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Emerald Article: Determining the viability of rental price to benchmark Islamic home financing products: Evidence from Malaysia Rosylin Mohd Yusof, Salina H. Kassim, M. Shabri A. Majid, Zarinah Hamid

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To cite this document: Rosylin Mohd Yusof, Salina H. Kassim, M. Shabri A. Majid, Zarinah Hamid, (2011),"Determining the viability of rental price to benchmark Islamic home financing products: Evidence from Malaysia", Benchmarking: An International Journal, Vol. 18 Iss: 1 pp. 69 - 85 Permanent link to this document: http://dx.doi.org/10.1108/14635771111109823 Downloaded on: 28-12-2012 References: This document contains references to 35 other documents To copy this document: permissions@emeraldinsight.com This document has been downloaded 1180 times since 2011. *

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Rosylin Mohd Yusof, Salina H. Kassim, M. Shabri A. Majid, Zarinah Hamid, (2011),"Determining the viability of rental price to benchmark Islamic home financing products: Evidence from Malaysia", Benchmarking: An International Journal, Vol. 18 Iss: 1 pp. 69 - 85 http://dx.doi.org/10.1108/14635771111109823 Rosylin Mohd Yusof, Salina H. Kassim, M. Shabri A. Majid, Zarinah Hamid, (2011),"Determining the viability of rental price to benchmark Islamic home financing products: Evidence from Malaysia", Benchmarking: An International Journal, Vol. 18 Iss: 1 pp. 69 - 85 http://dx.doi.org/10.1108/14635771111109823 Rosylin Mohd Yusof, Salina H. Kassim, M. Shabri A. Majid, Zarinah Hamid, (2011),"Determining the viability of rental price to benchmark Islamic home financing products: Evidence from Malaysia", Benchmarking: An International Journal, Vol. 18 Iss: 1 pp. 69 - 85 http://dx.doi.org/10.1108/14635771111109823

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Determining the viability of rental price to benchmark Islamic home nancing products
Evidence from Malaysia
Rosylin Mohd Yusof, Salina H. Kassim, M. Shabri A. Majid and Zarinah Hamid
Department of Economics, Kulliyyah of Economics and Management Sciences, International Islamic University Malaysia, Kuala Lumpur, Malaysia
Abstract
Purpose The purpose of this paper is to analyze the possibility of relying on the rental rate to price Islamic home nancing product. Design/methodology/approach By comparing two models consisting of either rental rate or lending rate (LR) and selected macroeconomic variables that could inuence property value, the study focuses on the Malaysian data covering the period from 1990 to 2006. The study adopts several econometric time-series analysis, such as the autoregressive distributed lag estimates, bi-variate Granger causality, and multivariate causality based on the vector error-correction model. Findings The study nds consistent evidence that the rental price (RP) is a better alternative than the LR to price Islamic home nancing product. In particular, the rental rate is found to be resilient to short-term economic volatility, while in the long run, it is truly reective of the economic fundamentals. Practical implications This feature of the RP renders it as a fair pricing mechanism for the Islamic home nancing product. Results of this study contribute towards nding an alternative benchmark for the Islamic home nancing product which is currently using the conventional interest rate as its benchmark. Originality/value To the best of the authors knowledge, the current study is the rst of its kind which provides empirical evidence for the possibility of relying on the rental rate to price Islamic home nancing product. Keywords Benchmarking, Rental value, Loans, Islam, Property nance, Malaysia Paper type Research paper

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1. Overview The Islamic banking and nance industry has witnessed a rapid and spectacular expansion since its inception in the last three decades. The number of Islamic nancial institutions worldwide has increased from one in 1975 to over 300 today, operating in more than 75 countries (El-Qorchi, 2005). These nancial institutions are mainly concentrated in the Middle East and Southeast Asia, with increasing presence in Europe and the USA. The total assets of the banking and non-banking nancial services being offered based on shariah principles throughout the world are estimated to be in the range of US$800 billion to more than US$1 trillion which is almost vefold of its magnitude ve years ago. Islamic nance is said to be among the fastest growing nancial segments in the world with an estimated annual growth rate of 20 percent (Bank Negara Malaysia, 2008).

Benchmarking: An International Journal Vol. 18 No. 1, 2011 pp. 69-85 q Emerald Group Publishing Limited 1463-5771 DOI 10.1108/14635771111109823

