. The indentures do not contain any provision specifically intended to protect holders of debentures in the event of a future leveraged transaction involving the REIT. Page 41 of 43 H&R REIT AND H&R FINANCE TRUST - MD&A – December 31, 2011 Availability of Cash for Distributions The REIT’s current proposed distribution policy is outlined under “Outlook”. As the monthly cash distribution paid by Finance Trust fluctuates monthly, the monthly cash distribution paid by the REIT will also fluctuate in order to result in an aggregate monthly cash distribution as previously outlined. Although the REIT intends to make distributions of its available cash to unitholders in accordance with its distribution policy, these cash distributions may be reduced or suspended. The actual amount distributed by the REIT will depend on numerous factors including monthly cash distributions paid by Finance Trust, capital market conditions, the financial performance of the properties, the REIT’s debt covenants and obligations, its working capital requirements, its future capital requirements, its development commitments and fluctuations in interest rates. Cash available to the REIT for distributions may be reduced from time to time because of items such as principal repayments on debt, tenant allowances, leasing commissions, capital expenditures or any other business needs that the trustees deem reasonable. The REIT may be required to use part of its debt capacity in order to accommodate any or all of the above items. The market value of Stapled Units may decline significantly if the REIT and/or Finance Trust suspends or reduces distributions. The REIT trustees retain the right to re-evaluate the distribution policy from time to time as they consider appropriate. Unit Prices Publicly traded trust units will not necessarily trade at values determined solely by reference to the underlying value of trust assets. Accordingly, the Stapled Units may trade at a premium or a discount to the underlying value of the assets of the REIT and Finance Trust. Investors in Stapled Units will be subject to all of the risks of an investment in units of Finance Trust and of an investment in units of the REIT. Holders of Stapled Units should consult the Management’s Discussion and Analysis of Finance Trust and specifically the risk factors therein. See also “Forward-Looking Disclaimer”. One of the factors that may influence the market price of the Stapled Units is the annual yield on the Stapled Units. Accordingly, an increase in market interest rates may lead investors in Stapled Units to demand a higher annual yield which could adversely affect the market price of Stapled Units. In addition, the market price for Stapled Units may be affected by changes in general market conditions, fluctuations in the markets for equity securities and numerous other factors beyond the control of the REIT and/or Finance Trust. Ability to Access Capital Markets As the REIT distributes a substantial portion of its income to unitholders, the REIT may need to obtain additional capital through capital markets and the REIT’s ability to access the capital markets through equity issues and forms of secured or unsecured debt financing may affect the operations of the REIT as such financing may be available only on disadvantageous terms, if at all. If financing is not available on acceptable terms, further acquisitions or ongoing development projects may be curtailed and cash available for distributions or to fund future commitments may be adversely affected. Dilution The number of units the Trusts are authorized to issue is unlimited. The trustees have the discretion to issue additional Stapled Units in certain circumstances, including under the REIT’s Unit Option Plan. Any issuance of Stapled Units may have a dilutive effect on the investors of Stapled Units. Redemption Right Unitholders are entitled to have their units redeemed at any time on demand. It is anticipated that this redemption right will not be the primary mechanism for unitholders to liquidate their investments. The aggregate redemption price payable by the Trusts is subject to limitations. In certain circumstances, the REIT’s Declaration of Trust provides for the in specie distributions of notes of H&R Portfolio LP Trust in the event of redemption of units of the REIT that are part of the Stapled Units. The notes which may be distributed in specie to unitholders in connection with a redemption will not be listed on any stock exchange, no established market is expected to develop for such notes and they may be subject to resale restrictions under applicable securities laws. Unitholder Liability The Trusts’ Declarations of Trust provide that unitholders will have no personal liability for actions of the Trusts and no recourse will be available to the private property of any unitholder for satisfaction of any obligation or claims arising out of a contract or obligation of the Trusts. The Declarations of Trust further provide that this lack of unitholder liability, where possible, must be provided for in certain written instruments signed by the Trusts. In addition, legislation has been enacted in the Provinces of Ontario and certain Page 42 of 43 H&R REIT AND H&R FINANCE TRUST - MD&A – December 31, 2011 other provinces that is intended to provide unitholders in those provinces with limited liability. However, there remains a risk, which the Trusts consider to be remote in the circumstances, that a unitholder could be held personally liable for the Trusts’ obligations to the extent that claims are not satisfied out of the Trusts’ assets. It is intended that the Trusts’ affairs will be conducted to seek to minimize such risk wherever possible. OUTSTANDING UNIT DATA The beneficial interests in the Trusts are represented by a single class of Stapled Units which are unlimited in number. Each unit carries a single vote at any meeting of unitholders. As at March 8, 2012, there were 175,413,549 Stapled Units issued and outstanding. As at December 31, 2011, the maximum number of Stapled Units authorized to be granted under the REIT’s Unit Option Plan was 18,000,000. Of this amount, 9,924,320 had been granted and 6,417,500 had been exercised and expired. As at March 8, 2012, there were 3,506,820 options to purchase Stapled Units outstanding of which 1,015,835 are fully vested. The following table lists the principal outstanding balance of the REIT’s convertible debentures as at March 8, 2012 and the number of Stapled Units required to convert the convertible debentures to equity: Convertible Debentures 2013 6.65% Debentures 2014 6.75% Debentures 2017 6.00% Debentures 2020 5.90% Debentures 2016 4.50% Debentures SUBSEQUENT EVENTS Principal outstanding as at March 8, 2012 Maximum number of Stapled Units issuable $114.9 million 93.9 million 169.4 million 100.0 million 75.0 million 4,969,710 6,706,000 8,917,474 4,254,894 2,918,288 a) In January 2012, the REIT received a U.S. mortgage for U.S. $250.0 million for Hess Tower in Houston, Texas, bearing interest at a rate of 4.50% per annum for an 8-year term. b) In February 2012, the REIT refinanced three U.S. mortgages totaling U.S. $72.6 million each bearing interest at a rate of 5.94% per annum, with three new non-recourse U.S. mortgages totaling $61.0 million, each bearing interest at a rate of 4.50% per annum for a 10-year term. c) In February 2012, the REIT refinanced ten Canadian mortgages totaling $28.5 million each bearing interest at a rate of 7.74% per annum, with ten new mortgages totaling $62.9 million, each bearing interest at a rate of 3.99% per annum for a 10-year term. d) In March 2012, the REIT purchased a 485,000 square foot, state-of-the-art office building in Toronto, Ontario for a purchase price of $186.0 million before transaction costs. The REIT has secured a $60 million interest only mortgage for a term of 20 years. The interest rate will be at a spread of 2.30% over the 20-year Government of Canada bond. The REIT has the right to place another $37.0 million first mortgage on this property. ADDITIONAL INFORMATION Additional information relating to the REIT and Finance Trust, including the REIT’s Annual Information Form, is available on SEDAR at www.sedar.com. Page 43 of 43 Combined Financial Statements of H&R REAL ESTATE INVESTMENT TRUST and H&R FINANCE TRUST Years ended December 31, 2011 and 2010 H&R REAL ESTATE INVESTMENT TRUST H&R FINANCE TRUST Combined Statements of Financial Position (In thousands of Canadian dollars) December 31 December 31 January 1 2011 2010 2010 $ 5,794,499 $ 4,524,958 $ 4,561,817 1,617,057 156,503 7,568,059 1,268,331 156,938 5,950,227 794,534 147,524 5,503,875 7,080 - 49,053 3,000 - 38,379 63,789 19,035 55,301 13,609 7,637,801 $ 7,034 5,998,640 $ 105,530 5,747,530 $ $ 3,163,593 $ 2,706,707 $ 2,818,476 1,370,917 126,695 - 8,640 6,072 440,173 175,849 965,828 105,652 - 3,409 3,317 89,045 170,544 654,655 84,010 469,842 2,923 - 13,560 169,182 5,291,939 4,044,502 4,212,648 2,345,862 1,954,138 1,534,882 $ 7,637,801 $ 5,998,640 $ 5,747,530 Assets Real estate assets Investment properties (note 4) Properties under development (note 5) Accrued rent receivable Mortgages and amount receivable Assets classified as held for sale (note 6) Other assets (note 7) Cash and cash equivalents (note 8) Liabilities and Unitholders' Equity Liabilities Mortgages payable (note 9) Debentures payable (note 10) Exchangeable units (note 11) Deferred tax liability (note 27) Unit options payable (note 12(a)) Derivative instruments (note 13) Bank indebtedness (notes 14) Accounts payable and accrued liabilities (note 15) Unitholders' equity Commitments and contingencies (note 28) Subsequent events (note 29) See accompanying notes to the combined financial statements 2 . H&R REAL ESTATE INVESTMENT TRUST H&R FINANCE TRUST Combined Statements of Comprehensive Income (Loss) (In thousands of Canadian dollars) Years ended December 31, 2011 and 2010 Property operating income: Rentals from investment properties (notes 17 and 26) Property operating costs Finance costs: Finance income Finance cost - operations (note 18) Gain (loss) on extinguishment of debt (notes 4 and 10(c)) Loss on change in fair value (note 19) Amortization and impairment (note 20) Trust expenses Gain on sale of investment properties Transaction costs on issuance of convertible debentures Net gain (loss) on foreign exchange Net income (loss) before income taxes Income tax recovery (expense) (note 27) Net income (loss) Other comprehensive income (loss): Unrealized gain (loss) on translation of U.S. denominated foreign operations Transfer of realized loss on cash flow hedges to net income Deferred income taxes (note 27) 2011 2010 $ 656,911 (219,997) 436,914 $ 617,427 (204,386) 413,041 1,051 (181,012) 19,726 (108,378) (268,613) (181,757) (15,366) 3,260 (2,813) 3,383 (24,992) (285) (25,277) 2,211 385 - 2,596 2,589 (174,120) (21,538) (83,282) (276,351) (77,429) (14,554) 3,576 (4,535) (6,828) 36,920 459,680 496,600 (7,449) 372 915 (6,162) Total comprehensive income (loss) attributable to unitholders $ (22,681) $ 490,438 See accompanying notes to the combined financial statements. 3 H&R REAL ESTATE INVESTMENT TRUST H&R FINANCE TRUST Combined Statements of Change in Unitholders' Equity (In thousands of Canadian dollars) Years ended December 31, 2011 and 2010 UNITHOLDERS' EQUITY Unitholders' equity, January 1, 2010 Proceeds from issuance of units Net income Distributions to unitholders (note 12(b)) Conversion of convertible debentures, note (10), net Other comprehensive loss Unitholders' equity, December 31, 2010 Proceeds from issuance of units Issue cost Net loss Distributions to unitholders (note 12(b)) Conversion of convertible debentures (note 10), net Other comprehensive income Accumulated other comprehensive Value of Accumulated Accumulated income (loss) Units net income distributions (note 16) Total $ 2,182,289 35,495 - - 7,019 - $ 727,175 - 496,600 - - - $ (1,371,328) - - (113,696) - - $ (3,254) - - - - (6,162) $ 1,534,882 35,495 496,600 (113,696) 7,019 (6,162) 2,224,803 1,223,775 (1,485,024) (9,416) 1,954,138 554,703 (22,465) - - 32,418 - - - (25,277) - - - - - - (150,251) - - - - - - - 2,596 554,703 (22,465) (25,277) (150,251) 32,418 2,596 Unitholders' equity, December 31, 2011 $ 2,789,459 $ 1,198,498 $ (1,635,275) $ (6,820) $ 2,345,862 See accompanying notes to the combined financial statements. 4 H&R REAL ESTATE INVESTMENT TRUST H&R FINANCE TRUST Combined Statements of Cash Flows (In thousands of Canadian dollars) Years ended December 31, 2011 and 2010 Cash provided by (used in): Operations: Net income (loss) Items not affecting cash: Finance cost - operations (note 18) Rent amortization of tenant inducements (note 17) Amortization and impairment (note 20) Gain on sale of investment properties Loss (gain) on extinguishment of debt (notes 4 and 10(c)) Unrealized loss (gain) on foreign exchange Deferred income tax recovery (note 27) Loss on change in fair values (note 19) Unit-based compensation (note 12(a)) Change in other non-cash operating items (note 21) Investing: Properties under development Investment properties: Net proceeds on disposition of investment properties Acquisitions (note 4) Capital expenditures (note 4) Leasing expenses and tenant inducements Mortgages receivable Restricted cash Financing: Bank indebtedness Interest paid Mortgages payable: New mortgages payable Principal repayments Proceeds from issuance of debentures payable Repayment of debentures payable (note 10(c)) Proceeds from issuance of units, net Finance cost - Class B LP unit distributions (note 18) Distributions to unitholders (note 12(b)) Increase (decrease) in cash and cash equivalents Cash and cash equivalents, beginning of year (notes 6 and 8) Cash and cash equivalents, end of year (note 8) Supplemental cash flow information (note 21) See accompanying notes to the combined financial statements. 5 2011 2010 $ (25,277) $ 496,600 181,012 1,028 181,757 (3,260) (19,726) (3,391) - 108,378 7,600 (23,394) 404,727 174,120 938 77,429 (3,576) 21,538 6,832 (460,138) 83,282 6,882 (4,126) 399,781 (292,007) (411,162) 12,078 (1,123,537) (11,259) (9,890) (4,080) 692 (1,428,003) 22,183 (80,422) (15,371) (5,517) 60,789 893 (428,607) 351,128 (220,333) 75,485 (207,822) 347,956 (175,201) 351,985 - 493,730 (5,302) (114,112) 1,029,851 6,575 7,034 13,609 $ 35,831 (107,273) 450,459 (227,752) 14,829 (4,282) (99,426) (69,951) (98,777) 105,811 7,034 $ H&R REAL ESTATE INVESTMENT TRUST H&R FINANCE TRUST Notes to Combined Financial Statements (In thousands of Canadian dollars, except unit and per unit amounts) Years ended December 31, 2011 and 2010 These combined financial statements include the accounts of H&R Real Estate Investment Trust (the "REIT") and H&R Finance Trust ("Finance Trust"). These combined financial statements are presented as supplementary information to the financial statements of the REIT and Finance Trust (collectively, the "Trusts"), all of which are filed on SEDAR. The REIT is an unincorporated open-ended trust and Finance Trust is an unincorporated investment trust both domiciled in Canada. The REIT owns, operates and develops commercial properties across Canada and in the United States. The principal office and centre of administration of the Trusts is located at 3625 Dufferin Street, Suite 500, Toronto, Ontario M3K 1N4. Unitholders of each Trust participate pro rata in distributions of income and, in the event of termination of a Trust, participate pro rata in the net assets remaining after satisfaction of all liabilities of such Trust. The combined financial statements are a result of the REIT's completion of an internal reorganization on October 1, 2008, pursuant to a Plan of Arrangement (the "Plan of Arrangement") as described in the REIT's information circular dated August 20, 2008, resulting in the stapling of the Trusts' units. The Plan of Arrangement resulted in, among other things, the creation on October 1, 2008 of Finance Trust. Each unitholder received, for each REIT unit held, a unit of Finance Trust. Each issued and outstanding Finance Trust unit is stapled to a unit of the REIT on a one-for-one basis so as to form stapled units ("Stapled Units"), and such Stapled Units are listed and posted for trading on the Toronto Stock Exchange ("TSX") listed under the symbol HR.UN. The units of each of the Trusts may only be transferred together as Stapled Units unless an event of "uncoupling" has occurred. The presentation of combined financial statements of the Trusts is useful to the unitholders on the following basis: • The units of the Trusts are stapled (as noted above), resulting in the two Trusts being under common ownership; • A support agreement between the Trusts ensures that until such time as an event of “uncoupling” occurs, when units are issued by the REIT, units must also be issued by Finance Trust simultaneously so as to maintain the stapled unit structure; • • The sole activity of Finance Trust is to provide capital funding to H&R REIT (U.S.) Holdings Inc. ("U.S. Holdco"), a wholly owned U.S. subsidiary of the REIT; and The investment activities of Finance Trust are restricted in its Declaration of Trust to providing such funding to U.S. Holdco and to make temporary investments of excess funds. 1. (a) Basis of preparation: Statement of compliance These combined financial statements have been prepared in accordance with International Financial Reporting Standards (“IFRS”) as published by the International Accounting Standards Board (“IASB”) and using accounting policies described herein. These are the Trusts’ first annual combined financial statements prepared in accordance with IFRS and IFRS 1 First-time Adoption of International Financial Reporting Standards (“IFRS 1”) has been applied. An explanation of how the transition to IFRS has affected the reported financial position, financial performance and cash flows of the Trusts is provided in note 3. The combined financial statements were authorized for issue by the REIT Board of Trustees on March 12, 2012. 