A reader has asked a question in respect of financing a real estate asset, which is to be constructed. She is working with an African Islamic bank where the bank uses Istisnah to finance the completion of properties.
Describing the procedure, she has written that the bank is the seller in the Istisnah contract with the understanding agreement that the developer will release the title to the described asset to the bank on completion.
She added that the bank does that since it is the one financing the client. The Islamic bank makes an upfront lump sum payment to the developer through the Istisnah contract. If the construction period is for 18 months for example, the Istisnah will run for 18 months.
The reader has summed up that on completion of the asset, the contract is switched to Ijarah for another 18 months whereby the rentals will be structured in a manner to compensate the bank for the funds released at the time of signing the Istisnah contract. She has asked if what has been described is the same as forward Ijarah?
Upon analyzing the aforementioned approach, I have come to the following conclusion:
1. If the Islamic bank is the seller under the Istisnah contract, then who is the buyer? Is it the client or the developer? If the client is the buyer, the Shariah title to the ownership of the described asset gets transferred to the client upon signing the Istisnah contract between the two parties. As for possession, the Islamic bank is liable to hand over the completed asset on the agreed delivery date.
Being the seller, the bank assumes all risks including completion risk, cost-escalation risk as well as risk of any damages to third parties arising out of the under-construction asset. On the contrary, the client being the buyer of the asset will only be exposed to credit risk, having paid the purchase price to the seller.
2. If the developer is the buyer in terms of the Istisnah contract signed by the bank, this seems inappropriate since by default, a developer is the one who is required to complete and hand over a real estate asset as the seller, and not to receive a completed asset from the Islamic bank.
3. Assuming that the buyer in terms of the Istisnah contract is the client, it will be holding the Shariah ownership of the described asset from the date of signing the Istisnah contract, waiting for the asset to be completed and delivered by the Islamic bank. Then how is the bank able to ‘switch’ the Istisnah contract into Ijarah without holding the ownership to the Istisnah asset which is held by the client?
4. Another point worth mentioning here from the reader’s description is that there is some sort of ‘understanding agreement’ with the developer to release the title to the Islamic bank upon completion of the asset. From the description, I deduce that perhaps the buyer under Istisnah is the client but the lump sum payment for the completion of the asset is made by the Islamic bank to the developer in terms of the ‘understanding agreement’.
5. As for the recovery of the Istisnah amount and compensation to the Islamic bank for the 18-month Istisnah period, the Istisnah contract is ‘switched’ to Ijarah for another 18 months; this goes against the established Shariah principles that each contract must be treated independently and that you cannot have two contracts amalgamated into one.
What I have gathered from the aforementioned is that the Islamic bank would like to finance an off-plan property for its client and upon completion and delivery by the developer, the Islamic bank would want to lease it to the client on a financial lease basis to enable it to recover its investment in the asset with profit. I suggest the following structure to achieve the purpose:
a. The Islamic bank signs the Istisnah contract with the developer whereby the developer is the seller and the Islamic bank is the purchaser. This way, the bank shall be able to avoid exposing itself to all risks assumed by the seller under Istisnah.
b. Before signing the Istisnah contract with the developer, the Islamic bank should enter into a forward lease contract (Ijarah Mawsufah fi Dhimmah) with the client with the same specification of the lease asset as described in the Istisnah contract. The commencement date of the lease term in terms of the forward lease contract shall coincide with the delivery date of the asset under the Istisnah contract. This way, the Islamic bank shall bind the client for taking the completed asset on lease.
c. The Islamic bank shall release the Istisnah purchase price to the developer as an upfront payment. The value of the lease asset stated in the forward lease agreement shall be the same as the Istisnah asset purchase price paid by the bank to the developer.
d. Upon receipt of the completed asset from the developer, the Islamic bank shall immediately deliver the asset to the client to commence the lease. The periodic lease rent shall be comprised of two elements viz. the fixed element which is partial recovery for the cost of the asset and the variable element representing the bank’s agreed profit on leasing the asset and the compensation for the Istisnah period.
e. By virtue of signing the Istisnah contract with the developer as the buyer, the Shariah ownership shall transfer to the Islamic bank forthwith, followed by the registered title upon completion and delivery of the asset by the developer.
f. Upon the successful completion of the agreed lease term, the Islamic bank shall transfer the registered title to the client through a separate sale agreement with a nominal price or simply by entering into a gift agreement.
I hope the reader would agree that the recommended Shariah mechanism is the right way to finance a client for an off-pan property. If not, please write back to me.
The purpose of this educative series and the article is not to hurt any religious or commercial sentiments either consciously or even unwittingly.
Sohail Zubairi is an Islamic finance specialist and AAOIFI-certified Shariah advisor and auditor. He can be contacted at [email protected].