Aiming to Bolster a Lagging Real Estate Market, Dubai Introduces Islamic REITs

Since the global economic downturn in 2008, Dubai has sought to display signs of financial improvement. And the glitzy sheikhdom of the United Arab Emirates (UAE) has begun to demonstrate growth — officials expect foreign direct investment to increase 30% this year — except in real estate. What was once the world’s fastest-growing property market has seen values fall 62% from their 2008 peak, according to a February report from Deutsche Bank. Largely prolonging the pain has been oversupply, as thousands of additional residential and commercial units are expected to enter the market, when roughly 40% of homes and offices remain vacant, according to Bloomberg.

Despite the pessimism pervading the market, Dubai launched a Shariah-compliant real estate investment trust (REIT) in November. Emirates REIT, jointly developed by Dubai Islamic Bank and Eiffel Management, a French REIT specialist, joins a number of Shariah-compliant REITs that have been set up Asia and the Middle East over recent months. Governments and Islamic financiers alike hope the new products will spur investment from Muslims and non-Muslims into these regional real estate sectors.

Officials have been quick to tout some encouraging signs. While European buyers have not returned, Dubai has remained afloat on purchases by real estate investors from India and China; according to the Abu Dhabi-owned newspaper The National, Indians were the biggest bloc of expatriate investors, buying US$2.4 billion worth of properties last year, while Chinese investors bought properties worth US$157 million last year, a 700% increase from 2008. On the heels of the Emirates REIT, the National Bank of Abu Dhabi plans to launch a trust this year.

The introduction of REITs could bring some additional relief to developers and owners of the region’s beleaguered properties, says Susan Wachter, Real Estate and Finance professor at Wharton. "REITs will bring liquidity to the real estate market in the Middle East," she notes. "This is a source of capital which enhances transparency. The market can be priced. Global funds will appreciate that."

A major recovery resource

As a financial instrument, REITs first appeared in the U.S. during the 1960s. More than 20 markets worldwide now have REIT regulation, and the REIT global market capitalization hovers near US$570 billion, according to Ernst & Young. Wharton professor Wachter expects REITs will become a "major resource of recovery," for the U.S. commercial real estate sector, as she sees two sources of funding still available for real estate buys: investments from REITs, and private equity funds.

In form and in principle, the Islamic REIT is no different from a conventional one. But to comply with Shariah, the Islamic code of law, the fund must abide by a number of rules. Foremost, an Islamic REIT must avoid interest. There are also restrictions on what it can invest in — the exclusions include investing in building or hosting conventional banks and insurance companies; gambling and adult entertainment establishments; and the manufacture or sale of haram (forbidden) products, such as tobacco, alcohol and pork. Islamic REITs are also conservative by nature: Selective asset choice, an emphasis on fair and regular distribution of income, and no direct investments.

As a result, an Islamic REIT requires more attention and work for the fund manager, who will have to inspect the activities of its clients and their financing. Additionally, an Islamic REIT will have an attached Islamic scholar board, which approves investment choices based on religious criteria. "It makes an Islamic REIT less liquid than a conventional one," says Oliver Laroche, principal at consulting firm A. T. Kearney UAE. "The REIT manager will have less choice for his portfolio when he wants to change assets." For example, an Islamic REIT cannot take an unrestricted position on shopping malls and resort hotels in its portfolio as a result, which usually are the most profitable rent producers for an REIT.

This doesn’t mean an Islamic REIT is narrowly limited in its investment possibilities. Shariah-compliant investors still have a wide range of options: Logistics and infrastructure investments are plentiful in the Gulf alone; schools or medical facilities; public buildings by sale and leaseback. Offices are fine if they are not leased to non-compliant tenants. And the conservative approach of an Islamic REIT can also be attractive to cautious or ethical investors.

Most Islamic funds do allow for some flexibility, notes David Sanson, a partner specializing in real estate at law firm DLA Piper Middle East. "The Islamic REIT prescribes that below a certain benchmark, non-permissible usage is allowed within the REIT," he says. "As a general rule, it is no more than 20%."

By its nature, a REIT is more likely to be raised by a bank than a developer. "A real estate investment trust is a medium-risk investment, where the return should be constant and over a long term," Laroche says. For this reason, a REIT is not designated to build new projects, but to offer profitability by renting a building. "Investors look for a return, immediately," Sanson says. "They don’t want waiting 12 months to get a yield."

But the process to develop Islamic REITs in the Middle East has been slow. Kuwait and Bahrain both have one Islamic REIT, but the product has not developed elsewhere in the region due to the global financial crisis, and the lack of regulation. This is not the case in Asia, where Muslim countries have pioneered Islamic REITs. Wachter says these countries are models to emulate. "Legislation already adopted, such as in Malaysia, will bring visibility to Islamic REITs and will help to raise that kind of capital," she suggests.

In Asia, REIT success

REITs have in fact been in the Islamic financial market since 1996, when the first was issued in Malaysia. They have since become increasingly available in Asia, drawing in numerous Middle Eastern investors. According to CB Richard Ellis, market capitalization of all Asian REITs rose 25% in the first half of 2010 to US$69 billion. "It is very fast going at the moment in Asia with REITs," Wachter notes. "While Asia grows, funds are coming from out of the region, to diversify. In Asia they definitely look for investors from the Middle East."

Arab countries wishing to capture that liquidity should study the Asian Islamic finance model, says Zuhaidi Mohd Shahari, an associate at Azmi & Associates law firm in Malaysia. "Malaysia has always been in the forefront in Islamic finance, and took a bold step in revamping its conventional finance and banking structure to support Islamic finance. Now they both complement each other."

