A new era: Mortgage legislation is set to transform the market

Long awaited, and under discussion for more than a decade, a mortgage law, or rather set of laws, is set to be introduced in November 2014. It will usher in a profound shift in the sector that could help to channel the vast demand and purchasing potential of the Kingdom’s 30m citizens into the housing market. At present, only around 30% of Saudis own property, a result of the deep disconnect between purchasing power and residential unit sales prices.

A GROWING PORTFOLIO: Much like the formal housing market, home financing in the Kingdom remained a small and underserved market for many years. As of the end of 2008, a time when the property market in other areas of the GCC had already reached a peak, housing credit by Saudi Arabia’s 12 commercial banks stood at SR14.8bn ($3.9bn), or just 1.03% of GDP. However, with the introduction of a mortgage law looking more like a reality, the Kingdom’s home loan portfolio has been growing steadily. By June 2013 housing credit had trebled in absolute terms to SR41.5bn ($11bn), or 1.48% of GDP.

This is still an extremely low penetration rate by international standards. But, in theory, the introduction of a new mortgage law could push this rate up substantially. Capitas Group International, a Jeddah-based Islamic finance company, estimates that the new law could increase residential lending to approximately $32bn per year.

Alongside the commercial banking sector, there are four dedicated home loan companies – Saudi Home Loans, Deutsche Gulf Finance, Amlak International for Real Estate Development and Finance, and Dar Al Tamleek – all of which should see strong potential for growth in the coming years.

Naif Abdulmohsin Al Baz, CEO of Deutsche Gulf Finance, told OBG, “Housing finance is the single best opportunity in the Kingdom’s real estate market. The demographic drive of the young, growing population, with its emerging middle class and high housing costs, is creating a gap that financing companies can fill. The market potential is not in the billions, but rather trillions of riyals.”

REGULATORY ENVIRONMENT: The new legislation should provide the regulatory environment to mitigate risk and give the banking sector the confidence to meet demand for credit. The legislation is in reality a number of laws that will create the legal architecture for lending against property. They include the enforcement law, which will allow judges to hear enforcement disputes and insolvency cases; the real estate finance law, which will create the platform for banks and financing companies to enter the real estate market; the registered real estate mortgage law for the registration and transfer of mortgages; and the finance companies control law, which will develop a framework for the supervision of shariacompliant real estate financing companies. In February 2013 three of the five laws that make up the overall mortgage regulation package were finalised.

Key considerations under these laws include a minimum paid-up capital of SR200m ($53.3m) for mortgage companies; the creation of the Saudi Real Estate Refinancing Corporation, a body like Fannie Mae and Freddie Mac in the US, which will develop a secondary market by issuing Islamic bonds and securities backed by mortgages with a paid-up capital of $1.3bn; and a loan-to-value (LTV) ratio of 70% for mortgages regulated by the central bank, the Saudi Arabian Monetary Agency (SAMA).

EXPECTED IMPACT: Once details on enforcement and registration have been completed, and the legislation is published in the Official Gazette, the law will take full effect. The reaction from the industry so far has been mixed. According to Asif Iqbal, head of research and advisory at realtor Century21, “The aim of the mortgage law is to regularise the market, but there is a question mark over its negative impacts on the real estate market during early years of implementation as the market has to go through several adjustments in order to execute the law completely and effectively.” In the short term the biggest implication of the new law is likely to be a restriction on the LTV ratio that lenders can offer. Currently, home finance companies and banks are offering 100% LTVs to selected clients, or loans that cover the total sales cost of a property. However, under the new law, the maximum LTV ratio will be set at 70%. The measure is aimed at preventing a Dubai- or US-style collapse in the local housing market by preventing a move towards over-indebtedness. But it is also likely to curb demand in the market, pricing out those who cannot afford a 30% down payment.

According to Moath Jamaan, the head of sales at Saudi Home Loans, “The SAMA regulation will have a huge impact on the price of villas, apartments and land. I believe it will produce a 20% to 25% decrease in sales prices.” The regulation will also have an impact on the business of home finance lenders. “The number one competitive edge you can have is affordability. All banks are competing on this and that is why you have a debt service ratio of up to 65%. But with the requirement for a 30% down payment that competitive edge is limited,” Jamaan added. Indeed, in the short term the regulation may lead to instability as the market adjusts to the changes.

WORKABLE SYSTEM: Numerous markets impose a maximum LTV ratio as a means of combating excessive indebtedness. It can be argued, however, that the local environment is unlike Dubai or other places where the property market has collapsed. The Kingdom’s current home financing infrastructure has developed a workable and largely secure system. The default rate across mortgage portfolios remains low, with Jamaan estimating it is below 2%. Pre-payment is also common, with mortgages often paid off within seven years. Given the size of the debt service ratio in the market, this may seem strange.

However, according to Jamaan, “Most Saudis have other incomes that we do not calculate when we offer the loan. This could be standard annual salary increases or a change in jobs. Also the family can often help in paying off the loan.” Moreover, most borrowers are buying homes to live in rather than for investment. However, the biggest security for lenders is salary assignment, in which repayments are taken directly from a borrower’s bank account and lenders only accept customers that bank with them (or in the case of Saudi Home Loans, Arab National Bank, which has a 45% stake in the company). Furthermore, many lenders only extend financing to customers who are employed in the public sector.

