In the Media – UK Islamic Finance News – Real Estate Roundtable: A positive outlook for UK property
Gathering market leaders and industry experts together for a frank and open exchange, the UK Islamic Finance roundtable is designed to provide invaluable insights into the most important issues affecting the UK market. For our inaugural issue, what better platform to start from than a look at the property investment market – one of the UK’s most valuable assets in attracting inward investment and a key driver in the development of Shariah compliant structures and fundraising channels.
Philip Churchill, founder and managing partner, 90 North
Tracey Folkes, co-founder and director, Broadoak Real Estate Finance
Naomi Heaton, founder and CEO, London Central Portfolio
Sarah Gooden, partner, Trowers & Hamlins
Michael Dey, real estate division, Gatehouse Bank
How is the market currently performing – and how is 2017 looking compared to previous years?
Philip: The UK real estate market is still determining what Brexit means and what impact it could have in terms of the economy and interest rates, both of which have an inevitable impact on property values. You only have to read the papers to see there’s a broad and variable spectrum of opinion out there. The uncertainty is encouraging some landlords to hold onto their properties, but there is still plenty being traded.
Michael: Geopolitics, Brexit and the according impact on the UK economy have proved for some interesting dynamics. The occupational market seems to be broadly performing sideways at best with investment yields and/or exchange rates providing a good investment opportunity for some investors. Overall investment activity is expected to be of a similar tone to 2016 and less than 2015. This has proven for some attractive risk-adjusted opportunities from a debt perspective.
Naomi: The demand for Shariah compliant investment solutions in UK real estate has grown significantly since the launch of the government’s sovereign Sukuk three years ago, which invested in commercial property. With no plans from the UK government to launch another Islamic product, Shariah-conscious investors have been making a clear call for new real estate solutions as they look at ways of diversifying their portfolios. This is increasingly the case as the pound remains weak against other currencies, especially for dollar-denominated investors.
Sarah: The main problem that potential purchasers are having is a shortage of properties to buy. We understand anecdotally that many properties that are changing hands are being sold off-market and accessing opportunities to buy can be challenging. This is a problem that has been affecting the market for at least the last couple of years. Brexit has not, so far, had the negative impact that was initially feared and the UK still appears to be attractive to overseas investors.
Where is the money coming from, and where is it going to?
Philip: From an Islamic finance perspective, the countries of the GCC are all still very active. However, the region’s opinion on Brexit is split, especially regarding currency, with almost no one sitting on the fence. Many see sterling weak against the US dollar and are very keen to buy, while others who perceive uncertainty and volatility are staying away.
Tracey: In 2016, overseas investors accounted for 43% of the total volume of completed transactions and interest from overseas continued in 2017. The focus has moved away from just London with the assets located in the regions now being of firm interest. Deal sizes tend to be larger at £25 million-plus, although smaller deals in the right location with strong covenants will be considered. All asset classes [are] considered with [the] most popular being office, retail and student housing.
Sarah: The majority of interest comes from the Middle East and Malaysia for obvious reasons. Additionally, we are aware that investors from other parts of the world, particularly China, Korea and Taiwan, have been active in the market. Interestingly, we are also seeing Chinese banks increasingly becoming involved in the real estate finance market. In terms of investor preference, many of our Middle East-based clients are focusing on the regions rather than London where some view the market as overpriced. Malaysian institutions still appear to be more focused on London and more comfortable with that market.
Where are the hotspots for UK Islamic investment into real estate, and what recommendations do you have for overseas investors?
Philip: Central London remains a hotspot. For those who see value in sterling, yields on core office properties not exposed to the potential impact of Brexit on the City are stable, but very low. However, for Islamic investors looking for better returns, I’d recommend they take a broader look across the property sector and the UK. The opportunities are out there if investors look hard enough.
Michael: Real estate debt currently provides for good risk-adjusted returns in an uncertain market.
Naomi: As many more people in the UK elect to rent, rather than buy, the Private Rented Sector (PRS) has become of increasing interest. Build to Rent is currently a hot topic and UK Islamic finance providers such as Gatehouse Bank have been investing [in] the sector. However, while the volume potential appeals particularly to institutional investors, Build to Rent is an untried concept taking significant development risk, targeting an untested domestic market. It could take a generation to become established. [However], overseas investors should also take advantage of residential real estate funds which now offer significant tax advantages over direct investment as well the benefits of diversification, buying power and professional management.
Sarah: There is a continuing appetite among Shariah compliant investors for office accommodation, logistics warehouses and light industrial properties. There is generally less interest from this type of investor in retail properties such as shopping centres and supermarkets because of additional Shariah compliance issues that can arise from the sale of certain types of goods and services (eg alcohol, pork products) but we do still see clients investing in properties occupied by retail tenants with a strong covenant. Build to Rent is a sector attracting increasing interest and activity and student accommodation has fallen out of favour.
What duration are investors seeking, and what returns can they expect?
Philip: Most investors still have an initial business plan horizon of three to five years, but that is not to say that such business plans won’t be extended in due course.
Michael: Generally 4-7% unlevered returns for direct property investments over a period of 4-7 years.
Tracy: Loan terms range from three to five years with average weighted lease lengths tending to be eight-10 years plus. Double-digit IRR with cash on cash returns in excess of 8% have been achieved.
Sarah: Typically four to five years but some investors such as Malaysian institutions are investing more for the long term.