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Against the backdrop of a burgeoning growth of the Islamic banking and nance industry, it is not surprising that voluminous studies have been conducted on various aspects of the industry. Among the recurring issues are shariah-compliancy of Islamic banking products, development of new Islamic banking products and services, measurement of the Islamic banks performances, and evaluation of the social and macroeconomic implications of developing the Islamic nancial system. Of these issues, the one that is given due attention is the Islamic home nancing as offered by Islamic banks throughout the world. In general, Islamic home nancing constitutes around 60-90 percent of total nancing offered by Islamic banks in some parts of the world. The most commonly practiced mode of Islamic home nancing in Malaysia is based on the murabahah (cost-plus arrangement) combined with the bai-bithaman-ajil (BBA) (payment of price is deferred to a future date) contracts. Although BBA-murabahah is a very popular mode of nancing offered by Islamic banks all over the world (particularly in Malaysia), the implementation is argued to be similar to that of a conventional home nancing. According to Obaidullah (2005), it is merely a prot rate or mark up for the interest rate, hence, leads to the convergence of both the Islamic and the conventional home nancings. The issue of shariah permissibility on the BBA-murabahah is still a subject of debate among the Muslim scholars, with scholars in the Middle East disapprove of the implementation of the BBA-murabahah concept in home nancing, whereas in Malaysia, Indonesia, and Brunei; its implementation is widely acceptable on the premise that it helps to kick-start and develop the industry. An alternative mode of Islamic home nancing developed in the recent years is the Musharakah Muthanaqisah partnership (MMP) which is based on a diminishing partnership contract. MMP is deemed to be more shariah-compliant by many scholars and is more commonly practiced in the Middle Eastern countries, Canada, the USA, and Australia. According to Meera and Abdul Razak (2006), apart from being consensus shariah-compliant, it can be implemented to avoid riba (interest) totally since the MMP uses rental index or house price index. At the same time, the MMP is argued to be able to reduce the cost of nancing the property and the duration of the nancing. Based on the MMP, both the client and bank co-own the property with an initial pre-determined share of ownership, such as 10 percent (client) and 90 percent (bank). The client will gradually redeem the banks share throughout the nancing period until the property is fully owned by the client. In determining the rental rates in MMP, home nancing offered by some Islamic banks all over the world (such as American Finance House LARIBA and Islamic Bank of Britain) are still tied to the implied or indicative conventional interest rates. Although benchmarking against the conventional interest rates is permissible, Muslim scholars urge that Muslim scholars (economists, in particular) should seek an alternative which is not dependent on the conventional interest rates. In this regards, this study hopes to contribute to the literature in establishing some empirical link between the property sector and the Islamic banking sector based on the Malaysian case during the period 1990-2006. In the quest of modeling an alternative benchmark for Islamic home nancing, the paper hopes to shed some light on the possibility of rental price (RP) as an alternative to the conventional interest rates in benchmarking the Islamic home nancing products. This study therefore seeks to model an alternative benchmarking for the Islamic home nancing based on the Malaysian case. It attempts to examine the determinants

of retail property rents in order to come up with the rental values to be benchmarked against the rate of prots of Islamic home nancing. The study hopes to shed some light on the possibility of equilibrium rental values as an alternative benchmark against the conventional interest rates (such as LIBOR, KLIBOR, or EURIBOR). Despite the wide literature collection on estimating, predicting, and identifying the signicant variables of property sector, studies on the relationship between the housing prices and rents and the nancial sector are still inadequate considering the vast development in the nancial sector. In fact, studies on the link between dynamic pricing of property sector and Islamic nancial system are meager. The rest of the study is organized as follows. The next section reviews the literature on the relevant factors inuencing the property rental values, the methods undertaken to empirically determine the property rental values, and the Islamic home nancing as offered by the Islamic banks in Malaysia. The following section discusses the methodology undertaken in this study including the empirical models and data issues. Subsequently, the results are presented and nally, the last section concludes. 2. Literature review In efforts to understand the relevance of RP as a pricing mechanism for home nancing, this section reviews the major factors determining property rental values as mentioned in the existing literature. Subsequently, it highlights the major empirical methods undertaken to determine the rental values. The reviews on these aspects of rental values would provide the basis for the variables included and method employed in this study. 2.1 Factors determining property rental values Voluminous studies have been conducted to model, predict, and forecast rental values of various types of property in both the developed and developing economies. Studies on determination of property rental rate establish the attributes most relevant in inuencing property prices and incorporate these attributes in the pricing equation. Indeed, quantifying property rental is denitely a challenging task due to the complex nature of the housing market. Several factors have potential effects on the value of the property, leading to the determination of its RPs. Most studies group these possible factors into major categories of attributes that later can be quantied. Subsequently, these variables are employed in the property valuation and being determined their signicance in inuencing the property prices. For instance, Linz and Behrmann (2004) provide three characteristics of the factors determining house prices, namely physical, locational, and generally price variables characteristics. Day (2003) categorizes the various attributes of housing into structural, accessibility, neighborhood, and environmental characteristics. Meanwhile, Can (1990) highlights the importance of neighborhood characteristics in determining RPs which include quality of schooling system, level of noise pollution, air quality, proximity to parks, proximity to bodies of water, and quality of transportation system. Other inuential characteristics are physical characteristics, such as number of bedrooms, number of bathrooms, oor area, and age of property; demographic characteristics, such as median household incomes, crime rate, and cultural attractions; policy-specic characteristics, such as rent regulations and rent subsidies; and amenities/facilities characteristics, such as the availability of in-door pools, gymnasiums, and covered parking.