6 H&R REAL ESTATE INVESTMENT TRUST H&R FINANCE TRUST Notes to Combined Financial Statements (In thousands of Canadian dollars, except unit and per unit amounts) Years ended December 31, 2011 and 2010 1. Basis of preparation (continued): (b) Basis of measurement The combined financial statements have been prepared on the historical cost basis except for the following material items in the statement of financial position which have been measured at fair value: (i) (ii) Derivative financial instruments; Liabilities for cash-settled unit-based payment arrangements; and (iii) Financial instruments at fair value through net income (loss). (c) Functional currency and presentation These combined financial statements are presented in Canadian dollars, which is the Trusts’ functional currency. All financial information presented in Canadian dollars has been rounded to the nearest thousand. The Trusts present their combined statement of financial position based on the liquidity method, where all assets and liabilities are presented in ascending order of liquidity. (d) Use of estimates and judgements The preparation of these combined financial statements in conformity with IFRS requires management to make judgements, estimates and assumptions that affect the application of accounting policies, the reported amounts of assets, liabilities, income and expenses and disclosure of contingent assets and liabilities at the date of the financial statements. Actual results may differ from these estimates. (i) Use of estimates Estimates and underlying assumptions are reviewed on an ongoing basis. Revisions to accounting estimates are recognized in the period in which the estimates are revised and in any future periods affected. Information about assumptions and estimation uncertainties that have a significant risk of resulting in a material adjustment within the next financial year are included in the following notes: • • Fair value of investment properties; Impairment of investment properties; • Useful lives of investment properties and the significant components thereof used to calculate amortization; • • Fair value of financial instruments; and Fair value of cash-settled unit-based compensation. 7 H&R REAL ESTATE INVESTMENT TRUST H&R FINANCE TRUST Notes to Combined Financial Statements (In thousands of Canadian dollars, except unit and per unit amounts) Years ended December 31, 2011 and 2010 1. Basis of preparation (continued): (ii) Use of judgements The critical judgements made in applying accounting policies that have the most significant effect on the amounts recognized in these combined financial statements are as follows: • Leases The REIT’s policy for property rental revenue recognition is described in note 2(h). The REIT makes judgements in determining whether certain leases, in particular those tenant leases with long contractual terms and long-term ground leases where the REIT is the lessor, are operating or finance leases. The REIT has determined that all of its leases are operating leases. • Income taxes The REIT is a mutual fund trust and a real estate investment trust pursuant to the Income Tax Act (Canada). Under current tax legislation, the REIT is not liable to pay Canadian income tax provided that its taxable income is fully distributed to unitholders each year. The REIT is a real estate investment trust if it meets prescribed conditions under the Income Tax Act (Canada) relating to the nature of its assets and revenue (the "REIT Conditions"). The REIT has reviewed the REIT Conditions and has assessed its interpretation and application to the REIT's assets and revenue, and it has determined that it qualifies as a real estate investment trust pursuant to the Income Tax Act (Canada) for the year. • Investment property componentization The REIT’s accounting policies relating to investment property componentization are described in note 2(c). In applying this policy, judgement is made in determining the degree of componentization for each property. • Tenant improvements The REIT makes judgments with respect to whether tenant improvements provided in connection with a lease enhance the value of the leased property, which determines whether such amounts are capitalized to investment properties. 8 H&R REAL ESTATE INVESTMENT TRUST H&R FINANCE TRUST Notes to Combined Financial Statements (In thousands of Canadian dollars, except unit and per unit amounts) Years ended December 31, 2011 and 2010 2. Significant accounting policies: The accounting policies set out below have been applied consistently to all periods presented in these combined financial statements and in preparing the opening IFRS statement of financial position at January 1, 2010 for the purposes of the transition to IFRS. (a) Basis of combination The principles used to prepare combined financial statements are similar to those used to prepare consolidated financial statements. The combined financial statements include the assets, liabilities, unitholders' equity, comprehensive income (loss) and operating results of the Trusts, after elimination of the following: (i) the REIT's notes payable to Finance Trust; and (ii) the REIT's interest expense and Finance Trust's interest income from the notes payable to Finance Trust. The foreign exchange gain (loss) recorded in net income as a result of exchanging Finance Trust's U.S. dollar note receivable from U.S. Holdco is not eliminated on combination as U.S. Holdco is a U.S. denominated foreign operation of the REIT, which results in the foreign exchange on the note payable being reported in accumulated other comprehensive income. The combination of the Trusts does not result in the elimination of the equity of Finance Trust as neither of the Trusts hold any interest in the other. The equity of the Trusts is presented by way of combining the two together. (b) Basis of consolidation These combined financial statements include the accounts of all entities in which the REIT holds a controlling interest. Finance Trust does not hold a controlling interest in any entity. The REIT carries out a portion of its activities through co-ownership agreements and records its proportionate share of assets, liabilities, revenues, expenses, and cash flows of all co-ownerships in which it participates. All material intercompany transactions and balances have been eliminated upon consolidation. (c) Investment properties Investment properties are held to earn rental income or for capital appreciation or for both, but not for sale in the ordinary course of business. All of the REIT’s commercial properties are investment properties which are measured at cost less accumulated depreciation and impairment losses. The cost of replacing a major component of a building is recognized in the carrying amount of the building if it is probable that the future economic benefits embodied within the component will flow to the REIT, and its cost can be measured reliably. The carrying amount of the replaced component is derecognized at the time of replacement through the statement of comprehensive income. Upon acquisition, the REIT performs an assessment of investment properties being acquired to determine whether the acquisition is to be accounted for as an asset acquisition or a business combination. A transaction is considered to be a business combination if the acquired property meets the definition of a business: being an integrated set of activities and assets that are capable of being managed for the purpose of providing a return to the unitholders. 9 H&R REAL ESTATE INVESTMENT TRUST H&R FINANCE TRUST Notes to Combined Financial Statements (In thousands of Canadian dollars, except unit and per unit amounts) Years ended December 31, 2011 and 2010 2. Significant accounting policies (continued): Whether the acquisition is accounted for as an asset acquisition or a business combination, the REIT determines the fair value of assets acquired and liabilities assumed including land, building and intangibles such as above- and below-market leases, in- place operating leases and tenant renewal value. The REIT expenses transaction costs on business combinations and capitalizes transaction costs if it is an asset acquisition. (d) Properties under development: Property under development for future use as investment property is accounted for as investment property under IAS 40, Investment Property. The cost of properties under development includes direct development costs, realty taxes and borrowing costs that are directly attributable to the development. Borrowing costs associated with direct expenditures on properties under development are capitalized. Borrowing costs relating to the purchase of a site or property acquired for redevelopment are also capitalized. The amount of borrowing costs capitalized is determined first by reference to borrowing specific to the project, where relevant, and otherwise by applying a weighted average cost of borrowings to eligible expenditures after adjusting for borrowings associated with other specific developments. 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 REIT considers practical completion to have occurred when the property is capable of operating in the manner intended by management. Generally this occurs upon completion of construction and receipt of all necessary occupancy and other material permits. Where the REIT has pre-leased space as of or prior to the start of the development and the lease requires the REIT to construct tenant improvements which enhance the value of the property, practical completion is considered to occur on completion of such improvements. (e) Assets held for sale and discontinued operations Non-current assets comprising assets and liabilities, that are expected to be recovered primarily through sale rather than through continuing use, are classified as held for sale. For this purpose, a sale is highly probable if management is committed to a plan to achieve the sale; there is an active program to find a buyer; the non-current asset is being actively marketed at a reasonable price; the sale is anticipated to be completed within one year from the date of classification; and it is unlikely there will be changes to the plan. Immediately before classification as held for sale, the assets are re-measured in accordance with the REIT’s accounting policies. Thereafter the assets are measured at the lower of their carrying amount and fair value less cost to sell. Impairment losses on initial classification as held for sale and subsequent gains or losses on re-measurement are recognized in net income (loss). Gains are not recognized in excess of any cumulative impairment loss. The net income (loss) arising on sale of such an asset will be recognized as a gain (loss) on sale. In accordance with IFRS 5, Non-Current Assets Held for Sale and Discontinued Operations, investment properties that constitute a component of the REIT that has either been disposed of or is classified as held for sale are presented as discontinued operations in all periods presented if the property operations are expected to be eliminated and the REIT will not have significant continuing involvement following the disposition. A component of the REIT will generally represent a major line of business or geographical area of operation. 10 H&R REAL ESTATE INVESTMENT TRUST H&R FINANCE TRUST Notes to Combined Financial Statements (In thousands of Canadian dollars, except unit and per unit amounts) Years ended December 31, 2011 and 2010 2. Significant accounting policies (continued): (f) Depreciation and amortization Depreciation is based on the cost of an asset less its residual value. Significant components of individual assets are assessed, and if a component has a useful life that is different from the remainder of that asset, then that component is depreciated separately. Depreciation is recognized in net income (loss) on a straight-line basis over the estimated useful life of each component of an item of property, plant and equipment. Land is not amortized. Depreciation and amortization methods, useful lives and residual values are reviewed at each annual reporting date and adjusted as appropriate. Buildings are depreciated on a straight-line basis over their useful lives for a period of approximately 40 years. Building improvements are depreciated over their useful lives, which typically vary between 5 and 20 years. Improvements that do not meet the capitalization criteria are expensed in full in the period incurred. Paving and equipment are depreciated on a straight-line basis over their useful lives, which is typically 10 years. Intangibles resulting from in-place leases and above- and below-market leases are amortized over the related lease terms. Leasing costs, such as commissions and tenant inducements, are deferred and amortized on a straight-line basis over the terms of the related leases. (g) Impairment of investment properties The carrying amount of the REIT’s investment properties and properties under development is reviewed at each reporting date to determine whether there is an indication of impairment. If such indicator exists, then the asset’s recoverable amount is estimated. An asset is impaired when its carrying amount exceeds its recoverable amount. The recoverable amount of an asset is the greater of its value in use and its fair value less costs to sell. In assessing value in use, the estimated future cash flows are discounted to their present value using a pre-tax discount rate that reflects current market assessments of the time value of money and the risk specific to the asset. Impairment losses are recognized in net income (loss). Impairment losses recognized in prior periods are assessed at each reporting date for any indications that the loss has decreased or no longer exists. An impairment loss is reversed if there has been a change in the estimates used to determine the recoverable amount. An impairment loss is reversed only to the extent that the asset’s carrying amount does not exceed the carrying amount that would have been determined, net of depreciation or amortization, if an impairment loss had not been recognized. (h) Revenue recognition: The REIT retains substantially all of the benefits and risks of ownership of its investment properties and therefore, accounts for its leases with tenants as operating leases. Rentals from investment properties include all amounts earned from tenants, including recovery of operating costs. Rental revenue from investment property is recognized in net income (loss) on a straight-line basis over the term of the related lease. The difference between the rental revenue recognized and the amounts contractually due under the lease agreements is recorded in accrued rent receivable. Lease incentives granted are recognized as an integral part of total rental income over the term of the lease. 11 H&R REAL ESTATE INVESTMENT TRUST H&R FINANCE TRUST Notes to Combined Financial Statements (In thousands of Canadian dollars, except unit and per unit amounts) Years ended December 31, 2011 and 2010 2. Significant accounting policies (continued): (i) Income taxes: Income tax expense comprises current and deferred tax. Current tax and deferred tax are recognized in net income (loss) except to the extent that it relates to a business combination, or items recognized directly in equity or in other comprehensive income (loss). Current tax is the expected tax payable or receivable on the taxable income or loss for the year, using tax rates enacted or substantively enacted at the reporting date, and any adjustment to tax payable in respect of previous years. The REIT is a mutual fund trust and a real estate investment trust pursuant to the Income Tax Act (Canada). Under current tax legislation, a real estate investment trust is entitled to deduct distributions of taxable income such that it is not liable to pay income tax provided that its taxable income is fully distributed to unitholders. The REIT intends to continue to qualify as a real estate investment trust and to make distributions not less than the amount necessary to ensure that the REIT will not be liable to pay income taxes. For periods in which the REIT does not qualify as a real estate investment trust and for the REIT’s corporate subsidiaries, deferred tax is recognized in respect of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for taxation purposes. Deferred tax is not recognized for the following temporary differences: the initial recognition of assets or liabilities in a transaction that is not a business combination and that affects neither accounting nor taxable net income (loss), and differences relating to investments in subsidiaries and jointly controlled entities to the extent that it is probable that they will not reverse in the foreseeable future. In addition, deferred tax is not recognized for taxable temporary differences arising on the initial recognition of goodwill. Deferred tax is measured at the tax rates that are expected to be applied to temporary differences when they reverse, based on the laws that have been enacted or substantively enacted by the reporting date. Deferred tax assets and liabilities are offset if there is a legally enforceable right to offset current tax liabilities and assets, and they relate to income taxes levied by the same tax authority on the same taxable entity, or on different tax entities, if such entities intend to settle current tax liabilities and assets on a net basis or the entities tax assets and liabilities will be realized simultaneously. A deferred tax asset is recognized for unused tax losses, tax credits and deductible temporary differences, to the extent that it is probable that future taxable profits will be available against which they can be utilized. Deferred tax assets are reviewed at each reporting date and are reduced to the extent that it is no longer probable that the related tax benefit will be realized. Finance Trust qualifies as a mutual fund trust that is not a specified investment flow-through trust under the Income Tax Act (Canada). In accordance with the terms of Finance Trust’s Declaration of Trust, all of the net income for tax purposes will be paid or be payable to unitholders in the taxation year so that no income tax is payable by Finance Trust. For financial statement reporting purposes, the tax deductibility of Finance Trust's distributions is treated as an exemption from taxation as Finance Trust has distributed and is committed to continue distributing all of its taxable income to its unitholders. 