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TORONTO, March 22, 2016 /CNW/ - Inovalis Real Estate Investment Trust (the "REIT") (TSX: INO.UN) today reported its financial results for the fourth quarter and the year ended December 31, 2015. Inovalis REIT's management team will be holding a conference call on March 22, 2016 at 11:00 am EST to discuss the results. The dial-in numbers for the conference call are: in Toronto 1-416-764-8688; outside Toronto (toll free, within North America) 1-888-390-0546.

HIGHLIGHTS

• 17.8% year-over-year growth in IFRS book equity per unit of which 9.8% comes from the addition of high quality properties and the cap rate compression in France and in Germany. The further appreciation of the Euro against the Canadian dollar since Q4 2014 accounted for 7.8%.
  
  
• Funds from operations (FFO) for the quarter ended December 31, 2015 of $3,873 or $0.22 per unit (fully diluted), with a FFO payout ratio of 93.9%, compared to $0.21 per unit and payout ratio of 100.4% for the same period in 2014. FFO for the year ended December 31, 2015 of $15,154 or $0.87 per unit (fully diluted), with a FFO payout ratio of 95.2%, compared to $0.83 per unit and payout ratio of 97.0% for the same period in 2014, reflecting a 2.6% year-on-year increase.
  
  
• Adjusted funds from operations (AFFO) for the quarter ended December 31, 2015 of $4,535 or $0.26 per unit (fully diluted) with an AFFO payout ratio of 80.1%, compared to $0.23 per unit and payout ratio of 91.6% for the same period in 2014. AFFO for the year ended December 31, 2015 of $17,190 or $0.98 per unit (fully diluted), with an AFFO payout ratio of 83.9%, compared to $0.92 per unit and payout ratio of 89.4% for the same period in 2014, reflecting a 6.6% year-on-year increase.
  
  
• Occupancy rate on the REIT's portfolio was 89.0% and weighted average lease term was 6.3 years as at December 31, 2015. Taking into account the leases signed subsequent to the quarter, overall occupancy reaches 90.8%.
  
  
• Debt to book value of the REIT was 53.0% as at December 31, 2015. Net of the cash available, debt to book value was 51.9%.
  
  
• During the fourth quarter of 2015, the REIT completed the acquisition, on a joint-venture basis, of a newly completed 65,530 square feet office property located in Cologne, Germany. The property is fully let to an investment grade tenant under a lease expiring in 2025. The property was acquired at a going-in cap rate of 5.0% for an all-in-cost of approximately €23 million (C$ 32 million).
  
  
• During the fourth quarter of 2015, the REIT also completed the refinancing of the Sablière property. The finance lease in place was terminated and replaced with a mortgage financing with a view to optimizing the REIT's balance sheet (generating net additional financing proceeds of approximately $5 M), increasing the weighted average term to maturity up to 7.2 years as at December 31, 2015 while locking in a very low fixed interest rate at 2.11% for 6 years and reducing the principal repayment charge paid under the previous leasehold interest.
  
  
• Subsequent to year-end, the REIT terminated the finance lease on the Hanover property and refinanced it with an interest-only 7-year mortgage financing of €12.6 million ($18.9 million). While net of the transaction costs associated with the refinancing, senior debt amount for this property remains unchanged, the purpose of this operation was to make the REIT benefit from a fixed interest rate as low as 1.85% on this property for a longer term of 7 years.
  
• On March 21, 2016, as designed in the Metropolitan Acquisition Loan agreement, and as approved by the REIT's unitholders at a special meeting held on January 20, 2016, the REIT exercised its option to buy at a discount the Metropolitan property. The REIT bought the property at an entry cap rate of 4.8% (after expiry of the rent free periods) and a purchase price of approximately $70 million, reflecting a 12% discount on the market value as determined by Jones Lang LaSalle acting as external valuer. The Metropolitan is a 79,000 square feet office property benefiting from an excellent location in a gentrifying area within downtown Paris. By acquiring this property, the REIT exercised its option to buy further to the Acquisition Loan granted to Inovalis SA in November 2014. The property has a weighted average lease term of 8.0 years with tenants in diversified industries and of good credit quality. The property also offers potential for further capital appreciation and higher rental income that could be achieved through the re-letting of the current vacant area (9% of total space) and the reversion potential on passing rent.

About Inovalis Real Estate Investment Trust

Inovalis Real Estate Investment Trust is an unincorporated, open-ended real estate investment trust established pursuant to a declaration of trust under the laws of the Province of Ontario. The REIT has been created for the purpose of acquiring and owning office properties primarily located in France and Germany but also opportunistically in other European countries where assets meet the REIT's investment criteria. The REIT currently owns an interest in ten office properties in France and Germany, comprising approximately 1,004,000 square feet of gross leasable area (taking into account the interests in the properties owned in joint-ventures).

Management's discussion and analysis
(Dollar amounts in the MD&A are presented in thousands of Canadian dollars, except rental rates, Unit or as otherwise stated)

OVERVIEW

BASIS OF PRESENTATION

The following management's discussion and analysis ("MD&A") of the financial condition and results of operations of Inovalis REIT should be read in conjunction with the REIT's audited consolidated financial statements for the year ended December 31, 2015, and the notes thereto. This MD&A has been prepared taking into account material transactions and events up to and including March 21, 2016. Financial data provided in the audited consolidated financial statements have been prepared in accordance with International Financial Reporting Standards. All amounts in this MD&A are in thousands of Canadian dollars, except per unit amounts and where otherwise stated. Historical results, including trends which might appear, should not be taken as indicative of future operations or results. Additional information about Inovalis REIT has been filed with applicable Canadian securities regulatory authorities and is available at www.sedar.com. The exchange rate used throughout this MD&A for statement of earnings items is the average rate during the said period, i.e. 1.4609 Canadian dollars per Euro for the three-month period ended December 31, 2015 and 1.4185 Canadian dollars per Euro for year ended December 31, 2015. For balance sheet items, projections or market data, the exchange rate used is 1.5029 (exchange rate as at December 31, 2015).

FORWARD-LOOKING INFORMATION

Although we believe that the expectations reflected in the forward-looking information are reasonable, we can give no assurance that these expectations will prove to have been correct, and since forward-looking information inherently involves risks and uncertainties, undue reliance should not be placed on such information. Certain material factors or assumptions are applied in making forward-looking statements and actual results may differ materially from those expressed or implied in such forward-looking statements. The estimates and assumptions, which may prove to be incorrect, include, but are not limited to, the various assumptions set forth in this document as well as the following: (i) we will continue to receive financing on acceptable terms; (ii) our future level of indebtedness and our future growth potential will remain consistent with our current expectations; (iii) there will be no changes to tax laws adversely affecting our financing capability, operations, activities, structure or distributions; (iv) we will retain and continue to attract qualified and knowledgeable personnel as we expand our portfolio and business; (v) the impact of the current economic climate and the current global financial conditions on our operations, including our financing capability and asset value, will remain consistent with our current expectations; (vi) there will be no material changes to government and environmental regulations adversely affecting our operations; (vii) conditions in the international and, in particular, the French and German real estate markets, including competition for acquisitions, will be consistent with the current climate; and (viii) capital markets will provide us with readily available access to equity and/or debt financing.

The forward-looking statements are subject to inherent uncertainties and risks, including, but not limited to, the factors listed under the Risk and Uncertainties section of this MD&A. Consequently, actual results and events may vary significantly from those included in, contemplated or implied by such statements.

MARKET AND INDUSTRY DATA

This MD&A includes market and industry data and forecasts that were obtained from third-party sources, industry publications and publicly available information as well as industry data prepared by Inovalis SA on the basis of its knowledge of the commercial real estate industry in which we operate (including Inovalis SA estimates and assumptions relating to the industry based on that knowledge). Inovalis SA's knowledge of the real estate industry has been developed through its 18 years of experience and participation in the industry. Inovalis SA believes that its industry data is accurate and that its estimates and assumptions are reasonable, but there can be no assurance as to the accuracy or completeness of this data. Third-party sources generally state that the information contained therein has been obtained from sources believed to be reliable, but there can be no assurance as to the accuracy or completeness of included information. Although Inovalis SA believes it to be reliable, Inovalis SA has not verified any of the data from third-party sources referred to in this MD&A, or analyzed or verified the underlying studies or surveys relied upon or referred to by such sources, or ascertained the underlying assumptions relied upon by such sources.

