The global recession has sparked interest in Islamic finance with its emphasis on risk aversion. And real estate is the ideal asset class for Sharia investment. Henri Vuong explains

Interest in Islamic finance accelerated with the downturn of the international financial markets. Its risk aversion was assumed by many to ‘insulate' against the global economic and financial slowdown. It has been regarded as a potential source of capital for markets starved of cash for investment, either through the equity route (creating Sharia compliant products to attract capital from Islamic countries) or through the debt route (creating Islamic financial structures to raise capital). Either way Islamic finance still faces some challenges of its own in its attempts to drive the market forwards.

The lack of harmonisation in the interpretation of the Sharia, the rules that govern the Islamic way of life, remains its Achilles' heel. Asian countries tend to gravitate towards a more regulated environment, while the Gulf Cooperation Council countries (Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates) prefer to respond to market demand.

Either way, if the end goal is to attract Islamic investors to non-Islamic markets or conventional monies to Islamic jurisdictions, then the current economic environment and market globalisation seem to be narrowing the gap between the two sides, financially speaking, and these two ideologies may eventually fuse in order to drive the nascent market forwards.

Sharia compliant products are underpinned by the principles of Islamic law, which strictly prohibit investment in pork products, pornography, conventional financial services, arms and munitions, cinema, tobacco and alcohol, and anything involving gambling (maysir) or uncertainty (gharah). At the heart of Islamic financial practice lies the prohibition of usury (riba), which forbids the exchange of interest. Islamic finance structures have an intrinsic preference for equity rather than debt, and are generally based on tangible assets.

Manifestly, short selling, speculation and investment in highly leveraged assets are generally forbidden. Islamic finance is essentially a form of ethical investment, and ethical lending with risk sharing is highlighted as being one of the quintessential features of its practice.

So by its very nature, real estate lends itself to Sharia principles better than almost any other asset class. Islamic investors seeking stable, periodic income streams equivalent to interest incomes on conventional bonds or loans find real estate an attractive investment because of its rental stream. In this regard, a leased property makes a fairly straightforward Islamic investment because of its relatively fixed and periodic cash flow. Structurally there is little difference between a non-geared conventional real estate fund and one that complies with the Sharia.

For example, the Musharakah, a risk and reward sharing partnership, is analogous to a joint venture partnership, while the Mudarabah, an investment partnership, is akin to the conventional arrangement between fund manager and its investors. In a Musharakah all partners contribute funds and have the option to participate in the management of the venture. Losses are borne in proportion to each capital investment, but profits are distributed in accordance with a pre-agreed ratio.

In a Mudarabah, however, only one partner provides capital investment while the other provides the expertise. This partner, known as a mudarib, manages the venture and invests on behalf of the other partners, earning a predetermined share of the profits. If no profit is made, the loss is borne by the external investors and the mudarib does not earn a fee.

Besides the risk sharing philosophy, such funds fundamentally differ in their respective stock and tenant selection processes, as investments in and lettings to businesses that trade in the forbidden practices are generally not permitted under Sharia law. Operationally it may appear difficult to impose such controls, but a degree of pragmatism is allowed.

The process of ‘portfolio purification' allows up to 5% to be invested non-compliantly, subject to a donation offset to a Sharia approved charity. Capital flows must also comply. Islam's prohibition of usury implies that accrued interest must also be donated in a similar fashion. Capital flow management may be undertaken through a Sharia compliant special purpose vehicle or an Islamic bank, such that ‘profit' rather than interest is receivable.

Undoubtedly such criteria require further due diligence, as Sharia compliant structures require approval by a Sharia board. Every transaction, whether acquisition, disposal or letting, and cash flow arrangements must be approved by a panel
of Islamic scholars with expertise on both Islam and finance.

The board may also provide guidance on fund structure, investment guidelines and portfolio purification, and undertake an independent periodic audit of all transactions to ensure that a Sharia compliant fund has met the requirements of the Islamic investment principles.

In some ways the divergence in views among participants has hindered the market's growth. Islamic financial markets and the Sharia approval process are currently unregulated by any global central body. In the Middle Eastern region the Accounting and Auditing Organisation for Islamic Financial Institutions sets the standards for Sharia compliance. In Southeast Asia the Islamic Financial Services Board was established for similar reasons.

Undeniably both have been driving forces behind market transparency and standardisation in their regions. However, look to the east and you will see a more regulated solution; look to the west and you will find a more market-driven one.

Irrefutably both are working towards the same goal, namely to aid the rapid growth of this sector and with it to meet the pent-up demand for Sharia compliant offerings. The global financial downturn has only helped to highlight some of the advantages of the risk aversion concepts of Islamic financing.

However, in order for it to compete in today's diverse market it must be able to operate on a level playing field by competing effectively on price and performance. In this regard, it seems the way forward varies considerably between the twin hubs of Islamic finance with one putting its trust in the market and the other in regulation.

Certainly the arguments on both sides are well founded, but neither system in isolation is the solution for the development of Islamic finance. Both are needed but with a modicum of intelligence and fairness thrown in. Over-regulation stifles growth, but under-regulation gives freedom for unscrupulous market players to exploit it towards their
own ends.

Despite the friction, players from both sides of the ideological divide recognise that some kind of synthesis will help to drive the market forwards.