Real estate finance--shari'ah-compliant transactions

Transcription

1 Page 1 Real estate finance--shari'ah-cmpliant transactins Prduced in partnership with K&L Gates LLP Real estate is an increasingly imprtant asset class fr Islamic-cmpliant transactins and banks in the UK. Islamic-cmpliant finance has prved t be an alternative surce f funds entering the UK real estate market as witnessed by such high-prfile Lndn real estate deals as the Chelsea Barracks and the Shard. Real estate as an asset class fr Islamic finance and hybrid structures Islamic finance uses real estate as an investible, tangible asset class n which t base its financial structures. Since 2010 there has been a ntable increase in the number f Islamic funds and Islamic banks prviding mezzanine finance fr real estate finance transactins. In such structures: a cnventinal senir bank lends the majrity f the debt n an interest payment basis the investrs inject their equity, and the mezzanine finance tranche is put int the structure in an Islamic-cmpliant way This type f hybrid structure is a way f accessing finance frm Islamic funds and Islamic banks. What is Islamic-cmpliant finance? Fr infrmatin n Islamic finance in a general cntext, see Practice Ntes: Key principles f Islamic finance and Surces f Shari'ah law. The principles f Islamic finance will influence all aspects f an Islamic-cmpliant real estate finance transactin r the frmatin f an Islamic investment fund, as well as every aspect f the peratin and cnduct f the underlying real estate business. Shari'ah cmpliance In many real estate finance transactins, nly ne party may be cncerned that the deal is Islamic-cmpliant. In that case, it is imprtant that each party represents t the ther that it is satisfied with the Islamic cmpliance frm its viewpint and will nt seek t use a later finding f nn-cmpliance as a reasn t renege n the transactin. The representatin is usually made in ne f the main deal dcuments and shuld apply t all ther dcuments and transactins between the parties. The rle f Shari'ah schlars Over the last few decades, the mechanism that has evlved t prvide cmfrt with respect t Shari'ah cmpliance is the Shari'ah supervisry bard (Shari'ah bard) f a financial institutin r investr. Shari'ah bards are ften cmprised f a grup f Islamic schlars. Frequently, they are cmprised f ne r mre f the leading 'internatinalist' schlars, sme reginal schlars, and sme lcal schlars. The schlars usually cnsider the underlying structure f the transactin and the main deal dcuments in rder t check that they cmply with their institutin's r investr's interpretatin f Shari'ah principles. Often they will issue an pinin r fatwa cnfirming cmpliance and that the transactin may prceed. Prhibited business activities Fr real estate finance transactins, it is imprtant t cnsider the activities f the tenants f the real estate which is being financed. This is because many large ffice buildings and cmplexes have tenants that engage in business activities that are nt Shari'ah-cmpliant, such as retail branches f cnventinal banks, restaurants that serve prk r alchl, r supermarkets r cnvenience stres that sell thse prducts. In the purest case, the entire building r cmplex wuld be an impermissible investment. Hwever, mst Shari'ah schlars have taken a pragmatic view. Rules have been develped that allw investment in these

2 Page 2 prperties fr certain impermissible uses. Fr example, if the branch bank serves a retail market, there are insufficient ther banking pprtunities in the defined area, and the branch bank ccupies a small percentage f the prperty (say, 1% r less), sme Shari'ah bards will permit the prperty acquisitin and allw renewal f the lease t that branch bank. The develpment f these rules which permit investment in a small number f impermissible tenancies greatly expands the types and amunts f prperties available fr investment thrugh Islamic finance. Islamic real estate finance structures The key Islamic-cmpliant finance structures used in real estate finance are: the lease structure (ijarah) the sale at a mark-up structure (particularly murabaha), and the jint venture structures (mudaraba and musharaka) Ijarah and murabaha are mst cmmnly encuntered. Ijarah (lease) structures A cmmn acquisitin and perating financing structure in Islamic real estate finance in Eurpe is the ijarah (lease). Fr infrmatin n ijarah in a general cntext, see Practice Nte: Structure and key features f an Ijarah transactin. Ijarah structure diagram The investment