BUSINESS OVERVIEW AND STRATEGY

Inovalis REIT is an unincorporated open-ended real estate investment trust governed by the laws of the Province of Ontario. Inovalis REIT was founded and sponsored by Inovalis SA, our asset manager. Our Units have been listed on the Toronto Stock Exchange under the trading symbol INO.UN since April 10, 2013. Our head and registered office is located at 151 Yonge Street, 11^th floor, Toronto, Ontario, M5C 2W7.

Our long-term objectives are to:

• generate predictable and growing cash distributions on a tax-efficient basis from investments in income-producing office properties
  
  
• maximize the long-term value of both our properties and Units through active and efficient management
  
  
• grow our asset base, primarily in France and Germany, but also opportunistically in other European countries where assets meet our investment criteria
  
  
• increase the cash available for distribution to holders of Units ("Unitholders"), through an accretive acquisition program that successfully leverages Inovalis SA's extensive relationships and depth of commercial property and financing.

The REIT's Investment criteria encompasses office properties outside of Canada with an occupancy level above 80% (unless AFFO accretive), secured rental cash flows, a property value between €20 million ($29 million) to €60 million ($88 million) (unless AFFO accretive) and a potential future upside with respect to matters including rent and area development. According to management, this target investment size falls within a very liquid segment of the real estate market in Europe, and debt financing for such acquisitions is readily available from local lenders.

BUSINESS ENVIRONMENT

French commercial real estate investment market
Investment in commercial real estate in France reached €29.0 BN ($43.6 BN) in 2015, 45.0% higher than the last ten year average of €20.0 BN ($30.1 BN). Despite its slow economic growth, France is still much sought after, enjoying its second best year ever for investment after 2007. The Greater Paris region accounted for the largest share of acquisitions (76%). Offices are still investors' favorite, attracting 61% of investment.

According to BNP Paribas Real Estate, the prime yield in the Central Business District compressed down to 3.25% as at Q4 2015 (from 4.00% as at Q4 2014) and the prime yield in the Inner Rim further down to 4.50% (from 5.30% as at Q4 2014). Investors have increasingly bought properties beyond Paris business districts, which are structurally incapable of supplying demand and which offer low yields. Non-prime office yields have also declined in the majority of markets in the Greater Paris Region and are increasingly sought after.

As at December 31, 2015, the vacancy rate in the Greater Paris Region was 6.9% and inside Paris was below 4.7%. This figure is mainly comprised of lower quality properties as, according to CBRE, new and redeveloped properties only accounted for 18% of the immediate supply.

German commercial real estate investment market
Investment in commercial real estate in Germany reached €56.3 BN ($84.6 BN) in the 2015, 40% higher than in 2014 and the second-beat year ever, exceeded only in 2007. Offices have become investors' favorite, attracting 42% of investment. For investors, Germany continues to offer an extremely attractive and stable environment with interest rates still low, active consumers, upward-trending early indicators and a labor market that remains robust.

Office yields have declined throughout Germany over the last few years and, according to BNP Paribas Real Estate, prime office properties in the largest cities (Berlin, Cologne, Dusseldorf, Frankfurt, Hamburg, Munich) trade at a cap rate ranging between 3.65% and 4.45%, the average for the largest big 6 cities being 4.12%, i.e. 40 bps lower than one year before.

Banks are competing for the financing of first class office properties with long-term leases in good locations. As competition increases, banks are increasingly financing slightly riskier properties.

REAL ESTATE MANAGEMENT AND ADVISORY SERVICES

Pursuant to a management agreement, Inovalis SA is the manager of the REIT and provides the strategic, advisory, asset management, project management, construction management, property management and administrative services necessary to manage the operations of the REIT.

Upon the earlier of (i) the REIT achieving a market capitalization of $750 million (including any Exchangeable securities held by Inovalis SA) based on the volume weighted average price (VWAP) over a 20-day trading period and (ii) April 10, 2018, the Management Agreement will terminate and the management of the REIT will be internalized at no additional cost.

OUR OPERATIONS

Performance indicators⁽¹⁾

Portfolio
The REIT has an interest in 10 properties, of which 6 are entirely owned by the REIT (Baldi, Courbevoie, Jeuneurs, Sablière and Vanves in France, Hanover in Germany) and 4 are held through partnerships with various global institutional funds (Arcueil in France, Bad Homburg, Cologne and Duisburg in Germany).

Occupancy
The overall weighted average occupancy rate across our portfolio was 89.0% at December 31, 2015. The Vendor Lease on the Vanves property on 4,521 sq.ft (or 0.5% of total GLA) generating an annual income to the REIT of $260 will expire in April 2016. External brokers are working with the Inovalis SA team to lease remaining vacant premises on the REIT's portfolio.

Subsequent to the quarter, the REIT relet vacant areas in the Sablière (3,983 sq.ft), Véronèse (9,795 sq.ft) and Bad Homburg (4,166 sq.ft) properties. Taking these new leases into account, overall occupancy increases from 89.0% to 90.8%. The Baldi property, which is an office mainly property, also comprises 31,603 square feet of mixed-used and storage areas, on which we did not put any value when the REIT bought the property in November 2014. Excluding these areas in our square footage calculation, occupancy rate throughout the portfolio would reach 94.0%, in line with the market vacancy rate of 6.9% in the Greater Paris Region.

Tenants
The tenant base in the portfolio is well diversified from an industry segment standpoint, with many tenants having large national or multinational footprints. 83% of 2016 estimated gross rental income come from French public agencies, are guaranteed by large German or international banks, or are signed with investment grade corporates or are affiliates of investment grade corporates.

The table above shows our five largest tenants, sorted out by contribution to gross leasable area (GLA). Tenants marked with ⁽*⁾ have leases in properties owned on a partnership basis. The GLA shown for these tenants reflects the percentage of ownership the REIT has in the underlying property. Our largest tenant Orange is rated BBB+/Baa1/BBB+ by S&P/Moody's/Fitch and has leases in two of our properties, the Vanves property and the Arcueil property (held in partnership).

Leasing profile
Rental indexation
All leases have rental indexation based on either the French ICC (construction cost index) or ILAT (index averaging construction costs and CPI indexes) or the German Consumer Price Index, as applicable.

Lease rollover profile
The REIT has an average remaining lease term of 6.3 years (not including tenant early termination rights). Assuming all tenants leave at the earliest possible early termination rights, which is a highly improbable scenario, the average remaining lease term in our portfolio is 4.6 years. The following graph sets out the amount of GLA and percentage of total GLA of the properties subject to leases expiring during the periods shown (excluding early lease terminations).

Lease Maturity Profile as at December 31, 2015
(% of total GLA)

 

CONSOLIDATED FINANCIAL INFORMATION

Net rental earnings
Net rental earnings for the three-month period ended December 31, 2015 reached $5,784 compared to $5,167 in 2014, an increase of 11.9%. The growth is principally due to the addition of the Baldi and Sablière properties, which were acquired in November of 2014 and therefore only partially taken into account in the fourth quarter of 2014. The increase is also accounted for by an overall slightly higher occupancy rate and the indexation on rent.

For the year ended December 31, 2015, net rental earnings increased by 20.4% over the same period in 2014 and reached $21,589. This amount includes a gain of $1,240 during the period on the recovery of an indemnity paid at the time of the purchase of the Vanves property for possible repairs that are no longer required. In addition to an overall higher occupancy rate and higher rentals, the REIT benefited from additional net rental earnings from the Sablière and Baldi properties.

As mentioned in prior reports, net rental earnings does not include the revenues generated from the properties held through joint-venture arrangements. The contribution of these properties stands in the Finance income and in the Share of the net earnings of investments accounted for using the equity method sections as detailed below.

