Real Estate Financing and Sukuk

1. Real Estate Financing and Sukuk Mian Muhammad Nazir Senior Vice President Dubai Islamic Bank PJSC

2. Real Estate Financing and Sukuk • Overview • Commonly used modes in Real Estate Financing • Murabaha – ready property • Ijara – ready property • Forward Ijara – under construction property • Istisna – under construction property • Mudaraba • Agency – Wakala • Musharaka • Sukuk

3. Real Estate Financing and Sukuk • Sharia offers various structures for Real Estate Financing based on the requirements of the respective parties • Each Sharia compliant mode of financing distinctly exemplifies the essential feature of ownership and risk • Growth witnessing assets exceeding $1.7 trillion and expected to reach $2.7 trillion by 2010. • In year 2007, 76% of corporations’ non-loan fundings were Sharia compliant in the MENA region. • 2008 shows slow growth due to credit crunch. 3

4. Real Estate Financing and Sukuk Commonly Used Modes • Murabaha • (ready property) 4

5. Customer Step 5 Sale of Property to Customer on Murabaha basis Title and Possession to the Property Owner/Developer Step 1 Promise to Purchase Step 3 Purchase of Property through purchase agreement Step 6 Sale Price Deferred Step 4 Purchase Price Step 2 Purchase Offer Title & Possession to the Property Islamic Bank Real Estate Financing and Sukuk • Murabaha • (Only in case of ready property) • Step by Step 5

6. Real Estate Financing and Sukuk • Murabaha • Murabaha is widely used mode of finance in Islamic Finance Industry in general and for Real Estate Financing in particular. • However, it can only be used for: • ready property; • for a shorter financing tenor for the reason of fixed return • Involves less risks as it creates debt obligation on the customer – No ownership risk. 6

7. Real Estate Financing and Sukuk • Murabaha • The Bank buys the Property and sells it to the customer on Murabaha (cost + profit) basis. • Murabaha sale price is paid normally on a deferred basis. • Liability is known from day one – No surprises or uncertain exposure. 7

8. Real Estate Financing and Sukuk • Ijara • ready property 8

9. Customer Step 5 Lease of the Property to the customer through Lease Agreement Usufruct of the Property Owner / Developer Step 1 Promise to lease Step 3 Acquisition of the Property through purchase agreement Step 6 Lease Rental Step 4 Purchase Price Step 2 Purchase Offer Title & Possession to the Property Islamic Bank Real Estate Financing and Sukuk • Purchase and Ijara • ready property • Step by Step 9

10. Real Estate Financing and Sukuk • Ijara • Ijara is less risky as compared to other financing structures • Strict compliance with Sharia and the applicable law is required for enforceability. • Best suited for Islamic Financial Institutions – conventional institutions may have some regulatory problems in Ijara • It is generally perceived that notwithstanding Sharia requirements, the documentation should be in accordance with the applicable law which is not free from risk from Sharia compliance perspective. 10

11. Real Estate Financing and Sukuk • Ijara • Liability is known from day one – No surprises or uncertain exposure. • Unlike conventional finance, Sharia has a special treatment to issues such as increased cost, mandatory cost, asset ownership, taxes, major maintenance, asset insurance and remedies in the event of total or partial loss. 11

12. Real Estate Financing and Sukuk • Ijara • Ijara structure involves purchasing an asset from the customer or a third party and leasing the same to the customer. • Care needs to be taken in order to ensure that the transaction does not become a conditional sale or a contract of Inah. • Sharia requires extraordinary caution in putting together a rental framework for a lease transaction which involves a variable element of rental 12

13. Real Estate Financing and Sukuk • Ijara • Ijara: Two types • Ijara Muntahia Bittamleek (Finance lease) • Operating Lease • In Ijara Muntahia Bitammaleek, transfer of ownership at the expiry of lease term must be through a unilateral undertaking to be exercised at the expiry of the lease term and the transfer should either take the form of sale at nominal price or gift. • Appropriate structure for all purpose financing needs 13

