Islamic real estate finance: key terminology

Many high-profile real estate transactions in the UK involve inward investment, and so it should be no surprise that Islamic finance has been successfully used to finance real estate assets in the UK for decades. Despite this, Islamic finance is still considered a niche area by real estate professionals. Yet, as Islamic investors continue to focus on the UK market, it is set to become more prevalent. It is worth noting that Islamic finance may also appeal to those who do not subscribe to the Islamic faith, especially if the financial products are priced competitively, as some of the principles which are explored further below are also found in other faiths and cultures. This is the first in a series of articles which aim to provide an overview of some key concepts and terminology to help demystify this area of financing for commercial real estate professionals. What is meant by Islamic finance Islamic finance is a form of financing based on the principles of Islamic law. It differs from conventional finance in multiple ways (it is not just a prohibition on the receipt and payment of interest, although this is probably its most commonly known feature) but the ultimate purpose is usually the same – to provide a customer with funds that can be used to further its legitimate commercial activities. What is Shari’ah-compliant? Shari’ah (which literally means “the way”) is the body of Islamic law which sets out rules, principles and standards which govern every aspect of a Muslim’s life, including economic and commercial activity. There are two primary sources: The Qur’an The sacred book Muslims believe records the word of God, as revealed to the Prophet Muhammad; and The Hadith The body of documents Muslims believe records the Sunnah (the practice) of the Prophet Muhammad. Practising Muslims will refer to these sources to ensure that their activities are halal (permissible). However, as with many theological and legal principles, there may not always be a consistent interpretation. There are some parts of Shari’ah that are quite specific, but others are of wider application and so may require further interpretation. How is compliance with Shari’ah established? English qualified lawyers do not opine on Shari’ah compliance. The transaction will instead need to be blessed by a Shari’ah scholar. As a result, financial institutions involved in Islamic finance may appoint scholars to form a supervisory board tasked to consider and advise on the acceptability of transactions from a Shari’ah compliance perspective. Such an advisory board is often expected to advise on compliance at the outset of a transaction as well as ongoing, holistic compliance for that institution. A Shari’ah scholar will either use: Shari’ah Qiyas (ruling by analogy) to deal with cases where a precedent exists; or Ijtihad (derivation of law through personal reasoning) to deal with cases where Qiyas is not deemed possible. If the scholar is satisfied that the structure of a transaction and the documentation proposed are acceptable, a fatwa may be issued (being a pronouncement by a Shari’ah scholar). This has greater weight if there is a consensus (ijma’a) among several scholars, which is why a supervisory board is typically formed. What are the core principles? The following principles are particularly relevant in determining whether the proposed transaction will be acceptable: No assured profit An Islamic financier must assume at least some of the risk in the project in which the financier invests. Indeed, it is the sharing of profit, loss and risk which many consider to be the key differentiating feature from conventional financing. However, taking security over assets is permitted in order to guard against negligence, wilful wrongdoing or breach of contract by parties to the contract. No unfair gain Riba is a prohibition on usury or unjust enrichment, which includes the prohibition against the charging of interest. No uncertainty Gharar is a prohibition on uncertainty (there is a similar principle in English law which does not extend as far). When entering into a contractual relationship which is Shari’ah-compliant there must be full disclosure by both parties, and all the fundamental terms (such as the subject matter, term and price of a contract) should be fixed at the outset. No speculation Maisir is a prohibition on transactions that rely on chance, speculation or gambling rather than human effort to obtain a financial return. However, this does not prevent ordinary commercial risk-taking. Unethical investment Investment must be Shari’ah-compliant in essence. Therefore, transactions which involve certain products are prohibited, including alcohol, armaments and pork, as well as activities such as gambling, entertainment and hotels. This may lead to difficulties with certain investments such as portfolio acquisitions or mixed-use assets. Community benefit Hoarding money is strongly condemned, according to the Qur’an, and investments which result in a benefit to the community are encouraged. This makes certain assets more favourable to Islamic investors and financiers, such as infrastructure projects and residential schemes. What are the principal contracts used in Islamic transactions? There are many different contractual structures that may be used, and acceptable commercial contracts and legal relationships have developed over time. The most common are briefly introduced below. Murabaha This is a form of cost-plus financing. The property is initially acquired by the financier and is immediately sold to the purchaser for the original cost plus a profit (although the price payable is generally deferred). This structure works well for acquisitions of property. The commodity murabaha is a widely used version of the murabaha structure which allows the financier to provide longer-term financing without acquiring the asset which is the subject of the financing. Ijara This is based on a leasing agreement in which the lessee pays the lessor a rental fee to use an asset for a prescribed period of time, sometimes with an option to purchase the asset. This is similar to shared ownership schemes. Mudaraba This is a form of trust financing which is typically used to enable syndication. Diminishing musharaka This is a form of diminishing joint ownership (similar to a trust) and can be used for both acquisition and construction finance. It is particularly attractive to Islamic investors as it is based on the fundamental principle of sharing risk. Istisna’a This form of contract requires the manufacture or construction of an asset in accordance with specified terms and includes an obligation to deliver the asset on completion. This may be combined with the ijara structure. It is well-suited to property development transactions, but in practice the commodity murabaha structure is used more frequently in the UK. Hybrid structures It is also possible to structure Islamic equity investment with conventional debt financing. However, this does require careful structuring to ensure it works as intended for all parties. What is the governing law of the transaction? It is usual for the documents to be governed by English law (and if there are overseas elements in respect of companies involved, there may also be documents governed by such local law, as is the case for conventional financing). It is also typical for the finance documents to contain a confirmatory statement or warranty that both parties have reviewed and assessed that the transaction is in accordance with Shari’ah principles and that neither party will raise an objection as to a matter of Shari’ah compliance. Following Beximco Pharmaceuticals Ltd and others v Shamil Bank of Bahrain [2004] EWCA Civ 19, if a Shari’ah supervisory board has approved the documents, the English courts will simply look to the agreed contractual provisions and enforce these in accordance with English law. Therefore, a fatwa from a board of Shari’ah scholars is helpful to protect against suggestions that a transaction or financial product is not Shari’ah-compliant. Juliette Kelly is a senior associate at Norton Rose Fulbright LLP Photo © Anne Nygård/Unsplash