Administration expenses
Administration expenses are primarily comprised of asset management fees paid to Inovalis SA and of other general administrative expenses such as trustee fees, directors' and officers' liability insurance, professional fees (including accounting fees), legal fees, filing fees, shareholders related expenses and other expenses. Administration expenses for the quarter ended December 31, 2015 amounted to $1,207 vs. $860 for the quarter ended December 31, 2014. $578 is related to the asset management fees paid to Inovalis SA (vs. $479 for the quarter ended December 31, 2014) and $629 to other expenses (vs. $381 for the quarter ended December 31, 2014).               

Administration expenses for the year ended December 31, 2015 amounted to $4,266 vs. $3,555 for the year ended December 31, 2014. $2,179 is related to the asset management fees paid to Inovalis SA (vs. $1,793 for the year ended December 31, 2014) and $2,087 to other general administrative expenses (vs. $1,762 for the year ended December 31, 2014). The increases in these expenses are partly accounted for by the increased complexity associated with the higher number of buildings, rapid growth and regulatory and corporate compliance.

Net change in fair value of investment properties
The net change in fair value of investment properties relates only to the properties that are owned solely by the REIT and do not include the properties owned in joint ventures. It applies mainly to the French properties as almost all of them are directly held by the REIT (only Arcueil is owned through a joint venture). As for our German properties, only Hanover is owned directly by the REIT, the other three properties being owned in joint venture.

During the quarter ended December 31, 2015, the net change in fair value of investment properties recognized in earnings was a gain of $8,800. The Company had recognized a net increase in fair value of $6,173 during the corresponding quarter ended December 31, 2014.

For the year ended December 31, 2015, the net change in fair value of investment properties recognized in earnings was $21,523 compared to a gain of $5,248 in 2014. This strong increase in 2015 is accounted for by the strong cap rate compression witnessed in the European real estate office markets.

Gain (loss) on financial instruments at fair value through profit and loss
The REIT recognized a small gain on financial instruments at fair value through profit and loss for the quarter ended December 31, 2015 of $77. For the year ended December 31, 2015, the REIT recognized a loss of $951. These gains and losses are mostly the result of the variation in value realized on the foreign exchange ("FX") contracts purchased in 2015. These 2015 contracts have a strike price of 1.4956 Canadian dollar per Euro, but the recent increase in exchange rate has impacted the estimated realizable value of the future contracts. As at December 31, 2015 the exchange rate for the Euro was 1.5029. During the fourth quarter ended December 31, 2015, the average FX rate was 1.4609 while it had closed at 1.4965 on September 30, 2015. During the quarter, there was also a fluctuation in the value of the interest swaps and interest cap, which combined with the exchange fluctuation, resulted in a gain of $77. During the quarter ended December 31, 2014, the REIT recorded a gain of $460 as most of the FX contracts held at the time were accounted for using hedge accounting. For the year ended December 31, 2014, the Company had recorded a loss of $346 caused by the unfavorable contracts that were liquidated during the second quarter of 2014.

Share of net earnings from investments accounted for using the equity method
As mentioned above, during the quarter ended December 31, 2015, the REIT completed through its subsidiary its 49% interest investment in Cologne, a joint venture which purchased a company that owns an office property located in Cologne, Germany. The share of net earnings from the joint venture investments in Duisburg, Walpur and Cologne was a loss of $123 for the quarter ended December 31, 2015 and a profit of $517 for the year ended December 31, 2015 which can be broken down as follows: profits for Duisburg of $283 and $1,376 for Walpur and a loss for Cologne of $1,142. The share of earnings in Arcueil is presented as part of the finance loss generated from loans to joint ventures.

In 2014, the Company had only the Duisburg property, which was acquired in July of 2014. The share of earnings from Duisburg for the three-month period ended December 31, 2014 was $3,955 and it was $4,076 for the year ended December 31, 2014.

Please refer to note 8 of the consolidated financial statements for the year ended December 31, 2015 for a more complete discussion regarding the investments in joint ventures.

Finance income
During the quarter ended December 31, 2015, the REIT recorded negative finance income of $2,188, which is principally composed of a finance loss of $2,591 generated from its loans to the joint ventures and interest revenue of $403 from the Acquisition loan to Inovalis SA. The finance loss of $2,591 during the quarter is mainly due to the accounting for of the REIT's share of the hedging cost of Arcueil's partner for an amount of $2.6 million and the adjustment of the gain on bargain purchase for an amount of $2.1 million. During the year ended December 31, 2015, the REIT recorded total finance income of $2,236, which is composed of finance income of $679 generated from its loans to the joint ventures, $1,550 from the Acquisition loan to Inovalis SA and interest income of $7.

During the quarter and for the year ended December 31, 2014, the REIT recorded respectively $375 and $752 of interest revenues from its loan to its joint-venture investment in Duisburg and interest revenues of $227 from the Acquisition loan to Inovalis SA. Please refer to note 8 and note 9 of the consolidated financial statements for the year ended December 31, 2015 for a more complete discussion regarding the investments in joint ventures and the Acquisition loan.

Finance costs
For the three-month period ended December 31, 2015, finance costs amounted to $1,253 including notably $900 for interest costs related to finance leases, mortgage loans and lease equalization loans. For the same period in 2014, total finance costs amounted to $1,133, of which $877 related to finance leases, mortgage loans and lease equalization loans. For the year ended December 31, 2015, finance costs amounted to $4,919 including $3,501 for interest costs related to finance leases, mortgage loans and lease equalization loans. For the same period in 2014, total finance costs amounted to $4,125, of which $2,805 related to finance leases, mortgage loans and lease equalization loans.

Please refer to note 20 of the consolidated financial statements for the year ended December 31, 2015 for a more detailed description of the main components of finance costs for the year of 2015 and 2014. The variation between the periods is the result of the addition of two properties in the fall of 2014 and the impact of the renegotiation of the long-term debt that was done in the second quarter of 2014.

Distributions on Exchangeable securities
Distributions to the holders of Exchangeable securities are calculated in a manner to provide a return that is economically equivalent to the distributions received by the Unitholders. They are, however, subordinated to the distributions to the other Unitholders until April 10, 2016. During the three-month period ended December 31, 2015 the distribution recognized on Exchangeable securities was $423 while it was $379 for the same period in 2014. During the year ended December 31, 2015 the distribution recognized on exchangeable securities was $1,688 while it was $1,267 for the same period in 2014. The increase for both the three-month and for the year is the result of the additional Exchangeable securities purchased by Inovalis SA at the time of the Unit offering in November 2014 and from the additional Exchangeable securities received by Inovalis SA in lieu of asset management fees.

Net change in fair value of Exchangeable securities
The net change in value of the Exchangeable securities, as well as the cost of distributions recognized on Exchangeable securities, are recognized in profit and loss because, for financial reporting purposes, the Exchangeable securities have been classified as a liability at fair value through profit or loss.

For the three-month period ended December 31, 2015, the REIT reported a loss of $1,189 which is the result of the decrease in the amount of the debt following the conversion of $642 of Exchangeable securities into 64,500 units of the REIT in December of 2015 combined with the change in the closing price of Units on the TSX which was $9.37 on December 31, 2015 compared to $8.81 as at September 30, 2015. During the year ended December 31, 2015, Inovalis SA converted Exchangeable securities in the amount of $2,529 into 264,500 units. The net loss resulting from the change in fair value of the exchangeable securities was $1,118 for the year ended December 31, 2015. The closing price on the TSX was $9.37 on December 31, 2015 and $8.88 on December 31, 2014. 

Last 8 Quarters Key Financial Information
The information provided in this section shows the figures as per the consolidated financial statements.

NON-IFRS FINANCIAL MEASURES

Funds from Operations and Adjusted Funds from Operations
Funds from operations ("FFO") and adjusted funds from operations ("AFFO") are not measures recognized under IFRS and do not have standardized meanings prescribed by IFRS. FFO and AFFO are supplemental measures of performance for real estate businesses. We believe that AFFO is an important measure of economic performance and is indicative of our ability to pay distributions, while FFO is an important measure of operating performance and the performance of real estate properties. The IFRS measurement most directly comparable to FFO and AFFO is net earnings. See the Non-IFRS Reconciliation (FFO and AFFO) section for reconciliation of FFO and AFFO to net earnings.

