As traditional sources of real estate debt dry up, Islamic finance has been able to step in to provide greater liquidity in the UK, says Jervis Rhodes

With humble beginnings in the 1970s, Islamic finance assets today total nearly $1trn (€759m) globally. Despite its exponential growth in recent years, expanding at a compound annual growth rate of 20% over the past three years, it remains a tiny subset of the global financial industry.

Deutsche Bank estimated in a report last November that Islamic finance would almost double to $1.8trn in assets by 2016, as stagnant conventional lending pushed companies to seek alternative financing methods. One of the areas where this trend has been most prominent over the past four years in particular has been property finance.

Over the past four years the financial services industry has changed beyond all recognition. The failure and subsequent bailout of some conventional banks has led to major reputational damage. The subsequent fallout has raised a fundamental question mark over attitudes to risk, with disillusioned customers demanding increased transparency and a more responsible approach to lending.

Against this backdrop, the principles at the heart of Islamic finance - sharing risk and reward with clients and a deep commitment to promoting justice and fairness in all financial dealings - have taken on renewed meaning. In many ways these principles mean that Islamic banks' closest conventional counterparts are the ethical financial institutions.

There used to be a misconception that Islamic finance was available only to Muslims or that companies would pay a premium for an Islamic product. In fact, the policy of the UK's Financial Services Authority (FSA) towards Islamic banks has been summed up as ‘no obstacles, no special favours'. So Islamic banks compete on a level playing field with their conventional counterparts and provide a comparable and competitive offering for any client who is looking for a more responsible and sustainable approach to property financing.

Although Islamic banks were not immune to the financial crisis, some of their inherent business practices protected them from the worst of the excesses. Although the financial crisis presented serious challenges to Islamic banks, it also provided to those with the liquidity a platform for growth.

Property has always been a popular asset class for Islamic financial organisations, as every Islamic transaction must be backed by a real, tangible asset. Property financing, including development finance, is a natural fit with Islamic finance.

Many of the conventional banks that severely curtailed their lending over the financial crisis remain relatively inactive in the property sector. Islamic banks generally had higher levels of liquidity than many of their conventional counterparts, so they were in a position to step in and fund some of these property developments and acquisitions. In our experience, many of those clients are still working with the Islamic banks today.

There have been many refinancing opportunities in recent years as banks decreased their property exposures with specific counterparties. Islamic banks have therefore been able to step in at a time when capital supplied by traditional sources had dried up, leaving thousands of property companies stranded.

In recent years there have been some large, high-profile Islamic property deals in London such as The Shard and Chelsea Barracks. Although these trophy deals will remain an important element in the Islamic finance property market, there is now a move toward diversification and innovation.

There has also been continued growth and innovation in the Islamic retail property market. Islamic Bank of Britain (IBB) offers mortgage products to personal clients that include a ‘home purchase plan' and a ‘buy to let' purchase plan. In order to reach the maximum customer base, in addition to these products being offered out of their branch network in the same way as a conventional organisation, they have office space in local estate agents. This has attracted increased interest since it has not been impacted by the stamp duty and capital gains tax changes announced in the Budget last month.

Over the past few years, there has been some significant innovation in the Islamic property fund market, including the development of a vehicle by Bank of London and the Middle East (BLME) to invest in light industrial buildings in the UK. The UK multi-let light industrial building sector currently covers over £30bn of properties, located in approximately 6,000 industrial estates. These are typically low-tech, low--obsolescence buildings constructed of concrete, brick or steel, and are used for light manufacturing, assembly, storage, warehousing and distribution activities. It is typically a sector overlooked by property investors, despite the fact that pricing in this sector is considered attractive, with high yields available on many types of industrial assets. Furthermore the lack of development in the sector over the past few years, as well as the strengthening of occupier demand, supports the prospect for rental growth in future.

Another growth area in the UK is Islamic real estate investment trusts (REITs). The REIT structure naturally complies with many of the Sharia'a financing rules. The reasons that they work with little restructuring is that income is based on predictable rents rather than interest, which is prohibited. Also, the assets are assessed not only for their underlying value but also their use. This means that some of the riskier or more speculative investments are avoided. Finally and importantly, the investment and cash flows are asset-backed.

However, significant momentum in this market segment might still be some time off; it took some time for the international Islamic community to embrace REITs fully, with Malaysia leading the way in 2006 following guidelines introduced by the Malaysian Securities Commission in 2005. The first Islamic REIT was launched in the US by the United Bank of Kuwait in the 1990s.

While the Islamic finance industry has stepped into the breach as an alternative finance provider in recent years, the key to sustaining this move will inevitably be the dissemination of knowledge and the broadening of the counterparty base.

The more companies and individuals that use Islamic products and services, the more comfortable the whole market gets. Interestingly, most legal and accounting firms have at the least an Islamic finance expert and some have whole Islamic finance divisions. With the professional services investing and Islamic banks working with them closely the level of knowledge and interest increases in the Islamic market and spurs further growth.

Jervis Rhodes is head of corporate banking at Bank of London and the Middle East