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In addition to the property-specic characteristics, there are also other economic-related factors which inuence the property prices, such as the transaction or clustering effect. As shown by Palmon et al. (2004), factors, such as listing price, closing price, number of days on the market, and number of available properties listed during the transaction have signicant impacts on the property prices. Some other studies emphasize the importance of economic characteristics, such as wage levels, business cycles or gross domestic product (GDP) levels, and interest rate environment in affecting property prices during a particular time period. For example, Wong et al. (2003) use econometric analysis to determine the impact of interest rate movements on house prices from 1981 to 2001 in Hong Kong and nd that house prices and interest rates are negatively related in the pre-1997 period. However, in the post-1997 period, the negative relationship seems to be non-existent. Thorough analysis should ideally incorporate all the potentially relevant data that reect the degree of contribution of these factors in determining the rental rate of the property. Similarly, any empirical models should be comprehensive enough to include all the signicant attributes in arriving at the propertys rental values. However, due to the complexity of the housing market which is considered as multidimensional and highly differentiated, most of the studies focus on selected major attributes determining the house prices or rental rate for a particular location. For example, Marco (2007) focuses on the location and demographic attributes in determining rental rate in the New York City neighborhoods. Based on data collected from ve community districts, the study analyzes the relationship between selected indicators to represent the demographic attributes and the median monthly rent as the dependent variable. In particular, the physical characteristics are represented by the location of the property, while the demographic factors are represented by the crime rate, median household income, and percentage of rent-regulated housing. The study nds that the premiums are charged based on the location of the property (rental rates are largely location dependent) and all the identied demographic factors are signicant in inuencing the median monthly rent. In a related study, Hui et al. (2007) analyze the importance of physical characteristics (which include age, total oor area and occupancy rate), market position and location as the possible factors determining the rental values of properties in Hong Kong. Ibrahim et al. (2005) test the importance of physical characteristics (oor area and oor level), distance from central business district and distance from mass rapid transit station in determining the rental values in various sub-markets in Singapore. Other macroeconomic variables are also shown to be important in determining the rental values of property. This includes economic output, interest rate, and vacancy rate (Chow et al., 2002) and consumer expenditure, employment and economic output (White et al., 2000). The study by Matysiak and Tsolacos (2003) analyses rental pricing from a different dimension by examining the role of selected economic and nancial series which are used as leading indicators in explaining the monthly variation in property rents in the UK. The leading indicators comprised of ve nancial variables (treasury bill rate TBR, yield of 20-year gilts, narrow-money supply, broad-money supply and price on FTSE), three real economic variables (car registration, volume of retail sales, and job vacancies), and two sentiment indicators (consumer condence and expectations in the property market development). The study nds that the economic variables are inuential factors in determining the rental values of property.

2.2 Methods undertaken to determine property rental values Methods to quantify and determine the property rental values can broadly be divided into two approaches: the hedonic pricing model (HPM) and more recently, the econometric analysis. The HPM analysis is a statistical technique which can be applied to a series of property values, together with their associated characteristics to identify and quantify the signicance of the characteristics in determining the propertys value (Dunse and Jones, 1998). It is a well-established technique which has been widely applied for pricing of residential housing market and commonly used in the valuation of property in the USA and the UK. Further extension of the HPM results in the automated valuation model adopted by Ibrahim et al. (2005). In estimating the housing price for resale market in Singapore for the period 1995-2000, the study nds that variables, such as oor area, age, distance to central business district, and distance to the mass rapid transit are signicant determinants of the Housing Development Board resale ats price. More recent approaches in determining property rental rates involve the applications of sophisticated econometric analysis. This involves the adoption of various econometric analyses ranging from the simple ordinary least square (OLS) analysis to the vector error-correction model (VECM), variance decompositions analysis, and impulse response functions. These analyses are intended to examine the dynamic causality among the variables and to capture the relative strength of the causality among the variables beyond the sample period. In other words, while the application of the OLS analysis involves testing the explanatory power of the identied determinants on the property rental rate, the other econometric analysis helps to provide further details on the dynamic relationships among the variables. For example, Chaplin (1996) seeks to demonstrate the importance and possible value of the procedure of modeling, predicting, and forecasting commercial rents in ofce, industrial and retail markets in Great Britain for the period 1986-1995. By employing the Pesaran et al. (1996) and VAR estimation, the study concludes that the theory appears to be a better indicator of the correct model structure than maximizing the historic t. Meanwhile, White et al. (2000) and Ooi (2000) employ time series technique and censored regression analysis to model property rents in both Scotland and in the UK. In particular, White et al. (2000) compare and contrast the distinctiveness and commonality of the three main sectors of the property market, and Ooi (2000) links stock prices of the property sector to several macroeconomic variables. For the emerging economies, studies conducted on the rental values of the property markets mainly focused on the modeling, estimating, and predicting rental values for the property sector. By employing regression analysis, Hui et al. (2007) explore the relationship between market positioning and rents of retail facilities in Hong Kong for the period 1997-2003. In identifying the macroeconomics determinants of private housing in Singapore, Kim and Cuervo (1999) provide empirical evidence that housing price in Singapore is cointegrated with real GDP, prime lending rate (LR), and private housing starts. 2.3 Islamic home nancing in Malaysia as practiced by Bank Islam Malaysia Berhad The Islamic nancial system in Malaysia is enjoying a rapid and spectacular growth in the last three decades. The rst full-edged Islamic bank in Malaysia Bank Islam Malaysia Berhad (BIMB) which was established since 1983, continues to poise itself as a competitive and viable institution in the domestic nancial infrastructure. Against the backdrop of a conducive policy environment and a promising growth