FFO is defined as net earnings in accordance with IFRS, excluding: (i) acquisition costs, (ii) gain on bargain purchase, (iii) net change in fair value of investment properties, (iv) net change in fair value of financial instruments at fair value through profit and loss, (v) changes in fair value of Exchangeable securities, (vi) adjustment for property taxes accounted for under IFRIC 21, (vii) loss on exercise of lease option, (viii) adjustment for foreign exchange gains or losses on monetary items not forming part of an investment in a foreign operation, (ix) gain on disposal of an interest in a subsidiary and the non-cash portion of earnings from investments accounted for using the equity method, * finance income earned from loans to joint-ventures, (xi) non-recurring finance costs, (xii) deferred taxes and (xiii) gains or losses from non-recurring items. It has also been adjusted to exclude the distributions declared on Exchangeable securities. These distributions are recognized in profit and loss consistent with the classification of the Exchangeable securities as a liability. However, they are not to be considered when determining distributions for the Unitholders as indeed they are subordinated to the distributions to the Unitholders.

AFFO is defined as FFO subject to certain adjustments, including adjustments for: (i) the non-cash effect of straight line rents, (ii) the cash effect of the lease equalization loans (equalizing the rent payments, providing the REIT with stable and predictable monthly cash flows over the term of the France Telecom leases in the Vanves property, the Smart & Co. lease in the Courbevoie property and the Rue du Commerce leases in the Baldi property), (iii) amortization of fair value adjustment on assumed debt, (iv) the non-cash portion of the asset management fees paid in Exchangeable securities, (v) capital expenditures, (vi) capital expenditures paid by the vendors of the leasehold interest in the properties and/or tenants and (vii) amortization of transaction costs on mortgage loans.

FFO and AFFO should not be construed as alternatives to net earnings or cash flow from operating activities, determined in accordance with IFRS, as indicators of our performance. Our method of calculating FFO and AFFO may differ from other issuers' methods and accordingly may not be comparable to measures used by them.

Debt-to-book value
Our debt-to-book value ratio is calculated on a look-through basis and takes into account the REIT's apportioned amount of indebtedness at the partnerships' level. Indebtedness at the REIT's level, as well as at the different partnerships' levels is calculated as the sum of (i) finance lease liabilities, (ii) mortgage loans, (iii) lease equalization loans, (iv) other long-term liabilities and (v) deferred tax liabilities. Indebtedness does not take into account the contribution from shareholders that are recorded as a liability, as is the case at the REIT's level for the Exchangeable securities and at the partnerships' level for the contribution from the REIT and its partners.

NON-IFRS RECONCILIATION

FFO and AFFO

Management believes FFO is an important measure of our operating performance and is indicative of our ability to pay distributions. However, it does not represent cash flow from operating activities as defined by IFRS and is not necessarily indicative of cash available to fund Inovalis REIT's needs. This non-IFRS measurement is commonly used for assessing real estate performance. However, it does not represent cash flow from operating activities as defined by IFRS and is not necessarily indicative of cash available to fund Inovalis REIT's needs. Our FFO and AFFO calculations are based on the average foreign exchange rate for the period (1.4185 Canadian dollars per Euro for the year ended December 31, 2015) and does not take into account our foreign currency hedging arrangements (100% of our monthly cash distributions are covered until February 2019 at an average rate of 1.5091, taking into consideration foreign exchange contracts contracted in January 2016).

Investments in joint ventures
The REIT's proportionate share of the financial position and results of operation of its investment in joint ventures, which are accounted for using the equity method under IFRS in the audited consolidated financial statements, are presented below using the proportionate consolidation method, which is a non-GAAP measure. For the purpose of the proportionate consolidation, the initial investment of both partners in the joint ventures were considered as being equity investments as opposed to a combination of equity and loans and accordingly, the related proportionate consolidation balance sheet items were eliminated as well as the associated finance income and finance costs. A reconciliation of the financial position and results of operations to the audited balance sheets and consolidated statements of earnings is included in the tables showed in the Non-IFRS Reconciliation section. 

For the year ended December 31, 2015, the proportional financial results include the following proportion of the revenues and expenses of each one of the joint ventures: 50% for Duisburg and Walpur, approximately 63% for Arcueil and 49% for Cologne. For the quarter ended December 31, 2015, these same proportions of revenues and expenses were as follows: 50% for Duisburg and Walpur, approximately 92% for Arcueil and 49% for Cologne.  

In 2014, the proportional financial results included 50% of the revenues and expenses of Duisburg.

Balance sheet reconciliation to consolidated financial statements

 

Consolidated statement of earnings reconciliation to consolidated financial statements

 

PROPERTY CAPITAL INVESTMENTS       

Fair value
The fair value of our investment property portfolio as at December 31, 2015 was $456.2 million including the REIT's interests in the properties held in partnerships (vs. $344.0 million as at December 31, 2014). The fair value of the French properties was $352.2 million (77.2% of total value) and the fair value of the German properties was $104.0 million (22.8% of total value).

On a same store basis (i.e. excluding the 2015 Arcueil, Bad Homburg and Cologne acquisitions), the fair value of our investment property portfolio as at December 31, 2015, including the REIT's interests in the properties held in partnerships, was $394.1 million vs. $344.0 million as at December 31, 2014. The $50.1 million increase is accounted for by a $25.8 million increase in value of the properties and a $24.3 million increase due to foreign exchange movements.

Management principally uses discounted cash flows to determine the fair value of the investment properties. These values are supported by third party appraisals in conformity with the requirements of the Royal Institution of Chartered Surveyors Standards, and for the French properties also in conformity with the Charte de l'expertise immobilière, European Valuation Standards of TEGoVA (the European Group of Valuers' Association) and IFRS 13.

Please refer to note 7 of the audited consolidated financial statements for a more complete discussion on our investment properties and valuation rates used by the evaluators.

Building improvements
The REIT is committed to improving its operating performance by incurring appropriate capital expenditures in order to replace and maintain the productive capacity of its property portfolio so as to sustain its rental income generating potential over the portfolio's useful life.

Since the IPO in April 2013, a total of $1.7 million has been spent on the properties, funded by a reserve that was set aside by the vendors of the four initial properties.

Guarantees, commitments and contingencies
The REIT and its subsidiaries have provided guarantees in connection with the finance lease liabilities and the mortgage loans, including pledge of affiliates of the REIT, first mortgages and assignment of receivables and future receivables. As at December 31, 2015, guarantees provided by the REIT with respect to its long-term debts include a preferential claim held by mortgage lenders on the Jeuneurs, Veronese and Sablière properties in the amount of $72,202.

The REIT also has a share pledge on the shares of a company owned by Inovalis that holds certain properties to guarantee the Acquisition loan.

The REIT agreed to pledge up to May 6, 2016 its 49% equity investment in Cologne as a guarantee of the commitment to repurchase a €4,312 ($6,480) loan from the other partner in Cologne. Please refer to note 8 of the consolidated financial statements for a more complete discussion about Cologne.

OTHER SIGNIFICANT ASSETS

Restricted cash
Restricted cash amounted to $1,684 as at December 31, 2015 and is comprised of a collateral for the foreign exchange currency contracts.

Investments accounted for using the equity method
This section encompasses the 50% interest the REIT (through its subsidiaries) has in the Duisburg property, the 50% interest in the Walpur property, 25% interest in the Arcueil property and 49% interest in the Cologne property. The fair value of the investments accounted for using the equity method was $40,466 as at December 31, 2015 compared to $18,307 on December 31, 2014. The following table below outlines the share of the REIT's FFO coming from these investments.

