Thom Polson is Co-founder and CEO of Falah Capital, a Seattle-based Islamic asset management company. Graduate of the Institute of Islamic Banking & Insurance in London and Franklin College Switzerland. His area of expertise is in the field of Islamic mutual funds.
In recent years, we have seen property investments in the Arabia become highly speculative and increasing in price. Much of this has been due to the buying and continual of reselling of properties that have not been completed. Particularly in the United Arab Emirates this has built up a speculative bubble that took away actual property values to ones that was inflated and unsustainable. An investment such as this is highly dangerous and illiquid if you are the final buyer in the chain. What happens if the property is never completed or delayed for years such Hydra Properties projects in Abu Dhabi? Thankfully in places such as Saudi Arabia, the speculative bubble was never fully embraced, as so much of their property is purpose built or purchased for habitation.
For an investor or group to buy an office or residential building is a large undertaking. Not just in terms of the capital needed for the purchase, but also the costs of operations and maintenance. One must also think of whether they are going to sell off the units or rent them out. A clear problem of selling is that is a onetime only fee that doesn’t not reflect changes in the economy or demands, once a sale is final, no more profit can be gained from the tenant. Yes, some fees will flow from the tenants to cover building maintenance, but not enough to enhance the builders overall profit.
This scenario will undoubtedly lead the owner or group to consider renting the units. This is of course a much more stable and long-term way to recoup the investment though continual rental payments although there is the risk of illiquidity if the building owner is in need of capital. Being a building owner though presents a range of costs that have to be covered through the tenements rental payments. Those being the advertising and leasing available space, the maintenance and cleaning of the premises, and of course insurance. When we add up all these costs, what will the owners’ income really be, and more importantly will it remain constant or fluctuate from month to month?
This idea of rental space has applications not only to the tenant, but also the economy and financial system. This is because it is a rent producing asset, by where the cash flows can be commoditized for a mass of investors. Real Estate Investment Trusts have been used throughout the world as a way to deal with the costs of property ownership. They can be for commercial, industrial, retail, residential, and even medical or hospitality space. By having a mass of investors whether it is for an individual office building or thousands of units spread across hundred properties the principles will remain the same. For tax purposes, a REIT will devote 90% of its income to its investors through yearly dividend payments. But as well this structure is designed to a listed tradable security just as a stock is. There is also the ability to create REIT funds that act just as mutual fund does, by investing in range REITs throughout specific a region or even defined property types to gain returns from a much wider base.
As REITs are easily tradable in the market they have wide reaching implications, as with most real estate investments access to liquidity is a major concern that an investor has to deal with. This is especially true when one thinks of the billions of Dollars that were invested in Middle East Private Equity over the last few years for real estate development, especially as these placements will take years until the investors are able to redeem their shares. This brings to light the importance of the property itself when investing in real estate. Yes investing in real estate development is important, but may take years for those properties to produce a profit. While when dealing with REITs, they are based upon already built and inhabited properties.
Much like a Sukuk the dividend payments will come from the cash flows, but nonetheless the REIT investor is also an owner of the property(s). In terms of Islamic investing this is a very crucial point. There are so few products available to us that can provide for a dependable income payment without being involved with Riba. Sukuk has been the natural tool to deal with this as it is a Sharia compliant way to spread ownership of an asset and receive a fee from another’s use of it. Although unfortunately as important as this product is, it is not allowed in some jurisdictions and is not an efficient tool for the retail investor to partake in. This is because of the costs of sukuk ownership is very high, as a single share may amount to more than $100,000. However, this was not always the case as the minimum buy in for the 2003 Qatar Global Sukuk was only 10% of today’s average.
For this kind of Islamic quasi-fixed income investment system to flourish there has to be a more affordable way for the retail investor to become involved. The costs of Sukuk have risen mainly due to the complexity, time, and number of participants it takes to structure the transaction. However, the costs of participation in a REIT are left up to the market to decide as they are in essence listed equities and one can trade as many shares as they wish, when they want. Although at the moment for GCC investors there are no listed REITs, Islamic or conventional on exchanges such as Tadawul in Saudi Arabia. However, there is no basis for preventing ownership in foreign REITs. There are a number of Islamic REITs available in Malaysia and Singapore.
