Islamic Finance: Sustainable & Growth Alternative Financing Option, Suitable for Real Estate...

Islamic Finance:

A Sustainable and Growth Alternative Financing Option

Suitable for Western Real Estate Investments

in the Wake of the Financial Crisis?

(2008 survey; revisited 2013)

March 2013 James A. Sawyer

As the economic crisis deepened towards the end of 2008, I worked on a research

project to explore the impact of the economic downturn on attitudes to Islamic Finance

(IF). I was interested in discovering any correlation between this event and its increased

use as a financing instrument. Is IF a sustainable financing option in the long term and

how effective is its application as an alternative funding source in the area of real estate

investment in Western markets such as the UK? How well does IF stack up against

conventional finance in the wake of the current economic model being questioned?

Over a three month period, questionnaires were sent to

selected senior level influencers at leading institutions

specialising in IF to gain a variety of board and executive-level

perspectives on these and other questions, relating to the

practice of IF outside of predominantly Islamic centres and its

value in the context of real estate investment.

1

I. Recent industry developments: Growth in assets; UK attractiveness & UK property deals

II. Legal aspects: Sharia interpretations; scholar governance; standardisation & transparency

III. Macro factors: Ethics; financial crisis; globalisation; oil & political landscape

IV. Financial instruments: Preference; competitiveness; product innovation & real estate

V. Conclusion: Outlook of IF in the West & real estate markets; future concerns & issues to monitor

Outline






Outline

According to a recent report by Ernst & Young (EY, Dec 2012), Islamic

assets are valued at about $1.3 trillion in 2011, representing about 1%

of the global financial market. One scenario shows assets to have a

growth potential of a further 17% in 2012 to reach $1,800bn by 2013,

making a rise of about 250% from $509bn in seven years since 2006

and with double digit growth expected to continue beyond (Chart 1).

The UK is the leading Western country and Europe’s premier centre

with $19bn of reported assets (Chart 2). Five fully Sharia compliant UK

based banks and a further 17 Islamic banking windows (totalling more

than any other Western country) have formed to help accommodate a

growing appetite for cross border investments from IF geographies

such as the Middle East & Malaysia into Western territories.

There is much scope for growth in the IF industry. Underpinned by

high population growth in Muslim nations (expected to reach 30% of

global population by 2025), rising oil prices, economic and financial

stability in most countries (despite political unrest in a few arising

from the Arab Spring), the Banker estimates that only 12% of Muslims

worldwide use IF products. Also, the customer base is not restricted

to Muslims; others may be attracted by the ethical basis of IF. 4

Source: The Banker, UKIFS, *Ernst & Young estimates

Global assets of Islamic finance

388

151 133

94

80

58

52

28 19

83

Chart 1

Chart 2 Islamic Finance by Country

Source: The Banker, UKIFS

Banking, takaful & fund assets, $bn, end-2010

Iran

S. Arabia Malaysia

UAE

Kuwait

Bahrain

Qatar

Turkey UK

Others

509 677

861 933 1130

1334

1567

1800

0

250

500

750

1000

1250

1500

1750

2000

1 2 3 4 5 6 7 8 2011 2010 2009 2008 2007 2006 2012* 2013*

$bn, assets end-year

I – Recent industry development: Growth in assets; UK attractiveness & UK property deals

The UK macroeconomic environment and real estate market is an attractive destination for deployment of Islamic funds. Pull factors:

● political stability ● favourable legislative, regulatory, tax and legal environment ● geo positioning as a bridge for investment flows

into other major Western territories ● highly skilled and IF qualified labour market with specialist advisory business units ● supply

constraints due to strict planning controls and lack of land for development in Central London ● mature, deep and liquid property

investment market ● transparent land governing institutions ● large variety of stock and micro markets (no property/market is the

same) ● tangible quality of real estate is well suited to IF principles. Push factors: ● Arab Spring gave cause for investment flows to

seek out safe havens ● deepening eurozone crisis ● portfolio diversification away from commodity reliant economies ● oil revenue

surpluses ● growth within Muslim population throughout emerging markets in the MENA and Asia regions.

The maturation of Islamic money markets is evidenced by Thomson Reuters launching, in 2011, an Islamic Interbank Benchmark Rate

(IIBR), based on rates contributed by 16 Islamic banks and Islamic sections of conventional banks, which provides a sharia-compliant

alternative to traditional interest-based benchmarks; the industry has long used the London Interbank Offered Rate (LIBOR).

Emerging Islamic geographies include Oman as a future hotspot. In 2010, Oman introduced Islamic banking through a Royal Decree

and has awarded Islamic banking licences. EY estimates that Islamic banking could potentially gain up to 10% of the Oman market

share over the next five years (a $6- $10bn Islamic banking market), also facilitating sharia-compliant foreign investment.

