In the Islamic-finance world, real estate has always been, save for a few exceptions, a perfect asset class. You have a property that is occupied by a tenant. That tenant pays rent in exchange for the right to use and occupy that property. Once that rent is paid to the landlord, the landlord uses the rent to pay off various landlord expenses, including financing costs, and any balance goes into the landlord’s pocket as profit. The transaction is equitable, tangible and certain. There is no speculation, uncertainty or unjust gains. Tenants know exactly what they are getting for their money, what is owed as rent and when, and the same applies to landlords.
At this stage, you might be wondering what the exceptions are. Of course, the type and use of the property in occupation is also a relevant factor in Islamic finance. A building that contains a casino, a bar, a bank and an insurance company in occupation may not be appropriate for Islamic finance because its underlying operations—gambling, alcohol, payment of interest, speculation—are at odds with the core and morality of Islamic finance. This is not relevant at all, of course, in the financing of residential properties, and in the financing of commercial properties proportionality and ring-fencing may, in some cases, be viable workarounds to limit the exclusion of a property entirely as an investment option, if, for example, it only contains a small percentage of rental income from a non-Sharia compliant tenant who is at odds with Sharia principles.
How is Islamic finance used to finance real estate?
There are two main financing structures that are used in Islamic finance for real estate: the commodity murabaha structure and the ijara lease structure.
The commodity murabaha structure is typically used to finance commercial property, and the ijara lease structure is typically used to finance residential properties, although you do see the ijara lease structure also used to finance commercial property in jurisdictions in which the granting of the ijara lease is tax neutral.
Commodity murabaha structure
The commodity murabaha structure is built around the principle of cost plus profit. I have something (e.g., a commodity) to sell to you that costs me X (which I know, because I just bought it from the market for X). I will sell it to you for a profit (P), so the price for which I will sell it to you (Y) is the sum of my costs (X) and the profit that I seek to make (P). In the commercial exchange, if you are happy to buy the commodity for the price offered, Y, then we have a deal. As part of the arrangement we can agree that Y is paid to me in instalments rather than in one lump sum. So the price, Y, could be paid to me over a period of five years in quarterly instalments (calculated by reference to P, the profit payments) and a bullet payment (typically the equivalent of X) at maturity. Does this look familiar?
In the above scenario, I am the financier, and you are the investor. The price, the payment terms and underlying asset are certain. In real terms, sometimes the commodity is the property itself; however in most cases, the commodity is a tradable commodity such as copper, aluminium or coffee, for example.
For the purpose of a real-estate investment, once the buyer is sold that commodity, the buyer sells the commodity back to the market for cash (since the buyer already knows that the market price for the commodity is X), and the cash equivalent of X is then pooled with the buyer’s equity to buy the property. Security over the property is then granted to the seller as security for the monies owed to the seller over the term of the commodity murabaha facility.
All of this—the buying (by the buyer of the commodity from the market), the selling (of the commodity by the seller to the buyer), the selling (by the buyer of the commodity back to the market), the acquisition of the property by the buyer, and grant of security by the buyer (to the seller)—happens on the same day. The seller is entitled to enforce the security granted by the buyer in the event that the buyer fails to pay amounts owing to the seller under the commodity murabaha agreement, or the buyer breaches any other obligations in the commodity murabaha agreement, such as any financial covenants included in the agreement.
The seller may, for example, require that the buyer covenants to ensure that the value of the property is never greater than a certain percentage of X (the seller’s cost); or the seller might require that the buyer ensures that the rental income from the property is never below a certain percentage of the profit instalments payable to the seller, since it is known and understood that the income from the property will service the profit payments due over the term of the commodity murabaha facility. The seller may also require that the buyer properly manages the property, and keeps it properly insured and tenanted. The commodity murabaha agreement can be structured like any other financing agreement in this way, albeit the financing is done through the commodity trade.
Ijara lease structure
There are many variations to the ijara lease structure in existence in Islamic finance, and here we will describe a typical structure used in residential-property financing. In a residential-property scenario, the financier buys the property and then grants a lease to the tenant at a premium. The premium paid by the tenant is pooled with the financier’s own funds to pay the purchase price of the property by the financier. Rent is paid by the tenant to the financier as landlord over the term of the lease, and the tenant also has the option to buy the property from the financier as landlord at any time for a bullet amount, which will be the equivalent of what the financier paid for the property. In the event that the tenant exercises his or her option and pays the balance due, title to the property will then be transferred to the tenant.
Similar to the commodity murabaha structure, the lease can contain such financial covenants or obligations as the financier may require. In the event that the tenant breaches these obligations, the financier would be entitled to terminate or forfeit the lease, which, of course, motivates the tenant to comply with these terms.
Why is Islamic finance relevant in real estate?
It cannot be ignored that the global Muslim population is huge and only continues to grow. In some countries, the Muslim population is the majority, and most financing is therefore already structured in a Sharia-compliant manner. In many countries, such as those in Europe, for example, the Muslim population is in the minority but is still large in number and requires a niche product that is put together in a Sharia-compliant way. The offerings in these jurisdictions are still relatively niche and therefore only have scope to grow. In the business of property, many practising Muslims perceive their choices to be limited to renting, buying in cash or buying with Sharia-compliant finance. These individuals are typically not tapped into or interested in the conventional debt market.
In the commercial world, Sharia-compliant finance is well-established and accessible to all investors, not only to those who are interested in Sharia finance on moral or religious grounds. Sharia financiers can therefore compete with conventional lenders, albeit they have a unique offering that gives them access to a Sharia-investor market as well.
The growth of Islamic finance in real-estate finance is interesting and exciting. The potential to further develop the sukuk(Islamic bonds) market, with real estate as the underlying tangible asset, remains. As does the potential to develop a more mature takaful market, being a cooperative-structure alternative to the insurance market.
By Nada Jarnaz, Senior Counsel, Taylor Wessing LLP
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