12 H&R REAL ESTATE INVESTMENT TRUST H&R FINANCE TRUST Notes to Combined Financial Statements (In thousands of Canadian dollars, except unit and per unit amounts) Years ended December 31, 2011 and 2010 2. (j) Significant accounting policies (continued): Unit option plan: The REIT has a unit option plan available for REIT trustees, consultants, officers or employees as disclosed in note 12(a). The unit option plan is considered to be a cash-settled liability under IFRS 2, Share-based Payment and as a result is measured at each reporting period and at settlement date at its fair value. The fair value of the amount payable to participants in respect of the unit option plan is recognized as an expense with a corresponding increase or decrease in liabilities, over the period that the employees unconditionally become entitled to payment. Any change in the fair value of the liability is recognized as a component of trust expenses. (k) Cash and cash equivalents: Cash and cash equivalents include deposits in banks, certificates of deposit and short-term investments with original maturities of less than 90 days. (l) Restricted cash: Restricted cash includes amounts held in reserve by lenders to fund mortgage payments, repairs and capital expenditures or property tax payments. (m) Foreign currency translation: The REIT accounts for its investments in U.S. Holdco, a wholly owned subsidiary of the REIT, in the United States (“foreign operations”) as a U.S. denominated foreign operation. Assets and liabilities of foreign operations are translated into Canadian dollars at the exchange rates in effect at the balance sheet dates and revenue and expenses are translated at the average exchange rates for the reporting periods. The foreign currency translation adjustment is recorded as a separate component of accumulated other comprehensive income (loss) until there is a reduction in the REIT’s net investment in the foreign operations. The U.S. dollar denominated bank indebtedness is designated as a hedge of the REIT’s investment in self-sustaining operations. Accordingly, the accumulated unrealized gains or losses arising from the translation of this obligation are recorded as a foreign currency translation adjustment in accumulated other comprehensive income. Finance Trust’s U.S. dollar denominated assets and liabilities are translated into Canadian dollars at the exchange rates in effect on the balance sheet date and revenue and expenses are translated at the actual exchange rate on the date incurred, resulting in any gain (loss) recorded in comprehensive income. (n) Financial instruments: (i) Non-derivative financial assets Cash and cash equivalents, accounts receivable and mortgages and amounts receivable are non-derivative financial assets classified as loans and receivables with fixed or determinable payments that are not quoted in an active market. Such assets are recognized initially at fair value plus any directly attributable transaction costs. Subsequent to initial recognition, loans and receivables are measured at amortized cost using the effective interest method, less any impairment losses. 13 H&R REAL ESTATE INVESTMENT TRUST H&R FINANCE TRUST Notes to Combined Financial Statements (In thousands of Canadian dollars, except unit and per unit amounts) Years ended December 31, 2011 and 2010 2. Significant accounting policies (continued): The Trusts derecognize a financial asset when the contractual rights to the cash flows from the asset expire, or it transfers the rights to receive the contractual cash flows on the financial asset in a transaction in which substantially all the risks and rewards of ownership of the financial asset are transferred. Financial assets and liabilities are offset and the net amount presented in the statement of financial position when, and only when, the Trusts have a current legal right to offset the amounts and intends either to settle on a net basis or to realize the asset and settle the liability simultaneously. (ii) Non-derivative financial liabilities Non-derivative financial liabilities consist of mortgages payable, senior debentures, bank indebtedness and accounts payable and accrued liabilities. Such financial liabilities are recognized initially at fair value plus any directly attributable transaction costs. Subsequent to initial recognition these financial liabilities are measured at amortized cost using the effective interest method. The Trusts derecognize a financial liability when their contractual obligations are discharged or cancelled or expire. (iii) Derivative financial instruments The REIT holds derivative financial instruments to hedge its foreign currency and interest rate risk exposures. Derivatives are recognized initially at fair value; attributable transaction costs are recognized in net income (loss) as incurred. Subsequent to initial recognition, derivatives are measured at fair value at the end of each reporting period. Any resulting gain or loss is recognized in net income (loss) immediately unless the derivative is designated and effective as a hedging instrument. None of the REIT’s derivative instruments are accounted for as hedges. (iv) Financial liabilities measured at fair value through net income (loss). A financial liability is classified at fair value through net income (loss) if it is classified as held for trading or is designated as such upon initial recognition. The convertible debentures and Class B LP units of H&R Portfolio Limited Partnership (“HRLP”), a subsidiary partnership of the REIT, were designated at fair value through profit or loss upon initial recognition. Any gains or losses arising on remeasurement are recognized in net income (loss). (o) Stapled Units: Under IAS 32, Financial Instruments: Presentation (“IAS 32”), puttable instruments, such as the Stapled Units are generally classified as financial liabilities unless the exemption criteria are met for equity classification. As a result of the REIT receiving consent of its unitholders to modify the REIT’s Declaration of Trust to eliminate the mandatory distribution and leave distributions to the discretion of the trustees and the ability of the trustees to fund distributions by way of issuing additional units prior to the amendment, the REIT met the exemption criteria under IAS 32 for equity classification. Finance Trust also met the exemption criteria under IAS 32 for equity classification. Nevertheless, the Stapled Units are not considered ordinary units under IAS 33, Earnings Per Share, and therefore an income (loss) per unit calculation is not presented. 14 H&R REAL ESTATE INVESTMENT TRUST H&R FINANCE TRUST Notes to Combined Financial Statements (In thousands of Canadian dollars, except unit and per unit amounts) Years ended December 31, 2011 and 2010 2. (p) Significant accounting policies (continued): Finance costs: Finance costs are comprised of interest expense on borrowings, distributions on Class B LP units of HRLP classified as liabilities, gain (loss) on change in fair value of convertible debentures, gain (loss) on change in fair value of Class B LP units of HRLP, gain (loss) on derivative contracts and gain (loss) on extinguishment of debt. Finance costs associated with financial liabilities presented at amortized cost are recognized in net income (loss) using the effective interest method. (q) New standards and interpretations not yet adopted: Standards issued but not yet effective up to the date of issuance of these financial statements are described below. The Trusts intend to adopt these standards when they become effective. Financial Instruments: Classification and Measurement (“IFRS 9”) IFRS 9 as issued reflects the IASB’s work to date on the replacement of IAS 39, Financial Instruments - Recognition and Measurement (“IAS 39”), and applies to classification and measurement of financial assets as defined in IAS 39. The approach to classifying an asset as either amortized cost or fair value in IFRS 9 is based on how an entity manages its financial instruments in the context of its business model and the contractual cash flow characteristics of its financial assets. The standard is effective for annual periods beginning on or after January 1, 2015. In subsequent phases, the IASB will address hedge accounting and impairment. The Trusts have not yet determined the impact of IFRS 9 on their combined financial statements. Consolidated Financial Statements (“IFRS 10”) The IASB recently issued its new suite of consolidation standards, including IFRS 10, which replaces IAS 27, Consolidated and Separate Financial Statements. IFRS 10 defines the principle of control over an investee when (i) it is exposed or has rights to variable returns from its involvement with that investee; (ii) it has the ability to affect those returns through its power over that investee; and (iii) there is a link between such power and returns. This standard is effective for annual periods beginning on or after January 1, 2013. The Trusts have not yet determined the impact of IFRS 10 on their combined financial statements. Joint Arrangements (“IFRS 11”) On May 12, 2011, the IASB issued IFRS 11. This new standard replaces IAS 31, Interests in Joint Ventures. The new standard eliminates the option to proportionately consolidate interests in certain types of joint ventures. This may impact the jointly controlled entities which the Trusts currently proportionately consolidates under IFRS. The new standard is not expected to have an impact on unitholders’ equity or net income going forward but is expected to have a presentation impact on the financial statements. This new standard is effective for the Trusts’ year end beginning January 1, 2013. 15 H&R REAL ESTATE INVESTMENT TRUST H&R FINANCE TRUST Notes to Combined Financial Statements (In thousands of Canadian dollars, except unit and per unit amounts) Years ended December 31, 2011 and 2010 2. Significant accounting policies (continued): Disclosures of Interests in Other Entities (“IFRS 12”) The IASB issued IFRS 12 to replace the existing disclosure requirements for entities that have interests in subsidiaries, joint arrangements and associates. This standard also contains disclosure requirements for entities that have interests in unconsolidated structured entities. The disclosures aim to provide information in order to enable users to evaluate the nature of, and the risks associated with, an entity’s interest in other entities, and the effects of those interests on the entity’s financial position, financial performance and cash flows. This standard is effective for annual periods beginning on or after January 1, 2013. The Trusts have not yet determined the impact of IFRS 12 on their combined financial statements. Fair Value Measurement (“IFRS 13”) In May 2011, the IASB issued IFRS 13. This new standard replaces the fair value measurement contained in individual IFRS with a single source of fair value measurement guidance. The standard defines fair value as 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 standard also establishes a framework for measuring fair value and requires the fair value hierarchy to be applied to all fair value measurements and expands disclosure requirements for fair value measurements to provide information which allows users to assess the methods and inputs used to develop fair value measurements. The Trusts intend to early adopt this standard beginning January 1, 2012. The impact of this change will be to use market prices of financial instruments, and certain non-financial instruments should they arise, at the time of measurement. 3. Explanation of transition to IFRS: As stated in note 1(a), these are the Trusts’ first combined financial statements prepared in accordance with IFRS. The accounting policies set out in note 2 have been applied in preparing the combined financial statements for the year ended December 31, 2011 and December 31, 2010 and in preparation of an opening IFRS statement of financial position at January 1, 2010 (the REIT’s date of transition to IFRS). In preparing their opening IFRS statement of financial position, the Trusts have adjusted amounts reported previously in financial statements prepared in accordance with previous Canadian Generally Accepted Accounting Principles (“Canadian GAAP”). An explanation of how the transition from previous Canadian GAAP to IFRS has affected the Trusts’ financial position, financial performance and cash flows is set out in the following tables and the notes that accompany the tables. 16 H&R REAL ESTATE INVESTMENT TRUST H&R FINANCE TRUST Notes to Combined Financial Statements (In thousands of Canadian dollars, except unit and per unit amounts) Years ended December 31, 2011 and 2010 3. (i) Explanation of transition to IFRS (continued): Reconciliation of unitholders’ equity on January 1, 2010 and December 31, 2010 Assets Real estate Assets Investment properties Properties under development Accrued rent receivable Mortgages and amount receivable Assets classified as held for sale Other assets Cash and cash equivalents Liabilities and Unitholders' Equity Liabilities Mortgages payable Debentures payable Exchangeable units Deferred tax liability Unit options payable Derivative Instruments Bank indebtedness Accounts payable and accrued liabilities Liabilities classified as held for sale January 1, 2010 Effect of Previous December 31, 2010 Previous Effect of Note 3(iv) Canadian transition to Restated Canadian transition to Restated GAAP IFRS under IFRS GAAP IFRS under IFRS a,d $ 4,124,958 $ 436,859 $ 4,561,817 $ 4,022,517 $ 502,441 $ 4,524,958 e l f h l g i i 794,534 125,212 5,044,704 63,789 19,035 60,828 105,530 - 22,312 459,171 - - (5,527) - 794,534 147,524 5,503,875 63,789 19,035 55,301 105,530 1,268,331 136,605 5,427,453 3,000 - 38,379 7,034 - 20,333 522,774 - - - - 1,268,331 156,938 5,950,227 3,000 - 38,379 7,034 $ 5,293,886 $ 453,644 $ 5,747,530 $ 5,475,866 $ 522,774 $ 5,998,640 $ 2,818,476 $ - $ 2,818,476 $ 2,706,707 $ - $ 2,706,707 565,758 75,122 138,122 - - 13,556 166,971 2,215 88,897 8,888 331,720 2,923 - 4 2,211 (2,215) 654,655 84,010 469,842 2,923 - 13,560 169,182 - 822,340 77,261 - - 3,317 89,045 170,544 - 143,488 28,391 - 3,409 - - - - 965,828 105,652 - 3,409 3,317 89,045 170,544 - 3,780,220 432,428 4,212,648 3,869,214 175,288 4,044,502 Unitholders' equity 1,513,666 21,216 1,534,882 1,606,652 347,486 1,954,138 $ 5,293,886 $ 453,644 $ 5,747,530 $ 5,475,866 $ 522,774 $ 5,998,640 17 H&R REAL ESTATE INVESTMENT TRUST H&R FINANCE TRUST Notes to Combined Financial Statements (In thousands of Canadian dollars, except unit and per unit amounts) Years ended December 31, 2011 and 2010 3. Explanation of transition to IFRS (continued): (i) Reconciliation of unitholders’ equity on January 1, 2010 Equity Component of Warrants Accumulated Other Note 3(iv) Value of Accumulated Accumulated and Comprehensive Units Net Income Distributions Debentures Loss Total $ 2,182,289 $ 682,994 $ (1,371,328) $ 50,093 $ (30,382) $ 1,513,666 b a d f e h g l - - - - - - - - - (27,540) 563,145 (126,286) (38,804) 22,312 (8,888) (2,923) (336,835) 44,181 - - - - - - - - - - - - (50,093) - - - - (50,093) 27,540 - - - - - - (412) 27,128 - 563,145 (126,286) (88,897) 22,312 (8,888) (2,923) (337,247) 21,216 $ 2,182,289 $ 727,175 $ (1,371,328) $ - $ (3,254) $ 1,534,882 Unitholders' equity, January 1, 2010 as reported under previous Canadian GAAP Foreign currency translation adjustment Fair value as deemed cost Impairment of properties at January 1, 2010 Fair value of convertible debentures Accrued rent receivable Exchangeable units Unit-based compensation Deferred tax Sub-total opening IFRS adjustments Unitholders' equity, January 1, 2010, as reported under IFRS 18 H&R REAL ESTATE INVESTMENT TRUST H&R FINANCE TRUST Notes to Combined Financial Statements (In thousands of Canadian dollars, except unit and per unit amounts) Years ended December 31, 2011 and 2010 3. (i) Explanation of transition to IFRS (continued): Reconciliation of unitholders’ equity on December 31, 2010 Note 3(iv) Value of Accumulated Accumulated Contributed Warrants and Comprehensive Units Net Income Distributions Surplus Debentures Loss Total Equity Component of Accumulated Other Unitholders' equity, December 31, 2010 as reported under previous Canadian GAAP Opening IFRS adjustments, January 1, 2010 Fair value as deemed cost Reversal of impairment of properties taken on January 1, 2010 Depreciation on impaired properties Fair value of convertible debentures Accrued rent receivable Exchangeable units Unit-based compensation Net loss on foreign exchange Deferred tax Sub- total of IFRS adjustments Unitholders' equity, December 31, 2010, as reported under IFRS $ 2,216,361 $ 855,342 $ (1,485,024) $ 1,225 $ 55,757 $ (37,009) $ 1,606,652 a d d f e h g j l - - - - 2,046 - - 6,396 - - 8,442 44,181 (36,158) 101,165 575 (50,973) (1,979) (19,503) (5,657) (53) 336,835 368,433 - - - - - - - - - - - - - - - - - - (1,225) - - (50,093) 27,128 - - - (5,664) - - - - - - - - - - - - 53 412 (1,225) (55,757) 27,593 21,216 (36,158) 101,165 575 (54,591) (1,979) (19,503) (486) - 337,247 347,486 $ 2,224,803 $ 1,223,775 $ (1,485,024) $ - $ - $ (9,416) $ 1,954,138 19 H&R REAL ESTATE INVESTMENT TRUST H&R FINANCE TRUST Notes to Combined Financial Statements (In thousands of Canadian dollars, except unit and per unit amounts) Years ended December 31, 2011 and 2010 3. Explanation of transition to IFRS (continued): (ii) Reconciliation of comprehensive income for the year ended December 31, 2010 Property operating income: Rentals from investment properties Property operating costs Finance costs: Finance income Finance cost - operations Loss on extinguishment of debt Loss on change in fair value Amortization and impairment Trust expenses Gain on sale of investment properties Transaction costs on issuance of convertible debentures Net loss on foreign exchange Net income before income taxes, exchangeable units and discontinued operations Income tax recovery Net income before exchangeable units and discontinued operations Exchangeable units Net income from continuing operations Net income from discontinued operations Net income Other comprehensive loss: Unrealized loss on translation of self-sustaining foreign operations Transfer of realized loss on cash flow hedges to net income Deferred income taxes Year ended December 31, 2010 Note 3(iv) Previous Effect of transition Restated Canadian GAAP to IFRS under IFRS a,e,i,k $ 615,572 $ 1,855 $ 617,427 i f,h f,h a,d,i,k g i f j l h i (204,084) 411,488 2,589 (179,519) (21,538) (5,521) (203,989) (139,996) (8,897) - - (6,775) (302) 1,553 - 5,399 - (77,761) (72,362) 62,567 (5,657) 3,576 (4,535) (53) (204,386) 413,041 2,589 (174,120) (21,538) (83,282) (276,351) (77,429) (14,554) 3,576 (4,535) (6,828) 51,831 (14,911) 36,920 122,845 336,835 459,680 174,676 (6,272) 168,404 3,944 172,348 (7,502) 372 503 (6,627) 321,924 6,272 328,196 (3,944) 324,252 53 - 412 465 496,600 - 496,600 - 496,600 (7,449) 372 915 (6,162) Total comprehensive income $ 165,721 $ 324,717 $ 490,438 20 H&R REAL ESTATE INVESTMENT TRUST H&R FINANCE TRUST Notes to Combined Financial Statements (In thousands of Canadian dollars, except unit and per unit amounts) Years ended December 31, 2011 and 2010 3. Explanation of transition to IFRS (continued): (iii) Impact on the statement of cash flows The IFRS adjustments made to the comparative combined statement of comprehensive income (loss) for the year ended December 31, 2010 have also been made to the combined statement of cash flows for the same period. In addition, interest paid, which was previously disclosed as supplementary cash flow information, and borrowing costs capitalized in relation to qualifying assets, are presented as interest paid within the financing activity caption in the combined statement of cash flows. There are no other material differences between the statement of cash flows presented under IFRS and the statement of cash flows presented under previous Canadian GAAP. (iv) Notes to the IFRS reconciliations In preparing these combined financial statements in accordance with IFRS 1, the REIT has applied certain of the optional exemptions from full retrospective application of IFRS. The optional exemptions are described below in (a), (b) and (c). (a) Investment properties - fair value as deemed cost The REIT has elected to apply the fair value as deemed cost for certain properties as at January 1, 2010 and the cost model for subsequent accounting for its investment properties. The carrying values of these selected properties were adjusted to their fair market value at the transition date. Any adjustment to the carrying value at the transition date is reflected as an adjustment in investment properties and an offsetting adjustment to retained earnings. The resulting adjustment to the combined statement of financial position was: Investment properties: A decrease to land An increase to building and improvements An increase to intangible assets An increase to below-market rent A decrease to tenant inducements A decrease to leasing expense December 31 2010 January 1 2010 $ (7,595) $ (7,595) 144,158 426,574 (1,990) (22,461) 147,853 464,230 (2,365) (24,756) (11,699) 526,987 $ (14,222) 563,145 $ The resulting increased amortization expense of $38,453 for the year ended December 31, 2010 was included in amortization and impairment expenses. The resulting decreased rent amortization of tenant inducements by $2,295 for the year ended December 31, 2010 was included in amortization and impairment expense. (b) Foreign currency translation election In accordance with IFRS 1, the REIT has elected to deem all foreign currency translation differences that arose prior to the date of transition in respect of all foreign operations to be nil at January 1, 2010, with the balance reclassified to retained earnings. The only effect of this is a restatement within the accounts of the unitholders’ equity. 