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of the Islamic banking industry, BIMB continues to offer a wide spectrum of nancial services to meet the increasing demands of its customers. One of the products offered by BIMB that has gained competitiveness with the conventional banks is home nancing. For BIMB, the growth of home nancing has been encouraging. The percentage of nancing extended to the purpose of house purchases (residential) to total nancing ranges from around 14-37 percent for the period of 1994-2005. More importantly, there seems to be a remarkable increase in this nancing type, reaching a high of 67 percent in the recent years (2006 and 2007). The Islamic home nancing offered by the BIMB is based on the concepts of BBA, Istisna and variable rate BBA. Its most popular home nancing product is known as the Baiti Home Financing-I which is based on the BBA-murabahah contract, a method of sale with a deferred payment plan. It is said to be able to reduce borrowers risks against interest uctuations. It offers the amount of nancing of up to 100 percent with a maximum repayment period of 30 years. By combining the murabahah arrangement with the BBA, the customer is allowed to pay installments for the nancing. In Malaysia, the dominance of BBA as a mode of nancing compared to the equity-based nancing like mudharabah and musyarakah may have received wide support among banking practitioners as well as shariah advisors (Rosly, 2005). However, besides the limited applications, the operational issues of BBA are also subject of debates among Muslim scholars as well as banking practitioners. Nevertheless, it is not within the scope of this study to highlight the ongoing debates pertaining to the operational issues of BBA and murabahah. It is also important to note that, compared to the conventional home loan, a unique feature of the Islamic home nancing which is based on the BBA focuses on prot-margin. Prot margin is not subjected to uctuations in interest rates. The conventional home nancing, on the other hand, relies on the interest rates. Conventional home nancing rates usually comprise of a base LR and adjusted accordingly to different banks. 3. Methodology 3.1 Autoregressive distributed lag approach The autoregressive distributed lag (ARDL) approach adopted in this study was introduced by Pesaran et al. (1996). The ARDL approach has numerous advantages. Unlike the most widely adopted methods for testing cointegration, such as the residual-based Engle and Granger (1987), and the maximum likelihood-based Johansen (1988 and 1991) and Johansen and Juselius (1990) tests, the ARDL approach can be applied regardless of the stationary properties of the variables in the samples and allows for inferences on long-run estimates which is not possible under the alternative cointegration procedures. In other words, this procedure can be applied irrespective of whether the series are I(0), I(1), or fractionally integrated (Pesaran and Pesaran, 1997; Bahmani-Oskooee and Ng, 2002), thus avoiding the problems resulting from non-stationary time series data (Laurenceson and Chai, 2003). Another advantage of this approach is that the model takes sufcient numbers of lags to capture the data-generating process in a general-to-specic modeling framework (Laurenceson and Chai, 2003). The ARDL method estimates ( p 1) k number of regressions in order to obtain optimal lag-length for each variable, where p is the maximum lag to be used and k is the number of variables in the equation. The model can be selected using the model selection criteria, such as the adjusted R 2, Akaike information

criteria (AIC) and Schwartz-Bayesian criteria (SBC). The SBC is known as the parsimonious model (selecting the smallest lag length), whereas the AIC and adjusted R 2 are known for selecting the maximum relevant lag length. This study reports the models based on these criteria. Finally, the ARDL approach provides robust results for a smaller sample size of the cointegration analysis. The ARDL models used in this study can be written as the following general models: RP t a0 a1 GDP t a2 TBR a3 CPI t a4 REERt et LRt a0 a1 GDP t a2 TBR a3 CPI t a4 REERt et 1 2

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where RP and LR are the rental price and lending rate, respectively, while the macroeconomic variables employed are real GDP, interest rate (three-month TBR), and consumer price index (CPI). Considering the high degree of openness of the Malaysian economy, the external sector could have signicant impact on the domestic economy. Thus, we also include the real effective exchange rate (REER) variable in the models. A dynamic error-correction model (ECM) can be derived from the ARDL model through a simple linear transformation (Banerjee et al., 1993). The ECM integrates the short-run dynamics with the long-run equilibrium, without losing the long-run information. The error-correction representation of the ARDL models can be written as follows: D ln RP t a0
k1 X j1

bj D ln RP t2j

k2 X j0

cj D ln GDP t2j

k3 X j0

dj D ln CPI t2j

k4 k5 X X ej D ln TBRt2j f j DREERt2j n1 ln RP t21 n2 ln GDP t21 3 j0 j0

n3 ln CPI t21 n4 ln TBRt21 n5 REERt21 jt D ln LRt a0

k4 X j0 k1 X j1

bj D ln LRt2j

k2 X j0

cj D ln GDP t2j

k3 X j0

dj D ln CPI t2j

ej D ln TBRt2j

k5 X j0

f j DREERt2j n1 ln LRt21 n2 ln GDP t21 4

n3 ln CPI t21 n4 ln TBRt21 n5 REERt21 jt The terms with the summation signs in the above equation represent the error-correction dynamics, while the second part (terms with ns where s 1, 2, . . . , 5) corresponds to the long-run relationship. In the ECM model, the null hypothesis (H0: n1 n2 n3 n4 n5 0), which indicates the non-existence of the long-run relationship, is tested against the existence of a long-run relationship. The calculated F-statistics of the H0 of no cointegration is compared with the critical value tabulated by Narayan (2004). If the computed F-statistic falls above the upper-bound critical value, the H0 of no cointegration is rejected. However, if the test statistic falls below a lower bound, the H0 cannot be rejected. Finally, if it falls inside the critical value band, the result would be inconclusive. Once cointegration

