Real estate indices for equal risk sharing

While both conventional and Islamic banks use an interest-based benchmark to price their products and services, the use of a common benchmark, though allowed by Shariah scholars, has attracted reservations.

A specific Islamic banking standard is yet to be developed by either the regulators or the infant industry.

The central bank is also concerned that only 13.6pc of financing by Islamic financial institutions is based on profit sharing structures: Musharakah and Mudarabah-based products.

To make financing Shariah-compliant, some analysts believe it would be more appropriate to link product pricing directly to returns on the specific industry funded by Islamic banks.

The Pakistan Islamic Finance Report 2016 says that the central bank is considering developing new house financing products with payments based on market prices and rents.

Late last month, the issue came under the spotlight at a workshop on ‘application of real estate indices in Islamic financial institutions’ organised by the Centre for Excellence in Islamic Finance, IBA in Karachi.

The workshop was conducted by Dr Sheharyar Bokhari, a PhD in real estate and urban studies and a researcher at MIT Centre for Real Estate.

The real estate wing of the Arif Habib Group is reported to be mulling the idea of developing similar indices for Pakistan.

A Real Estate Price Index measures the change in the value of a residential or commercial property over time in a given geographical market. In this context, a nation’s housing price index could be an indicator of a nationwide home price trend.

Similarly, for a city, a Real Estate Rent Index could be an indicator of an office building’s rental income. Rent Index is also calculated from imputed rents on owner- occupied property as well.

Property is one of the most significant assets; valued at trillions of dollars. And rent indices have many uses: they are inputs for investment decisions, monetary policy, and measuring national wealth; serve as a tool for monitoring financial stability and are used for measuring economic growth and targeting inflation.

While explaining how real estate indices can be used for Islamic finance, and their implications, the presentation posed the question: Is Kibor (Karachi Interbank Offered Rate) the best benchmark to determine property rent?

A property’s rent (or the banks’ profit rate) is currently on a 12-month Kibor (Karachi Inter-Bank Offer Rate) for the next 12 months.

The scholar observes: real estate price and rent indices are analogous to stock market indices. They measure change in values and rents. Thus, the best benchmark for basing changes in the customer’s rent payments is the property market rent index. It must cover the geographical area where the property is based and ideally be representative of the local market instead of a broader region.

Both price and rent indices can be used for Diminishing Musharakah contracts for better measurements or change of value and rent of the underlying assets.

A case study demonstrates the application of a national rent index in calculating the monthly rent instalment in place of Kibor. The Rent Index directly measures the change in rent in the market which is more relevant than the inter-bank interest rate.

However, using the Rent Index instead of Kibor exposes Islamic banks to risks in the property rental market. In principle, rents can actually decline: go into negative rate of return.

This implies that the customer should pay lower a rent than before. It may also result in the bank making fewer profits over the period of the contract than it would under a Kibor based payment schedule.

Currently, the Islamic bank’s profits under Diminishing Musharakah are applied to the remaining principal (the bank’s remaining ownership share). This is fine as long as the profit rate is above zero per cent.

What happens if the change in rents turns negative? This becomes problematic for the calculation of the monthly rent payment schedule.

The case study recommends an alternative setup where rent instalments are independent of the remaining balance.

At the initial contract date, the property’s rent can be determined and thereafter any change in rent would be linked to a monthly market Rent Index. The monthly rent payment would then simply be the amount owed to the remaining balance of ownership units with the banks.

The case study recommends the combined use of (a) price index to determine the unit sale price and (b) the rent index to set the monthly rent.

It also recommends collecting detailed market information at the property level to facilitate the production of such indices on a regular basis.