21 H&R REAL ESTATE INVESTMENT TRUST H&R FINANCE TRUST Notes to Combined Financial Statements (In thousands of Canadian dollars, except unit and per unit amounts) Years ended December 31, 2011 and 2010 3. (c) Explanation of transition to IFRS (continued): Business combination election In accordance with IFRS 1, the REIT has elected to apply the business combination accounting standard prospectively to all business combinations subsequent to the January 1, 2010 transition date. (d) Impairment of investment properties Previous Canadian GAAP generally uses a two-step approach to impairment testing: first comparing asset carrying values with undiscounted future cash flows to determine whether impairment exists, and then measuring impairment by comparing asset carrying values to their fair value (which is calculated using discounted cash flows). IAS 36, Impairment of Assets uses a one- step approach for testing and measuring impairment, with asset carrying values compared directly with the higher of fair value less costs to sell and value in use (which uses discounted cash flows). This resulted in write-downs where the carrying value of assets were previously supported under previous Canadian GAAP on an undiscounted cash flow basis, but could not be supported on a discounted cash flow basis. Unlike previous Canadian GAAP, which does not permit reversals, IFRS allows the reversal of an impairment loss in prior periods for an asset if there has been a change in the estimates used to determine the assets recoverable amounts since the last impairment loss was recognized. The factors used in assessing fair value are described in note 4. This adjustment decreased investment properties in the statement of financial position by $126,286 at January 1, 2010 and $24,546 at December 31, 2010, which included a reversal of an impairment loss recognized in the year ended December 31, 2010 of $101,165 which was included in amortization and impairment expense. The resulting decreased amortization expense of $575 for the year ended December 31, 2010 was included in amortization and impairment expenses. (e) Accrued rent receivable Under IFRS and previous Canadian GAAP, rental revenue is recognized on a straight-line basis over the term of the lease, resulting in accruals for rents that are not billable or due until future years. Under IFRS, the accrued rent receivable amount resulting from straight-lining rent is determined from the inception of each lease or the date the REIT assumed the lease. Under previous Canadian GAAP only leases in place from January 1, 2004 were straight-lined. This adjustment increased accrued rent receivable in the statement of financial position by $22,312 at January 1, 2010 and $20,333 at December 31, 2010. This adjustment also decreased straight-lining of contractual rent by $1,979 for the year ended December 31, 2010. (f) Convertible debentures Under IFRS, the REIT has elected to measure the outstanding Convertible Debentures at fair value. At each period end, the fair value of these Convertible Debentures is measured based on the ask price of each series of Convertible Debentures. The fluctuation in the fair value between each period, is charged to gain (loss) in changes in fair values in comprehensive income. Under previous Canadian GAAP, Convertible Debentures were bifurcated into a liability component, net of issue costs, and an equity component, which represents the holders’ option to convert the Convertible Debentures into Stapled Units. Interest expense was recorded as a charge to income using an effective rate representing the coupon rate and the effective rate being credited to the debt component of the Convertible Debentures such that, at maturity, the debt component was equal to the face value of the then outstanding Convertible Debentures. 22 H&R REAL ESTATE INVESTMENT TRUST H&R FINANCE TRUST Notes to Combined Financial Statements (In thousands of Canadian dollars, except unit and per unit amounts) Years ended December 31, 2011 and 2010 3. Explanation of transition to IFRS (continued): This adjustment increased the Convertible Debentures liability in the statement of financial position by $88,897 at January 1, 2010 and $143,488 at December 31, 2010. The effective interest rate accretion of $9,681 for the year ended December 31, 2010 was eliminated. This adjustment also increased the loss on fair value of Convertible Debentures by $56,119 for the year ended December 31, 2010 and resulted in the expensing of transaction costs on issuance of the 2020 Convertible Debentures of $4,535 for the year ended December 31, 2010. (g) Unit-based compensation Under IFRS, the REIT is required to measure its cash-settled unit-based option plan at fair value and record a liability. The fluctuation in the fair value between each period is charged to trust expenses in comprehensive income. Under previous Canadian GAAP, the REIT expensed and charged to equity the cost of unit-based compensation over the weighted average vesting period. This adjustment increased the net liability to unit options payable in the statement of financial position by $2,923 at January 1, 2010 and $3,409 at December 31, 2010. This adjustment also increased trust expenses by $5,657 for the year ended December 31, 2010. (h) Exchangeable units (previously non-controlling interest) Under IAS 32, the Class B LP units of HRLP are considered puttable instruments and are classified as financial liabilities in the combined financial statements. At each period end, the fair value of these units is measured based on the ask price of Stapled Units. The fluctuation in the fair value is charged to comprehensive income and distributions on the Class B LP units of HRLP are reflected as a component of finance costs in earnings. Under previous Canadian GAAP, non-controlling interest was presented as a separate item between liabilities and unitholders’ equity in the statement of financial position, and the non- controlling interests’ share of income and other comprehensive income were deducted in calculating net income and comprehensive income of the REIT. Exchangeable units of $75,122 at January 1, 2010 and $77,261 at December 31, 2010 as determined under previous Canadian GAAP, has been reclassified as a liability. The fair value adjustment increased the exchangeable units liability in the statement of financial position by $8,888 at January 1, 2010 and $28,391 at December 31, 2010. The total effect of reclassifying the exchangeable units was $19,503 for the year ended December 31, 2010 as follows: Finance cost Loss on change in fair value Non-controlling interests' share of earnings Continuing operations Discontinued operations 23 2010 $ 4,282 21,642 (6,272) (149) 19,503 $ H&R REAL ESTATE INVESTMENT TRUST H&R FINANCE TRUST Notes to Combined Financial Statements (In thousands of Canadian dollars, except unit and per unit amounts) Years ended December 31, 2011 and 2010 3. (i) Explanation of transition to IFRS (continued): Discontinued operations The definition of discontinued operations under IFRS is more restrictive than under previous Canadian GAAP. Only disposals of significant operations, such as a major line of business or geographical area of operation, meet the IFRS requirements to present the results as discontinued operations. Discontinued operations in the financial statements as presented pursuant to previous Canadian GAAP have been reclassified to continuing operations on the IFRS financial statements as they do not meet the IFRS definition of discontinued operations. This does not affect unitholders’ equity under IFRS. As at January 1, 2010, liabilities classified as held for sale of $2,211 was reclassified to accounts payable and accrued liabilities and $4 was reclassified to bank indebtedness. The effect of reclassifying discontinued operations on the statement of comprehensive income for the year ended December 31, 2010 is as follows: Rentals from investment properties Property operating costs Amortization and impairment expense Gain on sale of investment properties Non-controlling interest from discontinued operations Net income from discontinued operations (j) Net loss on foreign exchange 2010 $ 860 (302) (41) 3,576 (149) (3,944) - $ The foreign exchange gain (loss) recorded in net income as a result of exchanging Finance Trust’s U.S. dollar note receivable from U.S. Holdco is not eliminated on combination as U.S. Holdco is a U.S. denominated foreign operation of the REIT, which results in the foreign exchange on the note payable being reported in accumulated other comprehensive income. Under IFRS, the extension option embedded in the note receivable between the REIT and Finance Trust meets the definition of a loan commitment and is no longer treated as a derivative. This adjustment increased the net loss on foreign exchange by $53 for the year ended December 31, 2010 as the translation of such derivative was no longer required. (k) Rent amortization of above- and below- market rents Under previous Canadian GAAP, the purchase price of an acquired property was recorded in several components, including intangible assets and liabilities for above- and below-market leases. These assets and liabilities were amortized against revenue over the life of the underlying leases. Under IFRS, these assets and liabilities are amortized and recognized in amortization and impairment expense. This adjustment increased amortization and impairment expense and increased rental from investment properties by $679 for year ended December 31, 2010. 24 H&R REAL ESTATE INVESTMENT TRUST H&R FINANCE TRUST Notes to Combined Financial Statements (In thousands of Canadian dollars, except unit and per unit amounts) Years ended December 31, 2011 and 2010 3. (l) Explanation of transition to IFRS (continued): Deferred tax Under both IFRS and previous Canadian GAAP, deferred income taxes are recorded for the temporary differences arising in respect of assets and liabilities for the periods when the REIT did not meet the REIT Conditions. This is determined at the tax rates that are expected to apply to the period when the asset is realized or the liability is settled. Under previous Canadian GAAP, future distributions were factored into the tax rate applied. Under IFRS, the tax rate applied to determine the deferred income tax liability on January 1, 2010 and December 31, 2010 was 46.41%, the applicable tax rate excluding future distributions. The deferred income tax liability was reversed during the quarter ended June 30, 2010 when the REIT met the REIT Conditions. This adjustment decreased the deferred tax asset by $5,527 and increased the deferred tax liability by $331,720 in the statement of financial position at January 1, 2010 and increased accumulated other comprehensive loss by $412 as at January 1, 2010 with an offsetting adjustment to retained earnings of $336,835. This adjustment also increased the income tax recovery by $336,835 for the year ended December 31, 2010. (m) Mandatory exception to retrospective application First-time adopters of IFRS must apply the provisions of IFRS 1. IFRS 1 requires adopters to retrospectively apply all IFRS standards as of the reporting date with certain optional exemptions and certain mandatory exemptions. In preparing these combined financial statements in accordance with IFRS 1, the REIT has applied the mandatory exemption from full retrospective application of IFRS for estimates. The mandatory exemption requires that estimates determined under previous Canadian GAAP cannot be revised due to the application of IFRS, except when necessary to reflect differences in accounting policies. 4. Investment properties: 2011 2010 Opening balance, beginning of year $ 4,524,958 $ 4,561,817 Acquisitions Dispositions Expenditures capitalized to building improvements Additions to leasing expenses and tenant inducements Amortization expense Impairment reversal Impairment loss Investment properties legal title transferred to lenders Change in foreign exchange Closing balance, end of year 1,443,290 (12,714) 11,259 9,383 (178,745) 2,852 (6,892) (47,665) 162,917 (17,429) 15,371 11,659 (164,670) 101,165 (14,862) (82,378) 48,773 5,794,499 $ (48,632) 4,524,958 $ 25 H&R REAL ESTATE INVESTMENT TRUST H&R FINANCE TRUST Notes to Combined Financial Statements (In thousands of Canadian dollars, except unit and per unit amounts) Years ended December 31, 2011 and 2010 4. Investment properties (continued): December 31, 2011 Land Building and improvements Paving and equipment Intangible assets Below-market leases Tenant inducements Leasing expenses December 31, 2010 Land Building and improvements Paving and equipment Intangible assets Below-market leases Tenant inducements Leasing expenses January 1, 2010 Land Building and improvements Paving and equipment Intangible assets Below-market leases Tenant inducements Leasing expenses Accumulated depreciation and Net book Cost amortization value $ 1,044,624 $ - $ 1,044,624 4,284,442 121,422 1,163,894 (119,665) 15,201 31,338 (451,150) (67,873) (235,464) 25,408 (5,420) (12,258) 3,833,292 53,549 928,430 (94,257) 9,781 19,080 $ 6,541,256 $ (746,757) $ 5,794,499 Accumulated depreciation and amortization Net book value Cost $ 866,393 $ - $ 866,393 3,257,289 120,126 895,084 (76,389) 15,311 25,551 (360,254) (59,606) (161,586) 18,731 (4,563) (11,129) 2,897,035 60,520 733,498 (57,658) 10,748 14,422 $ 5,103,365 $ (578,407) $ 4,524,958 Accumulated depreciation and amortization Net book value Cost $ 842,618 $ - $ 842,618 3,194,485 128,817 885,805 (74,826) 8,521 22,112 (289,909) (56,153) (102,605) 15,224 (3,480) (8,792) 2,904,576 72,664 783,200 (59,602) 5,041 13,320 $ 5,007,532 $ (445,715) $ 4,561,817 26 H&R REAL ESTATE INVESTMENT TRUST H&R FINANCE TRUST Notes to Combined Financial Statements (In thousands of Canadian dollars, except unit and per unit amounts) Years ended December 31, 2011 and 2010 4. Investment properties (continued): Legal title to each of the properties in the United States is held by a separate legal entity which is 100% owned, directly or indirectly, by U.S. Holdco. The assets of each such separate legal entity are not available to satisfy the debts or obligations of any other person or entity. Each such separate legal entity maintains separate books and records. The identity of the owner of a particular United States property is available from U.S. Holdco. This structure does not prevent distributions to the entity owners provided there are no conditions of default. During the year ended December 31, 2011 the lenders to five U.S. investment properties (December 31, 2010 - five investment properties) previously occupied by the bankrupt tenants Bruno’s Supermarkets LLC and Boscov’s Department Store (December 31, 2010 - Circuit City and Boscov’s Department Store) accepted title to such respective investment properties, thereby releasing the REIT from any further obligation with respect to the mortgages on such properties. The REIT recorded a gain on the extinguishment of this debt of $19,726 for year ended December 31, 2011 (December 31, 2010 - $17,296). Acquisitions: During the year ended December 31, 2011, the REIT acquired 11 investment properties (December 31, 2010 - 16 investment properties). These acquisitions have been recorded by the acquisition method with the results of operations included in these combined financial statements from the date of acquisition. The following table summarizes the fair value of the identifiable assets and liabilities as at the respective dates of acquisition: Assets Land Building Paving and equipment Intangible assets - in-place lease costs Intangible assets - above-market leases Intangible assets - tenant renewal value Intangible below-market leases Liabilities Mortgages payable, net of mark to market adjustments Total identifiable net assets at fair value settled by cash 2011 2010 $ 180,269 $ 35,308 1,031,952 100,801 2,782 187,289 33,695 49,720 (42,793) 1,442,914 4,173 16,253 8,485 1,640 (3,743) 162,917 319,753 82,495 $ 1,123,161 $ 80,422 During the year ended December 31, 2011, the REIT incurred additional costs of $376 in respect to 2010 acquisitions which are not included in the above table. Fair value disclosure: Investment properties are measured at cost less accumulated depreciation and impairment losses. In accordance with IFRS, the REIT is required to disclose the fair value of the investment properties. 