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Demystifying Islamic investing

Islamic investments in European property continue to grow, reaching nearly €2.5 billion in 2005, up from €2 billion in 2004. Investors are attracted to the low cost of debt and the quality of stock in key European markets, which still offer positive margins between rental yields and financing costs in major markets. Markets are well regulated and relatively stable, and are expected to remain so over the near to medium term.

While the ordinary perception remains that Islamic real estate investors must grapple with a labyrinth of prohibitions that govern their investment criteria and financing options, the fact is that they are as sophisticated and financially driven as their conventional counterparts. Ethical investing by no means suppresses the economic and business objective of achieving target returns.
Therefore, Islamic investors evaluate each transaction on its economic merits to eliminate quickly commercially unviable opportunities before spending further time assessing Shariah principles and whether to reject a real estate opportunity. The muqasid or objective of the transaction is clearly profit, although the operative principle governing the investment remains compliance with the ethical code prescribed by Islamic law.

Investment opportunities are primarily screened for potential returns-whether income or capital growth. If the numbers do not achieve a particular hurdle rate, then the transaction is rejected by the Islamic investor before assessing whether it abides by Shariah principles.

Most Islamic investors are income-driven, seeking annual returns higher than 8% for European investments. Some will be motivated by total returns rather than cash yield, seeking capital growth of at least 30%. In either case, the Islamic investor will be motivated, in the first instance, quickly to assess the potential returns of an asset, to filter out transactions that deliver insufficient profits, before spending more time considering the underlying prohibitions. Much has already been written about the principles of Shariah.

Under Islamic law, investors are prohibited from deriving their source of income from activities that contravene the Shariah, such as the production or promotion of armaments, sale of pork, tobacco, alcohol, lewd films, interest-based banking and insurance services.

However, if a commercial asset with relatively few non-compliant tenants offered sufficient cash returns and attractive capital growth that fulfilled the Islamic investor's requirements, then mechanisms can be used to purify the income derived from the prohibited sources. Rachel Tan is associate director, DTZ Corporate Finance, which specialises in real estate products for institutional and private investors in the Middle East

On the verge of a boom

For some time we have heard and evidenced the growth of Islamic finance as an alternative banking product class and how it has become more mainstream. The numbers quoted in percentile terms of the growth over the past three decades, the annual growth rate, the amounts under management and the overall size of this growing market are obvious from the media coverage. The role played by the Islamic Development Bank (IDB) in the creation of multi-billion dollar market financial instruments has enabled the economic development of the Islamic ummah. The days of excitement by the development of the murabaha, musharika and ijara have been replaced by the emergence of the arboun and sukuk as the innovative counterparts to conventional options and bonds. However, the most dynamic development is that the products and applications are becoming uniform and the Shariah rules are being adopted across the wider market and jurisdictions.


Certain issues still remain and do vary from region to region and in some cases between Shariah scholars, but there is a lot more convergence, which is providing the impetus to the sector. Bankers are being innovative and are engaging the scholars to conduct the research that enables more exotic products to see the light of day.

The flavour of the moment is the real estate funds, as they lend themselves conveniently as an asset class under Shariah criteria. There are some good reasons for this. Primarily, post-9/11 investors are shying away from too much exposure to the US, and Europe is a maybe. Most of the investable capital is being poured back into "their own backyards", meaning the GCC states.

The emergence of investment in the region engenders the development of an industrial and infrastructure base. Further, the increased oil revenues are fuelling the boom. So far, one witnesses the boom in real estate in terms of concentration in commercial and residential developments. Some degree of diversification into other areas such as industry and the infrastructure must be put in place to match this. More than anything, there should be some form of local industrial development. The spiralling prices will not be able to be sustained, as there is too much speculation.
When all the projects are ready for occupancy and come to the market at a similar time, at that point it will become a buyer's market and prices will soften. The prevailing prices cannot be afforded by most people, and that is where the hurdle will lie. The local banks that have funded the mortgage market will find that their assets will show a fall in margins. The banks' clients may well find themselves in negative equity and dire straits.

(Majid Dawood is CEO Yasaar Ltd, 1 Liverpool Street, London EC2M 7QD.
Tel: +44(0)207 956 2014; fax: +44(0)20 795 62001; Yasaar LLC, Dubai, UAE, tel: +971(0)50324 7084)

In search of a common ground

The Islamic banking industry has grown rapidly since the 1970s, reflecting the demand by pious Muslims to manage their finances in a way that avoids interest and complies with Islamic law. More than 30 per cent of bank assets in Saudi Arabia are now classified as Shariah compliant, the figures for other Gulf states ranging from 10 to 20 per cent, while in Malaysia around 10 per cent of bank assets are Islamic.

The last five years have witnessed the rapid growth of Islamic securities, known as sukuk, with more than US$6 billion issued in 2004, and major western banks such as Citigroup and HSBC involved in their management. At the retail level in the UK, the Islamic Bank of Britain was given regulatory approval in 2004 and opened its first branch on the Edgeware Road in London, and four further branches were opened in 2005.

