UAE Laws and Islamic Finance

Laws of the UAE and Islamic Finance

Islamic Real Estate Investment Trusts

An Islamic Real Estate Investment Trust (REIT) is similar to a conventional REIT except that all forms of investment, deposit, and financing instruments should comply with the Sharia’h.

‘Structurally, there is no substantial difference between an REIT and an Islamic REIT. However, in the Islamic REIT, the true objective is to ensure the permissibility of the subject matter in the context of the Sharia’h. In addition, the Sharia’h adviser has an important function in the Islamic REIT in determining permissibility of the investments. In the REIT and the Islamic REIT alike, revenue generated through the use of the real estate and/or any capital gain constitutes revenue to the unit holder. In an Islamic REIT, however, the source of this revenue is scrutinized under Sharia’h binoculars to ensure permissibility of use. While the issuance of REITs in Malaysia is governed by the Securities Commission under the REIT Guidelines, Islamic REITs are also governed by the Islamic REIT Guidelines. Therefore, in Malaysia, the issuer of an Islamic REIT must comply with both the REIT and the Islamic REIT Guidelines.’ [1]

‘Investment trusts are companies that invest in the shares of other companies for the purpose of acting as a collective investment. When the shares of a trust fund are issued, the investors’ money is pooled into the trust fund. The board of trustees of the trust fund will usually engage a professional fund manager to invest in stocks, shares and other investment portfolios in order to garner positive returns over the investments. It follows, therefore, that the REIT is an investment trust which is a fund that is collectively pooled from investors and is used to invest in real estate only. The investment is normally in the form of buying, managing, selling, and leasing real estate or purchasing shares in publicly listed real property companies or investing in debt securities of real property companies. As an investment, a REIT combines the best features of real estate and stocks. It gives investors a practical and effective means to include professionally managed real estate in a diversified investment portfolio.’ [2] It also allows the smaller scale investor to invest in real estate projects which the investor might not be able to do on his or her own. This also has the side effect of channeling more money into real estate development under ethical guidelines and management.

‘Thus, a Real Estate Investment Trust (REIT) is a security that sells like a stock and invests in real estate directly or indirectly. There are different types of REIT’s such as Equity, Mortgage and Hybrid REIT’s. The Equity REITs invest in and own properties and their revenue is linked to the rent. On the other hand, Mortgage REIT’s deal in investment and ownership of property mortgages and their revenue is primarily linked to the interest they earn on the mortgage loans.’ [3]  A Hybrid REIT is a mixture of the Equity and Mortgage REIT.

An REIT offers several advantages to investors:

(1) ‘It allows accessible indirect investment in real estate. Participants can invest in a professionally managed portfolio of real estate that is held in tax transparent structures. This serves to open up real estate investment to the small investor who otherwise would not have had this investment opportunity;

(2) It enables participants to broaden their investment portfolio and diversify risk;

(3) It is typically tax transparent and there is only one level of taxation. The REIT does not pay tax on its profits, thereby maximizing dividends on profits made when they sell their shares. Typically, a US REIT will pay back at least 90% of its profits to its shareholders and in many cases even more than that, with some REITs distributing all their profits to their shareholders. REITs can also serve to eliminate some of the tax and other difficulties experienced by institutional investors such as pension funds and foreign inventors if they invest more directly in real estate;

(4) It provides ease of liquidation of assets into cash primarily due to the fact that they are traded on a stock exchange;

(5) It offers historically low volatility. REITs tend to be stable and therefore offer an attractive return for investors.’ [4]

REIT Structure

The parties to the transaction might include a management company, investors, trustee(s), tenants, and a property manager.

‘The Securities Commission of Malaysia defines REIT as ‘an investment vehicle that proposes to invest at least 50% of its total assets in real estate, whether through direct ownership or through a single purpose company whose principal asset comprise real assets’ (Securities Commission, 2005b). Different countries adopt different approaches in determining the requirements for a REIT especially with regards to the ratio of investing in real estate. In the United States, for example, the main requirement for a REIT is that it must invest at least 75% of the company’s total assets in real estate. As for Korea and Singapore, 70% is the minimum ratio of investing in real estate. In all cases, the REIT is an entity that accumulates a pool of funds from investors, which is then used to buy, manage, and sell assets in the real estate industry … the ratio of investment depending on the country of issuance.’ [5]

‘The owner of one REIT unit is actually buying a portion of a managed pool of real estate. This pool of real estate then generates income through renting, leasing, and selling of property and distributes it directly to the REIT on a regular basis. Hence, an investor may receive returns either in the form of dividend and/or capital gain for the asset holding duration.’ [6]

