The principles of Islamic finance

Islamic finance operates in accordance with the principles of Islamic law (or Shariah). The basic principle of Islamic finance is underlined by the prohibition of investment in interest-based ventures and businesses that provide goods and services considered contrary to its principles like tobacco, alcohol, gambling, vulgar entertainment and conventional finance.

Another fundamental principle of Islamic finance is highlighted in the sharing of profit and loss between parties in a business transaction. Common terms used in Islamic finance include profit sharing (Mudharabah), joint venture (Musharakah), leasing (Ijarah), safekeeping (Wadiah) and cost plus (Murabahah). Currently estimated to be worth around US$1 trillion globally with 300-plus Shariah compliant financial institutions operating in more than 75 countries today; this industry is growing at a remarkable pace of approximately 15%-20% on a yearly basis, thus representing a vast practice which has developed its presence on a global scale. Despite a widespread misconception, Islamic finance does not require specific laws and is not limited to the Muslim community. Except for several predictable prohibitions mentioned earlier, Islamic finance solutions are applicable everywhere and by anyone.

It is of standard practice that Islamic banks and banking institutions that offer Islamic banking products and services are required to establish a Shariah Supervisory Board to advise them and to ensure that the operations and activities of the bank comply with Shariah principles. An essential ingredient is a regulatory framework that can accommodate Islamic finance principles and a regulator that is prepared to work with Islamic institutions to overcome technical hurdles. There must also be a tax regime that enables Islamic financing structures and products to be treated in an equivalent manner to their conventional counterparts. 

The appeal for Islamic finance has become infectious to an extent where the largest Muslim populations in the world, most notably India has developed a profound interest for Shariah compliant products to cater for its community and business sector. In view of capitalizing on the opportunities that Islamic finance has to offer, the Indian government and corporates have taken the initiative to closely examine which Shariah compliant companies and sectors are able to further contribute to the development of Shariah market capitalization in India. This is solely due to the fact that India believes that by complying with the economic laws of Shariah, she can become an attractive destination for Islamic investments. The Islamic finance sector in the United Kingdom has also seen enormous growth both domestically and internationally. London is one of the top five financial centres in the world for Islamic finance.

Islamic finance has always been known and seen as a form of socially responsible investing whereby Shariah law requires that investments made have to be based on tangible assets and that lenders and borrowers in a business transaction share profits and losses. It is unfortunate however, that the rapid growth of Islamic finance has converted itself as a breeding ground for socially irresponsible investors who are ignorant about the social impact of investment. It is not unusual to come across conventional profit-driven investments these days that are dressed up to look like Islamic finance. The presence of Shariah-dress investments only serves as an invitation to unethical profit chasers who seek to threaten the health and reputation of the Islamic financial market. As such, it is vested within the powers of national financial watchdogs to ensure that Shariah-dressed investments are not part of an Islamic financial market that only decreases its immunity to the global financial crisis.

The issuance of sukuks, which conform to Islam’s prohibition of receiving or paying interest, has come under intense scrutiny in recent times over fears of a debt default in Dubai. Commonly referred to as Islamic bonds, companies that issue sukuks make payments to investors using profits from the underlying business instead of paying interest. The Dubai crisis has sparked speculation that Islamic finance is no different from conventional finance that led to the financial turmoil a couple of years ago.

However, many fail to understand that the main cause of the Dubai crisis is purely one of a credit issue where Dubai World and its subsidiary Nakheel have over borrowed and over expanded within the real estate and tourism sectors to an extent where near-term repayment obligations cannot be met. In short, the Dubai crisis demonstrates the fragility of the financial and economic system in Dubai, which is one based on excessive borrowing to finance excessively luxurious projects without giving much consideration to the economic feasibility of such projects. Notwithstanding, the assistance by Abu Dhabi in the form of USD10 billion has allayed all the fears.

Despite reservations held by several parties that Islamic finance is just as susceptible to the global economic turmoil, many still maintain that there is vast potential and opportunities for financial institutions to tap in the field of Islamic banking and finance. With the adoption of stringent Shariah principles, Islamic finance offers a huge alternative economic opportunity to the conventional methods that investors have become accustomed to. Many countries globally from Europe, Middle East, Asia, Australia and even the United States have realized the importance of Islamic finance. Malaysia, being one of the pioneers of Islamic finance and location of the highest number of sukuks issued globally remains at the forefront which provides guidance to others in terms of regulatory and legal aspects.

LAWorld News

Game Changer in Malaysian Real Property Investment

Malaysian law is changing.  Once rarely used, Real Estate Investment Trusts have recently come of age in Malaysia.  REIT’s, as they are called, provide an excellent investment vehicle to reach the burgeoning economic powerhouse of Southeast Asia.  

Andrew Carnegie (1835-1919), an American industrialist who was the richest person in the world of his day said, "90% of all millionaires become so through owning real estate". For many years, the most favourite way of investment was to buy a property.  However, many investors faced problem obtaining a bank loan, being exposed to interest rate volatility and even finding tenants who will pay rent that justified the investment. The landscape in Malaysia has changed by having an alternative property investment tool called Real Estate Investment Trust (REIT). A REIT is a fund or a trust that owns and manages income-producing commercial real estate. A management company for a REIT is permitted to deduct distribution paid to its shareholders from its corporate taxable income. REIT provides investors with an extremely liquid stake in real estate. They receive special tax considerations and typically offer high dividend yields.