According to the latest European property investment statistics by Savills (Mar 2013), the volume invested in the UK grew 12.5% over

2012 up to €44bn, amounting to 38% of total commercial investment volume across 13 countries surveyed, of which London

accounted for 23% of total turnover on its own. Cross border investment played an increasingly important role characterised by

growing activity from the Middle East and Asia (SWF, institutions and family offices). 5

I – Recent industry development: Growth in assets; UK attractiveness & UK property deals

Landmark London IF funded property deals include The Shard of Glass

and the redevelopment of Chelsea Barracks ($2.4bn ijara financing),

constituting the highest value UK land acquisition in history.

Sep 2012: CIT Group secured $406m from a Middle East consortium for the 30-

storey Kings Reach Tower scheme in London. Project funding came from a club

of Middle East banks led by ABC International Bank and Saudi-based

Mohammed Al Subeaei & Sons Investment Company (MASIC). As the largest

financier to the scheme, MASIC’s involvement marked its UK market entry.

6

Oct 2012: Gatehouse Bank completed £165m acquisition of the law firm SJ Berwin’s offices at 10 Queen Street Place, London, in

collaboration with a Malaysian Sovereign Wealth Fund (SWF). Gatehouse acted as Investment and Sharia advisor on the deal, which marked

the SWF’s first investment into the London real estate market and is a key part of its wider global investment strategy.

Dec 2012: a new entrant into the UK IF market – 90 North Real Estate Partners (an investment & fund manager co-founded by the serial

entrepreneur James Caan) – has secured funding for total assets under management of £90m over 1.5 years, including the acquisition of

L’Oreal’s UK logistics headquarters for its ‘LUXE’ luxury product division.

Feb 2013: Bank of London and Middle East (BLME), the largest Islamic Bank in Europe, was awarded ‘Best UK Islamic bank of the Year (2012)’

by Islamic Finance News. The accolade supplements its winning ‘Best Real Estate Deal of the Year (2011)’ for its financing of The Brewery

Square Development Company, a partnership between Resolution Property and Waterhouse to finance Phase 2 of Brewery Square,

Dorchester; the largest town centre regeneration project in the South West.

Central London’s The Shard of Glass; Europe’s tallest building; majority IF funded and 95% Qatari owned

I – Recent industry development: growth in assets; UK attractiveness & UK property deals






Outline

Sharia law appears flexible enough to accommodate the advancement of investment flows in non-Islamic countries (Chart 3).

Similarly, although sharia scholars are central to influencing product compliance, the majority of respondents note they are not

exclusively responsible (Chart 4), which might go some way towards explaining the growth in IF and its wide application in

predominantly conventional finance driven markets. As one lawyer pointed out: “The development of new sharia-compliant

financial products in recent years evidences the fact that sharia law (at least in finance) is capable of creative solutions.

Furthermore, interaction with sharia scholars indicates that they are willing to engage in a constructive discourse into the ways in

which various products may be brought into compliance with sharia principles”. But it is not broadly accepted that a counterbalance

exists in order to keep a check on the authority of scholars (Chart 5). Furthermore, the unlevel interpretations of laws / fatwa

issuances backing IF due to the various Islamic schools of thought give way to unilateral advancement and an element of

8 92%

8%

Yes No

38%

62%

Yes No

46%

31%

23%

Yes No No Comment

23%

69%

8%

Yes No No Comment

Chart 5 Chart 6 Chart 3

II – Legal aspects: Sharia interpretation; scholar governance; standardisation & transparency

Is sharia law flexible enough for the advancement of IF in non-Islamic countries?

Are sharia scholars exclusively responsible for product compliance?

Is there a counterbalance for keeping check on the authority of scholars?

Due to diversity of interpretation, is there a risk that a contract valid today is void tomorrow?

Chart 4

uncertainty that prompts a call for harmonisation, as pointed out by another lawyer: “At this point, the need to react to the

requirements of the market is driving scholars to ‘create’ legal interpretations in one jurisdiction which is prohibited in another. The

result is chaos.” Moreover, whilst it is widely accepted that Islamic contracts are iron-clad and free from retrospective change, they

appear to be not entirely risk-free from the diversity in interpretation (Chart 6). The majority of respondents conceded that the IF

industry is poorly standardised (Chart 7) and lacks transparency (Chart 8); by some margin in comparison to Western transparency

requirements (Chart 9). This may, in part, explain the complexity involved in structuring IF products versus conventional equivalents

(Chart 10). Though IF products can co-exist alongside conventional products without adversely affecting the enforceability of

national laws (Chart 11). A fund manager noted: “For most scholars national laws come first”. But what impact would the

standardisation of contracts, methods and, if possible, the opinions of scholars, have on IF industry growth in new geographies?