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is conrmed, the long-run relationship between the RP or LR and macroeconomic variables using the selected ARDL models are estimated. The last step of ARDL is to estimate the associated ARDL ECM. Finally, to ascertain the goodness of t of the selected ARDL model, the diagnostic and the stability tests are conducted. The structural stability test is conducted by employing the cumulative sum of recursive residuals (CUSUM) and the cumulative sum of squares of recursive residuals (CUSUMSQ). 3.2 Vector error-correction model To examine the multivariate causality relationship among the variables, the study employs the VECM framework. The VECM regresses the changes in both the dependent and the independent variables on lagged deviations. The multivariate causality test based on VECM can, therefore, be formulated as follows: DZt d Gi DZt21 Gk DZt2k PZt2k 1t 5

76

where Zt is an n 1 vector of variables and d is an n 1 vector of constant. In our case, Zt (RP, GDP, TBR, CPI, REER). G is an n n matrix (coefcients of the short-run dynamics), P ab0 where a is an n 1 column vector (the matrix of loadings) represents the speed of short-run adjustment to disequilibrium and b0 is an 1 n cointegrating row vector (the matrix of cointegrating vectors) indicates the matrix of long-run coefcients such that Yt converge in their long-run equilibrium. Finally, 1t is an n 1 vector of white noise error term and k is the order of autoregression. A test statistic is calculated by taking the sum of the squared F-statistics of G and t-statistics of P. The multivariate causality test is implemented by calculating the F-statistics (Wald-test) based on the H0 that the set of coefcients (G) on the lagged values of independent variables are not statistically different from zero. If the H0 is not rejected, then it can be concluded that the independent variables do not cause the dependent variable. On the other hand, if P is signicant (that is different from zero) based on the t-statistics, then both the independent and dependent variables have a stable relationship in the long run. From equation (5), two channels of causation may be observed. The rst channel is the standard Granger test, examining the joint signicance of the coefcients of the lagged independent variables. Whereas, the second channel of causation is the adjustment of the dependent variable to the lagged deviations from the long-run equilibrium path, represented by the error-correction term (ECT). If the ECT is found to be signicant, it substantiates the presence of cointegration as established in the system earlier and at the same time, it tells us that the dependent variable adjusts towards its long-run level. From these tests, we can reveal four patterns of causal interactions among pairs of the variables, i.e.: (1) a unidirectional causality from a variable, say x, to another variable, say y; (2) a unidirectional causality from y to x; (3) a bi-directional causality; and (4) an independent causality between x and y. 3.3 Data In this analysis, the estimations of RP and LR are linked to the macroeconomic variables. The macroeconomic variables employed in the study are real GDP, TBR,

ination rate (CPI), and REER. The data are extracted from various issues of the Ministry of Finance (1990-2006), Malaysias Property Market Reports, the International Financial Statistics published by International Monetary Fund (1990-2006) and various publications of the Bank Negara Malaysia. The study covers the period from 1990 to 2006. Except for LR and TBR, all other variables are transformed into natural logarithms. For RP, the study uses the rental rate for the single storey houses as the proxy for the property rental rate due to the unavailability of the aggregate housing rental index for Malaysia and the heterogeneity of the houses in Kuala Lumpur. 4. Results and discussions 4.1 Results of ARDL approach In estimating the short- and long-run relationships between the RP/LR and macroeconomic variables, we need to determine the lag length of the rst-differenced variables. Bahmani-Oskooee and Bohl (2000) have shown that the results of this rst step are usually sensitive to the lag length. To verify this, in line with Bahmani-Oskooee and Ng (2002), we impose the maximum lag length of two, due to small sample size employed in this study. We then computed the F-statistics for the joint signicance of lagged levels of variables as in equations (1) and (2). Based on the signicant F-statistics of the long-run estimates, we chose lag length 1 for the model containing RP as the dependent variable and lag length 0 for the model containing LR. As evidenced in Table I, the computed F-statistics for both models suggest that there are cointegrating relationships among the selected variables at the selected lag length. These results conrmed that the inclusion of the selected lags into our models is justied. The next step involves estimating the models using the appropriate lag length based on the AIC. As shown in Table II, the results for the model involving the RP show that RP is signicantly affected by TBR and GDP in the long run. This nding seems to be consistent with the fundamental theory of demand that income and substitution effects inuence the RPs for the properties or houses. The TBR is regarded as an alternative investment for buying a house. An increase in the TBR negatively affects the RP such that when interest rate rises, the return to investment in interest-bearing instrument increases, thus reducing the demand for houses. On contrary, the increase in income (GDP) signies the increase purchasing power and thus increases the demand for houses and in turn, creating an upward pressure on the RP. When LR is used as the dependent variable, the TBR and REER are signicantly affecting the LR. The signicance of TBR in inuencing LR suggests the importance of interest rate in determining the level of LR which is consistent with the common practice of the commercial banks in Malaysia. With regard to the importance of REER
Lag length 0 1 2 Rental price 3.6073 * 4.7462 * * 0.48559 Lending rate 4.2146 * 1.6302 1.2780

