Investment alternative: The Central Bank of Bahrain introduces new rules for real estate investment trusts

Pursuant to Bahrain’s Financial Trusts Law, in 2009 the director of the Financial Institutions Supervision Directorate of the Central Bank of Bahrain (CBB) authorised the first real estate investment trust (REIT). At the time, the existing collective investment unit (CIU) regulations recognised REITs as an asset class. The director had previously stressed that the CBB was committed to expand the existing CIU regulatory framework, to be in line with international practices regarding REITs, taking into account customisation to local and regional markets.

Shortly thereafter the CBB introduced a consultation paper on the CIU module of CBB Rulebook Volume 6, which has added, among other expansions, Module 7 specifically for Bahrain Real Estate Investment Trusts (BREITs). This set out the proposed rules to govern the REIT structure, relevant components and requirements in detail. As of April 2012, the CBB has issued a new Volume 7 Rulebook entirely dedicated to CIU, which were previously part of Module CIU of Volume 6 Capital Markets. The rules for the newly established CIUs are effective immediately.

BREIT DEFINED: The Bahrain Real Estate Module in Volume 7 defines BREITs as collective investment undertakings the objective of which are acquiring, holding, administering, managing and selling income-generating local and foreign real estate properties, either directly or indirectly. A main component of REITs is that that they typically enjoy tax benefits in return for an obligation to distribute a high percentage of their income. This, however, is not the case as Bahrain is a tax-free jurisdiction.

The REIT structure originated in the 1880s at a time when investors could avoid double taxation, or a tax at corporate and individual level, making it a tax designation for a corporate entity investing in real estate. In return, REITs are generally required to distribute 90% of their taxable income to investors. REITs evolved to provide a real estate investment structure similar to that which mutual funds provide for stocks. Investing in REITs is a liquid, dividend-paying means of participating in the real estate market.

Individuals can invest in REITs either by purchasing their shares directly on an open exchange or by investing in a mutual fund that specialises in real estate. An additional benefit to investing in REITs is the fact that many are accompanied by dividend reinvestment plans. Among other types of real estate assets, REITs invest in shopping malls, office buildings, apartments, warehouses and hotels. Some REITs will invest specifically in one segment of real estate or in one specific region, state or country. Further, REITs can be publicly or privately held. REITs can be classified as equity, mortgage, or a hybrid.

ISLAMIC VARIATION: Another type of REIT that could be appealing to investors in Bahrain is the Islamic REIT. Like their conventional counterparts, Islamic REITs are collective investment vehicles that pool money from investors to buy, manage and sell real estate, but they invest primarily in income-producing sharia-compliant real estate, and/or single-purpose companies that are sharia-compliant and whose principal assets comprise sharia-compliant real estate. The income from the real estate or companies is used to provide returns to its unit holders.

It is imperative to set up a legal framework to service Islamic REITs, because Islamic funds hold more than $1.5trn in sharia-compliant investments globally. Therefore, the CBB’s existing sharia-compliant CIU Module and the new Module on BREITs provide the legal framework for sharia-compliant investments in the form of Islamic REITs.

There are several key distinctions between conventional and Islamic REITs. For example, the latter must appoint a sharia committee/advisor to ensure compliance with sharia requirements. The trust manager must also consider the availability of Islamic insurance before opting for conventional insurance.

Malaysia is an Islamic REITs pioneer, with Al Aqar KPJ REIT (Alaqar) the first Islamic REIT initial public offering in the world. It owns six private hospitals in Malaysia operated by its parent company, KPJ Healthcare. These six properties are valued at $159m but are injected into the REIT at $152.4m, or at a discount of 4.1% on its market value. These results illustrate that a solid REITs structure is imperative for financial and economic growth.

ADVANTAGES: The new Volume 7 from the CBB sets standard key statistics to examine in a BREIT. For instance, a maximum of 20% of net asset value (NAV) may be invested in a development of existing owned property. And in keeping with the CBB’s conservative approach, the rulebook states that “BREITs are not permitted to invest in undeveloped land and mortgages.” This approach is in keeping with the CBB’s stance during a period of economic volatility, given that REITs face challenges that include both a slow economy and the late-2000s global financial crisis, which depressed share values by some 40-70%. The new Volume 7 on CIUs, is, however, looking to exploit the advantages of REIT legislation. This will help put Bahrain firmly back on the map as an international investment destination.

REITs offer a range of benefits, including: 1. Income and capital growth. Distribution yields on REITs are made either quarterly or semi-annually, allowing investors to regulate their cash flow. REITs may also offer the opportunity for capital growth. Rising yields or movements in other markets can cause REIT prices to rise. To ensure that this is applied, the rulebook states that a BREIT must distribute annual dividends of “not less than 90% of its audited net realised income to its participants, within six months from the end of its financial year”.

2. Low-cost exposure to real estate. REITs offer access to the property market with professional investment management at a relatively low transaction and management cost. This is especially appealing to investors in the Kingdom, where there are a substantial number of real estate developments. However, the CBB sets a minimum value requirement for a BREIT at “$20m or its equivalent in another currency at the initial closing”.

3. Improved liquidity. Unlike most property investments, part or all of one’s REIT holdings can be sold at short notice, therefore mitigating any sort of risk that an investor might face.

DISADVANTAGES: On a more sombre note, REITs face a market risk of investing in an asset class that may decline in value. For REITs, this could be caused by market sentiment owing to asset devaluations. Although real estate assets are prime investments, prices could be volatile due to political changes, as we have witnessed in the events of the Arab Spring in 2011. When such market volatility occurs, some REITs may borrow funds to increase potential returns, a technique called “gearing risk”, which can magnify both returns and losses. Therefore, past distributions by REITs cannot be guaranteed for the future and may vary over time. The rulebook recognises this risk and states that a BREIT “must limit its leverage to a maximum of 60% of its NAV for investment purposes”. And to further ensure that BREITs enjoy the benefits, the CBB Rulebook has set out specific reporting and disclosure requirements for the controlled entities of a BREIT and its financing debt position to ensure best practice, financial stability and international soundness.

THE FUTURE: Needless to say, the advantages clearly outweigh the disadvantages with regards to REITs in general. In many countries, REIT legislation has been enacted or is pending. At this stage, the US and Australia are the world’s leading REIT destinations. Germany and the UK, on the other hand, have been struggling with tax implications that REITs may cause. As a result, Asian REITs have developed more quickly than their European counterparts. It is therefore safe to say that with the enactment of the new Rulebook 7, a BREIT is able to hold its place amongst international players and provide a strong setup for those wanting to safely invest in local real estate.