The opportunities for investors to place capital and for developers to access funding are expanding as Saudi Arabia’s real estate market grows and matures. Indeed, there is an increasing realisation that real estate in the Kingdom is a sound asset class and, consequently, more funds are beginning to eye the market as a means of generating steady returns.
Breaking Into The Market
Real estate investment trusts (REITs) and funds are a relatively new phenomenon in the Gulf region. The first attempted foray into the trust investment vehicle in the Kingdom occurred in the summer of 2009, when Encore Management, a Swiss-based asset management company, announced plans to launch a REIT, targeting SR1bn ($266.5m) in investments. Elsewhere, the product has been gaining traction, with Kuwait launching the first Islamic REIT in the region in 2007. In 2014 Emirates REIT completed the first successful initial public offering (IPO) in the region on the Dubai Nasdaq. However, although Saudi Arabia has the largest capital market in the region, it does not currently have any listed REITs.
Globally, the REIT industry is in good health. In 2013 REIT IPOs totalled in excess of $20bn, more than twice the 2012 figure, according to global accounting firm EY. REITs have become one of the primary means of raising capital for real estate development around the world. According to EY, REIT IPOs make nearly three-quarters (72%) of all real estate IPOs, up from just under a quarter (24%) in 2006-07.
Yet despite a first foray into the Saudi market in 2009, the financial instrument has been slow to take hold. There are no specific financial regulations governing REITs in the Kingdom and, as is true in much of the region, the REIT concept – which often comes with special tax treatment in other markets – held little appeal in Saudi Arabia. Jane Clayton, partner at Norton Rose Fulbright in the Middle East told News, “No GCC jurisdiction offers special taxation treatment for funds investing in real estate, so there is no real regional REIT structure as the term is understood internationally. The term REIT, when used in relation to Middle East funds, is used as an indication of the commercial terms of an investment fund, as opposed to an indication of a special tax status.”
Tapping Into Potential
Despite this, financial institutions are beginning to see the potential of an increasingly diverse and deep Saudi real estate market. As such, there is a growing emphasis on real estate as an asset class, and while REITs are still a rare phenomenon, other types of sector-specific funds are beginning to sprout up in the market.
In February 2014, for example, Itqan Capital launched its third real estate income fund (REIF), a close-ended, four-year income-generating fund. The instrument, now in its third iteration, offers a cash yield of 7-8%, disbursed every six months, as well as capital gains in the medium term, according to Adil Saud Dahlawi, Itqan Capital’s CEO.
Local investment firm Jadwa Investments also announced plans to enter the real estate sector through partnerships with developers and the establishment of funds for real estate projects. Tariq Al Sudairy, CEO and managing director of the firm, told Reuters in November 2014, “We see a lot of potential for growth in this space – both in terms of real estate development projects and income generating projects. The type of projects are localised but in general, we expect residential to be in focus, along with retail and hospitality.” The company was managing a total of SR20bn ($5.33bn) worth of assets across a variety of classes in the third quarter of 2014.
Interest From Abroad
These are sure signs of increasing interest in Saudi property. However, with the Saudi Stock Exchange, also known as the Tadawul, allowing foreign institutional investors to trade as of June 2015, it is unclear where foreign inflows will be placed. While the opening is likely to generate substantial interest in the Kingdom’s flagship companies, such as Saudi Basic Industries Corporation (SABIC), it could also benefit the real estate sector as new investors get acquainted with the market. Indeed, companies related to property have been performing strongly on the local exchange and firms continue to return positive results.
There is certainly optimism about growth prospects moving forward. For example, Dar Al Arkan, the largest listed developer in the Kingdom, has set a target of 10% growth in 2015, with plans to increase investments to SR1bn ($266.5m) on projects in the year. The firm reported strong earnings in 2014, recording gross profits of SR1.3bn ($346.3m), a rise of 12.7% compared to 2013. This rate of expansion came on the back of property sales with higher profit margins. However, increased operating expenses meant that net income fell by 15.7%.
Dar Al Arkan is well placed to sustain its performance. The company has a land bank of almost 35m sq metres, but is looking to protect itself from the difficulties of this market, by reducing its revenue coming from land and property sales to 50% by 2020. The majority of the rest of its earnings will be expected to come from leasing commercial and residential properties (with a minority from equities and bank deposits). The firm’s rental portfolio increased by 105% in 2013 and 18.5% in the first half of 2014.
Other listed companies, such as Al Akaria, which has a sizeable land bank of 13m sq metres, are also well placed to perform strongly in the coming year. Indeed, sentiment in the market is positive. In the first half of 2015, real estate was the second-best-performing industry on the Saudi Stock Exchange after the transport sector. Prices of listed companies in the sector were up a combined 29% year-on-year on Tadawul All-Share Index (TASI).
As well as being a potential boon to listed real estate firms, the new regulations regarding foreign participation in the exchange could also pave the way for Saudi Arabia to experience its first publicly listed REIT. This would be another marker on the industry’s road to maturity and help bring funding to developments across a range of segments (see Capital Markers chapter).
Yet while the TASI performance is largely a sound reflection of the state of the industry, the issue of funding is not without its challenges. Basic bank financing, for example, is a key concern for real estate developers. Most commercial banks will only finance against land, rather than cash flows, which creates a challenge for smaller developers without sizeable land banks or those developing a project on leased land. Nonetheless, commercial credit to the construction sector has been increasing steadily over the last five years. Between 2010 and 2014, credit to the industry rose by SR27.6bn ($7.4bn), or 50%, to SR83.3bn ($22.2bn), according to data from the Saudi Arabian Monetary Agency.
Although this is good news, credit growth to construction was already slowing by the end of this period, registering a 1.6% rise in 2013 before regaining some pace to 8.8% in 2014. With the price of oil affecting the Saudi economy, the banking industry could become more cautious in its approach to the property sector. However, thus far, commercial banks in the Kingdom have suffered few ill effects from the fall in oil prices, with profit across the sector growing by 10.22% to SR41.47bn ($11bn) in 2014, while assets increased by 12% to SR2.1trn ($559.65bn).
This suggests, in the shorter term at least, that it should be business as usual. However, although financing might still be available for the property sector, its cost could begin to rise given the market’s connection to the US interest rate environment. “There’s a negative outlook for interest rates if the US Federal Reserve increases its rates,” Mohamed Tomalieh, an independent financial analyst based in Saudi Arabia, told OBG. “It might discourage some real estate companies from borrowing and make some projects less feasible.” The benchmark interest rate is at 2% as of mid-2015.
If the borrowing conditions from the commercial sector become more arduous, the property industry can turn to the government. “Government development companies are offering loans to stimulate the real estate sector,” Tomalieh told OBG. For example, in 2014 Al Akaria received approval for a SR1.5bn ($399.75m) loan from the Public Investment Fund of the Ministry of Finance to allow it to progress with large residential developments.
In the longer term, the ambition will be the development of a diversified offering that will benefit both developers and investors. Indeed, sector growth will be dependent on companies finding sources of capital beyond state-backed loans or traditional bank financing. As such, the increasing interest from real estate funds in the Saudi market is good news for developers. It should also prove positive for investors, as the underlying conditions for growth across all segments are strong. Indeed, for investors with a medium- to long-term investment horizon, Saudi Arabia should be a standout performer for the region.
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