Considering Islamic REITs in Malaysia provided returns between 15 to 20% last year, Shahari says the reason why trusts have grown is because they have received generous government policy support. "The Malaysian government has introduced incentives, a favorable taxation and regulatory regime, and special approvals for foreign investors and expatriates," he says.

Singapore, which already has a number of conventional REITs, launched an Islamic trust called Sabana REIT last year, which has already become the world’s largest. As Singapore’s first Islamic REIT, Sabana was 2.5-times oversubscribed and drew a quarter of its investors from the Middle East. "More Shariah-compliant real estate investment trusts will come to market in Asia in early 2011 as cross-regional in character," says Rafe Haneef, CEO of HSBC Amanah Malaysia Berhad. "Islamic investors increasingly embrace the product."

In 2006, the Dubai International Financial Centre passed an Investment Trust Law, and an Investment Trust and REITs Rules Instrument. Some earlier attempts to raise a REIT in the UAE failed, such as those by Nakheel, the troubled Palm Islands developer, which twice tried to start one.

One explanation for the false starts is that the Gulf region has lacked incentive for REITs because of its favorable tax regimes. Such trusts have gained popularity in the West because they allow for an important tax advantage: The payout of high dividends straight to investors, there is no tax on the vehicle, only at the individual level. "With its tax-free environment, the Gulf region might provide little incentive to invest in a REIT, given the investment requirements," Sanson adds.

The establishment of REITs in the Middle East still hinges on the question of regulation, which depends not only on legal norms of government, but also on Shariah scholars’ approval. And the approbation takes place on two levels: with national regulators, and within each fund. "It can take a long time because it is very subjective," Sanson says. "Two scholars could have opposite views during a feasibility study for a fund." In addition, there is a lack of scholars who are qualified in Islamic finance, so getting religious sanction becomes an issue of manpower.

"It took us 18 months to set up Emirates REIT because of regulation issues," admits Mark Inch, Director of Eiffel Holding, which jointly developed the Emirates REIT. "But Dubai Islamic Bank, thanks to its state-owned situation, took the lead in making the move. DIB wants to give the example. Though Islamic REITs are in the early stages, the future potential is certain."

Is Dubai ready for REITs?

Inch notes despite its experience with conventional REITs, this was the first time his firm had to work within Shariah constraints. Still, the deliverable remains the same. "The main task is to bring cash flow from rent," he says. "So the success of a REIT will depend on the management quality and its ability to maximize the portfolio. It must be credible and disciplined. An efficient management chooses the right building, highlights assets, and chooses when a market gets better."

An immediate challenge is that Dubai’s market hasn’t improved much since the downturn. A recent Jones Lang Lasalle report noted there is oversupply across the range of commercial, residential and retail properties in Dubai. Vacancy rates in Dubai’s office market have increased to 41% at the end of 2010. Vacancy in retail malls in Dubai has gone up from 15 to 30%, and the hotel occupancy rate was 70% on average during 2010. The residential market will continue being in oversupply, and prices are not expected to recover before 2012, according to the report.

But Inch argues now is the right time to invest in real estate in the UAE, considering that real estate is cheaper and there is variety in properties to be had. "Big real estate companies always started and grew when the situation seemed bad," he says. "When everything is fine, there is no need to seek capital. It is logical to go to Dubai now. Five years ago it was too early. Investments weren’t institutional, but more individual."

Thanks to the crisis, the market lowered prices, and investment funds can now afford to buy more properties, adds Laroche. "It is one of the rules of diversity. Every investor has an important share of his portfolio invested in real estate properties. But there is always time between the popping of a bubble and the moment investors are eager to invest again."

Additionally, a REIT targets a medium-risk investor, usually investing in existing buildings, whereas the real estate bubble in Dubai was based on off-plan sales. Indeed, the recent crisis has led to distressed asset sales. Single ownership of a whole building doesn’t often exist in Dubai, specifically in the residential market, where units were often sold separately. But REITs can only invest in single ownership buildings. In Dubai, office or retail buildings, the main target for a REIT, are still held by local families, groups or companies.

Also, the return for a REIT investor is typically regular, around 5% or 10%. With this revenue stream, a REIT can attract new kinds of investors, or those with holdings frozen by the real estate bubble. "The success of the Emirates REIT will be all about getting the pricing correct, and identifying sufficient product to make it large and diversified enough for investors," says Andrew Charlesworth, head of capital markets at Jones Lang Salle MENA. "If this scheme is successful, we would expect others to follow."

The Middle East is an important proving ground for Islamic financial products, as success translates into wider acceptance globally. "Dubai has an advantage for REITs," Laroche notes. "It’s an international market place with fresh assets, where companies want to be, and are ready to pay a high rent to be able to stay." With the current political turmoil in the Middle East, Dubai’s relative calm will draw only more companies, analysts predict. Abu Dhabi could have a similar draw, but there is a relative lack of assets there. Qatar and Bahrain are markets that are too small, while Egypt and Jordan don’t have enough modern assets for a REIT.

Investors, banks and governments are observing the Emirati REIT initiative. "The Emirates REIT aims to attract both local investors and public investors. It is a beginning. When the success will be clear, you will see other REITs listed on the market, in order to attract international investors," Laroche concludes. The Emirates REIT assets portfolio is currently focused on Dubai, but will be extended to other UAE states. If it is deemed a success, Eiffel Management will look at other markets in the Gulf where regional demand is high. Saudi Arabia will be among the first to be considered for a new Shariah-compliant REIT.

Inch is positive about the prospects of REITs in the Gulf. "Real estate suits Islamic finance well," he says, adding at the start, the Emirates REIT will probably be focused on retail assets than on the residential market. "There many possible assets to invest into, so long they bring regular cash flow which will turn into dividends. Even a car park or a toll road can be an asset for a REIT."

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