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Notes: F-statistics falls above the *95 and * *99 percent upper bounds; the relevant critical value bounds are taken from Narayans (2004) Appendices A1-A3 for case II: with a restricted intercept and no trend; number of regressors 4. They are 4.280-5.840 at the 99 percent signicance level, 3.0584.223 at the 95 percent signicance level and 2.525-3.560 at the 90 percent signicance level

Table I. F-statistics for testing the existence of long-run equation

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in inuencing the LR, this nding suggests that in Malaysia, being a small and open economy, is also affected by the external factors. As suggested by the results, the LR is sensitive to changes in the external economy, while the RP is more reective of changes in the domestic economy. 4.2 Results of bi-variate causality analysis The bi-variate Granger causality analysis shows the short-run causality between two variables in a system. As shown in Table III, the results indicate that there is no signicant nexus of causality involving RP in the short run. In contrast, for the LR, there is a signicant unidirectional causality from GDP to LR at the 10 percent level. For the macroeconomic variables, signicant causality runs from GDP to TBR and GDP to CPI where the joint F-statistic is signicant at the 5 percent level for both cases. The result also shows a signicant F-statistic at the 10 percent level from CPI to REER. 4.3 Results of multivariate causality analysis The multivariate analysis allows us to examine the transmission channel of which the RP and LR are affected by the macroeconomic variables. The short-run causalities are depicted by the t-statistics for the individual variables, while the long-run causalities are indicated by the F-statistics for the ECT. As reported in Table IV, there is no signicant short-run causality running from macroeconomic variables to RP. However, for the long-run relationship, all the macroeconomic variables are signicant in causing the RP as shown by the signicant ECT. These results re-afrmed the earlier ndings based on the bi-variate Granger causality and long-run ARDL estimates. For LR, similar to RP, there is no signicant short-run causality from the macroeconomic variables to LR (Table V). However, contrary to RP, all the macroeconomic variables are not signicant in affecting the LR in the long run as reected by the insignicant ECT. The insignicance of the ECT when LR is the dependent variable instead of when RP is, suggests that all the macroeconomic variables adjust towards long-run equilibrium when RP is the dependent variable. This implies that in the long run, the RP is more reective of the fundamental economic conditions compared to the LR. In view of this, it can be further implied that the rental rate is a better pricing mechanism for the Islamic home nancing product rather than the LR. We then proceed to examine the stability of the long-run coefcients together with the short-run dynamics. Following Pesaran and Pesaran (1997), we apply the CUSUM and CUSUMSQ tests proposed by Brown et al. (1975) on both models. As highlighted
Rental price C REER TBR GDP CPI t-statistics Lending rate t-statistics

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Table II. Long-run ARDL model estimates

2.0556 1.6400 0.4394 0.2957 2 0.4394 * * * 2 7.8680 0.8820 * * 3.4303 2 1.5750 2 1.7667 2 Adj 2 R 0.9790; D 2 W 2.7485

2 95.1572 2 4.7528 * * * 11.4407 4.6616 * * 1.7870 * * 3.6785 2.4628 0.8262 3.0562 0.3863 Adj 2 R 2 0.9344; D 2 W 2.1326

Notes: Signicance at: *10, * *5 and * * *1 percent levels; D-W denotes Durbin-Watson test for autocorrelation

Null hypothesis TBR does not Granger Cause RP RP does not Granger Cause TBR CPI does not Granger Cause RP RP does not Granger Cause CPI GDP does not Granger Cause RP RP does not Granger Cause GDP REER does not Granger Cause RP RP does not Granger Cause REER TBR does not Granger Cause LR LR does not Granger Cause TBR CPI does not Granger Cause LR LR does not Granger Cause CPI GDP does not Granger Cause LR LR does not Granger Cause GDP REER does not Granger Cause LR LR does not Granger Cause REER CPI does not Granger Cause TBR TBR does not Granger Cause CPI GDP does not Granger Cause TBR TBR does not Granger Cause GDP REER does not Granger Cause TBR TBR does not Granger Cause REER GDP does not Granger Cause CPI CPI does not Granger Cause GDP REER does not Granger Cause CPI CPI does not Granger Cause REER REER does not Granger Cause GDP GDP does not Granger Cause REER

F-statistic 1.31056 1.04619 0.10092 0.01124 0.02443 0.04177 0.52895 0.68907 0.01778 2.15550 0.21804 2.45005 4.44288 0.07992 0.93279 0.15086 1.25117 0.35271 4.76818 0.00379 1.39987 0.05886 7.89342 1.51753 0.30456 3.55251 0.12581 0.90162

