I concluded the last article 117 on the note that the beauty of Islamic financing and investment contracts is that they provide risk mitigation from within the structure instead of seeking external support. Now the onus is on me to prove it in the case of diminishing Musharakah.
I had invited readers to spot this aspect after having read article 117 but despite a lapse of two weeks, I have not received any feedback. However, do not worry. I will explain it, but you will have to wait a little since today I will first explain another manner through which the diminishing partnership can be carried out.
As against the single Musharakah contract and an irrevocable unilateral undertaking (promise to purchase) from one of the partners explained in the last article, this hybrid structure requires two contracts to be signed at the same time. These are the Musharakah contract and the Ijarah contract. Let me explain.
Khalid who works as a quality control manager with a multinational corporation in Jabel Ali Free Zone in Dubai spotted a newly completed semi-detached town house in a gated community in the Dubai-South locality. He finds the dwelling suitable for his small family, in addition to it being closer to his workplace, and most importantly the couple being educated and wanting to live in Dubai for some time were on the lookout to convert the rent expense into an investment.
Khalid approached the Islamic bank where he maintains a salary account to find out if the bank can assist him to fund the purchase of the property. The relevant bank officials took the necessary details of the property and based on the bank’s policy ascertained that Khalid is eligible for the Islamic home finance facility provided he contributes a minimum 30% of the purchase price while the bank shall finance the remaining amount. Since Khalid is a young candidate, he easily fitted in to a 15-year financing period as per the Islamic bank’s policy and was thrilled that the monthly installment came to lower than the rent currently paid by him.
Khalid had never taken any bank facility before so he was naturally curious to know how it all works, especially in an Islamic bank. He was offered a hybrid Musharakah and Ijarah financing solution which was obviously beyond Khalid’s comprehension. The head of the Islamic home finance section took Khalid to the conference room where he played a product presentation on the big screen to make it easy for Khalid to understand how the product is most suitable for his purpose. Starting from scratch, Khalid was advised that once he provides the 30% contribution, the bank shall also release its 70% participation upon signing the Musharakah contract for an agreed period of 15 years with him. The bank shall immediately proceed to purchase the townhouse from the developer by making full payment for it. The property shall be registered in the joint names of the bank and Khalid.
Upon acquiring the property, Khalid and the bank shall also sign the financial lease (Ijarah Muntahiya Bil Tamleek) contract pursuant to which the bank shall lease its 70% undivided pro-rata ownership in the townhouse to Khalid for the period of 15 years, ie the same period as the Musharakah contract. Khalid shall be required to pay the monthly lease rent to the bank.
Readers shall recall the detailed discussion in article 72 on the 2nd October 2019 on the constituents of the lease rent. For the sake of convenience and for ease of understanding the diminishing partnership based on Ijarah, I reproduce in the following the elements of rent I had explained a year ago:
a. Fixed element: This part is embedded within the amount of periodic rent the customer pays to the Islamic bank and represents the recovery of the investment made by the Islamic bank in purchasing the asset from the third party. This amount is arrived at by dividing the total amount invested by the Islamic bank in purchasing the asset by the total number of installments to get the equal amount for all installments. It is also possible that the Islamic bank may tailor this amount lower in the initial few years and subsequently increase it to encourage customers, or it could also be vice versa.
b. Variable element: This is the profit the Islamic bank would like to earn from the investment it has made in purchasing the leased asset. The variable element is determined by applying the agreed rate (a percentage) on the outstanding fixed element amount related to a certain period. There are two approaches to ascertaining the amount of the variable element:
i. Fixed rate (percentage) for the entire lease term: Here, the agreed percentage is applied on the outstanding fixed element during the entire lease term based on the agreed amortization model. The benefit of the fixed rate is that the installment for each period for the entire lease term can be determined at the outset, or
ii. Floating rate: In this approach, the Islamic bank and the customer agree in the lease contract that the Islamic bank shall calculate the variable element based on a reference rate plus a margin. While the daily local reference rate is determined by the central bank of the country, the global reference rate known as LIBOR is calculated by the Atlanta-based Intercontinental Exchange.
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: Explanation on diminishing Musharakah shall continue.