With PML-N government trying to find ideas for GDP growth, BR Research has been advocating the need to focus on housing, construction and real estate development. In that vein, we thought it would be nice to sit down with the boss of Arif Habib Dolmen REIT Management Limited, which is Pakistan's first REIT Management Company aimed towards bringing real estate investment to the reach of wider masses. Their first fund is expected to boast a full year dividend yield of about 9.5 to 10 percent, whereas its NAV has gained about 7.5 percent (on annualised basis) in the six months ending December 2015.

In this interview, Muhammad Ejaz, an IBA alumnus and a former banker, talks about the need to develop REITs, to formalise the real estate development sector and the issues that need to be addressed to achieve the same. Below are edited transcripts.

<B>BR Research: There are so many great business opportunities to explore in this country. Why then real estate?</B>

<B>Mohammad Ejaz:</B> Construction or real estate development is one of the mother industries anywhere in the world. Its size, scope and opportunities - all point to the same direction. It nurtures life whether in the complex form of industrial and retail development or addressing the basic need of housing.

Housing shortage in Pakistan is very severe with an estimated shortfall of 10 million units. According to the most recently available national statistics the average household size in Pakistan is 6 persons, which means that about 60 million people don't have housing of their own. This translates to about one in every three or three and half persons in the country depending upon the total population figures one agrees on. So it's a big number.

One must also bear in mind that the ecosystem of any society or economy is housing. It is from housing that communities evolve; more than simply four walls and a roof, it is the place where a family is raised making it a central element of modern societies.

And the only way such a critical part of economy and indeed society can be developed in a sustainable way to make it a part of formal economy, such that it develops in a transparent way; as long as it is a part of informal economy, social evils will continue to breed, and there will be instances of bad planning which will lead to bad execution.

The unfortunate part is that currently policymakers do not even have accurate data to base their planning and foresight on. The estimated shortage of 10 million units is only a conservative guess, based on dated estimates while the actual number may in fact be higher.

Therefore, our basic argument is that construction or real estate development should operate in the formal sector. Until that happens, our mortgage to GDP ratio will remain the lowest in the world, our concentration or housing density measured by number of people living per room is one of the highest amongst peer economies. While these facts are daunting, they represent some of the reasons why we see great potential in real estate in the years to come.

<B>BRR: How can these sectors be brought into the formal sector?</B>

<B>ME:</B> To bring these transactions into the formal sector the investor/financier need to be from the formal sector. Two major sources of formal financing could be banking and the capital markets. Banking is by and large, over-occupied with financing the government. As far as capital market is concerned, we have this product called REIT (Real Estate Investment Trust). A deterrent is that the country's capital markets are not sufficiently developed compared to the banking sector as well as to capital markets of peer economies.

<B>BRR: What is the reason why REIT hasn't been successful so far, even though the regulations were rolled out as far back in 2008? Is the market not ready yet?</B>

<B>ME:</B> The regulatory framework is not conducive; both the REIT framework given by the SECP and the taxation on REIT by the federal government.

<B>BRR: Let's talk about the SECP regulations first.</B>

<B>ME:</B> The existing set of REIT regulations has merged three roles under one umbrella, which not only prevents the growth of the sector but also, conceptually creates a conflict of interest. Under the existing regulations, the REIT management company (RMC) is an investment manager, an investor and a real estate business manager. It is difficult to gather all three roles under one roof; there is reason why modern economies work on the principle of competitive advantage and specialisation of skills or labour.

Secondly; transactional level approvals sought from the regulator tend to impede growth of any business model.

<B>BRR: What are international best practices as regards an RMC?</B>

<B>ME:</B> Internationally a REIT Management Company is only supposed to be an investment manager which operates like an ordinary company. The only difference is that it has to distribute 90 percent of its profits annually to its unit holders to be able to operate as a tax pass-through vehicle. It's like an asset management company managing a real estate mutual fund, just as there are asset management companies managing stocks and bonds mutual funds. This implies that you raise money from investors and use your investing skills to invest in real estate projects, and charge a management fee against that.