14. Real Estate Financing and Sukuk • Forward Ijara • under construction property 14

15. Customer Step 5 Lease of Property on the basis of Forward Ijara Delivery of Leased Property to Customer at completion Owner / Developer Step 1 Promise to Lease on Forward Ijara basis Step 3 Purchase of the described Property through Istisna Agreement Step 4 Istisna Purchase Price Step 6 Lease Rental Step 2 Purchase Offer Delivery of the described Property after completion Islamic Bank Real Estate Financing and Sukuk • Forward Ijara • for under construction property • Step by Step 15

16. Real Estate Financing and Sukuk • Ijara Mousoofa Fizzimma (Lease of specified item(s) which are to be delivered after manufacturing or construction) • Ijara in respect of an asset under construction takes the form of Ijara Mousoofa Fizzimma. • Lease of the underlying assets starts on the date of delivery of the asset to the lessee and the lessee’s obligation to pay rental triggers with the commencement of the lease. • An investor receives return on its investment out of the amount received from the lessee on account of rental which is adjusted against the actual rental. 16

17. Real Estate Financing and Sukuk • Ijara Mousoofa Fizzimma • Although investment in assets under construction through Ijara Mousoofa Fizzimma may not be free from certain downsides, it still has potential to serve both the parties, i.e. customer and financier – addressing the Project Financing requirements. • Appropriate structure for project financing. Example: • QREIC Sukuk (Qatar) 17

18. Real Estate Financing and Sukuk • Istisna • under construction property 18

19. Customer Step 5 Sale of the described Property on Parallel Istisna basis Delivery to the Customer after at completion Owner / Developer Step 1 Promise to Purchase on Parallel Istisna basis Step 3 Purchase of the described Property through Istisna Agreement Step 4 Istisna Purchase Price Step 6 Parallel Istisna Purchase Price Step 2 Purchase Offer Delivery of the described Property after completion Islamic Bank Real Estate Financing and Sukuk • Istisna • for under construction property • Step by Step 19

20. Real Estate Financing and Sukuk • Istisna • In Istisna sale, the seller sells a described property to be delivered to the purchaser once the same is completed. • Istisna requires combination of either lease of the purchased assets back to the seller or sale of the purchased assets to the customer, provided that the purchase is not from the same customer. • Used in QREIC Sukuk involving purchase of the described assets by sukuk-holders and leasing back to the Seller. 20

21. Real Estate Financing and Sukuk • Mudaraba 21

22. Islamic Bank (Rab Al Mal) Mudaraba Agreement Project Step 1 Business Plan Rab al Mal’s Share Step 3 Joint Capital (after commingling of Mudaraba Capital with Net Assets Of Mudarib if any) Step 6 Mudaraba Capital Mudarib Profit Developer (Mudarib) Net Profit Mudarib’s Share Mudaraba Profit Real Estate Financing and Sukuk • Mudaraba • Step by Step 22

23. Real Estate Financing and Sukuk • Mudaraba • Mudaraba is a very flexible real estate financing structure. • Mudaraba can be of two types: • Project basis – no need for Sharia compliance of financial ratio, however, underlying activities must be Sharia compliant. • Unrestricted Mudaraba on commingling basis which requires Sharia compliance of the customers’ business activities as well as the financial ratio. • Mudaraba operates on trust which means a partnership in profit. • The Mudaraba capital can be cash and/or tangible assets. 23

24. Real Estate Financing and Sukuk • Mudaraba • Mudaraba financing is an investment, therefore, it requires an investment plan. • Mudarib’s performance is assessed on the basis of the Investment Plan it has provided to the financier in order to obtain financing. • In 2007, Mudaraba was considered to be a preferable financing structure because it does not involve sale of the assets. (Example: DIFC Sukuk) • However, recent discussions amongst Sharia scholars on redemption through purchase undertaking resulted in reduction of the use of Mudaraba structure. 24

25. Real Estate Financing and Sukuk • Agency 25

26. Islamic Bank (Principal) Agency Agreement Project Agency Fee Step 1 Investment Plan Step 3 Investment Amount Step 6 Investment Amount Incentive Developer (Agent) Profit Real Estate Financing and Sukuk • Agency • Step by Step 26

