Combining Conventional and Islamic Real Estate Finance Techniques: How to Get The Deal Done

CRE Finance World, Winter 2014

Combining Conventional and Islamic Real Estate Finance Techniques: How to Get the Deal Done lobal Islamic finance assets were estimated at $1.8 trillion in 2012, and are expected to double over the next three years. The global demand for sukuk (Islamic compliant bonds, often backed by real estate assets) is forecast to grow three-fold from $300 billion to $900 billion by 2017. Due to the importance of having assets to back Islamic compliant structures, this demand has been reflected in the financing of real estate acquisitions in the US and in key cities globally. Equally, non-Islamic investors have sought out alternative sources of finance, including Islamic compliant finance, since usual financing methods have been constrained. The structural differences between conventional and Islamic compliant tranches of finance mean that issues surrounding drawdowns, payments, cash treatment, intercreditor arrangements, prepayments, security and enforcement need to be considered and documented carefully. Overview of Islamic Finance Key principles of Islamic (or Shari’a) finance include: • Prohibition of the payment or receipt of interest; • Avoidance of uncertainty; and • Prohibition of involvement with certain industries, including gambling and alcohol. Islamic finance principles in relation to real estate finance do not form a codified system of law and may be subject to varying interpretation by boards of Islamic scholars that oversee the activities of Islamic compliant financial institutions and funds. Interpretations of Islamic principles can differ substantially. Accordingly, it is important for a conventional lender or borrower to identify any specific Shari’a related issues early in the process of working with an Islamic compliant counterparty. In the vast majority of cases co-financing documentation will be governed by New York, English or other national law, so that the Islamic compliant principles of the transaction need to be documented via such national law. Structuring Loan Payments In a conventional loan, the principal amount may either be drawn in one amount or in stages during an availability period. This will not always be the case with an Islamic tranche of finance. For example, in an ijara (Islamic compliant sale and leaseback structure) facility, where the real estate asset exists when the Islamic compliant facility is entered into, the seller must be paid the full purchase CRE Finance World Winter 2014 66 price upfront. However, if a forward lease is used in conjunction with an istisna’a (Islamic compliant real estate financing structure), the payments could be made by installments or at the end of the istisna’a. It is therefore important to ensure that the istisna’a stage payments match the drawdown profile of the conventional lenders. In order to coordinate payments to financiers, interest periods under a conventional loan should correspond to the relevant periods under the Islamic financing (which may, for example, depend on lease periods, deferred payment periods or periodic distribution dates) so that payments are made to the Islamic financiers and the conventional lenders at the same time, if this is the commercial deal. How Does a Lender Get Paid? As interest should not be charged or received by an Islamic compliant financier, a return to the financier is structured in other ways, such as a rental or profit payment. In a co-financing, payments are often made in accordance with a common cash flow waterfall with cash being applied at a particular level of the waterfall towards payment of principal and interest under the conventional facility and, for example, the deferred purchase price or base rental and profit on the Islamic compliant financing structure on a pro rata and pari passu basis. A minor exception to this principle is that although certain amounts may be claimed by financiers on the conventional facility on an immediate indemnity basis (for example, increased costs), financiers of the Islamic compliant financing structure may only be able to claim the equivalent amount at a later date because they will be factored into the deferred purchase price or rental payable by the obligor in a subsequent period. Dealing with Intercreditor Issues In certain circumstances, Islamic financiers and conventional lenders may enter into formal intercreditor documentation, documenting the priority of payments and the ranking of security. This is most likely the case where structural subordination (illustrated in the case study below) is not possible and where the same entity is the borrower under both the conventional and Shari’a finance. An intercreditor agreement between Islamic compliant financiers and conventional lenders is likely to address many similar matters covered in such an agreement between solely conventional lenders, with such adaptation as may be required to account for the Islamic financing structure and the compliance requirements of the parties. The intercreditor agreement may need to identify the respective rankings of payments under the Islamic and conventional finance documents to deal with allocation of income or proceeds following G Katie Hillier Senior Associate K&L Gates Stacy Ackermann Partner K&L Gates Jonathan Lawrence Partner K&L Gates


CRE Finance World, Winter 2014
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