Naomi: Our listed closed-end funds typically have a five to eight-year investment cycle. However, Middle Eastern investors in particular have been making increasing calls for regular distributions in the current low interest rate environment. To meet this demand, our next fund, planned to launch later this year, will look to offer annual returns of 5% together with a capital return on exit.
What are the most popular structures used, and are these fit for purpose?
Sarah: Financing structures are still dominated by Tawarruq/Murabahah, particularly for the Malaysian investors and their Malaysian-friendly banks who can generally provide Shariah compliant finance on this basis. Middle East investors generally obtain finance from UK-based banks. There is very limited availability of Shariah compliant bank finance, which does not tend to be available on competitive terms.
As a result, we generally utilize structures designed to accommodate conventional interest-based debt while preserving Shariah compliance for the investors. This normally involves borrowing by orphan companies which also receive funding from the investors via a Shariah compliant financing instrument.
There are a number of funds which require Ijarah (eg EXIM Bank of Malaysia’s Sukuk funds must be placed in Ijarah structures). This can be difficult in the UK market. Islamic banks seem to be comfortable using Ijarah for home finance but less so for commercial property where the values are much higher and VAT treatment in particular can cause difficulties.
Are we seeing any innovation in terms of financial structures and if not, why not?
Philip: Honestly, within the UK I’m not seeing any innovation in financial structures. There is no need as what we have works and where investors – as most do – wish to have senior finance on the properties as well, the banks won’t entertain anything that doesn’t look familiar.
Michael: In the context of capital cost, it is arguable that not all UK banks are on a level-playing field (challenger banks versus more established banks). This is further exacerbated when compared to European banks. This is an issue which needs addressing to provide for a more competitive landscape.
Naomi: Cost is a factor that needs to be looked at. Shariah finance is often uncompetitive with conventional finance costs. This can be off-putting to both potential investors and institutions operating in the space, looking for equivalent returns. In addition, Shariah audits, for example, are extremely expensive and often not perceived to offer value for money.
Are there any challenges to investing in the UK from a regulatory angle?
Naomi: The main issues with regard to UK real estate investment are tax-related, rather than regulatory. In an effort to increase tax revenues, stamp out unscrupulous landlords and free up homes for domestic buyers, the last five years have seen successive increases in residential taxes. These have been particularly targeted at foreign buyers and the luxury end of the market and have led transactions to fall to an all-time low. To address this fiscal drag, the UK government needs to renew buyer confidence by affirming the status quo for current tax legislation. Buyers can then structure their investments appropriately, assimilate the extra buy-in costs and re-enter the market with confidence. This will have the added benefit of supporting economic growth during Brexit while demonstrating that the UK really is open for global business.
Tracey: Lenders are regulated differently depending on sector (clearing bank, life company, debt fund, etc), which can impact on the terms they can offer.
How does the Islamic real estate market relate to/tie in with other sectors and markets in the UK? Where could relationships be developed or improved ?
Philip: I’m still keen to see more progress in the Takaful market to allow commercial properties in the UK to be insured in a Shariah compliant manner. There is a huge opportunity there.
Michael: Education has improved regarding Islamic finance and mainstream investors are more open to it.
Naomi: The Islamic real estate market is still small and needs further support to actively encourage new players into the space. Setting up a UK Islamic Finance Federation, for example, would help bring together relevant professionals, equity investors and finance providers, exploring different Islamic solutions and driving growth in the market. It could also assist conventional businesses, often with very limited understanding of how to start structuring Shariah products.
Sarah: Real estate is still the most popular asset for Islamic funds. If funds were able to consider longer tenures (perhaps Malaysia rather than GCC investors?) they may be able to target infrastructure deals? [However], UK Islamic banks are not playing a significant role in the market. There is insufficient liquidity and pricing is not generally competitive with conventional finance.
What is your outlook for 2017-18 and beyond?
Michael: We are generally mindful of the political environment but nonetheless good risk-adjusted opportunities do exist as a result.
Naomi: Despite Brexit uncertainty and uncomfortable tax changes, the entry-level sector which rental investors prefer has remained resilient. We expect this price growth to increase significantly as low finance costs, [a] weak sterling and an attractively priced market encourage buyers back in. London will remain a big draw for Islamic investors seeking safe havens. The luxury and new build sectors, on the other hand, may remain sluggish given the greater buy-in costs and the new non-dom IHT. Bad publicity for these sectors has already turned many Shariah-conscious investors away from their traditional luxury stomping ground towards the more cost effective and higher yielding investment sector of the market. In terms of tips for investment, go for small flats in unique heritage buildings in Prime Central London. These are in limited supply with potential to add value and provide long-term capital growth. Small units are also the most popular as tenants typically have budget ceilings, generating the highest returns.
Tracey: There is a potential shortage of investment stock to satisfy investor demand; all in cost of funds expected to remain low for the next 12-24 months; plus unknowns due to Brexit and political uncertainty.
Philip: The hunt for yield continues and everyone wants as much certainty as they can get so as to bridge any volatility as Brexit continues along its path. My forecast is that the best assets that provide these attributes will maintain or increase in value, while poorer assets will suffer. The fundamental attractions of the UK for Islamic real estate investors remain: namely, a stable legal system, clear land ownership, familiarity with the country and a critical mass of Islamic finance professionals. These are not going to fall away.