Real estate: Go lower or embrace risk

Shariah compliant real estate investment has long been an established product offering for Islamic investment managers. Now more than ever, the allure of bricks and mortar runs deep, with investors seeking an attractive income component ahead of what can be achieved with other investments.

Real estate suits Shariah compliant investing well with a genuine business being undertaken, either to build from scratch or to purchase an existing property for its rental income. The mechanisms to assess the compliance of tenants are well established, with increasing recognition that such criteria fit well within the responsible investment ethos of environmental, social and governance criteria.

While there is a global band of professionals able to assist with selecting, structuring and closing acquisitions, what remains lacking is a scale to Islamic banks outside of the Middle East and Southeast Asia able to provide Shariah compliant finance for larger transactions, with conventional finance and a structure to insulate investors from the non-compliant payment of interest required in a pragmatic approach to allowing transactions to occur.

Review of 2021

We entered 2021 speculating on whether the strong demand for real estate investments from the last quarter of 2020 was pent-up demand from the full COVID-19 lockdowns, or something more permanent. It became clear that it was the latter, with Islamic investors competing with others to secure opportunities.

Long-leased logistics remained the most favoured, but also became out of reach for many investors with a target minimum cash yield. Life sciences and health-related properties quickly went the same way, with private residential, so-called multi-family in the US, seeing significant price increases. Everyone was looking for fundamentals they could lean on to support their acquisition decisions.

This made the office sector very interesting, which went from distinctly off the agenda as the impact of working from home was being played out, to be back in demand. Investors realised that as the largest sector of real estate it could not be ignored, but with an understandable focus on quality and local amenities that would tempt employees back in.

Investors’ confidence in the retail sector grew as the year progressed, with the death of this industry outside online having been significantly overstated. There was a realisation that people still had to eat, that home improvements were in high demand as workers spent more time in said home and that the convenience of out-of-town shopping had remained very resilient.

While much of this investing was through syndicated club transactions, REITs continued to grow in strength, but almost exclusively those out of Saudi Arabia. Singapore lost its only listed Islamic REIT, while Oman and Indonesia continued to make preparations to embrace this investment conduit.

As the year drew to a close, investors reflected on what they had achieved, with many realising that their investment volumes had been materially lower than they had wished. The opportunities had been out there, but intense competition had driven yields to unexpectedly low levels on almost anything with a long secure income stream.

It felt like a fork in the road, where the options were either to accept a lower cash yield or to embrace some risk, either with shorter leases or some vacancy. Few wanted to compromise on property quality, but equally continuing on the same path as before was no longer an option.

Preview of 2022

As we tip from 2021 into 2022, economies are doing well, inflation is high, benchmark interest rates are creeping up and investor demand for real estate remains undiminished. Inflation is important here, as recent research has reasserted the benefit of property as a hedge for inflation, but there is a lingering doubt that rising interest rates may make the exit in years to come harder to achieve.

Everyone is looking for trends and demographic or economic patterns to determine where to put their money, with a realisation that some level of risk may now be acceptable with strong economic fundamentals.

Global tax rules, not of course restricted to Islamic structuring, continue to tighten and will bite further in 2022. Everyone should get used to paying tax. Governments need to fill the coffers back up following COVID-19 lockdowns and start their funding of green initiatives.

Could 2022 be the year of energy efficiency? I think there is a strong chance and an even stronger business case that a focus on a building’s green credentials should rank up there with lease length, tenant strength and cash yield. Without a future-proofed property in this regard, tenant demand and in turn future investor demand will fall rapidly.

Last but certainly not least, with the volume of money left uninvested during 2021, I can see a renaissance in fund structures. Investors want their money deployed, not stuffed under the mattress, with those managers who can demonstrate an ability to transact being in the best position to maximise this.

Conclusion

With strengthening economies, new population behavioural patterns established and the importance of energy efficiency and sustainability established, it is a great time to be investing into real estate. Just do not expect to be the only one looking to buy. Yields will be lower, but it is also not a bad time to be taking on some risk.

Written by Philip Churchill, first published in Islamic Finance Annual Guide 2022.