9

How standardised is the IF industry? 1 = poorly standardised 5 = well standardised

Transparency of legal framework for structuring IF products. 1 = very opaque 5 = very transparent

Chart 7 Chart 8

33%

67%

Yes No

Chart 9 Chart 10


Does IF compare well with Western transparency requirements?

Is the sharia compliance process more or less complex compared to conventional financial compliance? 1 = less complex 5 = more complex

8% 31% 38% 15% 8%

1 2 3 4 5

18% 45% 18% 18%

1 2 3 4 5

7% 7% 14% 50% 21%

1 2 3 4 5

The level of response indicates that standardisation would strongly benefit the IF

industry (Chart 12). However, standardisation does appear to come with a health

warning. One senior bank advisor comments: “While standardisation has its

benefits in creating a structured and organised approach to IF products, it can be

a threat as well. This is because a lot of what attracts people to IF is the

innovation of its products, which is only possible through the flexibility. This

flexibility allows IF to adapt to different countries, laws, and cultures”. One

lawyer argues that: “Standardisation would lead to greater certainty in the IF

market. It would also increase the ease with which transactions could be carried

out, decrease the costs involved in carrying out the transaction and, as such,

increase the volume of deals being done”.

10

Effects of IF standardisation...

“IF products will be universally marketable” (Academic)

“It will reduce costs” (Accountant)

“Increase the volume of deals being done” (Lawyer)

“Create a structured and organised approach for IF products” (Investment Banker)

Chart 11


50% 42%

8%

Benefit Threaten

Both No Comment

Does sharia interfere with the enforceability of national laws in Islamic and non-Islamic countries?

Chart 12

Would standardisation benefit or threaten the IF industry?

17%

75%

8%

Yes No No Comment






Outline

Results clearly demonstrate IF will succeed in conventional financial markets

(Chart 13). Respondents commented on supporting fundamentals: ● “There is a

certain segment of the market that requires this service; they are not going

anywhere and their needs are growing” ● “Markets are global; not restricted to

specific countries” ● “Added layer of complexity, though clearly aspects of IF are

being implicitly adopted” ● “IF is an alternative source of finance and as long as

it is competitive it can succeed” ● “Conventional financial markets are becoming

more willing to place IF structures on equal footing with conventional

structures” ● “IF is a fast growing product; there is no reason to believe that it

will not become more widely available over time”.

But how has the credit crisis affected IF’s ascendancy and future path towards

growth? The underlying principles in IF appear to be a winning formula for its

wide application, with 67% of respondents in agreement. Yet they are not the

only factors at play and external factors, such as exponential Muslim population

growth as well as the oil boom, might also be viewed as success contributors

(Chart 14). When asked about the merits of using IF compared to conventional

finance, and aside from any ethical considerations, respondents acknowledged a

variety of market drivers. An advisory services partner stated: “Lack of

speculative transactions and short sales”. A lawyer mentioned: “The use

12

III – Macro factors: Ethics; Financial crisis; globalisation; oil & political landscape

Is IF likely to succeed in conventional markets compared to Islamic financial markets?

Given Muslim population and oil revenue growth, does IF’s success lie in its inherent principles or extrinsic circumstance?

67% 8%

17%

8%

Inherent External

No Comment Both

75%

25%

Yes No

Chart 13

Chart 14

of IF allows a new investor base (significantly the Gulf region and Malaysia) to be

tapped into, bringing with it new streams of capital”. One banker noted: “Less

risky (shared risk) – everything loaned is backed by collateral, interest free, not

centred on credit worthiness and ability to pay loan and interest, but the actual

merit and profitability of the project”, whilst an accountant expressed: “Are not

ethics enough? Some of the features of transactions can make it more flexible,

or commercially efficient”. The above points might infer that the excessive risk

taking and short-termism characterised by conventional financial markets in the

lead up to the credit crisis has helped bring IF to the fore. Indeed, IF appears to

have been on a different track and a 67% majority confirms that the financial

crisis has helped bolster the audience for IF funding, but its appeal will continue

regardless with a 91% vote of confidence (Charts 15 & 16 respectively).

Since this survey, the degree of fallout from the banking crisis would surely have

maintained such a majority view. The UK Islamic Finance Secretariat (UKIFS, Mar

2012), noted: ‘at a time when global recovery has slowed and conventional

banking in Western countries has remained under pressure... infrastructure

projects require funding’ and ‘the customer base in Western countries is not

necessarily restricted to Muslims: other customers may be attracted to the

ethical basis of IF’.

