What is Malik Riaz up to now?

On the surface, it is a transaction that makes absolutely no sense: why on earth is Bahria Town, Pakistan’s largest private sector real estate developer, buying the unfortunately named and even more unfortunately managed Escorts Investment Bank? Buying a commercial bank to start offering financing to its buyers would make sense, but an investment bank? This acquisition cannot also be about mortgages, can it? Yes, ladies and gentlemen, it can. It absolutely can. Occam’s Razor: the simplest explanation is the one most likely to be correct.

To understand why this acquisition is taking place – and why any observer of Pakistan’s economy, and specifically its financial service sector should care about it – one first needs to understand Bahria Town’s history, its business model, and its place within the larger context of Pakistan’s real estate development sector.

A brief history of Bahria Town

Strictly speaking, Malik Riaz Hussain, the founder and largest shareholder of Bahria Town, does not have a rags-to-riches story in that he was born to a relatively well-off construction contractor in Sialkot. The family, however, fell on hard times when Riaz was relatively young, and the money troubles were stark enough that he had to stop his education after matriculation (10th grade) and start working several irregular blue collar jobs, including many involving manual labour, to help the family’s finances.

Lacking in a completed formal education though he may have been, Malik Riaz was a shrewd businessman, and concentrated his early business efforts in the old family business: residential real estate construction. Over the quarter century following his father’s bankruptcy, Riaz built up a small but thriving business. It was not until the 1990s, however, that his business really took off, when he started cultivating contacts with senior military officials to become a preferred contractor for many real estate projects owned by such officials (including some that were later subject to criminal investigation).

He got his big break in the early 2000s, when a joint venture with the Pakistan Navy fell through, but through litigation, Malik Riaz was able to keep the rights to the name Bahria Town. (Under the 1984 Companies Ordinance, no non-military-owned business in Pakistan is allowed to have the names Askari, Bahria, Fauji, Fazaiya, or Cadet, but since the Navy had previously owned a share in Bahria Town, the name was legal, and Malik Riaz was able to keep it even after they pulled out.)

The timing of this break was crucial: the year 2000, the beginning of Musharraf Administration and the rise of a burgeoning Pakistani middle class which led to, among other things, a rise in the demand for suburban housing, which Malik Riaz and Bahria Town specialized in providing. The company built large, Levittown-style gated communities that frequently built their own infrastructure for electricity, water, and sewage in order to compensate for the government’s lethargy and inefficiency in providing these services in most parts of most cities in Pakistan.

In that respect, Bahria Town has a lot in common with the largest real estate developer in Pakistan, the military-owned Defence Housing Authority (DHA), which also builds large developments that have a level of infrastructure considerably better than the average for most Pakistani cities. Indeed, in some respects, Bahria Town’s developments are often considered second in order of consumer preference only to DHA itself and sold to consumers who cannot afford the best of DHA’s offering.

While Bahria Town’s business practices have been the subject of constant investigation and litigation – and Malik Riaz has openly admitted on national television to bribing senior government officials and politicians to get the necessary approvals and land acquisition for his projects – neither the company nor Malik Riaz personally have been convicted of any major felonies.

The suburbanization of the Pakistani middle class

This article, however, is not focused on Bahria Town’s business practices, but rather how it fits into the larger context of Pakistan’s urban geography and its relationship to expanding middle class incomes and their related propensity to spend on real estate.

When Bahria Town won its litigation against the Pakistan Navy in 2000, Karachi and Hyderabad were two separate cities 100 miles apart and Sheikhupura was a small city an hour’s drive outside Lahore. Seventeen years later, the Karachi and Hyderabad metropolitan areas are about to merge (on the verge of becoming Pakistan’s equivalent of the Tokyo-Yokohoma megalopolis) and Sheikhupura is now effectively a suburb of Lahore.

How did this happen? Well, for starters, the length of the national highway network nearly doubled in the two decades between 1997 and 2017 – from 6,587 kilometers to over 12,000 kilometers according to data from the National Highway Authority (NHA) and the Pakistan Bureau of Statistics (PBS) – and both the number and length of provincial highways increased by even more. And per capita income more than tripled from $490 in 1997 to $1,510 in 2016, according to data from the World Bank.

With the shrinking of geographic distance (through better roads) and expanding middle class incomes, the demand for housing – especially suburban housing – has dramatically increased. While data from the 2017 census are not yet available, they are expected to show a substantial increase to the 19.2 million housing units that existed in the country at the time of the 1998 census.

The population is expected to have increased by at least 50% since the last census. Meanwhile, the average household size has declined by approximately 8% since 1998, according to the 2016 Household Integrated Economic Survey conducted by the PBS. Those numbers imply that the total number of housing units in Pakistan reached 31.3 million in 2016, an increase of 12.1 million units in 18 years. The World Bank estimated in 2010 that approximately 61% of housing in Pakistan consists of permanent structures, suggesting that approximately 7.4 million new housing units have been constructed in the country since 1998.