‘In essence, REITs in Malaysia operate like any other trust fund involving stakeholders such as a Management Company, trustee and unit holders. The relationship of these parties is outlined and governed by a trust deed. The trust deed is essentially a formal document outlining the objectives and principles of the REIT and the rights and responsibilities of a management company and a trustee respectively. The REIT must be managed and administered by a management company approved by the Securities Commission. Among the main functions of the REIT manager includes setting up the strategic direction of the REIT and recommending to its trustee on the possible acquisitions, divestments or enforcements of assets and ensuring compliance with applicable regulations.’ [7]

‘The REIT is required to have a trustee who acts as the custodian of the assets of the fund and to safeguard the interests of the unit holders. This requires continuous supervision and monitoring of the funds managed by the management company so that it complies with the objectives and the deed of the fund and all related regulatory requirements and guidelines set by laws and the Securities Commission. In Malaysia, functions of a trustee can only be assumed by a trust company which is registered under the Trust Companies Act 1989. The trustee earns trustee’s fees for its functions in holding the assets for the benefits of the unit holders.’  [8]

‘The Property Manager provides property management services and in return earns property management fees. He or she manages and controls the assets of the REIT, prepares budgets and maintains financial records for the properties as well as advises on sale and purchase decisions.’ [9]

Equity REITs

‘Equity REITs own and operate income-generating real estate which involves a wide range of activities including leading, development of real properties and tenant services. A distinctive feature of equity REITs is that they acquire and develop real estate properties with the intention to manage them as part of its portfolio rather than resell them once they are developed. Equity REITs are the most common type of traded REIT’s.’ [10]

Mortgage REITs

‘Mortgage REITs primarily hold long-term mortgages but many also engage in short-term construction financing. This type of REIT offers interest-based loans to real estate owners, operators or developers. It involves greater risk since mortgage REITs tend to be more sensitive to volatility in the market interest rates. This is due to the fact that mortgage REITs hold mortgages whose prices move in the opposite direction of interest rates.’ [11]

Hybrid REITs

‘Hybrid REITs are a combination of equity and mortgage REITs. In other words they own and operate real estate and at the same time extend loans to real estate owners and operators.’ [12]

In November 2005, the Malaysian Government through the Securities Commission issued guidelines for the Islamic REIT, making Malaysia the first jurisdiction to introduce such guidelines in the industry. Malaysia is the only government thus far to issue such guidelines and has therefore been at the forefront of the Islamic finance industry as usual, setting a new global benchmark for the development of Islamic REITs on the world stage. On a global level, there is a huge, untapped market for Islamic REITs. [13]

Guidelines For Islamic Real Estate Investment Trusts  [14]

Date Issued: 21 November 2005

(1) Rental of Real Estate by Islamic REIT for Business Purposes

1.1 Acquiring real estate with existing tenants

(a) Sharia’h Compliant assessments must be carried out by the appointed Sharia’h committee/ Sharia’h adviser to assess any property to be acquired by an Islamic REIT. In general, an Islamic REIT is a collective investment scheme in real estate in which the tenants operates permissible activities according to the Sharia’h. However, in the event that the tenants is found to operate non-permissible activities, the fund manager for the Islamic REIT must perform additional compliance assessments;

(b) The fund manager must obtain the rental from each non-permissible activity operating at the property to be acquired. Rental from each non-permissible activity must be added to obtain the total rental from non-permissible activities. The list of non-permissible activities as decided by the Sharia’h Advisory Council (SAC) of the Securities Commission is attached in the Appendix;

(c) Subsequently, the total rental from non-permissible activities will be compared to the total turnover of the Islamic REIT (latest financial year) to obtain the percentage of rental from non-permissible activities. The percentage amount will be referred to the 20% benchmark as determined by the SAC for the criteria on rental from non-permissible activities.

(d) In the event that the percentage exceeds the benchmark, the Sharia’h committee/Sharia’h adviser shall advise the Islamic REIT fund manager not to invest in the said real estate and;

(e) However, an Islamic REIT is not permitted to own real estate, for example, a building, in which all the tenants operate non-permissible activities, even if the percentage of rental from that building to the total turnover of the Islamic REIT is still below the benchmark (20%) This is to protect the image of the Islamic REIT.

1.2 Renting out Real Estate to a New Tenant(s)

The Sharia’h committee/Sharia’h adviser must advise the Islamic REIT fund manager not to accept a new tenant(s) whose activities are fully non-permissible.

1.3 Method for calculating the portion of rental non-permissible activities from the total rental paid by a tenant(s) operating mixed activities (non-permissible and permissible activities).

(a) Calculation of the rental of non-permissible activities from a tenant(s) operating mixed activities can be based on the ratio of area occupied for non-permissible activities to the total area occupied. The percentage will be used as the basis for determining the ratio of rental of non-permissible activities to total rental paid by the tenant(s); and

(b) For activities that do not involve the usage of space, such as service-based activities, the calculation method will be based on the ijtihad of the Sharia’h committee/Sharia’h adviser of the Islamic REIT.