The year of 2015 marks the first decade of Malaysian REIT (M-REIT). M-REIT market has shown steady growth over the past 10 years. As at 30 June 2016, M-REIT market had a total market capitalization of RM41.07 billion.  The M-REIT industry started off with Property Trust Fund listed on the Kuala Lumpur Stock Exchange in 1989. The term REIT was subsequently adopted and the industry grew with an increasing number of listed REIT. M-REIT is represented by 17 REITs, including four Islamic REITs of which one is part of a stapled structure. The development of the M-REIT market is unique as it provides a common platform for the existence of both conventional and Islamic REIT. M-REIT owns a wide range of real estate, including office buildings, retail malls, hotels, healthcare establishments and industrial properties. Many iconic properties such as the PETRONAS Twin Towers, Mid Valley Megamall, Pavilion Kuala Lumpur, Sunway Pyramid and the Ritz-Carlton Kuala Lumpur are now held under a REIT structure. This could be read as a vote of confidence from property owners to the viability of REITs in Malaysia.

Legally, REITs exists in the form of unit trust in Malaysia. It is governed by general trust law. Trusts are not separate legal entities, but are generally a set of obligations accepted by a trustee in relation to the properties held in trust for beneficiaries. A typical M-REIT consists of a Trustee who holds the units on behalf of the unitholders, a REIT Manager who acts as the asset manager,  and a Property Manager who mainly acts as  the  manager  of  the  portfolio  of  properties.  The REIT Sponsor  is another  key component  of  M-REIT  as  it  is  usually  the largest  unitholder  of  the  REIT  and  shareholder the REIT Manager.  The Sponsor is also viewed as provider of pipeline assets to the REIT.  In  addition  to  the  main components,  an Islamic  REIT in Malaysia  must maintain  a  Shariah  Advisor who comprises learned scholars in Shariah for the purpose of dispensing Shariah-related advice to the REIT Manager on  Islamic asset  management  principles. The instrument constituting REIT is a Tripartite Agreement between three parties which are the manager, the trustee and unitholders. This tripartite relationship is governed by a Deed registered with the Securities Commission. As prescribed under section 288(1)(b) of the Capital Market and Services Act 2007, a management company should ensure that there is a deed in force for a fund. The deed should contain the minimum requirements prescribed under Schedule A of SC Guidelines and those specified under securities laws. A management company, or its adviser should submit an application to register and lodge the deeds in accordance with the requirements and procedures set out in Appendix III of Schedule D of SC Guidelines on REIT.

In Malaysia, the Guideline on REIT is issued by the Securities Commission under section 377 of the Capital Market and Services Act 2007. The first version of the Guidelines was issued on 3 January 2005. On 21 August 2008, the Securities Commission issued the revised Guidelines on REIT to enhance the attractiveness of Bursa Malaysia as a destination for REIT listings and promote a vibrant and competitive REIT industry domestically and regionally. The same Guideline was updated on 28 December 2012. To further facilitate the sustainable growth of the M-REIT market, the Securities Commission is currently undertaking a comprehensive review of the REIT Guideline through the Public Consultation Paper No. 3/2016 dated 14 July 2016. In undertaking this review, the Securities Commission has taken into consideration the evolving needs of investors and the REIT as well as developments and regulatory requirements in the regional markets. The Securities Commission has had discussion with various stakeholders in relation to the proposals under this consultation paper and some of their views have been incorporated. The 16 proposals by SC will expand the scope of permissible activities, significantly enhance corporate governance on M-REIT disclosure and streamline the efficiency in post-listing requirements. Through this Consultation Paper, SC has proposed further liberalization to the permissible list of activities to be undertaken by M-REITs. The key proposal is to allow M-REITs to acquire vacant land and to undertake property development subject to a cap of 15% of the enlarged total asset value of the REIT. SC further proposes to cap the leverage level at 50% of total asset value and to  remove  the  option  of  allowing  REITs  to  increase  their  leverage thresholds by obtaining the unitholders’ approval. In addition, since the current REITs Guidelines have no provisions for REITs to buy back their units, the SC proposes to allow listed REITs to buy back their own units.

International investors may have read about the recent Sime Darby Bhd proposed reverse takeover (RTO) of Singapore-listed Saizen REIT is regarded as a positive development as the exercise will enable Malaysian conglomerate to monetize assets in Singapore and Australia. The discussion is still at framework agreement stage and pending signing of sale and purchase agreement. Under the propose RTO, Sime Darby will inject some of its industrial properties located in Australia to Saizen REIT for the exchange of new units in Saizen REIT and cash. The REIT platform is expected to have greater flexibility in its future fundraising exercises to build a sizeable international portfolio assets, in which Sime Darby will benefit from its direct stake in Saizen REIT.

However, unlike Singapore, Hong Kong and Japan, M-REIT market is still relatively small and untapped. According to analysts, the implementation of the goods and services tax (GST) in April last year caused a slowdown in domestic consumption and lower retail sales had a negative impact on M-REIT with exposure to shopping malls. This is because some managers have a higher proportion of turnover rent, which is charged based on the tenant’s monthly revenue, than fixed base rent. Such is the case of IGB REIT, which owns MidValley Megamall and The Gardens. The performance of M-REIT is also impacted by the sluggish economic outlook and uncertainties surrounding global crude oil prices. Despite these strong headwinds, the period of uncertainly is unlikely going to last long before M-REIT gets back in the game again especially after the proposed amendment to REIT Guidelines by the Securities Commission. According to Securities Commission, the move to liberalize the requirements on M-REIT will enable them to create more value for their investors.

For more information please contact Mohamed Ridza, our Malaysia LAWorld member in Kuala Lumpur.

Mohamed Ridza & Co.

Tel. +603-20924822

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