13

Has the recent financial crisis increased the audience for IF funding?

Assuming funding levels return to normal, would Sharia-compliant financing decrease in popularity?

III – Macro factors: Ethics; financial crisis; globalisation; oil & political landscape

91%

9%

Yes No No Comment

Chart 15

Chart 16

67%

33%

Yes No

IF’s relatively recent integration into mature global financial markets may have

offered some form of protection from crises with one third of respondents in

agreement (Chart 17) but, whilst the effects of globalisation has impacted

mature markets, it was not the sole reason for its resilience (59%), which further

supports IF’s inbuilt strengths as well as other circumstantial factors. There is a

consensus that gradual ascent and petrodollars have helped (Chart 18).

However, it does appear that IF is not entirely immune to systemic shocks. One

lawyer stated: “IF is still finance and all the finance markets have been severely

impacted by the credit crisis. The Middle East finance market (both IF and

conventional) has been equally affected”.

Nor is IF free from oil market pressures, as 41% of respondents have concerns

that reduced oil revenues would adversely affect IF progress (Chart 19). Indeed,

a key driver of Gulf investment in the West is surplus liquidity from high oil

revenues. Though less commodity dependent markets exist to pick up any slack

in the event of such scenarios, as pointed out by one lawyer: “Significantly

reduced oil prices will adversely affect the Middle East economies and therefore

adversely affect the need for and availability of finance. IF is also prevalent in

parts of Asia which will be less oil dependent and therefore less affected”.

9% 18% 36% 27% 9%

1 2 3 4 5

Has IF’s gradual ascent into mainstream financing and the amount of petrodollars behind it helped to avert global financial crisis? 1 = not helped 5 = helped

Chart 18

Would low oil prices, or even oil shortages adversely affect the progress of IF? 1 = minor effect 5 = major effect

Chart 19

8% 17% 33% 33% 8%

1 2 3 4 5

14


Is IF largely unaffected by crises because its market is not yet fully interconnected with other world financial markets?

33%

59%

8%

Yes No No Comment

Chart 17

What level of political risk is posed on the advancement of IF? 1 = high risk 5 = low risk

How do the politics of both mature economies and emerging nations, such as those in the Gulf and SE-Asia, affect IF? At the

time of this survey, modest political risk (non-country specific) threatened the advancement of IF (Chart 20). Following the Arab

Spring in 2010, a broad flight to safety in more stable Western environments such as the UK out of the MENA region has been

witnessed. Interestingly, opinion was split on political differences impacting IF’s reception in the West (Chart 21), which leaves

this question open to further debate. Increased government stakes in the banking sector is viewed as highly beneficial, however

results show some concern exists (Chart 22). In the main, respondents cited assistance in standardisation, boost in investor

confidence, improved capitalisation and better regulation as being positive by-products of government involvement. One banker

noted: “Islamic banks (like conventional banks) will need to consolidate to grow; government shareholdings could accelerate this

process” and a fund manager pointed out: “The current Islamic investor market is a private banking one; SWF investments will

make it a more institutional one”. Cautionary remarks included: “Political involvement in IF in the form of negative interferences

would adversely affect the development of IF” and “Strengthen locally and regionally, weaken internationally”.

8% 8% 25% 33% 25%

1 2 3 4 5

Do differences in political rule between Western and Islamic states affect IF’s reception in the West?

Chart 20 Chart 21

42%

50%

8%

Yes No No Comment

Could larger government stakes in Islamic banking strengthen or weaken IF?

Chart 22

15


50% 42%

8%

Strengthen Weaken

Both No Comment




IV. Financial instruments: Preference; competitiveness; product innovation & real estate investment


Outline

17

IV – Financial instruments: Preference; competitiveness; product innovation & real estate investment

Across asset classes, murabaha followed by ijara are the two most prevalent IF instruments (Chart 25). When prompted for

reasons as to why, murabaha was most favoured due to its simplicity, cost and short-term nature (Chart 26). As one accountant

put it: “Because it gets closest to the economics of conventional debt”. Moreover, a lawyer noted: “murabaha is the most

standardised IF instrument. As such, it is the most cost/resource effective to structure and the most widely used. The popularity

of the instrument is further attributable to the fact that murabaha transactions offer a predictable rate of return to lenders as

the marked-up re-sale price is set at the outset”. Chart 27 illustrates a commodity murabaha property investment transaction

structure. However, there is some resistance amongst Shariah scholars as to its appropriateness for broad application, as noted

by one lawyer: “Commodity murabaha are the most prevalent for straight-forward deposit/loan arrangements but not for asset

finance as the scholars tend not to approve for that purpose.” Ijara also ranks high due to the volume of transactions that

require such a structure, as remarked by one lawyer: “Leasing of cars, aircraft, etc. is more common than projects”.