27 H&R REAL ESTATE INVESTMENT TRUST H&R FINANCE TRUST Notes to Combined Financial Statements (In thousands of Canadian dollars, except unit and per unit amounts) Years ended December 31, 2011 and 2010 4. Investment properties (continued): The estimated fair values of the REIT’s investment properties (excluding properties under development) are as follows: December 31, 2011 December 31, 2010 January 1, 2010 Canada United States Total Net Book Fair Value Fair Value Fair Value Value* $ 5,004,227 $ 2,206,770 $ 7,210,997 $ 5,951,002 4,334,526 4,047,379 1,167,478 1,070,286 5,502,004 5,117,665 4,681,896 4,727,954 * Net book value includes investment properties and accrued rent receivable (including amounts in note 6). The estimated fair values presented above are based on the following methods and key assumptions: (i) Consideration of recent sales of similar properties within similar market areas; (ii) The discounted cash flow analysis which is based upon, among other things, rental income from current leases and assumptions about rental income from future leases reflecting market conditions at each reporting period, less future cash outflows in respect of such leases discounted generally over a term of ten years; (iii) The direct capitalization method which is based on the conversion of current earnings directly into an expression of market value. The normalized net income for the year is divided by an overall capitalization rate; and (iv) For the December 31, 2011 fair value assessment, 38.9% (December 31, 2010 - 19.6%, January 1, 2010 - 96.7%) of the portfolio was valued by professional external independent appraisers. The remainder of the portfolio is valued by the REIT’s internal valuation team. The REIT obtained valuations of selected properties prepared by qualified valuation professionals and considered the results when arriving at its own conclusions on values. The final investment property valuation includes the accrued rent receivable value of $156,503 (December 31, 2010 - $156,938, January 1, 2010 - $147,524) which is disclosed as a separate line item on the statement of financial position. The REIT utilizes capitalization and discount rates within the ranges provided by external industry sources. To the extent that the externally provided capitalization rate ranges change from one reporting period to the next, the fair value of the investment properties would increase or decrease accordingly. 28 H&R REAL ESTATE INVESTMENT TRUST H&R FINANCE TRUST Notes to Combined Financial Statements (In thousands of Canadian dollars, except unit and per unit amounts) Years ended December 31, 2011 and 2010 4. Investment properties (continued): The REIT has utilized the following weighted average capitalization rates in estimating the fair value of the investment properties (excluding properties under development): Overall Capitalization Rate Discount Rate Terminal Capitalization Rate Range December 31, 2011 5.75%-9.50% December 31, 2010 6.25% -10.00% January 1, 2010 6.50% -11.00% Canada 6.55% 6.98% 7.49% United States 6.99% 7.89% 8.60% Total Canada 6.68% 7.17% 7.70% 7.42% 7.85% 8.52% United States 7.72% 8.45% 8.89% Total Canada 7.51% 7.97% 8.59% 6.90% 7.36% 7.82% United States 7.33% 8.22% 8.97% Total 7.03% 7.54% 8.05% 5. Properties under development: Project Address The Bow (note 28(a)) Heart Lake Airport Road 5th Ave. at Centre Street, Calgary, AB Mayfield West Business Park, Caledon, ON 7900 Airport Road, Brampton, ON December 31 2011 December 31 2010 January 1 2010 $ $ $ 1,479,117 87,954 49,986 1,617,057 1,150,094 80,195 38,042 1,268,331 $ $ $ 719,173 39,809 35,552 794,534 The estimated fair value of the REIT’s properties under development as at December 31, 2011 is approximately $1,730,000 (December 31, 2010 - $1,449,000, January 1, 2010 - $962,000). The fair value of the Bow was determined by using a 5.50% capitalization rate on the first full year’s operating income less the cost to complete. Heart Lake and Airport Road were valued at the estimated market value per acre. Balance, beginning of year Acquisitions Development including capitalized interest Balance, end of year 2011 2010 $ 1,268,331 $ 794,534 17,500 331,226 1,617,057 $ - 473,797 1,268,331 $ 29 H&R REAL ESTATE INVESTMENT TRUST H&R FINANCE TRUST Notes to Combined Financial Statements (In thousands of Canadian dollars, except unit and per unit amounts) Years ended December 31, 2011 and 2010 6. Assets classified as held for sale There are currently no properties held for sale as at December 31, 2011 (December 31, 2010 - nil, January 1, 2010 - one industrial and one office property). The following table sets forth the balance sheet items associated with investment properties classified as held for sale: Assets Investment properties (net of accumulated depreciation of $4,378) Accrued rent receivable Other assets Cash and cash equivalents 7. Other assets: Current: Restricted cash* Accounts receivable Prepaid expenses and sundry assets Derivative instruments (note 13) Deferred income tax asset (note 27) December 31 December 31 January 1 2011 2010 2010 $ - $ - $ 18,425 - - - - 188 141 - $ - - $ - 281 19,035 $ December 31 December 31 January 1 2011 2010 2010 $ 22,110 $ 22,802 $ 23,695 12,711 12,959 1,273 7,420 6,932 1,225 6,543 12,811 3,463 - 49,053 $ - 38,379 $ 8,789 55,301 $ * Included in restricted cash are bank term deposits of $8,395 (December 31, 2010 - $3,696, January 1, 2010 - $3,694) at rates of interest varying between 0.90% to 1.03% (December 31, 2010 - 1.00%, January 1, 2010 - 0.26%). 8. Cash and cash equivalents: Cash and cash equivalents at December 31, 2011 includes cash on hand of $13,358 (December 31, 2010 - $6,785, January 1, 2010 - $9,281) and bank term deposits of $251 (December 31, 2010 - $249, January 1, 2010 - $96,249) at a rate of interest of 0.75% (December 31, 2010 - 0.93%, January 1, 2010 - 0.11% to 0.20%). 30 H&R REAL ESTATE INVESTMENT TRUST H&R FINANCE TRUST Notes to Combined Financial Statements (In thousands of Canadian dollars, except unit and per unit amounts) Years ended December 31, 2011 and 2010 9. Mortgages payable: The mortgages payable are secured by investment properties and letters of credit in certain cases, bearing fixed interest with a contractual weighted average rate of 5.89% (December 31, 2010 - 6.20%, January 1, 2010 - 6.20%) per annum and maturing between 2012 and 2035. Included in mortgages payable at December 31, 2011 are U.S. dollar denominated mortgages of U.S. $1,125,656 (December 31, 2010 - U.S. $824,066, January 1, 2010 - U.S. $826,906). The Canadian equivalents of these amounts are $1,148,169 (December 31, 2010 - $815,826, January 1, 2010 - $868,252). Debt related to certain Canadian properties is held by separate legal entities, where the rent received from each property is first used to satisfy the related debt obligations with any balance then available to satisfy the cash flow requirements of the REIT. Future principal mortgage payments are as follows: Years ending December 31: 2012 2013 2014 2015 2016 Thereafter Mortgages payable due on demand (net of financing cost of $152)* Financing costs and mark-to-market adjustment arising on acquisitions $ 379,068 218,224 296,030 349,138 401,870 1,493,401 3,137,731 20,675 5,187 $ 3,163,593 * Relates to two non-recourse mortgages to the REIT for investment properties in which the tenant Great Atlantic and Pacific Tea Company (“A&P”), has filed for protection under Chapter 11 of the United States Bankruptcy Code. The REIT expects to be released from any further obligations under these non-recourse mortgages upon the transfer of title to the lenders. 31 H&R REAL ESTATE INVESTMENT TRUST H&R FINANCE TRUST Notes to Combined Financial Statements (In thousands of Canadian dollars, except unit and per unit amounts) Years ended December 31, 2011 and 2010 10. Debentures payable: The full terms of the debentures are contained in the public offering documents and the following table summarizes the key terms: December 31 December 31 January 1 2011 2010 2010 Contractual Effective interest interest Conversion Maturity rate rate price Face value Carrying Carrying Carrying value value value Convertible Debentures (a) 2013 Convertible Debentures (HR.DB) June 30, 2013 2014 Convertible Debentures (HR.DB.B) December 31, 2014 2017 Convertible Debentures (HR.DB.C) 2020 Convertible Debentures (HR.DB.D) June 30, 2017 June 30, 2020 2016 Convertible Debentures (HR.DB.E) December 31, 2016 Senior Debentures (b) Series A Senior Debentures Series B Senior Debentures Series C Senior Debentures Series D Senior Debentures Series E Senior Debentures February 3, 2015 February 3, 2017 December 1, 2018 July 27, 2016 February 2, 2018 6.65% 6.75% 6.00% 5.90% 4.50% 5.20% 5.90% 5.00% 4.78% 4.90% 6.65% $ 23.11 $114,900 $126,218 $121,325 $117,875 6.75% 6.00% 5.90% 4.50% 14.00 19.00 23.50 25.70 5.40% - 6.06% - 5.30% - 4.96% - 5.22% - 127,935 169,871 99,990 75,000 587,696 115,000 115,000 125,000 180,000 100,000 635,000 214,393 210,640 112,989 78,000 742,240 114,346 114,204 122,860 178,718 98,549 628,677 203,038 173,100 188,125 174,913 102,500 - - - 614,988 465,888 114,154 114,073 122,613 - - 350,840 - - - - - - Non-Convertible Debentures (c) - 11.50% 12.90% - - - - 188,767 $1,222,696 $1,370,917 $965,828 $654,655 The carrying value of the Convertible Debentures is determined using the ask price on December 31, 2011, December 31, 2010 and January 1, 2010. (a) 2013 Convertible Debentures, 2014 Convertible Debentures, 2017 Convertible Debentures, 2020 Convertible Debenture and, 2016 Convertible Debentures (collectively, the “Convertible Debentures”): In June 2008, the REIT completed a public offering of $115,000 convertible unsecured subordinated debentures (the “2013 Convertible Debentures”). The 2013 Convertible Debentures could not be redeemed by the REIT on or before June 30, 2011. Thereafter, but prior to June 30, 2012, the 2013 Convertible Debentures may be redeemed, in whole or in part, only if the current market price of a Stapled Unit is at least 125% of the conversion price. On or after June 30, 2012 and prior to the maturity date, the 2013 Convertible Debentures may be redeemed by the REIT, in whole or in part, at a price equal to the principal amount plus accrued interest. 32 H&R REAL ESTATE INVESTMENT TRUST H&R FINANCE TRUST Notes to Combined Financial Statements (In thousands of Canadian dollars, except unit and per unit amounts) Years ended December 31, 2011 and 2010 10. Debentures payable (continued): In July 2009, the REIT completed a public offering of $150,000 Series B convertible unsecured subordinated debentures (the “2014 Convertible Debentures”). The 2014 Convertible Debentures may not be redeemed by the REIT on or before July 30, 2012. Thereafter, but prior to July 30, 2013, the 2014 Convertible Debentures may be redeemed, in whole or in part, only if the current market price of a Stapled Unit is at least 125% of the conversion price. On or after July 30, 2013 and prior to the maturity date, the 2014 Convertible Debentures may be redeemed by the REIT, in whole or in part, at a price equal to the principal amount plus accrued interest. In December 2009, the REIT completed a public offering of $175,000 Series C convertible unsecured subordinated debentures (the “2017 Convertible Debentures”). The 2017 Convertible Debentures may not be redeemed by the REIT on or before June 30, 2013. Thereafter, but prior to June 30, 2015, the 2017 Convertible Debentures may be redeemed, in whole or in part, only if the current market price of a Stapled Unit is at least 125% of the conversion price. On or after June 30, 2015 and prior to the maturity date, the 2017 Convertible Debentures may be redeemed by the REIT, in whole or in part, at a price equal to the principal amount plus accrued interest. In July 2010, the REIT completed a public offering of $100,000 Series D convertible unsecured subordinated debentures (the “2020 Convertible Debentures”). The 2020 Convertible Debentures may not be redeemed by the REIT on or before June 30, 2014. Thereafter, but prior to June 30, 2016, the 2020 Convertible Debentures may be redeemed, in whole or in part, only if the current market price of a Stapled Unit is at least 125% of the conversion price. On or after June 30, 2016 and prior to the maturity date, the 2020 Convertible Debentures may be redeemed by the REIT, in whole or in part, at a price equal to the principal amount plus accrued interest. In November 2011, the REIT completed a public offering of $75,000 Series E convertible unsecured subordinated debentures (the “2016 Convertible Debentures”). The 2016 Convertible Debentures may not be redeemed by the REIT on or before November 30, 2014. Thereafter, but prior to November 30, 2015, the 2016 Convertible Debentures may be redeemed, in whole or in part, only if the current market price of a Stapled Unit is at least 125% of the conversion price. On or after November 30, 2015 and prior to the maturity date, the 2016 Convertible Debentures may be redeemed by the REIT, in whole or in part, at a price equal to the principal amount plus accrued interest. Each Convertible Debenture is convertible into freely tradeable Stapled Units at the holder’s option at (i) any time prior to the maturity date and (ii) the business day immediately preceding the date specified by the REIT for redemption of the Convertible Debentures, at a specified conversion price, subject to adjustment upon the occurrence of certain events in accordance with the indenture governing the Convertible Debentures. On redemption or maturity of the Convertible Debentures, the REIT may, at its option and subject to certain conditions, elect to satisfy its obligation to repay all or any portion of the principal amount of the Convertible Debentures that are to be redeemed or that are to mature through the issuance of Stapled Units by way of issuing (or causing it to be issued) a variable number of Stapled Units equal to the principal amount of the Convertible Debentures that are to be redeemed or that are to mature divided by 95% of the then fair market value of the Stapled Units. Interest on the Convertible Debentures is payable semi-annually on June 30 and December 31. 33 H&R REAL ESTATE INVESTMENT TRUST H&R FINANCE TRUST Notes to Combined Financial Statements (In thousands of Canadian dollars, except unit and per unit amounts) Years ended December 31, 2011 and 2010 10. Debentures payable (continued): (b) Series A Senior Debentures, Series B Senior Debentures, Series C Senior Debentures, Series D Debentures and Series E Senior Debentures (collectively, the “Senior Debentures”): In February 2010, the REIT issued $115,000 Series A unsecured senior debentures (the “Series A Senior Debentures”). The interest on the Series A Senior Debentures is payable semi-annually on February 3 and August 3. On issuance, the REIT recorded a liability of $113,981, net of issue costs of $1,019. In February 2010, the REIT issued $115,000 Series B unsecured senior debentures (the “Series B Senior Debentures”). The interest on the Series B Senior Debentures is payable semi-annually on February 3 and August 3. On issuance, the REIT recorded a liability of $113,953, net of issue costs of $1,047. In September 2010, the REIT issued $125,000 Series C unsecured senior debentures (the “Series C Senior Debentures”). The interest on the Series C Senior Debentures is payable semi-annually on June 1 and December 1. On issuance, the REIT recorded a liability of $122,525, net of issue costs of $2,475. In January 2011, the REIT issued $180,000 Series D unsecured senior debentures (the “Series D Senior Debentures”). The interest on the Series D Senior Debentures is payable semi-annually on January 27 and July 27. On issuance, the REIT recorded a liability of $178,475, net of issue costs of $1,525. In October 2011, the REIT issued $100,000 Series E unsecured senior debentures (the “Series E Senior Debentures”). The interest on the Series E Senior Debentures is payable semi-annually on February 2 and August 2. On issuance, the REIT recorded a liability of $98,510, net of issue costs of $1,490. Interest expense is recorded as a charge to income and is calculated at an effective interest rate with the difference between the coupon rate and the effective rate being credited to the carrying value such that, at maturity, the carrying value is equal to the face value of the then outstanding Senior Debentures. At its option, the REIT may redeem any of the Senior Debentures, in whole at any time, or in part from time to time, prior to maturity on payment of a redemption price equal to the greater of (i) the Canada Yield Price as defined in the relevant supplemental trust indenture and (ii) par, together in each case with accrued and unpaid interest to the date fixed for redemption. The REIT will give notice of any redemption at least 30 days but not more than 60 days before the date fixed for redemption. Where less than all of any Senior Debentures are to be redeemed pursuant to their terms, the Senior Debentures to be so redeemed will be redeemed on a pro rata basis according to the principal amount of Senior Debentures registered in the respective name of each holder of Senior Debentures or in such other manner as the indenture trustee may consider equitable. The Senior Debentures are rated BBB (with a Stable trend) by DBRS Limited. 34 H&R REAL ESTATE INVESTMENT TRUST H&R FINANCE TRUST Notes to Combined Financial Statements (In thousands of Canadian dollars, except unit and per unit amounts) Years ended December 31, 2011 and 2010 10. Debentures payable (continued): (c) Non-Convertible Debentures: In April 2009, the REIT issued $200,000 of unsecured debentures (the “Non-Convertible Debentures”). In February 2010, the REIT repaid the outstanding Non-Convertible Debentures for a total repurchase price of $229,989. The repurchase price included accrued interest of $2,237. The REIT recognized a one-time non-recurring charge to the combined statement of comprehensive income of $38,834, representing the difference between the repurchase price, excluding accrued interest expense, and the carrying value of the Non-Convertible Debentures of $188,918. A summary of the carrying value of debentures payable is as follows: December 31 December 31 2011 2010 $ 614,988 $ 465,888 - 100,000 75,000 (103) (26,436) (5,869) (10) 84,670 742,240 - - (7,019) - - 56,119 614,988 350,840 - - 350,459 276,985 852 628,677 - - - - - 381 350,840 188,767 151 (188,918) - $ 1,370,917 $ 965,828 Convertible Debentures (note 10(a)) Carrying value, beginning of year Issued - 2020 Convertible Debentures Issued - 2016 Convertible Debentures Conversion - 2013 Convertible Debentures* Conversion - 2014 Convertible Debentures* Conversion - 2017 Convertible Debentures* Conversion - 2020 Convertible Debentures* Loss on fair value (note 19) Carrying value, end of year Senior Debentures (note 10(b)) Carrying value, beginning of year Issued - Series A, B and C Senior Debentures Issued - Series D and E Senior Debentures Accretion adjustment Carrying value, end of year Non-Convertible Debentures (note 10(c)) Carrying value, beginning of year Accretion adjustment Redemption Carrying value, end of year * The conversion amounts above equals $32,418 (2010 - $7,019). 