<B>BRR: Surely the SECP must also be cognisant of international best practices. What do they say when you and your colleagues from the industry talk to them?</B>

<B>ME:</B> At this stage, the SECP is overwhelmed by its concern over the interests of small investors. One has to understand that REITs are meant to allow those people who do not have deep enough pockets to invest in a Rs3-4 million property. REIT allows small savers - say people who have Rs10,000 of savings or even less - to invest in real estate by pooling in with the savings of a large number of small and big savers.

Typically, there are two big challenges to investing in real estate: first, you need large amounts, and second you cannot encash small amounts, you can either sell the whole property or not sell at all; you cannot sell one quarter of a plot or one room of a house, apartment or an office space. With REITs you can address both these challenges, allowing you to enter and exit the real estate market as and when you need without any limitations of the size of investment.

So the objective of REITs is that real estate investment shouldn't only be a playground for big investors but that the small investors should also have access to the real estate market, because after all real estate is one of the safest of all asset classes.

Coming back to your question, the SECP is mostly concerned with the interest of small savers. And the best solution they came up with was that the RMC should be asked to play three roles of investment manager, an investor and also a business manager who manages the real estate business. This is to ensure that the interest of the RMC, whose principle job is that of an investment manager, is aligned with interests of the investor, and because the RMC is also the project manager, if anything goes wrong with the real estate project, the SECP can take the RMC to task.

<B>BRR: Are there developers in the market who are in need of financing? So imagine if tomorrow the SECP strikes off the roles of investor and business manager from the RMCs, would developers throng to RMCs for project financing?</B>

<B>ME:</B> Ideally, an RMC should be able to launch funds as any other asset management company, after which it can make investments on their behalf in a diversified set of projects from different real estate developers - of course after doing all the due diligence so that public monies are protected.

<B>BRR: But then developers do not want to engage with formal modes of financing. One, apparently they don't need financing unless it's for very large projects for which there may be a cash flows mismatch in short run. Second, they want to avoid formal ways of financing because both they and their clients do not want to come into the tax system which formal sector forces you to do.</B>

<B>ME:</B> This is indeed a problem. There are two economies operating in Pakistan, black and white. But I will not go as far as to say that there are zero buyers under white economy. It is not as if the hundred percent of real estate buyers are or want to be out of the white economy. Given the size and potential of the real estate market in Pakistan, there will never be time that entire financing of real estate projects is done by REITs.

<B>BRR: What is the positive side of current REIT regulations?</B>

<B>ME:</B> Well it enforces discipline in real estate project management. It forces you into an organized approach from planning to mobilising relevant and skilled resources such as hire a developmental advisor, trustees, quality assurance manager and project accountants etc. The regulations also ensure that cash flows are not misused and that the projects are delivered on time.

<B>BRR: Can the existing regulations be tweaked to ensure that an RMC's role is confined to an investment manager which can only invest in projects that have the desired discipline?</B>

<B>ME:</B> Yes of course. If REIT is established as an alternate vehicle for financing of real estate development projects, then developers will automatically follow this discipline. When developers acknowledge that a set of big institutional financiers exist in the market, then they will meet the desired standard and quality - and therefore all the pieces of the puzzle fall into their respective places. In turn, those developers who will seek RMC financing for their projects will be pushed towards becoming formal, achieve transparency and timely delivery of quality projects thus creating a healthy competition in the market.

<B>BRR: Economists say that the existing zoning laws are a tax on real estate. Do you agree with this and whether it prevents the growth in REITs?</B>

<B>ME:</B> Zoning laws form a part of the master plan of cities. I don't think we have shortage of land in Pakistan, but we have to prevent its wasteful usage, and make it accessible to the common man. The reason why land has become inaccessible to the common man is because untaxed money from various sources is being parked in real estate, which shoots up the price of real estate and makes it inaccessible for the masses. All this doesn't prevent REIT; REIT is a financing vehicle. While the zoning laws do impact the real estate business in general; they do not specifically impede REITs.

<B>BRR: With Bahria Town and DHA phase-9 being developed on the other side of Karachi, can we now expect a full fledge expansion of the city towards that end?</B>

<B>ME:</B> Yes. That's where the city would grow, though there will be vertical growth in the south and centre of Karachi as well. The main city centre areas have become so costly that they have fallen out of reach for the average buyer. Therefore, one can expect the city to naturally grow around Port Qasim in due course, along with its own financial districts, industrial hubs, downtown shopping areas and so forth.

