Combining Conventional and Islamic Real Estate Finance Techniques: How to Get the Deal Done Real Estate Financing Case Study A recent transaction in the United Kingdom involved the use of conventional and Islamic compliant financing to finance the purchase of a major department store. The investor group had incorporated two special purpose vehicle companies — Holdco and Propco, Holdco being the parent of Propco. Holdco was to receive the Islamic compliant finance and Propco to receive the conventional loan. There was therefore an immediate structural separation between the tranches of finance. However, this deal must be seen on its own facts as other Islamic compliant financiers may immediately have an issue with a subsidiary of its customer taking on conventional debt. The Islamic financiers comprised the investors and a special purpose vehicle company incorporated for the purpose of the transaction (the SPV). The Islamic financiers had their own board of scholars who approved the whole transaction. However there was a representation in the documentation that a party that itself abided by Islamic principles should not seek to later rely on this status to avoid or disclaim a contract: “Insofar as it wishes or is required for any reason to enter into transactions, agreements and arrangements which comply or are consistent with the principles of the Shari’a (‘Shari’a compliant’ or ‘Shari’a compliance’), each party has made its own investigation into and satisfied itself as to the Shari’a compliance of this agreement and all necessary action to confirm that this agreement is a Shari’a compliant agreement has been taken (including the obtaining of a declaration, pronouncement, opinion or other attestation of a Shari’a adviser, board or panel relevant to it where required).” The investors put their cash into the SPV. Then the SPV and the Holdco entered into a tawarruq (or reverse/monetizing murabaha). This is a technique whereby the SPV funded Holdco in order for Holdco to buy an asset (in this case a quantity of platinum) on a deferred repayment basis (plus an agreed mark up). Holdco immediately resold the platinum on the spot market for cash to a third party. This transaction meant that Holdco had an amount of funds in order to make a shareholder loan into Propco. That shareholder loan was interest bearing, which was approved within the context of this transaction; however, an equity investment or non-interest bearing loan by Holdco into Propco may have been required in other circumstances. Propco then borrowed conventionally from a bank and used that loan and the shareholder loan from Holdco to purchase the investment property. CRE Finance World Winter 2014 68 The terms of the conventional finance documents controlled Propco’s cash flow so that rental and other income from the property was paid into an account controlled by the conventional bank and went first to service payments due in respect of the conventional loan. In addition, the conventional finance documents limited Propco’s ability to distribute funds to its parent, Holdco. Dividend payments were restricted so that they could only be made in certain circumstances, such as while no default was continuing under the conventional finance documents. HoldCo’s shareholder loan to Propco was formally subordinated in a subordination deed between the conventional bank, Propco and Holdco. Whether purely as a result of the structure and the conventional bank’s control of cash flow, and/or by a formal subordination deed, the effect was that the Islamic compliant finance was subordinated to that of the conventional bank. Propco granted conventional security over the property and its other assets to the bank. In addition, Propco entered into a sale undertaking in favor of the SPV, which gave the SPV the right to call for the real estate to be transferred to it. This may seem broadly analogous to third party security for Holdco’s payment obligations under the tawarruq, but there were crucial differences: • The sale undertaking was not expressed to be granted by way of security. • The SPV’s rights pursuant to the undertaking were not exercisable only when Holdco defaulted. Given the second of these points, the conventional lender required comfort that its security had priority over the SPV’s rights under the sale undertaking. In this transaction, the effect of registering the conventional lender’s security at the central land registry gave rise to a restriction on the title. This meant that the sale undertaking could not be exercised without the conventional lender’s written consent. That ought to remain the case, whether or not the sale undertaking was registered as an option over the land in question, provided there was sufficient evidence of the parties’ intentions that the sale undertaking was to be subject to the conventional lender’s security. Conclusion As this type of co-financing becomes more common, investors, financiers and their advisers will need to be adept at understanding and combining finance tranches with contrasting structures.
CRE Finance World, Winter 2014
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