Trying to grow real estate demand without mortgages

The above numbers suggest astounding growth in the Pakistani housing sector. Yet the country is still considered to be short by at least 9 million housing units, suggesting that there is still plenty of pent-up demand in the country.

The reason for the shortage is simple: while there are plenty of people in Pakistan who wish to buy homes, and a sufficient number of real estate developers willing to construct those homes for people, the buyers often do not have the kind of large sums of money required to buy a house outright. The obvious solution, of course, would be to get a mortgage from a bank, but that would assume that the entire Pakistani banking sector is not filled with lethargic institutions utterly disinterested in actual lending activity.

Pakistan’s mortgage market is shockingly small, even by regional standards. The Indian mortgage market equals about 9% of the Indian gross domestic product (GDP), according to the World Bank, For Bangladesh, the equivalent number is 3% of the total size of the Bangladeshi economy. For Pakistan? A measly 0.2% of GDP, and even that is an improvement over the absolutely appalling numbers witnessed in 2009.

The total amount of mortgages outstanding across the entirety of the Pakistani financial sector was Rs65.8 billion, as of September 30, 2016, the latest period for which data is available from the State Bank of Pakistan. If the Pakistani mortgage market was as developed as India’s, that number would be closer to Rs2.8 trillion.

Why is Pakistan’s mortgage market so underdeveloped? There are several reasons, but three major ones.

Firstly, between 2004 and 2008, it looked as though Pakistan’s mortgage finance industry, along with consumer finance in general, was about to take off. Then came the inevitable crash in late 2008, followed by bad loans hangover so bad (over one-third of the total volume of outstanding loans went into default) that the financial services industry as a whole appears to have sworn off consumer finance altogether.

Secondly, the government of Pakistan has historically been discouraging of using bank deposits to finance a mortgage market, and it was seen as too risky. Until the 1980s, the banks were outright forbidden from mortgage lending altogether. While the banks were eventually allowed to lend again, there are very strict limits on the total volume of loans that banks are allowed to deploy towards consumer lending as whole.

And lastly, the only mortgage lender in the country is the state-owned House Building Finance Corporation (HBFC), a highly mismanaged lender that has a dominant share in the mortgage market but accounts for even more of the non-performing loans.

The anemic mortgage market, in turn, means that many people who might otherwise become homeowners are not able to do so. That matters especially to Pakistan’s largest private sector real estate developer, which has seen its spectacular growth stall in the face of a lack of financing options. After growing by an astounding average of 75% per year between 2012 and 2015, Bahria Town’s revenues effectively flatlined during the financial year ending June 30, 2016, ending at Rs66.8 billion.

In other words, Bahria Town has run out of upper middle class Pakistanis who can afford to buy its houses and apartments outright and needs to go one level lower: to people who can afford a 20-25% down payment on the price of a Bahria Town home and can comfortably afford the monthly mortgage payment.

The Burj Bank acquisition attempt

Given these circumstances, the easiest and most logical move for Bahria Town would be to partner with one or more commercial banks to start offering mortgages for well-qualified borrowers to buy its properties. Yet despite being in business for several decades, Bahria Town has been unable to cultivate those relationships.

Kazim Alam, a financial reporter for Dawn, elucidated on the reasons as to why that might be on his personal blog: “Few banks offer mortgages on Bahria Town properties. Housing finance for Bahria Town is scarce for the same reason it is scarce for the rest of Pakistan’s urban centers: banks require clean, undisputed titles of land ownership for any house/flat they finance… According to mortgage bankers at several lending institutions, the land titles of Bahria Town properties are not as clean and transparent as they appear to the general public. This means that bankers look at Bahria Town properties with as much suspicion as they would look at a housing project in, say, Korangi (an industrial and low-income residential area in Karachi).”

The lack of financing was becoming a limiting factor on Bahria Town’s growth in 2015, right in the middle of its first foray into the highest end of the Pakistani real estate market. That year, Bahria Town’s most expensive property – the 62-storey BT Icon in Karachi, the tallest residential building in Pakistan – was being marketed to upper middle class buyers and coming onto the market.

Something had to be done and Malik Riaz Hussain would stop at nothing to keep the growth of his company going. Riaz is not the kind of person who lets obstacles get in his way. When it was becoming clear that the roads in front of the BT Icon were not equipped to handle the traffic from a 62-storey high-density building in a city without mass transit, Malik Riaz spent $18 million to build a series of overpasses and underpasses to ease congestion. He certainly was not going to let the banks’ refusal to lend to his buyers stop him.

In the summer of 2015, Bahria Town began an earnest due diligence of Burj Bank, an Islamic bank and the smallest bank in the country. Burj Bank had functionally been up for sale since the financial crisis of 2008, but had consistently struggled to find a buyer. By early 2016, it looked as though a deal may be possible, but the transaction was blocked at the last minute by the State Bank of Pakistan. The SBP worried that Bahria Town and Malik Riaz were not the kind of people it wanted to entrust with retail deposits from the general public.