This investment vehicle could become very important in the sphere of Islamic investing as will become evident. The principle reasons are that the yearly dividend can either be taken as a cash payment or reinvested, increasing ones ownership percentage as the years go by. This is very important because when an investor does decide to take the dividend as an income payment it will be linked to the economy and not as a set payment derived from Sukuk. As well Sukuk generally are short term that range in life from 5-10 years. When this time is up, the investor will have to find a new place to invest. And what if there is no Sukuk at the time that meets their criteria? However, with a REIT, this is a perpetual income stream because as long there are renters, there will be owners. This is because the dividend payment is based upon the REITs income, profitability and inflation rate. There are some key reasons for this as income is derived from renters and the fewer vacancies a property has the more profit it will receive. Also, the more the REIT takes care of its properties through regular maintenance and refurbishments are ways to keep occupancy high increase rents over time. The economy and inflation are key factors as well, because as the economy expands, people’s incomes go up meaning that the cost of living should rise at the same pace. Although REITs can also achieve growth from the negative effects of the financial system, as unfortunate as it when an economy turns people may lose their homes as was seen in the United States and England over the past few years. The scenario put higher demands on the need for rental housing; thus occupancy rates and the REITs income grew. All of these factors are reasons to think of why this easily developable Sharia-compliant product falls into the category of a buy and hold asset
There is clear evidence from the United States, which have had REITs since the 1960s. When rates of return under the buy and hold mentality are computed, REITs have a favored advantage over other fixed income vehicles. A study from the Journal of Real Estate Finance and Economics found that from 1990-1996 average yearly returns were 4.9% for Treasury Bills, 11.2% for the S&P Market Portfolio, and 14.2% for REITs. But more importantly if we widen the time frame, The National Association of REITs in Washington, DC found that from 1972 to 2008 average annual dividends amounted to 8.3% of one’s total holding. For example, if $50,000 was invested the payout would be $4,150; however this would undoubtedly rise as the investor’s holdings increased over the years and or the economy expanded. But as well the National Association of REITs found that the average annual total returns (dividends + capital gains) were 11.2%. If we think logically about the future, that as people are living longer, their retirements could easily last 30 years and will undoubtedly need an income from investments that matches inflation of which a REIT can provide for.
However, when we bring the focus back to the GCC, we have to consider the population as a very important factor in the growth of residential Islamic REITs. Not just in the need for individuals to invest in them, but from a REITs operational sense there is the obvious need for renters to complete the system. Yes, the expatriates in many of these countries are a dependable base to fill up rental units, but in all realties a good portion of GCC society will need rental units as well. The majority of the population is under 30 years old, the price of single family homes for ownership has gone up considerably, and the cities cannot expand outward forever. As with other countries and cities that have grown; the villa has been replaced by multi-family properties as the dominant practice of construction. Not just because of the lower costs, but from the practicality of it all. It takes much more time and space to construct 100 villas, than it does to build a single high rise tower. And as well once a high rise is completed the natural conduit for ownership in many parts of the world is not the sole investor, but a REIT with thousands of like-minded investors behind them.
Sharia-compliance is of course the primary factor that has to be worked through for this discussion to really take hold. Would the rules for a Malaysian Islamic REIT hold up in the GCC? A Malaysian Islamic REITs says that no more than 20% of the total rented space and income can be derived from haram actives. For example, if a 1,000 square meter supermarket was the asset base, up to 200 square meters could be used for the sale of alcohol or pork. Now while these products are not sold in the majority of the GCC, what factors would be in play? If the asset base was an office building, could a conventional financial firm take up to 20% of the space and rental income or would it be 5%? As 5% of income is generally the maximum a company, under GCC Sharia-compliance can attain from haram activities in order for compliance to be had. From this sense is real estate, different from equities? As well if it were it were in the form of an Islamic REIT fund, which invests in various REIT operators. Would Sharia-compliance be achieved by passing a known set of qualitative and quantitative screens as is already the case when constructing an Islamic mutual fund? I do not know, but these are real questions that need to be answered before a GCC wide Islamic REIT industry could take hold. However, as there will mostly likely be a massive need for rental units in the future; this asset class could prove to be one of the most vital for building a more credible and effective way for Islamic inclined investors to profit from real estate.