Basics of Shariah Financing in Real Estate - ABA YLD 101 Practice Series

By Gina Matthiesen

According to the Encyclopaedia Brittanica's 2005 Book of the Year, there are approximately 4.7 million Muslims in the United States. According to a 2004 Zogby survey, one in three of American Muslim households have an income of $75,000 a year or more. American Muslims have become increasingly interested in investing their money by buying property and starting businesses. As this population grows in numbers and influence, more financial vendors are seeking their business by offering Shariah (Islamic law) compliant financing products.

Under Shariah, the payment of interest, or riba, is forbidden. Therefore typical financing instruments that bear interest, such as the mortgage, are against Islamic law. However, banks are profit-making entities, and charge for the time value of the use of their money. Since the 1980's, North American banks have been working on creating Shariah compliant financing products that meet the needs of both observant Muslim customers and the banking industry. As the use of these products expands, lawyers need to be aware of the terms and concepts involved in Shariah transactions. This article will concentrate on three of the most common real estate financing products in the United States: Murabaha, Ijara, and Musharaka. Please note that this list is not exhaustive.

  1. Murabaha: "cost plus sale" of the property to the customer
    Murabaha translates into "cost plus sale." In this type of transaction, the purchaser knows the price at which the seller obtained the property, and agrees to pay the seller a premium, or profit, over the purchase price. This premium may be either a fixed dollar amount, or a percentage of the total purchase price. The purchaser is not required to pay this amount immediately in one lump sum. Instead, the purchaser may defer payment, bai bithaman ajil, or pay in installments, bai muajall. Observant Muslims may use installment or deferred payments with profit added, but are strictly prohibited from using interest-bearing loans.

    In real estate sales in which a bank is providing financing, the murabaha transaction would involve the bank and its customer. The bank purchases the property at closing, and discloses the purchase price to its customer. Then, the bank sells the property to its customer for a fixed price, which includes the bank's profit. In the United States and other western countries, the bank bases the calculation of its profit on the current mortgage rate. The final total purchase amount, monthly payment amounts, and due dates are fixed at closing. The customer will also pay earnest money to reserve the property.

    The murabaha transaction, with installment payments, resembles a regular fixed-rate mortgage. However, there are a few key differences. For example, the bank may not increase the interest rate if the customer fails to make a timely payment. Also, payment amounts may not increase or decrease with changes in interest rates. Finally, the bank retains ownership interest (rather than a lien interest as with a conventional mortgage) in the property until the customer pays the full amount of the initially agreed upon price.
  2. Ijara: "rent to own" sale of the property to the customer
    Ijara translates into "lease." The sale of a right to use property (lease) is permissible under Islamic financing. However, unlike a conventional rent to own transaction, shariah requires that the lessor fully owns the leased property for the duration of the lease. Additionally, shariah prohibits late payment fees because they are considered interest. At the end of the lease, the lessor may sell the property to the lessee for a pre-specified residual value.

    In real estate sales in which a bank is providing financing, the ijara transaction would involve the bank and its customer. The bank will purchase the property in question, and place it into a holding entity. The customer makes payments to the holding entity, and will own the property once the final purchase amount is achieved. The bank and its customer will negotiate the terms of the payments and final purchase price up front. Finally, the customer will pay rent to the holding entity until the lease ends, and ownership is transferred to the customer.

    The ijara transaction resembles a conventional adjustable rate mortgage. However, the contract must be carefully crafted so that payments are clearly rent, and not interest.
  3. Musharaka: combination of "joint venture" and "rent to own"
    Musharaka translates into "partnership." In a musharaka agreement, both the customer and the financing agency initially share ownership of the property, and share in the profits from ownership. The most common form of musharaka used in North America is the diminishing partnership, where the customer both pays rent and buys out the financing agency's share in the property over time. Once the customer has completely bought out the financing agency's share, the musharaka contract is terminated.

    In real estate sales where a bank is providing financing, the musharaka transaction would also involve the bank and its customer. The bank purchases the property, and the customer buys into the property over time, plus pays rent for using the property. The bank and the customer will share profits from the property, based on the percentage of ownership, if the property is sold before the customer buys the bank's interest out completely. Over time, the customer will completely buy the bank's interest out, and the financing contract terminates.

    This type of musharaka transaction resembles a conventional mortgage, with the rent resembling interest and the buy-out payments resembling principal. As in a conventional mortgage, once the principal is completely paid, the contract terminates. However, the contract must be written carefully so that the payments are clearly rent and not interes
    t.

Sources for Shariah Financing
If you have a client that is interested in Shariah compliant financing to purchase property, it is best to consult heavily with experts at a financial institution that offers Shariah products. The wording of these financial products must be rather specific, so that the customer is not paying interest or even interest masked as rent. Therefore, do not try to draft these contracts yourself, unless you have a lot of experience in Shariah financing. Simply replacing the word interest with rent will not make a contract Shariah compliant. Unfortunately, the extra preparation needed to use these products will add costs for your Muslim clients. However, you can keep these costs lower for your Muslim clients by using a financial institution that routinely uses Shariah products.

Make sure that the Shariahh Supervisory Board of America has approved the financing institution's products, before advising your client to proceed. Good resources for Shariah compliant real estate financing include Devon Bank, the banks affiliated with LARIBA-America Finance House, Fannie Mae, and Freddie Mac.


Resources:
Devon Bank "Islamic Financing" http://www.devonbank.com/Islamic/
LARIBA-American Finance House http://www.lariba.com/
El-Gamal, Mahmoud Amin, June 2000, "A Basic Guide to Contemporary Islamic Banking and Finance," http://www.ruf.rice.edu/~elgamal/files/primer.pdf
Thomas, Abdulkader, "Methods of Islamic Home Finance in the United States, http://www.guidancefinancial.com/pdf/Islamic_HFUS.pdf
Freddie Mac News, January 10, 2005 "Devon Bank, Freddie Mac Announce Expanded Financing Opportunities for Muslim Homebuyers: http://www.freddiemac.com/news/archives/afford_housing/2005/20050110_devonbank.html
Fannie Mae News Release, December 6, 2002 "Fannie Mae to Invest $10 Million in Unique Islamic Home Financing Model with American Finance House LARIBA" http://www.fanniemae.com/newsreleases/2002/2291.jhtml?p=Media&s=News+Releases

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About the Author

Gina Matthiesen is an attorney with Near North National Title, LLC. She practices in the area of commercial real estate.

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