35 H&R REAL ESTATE INVESTMENT TRUST H&R FINANCE TRUST Notes to Combined Financial Statements (In thousands of Canadian dollars, except unit and per unit amounts) Years ended December 31, 2011 and 2010 11. Exchangeable units: Exchangeable units represents the Class B LP units of HRLP issued to participating vendors in exchange for properties acquired by HRLP. The accounts of HRLP are consolidated into the REIT, and thus included in the combined financial statements. The Class B LP units are puttable instruments where the REIT has a contractual obligation to issue Stapled Units to participating vendors upon redemption. These puttable instruments are classified as a liability under IFRS and are measured at fair value through net income (loss). Fair value is determined by using the ask prices for the listed Stapled Units as all of the 5,437,565 Class B LP units of HRLP are exchangeable on a one-for-one basis, at the option of the holder, into Stapled Units. The ask price as at December 31, 2011 was $23.30 (December 31, 2010 - $19.43, January 1, 2010 - $15.45). Holders of the Class B LP units of HRLP are entitled to receive distributions on a per unit amount equal to a per Stapled Unit amount provided to holders of Stapled Units. Under IFRS, these distributions are considered interest expense and are included in finance costs in the statement of comprehensive income (loss). As a result of a reorganization in 2009, HRLP, the REIT, Finance Trust and H&R Portfolio LP Trust (a subsidiary of the REIT) entered into an exchange and support agreement that provides, among other things, for (i) certain capital contributions to be made by the REIT in case HRLP has insufficient (a) funds to pay the required distributions on the Class B LP units of HRLP, or (b) U.S. Holdco Notes to pay the fair market value of the Finance Trust units required to be delivered upon exchange of any Class B LP unit; and (ii) the mechanics whereby Class B LP units may be exchanged for Stapled Units. 12. Unitholders’ equity: The REIT is an unincorporated open-ended trust. The beneficial interests in the REIT are represented by a single class of units which are unlimited in number. Each unit carries a single vote at any meeting of unitholders and carries the right to participate pro rata in any distributions. Finance Trust is an unincorporated investment trust. The beneficial interests in Finance Trust are represented by a single class of units which are unlimited in number. Each unit carries a single vote at any meeting of unitholders and carries the right to participate pro rata in any distributions. The units of the REIT are stapled with the units of Finance Trust effective October 1, 2008. These Stapled Units are listed and posted for trading on the TSX. The Trusts have entered into a support agreement (“Support Agreement”) to coordinate the issuance of Stapled Units under various arrangements (note 12(c)). The units of the Trusts are freely transferable and, other than as disclosed herein, the trustees of the Trusts shall not impose any restriction on the transfer of units. Provided that an event of uncoupling (“Event of Uncoupling”) has not occurred: (a) each REIT unit may be transferred only together with a unit of Finance Trust; (b) no unit may be issued by the REIT to any person unless: (i) a unit of Finance Trust is simultaneously issued to such person, or (ii) the REIT has arranged that units will be consolidated (subject to any applicable regulatory approval) immediately after such issuance, such that each holder of a REIT unit will hold an equal number of Finance Trust units and units of the REIT immediately following such consolidation; and (c) a unitholder may require the REIT to redeem any particular number of units only if it also requires, at the same time, and in accordance with the provisions of the Finance Trust Declaration of Trust, Finance Trust to redeem that same number of units of Finance Trust. Equivalent provisions apply with respect to the transfer, issuance, consolidation and redemption of Finance Trust units. 36 H&R REAL ESTATE INVESTMENT TRUST H&R FINANCE TRUST Notes to Combined Financial Statements (In thousands of Canadian dollars, except unit and per unit amounts) Years ended December 31, 2011 and 2010 12. Unitholders’ equity (continued): An Event of Uncoupling shall occur only: (a) in the event that unitholders of the REIT vote in favour of the uncoupling of units of Finance Trust and units of the REIT such that the two securities will trade separately; or (b) at the sole discretion of the trustees of Finance Trust, but only in the event of the bankruptcy, insolvency, winding-up or reorganization (under an applicable law relating to insolvency) of the REIT or U.S. Holdco or the taking of corporate action by the REIT or U.S. Holdco in furtherance of any such action or the admitting in writing by the REIT or U.S. Holdco of its inability to pay its debts generally as they become due. The trustees of the Trusts shall use all reasonable efforts to obtain and maintain a listing for the units of the REIT and, unless an Event of Uncoupling has occurred, the Stapled Units, on one or more stock exchanges in Canada. The unitholders have the right to require the Trusts to redeem their units on demand. Provided that no Event of Uncoupling has occurred, unitholders who tender their units of one of the Trusts for redemption will also be required to tender for redemption corresponding units of the other Trust in accordance with the provisions of the respective Declarations of Trust. Upon the tender of their units for redemption, all of the unitholder’s rights to and under such units are surrendered and the unitholder is entitled to receive a price per unit as determined by the applicable Declaration of Trust. Upon valid tender for redemption of each unit of the REIT, the unitholder is entitled to receive a price per unit of the REIT as determined by a formula based on the market price of Stapled Units less an amount based on the principal amount of U.S. Holdco Notes owing per outstanding unit of Finance Trust. The redemption price payable by the REIT will be satisfied by way of a cash payment to the unitholder or, in certain circumstances, including where such payment would cause the REIT’s monthly cash redemption obligations to exceed $50 (subject to adjustment in certain circumstances or waiver by the trustees) an in specie distribution of notes of H&R Portfolio LP Trust (a subsidiary of the REIT). Upon valid tender for redemption of each unit of Finance Trust, the unitholder is entitled to receive, except as provided below, a price per unit payable in cash equal to the Canadian dollar equivalent of the outstanding principal amount of the U.S. Holdco Notes as of the redemption date, divided by the total number of Finance Trust units issued and outstanding immediately prior to the redemption date. In certain circumstances, including where such payment would cause Finance Trust's monthly cash redemption obligations to exceed $50 (subject to adjustment in certain circumstances or waiver by the trustees) the redemption price per Finance Trust unit being redeemed, to which a redeeming unitholder is entitled shall be the fair market value of the Finance Trust units being redeemed, as determined by the trustees, which shall be payable by way of delivery of U.S. Holdco Notes. 37 H&R REAL ESTATE INVESTMENT TRUST H&R FINANCE TRUST Notes to Combined Financial Statements (In thousands of Canadian dollars, except unit and per unit amounts) Years ended December 31, 2011 and 2010 12. Unitholders’ equity (continued): The following number of Stapled Units are issued and outstanding: As at January 1, 2010 Issued under the Distribution Reinvestment Plan and Unit Purchase Plan (the "DRIP") 2014 Convertible Debentures converted into units Options exercised As at December 31, 2010 Issued under the DRIP Issued on May 31, 2011 (at a price of $22.15 per unit) Issued on November 22, 2011 (at a price of $22.00 per unit) Issued on December 22, 2011 (at a price of $23.30 per unit) 2013 Convertible Debentures converted into units 2014 Convertible Debentures converted into units 2017 Convertible Debentures converted into units 2020 Convertible Debentures converted into units Options exercised As at December 31, 2011 143,825,262 814,074 355,205 1,126,101 146,120,642 1,726,620 9,030,000 8,500,000 5,370,000 4,327 1,220,874 269,940 425 311,169 172,553,997 The weighted average number of basic Stapled Units for the year ended December 31, 2011 is 154,168,966 (December 31, 2010 – 144,348,657). (a) Unit option plan: As at December 31, 2011, a maximum of 18,000,000 (December 31, 2010 - 8,800,000) Stapled Units were authorized to be issued to the REIT's officers, employees, consultants and certain trustees, of which 8,700,000 options (December 31, 2010 - 7,600,000 options) have been granted. The exercise price of each option approximated the market price of the Stapled Units on the date of grant and shall be increased by the amount, if any, by which the fair market value of one Finance Trust unit at the time of exercise of such option, exceeds the fair market value of one Finance Trust unit at the time of grant of such option. The options vest at 33.3% per year from the grant date, will be fully vested after three years, and expire ten years after the date of the grant. During the year ended December 31, 2011, 1,100,000 options were granted (December 31, 2010 – 600,000). 38 H&R REAL ESTATE INVESTMENT TRUST H&R FINANCE TRUST Notes to Combined Financial Statements (In thousands of Canadian dollars, except unit and per unit amounts) Years ended December 31, 2011 and 2010 12. Unitholders’ equity (continued): As described in note 2(j), under IFRS the unit option plan is considered a cash-settled plan with the value of the units recorded as a liability on the combined statement of financial position. The liability is released to equity when the unit options are converted to REIT units. The liability is revalued each reporting date based on the trading value of the Stapled Units. The fair value of the unit options is measured using the Black-Scholes model. Measurement inputs include unit price on measurement date, exercise price of the instrument, expected volatility (based on weighted average historic volatility adjusted for changes expected due to publicly available information), weighted average expected life of the instruments (based on historical experience and general option holder behaviour), expected distributions, and the risk-free interest rate (based on government bonds). Service and non-market performance conditions attached to the transactions are not taken into account in determining fair value. The fair value of the vested unit options as at December 31, 2011 is $8,640 (December 31, 2010 - $3,409 and January 1, 2010 - $2,923). Unit-based compensation expense of $7,600 for the year ended December 31, 2011 (December 31, 2010 - $6,882) was included in trust expenses in the statement of comprehensive income (loss). A summary of the status of the unit option plan and the changes during the respective periods are as follows: Outstanding, beginning of year Granted Exercised Expired Outstanding, end of period 2011 Weighted average exercise price Units 2010 Weighted average exercise price Units 1,560,333 $ 13.95 2,086,434 $ 13.05 1,100,000 (311,168) (66,665) 2,282,500 20.20 12.74 600,000 (1,126,101) 15.42 13.06 14.18 17.12 $ - 1,560,333 - 13.95 $ Options exercisable, end of period 657,501 $ 14.95 410,333 $ 15.00 The options outstanding at December 31, 2011 are exercisable at varying prices ranging from $9.30 to $20.83 (December 31, 2010 - $9.30 to $16.56) with a weighted average remaining life of 8.3 years (December 31, 2010 - 8.4 years). The vested options are exercisable at varying prices ranging from $9.30 to $16.56 (December 31, 2010 - $9.30 to $16.56) with a weighted average remaining life of 7.1 years (December 31, 2010 - 7.7 years). (b) Distributions Under the REIT’s Declaration of Trust, the total amount of income of the REIT to be distributed to unitholders for each calendar month shall be subject to the discretion of the trustees. The present intention of the trustees is to distribute and make payable to the unitholders all of the amount necessary to ensure that the REIT will not be liable to pay income tax under Part I of the Income Tax Act (Canada) for any year. For the year ended December 31, 2011 the REIT declared per unit distributions of $0.88 (December 31, 2010 - $0.68). 39 H&R REAL ESTATE INVESTMENT TRUST H&R FINANCE TRUST Notes to Combined Financial Statements (In thousands of Canadian dollars, except unit and per unit amounts) Years ended December 31, 2011 and 2010 12. Unitholders’ equity (continued): Pursuant to Finance Trust’s Declaration of Trust, unitholders of Finance Trust are entitled to receive all of the Distributable Cash of Finance Trust, as defined in the Declaration of Trust. Distributable Cash means, subject to certain exceptions, all amounts received by Finance Trust less certain costs, expenses or other amounts payable by Finance Trust, and less any amounts which, in the opinion of the trustees, may reasonably be considered to be necessary to provide for the payment of any costs or expenditures that have been or will be incurred in the activities and operations of Finance Trust and to provide for payment of any tax liability of Finance Trust. Finance Trust paid per unit distributions of $0.10 for the year ended December 31, 2011 (2010 - $0.11). The details of the distributions are as follows: Cash distributions to unitholders Unit distributions (issued under the DRIP) (c) Support agreement: 2011 2010 $ $ 114,112 36,139 150,251 99,426 14,270 113,696 $ $ Pursuant to provisions of the Declarations of Trust for Finance Trust and the REIT, at all times, each REIT unit must be stapled to a Finance Trust unit (and each Finance Trust unit must be stapled to a REIT unit) unless there is an Event of Uncoupling. As part of the Plan of Arrangement, the REIT and Finance Trust entered into the Support Agreement which provided, among other things, for the co-ordination of the declaration and payment of all distributions so as to provide for simultaneous record dates and payment dates; for co-ordination so as to permit the REIT to perform its obligations pursuant to the REIT’s Declaration of Trust, Unit Option Plan, DRIP and Unitholder Rights Plan; for Finance Trust to take all such actions and do all such things as are necessary or desirable to enable and permit the REIT to perform its obligations arising under any security issued by the REIT (including securities convertible, exercisable or exchangeable into Stapled Units); for Finance Trust to take all such actions and do all such things as are necessary or desirable to enable the REIT to perform its obligations or exercise its rights under its convertible debentures; and for Finance Trust to take all such actions and do all such things as are necessary or desirable to issue Finance Trust units simultaneously (or as close to simultaneously as possible) with the issue of REIT units and to otherwise ensure at all times that each holder of a particular number of REIT units holds an equal number of Finance Trust units, including participating in and cooperating with any public or private distribution of Stapled Units by, among other things, signing prospectuses or other offering documents. In the event that the REIT issues additional REIT units, pursuant to the Support Agreement, the REIT and Finance Trust will co- ordinate so as to ensure that each subscriber receives both REIT units and Finance Trust units, which shall trade together as Stapled Units. Prior to such event, the REIT shall provide notice to Finance Trust to cause Finance Trust to issue and deliver the requisite number of Finance Trust units to be received by and issued to, or to the order of, each subscriber as the REIT directs. In consideration of the issuance and delivery of each such Finance Trust unit, the REIT (on behalf of the purchaser) or the purchaser, as the case may be, shall pay (or arrange for the payment of) a purchase price equal to the fair market value (as determined by Finance Trust in consultation with the REIT) of each such Finance Trust unit at the time of such issuance. The remainder of the subscription price for Stapled Units shall be allocated to the issuance of REIT units by the REIT. 40 H&R REAL ESTATE INVESTMENT TRUST H&R FINANCE TRUST Notes to Combined Financial Statements (In thousands of Canadian dollars, except unit and per unit amounts) Years ended December 31, 2011 and 2010 12. Unitholders’ equity (continued): (d) Short form base shelf prospectus: On March 31, 2011, the Trusts issued a short form base shelf prospectus allowing the Trusts to offer Stapled Units and the REIT to offer and issue the following securities: (i) preferred units; (ii) unsecured debt securities; (iii) subscription receipts exchangeable for Stapled Units and/or other securities of the REIT; (iv) warrants exercisable to acquire Stapled Units and/or other securities of the REIT; and (v) securities comprised of more than one of Stapled Units, debt securities, subscription receipts and/or warrants offered together as a unit, or any combination thereof having an offer price of up to $2,000,000 in aggregate (or the equivalent thereof, at the date of issue, in any other currency or currencies, as the case may be) at any time during the 25-month period that the short form base shelf prospectus (including any amendments) remains valid. As at December 31, 2011, $512,136 Stapled Units, $100,000 Senior unsecured debentures of the REIT and $75,000 convertible unsecured subordinated debentures of the REIT have been issued under the short form base shelf prospectus. 13. Derivative instruments Fair value (liability) asset ** Unrealized gain (loss) on derivative contracts * December 31 December 31 2010 2011 January 1 2010 December 31 December 31 2010 2011 Foreign exchange forward contracts Foreign exchange swap Foreign exchange swap Interest rate swap - the Bow Facility Mortgage interest rate swap (a) (a) (a) (b) (c) $ $ $ $ $ (730) 1,273 (1,106) (3,520) (716) (4,799) 1,225 - - (2,897) (420) (2,092) - - - 3,463 - 3,463 (1,933) 1,273 (1,106) (623) (276) (2,665) 1,274 - - (6,360) (435) (5,521) $ $ $ $ $ a) The REIT entered into foreign exchange forward contracts and swaps with Canadian chartered banks effectively locking the REIT’s rate to exchange U.S. dollars into Canadian dollars. b) The REIT entered into an interest rate swap that is intended to limit its interest rate exposure during the term of the Bow Facility (note 14(b)). As at December 31, 2011, the expected annual effective interest rate for the Bow Facility, including the cost of the swap, is 4.65% (December 31, 2010 - 4.65%). c) The REIT entered into an interest rate swap on one U.S. mortgage. The expected annual effective interest rate for this mortgage is 5.25%. * Excludes amounts relating to foreign exchange which have been recorded in accumulated other comprehensive income (loss) note (16). ** Derivative instruments in asset and liability positions are not presented on a net basis. When a derivative instrument is in an asset position, the amount is recorded in other assets (note 7). 