58%

25% 8% 8%

33%

67%

8% 8%

58%

25%

33%

67%

Murabaha Ijara Mudaraba Musharaka

4

3

2

1

Which instrument is most prevalent in IF ? 1 = most prevalent 4 = least prevalent

Chart 25 Reasons for first choice... (Murabaha)

“Simplicity” (Banker)

“Ease and cost” (Lawyer)

“Relatively straight-forward, fair method for short-term financing” (Advisory Services)

58% 17%

25%

Short-term

Long-term

No Comment

Which instrument is increasingly popular?

Chart 26

“Used for short-term liquidity management” (Lawyer)

18


1. Investment Advisor screens & secures

target acquisition, conventional + IF

funding e.g. 70% LTV. Fatwa issued.

2. Conventional finance is raised in parallel

offshore SPV with equity buy-in from

Investment Agent & Islamic Investor(s).

3. Interest bearing (riba) debt is purified via

the commodity trade (murabaha) of an

underlying asset (e.g. metal or palm oil) on

a deferred cost + mark-up payment basis.

4. Trade is instantaneous between

commodity supplier & buyer in a market

such as LME and payment at a fixed price

pre-agreed at outset.

5. Offshore SPVs are set up reducing

corporate income tax from 28% to 20%

and zero capital gains tax on sale.

SPV Holdco

Leverage Provider

Property

SPV Propco

Islamic Investor

Metal Supplier

Spot payment Metal

Metal Buyer

Commodity trade

Murabaha (leverage)

2

4

3 Deferred Payment

Investment Advisor

1

4

5

Chart 27

Example commodity murabaha property investment financing structure

LIBOR / IBBR benchmarking

In examining the competitiveness of Islamic versus traditional finance products,

two thirds agreed it is less competitive on cost (Chart 28) for several reasons:

“Additional structuring costs, sharia audit costs and asset related costs (e.g.

brokerage fees on commodity trades)”; “Market is not as liquid”; and “Less

standardised which can lead to higher transaction costs and funding”. Though

costs are sometimes marginal: “Requires more transactions. However, while it is

not cost competitive the excess cost can be very small”. The term competitive

caused quite a reaction in the light of IF’s religious underpinnings, as one lawyer

stated: “You are missing the point. IF is a product that competes for a narrow

sliver of the market – it essentially ‘locks up’ that market. There is an extra cost

to launch IF products, but the sliver of market is willing to pay those added costs.

When IF and conventional go head to head, non-economic factors are driving

costing. As a result, the conventional product is the benchmark for cost, yet

because it is naturally unfit for the purposes in question, it is not ‘competitive’

with IF”. But varying degrees of devotion were considered alongside cost

implications, as another noted in the view of ‘yes’: “It has to be. If two products

are available, one IF and one traditional, and both are the same cost (and no

adverse tax consequences), the relevant market will opt for the IF. Yet if one is

more costly or less tax-efficient, my impression is that all but the most devout

will opt for the non-IF alternative”. One accountant points out: “IF is based upon

Is IF cost competitive against Western conventional financing?

Chart 28

33%

67%

Yes No

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

2007 2008 2009 2010 Q1 2011

Management fees of Islamic funds Chart 29

Average management fee, % of fund value

Source: EY analysis based on Zawya and Eurekahedge data (369 Islamic funds)


19

using a subset of the universe of possible financial contracts. This subset is

chosen for religious reasons. Logic therefore suggests that the financial

outcomes from using this subset of possible contracts should be inferior to the

results achievable from using the full universe of possible contracts”. Whilst

overall costs may be high, a 30% compression in management fees posted by

Islamic funds, points to positive investor benefits from growing competition in

this space (Chart 29). In terms of product development, opinion is divided on the

IF industry’s ability to develop sophisticated products (Chart 30), yet research

and consultation is ongoing and demand plays an important role, as one fund

manager noted: “Tough question. Whilst the scholars are divided the market

demands such products. Historically demand normally wins”. One lawyer noted:

“All the major investment banks and law firms are involved in IF and focussing on

these issues in conjunction with the leading scholars”. Responsible innovation

will be essential, as one lawyer observed: “Due to the fact that IF structures had

not invested in products akin to CDO2, its exposure to the effects of the financial

crisis has been more contained. However investor confidence (even Islamic) is

subject to the global concerns in the conventional markets as all economies are

interconnected”. Strives towards innovation have been made, but not without

pockets of resistance as noted by another lawyer: “There are already examples

of sharia-compliant derivatives, and rated asset-backed securitisations in the

Chart 30

IF industry ability to develop sophisticated products such as derivatives and CDOs.

