There are micro frictions that are hindering major economic sectors to attain their true potential. Real estate is a major sector where pick-up in formal construction and development will not only enhance taxation but will also create much needed jobs. The government’s focus is on documentation, to create jobs and provide housing to the masses. This can be achieved if the real estate is developed. The question is how to unlock it.
The quantum of tax evasion is huge in the real estate sector, but there is not much noise surrounding it, because all the stakeholders – be it politicians, bureaucrats, technocrats, gurus of establishment etc, all have invested their savings in real estate. Alarmingly, there are frictions in formal transactions in the sector and that is hindering its potential.
If a builder thinks about developing a project formally - say under a REIT structure, the opportunity cost is huge under existing market dynamics. For example, in Karachi on an acre plot costing Rs500 million with a construction cost of Rs1.8 billion, the project can be sold for approximately Rs3.4 billion. The return is around Rs900 million on a land of Rs500 million. This is a lucrative arrangement under developmental REIT; but developers are not doing it due to high cost of documentation and taxation.
The FBR rate for an apartment in the area is Rs1,500 per square feet while the selling price is around Rs7,500 per square feet. The gap is five times; and in case of REIT, the amount is to be fully disclosed, and in informal arrangement FBR or DC rates are applied to document the transactions and prepare accounts. The problem is of similar nature in Lahore too.
According to talks to industry players, considering the normal profit and cost, on that one acre project, the tax potential under REIT is around Rs200-220 million while under prevailing rates, the collection is at Rs20 million – FBR is getting merely one tenth of the potential revenue. That incentivizes builders to go informal.
The other friction is that customer advances under REIT are to be put in an escrow account while developers use customer advances for purchase of land for the next project – leveraging in informal sector eluding formal settings. Then there are other documentation and regulatory costs associated with REITs which are absent in the informal arrangement.
REITs can become viable either by providing it with tax/fiscal incentives or by bringing the same conditions for the informal sector. Reducing the gap is important, and that can go a long way in documenting the economy. Real estate businesses have to come within the fold of the formal economy. Government should either establish a Real Estate Regulatory Authority (RERA) on the lines of other economies such as UAE, India etc. or reform building control and development authorities such as SBCA and LDA to serve the purpose.
The builders and developers are to be regulated and rated to gain the trust of low and middle income household. The money received by developers for a project must be utilized for the same project only through escrow account arrangements as it happens around the globe. The disincentives for the formal sector entities engaged in the real estate business must be removed. Currently, REITs are at a severe disadvantage in terms of taxation. Back of the envelope calculation (explained above) suggests that REITs would be paying more than 10 times income tax as compared to the present practice. This is in addition to the compromise on liquidity and flexibility.
The transfer duties and other provincial taxes have to be rationalized to encourage honest disclosure of transaction cost. Land titles must be digitized as clarity in titles is imperative for growth in the formal real estate sector. Real estate is a provincial subject and the federal government or NPHA is required to engage with provincial and city level bodies to encourage them in making land parcels available for development in a transparent and competitive manner.
The housing finance is a big impediment, and enhancing documentation efforts in the sector can go a long way towards access of finance to both developers and end users. Commercial banks are not interested in this sector; the Indian housing market leaped forward by creating specialized housing companies. Pakistan is required to do the same – at this point only HBFC is working in this domain and its toxic legacy is a big road block. The country needs more companies in this domain.
In the case of cities, continuity of mater plan is important, and development to take place in accordance to the master plans. To avoid ghettos and ghost houses, necessary trunk infrastructure, and connectivity to city centers is imperative. There should be PPP engagement or city level taxes for financing trunk infrastructure. Else, haphazard development can create problems which Karachi is facing today.
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