A REIT Scheme is a closed end Mutual Fund which is established by a REIT Management Company to invite public money through Initial Public Offering to raise funds to develop Real Estate projects with an objective to earn capital gains or rental Income.
Pakistan being a developing country has large potential for development of Real Estate projects including housing schemes, commercial buildings, shopping malls and apartment buildings under REIT Scheme structure. With the development of REIT Schemes it would be possible for small investors to make investment in real estate which is currently not possible due to large investment required. Moreover, large foreign investment can also be brought in to Pakistan by providing foreign investors an opportunity to take exposure in real estate through REIT Schemes.
In Pakistan REIT Regulations were implemented during the year of 2008. However, the growth in REIT sector is almost nil, only two REIT Management companies were licensed by SECP since 2008, however these two entities have not been able to start any REIT Schemes. As the concept of REIT Schemes has not been developed in Pakistan, an Individual investor always prefer his own investments in Real Estate sector, through purchase of individual properties, according to the funds available.
With the development of REIT Schemes the Mutual Fund industry of Pakistan will grow further and more Investment and saving opportunities will be available especially to small investors. This development will also make it possible to bring foreign investment in Pakistan.
Initiatives by government: Various tax exemptions have been provided by the Government to REIT schemes to benefit their unit holders including if minimum 90.00% of income, as reduced by unrealized capital gain, derived by REIT Scheme is distributed to the unit holders then the income of such REIT Scheme is totally tax exempted. Further profits and gains accruing to a person on sale of immoveable property to a REIT scheme are also exempted upto year 2015. However the desired growth is not possible in this sector. There is an urgent need that REIT Regulations are revamped and tax laws are made clear as soon as possible so to promote the development of REIT Schemes in Pakistan.
Practical problems being faced by new entrants are as follows:
1. The minimum fund size of REIT schemes is on higher side like Pak Rs 2.00 billion for Rental and Developmental REIT and Pak Rs. 3.00 billion for Hybird REIT’s;
2. REIT Management Companies (“RMC’s”) are required to take exposure of atleast 20.00% in REIT Scheme which is on higher side;
3.Prior to approval of REIT Scheme, project land is required to be transferred in the name of Trustee which also requires sizeable investment from RMC’s, which may be up to 50% of the total project investment;
4.REIT Management fee is proposed @ of 1.00% only, in case of Developmental REIT which is on lower side as against 3.00% in case of Rental REIT.
Taxation issues: Although profits of REIT Schemes are tax free, if not less than 90.00% are distributed, however, there are other tax issues, which appear also will have substantial impact, unless specifically exempted, on the profitability of REITs and a deciding factor to start a REIT scheme in Pakistan;
1.In the case of Mutual Funds gains made on disposal of securities are exempted whereas in case of Capital Gains on disposal of Properties the rate of taxation is 10.00%, in accordance with section 37 (1A) of Income Tax Ordinance
2.Section 236 K of Income tax Ordinance requires purchaser of Immoveable Property advance tax at a rate of 1% of the Gross amount of the consideration paid. This is increased to 2% in case the seller is non-filer as defined by the FBR. However, this condition is not applicable where the value of property is less than Rs. 3.00 mn.
3.Section 236 C of Income tax Ordinance requires deduction of tax on sale or transfer of Immoveable Property at a rate of 0.5% of the Gross amount of the consideration. This is increased to 1% in case the seller is non-filer as defined by the FBR
4.Section 155 of the Income Tax Ordinance also requires the rate of tax to be withheld on income from property @ 15.00% of the gross amount of rental income;
5. Sales tax on services as property developer and contractor @ 16.00% in Punjab and Sindh;
6.Further, other taxes applicable to immoveable properties at provincial level are as under;
Capital Value Tax,
The Government should provide incentives regarding other taxation matters especially to REIT Schemes as highlighted above to attract Investors for development of REITs;
Risks involved in REIT investments: The Risk factor is much higher in REITs formation as the property over which a REIT would be established must be clean regarding its title, other factors which are relevant include unnecessary delay in approvals from concerned authorities especially lay out plans of the REIT project and other unseen factors like cost overruns. Since the REITs will work under closed end mechanism the growth of these schemes will also be defined by their ultimate price available in the secondary market. The price of REIT units may be different from the Net Asset Value of such REIT as seen in the case of closed end funds previously working in Mutual Fund sector and which were converted into open end structure as per directives of SECP, on the argument that these closed end funds were trading considerable below to their NAV’s.
The valuation of Properties on quarterly basis at Market Value to determine the NAV will be an issue, the market price of real estate properties may not be readily available in the market which will determine the market price of REIT units.
Conclusion: The Government should make the regulatory requirements easier to promote REITs and should provide tax and other benefits to new entrants to develop this sector in order to bring more foreign inflows in Pakistan and to bring small investors of Real Estate in tax net, this will ultimately help development of Real Estate through corporate sector in Pakistan. Moreover, the Asset Management Companies in Pakistan should come forward to start new REITs to benefit from this sector as the profits in Real Estate may be unlimited despite of heavy tax issues and ultimate development of Pakistan.
Written by Shahzad Jawahar and published in “Daily Times” on July 5th 2014.