50% 50%

Yes No

Product development rate. 1 = slow 5 = rapid

Chart 31


15% 54% 15% 15%

1 2 3 4 5

20

market. However, certain barriers such as truly tangible assets (i.e. no receivables) would prevent CDOs”. A banker further

highlighted fundamental obstacles in view of ‘no’: “Because of the speculative nature involved as well as ‘selling what one does

not own’”. Another reasoned: “Essentially prohibited under sharia”. A lawyer and accountant added respectively: “Many

derivative products and forward contracts are argued to not be sharia-compliant (heavily debated)” “Some of these should be

precluded by sharia-compliance”. But collaboration and pulling of wider resources would help: “The IF industry is connected to

the conventional banking system and can learn and benefit from the skill sets available in the wider market”. Whilst this survey

showed that products were developing at a brisk and innovative pace (Chart 31), EY recently noted that responsible innovation

requires urgent attention (2013), following their previous report and more specifically: ‘product innovation e.g. credible and

compliant alternatives to commodity murabaha’ (2011-2012). The appeal of Western real estate for IF funding is clearly

significant with 54% agreeing that it is either important or very important (Chart 32) supported by various comments: “There is a

11%

18%

15%

20%

25%

24%

33%

25%

25%

35%

32%

36%

2008

2009

2010

Islamic Banks

16%

11%

11%

12%

16%

16%

33%

32%

33%

39%

41%

40%

Conventional Banks

Source: Company Reports, Zawya, EY analysis (sample based on selective Islamic and conventional banks) (rounded numbers)


Level of importance of Western real estate to IF funding? 1 = very unimportant 5 = very important

Chart 32 Chart 33

Real estate exposure, Islamic versus conventional banks

21

9% 18% 18% 36% 18%

1 2 3 4 5

high propensity to invest in real estate”; “There is a big desire to invest in Western real estate”; “Just look at the Chelsea

Barracks financing. There is much Middle East interest in European property and if it can be financed with IF that will usually be

the preferred option”. And levels of importance works both ways, for Western real estate markets as well as for IF, as observed

by one lawyer: “It is more accurate to say that IF is important for Western real estate (as evidenced by the Chelsea Barracks

transaction) rather than vice versa”, whereas another stated: “Not important, but a perfect fit for this area”. The preference for

real estate assets is reinforced when Islamic and conventional bank holdings are juxtaposed (Chart 33), but a higher exposure

compared to conventional banks might also give cause for concern. Returns are underpinned by property values (driving capital

and rental yields) which are vulnerable to asset price corrections caused by systemic shocks, albeit such risks can be mitigated,

on a deal by deal basis, by altering location, covenant, lease term, leveraging, and purchase/exit date parameters. The most

common structures for IF real estate investments are ijara followed by musharaka in the first instance (Chart 34), as the majority

Chart 35

Does real estate investment conflict with the sharia principle of gharar?

91%

9%

Yes No No Comment

Chart 36

Can conventional finance be raised alongside IF in real estate investments?

60% 20% 10% 10%

Ijara Musharaka Mudaraba Murabaha

20% 20% 20% 40%

First most common

Second most common

Which structure is the most common for IF real estate investments?

Chart 34


22

58% 17%

25%

Yes No No Comment

of the sample have dealt in land transactions, exemplified by one lawyer: “Diminishing musharaka (coupled with ijara) is the

most sharia-compliant and tax-efficient form of IF”. When prompted for the second most common finance structure, murabaha

re-emerges. The aforementioned “perfect fit” when considering real estate as the underlying asset is helped by 91% agreeing

that it is void of speculative qualities – the sharia forbidden principle of gharar (Chart 35). Challenges do exist for real estate IF

practitioners in conventional markets whose investment spectrum can be considerably narrowed, not only due to a smaller pool

of investable products after screening for appropriate, halal, assets, but also the deal size can affect the IF decision to invest and

ability to generate desired returns. When asked, one lawyer replied: “Yes and no –depends on the economics of the deal” and a

fund manager responded: “Small projects are problematical as sharia costs tend to be fixed”. Amidst practical challenges, real

estate enjoys many sustainable drivers and one more than others in the form of diversification taking poll position.

