Unlocking a pent-up demand

Unlocking a pent-up demand - Shariah-compliant investment poses challenges for Islamic institutions … and an opportunity for real estate fund managers.

• The challenge facing Shariah-compliant institutions is twofold. They face the same challenges as conventional investors in finding attractive investment opportunities in today’s low-return environment. In addition, an increasing number of their clients demand that their assets are invested in strict compliance with Shariah principles, and this both limits their investable universe and can increase costs.

• There has been a consistent theme among Islamic investors, be it institutions across Asia and the Middle East - strong demand for long-leased assets with creditworthy tenants that can provide an attractive income yield while matching the duration of investors’ assets with their long-term liabilities.

• Three core principles govern Shariah-compliant finance and investment.

• First, the principle of equity holds that all parties in a transaction only earn a return if they equitably bear the risk of engaging in a productive activity. This is the rationale behind the prohibition of predetermined payments or interest (riba in Islam). This is also the basis for prohibiting excessive uncertainty (gharar) where transacting parties have a moral duty to disclose information before engaging in a contract, reducing information asymmetry and making the subject matter, price and time of delivery known at the outset of a contract.

• Second, the principle of participation - “Reward comes with risk taking.” Therefore, an investment return has to be earned in conjunction with risk-taking rather than with just the passage of time. Speculation (maisir) is prohibited under Shariah, as transactions that rely on chance or speculation rather than effort and participation to produce a gain are prohibited. Commercial risk-taking is acceptable but those that amount to gambling in this interpretation, which includes some conventional derivative transactions including swaps, futures and options, are disallowed.

• Third, the principle of ownership - The rulings of “do not sell what you do not own” mandate the ownership of an asset before a transaction can occur. Islamic finance has come to be known as a form of asset-based financing, with a clear link between finance and the real economy. It also requires that property rights be respected and preserved, and that contractual obligations are upheld.

• In practice, Shariah scholars have developed “screening criteria”  to help determine whether an investment would be Shariah-compliant or not. These criteria focus on the activities carried out by the business to determine their permissibility under Shariah. Companies or tenants of commercial property that are involved in industries such as alcohol, tobacco, pork, adult entertainment, gambling, weapons and conventional banks or conventional derivatives are disallowed under Shariah.

• Limiting the costs of compliance often requires doing things differently and working with Shariah boards and advisers to align incentives and establish bespoke fee arrangements that match the specific fund strategy. Size is also important to achieve economies of scale around the costs of Shariah compliance.

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Published on Institutional Real Estate, Inc (IREI), Jan 2017

Unlocking a pent-up demand - Shariah-compliant investment poses challenges for Islamic institutions …

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