Despite being so publicly rebuffed by the country’s most important financial regulator, Malik Riaz was undeterred. He would find a way around the SBP’s decision. In order to do that, he would need to find another financial institution to acquire, one that did not take public deposits, and preferably one that did not fall under the purview of the State Bank itself.

In late 2016, he found just such an entity in Escorts Investment Bank. On February 8, 2017, Bahria Town announced its intention to acquire Escorts from the family-owned business group that controlled over 71% of its shares.

The Escorts transaction

To call it an acquisition would be somewhat laughable, considering the fact that Bahria Town is getting Escorts almost literally for free, paying the princely sum of one rupee for over 71% of the shares of the company.

Nonetheless, for a moment it looked like a too-clever workaround. It was clearly a transparent bid to get around the State Bank. And two days later, it looked like Bahria Town would be rebuffed again, when the Securities and Exchanges Commission of Pakistan (SECP) announced that it would not allow the transaction to go through.

It turns out, however, that the SECP was not trying to halt the transaction in solidarity with the State Bank (or for the same concerns), but rather because Escorts had not followed the necessary procedures for an acquisition: under the Pakistan’s securities laws, a company’s majority shareholders cannot simply sell away their shares without also offering minority shareholders to sell their shares at the same price or better.

In their haste to undertake that transaction, Bahria Town and Escorts forgot to make the offer to the (very few) minority shareholders of Escorts. They finally got around to fulfilling that requirement on July 24, when Bahria Town announced that it had acquired over 71% of the shares in Escorts Investment Bank for a grand total of one rupee.

Not one rupee per share, mind you. One rupee total.

What Bahria Town gets out of the deal

When you get something for just one rupee, you get what you pay for. Escorts Investment Bank is without question one of the worst-run financial institutions in the country. Indeed, it is a wonder it still exists given just how consistently it has been unable to make money.

Before we get to Escorts’ financials, however, let us examine exactly what an investment bank is and how Bahria Town might be able to benefit from owning one.

An investment bank – in the Pakistani context – is very similar to an investment bank in the United States: a lightly regulated financial institution that primarily engages in trading and investing in equities, fixed income, and money market instruments, in addition to advising and underwriting capital raising and mergers and acquisitions, as well as providing its corporate clients with strategic advice.

In theory, such an institution should be the farthest thing from being the kind of institution that would allow Bahria Town to get into the mortgage business. But investment banks are allowed considerable leeway by the SECP in terms of what they are allowed to invest in, and lending is technically a form of fixed income investment.

It is often incorrectly assumed that investment banks cannot engage in retail finance operations. Strictly speaking, this is at least partially true: investment banks cannot accept retail deposits and can only raise money market term deposits from institutional investors and high net-worth individuals, and they cannot advertise on any venue that would be available to the general public at large.

Lending, however, is another matter entirely. Investment banks frequently offer personal loans and even offer car leasing (Escorts, in fact, offers such a product). As stated above, lending is technically a form of fixed income investment, and that is completely within the purview of investment banks. The government’s financial regulators justify this lax attitude by pointing out, correctly, that the risk to the broader financial system from investment banks is limited by the fact that they cannot accept deposits from ordinary citizens and instead only from entities that have the capacity to bear higher levels of risk.

Nonetheless, just because investment banks can lend to consumers does not make them ideal vehicles for doing so. Indeed, investment banks have historically had a horrendous record of consumer lending. Escorts is among the very worst in the country, with its interest income from its lending activities amounting to less than half of the interest it has to pay out to its institutional and high net-worth depositors.

In an ideal world, Bahria Town should have acquired a housing finance company. That, of course, was not a real possibility, since the only such company is HBFC, which is government owned and the government has been unwilling to sell it to anyone. The next best option would have been to create a housing finance company from scratch, but perhaps the hassle of having to create a financial institution with no expertise in building one were simply too much for Bahria Town and they decided to buy the third-best option.

So will this work?

Absolutely not. This transaction does not have a snowball’s chance in hell of working out.

Bahria Town is the wrong company to try to revolutionise mortgage lending in Pakistan, having absolutely no experience in consumer finance in the past. An investment bank is far from an ideal instrument to select in order to embark on a mortgage lending spree. And even if it was, Escorts is far from the best institution to pull it off. It has neither the capital, nor the talent, nor the relationships to be the kind of innovative institution that Bahria Town would need it to be for this experiment to work.

We hate to be the bearers of bad news. The mortgage market in Pakistan clearly needs to be infused with new energy and the idea of a real estate developer – particularly the largest private sector developer – is not a bad one. But this is not going to achieve the results Bahria Town is hoping for, even if we assume that the SECP will not eventually step in and stop Escorts from effectively transforming itself into a mortgage lending institution.

One day, some institution will do something that will truly jump-start Pakistan’s mortgage market. Unfortunately, we are nowhere there yet, though we applaud Bahria Town for trying.