Islamic finance continues to grow as a prudent alternative to conventional debt-based structures. Financial assets total more than US$1.3 trillion and instruments are expanding into new countries beyond its traditional markets in the Middle East and Malaysia. At its core, Shariah principles favour the development and sharing of risk in physical assets, which contribute to the economic growth of society. There is therefore a natural match between the Islamic finance model and the acquisition and development of real estate assets. Moreover, Islamic finance is a flexible tool which can be used for a wide range of real estate financings. This ranges from residential mortgages (such as the United National Bank of Pakistan's lease-based mortgage, the first of its kind in the UK), to large scale financings such as Qatari Diar's acquisition of the Chelsea Barracks and the construction of the Shard of Glass in London. More recently, Islamic finance techniques were used by Emaar Properties in Dubai to refinance existing facilities for the development of the Dubai Mall, the world's largest shopping and entertainment destination.
Islamic investors, including certain Middle East sovereign wealth funds, have traditionally preferred investing in prime real estate in the UK and Europe. In view of the economic uncertainty in Europe, there are increasing capital flows into commercial real estate in Asia and Australia, particularly in the industrial and commercial sectors. This presents an ideal opportunity to explore Islamic finance as an alternative to traditional debt funding. Islamic finance can be adapted to suit the size and tenor of the financing, the local tax laws, and may even be used alongside conventional finance. There is also the potential for more innovative techniques such as Shariah-compliant real estate investments trusts (Reits), as demonstrated by the success of Singapore's Sabana Reit in 2010.
A key consideration for Shariah-compliant real estate financing is the proposed use of the property. Islam forbids the preparation or consumption of certain types of products including pork, alcohol, armaments as well as activities such as gambling and conventional banking. As such, the use of Islamic finance to fund a pork factory or a casino would not be permitted. However, it is less clear cut in the case of a multi-let property such as a large commercial building which may, for example, include a small branch of a conventional bank. While such activities are prohibited, they do not form part of primary usage of the property. In these situations, Shariah scholars have generally accepted that Islamic financing can be used for multi-let properties where the threshold of non-permissible activities is below five percent. However, the income received from such activities must, in a manner of speaking, be cleansed. Such income may be donated to charity and should not form part of the profit distributed to investors. The threshold of non-permissible activities for the Sabana Reit (which invests in industrial real estate) has consistently been below that threshold. The income received from these activities will need to be donated to charity before making any distributions to investors. However, unless the income from non-permissible activities is very low or negligible, the element of cleansing may deter the use of Shariah-compliant financing, as it means a slice of the income will not be available to pay returns to investors.
Local tax laws should also be considered carefully as many countries impose heavy taxes and stamp duties on the transfer of ownership in real property. This is particularly important for certain structures such as the Ijarah (or lease) structure which involves an initial sale and purchase of an ownership interest in property coupled with an undertaking by the obligor to purchase the property at the end of the tenor. Depending on the jurisdiction, the taxes and stamp duties which could potentially be imposed on both sets of transfers could result in prohibitively high costs for the customer and the investors.
However, a number of jurisdictions have enacted amendments to the local tax legislation to ensure that Islamic finance transactions are granted the same tax treatment as conventional financing techniques. For example, in the UK, following a consultation process, successive amendments were made to the Finance Act to provide relief from stamp duty land tax for 'alternative finance arrangements', which includes Islamic finance techniques such as the Ijarah. The amendments to the Finance Act meant that the acquisition of Chelsea Barracks, which at the time was the most valuable residential plot to be redeveloped in Britain, could be wholly funded through an Ijarah structure without attracting high taxes and stamp duties.
Other jurisdictions such as Singapore and Malaysia have adopted similar amendments to local legislation. However taxes and stamp duties continue to pose difficulties in some key jurisdictions such as Indonesia. Until there is legislative amendment, uncertainty remains regarding the application of Indonesia's tax laws, which has deterred some financial institutions and corporates from participating in Islamic financing transactions. Australia has also faced some challenges in this respect. In May 2010, the Australian Federal Government asked the Board of Taxation to review and produce a report on the taxation treatment of Islamic finance products. Although the report was presented to the government in June 2011, it has not yet been publicly released. While we await the reforms necessary to provide clearer pathways for Islamic finance under Australian tax laws, transactions are still been done under the country's existing laws using a number of different and innovative structures, which can be used for real-estate funding.
Types of structures
Islamic financing structures used for real-estate financing range from those which provide investors a fixed return, to those in which investors take an equity risk in the development and performance of the property. Shariah scholars favour the latter, as it involves both the obligor and the financiers sharing in the risks and rewards of a project. This is considered to be fairer and more in line with Shariah principles. The key methods for real estate financing are outlined below.
Murabahah (cost plus financing)
A murabahah contract comprises of a two stage process whereby the financier purchases an asset (typically commodities, such as metals from a metals exchange) from the vendor at cost price, and immediately sells it on to the customer for a deferred, fixed sale price. The deferred payment entitles the financier to charge the customer a profit margin. The customer then sells the commodity to a third party at cost price with immediate payment and thereby obtains the financing to purchase the real-estate asset. The murabahah is favoured for its simplicity and the financier's profit margin can be set by reference to a benchmark such as the London Interbank Benchmark Rate (Libor). In addition, the financier takes limited or no risk in the property.