<B>BRR: At what prices should real estate transactions be recorded and taxed - should it be as per transaction value or as per valuation table?</B>

<B>ME:</B> The transactions should be recorded and taxed at the exact transaction value. However, the tax rate should be simultaneously brought down. Currently, transactions are being taxed as per the valuation table or the transaction value, whichever is higher. People, however, understate their transaction value to avoid taxation. If you can lower taxation rate, and tax the transaction at its actual transaction value, the government would be able to collect the same revenue and also be able to have accurate record of real estate transactions.

<B>BRR: You mentioned earlier that land is being wasted. Can you please explain a bit?</B>

<B>ME:</B> Currently the real estate resource is being wasted as the land is not being put to productive use; there are investors who do nothing for months and only buy and sell plots and indulge in speculative activities. Elsewhere in the world, such practices are discouraged. For example, mortgage to let is at a higher rate than mortgage to live; likewise there are differences in taxation applied based on different purposes of real estate purchases.

<B>BRR: Now that housing is a provincial subject. What has been your experience with provincial governments so far?</B>

<B>ME:</B> REIT is a new concept in Pakistan and that is why we have to tread cautiously. We have gotten a positive response from government of Sindh, which is where we are currently operating. They have rationalised transfer duties and taxes, and we reported transactions at the actual value. Now we are requesting Sindh government that the incentives they have provided to REITs should be extended to all of the industry.

The incentives were to calculate taxes (a) as per the prescribed rates applied on the value as per the valuation table, and (b) as per concessional rates but applied on the actual transaction value. The final tax liability would be the higher of the two which we consider to be a fair proposition.
And what were the REIT rates? They reduced CVT to 50 basis points, stamp duty to 25 bps, and registration duty to 25 bps. In contrast, the prescribed rates on valuation table were: 2.5 percent CVT and 2 percent each stamp duty and registration duty.

<B>BRR: Then why not do away with the valuation table, which is what you suggested at the start of this discussion?</B>

<B>ME:</B> We think there is a risk that people would understate the transaction value and the government would be at a loss. Plus, there needs to be some kind of benchmark.

<B>BRR: But what makes you think that they will not understate the transaction value in the model you are just proposing? In fact people with ill-gotten monies might as well pay 6.5 percent taxes and stay off the record than pay 1 percent tax at the actual value and get into the record.</B>

<B>ME:</B> You are right. In this model, those want to hide their record might pay 6.5 percent taxes and stay off the record instead of paying 1 percent tax and record transaction at the actual value. But at least in this model those people, who don't wish to hide their wealth can chose to record their transaction at actual value, whereas in the existing model, even those people whose earnings are white are forced to hide their transaction value just to avoid the high rates of taxation.

<B>BRR: How are FBR taxes affecting your business?</B>

<B>ME:</B> If a property is sold to a REIT scheme, the actual transaction value will be reported, which will result in capital gain for the seller because the initial reported value would likely have been very low. Being cognisant of this, a capital gain tax exemption was allowed but it is currently restricted to development REITS for residential purposes only. This runs contrary to the real estate development model, because the economics of real estate projects demands that we do mixed projects, where we get profit from commercial units of the project and achieve positive cash flows from other components such as apartments. This is because apartments are sold before they are developed and therefore help the developer to meet costs whereas shops and offices are sold after their development, which contributes to the profits - therefore developers go for mixed projects. Pure residential projects are generally negligible in volume.

Second, REITs raise finances from the capital market. Investment by companies is not only an important source of finance but also act as a source of confidence for smaller, individual investors. In order to promote this new instrument, it is imperative to encourage companies to invest in REITs. There is a stark WHT disparity for companies where WHT is charged at 10 percent if they invest in stock funds while for REITs the applied WHT is currently 25 percent. This anomaly needs to be rectified.

This signifies a misconceived regulator perception of REITs as an investment for tax avoidance. In reality, companies can reduce their tax bill through leveraging their balance sheet and deferring dividend payments if they operate outside the REIT structure.