Introduction to Islamic property finance & investment

Islamic property finance is becoming increasingly mainstream. The purpose of this note is to equip property and finance lawyers with a good basic understanding of the principles and practicalities involved in Islamic financing and investment, in the context of UK real estate transactions.

Basic principles

All forms of Islamic financing, including Islamic property finance, require an understanding of the foundations of Islamic law (Sharia).

The two primary sources of Sharia are: (i) the Quran; and (ii) the traditions and sayings of the Prophet Muhammed, the Sunna. Sharia deals not only with matters of ritual worship, but also extends to every aspect of a Muslim's life, including business, commerce, and property transactions. Therefore a Muslim's ability to participate proactively in commercial and personal financial transactions can be affected as Sharia sets down a number of prohibitions which require parties to a transaction to be just, fair, and ethical in their dealings.

A well-known prohibition under Sharia is that against usury (riba). By forbidding the unjust exploitation of another and prohibiting the charging or receiving of interest, this prohibition has traditionally resulted in Muslims having to make the decision whether to subscribe to standard UK banking products at the expense of their beliefs or, alternatively, refrain from taking any loans. It is therefore clear from the outset that this prohibition, along with various other Sharia stipulations such as the prohibition on making profit from speculation and the requirement for certainty, are particularly relevant to the structuring of Islamic finance products.

Structuring of Islamic property finance transactions

The ideal business transaction under Sharia is one based on partnership (Musharakah), where each party shares in the risks and rewards of a venture, and most Islamic finance products have an element of this spirit.

This spirit can be found in Islamic property finance transaction structures as well. There are many and various ways to structure an Islamic property finance transaction, but the most common of these are Murabaha, commodity Murabaha, Ijarah and diminishing Musharakah, and Istisna.

Murabaha

Murabaha (also known as cost-plus financing) is a mechanism whereby an asset is purchased by the bank and then immediately sold to the buyer on a deferred payment basis.

In a property scenario, the bank buys the property from the seller for, say, £500,000 and then immediately sells it to the buyer for an increased purchase price of, say, £600,000. The bank and the buyer agree to a fixed-term instalment arrangement for the payment of the increased purchase price. A legal charge over the property in favour of the bank secures the payments.

The maximum repayment term for this structure tends to be limited as the payment amounts are completely fixed throughout the repayment term. The effect of this is similar to a fixed-rate mortgage.

It should be noted that Murabaha can only be used for a purchase and not a refinance.

Commodity Murabaha

An alternative structure, which tends to be less favoured by Sharia scholars but is commonly used by banks in practice, is known as commodity Murabaha. This involves trading a commodity to create a debt which can then be secured on a property. This scheme is very flexible, in that it can be used for a purchase or re-finance or even for unsecured financing.  A variable rate can be achieved by conducting multiple trades.

In a scenario where an Islamic investor wants £1m to buy or refinance a property worth £1.3m, the commodity Murabaha works as follows. On the day of completion, the bank will either be holding or will acquire £1m worth of non-precious metal (or any other commodity). This metal will be sold to the investor for say £1.2m, payable by fixed monthly instalments over a period of say 10 years. On the same day, the investor will sell the metal to a broker for £1m in cash. The bank would secure the investor's payment obligations by taking a legal charge over the property.

A step-by-step guide to the commodity Murabaha transaction can be found below:

Commodity flow

Ijarah and diminishing Musharakah

Ijarah, which is widely used in the UK residential property market, is an alternative and flexible mechanism that has great potential in the private rented sector.

In this case, the bank buys the property from the seller, but instead of selling it on to the buyer, the bank grants a lease to the buyer for a certain term. At the same time as granting the lease, the bank promises to transfer the property to the buyer at the end of the term of the lease. The buyer then makes payments to the bank during the term of the lease, which comprise of both rental payments and capital contributions.

The bank is required to own the property in order to have a right to receive rental payments. This must be ownership in substance, not just prima facie. This means that the bank must assume the risk for the property, including responsibility for major repairs. This risk can be balanced by the bank ensuring adequate insurance or the Islamic equivalent, takaful, is in place. It would rarely be practicable for the bank to arrange for repairs, so responsibility for these can be delegated to the buyer or another agent appointed by the bank.

To increase Sharia compliance in this type of structure, the bank should transfer a beneficial share in the property to the buyer as each capital contribution is paid. This arrangement is known as diminishing Musharakah. The word Musharakah means partnership, referring to the partnership in ownership between the buyer and bank. The bank's share in this case diminishes over time as ownership of the asset moves incrementally to the buyer.

Ijarah and diminishing Musharakah can be used for a refinance, as well as a purchase, and the rental payments can (within limitations) be variable. An Ijarah refinance transaction works in a very similar way to a sale and leaseback, in that the bank buys the property from the customer and then lets it back.

