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Recent Developments in Saudi Arabian REITs

Guiding Principle
Investment in real estate frequently offers a number of positive aspects with regard to security, profitability and sometimes tax. On the downside, real estate investments require a high amount of capital for starters, thus limiting its benefits in many cases to exclusive circles. From the sixties onwards democratization of this kind of investment in the form of Real Estate Investment Trusts or REITs was fostered in many parts of the globe and has frequently proven to be a history of success. In the Middle East, this kind of investment opportunity has only become a topic after the turn of the Millennium. It still develops actively and shows a particular dynamic these days in Saudi Arabia.

A. History, Definition and Features of REITs
In 1960, US-President Eisenhower signed Public Law 86-779 into force, amending Subchapter M of chapter 1 of the Internal Revenue Code (US-IRC) of 1954 and adding Sections 856-858 to it. What sounds like a mere and simple administrative action, left and leaves its traces in worldwide capital markets until today. By establishing a legal regime for Real Estate Investment Trusts (REITs) Eisenhower managed to democratize real estate investment in the USA. All of a sudden, it became possible for middle class citizens to invest their fortune into real estate and participate in the same benefits that used to be a privilege of those being able to afford the sums needed for these kinds of investments on their own or financed by loans.

Generally speaking, US REITs are modelled close to mutual funds. Sec. 856 of the US internal revenue code outlines the general features of a REIT. It has to be a cooperation, trust or association, whose beneficial ownership is evidenced by transferable shares and distributed amongst 100 persons or more. It has to gain 95% of its income derived from dividends, interest, and property income sources and at least 75% of its gross income from rents or mortgage interest. 75% of the value of its assets has to be made up out of certain real estate assets. It has to pay dividends of at least 90% of the REIT’s taxable income. In turn, corporate tax for the REIT is reduced or eliminated.

This approach proved very successfully word wide and in the US has become a major pillar of securities investment.

B. The Current Saudi Structure of Real Estate Funds and Financial Markets

   I. General Legal Structure of the Kingdom of Saudi Arabia
In order to understand the Saudi Legislation on REITs and in particular the terminology, it has to be taken into account, that Saudi Arabia is one of the few countries in the world to apply Islamic law directly. Even though the country has a Basic Law (SA-BL) organizing the public Power, this law sees itself subject to Islamic law. In consequence, it is not called a constitution. It also enlists any norm giving power below executive and judicial powers (cf. Art 44, 67, 70, 71 SA-BL) and does not call Laws by the Arabic word for law qānūn but nizām (lit. order) to underpin, that these norms only order the Islamic system without setting rules on their own. In English, they are still translated by the word Law. Below Laws, rules can be set by regulations (lawā’iḥ) and below them by Instructions (taʿlīmāt).

   II. Regulatory Structures of the Financial Market
The Saudi Capital Market Law (Nizām as-sūq al-mālīya) (SA-CML) forms the legal basis for any capital market structures in Saudi Arabia. This law sets up the main institutions of the Saudi capital market as well as the essential policy rules to be followed and the sanctions in case of their contraventions.

    1. The Main Institutions in the Saudi Financial Market
The main institutions are The Capital Market Authority (hay’a as-sūq al-mālīya) (SA-CMA), The Stock Exchange (as-sūq al-mālīya as-sāʿūdīya) including The Securities Deposit Centre (markaz īdāʿ al-awrāq al-mālīya) as a department of The Stock Exchange (Art. 26 a SA-CML) and the Committee for the Resolution of Securities Disputes (lajnat al-faṣl fī munāzaʿāt al-awrāq al-mālīya) (Art. 25 SA-CML).

    a) The Capital Market Authority (hay’a as-sūq al-mālīya) (SA-CMA)
The SA-CMA is set up as the main regulatory body of the Saudi Financial Market. It has been vested the power to set general rules under the SA-CML as well as to take a number of individual administrative decisions vis-à-vis individual market participants and to interpret the statutory provisions of the SA-CML (Art. 6 SA-CML). In summary, this presents the SA-CMA as the central and most dominant institution in the Saudi Capital Market with a clearly prevailing power and partially able to define its own scope of competences.