Acquisition loan
On November 6, 2014, Metropolitan LLC, a 100% subsidiary of the REIT, made a loan to Inovalis in the amount of €12,500 so that Inovalis SA could acquire a property in Paris, France (the "Acquisition loan"). As of December 31, 2015, the book value of this loan was $18,786. The loan is secured by a share pledge from a holding company owned by Inovalis SA (which also owns another property in the Greater Paris Region), bears interest at a rate of 8.75% for three years (with an option to extend for one year) and includes a right of first opportunity in favor of the REIT to purchase the property at a discount to the then market price, which was exercised further to the approval by the REIT's unitholders at a special meeting held on January 20, 2016. Subsequent to year-end, on March 21, 2016, the REIT bought the property at an entry cap rate of 4.8% (after expiry of the rent free periods) and a purchase price of approximately $70 million, reflecting a 12% discount on the market value as determined by Jones Lang LaSalle acting as external valuer.

Trade and other receivables
Trade and other receivables as at December 31, 2015 amounted to $4,800 compared to $2,852 as at December 31, 2014. The increase is principally the result of an increase in rent and service charges receivable from tenants.

Other current Assets
Other current assets as at December 31, 2015 amounted to $1,333 compared to $731 as at December 31, 2014. This amount is composed of sales tax receivable of $1,192 and prepaid expenses of $141.     

PRESENTATION OF OUR CAPITAL

Liquidity and capital resources
Inovalis REIT's primary sources of capital are cash generated from operating activities, credit facilities, sharing the ownership of actual assets owned entirely and equity issues. Our primary uses of capital include property acquisitions, payment of distributions, costs of attracting and retaining tenants, recurring property maintenance, major property improvements and debt interest payments. We expect to meet all of our ongoing obligations through current cash, cash flows from operations, debt refinancing and, as growth requires and when appropriate, new equity or debt issues. We can also sell some portion of assets owned in order to get access to capital but also in the perspective of diversification of our portfolio.

The REIT's cash available decreased from $24.2 million as at December 31, 2014 to $6.9 million as at December 31, 2015 because of the investments in the Bad Homburg and Arcueil properties completed respectively on April 8, 2015 and on July 7, 2015. The investment in the Cologne property was funded by a loan of $6.5 million from the partner that will be reimbursed in the course of the second quarter of 2016.

Financing activities
Our debt strategy is to have secured mortgage financing with a term to maturity that is appropriate in relation to the lease maturity profile of our portfolio and then to put in place, when appropriate, interest-only financings. We intend to search for fixed rate financings or floating rate financings with a cap. Our preference is to have staggered debt maturities to mitigate interest rate risk and limit refinancing exposure in any particular period. Our debt to book value stands at 52.8%, in line with our long-term targeted range of 50 to 55% and net of the $6.9 million of cash available as at December 31, 2015, this debt to book value stands at 51.8%.

During the fourth quarter ended December 31, 2015, the REIT exercised its option to purchase the Sablière investment property that had, up to the moment of the transaction, been leased by its Sablière SCI subsidiary. Concurrently, the REIT entered into a mortgage loan agreement. The mortgage loan, which has a principal amount of €13,500 ($20,289), has a term of ten years maturing on December 23, 2025. As a result of this transaction, the REIT was able to generate approximately $ 5 million in additional available cash.

Key performance indicators in the management of our debt are summarized in the following table, which also takes into account the interests the REIT has in all assets held in partnerships.

 

Leasehold and Mortgage Financing Maturity Profile
(% of amount outstanding as at December 31, 2015)

Equity
Our discussion about equity is inclusive of Exchangeable securities, which are economically equivalent to the REIT's Units. In our consolidated financial statements, the Exchangeable securities are classified as a combination of current and non-current liabilities under IFRS because of the conversion feature that can be exercised by the holder of those securities.

Our Declaration of Trust authorizes the issuance of an unlimited number of Units and an unlimited number of Special Voting Units. Issued and outstanding Units and Special Voting Units may be subdivided or consolidated from time to time by the Trustees without notice to or approval of the Unitholders of the REIT.

A total of 82,802 Exchangeable securities were issued during the period from October 1, 2015 to December 31, 2015 in favor of Inovalis SA as payment of the asset management fees for the second quarter of 2015. 50% of these Exchangeable securities (or 41,401 Exchangeable securities) are subject to an escrow agreement pursuant to which such Exchangeable securities will be released from escrow upon termination of the Management Agreement, except in the case of internalization of the management of the REIT, in which case (i) one third of the Exchangeable securities will be automatically released upon internalization of the management of the REIT, and (ii) one third of the Exchangeable securities will be released on the first and second anniversaries of the internalization of the REIT.

Further to the Distribution Reinvestment Plan ("DRIP") in place, a total of 26,613 Units were issued to Unitholders during the quarter ended December 31, 2015 and 93,983 Units were issued during the year ended December 31, 2015. As of December 31, 2015, 7.3% of the Units were enrolled in the DRIP.

During the year ended December 31, 2015, Inovalis SA converted 264,500 Exchangeable securities into the same amount of Units, increasing the total number of Units by 264,500 and decreasing the total number of Exchangeable securities by the same amount. This had no impact on the fully diluted number of Units (including Exchangeable securities).

Distribution and management of foreign exchange risk
Our Declaration of Trust provides our trustees with the discretion to determine the percentage payout of income that would be in the best interests of the REIT. Given that the level of working capital tends to fluctuate over time and should not affect our distribution policy, we do not consider it when determining our distributions.

In order to ensure the predictability of distributions to our Unitholders, we have established an active foreign exchange hedging program. Until February 2019 (included), the REIT is committed to sell €663 (on the average) at an average rate of 1.5091 and to receive $1,000 on a monthly basis. Approximately 60% of the contracts are forward contracts and 40% of the contracts are a combination of puts and calls. The puts and calls contracts were taken at the beginning of 2015 when the market conditions were such that this strategy enabled us to lock in a better rate than the one what we would have had with forward contracts.

We currently pay monthly distributions to Unitholders of $0.06875 per Unit, or $0.825 per Unit on an annual basis.

Trade and other payables
Trade and other payables as at December 31, 2015 amounted to $6,174 compared to $5,653 as at December 31, 2014. The increase is principally due the rise of the euro against the Canadian dollar in 2015.

ANALYSIS OF DISTRIBUTED CASH

As shown in the table above, the cash flows related to operating activities as reported in the REIT's consolidated statement of cash flows exceeded the cash distributions declared for the year ended December 31, 2015. The shortfall of $1,733 for the quarter ended December 31, 2015 was compensated by the excess cash flows generated in the previous quarters. Also, as shown in the table above, the earnings reported during the period exceeded the amount of distributions declared for the three-month and for the year ended December 31, 2015.

Every quarter, the REIT ensures that sufficient funds were being generated from rental operations to continue making distributions at the planned rate. To perform this assessment, management uses the FFO and AFFO measures presented in the section entitled Non-IFRS reconciliation (FFO and AFFO). These measures are used to determine the amount of funds generated by ongoing rental operations that are available for distribution. These measures remove from consideration those gains and losses that are recognized for accounting purposes but that do not impact cash flow. They also remove from consideration various revenues and expenses that are recognized in profit or loss for accounting purposes but which do not arise from ongoing rental operations, for example because they were incurred to acquire revenue generating assets.

As quantified in the FFO and AFFO calculations, the funds used to make the distributions during the current quarter were generated through the REIT's ongoing rental operations.

The REIT expects to continue paying distributions based on the current plan.

RISK AND UNCERTAINTIES

We are exposed to various risks and uncertainties, many of which are beyond our control, the occurrence of which could materially and adversely affect our investments, prospects, cash flows, results of operations or financial condition and our ability to make cash distributions to Unitholders. We believe the risk factors described below are the most material risks that we face, however they are not the only ones. Additional risk factors not presently known to us or that we currently believe are immaterial could also materially and adversely affect our investments, prospects, cash flows, results of operations or financial condition and our ability to make cash distributions to Unitholders and negatively affect the value of the Units.

Risks relating to the REIT and its business
Risks inherent in the real estate industry may adversely affect our financial performance
Real estate ownership is generally subject to numerous factors and risks, including changes in general economic conditions, local economic conditions, the attractiveness of properties to potential tenants or purchasers, competition with other landlords with similar available space, and the ability of the owner to provide adequate maintenance at competitive costs.