3 Page 3 The investrs make their investment int the prject cmpany (Prject Cmpany). Fr tax reasns, this investment is usually made thrugh a fund and at least ne entity is usually inserted in the structure between that fund and the Prject Cmpany. Acquiring the prperty A special purpse vehicle, the funding cmpany (Funding Cmpany), is established t acquire and hld title t the prperty in which the Shari'ah-cmpliant investment is t be made. The Prject Cmpany cntributes its investment (eg 40% f the acquisitin price) t the Funding Cmpany. A cnventinal interest-bearing lan is made by the bank t the Funding Cmpany (eg equal t 60% f the acquisitin price). The Funding Cmpany then acquires the prperty frm the seller. (This example assumes 60% cnventinal interest-based financing and 40% cntributin by the Shari'ah-cmpliant investrs but these percentages will vary with each transactin.) The lease The Funding Cmpany, as lessr, enters int an ijarah with the Prject Cmpany, as lessee. The rent payable under the ijarah is identical t the debt service n the cnventinal lan frm the bank and prvides the funds t pay that debt service. The lease must be Shari'ah-cmpliant, including: the lessr must have wnership f the real estate prir t leasing it the lease perid must be specified the real estate asset must cntinue t exist thrughut the lease term, and the lessr must be respnsible fr maintaining and insuring the prperty--under Shari'ah principles, a lessr may nt pass structural maintenance bligatins r crrespnding bligatins such as the maintenance f buildings insurance t a lessee. This means that the typical fully repairing and insuring lease is prhibited Future rents cannt be accelerated under a Shari'ah-cmpliant lease. Given that the utstanding principal is paid thrugh the ijarah, an acceleratin mechanism is necessary utside the ijarah itself. The understanding t purchase (r purchase undertaking) perfrms that functin (it als mirrrs all mandatry prepayment prvisins f the bank lan). The bank, thrugh the Funding Cmpany, 'puts' the prperty t the Prject Cmpany at a strike price equal t the utstanding principal (and ther utstanding amunts). The Prject Cmpany may als want t sell the Prperty during the perid that the lan is utstanding. The understanding t sell (r sale undertaking) prvides the mechanism (and als mirrrs the vluntary prepayment prvisins f the bank lan). Maintenance and insurance Under Shari'ah rules, althugh a lessr cannt pass structural maintenance and insurance bligatins t a lessee, it can hire anther entity t perfrm thse functins. In this case, the Funding Cmpany hires the Prject Cmpany t perfrm thse activities pursuant t the managing cntractr agreement. Tax The tax matters agreement prvides that the Prject Cmpany is the tax wner f the prperty and fr incme tax (and ther) purpses, this is deemed t be a lan frm the bank t the Prject Cmpany. The tax matters agreement utlines the cmpnents as between the cnventinal lan dcumentatin and the Shari'ah-cmpliant leasing dcumentatin. Murabaha (sale at a mark-up) structures Murabaha is a widely used sales structure. Mst simply defined, it is a sale at a mark-up. The murabaha structure results in an entity btaining a cash amunt that it can then spend twards purchasing an asset such as real estate. In Eurpe, a number f prperty investrs have used this structure as a banking tl t prvide finance t investrs purchasing real estate assets.

4 Page 4 Fr infrmatin n murabaha in a general cntext, see Practice Ntes: Structure f a murabaha transactin and Structure f a cmmdities murabaha transactin. Murabaha structure In the simple murabaha, a custmer f a finance prvider wants t purchase a cmmdity, piece f equipment, r ther asset (the Cmmdity). The custmer negtiates the terms f the purchase, including payment terms and precise specificatins, with the third party vendr (the Cmmdity Seller). The custmer then asks the finance prvider t finance the purchase f the Cmmdity. The custmer and the finance prvider enter int a murabaha agreement pursuant t which the finance prvider agrees t supply t the custmer a Cmmdity meeting the precise specificatins that were negtiated with the Cmmdity Seller. The murabaha agreement will require the custmer t make payment t the finance prvider fr that Cmmdity n a deferred purchase basis. The finance prvider, in turn, will enter int a cmmdity purchase agreement with the Cmmdity Seller and will purchase the Cmmdity frm the Cmmdity Seller fr immediate payment in full. Upn accepting delivery f the Cmmdity, the finance prvider will fulfil its bligatins under the murabaha agreement by re-selling the Cmmdity t the custmer. The key rules are: the finance prvider must have wnership risk with respect t the Cmmdity, and the custmer can, under mst schls f Islamic jurisprudence, act as the agent fr the finance prvider in cmpleting the arrangements between the finance prvider and the Cmmdity Seller In a real estate cntext, sme banks (mst ntably UK and Irish banks) have ffered murabaha by taking ntinal pssessin f a prperty's title at clsing and then selling the prperty t the custmer at a higher price. If the bank des nt want t, r cannt, acquire title t the prperty fr regulatry reasns, then the bank appints a transacting party t act as its acquiring agent. The acquiring agent then executes the sale in favur f the ultimate custmer. Wrking capital murabaha (als knwn as cmmdities murabaha)

