Alternative Real Estate Finance - The Potential of Islamic Finance Azadeh Farhoush Prof. Ali Parsa ERES 2012

Structure of Presentation Contextual background The need for an alternative model of financing in the post 2007/8 international banking crisis and the current European Union economic depression The increasing diversity of sources of finance (Asia and the Middle East) Importance of Middle Eastern Investors Application of Islamic finance to real estate investment and development Conclusion ERES 2012

Contextual Background Global financial crisis starting 2007, Euro crisis and the Arab spring have created uncertainty Collapse of Lehman Brothers in the US and other banks in the UK and Europe Massive bailout of conventional banking and finance institutions by governments in the US and Europe Increasing scrutiny of conventional methods of finance and investment (security of investment) Transparency and ethical issues related to conventional methods of finance and investment ERES 2012

Contextual Background Global market forces have a strong impact on real estate investment Diminishing sources of finance for urban development Need for alternative methods of financing real estate development and investment Emergence of Islamic finance as a global alternative to real estate finance and investment ERES 2012

Key Principles of Islamic Finance Prohibition against making profit without any risk Prohibition of generation of surplus money through investment of money Prohibition of speculation and uncertainty (maysir, gharar) Avoidance of business with forbidden branches (haram) Support of investment to avoid hoarding Transparency and sanctity of contracts ERES 2012

Growth of Islamic Finance There is disparity about the actual size of Islamic finance, however, it is universally agreed that there has been substantial growth in recent years. In 2011 about 348 financial institutions with Islam compliant activity were recorded (Source: The Banker) Global Mutual Fund Industry: $25.6 trillion AuM/Q12011 Global Islamic Fund Industry: $58bn AuM/2010 (Source: Ernst & Young Islamic Funds & Investment Report 2011) ERES 2012

Growth of Islamic Finance According to Zawya Research (2012) there has been substantial increase in the issuance of SUKUKs 2011 was the best year on record in terms of Sukuk issuance, with $79.5bn issued in the first 11 months of the year. The global Sukuk market reached a record level of around $180bn. Many countries are opening up Islamic banking on their territories – a trend that is expected to intensify in the short to medium term. ERES 2012

Potential of Islamic Finance “This is not to say that sharia-compliant banks have been not affected by the financial turmoil of Western markets. Islamic institutions in the Middle East with exposures in real estate have experienced difficulties as property values experienced corrections in various domestic markets. However, as Western markets continue a cycle of risk avoidance and investor pessimism, sharia-compliant bankers are seeing new opportunities for the development of Islamic funds and other financial instruments that have been lacking behind conventional banks. Islamic investors are seeking new investments, asset classes and mechanisms for greater risk diversification.” Source: Joseph DiVanna (2011, 1 November). Islamic Finance Roars Again. Retrieved from http://www.thebanker.com/ According to World Islamic Banking Competitiveness Report 2011-12 of Ernst & Young It is expected that Islamic financial assets reach $990bn by 2015. ERES 2012

Investment Target: Europe Despite the short term uncertainty about real estate markets international investors have continued cross border activity in real estate European cities: Still popular investment targets In Europe: 65% ($6.5bn) of total investment were cross-border investments in 2011 London: Most active city globally in 2011 Increasing importance of Middle Eastern investors outside the Middle East (Source: JLL, 2012) -total cross border investment for 2011 of almost $125 billion (31% of total investments), a 47% increase on 2010 and a firm indication that investors are prepared to increasingly look outside their own countries for suitable opportunities when macro circumstances allow. - MEI also sell - Offices most important, hotels increasing - Reasons: to gain influence, political goodwill and global recognition ERES 2012

Middle Eastern Investment activity Prefer mature, developed markets: The UK, the US and France top 3 $4.4bn cross-border transactions 2011 $3.8bn just invested in Europe (Source: JLL, 2012) $2.5bn invested in the UK (Source: Saudi Gazette, 2012) ERES 2012

Sharia Compliant Real Estate Finance Modern IF about 40 years old  limited research It is not allowed to invest in Pork products Pornography Financial services (conventional) Arms or munitions Tobacco Gambling Alcoholic liquor Careful and detailed analysis has to be done before an investment decision, a lease out etc. Investments in retail and commercial spaces (eg no casinos) or hotels (usually sell alcohol) have to be analysed carefully Retail: no lease of space to businesses who deal in non-permissible products Commercial/office: not to conventional financial services as well as advertising and media ERES 2012

Basic Instruments of Islamic Finance   Profit-and-Loss-Sharing-Instruments Non-Profit-and-Loss-Sharing-Instruments Musharakah Profit and Loss Sharing Agreement Qard al-Hasanah Beneficial Loan Mudarabah Profit Sharing Agreement Murabaha Cost Plus Financing Sukuk Islamic Bond Ijarah Leasing PLS: equity financing methods  Islamic banks tend to act more as partners in a venture rather than as passive lenders. - Equity financing are used less often than debt financing. This is due to a number of reasons including: (1) Equity financing is not suitable for short-term projects as a result of high risk. Therefore, to ensure liquidity, Islamic banks tend to engage in debt-like financing (mark-up). (2) Agency problems arise in partnership financing; this is because entrepreneurs have an incentive to report lower profits and a disincentive to being productive in comparison to a self-financed entrepreneur. (3) Islamic banks tend to offer debt-like financing which is less risky than partnership financing, so as to remain competitive with conventional banks and other finance institutions. (4) Profits are taxed, whilst interest payments are treated as costs, with partnership financing, there is an incentive to avoid tax by declaring lower profits to pay less tax, hence this make partnership financing less rewarding for Islamic banks. SUKUK: The Sukuk in recent years is a very popular Islamic instrument for the financing of real estate development and investment. Sukuk are Islamic bonds which are traded on capital markets. Sukuk are asset-backed and the bonds are backed by a profit-sharing arrangement, a loan or sale-leaseback arrangement. Investors own a part of the underlying asset and the asset serves as collateral for debt repayments ERES 2012