“Real estate lends itself to IF, investing in the West provides a degree of diversity by geography” (Banker)

“Stability and status” (Lawyer) “Diversification, returns, safety (low risk)” (Advisory Services)

“A strong revenue stream and a good return on capital” (Lawyer)

“Simply the quality and diversity of assets” (Lawyer)

“Consistent government policies and creates a diversified portfolio” (Academic)

“Currency diversification, low political risk, strong economies”

(Accountant)

“Currency diversification, low political risk, strong economies”

(Academic)

“Diversification and investment opportunity” (Banker)

“It’s a global asset class for Islamic investors” (Fund Manager)

Drivers for investment in Western asset classes, in particular real estate... Diversification is in poll position


23

“Despite an added layer of complexity, certain aspects of IF are being implicitly adopted” (Fund Manager)

“Consumer demand driven” (Accountant)

“There is a market segment that is deeply-rooted (Muslim) with growing needs that require IF service in Western markets, such as the UK” (Lawyer)

“IF is an alternative source of finance and as long as it remains competitive it will succeed” (Investment Banker)

How accessible is IF compared to conventional finance? 1 = highly inaccessible 5 = highly accessible

So long as products remain accessible, 33% believed this to be very much the

case (Chart 37), enough positive drivers exist for IF to endure over the long-term

and compete with conventional finance as supported by 92% (Chart 37). It is

clearly possible for a non-Islamic country such as the UK to be a forward-facing

global centres for IF with 83% of respondents in agreement (Chart 38), despite

some resistance.

Will IF compete with conventional finance over the long-term, or will it be a short-lived phenomenon?


24

As a non-Islamic country, can the UK become leading player in IF?

92%

8%

Long-term Short-term

83%

17%

Yes No

8% 15% 46% 23% 8%

1 2 3 4 5

IF long-term drivers...

Chart 37

Chart 38 Chart 39




IV. Financial instruments: Preference; competitiveness; product innovation & real estate investment


Outline

Conclusion: Outlook of IF in the West & in Real Estate Markets

Significant recent industry developments (a steady stream of IF backed UK real estate deals (‘big ticket’ and other), opening up of

new hotspots like Oman to IF and launch of the IIBR), coupled with strong annual industry, current and forecast growth rates (17%

CAGR) underscore both the capability and capacity for IF to fund investments in Western territories.

Cross-border investment is facilitated by equally strong push and pull factors and the UK’s ideal geographical positioning, as a bridge

for Islamic investment into global territories, puts it at a considerable advantage.

Mature, stable, liquid, low political risk economies such as the UK are in a position to benefit from capital flows driven by a key

component of the IF investment decision – diversification – fuelled by the Arab Spring and the investment mandates of Gulf

commodity reliant and emerging Asian economies.

Whilst the credit crisis (67% agreed) and oil revenues (36%) have aided the growth in IF, respondents are unanimously agreed that IF

can hold its own after a return to normal funding levels (p.12). And it is not so much IF’s gradual ascent (36%) or low-level pre-crisis

interconnectedness with world financial markets (33%), but due to its ethical underpinnings (67%). Faith based financing

requirements, compounded by the unchanging fundamental factor of a growing Muslim world population, will be the driving force

behind its sustainable use and availability over the long-term as a competitive alternative (92%). Put simply by one respondent:

“There is a market segment that is deeply-rooted (Muslim) with growing needs that require IF service in Western markets, such as

the UK”.

26

Conclusion

Western real estate is as much an important asset to IF (54%) as IF is to Western real estate. This interdependent relationship is

marked by non-speculative, tangible qualities and continued conventional banking constraints. Indeed, IF can help unlock funding for

sizeable infrastructure projects in western markets. Case in point is the myriad of Qatar UK investments.

Sharia flexibility (92%); scholar willingness; development of intelligent, proven structures and financial instruments that enable riba-

free, short-term and liquid products which can get closest to conventional economics and ability to raise conventional finance

alongside IF (58%) all serve to establish a viable, alternative source of financing capable of funding acquisitions and growth.

Concerns for the future & issues to monitor Since this survey, and when brought up to date with recent findings, several important themes remain unresolved:

Industry standardisation. Poor levels of standardisation (81% = medium- very poor) need careful review to provide increased

transparency (77% = medium- opaque), reduced complexity (85% = medium- very complex) and improved cost competitiveness (67%

= costlier) without threatening the creativity and flexibility that has helped its growth and wide application to date (42% =

standardisation can both strengthen & threaten IF).

Product innovation. A need to innovate beyond murabaha (92% agreed = most prevalent). The simplicity and ease of murabaha saw

it re-emerge as a second-choice finance instrument for real estate (40%). Whilst financiers, lawyers and scholars collaborate, the

50:50 stand-off for sophisticated product development requires responsible innovation, so as not to undermine IF’s governing

principles that aid its unique product differentiation and potential to attract non-Islamic investors in the wake of the financial crisis.