2. Investment, Deposit, and Financing for Islamic REIT

2.1 An Islamic REIT must ensure that all forms of investment, deposit and financing instruments comply with the Sharia’h principles.

3. Insurance

3.1 An Islamic REIT must use the Takaful schemes to insure its real estate. If the Takaful schemes are unable to provide the insurance coverage, then the Islamic REIT is permitted to use the conventional insurance schemes.

4. Forward Sales or Purchases of Currency for Risk Management

4.1 An Islamic REIT is permitted to participate in forward sales or purchases of currency and is encouraged to deal with Islamic financial institutions. If the Islamic REIT deals with Islamic financial institutions, then it will be bound by the concept of wa’d (only one party is obligated to fulfill his promise/responsibility). The party that is bound is the party that initiates the promise. However, if the Islamic REIT deals with conventional financial institutions, it is permitted to participate in the conventional forward sales or purchases of currency.

Rental Activities That are Classified as Non-Permissible [14]

1. Financial services based on riba (interest);

2. Gambling/gaming;

3. Manufacture or sale of non-halal products or related products;

4. Conventional insurance;

5. Entertainment activities that are non-permissible according to the Sharia’h;

6. Manufacture or sale of tobacco-based products or related products;

7. Stock-broking or share trading in Sharia’h non-compliant securities;

8. And hotels and resorts.

Apart from the activities listed above, the Sharia’h committee/Sharia’h adviser can apply ijtihad for other activities that may be deemed non-permissible to be included as a criterion in assessing the rental income for the Islamic REIT . [15]

Operations of an Islamic REIT

‘An Islamic REIT is permitted to own (purchase) real estate in which the tenants operate mixed activities that are permissible and non-permissible according to the Sharia’h. However, the Islamic REIT fund manager must perform some additional compliance assessments before acquiring real estate that has a tenant(s) who operates mixed activities.

An Islamic REIT must obtain the total rental from non-permissible activities from the property that it wants to acquire and substantially compare the total rental from non-permissible activities to the total turnover of the Islamic REIT (latest financial year). This is to obtain the percentage of rental from non-permissible activities. The percentage amount will be referred to the 20% benchmark as determined by the Sharia’h Advisory Council (SAC) of the Securities Commission for the criteria on rental from non-permissible activities. In the event that the percentage exceeds the benchmark, the Sharia’h committee/Sharia’h adviser shall advise the Islamic REIT fund manager not to invest in the said real estate. For example, if the total rental from non- permissible activities is RM 210,000 and the total turnover of the Islamic REIT for that financial year is 21% (which exceeds the 20% benchmark that has been determined by the SAC), the Sharia’h adviser may shall advise the Islamic REIT fund manager not to invest in the said real estate.

An Islamic REIT is not permitted to own real estate in which all the tenants operate non-permissible activities, for example, a casino building in which all the tenants are operating non-permissible activities, even if the percentage of rental from that building to the turnover of the Islamic REIT is still below the benchmark (20%).

For a new tenant(s) that plans to rent the real estate of the Islamic REIT, the decision made by the Sharia’h committee/Sharia’h adviser does not need to be based on the 20% benchmark because the rental contribution from non-permissible activities is still unknown. In this case, the Sharia’h committee/Sharia’h adviser shall advise the Islamic REIT fund manager not to accept a new tenant(s) that operates activities that are fully non-permissible like a gambling operator.

The calculation for the rental of non-permissible activities from a tenant(s) operating mixed activities can be based on the ratio of area occupied for non-permissible activities to the total area occupied. The percentage will be used as the basis for determining the ratio of rental of non-permissible activities to the total rental paid by the tenant(s).

For example, in a supermarket, if the total area rented out is 1,000 square feet and the area allocated for the sale of alcoholic beverages is 100 square feet, then the ratio of area used for the sale of alcoholic beverages is 10%. Therefore, the rental from non-permissible activities (sale of alcoholic beverages) is 10% of the total rental paid by the supermarket, which is RM300 a month (10% times RM 3,000). In addition, for activities that do not involve the usage of space, such as service based activities, the calculation method will be based on the ijtihad of the Sharia’h committees/Sharia’h adviser of the Islamic REIT. An example of a service-based activity is packaging that involves packaging of goods that are non-permissible.

An Islamic REIT must use Takaful to insure its real estate. If Takaful is unavailable to provide the insurance coverage, then the Islamic REIT is permitted to use conventional insurance schemes.

