Dato’ Seri Matthew Yeoh discusses how Islamic financing can be a viable alternative to conventional financing.
OWNERSHIP RIGHTS UNDER ISLAM
Under Islamic law, ownership rights originate from the concept of stewardship of property according to God’s will. This concept is based on the Islamic belief that God owns all property and men are merely trustees or custodians. Thus, traditionally, in Islam, when a State gave land to its subjects, it gave only the right to use the land and not full ownership. However, men are enabled to act for the care of the property and nothing in Islamic law prohibits the use of this property to generate wealth and other capitalistic aims.
Today, these Islamic beliefs continue to guide legislative land codes in Arabic Muslim countries although some governments have adapted their land ownership schemes to have greater control over the country’s political economy and to encourage increased agricultural production.
As it relates to land, the Islamic belief that man serves God when he makes use of property translates into the judicial law that property can be acquired under Islamic law through developing and using land that has been unclaimed by anyone. Generally, under Islamic tenure systems, land is classified into four main categories: milik (individual ownership with full rights); miri (state-owned land to which individuals may gain use rights); waqaf (religious foundation owned land “stopped for God”); and musha (collective or tribal owned land).
Malaysia’s National Land Code (1965) (the Code) offers a clear example of how Islamist beliefs have been incorporated into secular legislative codes. For example, under the Code, the owner of land left idle beyond a certain period is considered to be in breach of an implied condition. If the owner does not develop the land after the authorities notify him of the breach, the government may institute proceedings to forfeit the owner’s rights to the land and may take back the land without recourse from the owner.
Islamic finance continues to grow as a prudent alternative to conventional debt-based structures. Financial assets globally total more than USD1.3 trillion and instruments are expanding into new countries beyond its traditional markets in the Middle East, Indonesia and Malaysia. At its core, Syariah 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 financing. This ranges from normal residential mortgages, to large scale financings such as Qatari “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 Eastern 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 tenure of the financing, the local tax laws, and may even be used alongside conventional financing. There is also the potential for more innovative techniques such as Syariah-compliant real estate investment trusts (REITs), as demonstrated by the success of Singapore’s Sabana REIT in 2010.
A key consideration for Syariahcompliant 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, Syariah scholars have generally accepted that Islamic financing can be used for multi-let properties where the threshold of non-permissible activities is below 5%.
Syariah concepts and commercial realestate investments are complementary as they both adopt a risk-sharing model.
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 nonpermissible 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 distribution to investors. However, unless the income from non-permissible activities is very low or negligible, the element of cleansing may deter the use of Syariahcompliant 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 ijara (or lease) structure which involves an initial sale and purchase of an ownership interest in property coupled with an undertaking by the obligor (equivalent to borrower) to purchase the property at the end of the tenure. 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 customers and 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 ijara.
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.
Once this increased focus gains momentum and any necessary legislative changes are implemented, we will most likely see exponential growth in this area [Syariah financing].
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 case and there have been a number of innovations. One of the more innovative structures used to date are Syariah-compliant REITs. While REITs have been a useful tool for realestate investment, Syariah-compliant REITs have been far less common. Yet the appetite for these products was clear from the success of the Sabana REITs’ listing on the Singapore Stock Exchange in 2010. This was the first Syariah-compliant REIT in Singapore and it attracted a large order book from the Middle East and Asia, making it the largest Syariahcompliant REIT at the time.
In Singapore, consideration could also be given to using a business trust. Syariah concepts and commercial realestate investments are complementary 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.
THE KEY METHODS FOR SYARIAH REAL ESTATE FINANCING
MURABAHA (COST PLUS FINANCING)
A murabaha contract comprises 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 murabaha is favoured for its simplicity and the financier’s profit margin can be set by reference to a benchmark such as the Singapore Interbank Benchmark Rate (SIBOR). In addition, the financier takes limited or no risk in the property.
The murabaha 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 murabaha is not favoured by Syariah 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 ijara 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. Unlike the murabaha structure, the ijara 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 Syariah 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 ijara 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 ijara techniques were used to raise USD134 million to partially fund the development of the Bahrain Financial Harbour.
DIMINISHING MUSHARAKA (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 Syariah perspective, as both the financier and the customer share in the risks of the construction of the property as well as any decline 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 musharaka 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.
*Information above comes from research & various sources.