The properties generate income through rent payments made by our tenants. Upon the expiry of any lease, there can be no assurance that the lease will be renewed or the tenant replaced for a number of reasons. Furthermore, the terms of any subsequent lease may be less favorable than the existing lease. Our cash flows and financial position would be adversely affected if our tenants were to become unable to meet their obligations under their leases or if a significant amount of available space in our properties could not be leased on economically favorable lease terms. In the event of default by a tenant, we may experience delays or limitations in enforcing our rights as sub-lessor and incur substantial costs in protecting our investment. Furthermore, at any time, a tenant may seek the protection of bankruptcy, insolvency or similar laws, which could result in the rejection and termination of the lease of the tenant and, thereby, cause a reduction in the cash flows available to us.

An investment in real estate is relatively illiquid. Such illiquidity will tend to limit our ability to vary our portfolio promptly in response to changing economic or investment conditions. The costs of holding real estate are considerable and during an economic recession we may be faced with ongoing expenditures with a declining prospect of incoming receipts. In such circumstances, it may be necessary for us to dispose of properties at lower prices in order to generate sufficient cash for operations and making distributions and interest payments.

Concentration of tenants may result in significant vacancies on the Properties
Five of our largest tenants, by percentage of total GLA, occupy approximately 60% of the total GLA. Although all five tenants are committed to multi-year leases, which are set to expire gradually between 2020 and 2024, there is no assurance that such tenants will continue to occupy such premises for the remainder of their lease terms. Some of them have indeed break options before the end of their leases, and the soonest dates on which those five largest tenants may effectively move range between 2018 and 2021. In order to minimize this risk of vacancy, Inovalis REIT will continue to closely monitor all leases and ensure that they work with the current tenants to determine their future leasing plans, which would allow Inovalis REIT to source tenants in advance of the current tenants vacating the property.

Lease renewals, rental increases, lease termination rights and other lease matters
Expiries of leases for our properties will occur from time to time over the short and long-term. No assurance can be provided that we will be able to renew any or all of the leases upon their expiration or that rental rate increases will occur or be achieved upon any such renewals. The failure to renew leases or achieve rental rate increases may adversely impact our financial condition and results of operations and decrease the amount of cash available for distribution.

Although certain, but not all, leases contain a provision requiring tenants to maintain continuous occupancy of leased premises, there can be no assurance that such tenants will continue to occupy such premises which may have an adverse effect on us and could adversely impact our financial condition and results of operations and decrease the amount of cash available for distribution. In addition, certain leases contain a provision which gives tenants the right to terminate their leases upon payment of a penalty.

Moreover, pursuant to the lease agreement with the National Conservatory of Arts and Crafts, none of the value-added taxes on expenses legally due by the REIT are recoverable. However, property taxes and office taxes are recoverable. Similarly pursuant to the Fresh & Co. and French Environment and Energy and Management Agency lease agreements, several forms of taxes, including but not limited to, property taxes, household refuse taxes and annual office taxes will be borne by the REIT. As a result, we will bear the economic cost of increases to these taxes.

Head Lease for properties
According to the head leases for certain of the properties, the owners of such properties have certain participation rights with respect to such properties pursuant to which a French dedicated SPV (a "French SPV") or the German SPV, as the case may be, would need to obtain written consent from the respective owner prior to taking certain actions with respect to such property, including cancelling or amending lease agreements for such property. If the owner does not give its prior consent to such actions, it may terminate the applicable head lease.

Environmental contamination on properties may expose us to liability and adversely affect our financial performance
The properties may contain ground contamination, hazardous substances, wartime relics (including potentially unexploded ordnance) and/or other residual pollution and environmental risks. Buildings and their fixtures might contain asbestos or other hazardous substances above the allowable or recommended thresholds, or the buildings could bear other environmental risks. Prior to acquiring the interests in the properties (including the leasehold interests), we undertook environmental studies on each property. No sign of pollution was evidenced on any of the properties.

We are subject to various federal, state and municipal laws relating to environmental matters. Such environmental laws impose actual and contingent liabilities on us to undertake remedial action on contaminated sites and in contaminated buildings. The costs of any removal, investigation or remediation of any residual pollution on such sites or in such buildings as well as costs related to legal proceedings, including potential damages, regarding such matters may be substantial.

We have insurance in place to protect against certain environmental liabilities in respect of certain of the properties, with limits, which are customary and available for portfolios similar to ours.

We make the necessary capital and operating expenditures to ensure compliance with environmental laws and regulations. Although there can be no assurance, we do not believe that costs relating to environmental matters will have a material adverse effect on our investments, financial condition, results of operations or distributions or cash interest payments.

We may incur significant capital expenditures and other fixed costs
Certain significant expenditures must be made throughout the period of ownership of real property, regardless of whether the property is producing sufficient income to pay such expenses. In order to retain desirable rentable space and to generate adequate revenue over the long term, we must maintain or, in some cases, improve each property's condition to meet market demand, which can entail significant costs we may not be able to pass on to our tenants.

Any failure by us to undertake appropriate maintenance and refurbishment work in response to the factors described above could entitle tenants to withhold or reduce rental payments or even to terminate existing letting contracts. Any such event could have a material adverse effect on our cash flows, financial condition and results of operations and our ability to make distributions on the Units.

Financing risks, leverage and restrictive covenants may limit our ability for growth
The real estate industry is capital intensive. We will require access to capital to maintain our properties, as well as to fund our growth strategy and significant capital expenditures from time to time. There is no assurance that capital will be available when needed or on favorable terms. Our failure to access required capital could adversely impact our investments, cash flows, operating results or financial condition, our ability to make distributions on the Units and our ability to implement our growth strategy.

A high level of indebtedness increases the risk that we may default on our debt obligations. Our ability to make scheduled payments of the principal of, or interest on, and to otherwise satisfy our debt obligations depends on future performance, which is subject to the financial performance of our properties, prevailing economic conditions, prevailing interest rate levels, and financial, competitive, business and other factors, many of which are beyond our control.

Changes in government regulations may affect our investment in our properties
We are subject to laws and regulations governing the ownership and leasing of real property, employment standards, environmental and energy efficiency matters, taxes and other matters. It is possible that future changes in applicable federal, state, local or common laws or regulations or changes in their enforcement or regulatory interpretation could result in changes in the legal requirements affecting us (including with retroactive effect). In addition, the political conditions in the jurisdictions in which we operate are also subject to change. Any changes in investment policies or shifts in political attitudes may adversely affect our investments. Any changes in the laws to which we are subject in the jurisdictions in which we operate could materially affect the rights and title to the properties. All of the properties are located in France and Germany. Although the governments in France and Germany are stable and generally friendly to foreign investments, there are still political risks. It is not possible to predict whether there will be any further changes in the regulatory regime(s) to which we are subject or the effect of any such change on our investments.

Failure to receive deductions for interest payments may adversely affect our cash flows, results of operations and financial condition
In the course of the acquisition of the properties, we entered into financing transactions with third parties and affiliates. These debt financing agreements will require us to pay principal and interest. There are several rules in German tax laws restricting the tax deductibility of interest expenses for corporate income and municipal trade tax purposes. Such rules have been changed considerably on several occasions in recent past. As a result, major uncertainties exist as to the interpretation and application of such rules, which are not yet clarified by the tax authorities and the tax courts. The tax deductibility of interest expenses depends on, among other things, the details of the security structure for debt financings, the annual amount of tax net-debt interest, the amounts and terms of shareholder or affiliate financings and our general tax structure. There is a risk of additional taxes being triggered on the rental income and capital gains in case the tax authorities or the tax courts adopt deviating views on the above. If this were the case, this would result in a higher tax burden and, consequently, could have a material adverse effect on our cash flows, financial condition and results of operations and ability to pay distributions on the Units.