Probability 0.2682 0.3207 0.7546 0.9168 0.8776 0.8405 0.4769 0.4180 0.8955 0.1603 0.6465 0.1359 0.0502 * 0.7808 0.3477 0.7025 0.2789 0.5604 0.0433 * * 0.9516 0.2530 0.8112 0.0121 * * 0.2348 0.5882 0.0767 * 0.7272 0.3557

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Note: Signicance at: *10 and * *5 percent levels, respectively

Table III. Results of pair-wise granger causality tests

by Bahmani-Oskooee and Ng (2002), the CUSUM and CUSUMSQ tests employ the cumulative sum of recursive residuals based on the rst set of observations and is updated recursively and plotted against the break points. If the plots of the CUSUM and CUSUMSQ statistics are found to be within the critical bounds of 5 percent level, the H0 that all coefcients in the ECMs as in equations (3) and (4) are stable cannot be rejected. On the other hand, if the lines are found to be crossed, the H0 of coefcient constancy can therefore be rejected at 5 percent signicance level. Based on the graphical representations for CUSUM and CUSUMSQ tests for both models, the results indicate no evidence of any signicant structural instability[1]. 5. Conclusion and recommendations In efforts to determine the suitability of the RP to replace the conventional LR to benchmark Islamic home nancing product, this study compares two models comprising the RP and LR as the dependent variables and selected macroeconomic variables, namely GDP, TBR, CPI, and REER as the independent variables, and analyses the short- and long-run dynamics among these variables. Based on the long-run ARDL estimates, the study shows that the RP is signicantly affected by the interest rate and income level, while the LR is signicantly affected by the interest rate and exchange rate.

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Dependent variables DGDP 0.2202 0.4350 0.4406 0.0503 * * 8.1306 2 0.4309 9.4179 2 2.1435 0.6366 2 0.1564 1.5931 0.6461 2 0.1594 6.7318 * * 0.8158 0.3932 0.6957 0.0212 0.3817 0.5407 2 0.0480 0.1428 0.4110 0.0004 0.8298 0.7112 0.5318 0.9835 2 2 0.6230 * *
2

DRP DGDP DREER DTBR

Notes: Signicance at: * * *1, * *5 and *10 percent levels; ECTt2 1 is derived by normalizing the cointegrating vectors on the dependent variables, producing residual r; by imposing restriction on the coefcients of each variable and conducting Wald test, we obtain F-statistics for each coefcient in all equations; DW denotes Durbin-Watson test for autocorrelation

Table IV. Results of multivariate causality tests for rental price

Independent variables F-statistics DREER F-statistics DTBR F-statistics ECTt2 1 Probabilities for t-statistics Diagnostic tests R -adj. 0.0370; R 2-adj. 0.1588; R 2-adj. 0.0091; R 2-adj. 0.3362; DW 2.3232 DW 1.9354 DW 1.8309 DW 2.2467

DRP

DCPI

F-statistics

0.4046 0.0023 0.4982

0.1416 0.5350 0.9626 0.4919

0.7123 0.6459 0.6299 4.5848

Independent variables DCPI Diagnostic test

2

Dependent variables F-statistics 0.9901 0.4148 0.1534 0.0446 0.7331 0.0322 0.8263 2.5145 0.5354 0.1210 5.6582 * * 0.1351 0.4764 0.3897 3.0348 * 0.3638 0.0500 0.5425 0.1034 0.5560 0.3294 2.7209 0.4220 0.0112 0.5751 0.1213 0.5264 0.9171 2 0.1192 2 0.1122 2 0.0912 0.0018 0.1330 2 0.3284 2 1.6156 2 0.6573 0.0350 0.2301 DGDP Probabilities F-statistics DREER F-statistics DTBR F-statistics ECTt2 1 for t-statistics R -adj. 0.0444; DW 2.0583 R 2-adj. 0.4216; DW 2.4182 R 2-adj. 0.1542; DW 1.9854 R 2-adj. -0.1035; DW 1.7094 R 2-adj. 0.2603; DW 2.2744

DLR F-statistics

DLR DCPI DGDP DREER DTBR

2.8568 0.3834 0.0008 0.4173

0.1131 0.5457 0.9782 0.5288

0.0002 2 0.7062 2.2792 4.8643 * *

Notes: Signicance at: * * *1, * *5 and *10 percent levels; ECTt2 1 is derived by normalizing the cointegrating vectors on the dependent variables, producing residual r; by imposing restriction on the coefcients of each variable and conducting Wald test, we obtain F-statistics for each coefcient in all equations; DW denotes Durbin-Watson test for autocorrelation

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Table V. Results of multivariate causality tests for lending rate