An Islamic REIT is permitted to participate in forward sales or purchases of currency and is encouraged to deal with Islamic financial institutions. If the Islamic REIT deals with Islamic financial institutions, then it will be bound by the concept of wa’d (only one party is obligated to fulfill his promise/responsibility). The party that is bound is the party that initiates the promise. However, if the Islamic REIT deals with conventional financial institutions, it is permitted to participate in the conventional forward sales or purchases of currency.

The Guidelines of Islamic REIT’s do not supersede the Guidelines on REITs issued in Jan. 2005. They provide Sharia’h guidance on the investment and business activities of Islamic REITs and complement the SC’s guidelines on real estate investment trusts. The Islamic REIT must comply with both guidelines.’ [16]

Conclusion

Islamic REITs could possibly revive Dubai.

“Aside from providing an alternative investment in the Gulf Islamic finance industry, REITs could also inject more transparency and regulation in a property sector plagued by unrealistic expectations of returns and occasionally murky dealings.” Globally, the market capitalization for REITs was around $570 billion at the end of 2009 a 2010 Ernst and Young study said. Malaysia’s Axis Global Industrial real estate investment trust (REIT) is planning an initial public offering with an asset size of $1.05 billion making it the world’s largest Islamic REIT. Islamic REITs launched in Bahrain and Kuwait have been relatively small in size – Bahrain’s Inovest REIT and Kuwait’s Al Mahran Tower REIT launched with less than $95 million (DH 348.94) in capital each – and neither has been publicly listed. But an anticipated infrastructure boom in hot markets such as Saudi Arabia and Qatar and the launch of the UAE’s first Islamic REIT may buy faith in real estate investments creating a wider niche for the Sharia’h compliant trusts to thrive. Emirates REIT, which launched with seed capital from Islamic lender Dubai Islamic Bank last November, is aimed at medium income investors and offers returns of 6-8 per cent annually said Mark Inch director of Eiffel Holding and founding shareholder of Emirates REIT. There is a discipline and transparency that comes with a regulated REIT – buildings will not only be properly managed but financial management will also be completely transparent.” [17]

[1] Azmi and Associates, Lifting the Veil: Islamic Real Estate Investment Trusts, 2008, 1.

[2] Azmi and Associates, Lifting the Veil: Islamic Real Estate Investment Trusts, 2008, 1.

[3] KSAB Securities Limited, Research Paper on Real Estate Investment Trust, December 2005, 2.

[4] KSAB Securities Limited, Research Paper on Real Estate Investment Trust, December 2005, 2.

[5] Dr. Asryaf Wajdi Dusuki, ‘Practice and Prospect of Islamic Real Estate Investment Trusts (I-REITs) in Malaysian Islamic Capital Market, 27. return to unit holders constitute

[6] Dr. Asryaf Wajdi Dusuki, ‘Practice and Prospect of Islamic Real Estate Investment Trusts (I-REITs) in Malaysian Islamic Capital Market, 27.

[7] Dr. Asryaf Wajdi Dusuki, ‘Practice and Prospect of Islamic Real Estate Investment Trusts (I-REITs) in Malaysian Islamic Capital Market, 27.

[8] Dr. Asryaf Wajdi Dusuki, ‘Practice and Prospect of Islamic Real Estate Investment Trusts (I-REITs) in Malaysian Islamic Capital Market, 27.

[9] Dr. Asryaf Wajdi Dusuki, ‘Practice and Prospect of Islamic Real Estate Investment Trusts (I-REITs) in Malaysian Islamic Capital Market, 28.

[10] Dr. Asryaf Wajdi Dusuki, ‘Practice and Prospect of Islamic Real Estate Investment Trusts (I-REITs) in Malaysian Islamic Capital Market, 29.

[11] Dr. Asryaf Wajdi Dusuki, ‘Practice and Prospect of Islamic Real Estate Investment Trusts (I-REITs) in Malaysian Islamic Capital Market, 29.

[12] Dr. Asryaf Wajdi Dusuki, ‘Practice and Prospect of Islamic Real Estate Investment Trusts (I-REITs) in Malaysian Islamic Capital Market, 28.

[13] News Editor 1, ‘Islamic Trusts Could Revive Gulf Property Market,’ Gulf News, 2011.

[14] Suruhanjaya Sekuriti, Securities Commission of Malaysia, Guidelines for Islamic Real Estate Investment Trusts, Date Issued: 21 November 2005.

[15] Suruhanjaya Sekuriti, Securities Commission of Malaysia, Guidelines for Islamic Real Estate Investment Trusts, Date Issued: 21 November 2005.

[16] Suruhanjaya Sekuriti, Securities Commission of Malaysia, Guidelines for Islamic Real Estate Investment Trusts, Date Issued: 21 November 2005.

[17] News Editor 1, ‘Islamic Trusts Could Revive Gulf Property Market,’ Gulf News, 2011.

UAE Laws and Islamic Finance

Laws of the UAE and Islamic Finance

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