The SA-CMA itself has a legal personality and financial and administrative autonomy. It reports directly to the Council of Ministers (Art. 4 a. SA-CML). The core body in the SA-CMA is the Board (majlis hay’a al-sūq al-mālīya), which assumes the majority of the responsibilities of the institution (c.f. Art. 7 SA-CML).

    b) The Stock Exchange (as-sūq al-mālīya as-sāʿūdīya)
The stock exchange itself is organized as a joint stock company (c.f. Art. 20 SA-CML) with a number of legal specialties as set out in the SA-CML amongst them the composition of its board (Art. 22 b. SA-CML), which is competent to propose the necessary regulations, rules and instructions for the operation of the stock exchange for approval to the SA-CMA (Art. 23 SA-CML).

The Stock Exchange operates under the name tadāwul[1] (meaning “circulation” or “negotiation”) and operates its single transactions through brokers on behalf of their clients (c.f. Art. 21 SA-CML).

Furthermore the board is also the competent authority to establish the Securities Depositary Centre (markaz īdāʿ al-awrāq al-mālīya) as a department of the Stock Exchange authorized as the sole entity in the Kingdom to practice the operations of deposit, transfer, settlement, clearing and registering ownership of Saudi Securities traded on the Exchange (Art. 26 a. SA-CML).

    c) Committee for the Resolution of Securities Disputes (lajnat al-faṣl fī munāzaʿāt al-awrāq al-mālīya)
The Committee for the Resolution of Securities Disputes is established by the SA-CMA and assumes the task to have jurisdiction over public and private actions with regard to the provisions of the SA-CML, its implementing regulations and the regulations, rules and instructions issued by the SA-CMA and the Stock exchange (Art. 25 SA-CML).

    2. Essential Policy Rules of the Saudi Capital Market
Aside the core institutions of the Saudi Capital Market, the SA-CML also sets out the framework and the basic rules of the market. This includes amongst other things the rules for brokers (al-wusaṭā’) (Art. 31 -38 SA-CML) on disclosure (al-ifṣāḥ) (Art. 40 – 48 SA-CML), manipulation and insider trading (al-iḥtīyāl wa-at-tadāwul binā’an ʿalā maʿlūmāt dākhilīya) (Art. 49-50 SA-CML) as well as proxy solicitations, restricted purchase and restricted offer of shares (ṭalabāt at-tawkīl wa-sh-shirā’ al-muqayyad wa-l-ʿarḍ al-muqayyad li-l-ashum) (Art. 51-54 SA-CML). Finally yet importantly Art. 55 – 64 SA-CML sets out the Sanctions and Penalties for violations (al-ʿuqūbāt wa-l-aḥkām al-jizā’īya) of the capital market rules.

   III. Real Estate Investment Funds
After taking an introductory glance at the main features of the Saudi Capital market according to the SA-CML, the focus of the following shall be the structuring of investment fund in accordance with Saudi legislation and with a particular regard to real estate funds.

    1. Investment Funds in General
When analysing the SA-CMA with regard to investment fonts, immediately Art. 39 SA-CML comes to one’s focus of attention. This Article gives a general definition of investment funds (ṣanādīq al-istithmār, sg. ṣundūq al-istithmār) (Art. 39 a. SA-CML) as “a collective investment scheme aimed at providing investors therein with an opportunity to participate collectively in the profits of the scheme which is managed by a portfolio manager for specified fees”.

Hence investment funds in Saudi Arabia are regulated by the SA-CMA and in particular by its Investment Fund Regulation (lā’iḥat ṣanādīq al-istithmār) (SA-CMA-IFR) enacted 2006 and comprising 104 Articles. The main features of investment funds according to the SA-CMA-IFR are the differentiation between Fund Management and Custody on the one hand as well as between public and private funds on the other hand.

Managers and Custodians have to be installed for public and private funds alike (Art. 7, 22 SA-CMA-IFR). The Fund Manager has the main responsibilities of actually managing the fund and operating it (including administering it) and offering its units (Art. 9 c. SA-CMA-IFR). He is generally responsible for ensuring compliance with the applicable legal framework and for keeping registers and issuing statements. Therefore, he may delegate powers to sub managers and appoint advisors and the custodian. The custodian is responsible to keep the fund’s assets, which still belong collectively to the unitholders of the fund – in a separate account and to administer this account.