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The signicance of the interest rate (TBR) in affecting the RP is consistent with the fundamental theory of demand that income and substitution effects inuence the RPs for the properties or houses. The TBR is regarded as an alternative investment for buying a house. An increase in the TBR negatively affects the RP such that when interest rate rises, the return to investment in interest-bearing instrument increases, thus reducing the demand to rent and own houses. These ndings lend support to fundamental economic theory which states that income and substitutes affect the demand for houses and in turn affect the rental values. Meanwhile, the signicant relationship between TBR and LR is obvious, since by convention, all types of interest rates tend to move in tandem overtime. The results also showed that RP is signicantly affected by GDP, while the LR is signicantly affected by the exchange rate, suggesting that the RP is more reective of the real economic activity in the long run compared to the LR. Next, the short-run bi-variate causality analysis suggests a signicant causality running from GDP to the LR, while there is no signicant causality running from any of the macroeconomic variables to RP. The signicant short-run causality suggests that the LR is rather volatile in the short run, while the RP is relatively stable. Moving on to the long-run multivariate causality based on the VECM, the ndings suggest that all the macroeconomic variables are signicant in causing the RP as reected by the signicant ECT, while none of the macroeconomic variables are signicant in causing the LR in the long run. This nding suggests that the macroeconomic variables adjust towards a long-run equilibrium when RP is the dependent variable, implying that, the RP is a relevant indicator to predict the real economy in the long run. The short-run stability of the RP and its long-run sensitivity to changes in the macroeconomic conditions compared to the LR suggest that the RP could be an ideal and relevant indicator to price the Islamic home nancing product. The results of the study has shown the merits of using the RP to benchmark the Islamic home nancing product due to its short-run stability and close relation to the macroeconomic conditions in the long run. The negative relationship between the RP and interest rate (TBR) in the long run has major implications. Our results suggest that when the cost of borrowing is high, demand for houses is low as reected by the low RP. In the context of this study, it is obvious that rental rate that we are proposing as a benchmark for Islamic home nancing product is truly depending on cost of borrowing which is interest rate. A major deduction from this nding is that as long as the economic system depends on interest rate to determine the cost of borrowing, the demand for housing will continue to depend on the interest rate. On another note, with regard to benchmarking Islamic home nancing product, our results suggest that the RP is able to substitute the conventional interest rate which is the current practice of benchmarking the Islamic home nancing. Second, from an investor perspective, the RP reects the return by investing in properties, while TBR is the return from investing in interest-earning instruments, such as bonds. In this case, TBR is regarded as an alternative investment from buying a house. The practical implementation of the ndings, however, seems to be costly. If the Islamic banks were to adopt the RP to benchmark their home nancing products, there is a need to have a special valuation department at the bank level to accommodate the request for specic segment of home nancing. While benchmarking on the conventional interest rate can be conveniently applicable to all types of houses, the application of RP to determine the price for the home nancing can be cumbersome. The bank needs

to do a survey of the applicable RP for properties of the same characteristics to come up with the average RP for a particular property. In view of the additional costs to be incurred, banks might hesitate to adopt this approach. At the same time, a wide-scale implementation of adopting the RP to benchmark the Islamic home nancing product also need the support from the demand side or the consumer side. In this regard, consumer education plays a critical role in ensuring that the new Islamic home nancing product will be well received by the customers. The authority, in particular the central bank and the commercial banks need to introduce the concept and explain thoroughly to the consumer the merits that this system is providing. Consumer education is also important as part of Islamic banks risk management. There is a possibility that the customers opt for cheaper home nancing products which are based on the conventional LR when the interest rate environment is low. As being shown by the study, while the RP is sensitive to the macroeconomic conditions in the long run, in the short run, it is rather stable. The time lag needed for the RP to reect changes in the macroeconomy could be a weak point of this system and should be well communicated to the customers. Despite this, it is important to caveat that thus far, we have assumed that the data for the dependent and independent variables are measured without errors. Thus, in the regression of rental rate on macroeconomic variables, we assume that the data are accurate and they are not guess estimates, averaged or rounded off in any manner. When there are errors in the dependent variable (i.e. rental values and LRs), the estimates are unbiased as well as consistent but they are less efcient. On the other hand, if there are errors in the independent variables (i.e. macroeconomic variables), the estimates are biased as well as inconsistent. This study employs only the average rental values which incorporate the heterogeneity of several types of houses in Kuala Lumpur. More comprehensive analysis to better estimate the rental values by conducting survey to gather for primary data in some selected geographical areas in the country is recommended. This would therefore enhance the rigor of rental values being used as an alternative benchmarking. Owing to the very complex nature of the housing market, the study might provide bias and inconclusive results. The results of this study have opened a wide variety of possible extension and areas that warrant further research. First, a multidimensional framework which adopts the hedonic model that includes the physical, locational, and economic attributes of the property. This model is a well-established technique which has been widely applied for pricing of residential housing market and commonly used in the valuation of property in the USA and the UK. Second, for a more rigorous analysis on the rental values, we propose the use of rental index for Malaysia to be incorporated. Unlike more developed economies, Malaysia currently relies on rental values rather than rental index to reect the performance of the property sector. The construction of rental index which incorporates the heterogeneity of the houses and better estimates the performance of the property sector is very much needed in this quest of modeling an alternative benchmarking. Perhaps, more deliberations and concerted efforts among the practitioners in the property sector, bankers as well as academicians would bring more favourable results.
Note 1. To conserve space, we do not include the graphical plots in this paper. The plots are available upon requests from the authors.

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