41 H&R REAL ESTATE INVESTMENT TRUST H&R FINANCE TRUST Notes to Combined Financial Statements (In thousands of Canadian dollars, except unit and per unit amounts) Years ended December 31, 2011 and 2010 14. Bank indebtedness: The REIT has the following facilities: (a) A general operating facility which is secured by fixed charges over certain investment properties due on December 31, 2013. The total facility as at December 31, 2011 is $300,000 (December 31, 2010 - $295,300, January 1, 2010 - $284,650) and can be drawn in either Canadian or U.S. dollars (to a maximum of $150,000 U.S. dollars for U.S. borrowings). The amount available at December 31, 2011, after taking into account the bank indebtedness drawn of $207,173 (December 31, 2010 - $62,603, January 1, 2010 - $13,560) and the outstanding letters of credit and other items, is $63,027 (December 31, 2010 - $188,148, January 1, 2010 - $236,716). The Canadian dollar bank indebtedness bears interest at rates approximating the prime rate of a Canadian chartered bank. At December 31, 2011, the Canadian prime interest rate was 3.00% (December 31, 2010 - 3.00%, January 1, 2010 - 2.25%) per annum. Included in bank indebtedness at December 31, 2011 are U.S. dollar denominated amounts of $144,825 (December 31, 2010 - U.S. $101, January 1, 2010 - U.S. $33). The Canadian equivalents of these amounts are $147,722 (December 31, 2010 - $100, January 1, 2010 - $35). (b) A general operating facility which is secured by The Bow (“the Bow Facility”) due on November 21, 2013. The total facility as at December 31, 2011 is $400,000 (December 31, 2010 - $425,000, January 1, 2010 - $425,000) and can be drawn in either Canadian or U.S. dollars (to a maximum of $150,000 U.S. dollars). As at December 31, 2011, the REIT has drawn $233,000 (December 31, 2010 - $26,442, January 1, 2010 - $nil) under the Bow Facility and the amount available at December 31, 2011 is $167,000 (December 31, 2010 - $398,558, January 1, 2010 - $425,000). Included in bank indebtedness at December 31, 2011 are U.S. dollar denominated amounts of $150,000 (December 31, 2010 - U.S. $nil, January 1, 2010 - U.S. $nil). The Canadian equivalents of these amounts are $153,000 (December 31, 2010 - $nil, January 1, 2010 - $nil). 15. Accounts payable and accrued liabilities: Current: Accounts payable for properties under development Other accounts payable and accrued liabilities Debenture interest payable Prepaid rent Mortgage interest payable Non-current: Security deposits December 31 December 31 January 1 2011 2010 2010 $ 54,332 $ 66,890 $ 74,455 53,441 27,164 24,356 13,188 50,762 5,969 24,495 19,272 42,272 264 25,842 23,386 3,368 175,849 $ 3,156 170,544 $ 2,967 169,186 $ 42 H&R REAL ESTATE INVESTMENT TRUST H&R FINANCE TRUST Notes to Combined Financial Statements (In thousands of Canadian dollars, except unit and per unit amounts) Years ended December 31, 2011 and 2010 16. Accumulated other comprehensive income (loss): Balance as at January 1, 2010 Transfer of realized loss on cash flow hedges to net income Deferred income tax Unrealized loss on translation of U.S. denominated foreign operation Balance as at December 31, 2010 Transfer of realized loss on cash flow hedges to net income Unrealized gain on translation of U.S. denominated foreign operation Balance as at December 31, 2011 17. Rentals from investment properties: Rentals from investment properties Straight-lining of contractual rent Rent amortization of tenant inducements Operating Leases: Cash flow hedges Foreign operations Total $ (3,254) $ - $ (3,254) 372 915 - (1,967) 385 - - (7,449) (7,449) 372 915 (7,449) (9,416) - 385 - (1,582) $ 2,211 (5,238) $ 2,211 (6,820) $ 2011 2010 $ 658,227 (288) (1,028) 656,911 $ $ 609,445 8,920 (938) 617,427 $ The REIT leases out its investment properties held under operating leases (note 4). The future minimum lease payments under non-cancellable leases are as follows: December 31 2011 December 31 2010 January 1 2010 $ $ $ 505,100 2,129,411 5,187,791 7,822,302 401,428 1,795,801 4,738,906 6,936,135 387,812 1,691,840 4,878,173 6,957,825 $ $ $ Less than 1 year Between 1 and 5 years More than 5 years 43 H&R REAL ESTATE INVESTMENT TRUST H&R FINANCE TRUST Notes to Combined Financial Statements (In thousands of Canadian dollars, except unit and per unit amounts) Years ended December 31, 2011 and 2010 18. Finance cost - operations: Contractual interest on mortgages payable Contractual interest on debentures payable Interest on construction loans Effective interest rate accretion Bank interest and charges Exchangeable unit distributions Capitalized interest* 2011 2010 $ 171,193 $ 170,293 61,262 7,235 908 4,389 5,302 46,400 7,369 1,772 3,573 4,282 250,289 233,689 (69,277) 181,012 $ (59,569) 174,120 $ * The capitalized interest is determined using the REIT’s weighted average rate of borrowing on all financial liabilities of 6.10% (2010 - 6.58%). 19. Loss on change in fair value: Loss on fair value of convertible debentures (note 10) Loss on fair value of exchangeable units (note 11) Unrealized net loss on derivative instruments (note 13) 20. Amortization and impairment: Depreciation of investment properties Amortization of intangible assets on acquisitions Amortization of above- and below- market rents Amortization of leasing expenses Impairment loss on investment properties Impairment reversal on investment properties 2011 2010 $ (84,670) (21,043) (2,665) (108,378) $ $ (56,119) (21,642) (5,521) (83,282) $ 2011 2010 $ 107,240 $ 98,943 46,398 19,634 4,445 40,052 21,052 3,685 6,892 (2,852) 181,757 $ 14,862 (101,165) 77,429 $ 44 H&R REAL ESTATE INVESTMENT TRUST H&R FINANCE TRUST Notes to Combined Financial Statements (In thousands of Canadian dollars, except unit and per unit amounts) Years ended December 31, 2011 and 2010 20. Amortization and impairment (continued): During the year ended December 31, 2011, the REIT recorded an impairment loss of $6,892 on four Canadian investment properties and two U.S. investment properties. This impairment loss was recorded as the carrying value of the investment properties was determined to exceed the recoverable value of the property based on the value in use. The events leading to the impairments recorded resulted from the early termination of tenant leases or the bankruptcy of tenants. As a result of these events, the REIT determined that the market rental rates for these properties were unfavourable compared to the current cash flow stream. The REIT recorded a reversal of previously recorded impairment losses of $2,852 relating to two investment properties during the year ended December 31, 2011. IFRS allows for a reversal of a previously recorded impairment loss if there is a change in the estimated cash flows or discount rate used to determine the recoverable amount of the asset. As there were changes in the market conditions driving the estimated cash flows used to determine the previous impairment amount, a reversal of the impairment loss was recorded. The change in the estimated cash flows was the result of the following: • The REIT expected a tenant at one of their Canadian properties to vacate the property following the expiry of their lease, and estimated that the market rent the REIT would be able to re-lease the property for would be unfavourable compared to the existing tenant’s rent. A lease extension was renegotiated for a market rent greater than the previous estimated amount. • The strengthening of demand for one of the REIT’s supermarket anchored properties has resulted in a favourable adjustment to market rents and discount rates driving the estimated cash flows. During the year ended December 31, 2010, the REIT recorded an impairment charge of $14,862 on two of its U.S. investment properties. The tenants at these properties declared bankruptcy during the year, and the REIT determined that they would satisfy their mortgage obligations by transferring the title of the properties to the lender. The impairment loss represents the fair value of the income properties less the costs to sell. During the year ended December 31, 2010, the REIT recorded the reversal of $101,165 in previously recorded impairment losses on 63 properties (31 properties in the U.S. and 32 in Canada). These reversals of previously recorded impairment losses were triggered by the significant improvement of the real estate market during 2010. The economic downturn in 2008 and 2009 had decreased the market value of a number of the REIT’s investment properties due to weak demand. During 2010, the economy began to rebound and the REIT’s investment properties increased in value. This change in economic conditions increased the market rent and adjusted discount rates favourably for many of the REIT’s previously impaired properties. Management used the metrics disclosed in note 4 as a basis for the calculation of the fair value of the income properties less the costs to sell and the value in use of such properties that were found to be impaired during 2011 and 2010, as well as the properties where the previously recorded impairment loss was reversed during 2011 and 2010. 45 H&R REAL ESTATE INVESTMENT TRUST H&R FINANCE TRUST Notes to Combined Financial Statements (In thousands of Canadian dollars, except unit and per unit amounts) Years ended December 31, 2011 and 2010 21. Supplemental cash flow information: The change in other non-cash operating items are as follows: Accrued rent receivable Prepaid expenses and sundry assets Accounts receivable Accounts payable and accrued liabilities 2011 2010 $ 267 $ (9,285) (6,027) (5,291) (12,343) 5,984 (841) 16 $ (23,394) $ (4,126) The following non-cash amounts have been excluded from operating, financing and investing activities in the combined statements of cash flows: Acquisition of investment properties through assumption of mortgages payable, net of mark-to-market adjustments Acquisition of property under development through assumption of mortgage payable Release of mortgage obligations upon lenders' consent Release of mortgage interest obligation included in accounts payable and accrued liabilities Non-cash release of mortgage payable on disposition of investment property Non-cash transfer of investment properties to lenders Non-cash distributions to unitholders (note 12(b)) Non-cash conversion of convertible debentures (note 10) Increase (decrease) in accounts payable for properties under development Increase (decrease) in accounts payable for tenant inducements Non-cash proceeds on options exercised 2011 2010 $ 319,753 - (59,056) (9,038) (4,071) 47,665 36,139 32,418 (12,558) (507) 2,369 $ 82,495 18,000 (89,484) (9,675) - 82,378 14,270 7,019 (7,565) 6,142 - 46 H&R REAL ESTATE INVESTMENT TRUST H&R FINANCE TRUST Notes to Combined Financial Statements (In thousands of Canadian dollars, except unit and per unit amounts) Years ended December 31, 2011 and 2010 22. Capital risk management: The REIT’s primary objectives when managing capital are: (a) to provide unitholders with stable and growing distributions generated by revenue it derives from investments in income-producing real estate properties; and (b) to maximize unit value through the ongoing active management of the REIT’s assets, the acquisition of additional properties and the development and construction of projects which are pre-leased to creditworthy tenants. The REIT considers its capital to be its unitholders’ equity, exchangeable units, mortgages payable, debentures payable and bank indebtedness. As long as the REIT complies with its investment and debt restrictions set out in its Declaration of Trust, it is free to determine the appropriate level of capital in context with its cash flow requirements, overall business risks and potential business opportunities. As a result of this, the REIT will make adjustments to its capital based on its investment strategies and changes in economic conditions. The REIT’s level of indebtedness is subject to the limitations set out in its Declaration of Trust. The REIT is limited to a total indebtedness to gross book value ratio of 65% (provided that for this purpose “indebtedness” excludes Convertible Debentures, and U.S. Holdco notes payable to Finance Trust). As at December 31, 2011, this ratio was 50.5% (2010 - 50.3% based on previous Canadian GAAP). Management uses this ratio as a key indicator in managing the REIT’s capital. In addition to the above key ratio, the REIT’s general operating facilities (note 14(a) and 14(b)) have the following covenants which are required to be calculated based on the REIT’s and Finance Trust’s combined financial statements: (a) Maximum indebtedness to gross book value (b) Minimum interest coverage ratio (c) Minimum equity Covenant 2011 2010(1) 65% 1.65 : 1 57.6% 2.40 : 1 $1,000,000 $2,345,862 50.4% N/A(2) $1,606,652 (1) As originally stated as at December 31, 2010 based on previous Canadian GAAP. (2) For the year ended December 31, 2010, the financial covenant related to a minimum debt service coverage ratio of 1.20:1 which the REIT achieved 1.43:1. The REIT has various other covenants with respect to its debt. The REIT is in compliance with the covenants as at December 31, 2011. The REIT’s mortgage providers also have minimum limits on debt-to-service coverage ratios ranging from 1.10 to 1.50 as at December 31, 2011 and December 31, 2010. The REIT monitors these ratios and is in compliance with such external requirements, except for those on the mortgages due on demand (note 9). 47 H&R REAL ESTATE INVESTMENT TRUST H&R FINANCE TRUST Notes to Combined Financial Statements (In thousands of Canadian dollars, except unit and per unit amounts) Years ended December 31, 2011 and 2010 23. Risk Management: (a) Credit risk: The REIT is exposed to credit risk as an owner of income properties in that tenants may experience financial difficulty and be unable to fulfill their lease commitment or the failure of tenants to occupy and pay rent in accordance with existing lease agreements. Management mitigates this risk by carrying out appropriate credit checks and related due diligence on significant tenants. Management has diversified the REIT’s holdings so that it owns several categories of properties and acquires income properties throughout Canada and the United States. In addition, management ensures that no tenant or related group of tenants, other than investment grade tenants, account for a significant portion of the REIT’s cash flow. The only tenants which account for more than 5% of the rental income from income properties are Bell Canada and TransCanada PipeLines Limited. Each of these companies is rated with at least an A low rating by a recognized rating agency. Once the Bow is completed, EnCana Corporation is expected to also account for more than 5% of the rentals from income properties. EnCana Corporation’s current public debt rating is BBB high. The REIT’s exposure to credit risk is as follows: December 31 2011 December 31 2010 January 1 2010 Mortgages and amount receivable Accounts receivable (note 7) Derivative instruments (note 7) (b) Liquidity risk: $ $ $ 7,080 12,711 1,273 21,064 3,000 7,420 1,225 11,645 63,789 6,543 3,463 73,795 $ $ $ The REIT is subject to liquidity risk whereby it may not be able to refinance or pay its debt obligations when they become due. The REIT’s liquidity risk is as follows: Mortgages payable (note 9) Debentures payable (note 10) Derivative instruments Bank indebtedness (note 14) Accounts payable and accrued liabilities (note 15) 48 2012 Thereafter Total $ $ $ 399,895 - 6,072 - 172,481 578,448 2,758,663 1,370,917 - 440,173 3,368 4,573,121 3,158,558 1,370,917 6,072 440,173 175,849 5,151,569 $ $ $ H&R REAL ESTATE INVESTMENT TRUST H&R FINANCE TRUST Notes to Combined Financial Statements (In thousands of Canadian dollars, except unit and per unit amounts) Years ended December 31, 2011 and 2010 23. Risk management (continued): Management’s strategy for managing liquidity risk is to ensure, to the extent possible, that it will always have sufficient liquidity to meet its liabilities when they come due, under both normal and stressed conditions, without incurring unacceptable losses or risking damage to the REIT’s reputation. In order to meet this strategy, the REIT strives to enter into long-term leases with creditworthy tenants which assists in the REIT’s primary strategy of maintaining predictable cash flows. The REIT attempts to appropriately structure the term of mortgages to closely match the term of leases for each property. This strategy enables the REIT to meet its contractual monthly mortgage obligations. Due to the long-term length of most of the REIT’s mortgages, a significant amount of principal is usually paid by the time the mortgages mature. The agreements and indentures governing indebtedness of the REIT contain covenants that, among other things, require the REIT to maintain financial ratios and thresholds and impose on the REIT restrictions (subject in each case to exceptions) regarding: the disposition of the Bow, lands related to the Bow; the creation of liens or granting of negative pledges; the purchase or redemption of securities; the entering into any merger or similar transaction with any person; changes of a fundamental nature (including senior management, business objectives, purposes or operations, capital structure, constating documents, and subordinated debt); the cancellation or waiver of material contracts and changes to the Bow budget. As a result, the REIT is limited by such covenants and restrictions. Management monitors its liquidity risk through review of financial covenants contained in debt agreements and in accordance with the REIT’s Declaration of Trust. In order to maintain liquidity, the REIT has two general operating facilities, as described in note 14(a) and 14(b), available to draw on to fund its obligations. (c) Market risk: The REIT is subject to currency risk and interest rate risk. The REIT’s objective is to manage and control market risk exposure within acceptable parameters, while optimizing the return on risk. (i) Currency risk: A portion of the REIT’s properties are located in the United States, resulting in the REIT being subject to foreign currency fluctuations which may impact its financial position and results. In order to mitigate the risk, the REIT’s debt on these properties is also held in U.S. dollars to act as a natural hedge. A $0.10 weakening of the U.S. dollar against the average Canadian dollar exchange rate of $0.99 for the year ended December 31, 2011 (2010 - $1.03) would have decreased other comprehensive income by approximately $46,800 (2010 - $13,600) and decreased net income by approximately $200 (2010 - $500). This analysis assumes that all other variables, in particular interest rates, remain constant (a $0.10 weakening of the Canadian dollar against the U.S. dollar at December 31, 2011 would have had the equal but opposite effect). 