Changes in currency exchange rates could adversely affect our business
Substantially all of our investments and operations are conducted in currencies other than Canadian dollars; however, we pay distributions to Unitholders in Canadian dollars. We also raise funds primarily in Canada from the sale of securities in Canadian dollars and invest such funds indirectly through our subsidiaries in currencies other than Canadian dollars. As a result, fluctuations in such foreign currencies against the Canadian dollar could have a material adverse effect on our financial results, which are denominated and reported in Canadian dollars, and on our ability to pay cash distributions to Unitholders. We have implemented active hedging programs in order to offset the risk of revenue losses and to provide more certainty regarding the payment of distributions to Unitholders if the Canadian dollar increases in value compared to foreign currencies.

Changes in interest rates could adversely affect our cash flows and our ability to pay distributions and make interest payments
When concluding financing agreements or extending such agreements, we depend on our ability to agree on terms for interest payments that will not impair our desired profit and on amortization schedules and that do not restrict our ability to pay distributions. In addition to the variable rate portion of the leaseholds in respect of the properties, we may enter into financing agreements with variable interest rates if the current historical low level of interest rates continues. There is a risk that interest rates will increase, which would result in a significant increase in the amount paid by us and our subsidiaries to service debt, resulting in a decrease in distributions to Unitholders, and could impact the market price of the Units.

We rely on Inovalis SA for management services
We rely on Inovalis SA with respect to the asset management of our properties and the property management of the properties. Consequently, our ability to achieve our investment objectives depends in large part on Inovalis SA and its ability to advise us. This means that our investments are dependent upon Inovalis SA' business contacts, its ability to successfully hire, train, supervise and manage its personnel and its ability to maintain its operating systems. If we were to lose the services provided by Inovalis SA or its key personnel, our investments and growth prospects may decline.

While the Trustees have similar oversight responsibility with respect to the services provided by Inovalis SA pursuant to the management agreement, the services provided by Inovalis SA are not performed by employees of the REIT, but by Inovalis SA directly and through entities to which it may subcontract. In addition to its right to internalize management at any time, Inovalis SA has the right to terminate the management agreement upon 180 days' prior written notice to the REIT.

Investments in, and profits and cash flows from, properties may be lost in the event of uninsured or underinsured losses to properties or losses from title defects
We carry general liability, umbrella liability and excess liability insurance with limits which are typically obtained for similar real estate portfolios in France and Germany and otherwise acceptable to the Trustees. For the property risks we intend to carry "Multi-Risk" property insurance including but not limited to, natural catastrophic events and loss of rental income insurance (with at least a 12 to 18-month indemnity period). We also carry boiler and machinery insurance covering all boilers, pressure vessels, HVAC systems and equipment breakdown. There are, however, certain types of risks (generally of a catastrophic nature such as from war or nuclear accident) that are uninsurable under any insurance policy. Furthermore there are other risks that are not economically viable to insure at this time. We partially self-insure against terrorism risk for our entire portfolio. We have insurance for earthquake risks, subject to certain policy limits, deductibles and self-insurance arrangements. Should an uninsured or underinsured loss occur, we could lose our investment in, and anticipated profits and cash flows from, one or more of our properties, but we would continue to be obligated to repay any recourse mortgage indebtedness on such properties. We do not carry title insurance on the properties. If a loss occurs resulting from a title defect with respect to a property where there is no title insurance or the loss is in excess of insured limits, we could lose all or part of our investment in, and anticipated profits and cash flows from, such property.

IFRS reporting may result in our consolidated statement of financial position and consolidated statement of earnings being subject to volatility as the fair value of our portfolio changes
The fair value of our properties is dependent upon, among other things, rental income from current leases, assumptions about rental income from future leases reflecting market conditions, expected future cash outflow in respect of such leases, the demand for properties such as the properties, the availability and cost of financing and general economic conditions. A change in one or a combination of these factors, many of which are not controlled by us, may have a material impact to the fair value of our properties. Our chosen accounting policy under IFRS requires that real estate assets be recorded at "fair value" with changes in fair value being recorded in earnings in the period of change. Accordingly, our statement of financial position and our statement of earnings are subject to volatility as the fair value of its real estate portfolio changes and these changes may be material.

Reliance on partnerships
The REIT has a material non-controlling interest in partnerships with several institutional investors. These arrangements create a risk as the business objectives or economic interests of the partner, as in any joint business arrangement, may not be aligned with those of the REIT. The partner may want to make decisions that negatively affect the value of its real estate assets or income of the REIT. Such investments may involve risks not present in investments where a third party is not involved, including the possibility that a partner may have financial difficulties resulting in a negative impact on the investment or be liable for the actions of its third party partner. Although the REIT may not have control over these investments and therefore, may have a limited ability to protect its position, such partnership arrangements contain terms and conditions which, in the opinion of the independent trustees, are commercially reasonable, including without limitation such terms and conditions relating to restrictions on the transfer, acquisition and sale of the REIT's and any joint venturer's interest in the joint venture arrangement, provisions to provide liquidity to the REIT, provisions to limit the liability of the REIT and its Unitholders to third parties and provisions to provide for the participation of the REIT in the management of the joint venture arrangements. The REIT's investment in properties through joint arrangements is subject to the investment guidelines set out in the Declaration of Trust.

Risks Relating to Tax Matters
Taxation of Trusts
The REIT qualifies as a "unit trust" and a "mutual fund trust" for purposes of the Tax Act. There can be no assurance that Canadian federal income tax laws and the administrative policies and assessing practices of the Canadian Revenue Agency ("CRA") respecting mutual fund trusts will not be changed in a manner that adversely affects Unitholders. Should the REIT cease to qualify as a mutual fund trust under the Tax Act, the income tax considerations described under the section Certain Canadian Federal Income Tax Considerations in the IPO final prospectus dated March 28, 2013 would be materially and adversely different in certain respects.

Application of the SIFT Rules
The SIFT Rules apply to a trust that is a "SIFT trust" as defined in the Tax Act. Provided that a trust does not own "non-portfolio property" (as defined in the Tax Act), it will not be subject to the SIFT Rules. Based on the investment restrictions of the REIT, the REIT may not acquire any non-portfolio property and, therefore, is not subject to the SIFT Rules. However, there can be no assurance that the SIFT Rules or the administrative policies or assessing practices of the CRA will not be changed in a manner that adversely affects the REIT and Unitholders.

FAPI
The REIT's "participating percentage" (as defined in the Tax Act) of FAPI earned by CFAs of the REIT must be included in computing the income of the REIT for the fiscal year of the REIT in which the taxation year of such CFA ends, subject to a deduction for grossed-up "foreign accrual tax" as computed in accordance with the Tax Act. The deduction for grossed-up "foreign accrual tax" may not fully offset the FAPI realized by the REIT, thereby increasing the allocation of income to the REIT and, therefore, the allocation of income by the REIT to Unitholders. In addition, as FAPI generally must be computed in accordance with Part I of the Tax Act as though the CFA were a resident of Canada and in Canadian currency (subject to the detailed rules contained in the Tax Act), income or transactions may be taxed differently under foreign tax rules as compared to the FAPI rules and, accordingly, may result in additional income being allocated to Unitholders.

Foreign Currency
For purposes of the Tax Act, the REIT generally is required to compute its Canadian tax results using Canadian currency, including for purposes of computing FAPI earned by CFAs of the REIT. Where an amount that is relevant in computing a taxpayer's Canadian tax results is expressed in a currency other than Canadian currency, such amount must be converted to Canadian currency using the rate of exchange quoted by the Bank of Canada at noon on the day such amount first arose, or using such other rate of exchange as is acceptable to the CRA. As a result, the REIT may realize gains and losses for tax purposes by virtue of the fluctuation of the value of foreign currencies relative to Canadian dollars.

Change of Tax Law
There can be no assurance that Canadian or foreign income tax laws, the judicial interpretation thereof, the terms of any income tax treaty applicable to the REIT or its affiliates or the administrative policies and assessing practices and policies of the CRA, Finance and any foreign tax authority or tax policy agency will not be changed in a manner that adversely affects the REIT, its affiliates or Unitholders.