The murabahah structure has limitations, however. The fixed sale price limits the flexibility on rebates and increased costs. Further, break costs on prepayment are not permitted. These features restrict the customer's refinancing options prior to maturity. It is also fair to say that the murabahah is not favoured by Shariah scholars as a form of financing as it is not being used as a genuine sale and purchase contract, and because the financier does not take any property risk. Nevertheless, it has come to be an acceptable last-resort, if other financing methods are not feasible.
In the ijarah structure, the financier purchases the property and subsequently leases it to the customer for a fixed term in return for rent. The rental payments include the profit component paid to the financier and may also be set by reference to a benchmark. The customer enters into a purchase undertaking to purchase the property at maturity or upon a default for a price equal to the amount of the financing. For example, in the Chelsea Barracks acquisition, a syndicate of banks appointed a financier as their agent to acquire title to the property from the UK Ministry of Defence for subsequent lease to the project company (a joint venture between Qatari Diar and the CPC Group) in return for an agreed upon rental stream.
Unlike the murabahah structure, the ijarah requires the financier to take a measure of risk in the property. As long as the financier has an ownership interest in the property, it must also bear the liabilities arising from ownership, including responsibility for maintenance, structural repair and environmental matters. Under Shariah principles, a lessor cannot pass these responsibilities to the lessee but it can pass them on to an agent. It is accepted that the lessee (or an affiliate) may be appointed as the financier's agent to perform these obligations, with the rent being increased to reflect the agent's costs.
The istisna'a structure is typically used for construction financing, whereby the customer commissions the financier to develop the property for a fixed price on deferred payment terms. The financier will commission the contractor to do the same for a lower price, the difference in price being the financier's profit. When the property is delivered, the financier transfers title to the customer. The construction and payments may be phased or payments may be made on completion. The istisna'a may be coupled with an ijarah to achieve long-term floating rate financing to enable the financier to receive periodic returns as the property is being developed. A combination of the istisna'a and ijarah techniques were used to raise US$134 million to partially fund the development of the Bahrain Financial Harbour.
Diminishing musharakah (co-ownership akin to partnership)
This is a more recent development in the Islamic finance industry and has become increasingly popular. This is based upon the fundamental principle of risk sharing and is sufficiently flexible to incorporate a variable rate of return. The essence of this structure is that the financier and the customer co-own the property, where the proportions of ownership held by the financier and the customer reflect their contributions (whether financial or by way of contributions in kind, such as provision of management or other services). Each payment that the customer makes reduces the financier's share in the property by the same percentage. This structure is considered to be fairer from a Shariah perspective, as both the financier and the customer share in the risks of the construction of the property as well as any declines in market value. For example, the Emaar Properties financing, provided by a club of conventional and Islamic banks, comprised both an Islamic tranche structured on a diminishing musharakah basis as well as a conventional tranche. The financing was used primarily to refinance Emaar's existing facilities for the development of the Dubai Mall.
There are commonly held misconceptions that Islamic financing structures can be inflexible or limiting. In fact, the opposite is the case and there have been a number of innovations. One of the more innovative structures used to date are Shariah-compliant Reits. While Reits have been a useful tool for real-estate investment, Shariah-compliant Reits have been far less common. Yet the appetite for these products was clear from the success of the Sabana Reit's listing on the Singapore Stock Exchange in 2010. This was the first Shariah-compliant Reit in Singapore and it attracted a large order book from the Middle East and Asia, making it the largest Shariah-compliant Reit at that time.
In Singapore, consideration could also be given to using a business trust. This has been used in conventional financing, but it is also an appropriate vehicle for Shariah-compliant real-estate funding. Business trusts have been used in Singapore to invest in a wide range of sectors and assets that generate income, and can be adapted to meet Shariah principles. As with Reits, they are tradeable on the Singapore Stock Exchange. For many reasons, business trusts are more flexible than Reits as they can hold a variety of assets including, but not limited to, real estate. There is also no restriction on the number of properties that may be under development within the trust and, therefore, an Islamic business trust structure is ideal for real-estate development projects.
There is no doubt that the global appetite for Islamic finance and investment funds is growing - especially in the existing economic environment - as a viable alternative to conventional debt-funding. For entities seeking to raise funding, it gives them access to a larger investor pool.
Shariah concepts and commercial real-estate investments are complimentary as they both adopt a risk sharing model. Islamic financing has been used for real-estate transactions for decades in the Middle East and Malaysia, and non-Muslim countries such as the UK and Singapore have enacted legislative changes to pave the way for these types of financing arrangements. Throughout Asia and Australasia, there now seems to be increasing focus from a number of other countries looking to tap this alternative source of capital. Once this increased focus gains momentum and any necessary legislative changes are implemented, we will most likely see exponential growth in this area.
This article first appeared in International Financial Law Review. For more information, please visit www.iflr.com.
As Senior Foreign Counsel at Norton Rose Australia and based in Singapore, Natalie Breen is currently assisting the global real estate practice in developing relationships, leading and managing cross-border transactions with real estate clients across the Asia Pacific region.Natalie previously worked as the senior real estate in-house counsel at both a listed Australian financial services group and leading Australian REIT. She has extensive cross-border real estate transaction experience, having acted for REITS on the acquisition, disposal and asset management of investments offshore, particularly in Asia and Europe.
Ferzana Haq is Of Counsel based in Singapore with Norton Rose (Asia) LLP. She specialises in debt capital markets and Islamic finance. Ferzana advises financial institutions, sovereign,and corporate issuers on a broad range of debt capital markets transactions and Sharia compliant products.
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