Although the net effect of these arrangements does not appear to be very different from the that of repayment of conventional mortgages, the crucial difference is that, under the Ijarah or diminishing Musharakah structure, the buyer is paying rent for the share of the property owned by the bank, and is not paying for money (that is, interest).

Istisna

The Istisna contract is a purchase contract for future delivery of an asset to be built or constructed in accordance with an agreed specification and so can be used for property development. In essence, the bank will first of all enter into a development agreement with the developer and then a back-to-back development agreement with the customer, charging a profit element and allowing for deferred payment. This is often linked to an ijarah arrangement, when the property is constructed and occupied. In practice, we find that the commodity Murabaha structure is used much more frequently than Istisna for UK property development transactions.

Structuring with conventional borrowing

Sharia compliant property investments often use conventional bank financing or contain conventional institutional investment. This is achieved by separating a non-Islamic 'funding company' from the Islamic 'project company'. So long as the relationship between the project company and funding company is governed by a Sharia document (typically a commodity Murabaha agreement, an Ijarah lease, or Musharakah joint venture agreement), the Sharia scholars and Islamic investors are usually satisfied. 

Tax considerations

As all of the structures above involve multiple transactions, they can potentially give rise to multiple tax charges. In an attempt to create a level playing field, the Finance Act 2003 (and subsequent Finance Acts) addressed most of the problems created by this issue, by allowing, for example, these transactions to be treated for stamp duty land tax purposes as if they were a simple purchase (or refinance).

However, there are always other tax issues that need to be carefully considered in each case, including income tax treatment, capital allowances, withholding tax and VAT. It is therefore advisable to seek specialist tax advice.

Islamic property investment

It is important to be aware that Sharia considerations do not only affect the property financing transaction itself, but also the asset selection decision and the on-going management of the property.

Prohibited uses

Under Sharia certain types of uses involving alcohol, pornography, gambling and conventional financial services etc are not be permitted. These uses should be completely avoided, but it is generally accepted however that a small proportion of these activities might be tolerated as part of a large property fund. 

Ideally, the occupational leases should include controls for the landlord to be able to restrict changes of use or alienation which may result in the property being used for any of these prohibited activities.  In the event of there being a change of use to a prohibited use which the landlord is unable to prevent, it may be that the asset manager should seek to dispose of the property. 

Insurance / repairs

Under traditional Ijarah principles, it is the landlord who should be responsible for major repair items at the property. This is not likely to be an issue when you have internal demises as the landlord would normally maintain the structure and reclaim any expenditure through a service charge. 

When a whole building is demised to a tenant, it is often accepted by Sharia scholars that it is sufficient for the landlord just to retain the obligation to insure the property and it is even satisfactory for the cost of doing so to be passed back to the tenant.

However, one of the basic contractual principles of Sharia is that there should not be uncertainty in contracts and it is generally accepted that a conventional insurance contract falls foul of this particular rule. The Islamic alternative is a concept known as takaful which is based on a mutual fund principle. 

Interest penalties

Ideally, under Sharia there should be no reference to any interest being payable under any of the occupational leases. It is usual for an institutional lease to require a tenant to pay interest in the event of late payment of rent or other sums due under the lease. Under Sharia, the landlord should only be able to recover any actual losses incurred by the delayed payment, but may impose fixed penalties on the tenant to be paid to a charity.

However, in the context of acquiring and managing investment properties, it is generally accepted that while the presence of interest clauses do not invalidate the whole transaction, care will need to be taken if charging interest becomes necessary. Any interest collected should be donated to charity.

English law & Sharia

When getting into the detail of reviewing any Islamic financing documentation it helps to have a basic understanding of Sharia.

Transaction documents will often contain contractual provisions which can vary significantly from those expected under traditional financing arrangements. Elements such as discounts in the event of early payment, default interest payments, and arrangement / exit fees can work very differently (or be completely excluded) under Sharia compliant documentation, due to the prohibitions described at the outset of this Practice Note.

There will also be a number of unusual clauses in the documentation around Sharia compliance which will not be found in traditional finance documentation. For example, there may be clauses imposing an obligation on the customer to ensure for itself that the documentation is Sharia compliant. There may also be other clauses that prohibit the customer from challenging the documentation on the grounds of Sharia compliance as a means of guaranteeing that the customer cannot use Sharia as an excuse to get out of any of its contractual obligations.

Despite the obvious differences, English law and Sharia are in many ways very similar so it is not surprising that English law is the governing law choice for most Islamic finance transactions locally and globally.  It is for the Sharia scholars and transaction lawyers to ensure that the documents are drafted in accordance with Sharia.  The English courts can then, if called upon to do so, simply enforce the agreed contractual provisions.

Reproduced with the kind permission of LexisNexis.

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