With regard to the differentiation between public and private funds the Glossary of Defined Terms Used in the Regulations and Rules of the Capital Market Authority (CMA-GDT) defines public funds as those, whose units may be offered by the Fund Manager in accordance with Part Four (Art. 30 – 72) SA-CMA-IFR. This includes amongst other things an approval of the CMA to the fund upon application of the future fund Manager, a contractual fund structure established by the signature of the first potential unit holder and the fund manager, the establishment of a public Fund board as well as a number of provisions and limitations applying to all investment funds and only to those with a particular investment profile. In this context Art. 44 a. SA-CMA-IFR needs to be highlighted. This provision excludes public real estate investment funds from the SA-CMA-IFR and subjects them to a further regulation, the Real Estate Investment Funds Regulation (SA-CMA-RFR). On the contrary private real estate investment funds remain subject to the provisions of the SA-CMA-IFR (Art. 44 b. SA-CMA-IFR). In accordance with the given by CMA-GDT private funds are those, not fulfilling the requirements of public funds. The SA-CMA-IFR further defines and outlines the regulatory framework of private funds by limiting the potential investors to so called sophisticated investors (Art. 74 a., b. SA-CMA-IFR) and by requiring a minimum investment and trading amount in the secondary market of SAR 1,000,000/- (approximately US$ 26,600/-) (Art. 74 a. , 92 3) SA-CMA-IFR).

    2. Legal Framework for Real Estate Investment Funds in Particular
Though a different regulation, the Real Estate Investment Funds Regulation (SA-CMA-RFR) takes over the main structural shapes of investment funds in general for Real estate investment funds as well. As already stated, under the SA-CMA-RFR only public funds can be established.

With regard to the institutional construction of the fund, again, the positions of the fund manager and the custodian can be found, but for real estate investment funds, the fund manager can also assume the position of the custodian under certain circumstances (Art. 11 SA-CMA-RFR). An institution explicitly outlined in real estate funds is its board of directors. This means, that the fund is under collective supervision from within. Whereas in regular investment funds the CMA is entitled to change the Fund Manager, here it can only change members of the board of directors, i.e. the fund can change its management and accordingly its policies, but not the manager itself. The fund’s daily business is managed by a portfolio manager, who in the case of real estate funds has to be an employee of the fund manager in charge of managing the fund and has to be a registered person with the CMA as per the Authorized Persons Regulation (SA-CMA-APR)[2] (c.f. Art. 2 SA-CMA-RFR).

Art. 6 SA-CMA-RFR sets out the types and objectives of real estate investment funds. In Art. 6 (a) SA-CMA-RFR a number of standard types and objectives are set out. All of them are closed ended funds that foresee to sell the concerned real estate in the end and to terminate the fund afterwards. The differences between the three types of funds can be seen in the stage of development of the property to be undertaken by the fund: Either initial (Art. 6 (a) 1) SA-CMA-RFR) or construction development (Art. 6 (a) 2) SA-CMA-RFR) or one of the aforementioned combined with the intention of selling the property after a certain period of time (Art. 6 (a) 3) SA-CMA-RFR).

C. The New Development of Saudi REITs
As outlined above REITs have been a successful product on capital markets worldwide. Firstly for enabling small and medium sized incomes to participate in the advantages of real estate investment and secondly because in most jurisdictions REITs enjoy a number of taxation benefits. In contrary to these international developments the REIT market in the Middle East experienced a more reluctant development with regard to this kind of investment possibility. This might be due to a number of reasons. Firstly, Tax advantages in most GCC Countries would be close to none, as generally taxes are not imposed in this world region, but also since the market was always saturated with investors willing to contribute to projects outside REIT structures. Finally, legislation was not enacted in a way to allow REIT structures to be established.

   I. History of REIT Regulations in Saudi Arabia
From 2009 on, first attempts to initiate REITS in the Kingdom of Saudi Arabia were made by Encore Management, a Swiss-based asset management company.[3] After Dubai already adopted enabling legislation in DIFC in 2006 and Kuwait launched the first Islamic REIT in the GCC 2007 followed by Bahrain opening its legislative framework for REITs in 2009.[4] Despite the aforementioned announcements, concrete plans for a legislative framework to enable REITs in Saudi Arabia were not recognizable until early 2016, when the CMA announced to have approved rules governing the listing of real estate investment trusts.[5]

From July 31, 2016 until August 23, 2016[6] the CMA displayed the drafts online with an invitation to concerned and interested parties to provide their comments and observations in accordance with Art. 5 b. SA-CML.[7]

After considering comments and observations, the Real Estate Investment Traded Funds Instructions (SA-CMA-REITI) were issued by the CMA Board on October 24, 2016.

