I will pick up from where I left off in article 75.
To recap, I had stated that as per Shariah principles, under a forward lease contract, which is used for off-plan (under construction) properties, an Islamic bank can only commence charging the lease rent once it has delivered the property to the lessee. However, on the other hand, an Islamic bank shall continue to make payment to the developer of the property based on an agreed stage payment schedule from its own pocket.
This is in contrast with the conventional banking practice of applying interest from the day the bank makes the first payment to the developer by creating a mortgage loan facility in its ledger in the customer’s name.
Note the difference here: the conventional bank creates the loan in the customer’s name to make payment to the developer whereas the Islamic bank does not do so and make the stage payments to the developer from its own source.
The question I had posed in this backdrop is that while the conventional bank recovers its ‘cost of funds’ from day one together with the interest margin (profit) from the mortgagee, how does an Islamic bank cover its cost of funds if it waits until the completion and delivery of the property to the lessee which may take two to three years?
First of all, do Islamic banks have the cost of funds phenomenon in their operating model? The answer is no. Islamic banks do not incur any cost of fund. Why and how? Kindly refer to article 21 where I have explained this aspect in detail.
However, for the sake of convenience, let me explain it here again in a few lines.
Conventional banks borrow money at a fixed interest rate from depositors and hence they immediately incur a cost, which is the cost of borrowing the funds from depositors. On the contrary, Islamic banks do not borrow funds from depositors, but rather accept them as a trustee for investing the funds for and on behalf of depositors. Whatever profit is generated through such deployment of funds is distributed between the Islamic bank and the depositors based on a pre-agreed distribution ratio.
Well, if that is the case, how does an Islamic bank generate profit for its depositors and shareholders when it goes ‘dry’ for such a long time during the construction completion period?
Let me explain how an Islamic bank can make a profit for depositors in a Shariah compliant manner during the period when construction is still going on. The developer provides the schedule of payment to the Islamic bank beforehand, ie at the time of the Islamic bank entering into the ‘tripartite agreement’ (see article 65). Based on the payment schedule, the Islamic bank can assess when it will be required to make the phased payments, ie deploy the depositors’ funds for the completion of the property.
Since the forward lease contract includes the rate of the ‘variable lease rent’ (see article 72), the Islamic bank is able to apply this rate on the stage payment schedule and arrives at an aggregate amount of potential variable lease rent under the forward lease contract. This amount is added as the ‘additional rent’ in the forward lease contract with a stipulation that it will not be payable unless the property is delivered to the lessee in order to commence the lease. As such, the lessee is aware ahead of the delivery of the property and commencement of the lease that he or she is required to pay the ‘additional rent’ amount in addition to the fixed and variable rentals in the first lease period.
Hence, upon the delivery of the off-plan property and commencement of the lease, the Islamic bank is able to realize the profit related to the construction period for its shareholders and depositors in the first lease period. It is important to note that compared to a conventional bank’s immediate application of interest on the mortgage related to an off-plan property, an Islamic bank applies the additional rent only when the property is delivered and the lease has commenced.
There is a possibility that while the amount of additional rent has been locked at the outset, the developer may delay the completion and delivery of the property. In such a situation, the Islamic bank will not be in a position to increase the amount of the additional rent to cover the delayed period.
Let me tell you that this in fact happened in the UAE during the financial crisis of 2008 whereby thousands of units sold under the off-plan schemes were inordinately delayed, some as long as up to six years. While customers of conventional banks continued to pay the interest on their mortgage amounts, the potential lessees under the forward lease contracts with Islamic banks heaved a big sigh of relief since their additional rent amount was locked at the time of entering into the forward lease. Can you imagine the extent of their savings compared to their conventional counterparts?
Another fair approach by the Islamic bank financing the off-plan property is that if the project is abandoned permanently due to any reason, the Islamic bank will never be able to recover the additional rent from the customer since it will not be able to deliver the property to the customer and start the lease.
This is what I call fair practice which is fairly uncommon in today’s financial world. How sad.
The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinions of the Dubai Islamic Economy Development Centre, nor the official policy or position of the government of the UAE or any of its entities. The purpose of this article is not to hurt any religious sentiments either consciously or even unwittingly.
Sohail Zubairi is the senior advisor with the Dubai Islamic Economy Development Centre. He can be contacted at [email protected]
Next week: We shall continue with our discussion on the last few points on Ijarah.