The new methods of accepting deposits and providing financing without interest provide challenges for financial regulators, and there has been much debate about whether Islamic banks can be regulated in the same manner as conventional banks, or whether different criteria should be used. There is even debate about whether Islamic banks are actually banks, as their savings and investment accounts cannot be guaranteed and, therefore, arguably have some of the characteristics of investment companies.

Furthermore, much Islamic financing involves trading and leasing rather than conventional lending and, consequently, the institutions involved could be regarded as trading and leasing companies rather than banks. Some Muslim scholars see Islam and banking as being incompatible and, therefore, they object to the term "Islamic banking", which could be seen as using religion to promote banking. Hence, in Kuwait the largest Islamic financial institution is designated as a finance house, not as a bank.

Political factors ultimately determine the regulatory environment.1 In some countries, notably in North Africa, Islamic banks are perceived, rightly or wrongly, to be linked to Islamic political parties, and are, therefore, refused banking licences, as in Libya or Morocco.

Elsewhere, such as Egypt, Algeria and Tunisia, governments are extremely cautious. Although Islamic banks are tolerated on the fringes, there has been little official help or encouragement.

By contrast, in Bahrain and Malaysia there has been much official support and encouragement, which has been reflected in a positive regulatory approach. In Iran and the Sudan, laws have been passed to ensure that all domestic retail and commercial banking is undertaken interest-free.

The position in countries with non-Muslim majorities is generally less favourable, although there are exceptions, such as with regulators in some western countries, notably the UK, where the Financial Services Authority (FSA) has played a helpful role. In the US, despite the negative fall-out for the Muslim community from the events of September 2001, regulators have been generally helpful, as there is the desire not to be perceived as discriminating against any group on religious grounds.

In more mono-cultural and secularist societies, such as France, there is scepticism and even hostility towards Islamic banking, and it is unlikely that any licences would be granted to permit Islamic banks to operate. Similarly, in developing countries such as Nigeria or India, with histories of conflict between Muslims and other religious groups, no Islamic banks are allowed.

(Professor Rodney Wilson, University of Durham, Institute for Middle Eastern & Islamic Studies, tel: 44(0)191 374 2831; email:

Role change in state investment

Increasingly, the Gulf states are moving away from their traditional role as decision maker, investor and producer of goods and services. The view of many governments in the region is that they should move into a supervisory role and encourage the private sector to participate in areas once reserved exclusively for the state.

The main sectors that have been liberalised and deregulated are power, water, ports, airports and telecoms. With the exception of upstream activities, there has been a move towards engaging private companies to participate in the traditionally closely guarded hydrocarbon sector. The private sector has been encouraged, in particular, to invest and participate in petrochemical and refining activity.

Privatisation has come about in many forms. In relation to ports, airports and most recently transmission and distribution of utilities, the use of management contracts and operating concessions has been popular.

In other cases, joint ventures between public and private sectors have been established, such as the joint venture between the state-owned Abu Dhabi National Hotels Company and Compass Group plc. On this transaction, a new company was formed by merging the operations of Compass Group Middle East with various divisions of ADNH to penetrate regional markets more effectively.

The management contract/joint venture approach allows the state to reap many of the perceived benefits of private sector efficiency and skill-sets. However, it does not tackle the problems of market distortion and increasing demands placed on state fiscal budgets. This benefit can normally be achieved only by some form of divestiture option, including pursuing policies such as direct or partial sales, public share offerings and permitting the private sector to implement new projects in sectors once exclusively reserved for the state.

The growth in regional independent power purchase (IPP) and independent water and power purchase (IWPP) projects is an example of the divestiture approach, and in many ways, the first IPP in the Gulf at Al-Manah in the Sultanate of Oman in 1996, was a key turning point for infrastructure privatisation. In addition to allowing a private sector company to generate power for the country, it created a blueprint for future project financings in the region, including the development of precedent documentation for the single-buyer IPP model.

Following on from the ground-breaking Al-Manah IPP, Oman has pressed ahead with private power generation. The sixth such project (a brownfield development at Barka and the acquisition of the existing Rusayl power station) was recently put out to tender. What is perhaps even more significant is the promulgation of the 2004 Power Sector Law in Oman, which seeks to give private sector investors the primary role in generating power for Oman.

Privatisation is now the official policy in Oman and the private sector must be looked at first before the public sector can participate in any future power projects. It is interesting to note that a similar position now exists in Bahrain, too-all future power generation projects will have to be undertaken by the private sector.

While private involvement in the generation of power in Oman has become commonplace, privatisation of the distribution and transmission network in Oman has yet to be commenced and the government has stated that its preference is to encourage private investment in the generation sector first before moving to transmission and distribution.