II. Content of the Real Estate Investment Traded Funds Instructions (SA-CMA-REITI)
The CMA regulated REITs in the form of instructions. This kind of legislation is subject to Regulation, which do have a higher level in the Saudi hierarchy of norms. Though contradicting some of the passages of the SA-CMA-RFR in its wording, in the end the SA-CMA-REITI is conform to the SA-CMA-RFR, as Art. 6 b. SA-CMA-RFR allows for real estate funds to differ with regard to their types and purposes from the ones outlined above. Accordingly, REITs are structured differently in a number of respects than ordinary real estate investment funds.

A Saudi REIT is a real estate investment fund, that is publicly offered and the units of which are traded on the exchange, whose primary investment objective is to invest in constructionally developed real estates qualified to generate periodic and rental income, and distribute a prescriptive percentage of the fund’s net profit in cash to the unitholders at least annually (Part 2 C. SA-CMA-REITI). Furthermore, it can only take the shape of a closed ended Fund (Part 4 A. 1) SA-CMA-REITI), i.e. initial subscription to the fund is not possible after a closing date, from when on it will be traded only in the secondary market.

    1. Institutional Framework
As outlined, worldwide REITs have a very distinct, yet common structure, bearing a lot of similarities to publicly listed stock companies. From an institutional point of view, this means a significant increase of participation rights of the single unit holders. This is displayed in Part 6 and 7 SA-CMA-REITI. Both Provisions were not included in the initial draft and have been added after the consultation of the public in August 2016. Part 6 SA-CMA-REITI calls for the consent of the unitholders, when fundamental changes to the fund are to be made and Part 6 SA-CMA-REITI organises the meetings of the unitholders.

In contrary to the provisions established by the SA-CMA-RFR, the custodian has to be strictly separated from the fund manager, as is the case in normal investment funds regulated by the SA-CMA-IFR. Furthermore, the institution of a portfolio manager cannot be found in the SA-CMA-REITI, rather one or more property management companies have to be appointed by the fund manager for property management, property maintenance, leasing services and rent collection (Part 3 G SA-CMA-REITI).

    2. Policy of a Saudi REIT towards its Assets
In comparison to the outlined real estate funds under the SA-CMA-RFR it is not the pronounced aim of a Saudi REIT to develop and sell its property at some stage. The fund is rather focussed on the generation of continuous income. In consequence 75% of the of the fund’s total assets value according to the last audited financial statements must be invested in constructionally developed real estates qualified to generate periodic and rental income (Part 4 B. 1) SA-CMA-REITI). Consequently, the fund manager is restricted in investing in vacant lands. The fund manager is allowed to invest up to a maximum of 25% of the fund’s total assets value according to the last audited financial statements in real estate development whether on real estates owned by the fund manager or not, and to renovate or redevelop these properties (Part 4 B. 4) SA-CMA-REITI). Saudi REITs also focus on investing in real estate domestically. In turn, the fund manager shall not invest more than 25% of the fund’s total assets value according to the last audited financial statements in properties outside the Kingdom (Part 3 O. SA-CMA-REITI).

    3. Policy of a Saudi REIT towards its Unit Holders
As REITs aim to spread the risks of real estate investment between a large number of unitholders and to let them participate in the benefits of this kind of investment, the SA-CMA-REITI takes measures to ensure a large number of unitholders. The core term for Saudi REITs in this context is the ‘unitholder from the public’. As defined in Part 2 C. SA-CMA-REITI, unitholders from the public means unitholders who own units in the REIT other than any unitholder owning 5% or more of the REIT’s units, the fund manager and its affiliate or the fund’s board of directors. For a REIT’s units’ registration and admission to listing, it must have at least 50 unitholders from the public and at least 30% of the total REIT units are owned by unitholders from the public (Part 4 B. 2) a), b) SA-CMA-REITI). These requirements are a continuous obligation throughout the operation of the REIT and have to be upheld actively by the fund manager (Part 4 B 2) c), d) SA-CMA-REITI).

This broad distribution is also underpinned by the price of each unit set at SAR 10/- (US$ 2.66) and the amount to be raised of at least SAR 100,000,000/- (US$ 26,650,000) (Part 4 A.2), 3) SA-CMA-REITI)

On the other hand, the SA-CMA-REITI assures that at least 90% of the fund’s net profits must be distributed annually to the unitholders (Part 4 B. 3) SA-CMA-REITI). Finally, borrowing of the fund is limited to 50% of the total assets value of the fund (Part 4 B. 5) SA-CMA-REITI).

