Summary and implications
Shariah law provides the framework within which the public and private aspects of the lives of Muslims are regulated. The investment world has already seen an increased demand for Shariah compliant funds, and this trend is predicted to continue. It is anticipated that fund managers will seek to access the supply of equity available from Islamic investors, leading to a rise in the number of Shariah compliant real estate funds coming to market. This will lead to exciting times, as participants look to develop fund structures that both satisfy Shariah requirements and remain attractive to investors.
Practical issues for fund managers and investors in Shariah compliant funds include:
- The fund documentation, including the PPM, will need to be clear that the fund is established for Shariah compliant purposes, and that the structure and investments of the fund will be monitored accordingly;
- The fund will need to be structured to ensure that an annual audit takes place to monitor the ongoing compliance of the fund. This can be carried out by the fund’s Shariah board, but it is best practice for it to be carried out by third party Islamic scholars to avoid any perceived conflict of interest. The added layer of monitoring will inevitably have timing and cost implications for the fund;
- The pool of assets available to the fund will inevitably be smaller than for a non-Shariah compliant fund, as such assets must meet the criteria for Shariah compliance.
Whether any particular structure is Shariah compliant is a matter for determination for Islamic scholars, and therefore this note should be treated only as an introduction to the issues.
The key principles
While many Shariah principles apply to transactions in general, there are two main principles that impact on the structuring of real estate funds:
- The properties invested in must be used for Shariah compliant purposes; and
- The fund must avoid using leverage using methods prohibited by the Shariah.
In terms of evaluating the Shariah compliance or otherwise of investments and leverage, the role of the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) is vital. This organisation, based in Malaysia, seeks to regularise what structures and products are permitted. As a general rule, AAOIFI takes a practical approach to compliance, with the aim of establishing more Shariah compliant products. This reflects the pro-entrepreneurship approach of Islam in general. It should be noted, however, that this remains a developing area, and that there is still divergent opinion between Islamic scholars about whether certain structures and activities are haram or halal.
a) Shariah Compliant Real Estate Investments
Certain trades and activities are considered to be haram, and are thus prohibited under Shariah law. These include, but are not limited to:
- The production or sale of alcoholic products;
- The production or sale of pork products; and
- Conventional financing activities.
If a real estate asset is used primarily for haram purposes, for example a casino or an office block occupied solely by a traditional lending institution, it will not be an acceptable investment for a Shariah compliant fund.
It is, however, permissible for a small part of an asset to be used for haram purposes. For example, a Shariah compliant fund may invest in a shopping centre with an off-licence but where the majority of tenants conduct acceptable activities. In this example, the fund will need to be structured so as to permit “purification” of income from the off-licence.
b) Shariah Compliant Leverage
Real estate investment funds typically seek to leverage their investments. Mainstream lending is prohibited under Shariah law, as it is generally accepted that the payment or receipt of interest constitutes usury (riba), and is therefore prohibited. Consequently, funds which seek to be Shariah compliant will need to rely on Shariah compliant methods of financing.
This will affect both borrowing and any hedging strategy that the fund may wish to employ as, for example, instruments which offer traditional interest-rate hedging are not permitted.
There are two main structures used for Shariah compliant funds:
- Mudaraba; and
The Mudaraba structure is the most common Shariah compliant fund structure. It is similar to a limited partnership in theory and, in practice, an English limited partnership is often used as the fund vehicle. In this structure, investors (known as rabb ul-maal) provide capital to a mudarib (essentially a fund manager). The mudarib will use its expertise to manage the capital with the goal of realising profits, which will be divided between the mudarib and the rabb ul-maal in accordance with an agreed formula. Under this structure, the mudarib is permitted to charge management and performance fees, as would be the case in a non-Shariah compliant fund structure.
As with a traditional limited partnership structure:
- The investors are precluded from involvement in the day-to-day management of the fund;
- There are limitations on the scope of the authority of the mudarib under the fund documentation; and
- The liability of investors is limited to the extent of their investment (in the same way that the liability of a limited partner would be limited to the amount of its capital contribution, subject to compliance with the limited partnership legislation).
The Wakala structure is a less commonly used alternative to the Mudaraba structure. This is essentially an agency arrangement, where investors enter into a contract with a wakil, which acts as investment manager, charging a fixed fee. The wakil acts solely as an agent, following the instructions of investors, and therefore this structure is not familiar to many typical fund investors.
Structuring issues for Shariah compliant fund structures - click here to see table
Funds in the market - click here to see table