Application of Sharia finance to real estate: SUKUK “Islamic Bond“ Represents ownership of an identifiable and Sharia compliant asset Combinations with other instruments are common The market is becoming increasingly important: Growth from $8bn in 2003 to $45bn in 2010 (Source: Karimzadeh, 2012) Has become popular for real estate finance Investments in retail and commercial spaces (eg no casinos) or hotels (usually sell alcohol) have to be analysed carefully Retail: no lease of space to businesses who deal in non-permissible products Commercial/office: not to conventional financial services as well as advertising and media ERES 2012

Sukuk al-Ijarah (I) Obligor (Seller) Sukuk Holder SPV (Lessor) sells assets emits sukuk certificates Sukuk certificate passes proceeds periodic payments lease back 1 2 3 4 proceeds 5 Ijarah contract 6 distributes periodic payments 7 Obligor (Lessee) 8 sells back at maturity 1. The obligator sells certain assets to the SPV at an agreed pre-determined purchase price. 2. The SPV raises financing by issuing Sukuk certificates in an amount equal to the purchase price. 3. & 4. This is passed on to the obligator (as seller). 5. A lease agreement is signed between SPV and the obligator for a fixed period of time, where the obligator leases back the assets as lessee. 6. SPV receives periodic rentals from the obligator; 7. These are distributed among the investors i.e. the Sukuk holders. 8. At maturity, or on a dissolution event, the SPV sells the assets back to the seller at a predetermined value. That value should be equal to any amounts still owed under the terms of the Ijara Sukuk, and redemption of the certificates (Dar Al Istithmar, 2006) ERES 2012

Application of Sharia finance to real estate: SUKUK In 2006, Nakheel Group, real estate developers in Dubai launched a $2.5bn Sukuk bond for the financing of real estate developments In August 2006, Qatar real estate investment company issued a Sukuk worth $270m, the deal was structured by Standard Chartered Bank (2006) (Source: Ibrahim, Ong & Akinsomi, 2012) ERES 2012

Application of Sharia finance to real estate: I-REITs I-REITs funds invest in listed real estate securities that own or operate with real estate compliant to the Sharia Guidelines for I-REITs set by the Shariah advisory council of the Securities Commission in Malaysia in 2005: Investments in real estate with non-permissible activity accepted, but must be < 20% Rental income out of non-permissible activity accepted, but must be < 20% of total turnover.  Consequently, transparency is very important as it must be clear and calculable where the income comes from ERES 2012

Application of Sharia finance to real estate: IREITs Outside of the GCC there have been activities infinancing real estate investments with Islamic financing and Shariah compliant real estate activities: The world’s first listed Islamic REIT and Asia’s first healthcare REIT, Al aqar KPJ REIT listed on the Malaysian stock exchange in August 2006 with an asset size of $260m The largest Sharia compliant REIT by asset size, Sabana REITs in Singapore made an initial public offering of $510m in 2010, the average property valuation as at September 2010 was valued at $640m (source: Ibrahim, Ong & Akinsomi, 2012) ERES 2012

Application of Sharia finance to real estate development projects The evidence from our research in the Middle East indicates that it is possible to innovate financing methods, which are Sharia compliant For example in Iran significant number of urban regeneration projects, which are based on real estate development are financed through the Sharia compliant methods. These include: Participation bonds Project Shares Land and Construction Funds ERES 2012

Findings The presentation showed that there is a potential for Sharia compliant products Good means to avert risk and address ethical concerns, especially in times of globalisation and market uncertainty Can help to stabilise real estate markets as the methods are more transparent Because of the social and ethical aspect, it is easier to market in this age of crisis Not just for Muslims, and can reach investors who are important, but would not use conventional methods - 1.6 bn in 2010, expected to reach about 2.2 bn in 2030 ERES 2012

Findings Main differences between Sharia compliant and conventional finance: Regulations Methods of finance and investment Composition of portfolio or structure of development Supervision and monitoring Usually higher costs (no standardisation, scholars involved Investors want to get the same possibilities in Islamic finance compared to conventional finance ERES 2012

Further Research There is still a lot to do to Standardisation, common legal framework, total abolition of conventional elements etc. Western countries usually have to change or amend their regulations Increase its popularity in the West New and so the profitability for the real estate sector has still to be experienced - 1.6 bn in 2010, expected to reach about 2.2 bn in 2030 ERES 2012

Conclusion Islamic finance can be taken as a guideline to avoid the problems we could see ethically in finance, a product which could be used in the West even when it is not called Islamic. in a new source of liquidity especially from oil-rich countries particularly in the GCC. The use of Islamic financing or structuring would allow companies to reach out to investors who might otherwise be less accessible through conventional financing or structures. ERES 2012

Thank you for your attention Contact data: Ali Parsa Professor in Real Estate School of the Built Environment The University of Salford M5 4WT United Kingdom T +44 (0)161 295 5317 M +44 (0)7957 287 341 F +44 (0)161 295 5011 A.Parsa@salford.ac.uk Azadeh Farhoush PhD Candidate School of the Built Environment The University of Salford M5 4WT United Kingdom T +44 (0)161 295 5317 F +44 (0)161 295 5011 A.Farhoush@edu.salford.ac.uk ERES 2012