Most banks and mortgage companies generate the majority of their business from government employees. For example, government workers account for 85% of Saudi Home Loans’ business, with most of the rest coming from approved private sector companies, in essence quasi-government entities, such as Saudi Aramco and Saudi Arabian Airlines.

Saudi Home Loans and Deutsche Gulf Finance are the only companies that offer loans to employees of small private businesses and self-employed individuals. This helps to mitigate the risk of default and has allowed lenders to offer terms that have an LTV of 100%, a tenor of up to 30 years, a ticket size of up to SR5m ($1.3m), a debt service ratio of 65% and an interest rate of 3.75% on loans over 15 years (the average ticket size and tenor is much less than this).

The debt service ratio is a rate that includes all a customer’s loans. SAMA enforces a limit of 33% for personal loans, but no regulation that covers home financing. Most banks offer a debt service ratio in a range of 50% to 60%, with only high-income customers offered a higher rate. Even though this rate is for total indebtedness, it is extremely high. In the US, for example, the debt service ratio for mortgages was 4.82% in the fourth quarter of 2013, while for consumer loans it was 5.14%, according to figures from the US Federal Reserve.

EXPANSION OF MORTGAGES: It is thus hardly surprising that SAMA wants to get a grip on indebtedness and improve the environment for mortgage uptake by a wider section of the population. While the quality of the portfolio may not be in question, it is limited in size. The mortgage legislation should allow the extension of credit to customers in the private sector without damaging the performance of lenders’ portfolios. As the government looks to increase the contribution of the private sector to the country’s economic growth, the number of employees in this segment seeking credit is expected to grow. Furthermore, a robust regulatory infrastructure for mortgages should allow lenders to access lower-income segments of the market given the ability to take property as collateral (rather than salary assignment). Most lenders have a minimum salary requirement ranging from SR4000 ($1066) to SR6000 ($1600) per month to extend a loan (though Al Rajhi Bank goes as low as SR2000, or $533, per month).

The biggest impediment to this expansion remains the requirement for homebuyers to find a 30% deposit under the new law. Mohammed Al Abdani, director-general of the Real Estate Development Fund (REDF), a government-owned financing entity, believes as it stands this regulation could price many Saudis out of the housing market. “This raises a big question mark because 30% is a big amount for a middle-income customer to find.” Consequently, the fund is hoping to work with private financing companies and banks to reduce this challenge. The REDF currently offers loans of up to SR500,000 ($133,300) to Saudi citizens for the purchase or construction of a home. However, according to Al Abdani, the fund is looking to extend its remit to enable recipients to use the full amount of the allocation to cover the 30% down payment required under the new regulations. The REDF has already agreed with the commercial banking sector to this arrangement in principle. However, as of March 2014 it had yet to be approved by SAMA.

If this arrangement is endorsed by the central bank, it would effectively mean that Saudi customers can still get 100% LTV for property purchases, with 30% of this being offered interest-free.

CONVINCING THE MARKET: Under such an arrangement, the potential for mortgage loan expansion would be released. The only remaining limitations would likely be customer reticence. Given the pricing situation in the market, there is a pronounced divergence between rental rates and mortgage repayment rates for similar units. This disparity is likely to make the process of convincing consumers to seek finance for ownership a more difficult task (in the short term, at least, until there is convergence).

However, mortgage financing is an investment, whereas renting is an expense, so the market is likely to flourish as potential borrowers become better informed about the benefits.

The law should also help to resolve other issues that continue to inhibit the property sector. While the mortgage market has grown substantially in the past five years, there are nevertheless still obstacles. According to Jamaan, “Our major problem is that we don’t have a secondary market and most banks have reached the limit of their lending.” But Al Abdani sees the law as having a positive impact in addressing this deficit and improving the housing needs of the Kingdom. “The whole purpose of our funding programmes and the new mortgage law is to increase liquidity in the market. This should put pressure on the supply and demand imbalance. And with more people accessing private sector funds, it should enable us to help more people from our own fund,” he said.

The introduction of a state financing and refinancing body, the Saudi Real Estate Refinancing Corporation, should encourage the growth of a secondary market and allow for the proliferation of originate-to-sell home-financing companies – whereby a company generates a loan by acquiring a customer and then sells it on to another company – bringing more loans into the market.

TRANSPARENCY: The other issue will be transparency within the market. As banks’ risk assessments move from a focus solely on salary to encompass property details, it will be crucial for the financial sector to be able to assess property transaction and pricing data. The industry is taking the first steps in this direction. The Ministry of Housing is looking to institute an online system that will track transactions and payments in the rental market, for example. In November 2013 it was also announced that a new real estate index would be launched at Jeddah Chamber of Commerce, tracking pricing, projects and new developments across the property sector.

Such moves should help investors and also assist the banking sector to make decisions on lending and to feel secure in their mortgage portfolio.

Indeed, it is clear that the mortgage law signals the move towards greater maturity and depth in the Kingdom’s real estate market. In the short term the new legislation, which will shake up the existing system, may cause some instability in pricing and demand. However, in the longer term, it should create a platform for sustainable growth in the Saudi market.