Impact of increased VAT on KSA real estate market

While the introduction of VAT in 2018 has had little direct impact on the Saudi real estate market, conditions are now somewhat different, particularly in light of the withdrawal of many of the previous subsidies including the cost-of-living allowances to Saudi nationals.

From a real estate perspective, we expect the tripling of the current rate to 15% from 1st July 2020 to have a more significant impact on the development sector across all asset classes, as a result of increased development costs and a reduction in occupier and investor demand. 

Implications for developers

Developer margins have been under pressure in Saudi Arabia, and this trend is expected to exacerbate by the higher level of VAT being imposed at a time when market conditions are becoming increasingly challenging.

The immediate impact expected is for some of these projects to be delayed or deferred, as developers seek to focus on prioritizing their investments and projects. These delays could also result in developers facing additional costs in the form of vacant land tax, which would impose an additional burden on the developer.

While the Standard Rated VAT is designed to be a ‘pass through’ tax, with the burden falling on the eventual end user (the occupier or purchaser of the property), the consequences of this hit on developer cash flow should not be underestimated. For example, a developer of a SAR 500 million projects will now be faced with a SAR 50 million increase under the new regulations. With uncertainty around how quickly the VAT will be refunded and questions of how much of this increase can be passed through to the end user, developers will clearly have to re-examine their financial models and reassess the viability of projects.

One potential outcome of the increase in VAT could be to drive land prices down from their current inflated levels. If developers are squeezed they won’t be willing or able to buy land at current rates and existing land owners will be under pressure due to the vacant land tax, so the market may balance itself at lower levels of land pricing. Ironically, an increased tax could therefore actually benefit developers by reducing their overall cost of development.

Residential: Trending towards rental

Higher VAT will increase the cost of residential developments and sale prices, while maintenance and management charges will also be inflated. Although these increases may be partially offset by a reduction in mortgage rates, they are likely to result in reduced demand and therefore slower absorption. Some developers are responding by offering more attractive payment plans to attract buyers, but these will negatively impact their financial returns. The Ministry of Housing (MOH) has agreed to absorb the increased VAT for first time buyers of unit’s worth SAR 850K or less, providing a big incentive for developers to focus on the “affordable housing” segment for first time buyers.

One trend we anticipate as a result of this, is a shift towards the rental market amongst Saudi nationals. While the leasing market in Saudi remains largely restricted to expatriates, a number of developers are now recognizing opportunities to create residential products for rent to the local market. The rental market will become comparatively more attractive and cost competitive as a result of the higher rates of VAT imposed on properties for sale.

Office: Optimizing spaces

Under the current market conditions, many occupiers are looking to reduce their office space, and the imposition of higher VAT on commercial leases may further reinforce this trend. Given the current ‘tenant favorable’ condition of the office market in most locations, the more proactive developers may look to support their tenants by offering to split the increase in VAT upon the renewal of their leases or offer longer rent-free periods and fit-out contributions.

Another shift we may see is commercial tenant’s moving towards flexible and co-working office spaces. While VAT will apply to short term agreements, this sector of the market could pick up in a period of economic uncertainty where corporates may not want to sign up for long-term leases.

Retail: Minimal short-to-midterm impact

While spending on essential goods are likely to see minimal impact as a result of the VAT increase, discretionary spending on dining out and entertainment is likely to be reduced. However, the entertainment market is currently at a nascent stage in Saudi Arabia, with latent demand far exceeding the available supply, which is likely to minimise the impact of the additional costs due to VAT over the short to medium term. In the longer-term, and while the prospects for the F&B and entertainment sectors are positive, there is a high level of proposed entertainment supply, which may result in an adjustment in prices and rentals, regardless of VAT. 

Hospitality: Upward pressure on operator costs

Given the emphasis placed on tourism and hospitality in the Saudi Vision 2030, many new projects have been launched over the past few years, ranging from individual standalone hotels to mega integrated tourism developments such as the Red Sea Project , Neom, Qiddiya and others. While the initial stages of these mega projects are likely to continue on schedule, the combination of higher VAT and a slowdown in global economic growth, could result in delays in the timing of later stages. As with other sectors of the market, developers and owners of hotels and other hospitality products are unlikely to be able to pass on the full impact of higher VAT in the form of increased prices and room rates. They will therefore need to adjust their business models accordingly.

In summary, the imposition of higher rates of VAT is likely to have more impact on developers than tenants, as current market conditions mean that landlords are not able to pass on the full impact of the higher costs in the form of increased rents and sale prices. The most immediate impact of pressure on developers profit margins could be delays in commencing new projects, and a slowdown in the delivery of projects under construction.

While this would have negative short-term implications for contractors and those delivering projects, this could act as a positive in the longer term by reducing levels of future supply, therefore allowing prices and rentals to recover more smoothly once market conditions improve.