49 H&R REAL ESTATE INVESTMENT TRUST H&R FINANCE TRUST Notes to Combined Financial Statements (In thousands of Canadian dollars, except unit and per unit amounts) Years ended December 31, 2011 and 2010 23. Risk management (continued): (ii) Interest rate risk: The REIT is exposed to interest rate risk on its borrowings. It minimizes this risk by obtaining long-term fixed interest rate debt. At December 31, 2011, the percentage of fixed rate debt to total debt was 90.9% (2010 - 97.5% based on prevous Canadian GAAP). Therefore, a change in interest rates at the reporting date would not affect net income with respect to these fixed rate instruments. The bank indebtedness is subject to variable interest rates. An increase in interest rates of 100 basis points for the year ended December 31, 2011 would have decreased net earnings by approximately $1,700 (2010 - $300). This analysis assumes that all other variables, in particular foreign exchange rates, remain constant. (d) Fair values: (i) Financial assets and liabilities carried at amortized cost: The fair values of the REIT's mortgages and amount receivable, accounts receivable, cash and cash equivalents, bank indebtedness and accounts payable and accrued liabilities approximate their carrying amounts due to the relatively short periods to maturity of these financial instruments. The fair value of the mortgages payable has been determined by discounting the cash flows of these financial obligations using year-end market rates for debt of similar terms and credit risks. Based on these assumptions, the fair value of mortgages payable at December 31, 2011 has been estimated at $3,244,658 (2010 - $2,697,922) compared with the carrying value of $3,163,593 (2010 - $2,706,707). The fair value of the Senior Debentures payable has been measured based on the ask price of each series of Senior Debenture similar terms and credit risks. Based on these assumptions, the fair value of the Senior Debentures payable at December 31, 2011 has been estimated at $659,448 (2010 - $392,824) compared with the carrying value of $628,677 (2010 - $350,840). (ii) Assets and Liabilities carried at fair value: Financial instruments measured at fair value in the statement of financial position are categorized using a fair value hierarchy that reflects the significance of the inputs used in determining the fair values. • • • Level 1: quoted prices (unadjusted) in active markets for identical assets or liabilities; Level 2: inputs other than quoted prices included within level 1 that are observable for the asset or liability, either directly (i.e. as prices) or indirectly (i.e. derived from prices); and Level 3: inputs for the asset or liability that are not based on observable market data (unobservable inputs). 50 H&R REAL ESTATE INVESTMENT TRUST H&R FINANCE TRUST Notes to Combined Financial Statements (In thousands of Canadian dollars, except unit and per unit amounts) Years ended December 31, 2011 and 2010 23. Risk management (continued): December 31, 2011 Level 1 Level 2 Level 3 Total Assets Derivative instrument asset (note 7) Liabilities Convertible debentures (note 10) Exchangeable units Derivative instruments liabilities - - (742,240) (126,695) - (868,935) 1,273 1,273 - - (6,072) (6,072) - - - - - - 1,273 1,273 (742,240) (126,695) (6,072) (875,007) $ (868,935) $ (4,799) $ - $ (873,734) December 31, 2010 Level 1 Level 2 Level 3 Total Assets Derivative instrument asset (note 7) Liabilities Convertible debentures (note 10) Exchangeable units Derivative instruments liabilities - - (614,988) (105,652) - (720,640) 1,225 1,225 - - (3,317) (3,317) - - - - - - 1,225 1,225 (614,988) (105,652) (3,317) (723,957) $ (720,640) $ (2,092) $ - $ (722,732) 51 H&R REAL ESTATE INVESTMENT TRUST H&R FINANCE TRUST Notes to Combined Financial Statements (In thousands of Canadian dollars, except unit and per unit amounts) Years ended December 31, 2011 and 2010 23. Risk management (continued): January 1, 2010 Level 1 Level 2 Level 3 Total Assets Derivative instrument asset (note 7) Liabilities Convertible debentures (note 10) Exchangeable units Derivative instruments liabilities - - 3,463 3,463 (465,888) (84,010) - (549,898) - - - - - - - - - - 3,463 3,463 (465,888) (84,010) - (549,898) $ (549,898) $ 3,463 $ - $ (546,435) 24. Joint venture and co-ownership activities: These combined financial statements include the REIT’s proportionate share of assets, liabilities, revenue, expenses and cash flows of the joint ventures and co-ownerships. The REIT’s proportionate share of these joint ventures and co-ownerships range between 20% and 98.5%, summarized as follows: Assets Liabilities Revenue Expenses Operating income from properties Cash flows provided by operations Cash flows provided by (used in) financing Cash flows provided by (used in) investments 25. Related party transactions: 2011 2010 $187,722 80,694 26,724 18,550 8,174 9,377 16,508 (25,043) $186,031 89,713 26,802 18,806 7,996 11,276 (15,735) 4,194 H&R Property Management Ltd. (the “Property Manager”), a company partially owned by family members of the Chief Executive Officer, provides property management services for substantially all properties owned by the REIT, including leasing services, for a fee of 2% of gross revenue. The Property Manager also provides support services in connection with the acquisition, disposition and development activities of the REIT and is also entitled to an incentive fee. Acquisitions and development support services are provided for a fee of 2/3 of 1% of total acquisition and development costs. The support services relating to dispositions of investment properties are provided for a fee of 10% of the gain on sale of investment properties adjusted for the add back of accumulated depreciation and amortization. Services are provided by the Property Manager pursuant to a property management agreement which expires on January 1, 2015 with one automatic five-year extension. 52 H&R REAL ESTATE INVESTMENT TRUST H&R FINANCE TRUST Notes to Combined Financial Statements (In thousands of Canadian dollars, except unit and per unit amounts) Years ended December 31, 2011 and 2010 25. Related party transactions (continued): During the year ended December 31, 2011, the REIT recorded fees pursuant to this agreement of $23,978 (2010 - $14,657), of which $9,481 (2010 - $1,062) was capitalized to the cost of the investment properties acquired, $2,128 (2010 - $2,191) was capitalized to properties under development and $3,615 (2010 - $1,809) was capitalized to leasing expenses. The REIT has also reimbursed the Property Manager for certain direct property operating costs and tenant construction costs. For the year ended December 31, 2011, a further amount of $3,500 (2010 - $2,500) has been earned by the Property Manager pursuant to the above agreement, in accordance with the annual incentive fee payable to the Property Manager. Pursuant to the above agreement, as at December 31, 2011, $3,477 (2010 - $1,682) was payable to the Property Manager. The REIT leases space to companies affiliated with the Property Manager. The rental income earned for the year ended December 31, 2011 is $1,382 (2010 - $1,322). These transactions are measured at the amount of consideration established and agreed to by the related parties. Key management personnel compensation: Short-term employee benefits Employee unit-based compensation 26. Segmented disclosures: 2011 2010 $3,258 7,033 $10,291 $2,758 6,544 $9,302 Segmented information on identifiable non-current assets by geographic region and rentals from investment properties is outlined below. Investment properties and properties under development are attributed to countries based on the location of the properties. Canada United States December 31 December 31 January 1 2011 2010 2010 $ 5,359,726 $ 4,751,350 $ 4,338,286 2,051,830 1,041,939 1,018,065 $ 7,411,556 $ 5,793,289 $ 5,356,351 53 H&R REAL ESTATE INVESTMENT TRUST H&R FINANCE TRUST Notes to Combined Financial Statements (In thousands of Canadian dollars, except unit and per unit amounts) Years ended December 31, 2011 and 2010 26. Segmented disclosures (continued): Rentals from investment properties: Canada United States 27. Income tax recovery (expense): Income tax expense included in the determination of net income from continuing operations: Current Deferred Deferred income tax included in the determination of other comprehensive income 2011 2010 $ 534,681 $ 513,562 122,230 103,865 $ 656,911 $ 617,427 2011 2010 $ (285) $ (458) - (285) - 460,138 459,680 915 $ (285) $ 460,595 The Income Tax Act (Canada) contains legislation (the “SIFT Rules”) affecting the tax treatment of “specified investment flow- through” (“SIFT”) trusts. A SIFT includes a publicly-traded trust. The SIFT Rules provide for a transition period until 2011 for publicly-traded trusts like the REIT which existed prior to November 1, 2006. Under the SIFT Rules, distributions of certain income by a SIFT are not deductible in computing the SIFT’s taxable income, and a SIFT is subject to tax on such income at a rate that is substantially equivalent to the general tax rate applicable to a Canadian corporation. The SIFT Rules do not apply to a publicly-traded trust that qualifies as a real estate investment trust under the Income Tax Act (Canada). The REIT completed the necessary tax restructuring to qualify as a real estate investment trust effective June 30, 2010. For periods before it qualified, the REIT recorded deferred tax liabilities in respect of temporary differences expected to reverse after January 1, 2011. Such deferred tax liability was reversed as an adjustment to deferred income tax expense in income and as an adjustment to other comprehensive income during the second quarter of 2010, when the REIT became a qualifying REIT. 54 H&R REAL ESTATE INVESTMENT TRUST H&R FINANCE TRUST Notes to Combined Financial Statements (In thousands of Canadian dollars, except unit and per unit amounts) Years ended December 31, 2011 and 2010 27. Income tax recovery (expense) (continued): The SIFT tax effects of temporary differences that give rise to significant portions of the deferred income tax assets and liabilities are as follows: Deferred income tax liabilities: Investment properties Properties under development Accrued rent receivable Mortgages receivable Other assets Deferred income tax assets: Issue costs Mortgages payable December 31 December 31 January 1 2011 2010 2010 $ - $ - $ 387,389 - - - - - - - - - - - - - - - - 20,071 59,524 336 2,522 469,842 8,296 493 8,789 Deferred income tax liability $ - $ - $ 461,053 The REIT has certain subsidiaries in the United States that are subject to tax on their taxable income at a rate of approximately 38%. Deferred tax assets have not been recognized for these subsidiaries in respect of the following items: Deductible temporary differences Net operating losses and deferred interest deductions Total 2011 2010 $ 3,775 $ 16,594 125,229 113,158 $ 129,004 $ 129,752 Net operating losses will expire between 2018 and 2031. The deferred interest deductions and the deductible temporary differences do not generally expire under current tax legislation. Deferred tax assets have not been recognized in respect of these items because it is not probable that future taxable profit will be available against which these U.S. corporate subsidiaries can utilize these tax benefits. 55 H&R REAL ESTATE INVESTMENT TRUST H&R FINANCE TRUST Notes to Combined Financial Statements (In thousands of Canadian dollars, except unit and per unit amounts) Years ended December 31, 2011 and 2010 28. Commitments and contingencies: (a) (b) (c) The REIT is currently constructing a two million square foot office building in Calgary, Alberta (the “Bow”), which is fully pre- leased to EnCana Corporation for a 25-year term. The REIT has committed to incurring additional construction and development costs for this project of approximately $163,000, including capitalized interest, over the remaining construction period. As at December 31, 2011, the total cost incurred on the project amounted to $1,479,117 (note 5) (December 31, 2010 - $1,150,094, January 1, 2010 - $719,173). This budget includes the construction of 1,358 parking stalls. It is currently expected that the building will be occupied in tranches commencing in Q2 2012 with full occupancy expected by Q4 2012. Any delay in the delivery of the tranches will result in a delay cost of $1.67 per square foot per month. The estimated delay cost is approximately $24,100. In the normal course of operations, the REIT has issued letters of credit in connection with developments, financings, operations and acquisitions. As at December 31, 2011, the REIT has outstanding letters of credit totalling $29,775 (December 31, 2010 - $44,524, January 1, 2010 - $34,349), including $17,431 (December 31, 2010 - $17,939, January 1, 2010 - $18,164) which has been pledged as security for certain mortgages payable. These letters of credit are secured in the same manner as the bank indebtedness (note 14(a)). The REIT provides guarantees on behalf of third parties, including co-owners. As at December 31, 2011, the REIT issued guarantees amounting to $74,303 (December 31, 2010 - $41,307, January 1, 2010 - $43,278), which expires in 2016 (December 31, 2010 - expires between 2011 and 2016, January 1, 2010 - expires between 2011 and 2016), relating to the co-owner’s share of mortgage liability. In addition, the REIT continues to guarantee certain debt assumed by purchasers in connection with past dispositions of properties, and will remain liable until such debts are extinguished or the lenders agree to release the REIT’s covenants. At December 31, 2011 the estimated amount of debt subject to such guarantees, and therefore the maximum exposure to credit risk, is $113,407 (December 31, 2010 - $116,357, January 1, 2010 $119,150) which expires between 2013 and 2018 (December 31, 2010 - expires between 2013 and 2018, January 1, 2010 - expires between 2013 and 2018). There have been no defaults by the primary obligor for debts on which the REIT has provided its guarantees, and as a result, no contingent loss on these guarantees has been recognized in these financial statements. Credit risks arise in the event that these parties default on repayment of their debt since they are guaranteed by the REIT. These credit risks are mitigated as the REIT has recourse under these guarantees in the event of a default by the borrowers, in which case the REIT’s claim would be against the underlying real estate investments. (d) The REIT is involved in litigation and claims in relation to the investment properties that arise from time to time in the normal course of business. In the opinion of management, any liability that may arise from such contingencies would not have a significant adverse effect on the combined financial statements. 56 H&R REAL ESTATE INVESTMENT TRUST H&R FINANCE TRUST Notes to Combined Financial Statements (In thousands of Canadian dollars, except unit and per unit amounts) Years ended December 31, 2011 and 2010 29. Subsequent events: (a) (b) (c) (d) In January 2012, the REIT received a U.S. mortgage for U.S. $250,000 for Hess Tower in Houston, Texas, bearing interest at 4.50% per annum for an 8-year term. In February 2012, the REIT refinanced three U.S. mortgages totaling approximately U.S. $72,600 each bearing interest at a rate of 5.94% per annum, with three new non-recourse U.S. mortgages totaling $61,000 each bearing interest at a rate of 4.50% per annum for a 10-year term. In February 2012, the REIT refinanced 10 Canadian mortgages totaling approximately $28,500 each bearing interest at a rate of 7.74% per annum, with 10 new mortgages totaling $62,900 each bearing interest at a rate of 3.99% per annum for a 10-year term. In March 2012, the REIT purchased a 485,000 square foot, state-of-the-art office building in Toronto, Ontario for a purchase price of $186,000 before transaction costs. The REIT has secured a $60,000 interest only mortgage for a term of 20 years. The interest rate will be at a spread of 2.30% over the 20-year Government of Canada bond. The REIT has the ability to place another $37,000 first mortgage on this property. 57 Unitholder Distribution Reinvestment Plan and Direct Unit Purchase Plan: Since January 2000, H&R REIT has offered registered holders of its units resident in Canada the opportunity to participate in its Unitholder Distribution Reinvestment Plan (the “DRIP”) and Direct Unit Purchase Plan. The DRIP allows participants to have their monthly cash distributions of H&R REIT reinvested in additional Stapled Units of H&R at a 3% discount to the weighted average price of the Stapled Units on the TSX for the five trading days (the “Average Market Price”) immediately preceding the cash distribution date. The Direct Unit Purchase Plan allows participants to purchase additional Stapled Units on a monthly basis at the Average Market Price subject to a minimum purchase of $250 per month (up to a maximum of $13,500 per year) for each participant. For more information on the DRIP and/or the Direct Unit Purchase Plan, please contact us by email through the “Contact Us” webpage of our website, or contact our Registrar and Transfer Agent. Corporate Information H&R REIT Board of Trustees Thomas J. Hofstedter (1), President and Chief Executive Officer, H&R Real Estate Investment Trust Robert Dickson (2,4), Strategic financial consultant, marketing communications industry Edward Gilbert (1,2,3,4), Chief Operating Officer, Firm Capital Mortgage Investment Trust Laurence A. Lebovic (1,3,4), Chief Executive Officer, Runnymede Development Corporation Ltd. Ronald C. Rutman (2,3,4), Partner, Zeifman & Company, Chartered Accountants H&R Finance Trust Board of Trustees Thomas J. Hofstedter, President and Chief Executive Officer, H&R Real Estate Investment Trust Shimshon (Stephen) Gross (2), President, LRG Holdings Inc. Marvin Rubner (2), Manager and Founder, YAD Investments Limited. Neil Sigler (2), Vice President, Gold Seal Management Inc. (1) Investment Committee (2) Audit Committee (3) Compensation and Governance Committee (4) Nominating Committee Officers Thomas J. Hofstedter, President and Chief Executive Officer Larry Froom, Chief Financial Officer Nathan Uhr, Chief Operating Officer (H&R REIT) Cheryl Fried, Vice-President, Accounting (H&R REIT) Auditors: KPMG LLP Legal Counsel: Blake, Cassels & Graydon LLP Taxability of Distributions: 55% of the distributions made by the H&R REIT and 17% of the distributions made by H&R Finance Trust to Unitholders during 2011 were tax deferred. Plan Eligibility: RRSP, RRIF, DPSP, RESP, RDSP, TFSA Stock Exchange Listing: Stapled Units and debentures of H&R are listed on the Toronto Stock Exchange under the trading symbols HR.UN; HR.DB; HR.DB.B, HR.DB.C, HR.DB.D, HR.DB.E. Registrar and Transfer Agent: CIBC Mellon Trust Company, P.O. Box 7010, Adelaide Street Postal Station, Toronto, Ontario, Canada M5C 2W9 Telephone: 416-643-5500 within the Toronto area or 1-800-387-0825, Fax: 416 643 5501, E-mail: inquiries@cibcmellon.com, Website: www.cibcmellon.com Contact Information: Investors, investment analysts and others seeking financial information should go to our website at www.hr-reit.com, or e-mail info@hr-reit.com, or call 416-635-7520 and ask for Larry Froom, Chief Financial Officer, or fax 416-398-0040, or write to H&R Real Estate Investment Trust, 3625 Dufferin Street, Suite 500, Downsview, Ontario, Canada, M3K 1N4 H&R Real Estate Investment Trust and H&R Finance Trust             The Bow, Calgary                           Two Gotham Center, New York City  Hess Tower, Houston                                   Atrium on Bay, Toronto  www.HR-REIT.com             

Continue reading text version or see original annual report in PDF format above