By contrast, Abu Dhabi has grasped the transmission and distribution nettle by recently putting out to tender a project to operate, maintain and provide management services to Abu Dhabi Distribution Company and Al-Ain Distribution Company. The belief is that two experienced water and electricity operators will be contracted to improve investment efficiencies, create a more transparent and accountable business and ultimately reduce government subsidies in this sector.

(Adrian Creed is Partner, Trowers & Hamlins, London; tel. 020 7423 8200).

Stepping up a gear in Jersey

Jersey has ambitious plans to establish itself as a major centre for Islamic finance, and work has already begun to turn these plans into reality. However, it would be wrong to see this as a completely new direction for Jersey's financial services industry. Jersey has been undertaking Islamic finance work for around 20 years, and it already has significant expertise.

Jersey works closely with the City of London, and it has been interesting to see how London has been raising its own profile as a key centre for Islamic finance, culminating in the licensing by the Financial Services Authority of the Islamic Bank of Britain in August 2004. We view these developments positively.

There are three elements of Jersey's current, conventional offering which particularly lend themselves to Islamic finance: trusts, establishment and administration of funds, and corporate activity, including bonds and securitisations.

Jersey has been a leader in the provision of trust services for several decades and, as such, it is used by clients from all over the world. A trust is a legal device recognised throughout common law countries, but it is a concept that is also very similar to the Islamic waqf. Indeed, some academics have suggested that the concept of a trust was brought back from the Middle East by the Crusaders.

Whatever its origins, the trust concept has been developed over the centuries and it is now one of the most effective instruments available for tax, estate and succession planning. In the past few years, Jersey has been asked by an increasing number of clients to establish trusts in compliance with Shariah, while at least two major Middle Eastern banks have set up trust arms on the island.

As little as five years ago there was a sense that Muslims were uncomfortable or, at least, not entirely familiar with the use of trusts and there certainly seemed to be only limited demand for them. Today, though, there is a much more comprehensive appreciation of the benefits trusts can provide and, as a result, the use of trusts by Muslims has grown significantly.

Jersey's funds expertise spans over three decades, and Shariah-compliant structures have been established in the island since the mid-1980s. Historically, Jersey was a major player in the management and administration of retail funds, but in 1985 the European Union (EU) amended regulation in respect of such funds, which had the effect of limiting access to EU markets by non-EU members such as Jersey.
As a result, much of that retail business drifted away from Jersey to EU jurisdictions, such as Dublin and Luxembourg. Within Jersey there has been a gradual shift towards property, private equity and other bespoke funds, including, more recently, hedge funds.

In 2004, Jersey introduced its "expert funds" regime, which simplified its regulatory approach to expert structures, that is, non-retail. This refined approach has proved hugely successful and has resulted in more than 100 such funds being established in the first nine months of 2005. Apart from the expertise in its funds sector, Jersey offers Middle East fund promoters the opportunity to tap into European investors with the added advantage that such funds can be listed on the local Channel Island's stock exchange.

(Phil Austin is chief executive of Jersey Finance Ltd, St Helier, Jersey, tel: +44 (0)1534 83600.)

Creating products and raising awareness

Globally, Islamic banking finance industry assets have reached close to $300 billion in 2005 and the market has an estimated annual growth rate of more than 10 per cent, according to recent figures gathered by the Council for Islamic Banks.
With more than 270 Islamic financial institutions in more than 40 countries, it's hard to believe that UK Muslims would struggle to find banking services that fit with their faith, but at the moment the market is mainly concentrated in Muslim countries of the Middle East, North Africa and South East Asia. The European market is relatively untapped.

This seems quite an oversight, as the Muslim community is one of the fastest growing in Britain today. There are around two million Muslims living in the UK and about 700,000 temporary visitors. Many are homeowners, and nearly all require bank accounts, but until recently, there were few financial service products that met their needs while complying with Islamic law.

Our initial research showed that more than three-quarters of British Muslims wanted banking services that fitted with their faith. This presented us with a great opportunity and a challenge we simply couldn't turn down. In February 2005, Lloyds TSB became only the third British bank to launch a current account designed to comply with Shariah regulations following in the footsteps of HSBC and the Islamic Bank of Britain. The current account was followed in March with a home finance offer to help Britain's Muslims purchase their own homes.

Clearly, to move into Islamic financial services it was essential to adhere to the required conditions, namely, complete segregation of funds, existence of a Shariah supervisory board, management that is committed to Islamic financial concepts, safeguarding of Muslim funds from negligence, trespass and fraud, and compliance with the standards of the Accounting and Auditing Organization for Islamic Financial Institutions.

We talked to a number of scholars and put together a panel of four: Sheikh Nizam Yaquby, Dr Muhammed Imran Ashraf Usmani, Mufti Abdul Kadir Barkatullah and Muhammed Nurullah Shikder.  The board of scholars selected were highly qualified to issue fatawa on financial transactions. In addition, they had considerable experience in working with modern financial service companies around the world.

Paul Sherrin is head of Islamic financial services, Lloyds TSB



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