Different types of REITs
In this last article on REITs, I will discuss various types of conventional REITs available in the market and weigh them on the Shariah scale and give my opinion whether there can be a Shariah alternate for them and if so, provide a solution to bring them under the Shariah umbrella.
I have already explained in detail the Islamic version of this type of REIT where the investors’ funds are utilized to purchase Shariah compliant real estate and the rental income is distributed among the investors. The investors also enjoy capital gain if the REIT operator is able to sell an asset profitably.
In this type of conventional REIT, the operator deploys investors’ funds to purchase the mortgage loans to be able to receive the interest payable by the mortgagors for onward distribution to REIT investors.
The operator may also purchase the mortgage-backed securities (MBS). MBS are conventional bonds secured by a package of mortgages and receive periodic interest for distribution to investors. Since almost all mortgages carry the floater-based interest rate, the return to investors also fluctuates depending on the market.
Now, the question is whether there can be a Shariah substitute for the conventional mortgage REIT. The answer is yes and the alternate is for the REIT operator to purchase the properties, and not the mortgage loans.
Assume that a mortgage REIT wants to sell its portfolio to an Islamic REIT. The Islamic REIT operator will not be able to purchase the portfolio comprising the mortgage loans because Shariah does not allow the sale and purchase of debt.
If you remember, I had explained that there can be privately placed Sukuk Murabahah, Istisnah and Salam where the investors are required to hold the Sukuk amount until maturity without being able to sell it to a third party. Similarly, there cannot be tradeable and listed Sukuk Murabahah, Istisnah or Salam since this is tantamount to publicly trading in debt.
The Islamic REIT operator will actually go for the purchasing of the properties in the mortgage REIT portfolio, thereby acquiring its title and possession in favor of the Islamic REIT (representing the investors).
Immediately thereafter, the Islamic REIT operator shall arrange to lease the individual properties for and on behalf of the Islamic REIT to the erstwhile mortgagors who are now lessees. The mortgage REIT operator will arrange to get the mortgage on each property released against payment by the Islamic REIT operator.
There is no Shariah issue in fixing the lease rent based on the same conventional benchmark earlier applied on the mortgages. However, the main hurdle shall be for the mortgage REIT operator to convince the individual mortgagors to transfer the property title to the Islamic REIT.
This obstacle can be addressed by continuing to retain the registered title in their names and instead getting the title agency’s declaration or agreement signed by them. This will state that they hold the registered title as the trustee and agent (and not as owners) for and on behalf of the Islamic REIT, and that they shall immediately transfer the title to the Islamic REIT upon receiving the instruction to do so. The declaration shall be effective in case of a default by a lessee.
A complication which may arise at this juncture is what should be the value of the title to be transferred to the Islamic REIT? We know that the conventional mortgage is applied on the amount of the loan. Therefore, while the loan amount reduces over a period through mortgage repayments, the value of mortgage applied on the property continues to remain unchanged, providing the increased security position to the lender.
Hence, at the time of the Islamic REIT purchasing the mortgaged properties, there may be a situation where the mortgagors would want to retain part of the title corresponding to the amount settled by them. This may be resolved through an agreed formula to keep a title headroom of say 25% over and above the remainder amount of the mortgage loan, which now needs to be converted into Ijarah financing. Hence, the Islamic REIT and the lessee shall jointly own each property, and this ownership ratio shall continue to remain unchanged until the satisfactory completion of the lease term.
Coming to the MBS, the Shariah alternate lies in Islamic securitization Sukuk, also known as asset-backed Sukuk where the investors’ sole recourse is to the Sukuk assets. The securitization Sukuk proceeds shall be utilized either to purchase an existing Ijarah portfolio or to buy the new properties for onward leasing on a financial lease basis. Both approaches are acceptable from the Shariah angle but the former shall provide an immediate return to investors compared with the latter where the investors’ yield curve shall rise gradually.
This type of REIT invests in a combination of equity REITs and mortgage REITs. The REIT operator decides the ratio of investment in either genre. The Shariah compliant alternate of this REIT can be achieved by combining both types of Islamic REITs as explained above.
The purpose of this educative series and the article is not to hurt any religious or commercial sentiments either consciously or even unwittingly.
Next Week: Discussion on the other aspects of Islamic asset management.