27

Conclusion (Cont’d)_

Sharia governance. In the view of no counterbalance to keep an adequate check on scholars authority (69%) and a risk that contracts

can become null and void due to the diversity of interpretation (46%), improved governance is needed to avoid repetition of the

sukuk debacle.

Competitiveness. IF financial centres of excellence, including the pre-eminence of London as an IF hub and long-term position (83%)

will need to focus efforts to maintain marketshare, as emerging IF markets mature. Market players need to continue working in

tandem with government agents and further government investment in the IF banking industry would help (50%) to avoid risk of

losing a competitive advantage, but care must be taken (40%). Also, the industry could do more to educate consumers and promote

IF’s ethical risk-sharing qualities on a broader level to encourage non-Muslim investor take-up. Competitive costs through

standardisation would help to stimulate both Muslim and non-Muslim demand.

Systemic shocks & real estate investment. Islamic and non-Islamic investors have been equally affected following global asset price

corrections in the financial crisis. Whilst a higher exposure to real estate by Islamic banks versus conventional ones might pose an

element of concern, it demonstrates that real estate is a traditionally popular asset class. Also, low prices in Western markets present

attractive opportunities to new entrants and will assist in rebuilding the confidence of those who have sustained losses. Geo-political

turbulence across the MENA region has aided capital flows into the Western markets, but differences in political rule do affect IF’s

reception in the West (42%). Oil revenues have contributed to IF investment, but caution must be noted that oil price/supply shocks

might adversely affect the progress of IF (41%). Though institutions have the option to develop new investment channels and

diversify into growing Muslim wealth segments in fast emerging Asian economies that would be less affected.

28

Conclusion (Cont’d)

Ernst & Young The Islamic Funds & Investments Report 2011 The World Islamic Banking Competitiveness Report 2011-2012 The World Islamic Banking Competitiveness Report 2013 The World Takaful Report 2011 www.ey.com

UK Islamic Finance Secretariat (UKIFS) Financial Markets Series ‘Islamic Finance’ March 2012 www.thecityuk.com

Savills Market Report ‘European Commercial Investment’ March 2013 www.savills.com

CBRE MarketView ‘European Capital Markets’ Q4 2012 www.cbre.com

Sources of information

Islamic Finance News www.islamicfinancenews.com

Who? The target population was a mixture of senior level professionals from the fields of banking, advisory, accountancy, law and academia. The most influential and leading practitioners, as nominated by their peer group according to Islamic Finance News (IFN) Awards 2008 polling methodology, comprising of ‘Magic Circle’ and ‘Big Four’ advisory firms. And access to a critical group of practitioners at a Centre for Study of Financial Innovation (CSFI) ‘Sharia-compliant financial instruments’ roundtable. All are experienced in conventional banking & finance with a high proportion working exclusively in, and with specialist knowledge of, IF. 93% have experience of IF real estate investment transactions.

Approach & participants profile

London, UK (7)

Kuala Lumpur, Malaysia (1)

Dubai, UAE (4)

Manama, Bahrain (1)

Kuwait City, Kuwait (1)

1

1

1

2

3

6

Academic

Fund Manager

Accountant

Banker

Advisors

Lawyer

Profession

Area of operation

1

1

2

4

8

8

Academic

CEO

Directors

Senior Consultant

Senior Partners

Heads of IF Departments

Position

How? Email survey questionnaire – 35 items comprised of 6 question types: demographic, open-ended, dichotomous, multi-dichotomous, rank order and semantic differential scales.

When? Data collected between 29 Sep 2008 and 1 Dec 2008. Updated with industry developments over 2012-2013 period.

14 senior level respondents; 220+ cumulative years experience in IF

Where? Focused on UK, Middle East and South-East Asia.

93% experienced in IF real estate transactions

James Sawyer MSc BA

James worked as an analyst for Gatehouse Bank plc – an institution at the forefront of UK Islamic banking. His primary function was to support the real estate team in the origination, structuring & funding of sharia-compliant investment products. He graduated with a BA in History of Art from the University of East Anglia (UK) and an MSc in International Real Estate from the Royal Agricultural College (UK), which included a summer exchange programme at the National University of Singapore. Prior to working at Gatehouse, he gained a mix of property, sales & marketing experience at Savills, Colliers International, Jaguar, LVMH and more recently worked on an innovative venture capital backed transport project for the 2012 London Olympic Games.

James Sawyer is grateful to all those who participated in this survey and for their many insights on the topic of Islamic Finance.

About the author

Email: [email protected]

Skype: callto://sawyerAAA

Linkedin: uk.linkedin.com/in/jamessawyeruk

Website: www.sawyerAAA.com

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