5 Page 5 The transactin is identical t the murabaha transactin with an additinal element in that the custmer, upn taking title t the Cmmdity (here a permissible metal), immediately sells that metal t the Metal Purchaser fr a cash payment at the same spt market price as btained in the finance prvider purchase f that metal frm the Metal Seller (fees ignred). Metals usually cnstitute the assets which are subject t a wrking capital murabaha transactin. Any number f cmmdities culd be used fr this purpse, but the Islamic finance industry utilises metals fr practical reasns. Gld cannt be used as the metal in such transactins as it is treated as a frm f mney. The Metal Purchaser and Metal Seller are frequently affiliates. The net result is that the custmer ends up with cash equal t the spt market price f the metal and a deferred murabaha payment bligatin t the finance prvider in respect f that amunt plus a prfit factr. The cash is then used by the custmer t purchase real estate. Mudaraba (service prvider--capital prvider) structures A mudaraba is a type f jint venture and is a key methd fr rganising and acquiring real estate investments. Fr infrmatin n mudaraba in a general cntext, see Practice Nte: Structure f a mudaraba transactin. A mudaraba is mst frequently frmulated as a limited partnership, a limited liability cmpany r a fund. The base structure invlves ne partner prviding services and management (the mudarib). One can equate a mudarib t a fund manager. In that case, the mudarib may sub-cntract its duties t an experienced real estate management prfessinal. Usually, the mudarib des nt prvide cash r ther in-kind capital. Sme Shari'ah bards prhibit mudarib capital; all prhibit it withut the cnsent f the ther partner(s). The ther partner(s) (the rabb ul-maal) prvides capital, in cash r in kind, and generally may nt interfere in the management r service cmpnent. A simple mudaraba arrangement with multiple capital prviders

6 Page 6 Using cnventinal limited partnership agreements with a mudaraba As a general matter, and with a few mdificatins, a cnventinal limited partnership agreement wrks well t structure a mudaraba. Fr example, while a capital prvider may nt interfere in the management functin, mst Shari'ah bards permit 'minrity rights' prtectins such as are affrded t limited partners, and ther rights are permissible in mudarib default, breach and infringement scenaris. Acquiring the real estate and sharing in prfits and lsses The partnership r fund then acquires real estate assets mst cmmnly thrugh ijarah r murabaha structures. Prfit in a mudaraba is that amunt that exceeds the capital after deductin f all allwable mudaraba expenses. Cnversely, lss is the decrease in the mudaraba capital. The critical Shari'ah rule pertaining t lsses is that all lsses are brne by the capital prvider (the service prvider has lst its services and is nt seen as having incurred pecuniary lsses). Prfit allcatins must be specified, and must be pr rata (althugh frmulas specifying different allcatins upn satisfactin f hurdles have been accepted). Imprtantly, there can be n predetermined r cnclusive prfit allcatin t any f the parties and arrangements allcating all prfit t a single party are impermissible. Mre difficult issues arise with respect t scenaris in which a clawback f distributins may be necessary, as with lsses subsequent t distributins. Musharaka (capital prvider) structures The term musharaka refers t a wide range f partnership r jint venture arrangements, eg: al-sharika is a partnership fr prfit sharikat ul-amwaal is a prperty partnership, and

7 Page 7 al-musharaka is a finance methd derived frm a partnership cntract in which a bank participates with ne r mre clients Fr infrmatin n musharaka in a general cntext, see Practice Nte: Structure f a musharaka transactin. In a musharaka real estate transactin each f the partners cntributes capital, and there is significantly greater flexibility in allcating management respnsibilities amng partners than with mudaraba; jint rights f management are frequent and usual. Limited partnership agreements are als useful mdels fr structuring musharaka arrangements. Prfit and lss definitins are mainly the same as with mudaraba, with sme fundamental differences: prfits may be allcated in accrdance with a pints system, and that pints system may be structured t take accunt f the amunt f capital cntributed and the perid f participatin prfit frm a specific perid in relatin t the prperty may nt be allcated t a specified partner, nr may a lump sum be allcated t a specific partner in the majrity view, lsses, up t the amunt f a partner's capital cntributin, must be distributed in accrdance with the relative capital cntributins f the partners a partner may nt assume liability fr the capital f anther partner, including by way f guarantee