Non-Residents of Canada
The Tax Act may impose additional withholding or other taxes on distributions made by the REIT to Unitholders who are Non-Residents. These taxes and any reduction thereof under a tax treaty between Canada and another country may change from time to time. In addition, this prospectus does not describe the tax consequences under the Tax Act to Non-Residents, which may be more adverse than the consequences to other Unitholders. Non-Resident Unitholders should consult their own tax advisors.

Taxation of the REIT and the REIT Subsidiaries
Although the REIT and the REIT Subsidiaries have been structured with the objective of maximizing after-tax distributions, taxes (including corporate, withholding, land transfer, and other taxes) in the various jurisdictions in which the REIT invests will reduce the amount of cash available for distribution to the REIT by the REIT Subsidiaries and, therefore, reduce the amount of cash available for distribution by the REIT to Unitholders. No assurance can be given as to the future level of taxation suffered by the REIT or the REIT Subsidiaries. In addition, certain tax positions adopted by the REIT and the REIT Subsidiaries may be challenged by the CRA or a foreign taxing authority. This could materially increase the taxable income of, and taxes payable by, the REIT and the REIT Subsidiaries, and thereby increase taxable income of Unitholders and/or adversely affect the REIT's financial position and cash available for distribution to Unitholders.

The extent to which distributions will be non-taxable in the future will depend in part on the extent to which the REIT Subsidiaries are able to deduct depreciation, interest and loan expenses relating to our properties for purposes of the Tax Act. No assurances can be given that the CRA will agree with capital cost allowance claims by the REIT Subsidiaries and that expenses claimed by the REIT and the REIT Subsidiaries are reasonable and deductible.

Qualified Investors
We will endeavour to ensure that the Units continue to be qualified investments for Plans; however, there can be no assurance in this regard. In addition, Redemption Notes or other property received on an in specie redemption of Units may not be qualified investments for Plans. The Tax Act imposes penalties for the acquisition or holding of non-qualified investments.

German Taxes
As described under the heading Certain Non-Canadian Income Tax Considerations – Certain Material German Income, Withholding and Real Estate Transfer Tax Considerations in the IPO final prospectus dated March 28, 2013, the German SPV would be subject to municipal trade tax ("TT") if it acts through a German permanent establishment. We have assumed that the German SPV will not be subject to TT based on our current understanding of the structure. However, no assurances can be given that the German SPV will not be subject to TT.

The German real estate transfer tax (the "RETT") generally applies where there is a transfer of legal title of properties from one legal person to another. If the German SPV exercises the purchase option in respect of the Hanover Property (see Certain Non-Canadian Income Tax Considerations – Certain Material German Income, Withholding and Real Estate Transfer Tax Considerations in the IPO final prospectus dated March 28, 2013), legal title to German real estate would be transferred and, consequently, RETT would be payable in connection therewith.

OUTLOOK

We believe that the current market environment is a favorable one for the REIT to prosper. In addition to actively managing our properties, we are continuously assessing potential acquisitions in our target markets and will focus on the ones offering value and stability. Our long-term credit worthy tenants, low cost of debt with proper maturity and the foreign exchange rate contracts for our distributions until February 2019, not only provide investors with steady cash flows, but also serve as a basis for future growth. In addition of the cash available, we can also sell some portion of assets that we own to get access to additional cash and at the same time diversify our portfolio risk.

CRITICAL ACCOUNTING POLICIES

The preparation of the REIT's audited consolidated financial statements in conformity with IFRS requires management to make judgments and estimates affecting the reported amounts of revenues and investment properties owned directly and indirectly at the reporting date. However, uncertainty about these estimates could result in outcomes requiring a material adjustment to the carrying amount of the asset or liability affected in future periods.

We consider the following policies and estimates to be the most critical in understanding the assumptions and judgments that are involved in preparing our financial statements and the uncertainties that could affect our financial results, financial condition and cash flows: (i) recognition and valuation of investment properties; (ii) distinction between business combinations or asset acquisitions and (iii) classification of and accounting for joint arrangements.

A more detailed description of significant accounting policies and critical accounting judgment and estimates that we apply under IFRS is provided in notes 3 and 4 of the consolidated financial statements for the year ended December 31, 2015.

DISCLOSURE CONTROLS AND PROCEDURES AND INTERNAL CONTROLS OVER FINANCIAL REPORTING

The REIT's Chief Executive Officer (the "CEO"), and the Chief Financial Officer (the "CFO") of the REIT are responsible for establishing and maintaining the REIT's disclosure controls and procedures ("DCP") including adherence to the Disclosure Policy adopted by the Board of Trustees. The Disclosure Policy requires all staff and certain other personnel providing services to the REIT to keep senior management fully apprised of all material information affecting the REIT so that they may evaluate and discuss this information and determine the appropriateness and timing for public release.

The REIT's CEO and the CFO are also responsible for the design of internal controls over financial reporting ("ICFR"). Internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and disposition of the assets of the REIT, (2) provide reasonable assurance that all transactions are recorded as necessary to permit the preparation of financial statements in accordance with International Financial Reporting Standards, and that receipts and expenditures of the REIT are being made only in accordance with authorizations of the management and Trustees of the REIT, and 3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the REIT's assets that could have a material effect on the REIT's financial statements.

The CEO and CFO have evaluated the effectiveness of the Company's DCP and ICFR as required by National Instrument 52-109 issued by the Canadian Securities Administrators. They have concluded that as of December 31, 2015, the REIT's design and operation of its DCP and ICFR were effective in providing reasonable assurance that material information regarding this report, and the annual consolidated financial statements and other disclosures was made known to them on a timely basis and reported as required and that the financial statements present fairly, in all material aspects, the financial condition, results of operations and cash flows of the REIT as of December 31, 2015.

Given the continued growth and diversification of the REIT's investments portfolio, principally through the acquisition of interests in properties that are accounted for using the equity method, and given the addition or growth of several financial statement lines, several internal controls were newly implemented or modified during the year.  These changes were aimed principally at mitigating the risk of misstatement with respect to new investments accounted for using the equity method. In preparation for anticipated additional acquisitions, some additional changes and improvements are being planned for 2016.

A control system, no matter how well conceived and operated, can provide only reasonable, and not absolute, assurance that the objectives of the control system are met. As a result of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues, including instances of fraud, if any, have been detected. These inherent limitations include, amongst other items: (i) that Management's assumptions and judgments could ultimately prove to be incorrect under varying conditions and circumstances; or (ii) the impact of isolated errors. Additionally, controls may be circumvented by the unauthorized acts of individuals, by collusion of two or more people, or by Management override. The design of any system of controls is also based, in part, upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals.

SUBSEQUENT EVENTS

Acquisition of the Metropolitan property
On March 21, 2016, as designed in the Metropolitan Acquisition Loan agreement, and as approved by the REIT's unitholders at a special meeting held on January 20, 2016, the REIT exercised its option to buy at a discount the Metropolitan property. The REIT bought the property at an entry cap rate of 4.8% (after expiry of the rent free periods) and a purchase price of approximately $70 million, reflecting a 12% discount on the market value as determined by Jones Lang LaSalle acting as external valuer. The Metropolitan is a 79,000 square feet office property benefiting from an excellent location in a gentrifying area within downtown Paris. By acquiring this property, the REIT exercised its option to buy further to the Acquisition Loan granted to Inovalis SA in November 2014. The property has a weighted average lease term of 8.0 years with tenants in diversified industries and of good credit quality. Concomitantly with the acquisition, the REIT closed a new finance lease contract of approximately 65% of the value of the transaction. The property also offers potential for further capital appreciation and higher rental income that could be achieved through the re-letting of the current vacant area (9% of total space) and the reversion potential on passing rent.

Refinancing of the Hanover property
Subsequent to the quarter, the REIT refinanced the Hanover property by terminating the finance lease in place and replacing it with an interest-only 7-year mortgage financing of €12.6 million ($18.9 million). The purpose of this operation was to make the REIT benefit from a fixed interest rate as low as 1.85% on this property for 7 years.

SOURCE Inovalis Real Estate Investment Trust