27. Real Estate Financing and Sukuk • Agency (Wakala) • Investment agency structure for real estate financing is another flexible structure. • It operates on the principal similar to Mudaraba except the Profit distribution. • However, this structure is less used in real estate financing due to certain academic discussions amongst the Sharia scholars. 27

28. Real Estate Financing and Sukuk • Musharaka 28

29. Real Estate Financing and Sukuk • Musharaka (two structures) • Sharikatul Aqd (Contractual Partnership) • Musharaka Mutanaqisa (Diminishing Musharaka) • Normal Musharaka (Example: JAFZA Sukuk) • Sharikatul Milk (Co-ownership). • Volcano Sukuk, DIB Sukuk, and EIB Sukuk 29

30. Purchase of Units in Musharaka Purchase Undertaking Islamic Bank Customer / Developer Contribution Cash Contribution Cash + Kind Musharaka Agreement Profit + Incentive Profit Musharaka Entity Profit Investment Project Real Estate Financing and Sukuk • Musharaka Mutanaqisa • Step by Step 30

31. Lease of Bank’s Share Lease Rental Islamic Bank Customer / Developer Contribution Cash Contribution Cash + Kind Musharaka Agreement Profit + Incentive Profit Musharaka Entity Profit Investment Project Real Estate Financing and Sukuk • Musharaka – Bank leases its share in Musharaka to the Customer • Step by Step 31

32. Periodic Purchase of Undivided Share Purchase Undertaking Islamic Bank Customer / Developer Contribution Cash Contribution Cash Musharaka Agreement Lease Rental Lease Rental Purchase Price Ready Property Real Estate Financing and Sukuk • Musharaka – Sharikatul Milk (Ready Property) • Step by Step 32

33. Real Estate Financing and Sukuk • Sukuk (Islamic Bonds) 33

34. Real Estate Financing and Sukuk • Sukuk (Islamic Bonds) • Sukuk certificates represent ownership in the underlying assets, usufruct and services or the assets of particular projects or investment activities. • The ownership must be real, not beneficial, i.e. economic benefits or entitlements. (AAOIFI’s resolution). • Provides viable alternative to conventional bonds and securities. • Receivables cannot be underlying assets for Sukuk. 34

35. Real Estate Financing and Sukuk • Sukuk (Islamic Bonds) • Global Sukuk issuance reaches $109 billion. • Indicating impressive growth in MENA region. Global Local Currency and Dollar Sukuk Issued by Country (2007) MENA Bond issuance Sukuk vs. Conventional Bonds 35

36. Real Estate Financing and Sukuk • Sukuk (Islamic Bonds) • Sukuks are issued on any of the foregoing Sharia contracts. • For real estate, Sukuk can be issued using any of the Sharia contracts for the following: • (i) the development of a particular real estate project; or • (ii) the working capital or the construction cost 36

37. Real Estate Financing and Sukuk • Sukuk (Islamic Bonds) • Choosing a structure for a Sukuk depends on the following: • Purpose for which the money is required; • Assets which will be used to raise money; • Income stream and payment; and • Tenor • Using a right structure in view of the transaction requirements is a real Sharia issue. • Examples: Al Dar, Nakheel, Tamweel, PCFC and DCA. 37

38. Real Estate Financing and Sukuk • Sukuk (Islamic Bonds) • Sukuk are more economical than conventional financing • Investor gets comfort from the fact that, being a public transaction, the structure, commercial issues and documentation may have gone through the eyes of experts (including Sharia scholars) • Tradability of Sukuk depends on the assets’ ownership and the Sharia structures on which they are based. • Most of the Sukuk structures are tradable. 38

39. Real Estate Financing and Sukuk • Sukuk (Islamic Bonds) • Increase in volume and popularity throughout the world would definitely make the Sukuk a better alternative for Project Financing. • However, in order to make Sukuk less expensive and preferable financing choice, standardization and regulation at local and industry level is very much required. • Sukuk is also suitable for closely held family real estate development businesses. • In view of the recent academic controversies, new structures such as Sharika tul Milk, Asset Purchase and Lease Back, have become increasingly popular. 39

40. Thank You