D. Assessment and Conclusion
Saudi Arabia is frequently compared to a huge crude oil tanker vessel, not only due to its main and predominant export product, but also because it is by far the largest economy and population in the GCC and thus politically far more difficult to manoeuvre than other countries in this region. However, certain factors like a constant population growth and low oil prices (amongst other things) have presented themselves as shallow waters in which the country has to manoeuvre. Thus, the country is presenting its plans to the future in form of the royal vision 2030, which is a huge transformation plan with a large impact in the legal, social and economic framework of the country. One of the main goals of this vision is to diversify the national economy. This applies not only to the ways of generating income and funding to move away from an economy strictly relying on oil revenues, but also to the way of spending money and taking into account that the Saudi population has become more and more differentiated with regard to income and asset wealth. It is this context, in which the establishment of REITs in Saudi Arabia has to be seen. On the one hand, the country has a considerable housing problem that needs to be tackled[8]; on the other hand, funds for real estate operation cannot come from solely from oil revenues distributed by the state. In this context, it seems only consequent that private initiative is fostered also on financial markets and in accordance with differently distributed wealth in the Kingdom, it seems moreover consequent to try and find an approach to open the benefits of real estate investment to all layers of society and safeguard this in the respective legislation.

As the Vision 2030 on a large scale for the Kingdom, the introduction of REITs to the Saudi Capital Market is a huge endeavour for this Market and the CMA. The number of amendments to the original draft shows, that a lot of dialogue was necessary between concerned sides to enable this new kind of financial product to the Saudi market.

From an institutional point of view, no investment fund product offers participation rights and possibilities of control that close to the single unit holder. In usual investment funds, the fund manager may appoint advisors (Art. 18 SA-CMA-IFR), in other real estate funds, a board partly comprised of independent directors is obligatory (Art. 7 SA-CMA-RFR), but only in REIT’s a direct participation of the unit holders becomes possible.

From a policy point of view, a continuous and far-reaching distribution of profits is legally enacted and provides quicker and safer revenue to investors than in other kinds of real estate investment funds in the Kingdom.

The main feature of REITs in other parts of the world, the tax benefits, still do not apply to Saudi REITs. However, with the deep changes ahead in some of the GCC economies and the Saudi economy in particular even this perspective does not seem out of thinkable options for the future.

Overall, the Kingdom seems to manoeuvre on the course, president Roosevelt once set so successfully in the US: to open up and diversify its real estate markets in order to let everyone in the Kingdom participate from its benefits.

Since November 2016, the first REIT started trading at tadāwul and has a price at around SAR 11.10 per January 2, 2017.

 


[1]  https://www.tadawul.com.sa/wps/portal/tadawul/about/company/about-tadawul

[2]  This is a core difference to the general definition of the defined terms used in the regulations and rules of the CMA, as the Portfolio Manager of a real estate investment fund thus has to be a natural person.

[3]  C.f. Oxford Business Group: New trusts and funding vehicles aid property investment in Saudi Arabia, https://www.oxfordbusinessgroup.com/analysis/finding-finance-new-trusts-and-funding-vehicles-offer-solutions-property-investment-needs (last visited January 2, 2017).

[4]  C.f. Alawi, Abdullah; al Kadi, Sultan: Real Estate Investment Trusts (REITs), KSA Real Estate, Thematic Report, http://www.aljaziracapital.com.sa/report_file/ess/SPE-165.pdf (last visited January 2, 2017), p. 4.

[5]  C.f. Reuters: Financials, Jan 13, 2016 (http://www.reuters.com/article/saudi-reit-regulations-idUSL8N14X1BX20160113) (last visited January 2, 2017).

[6]  C.f. Al Arabia: Hay’at al-sūq al-saʿūdīya tuqirr qawāʿid ṣanādīq al-ʿaqār al-mutadāwala, https://goo.gl/8thltT (last visited January 2, 2017).

[7]  http://www.cma.org.sa/En/News/ Pages/CMA_N_2096.aspx (last visited January 2, 2017).

[8]  Barnard, Lucy: Affordable home shortage in Saudi Arabia ‘likely to worsen’ in The National, May 31, 2016 http://www.thenational.ae/business/property/affordable-home-shortage-in-saudi-arabia-likely-to-worsen (last visited January 2, 2017).

January, 2017 Heinrich Köllisch
Meyer-Reumann & Partners, Riyadh Office
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