Islamic finance, the process of capital-raising in adherence to Sharia (Islamic law) represents a unique avenue of socially responsible investment. It embraces not only the means by which businesses and individuals procure funds but also the permissible investment opportunities that align with Shariah.
Islamic law perceives lending with interest as a relationship that perpetuates unfair advantages for the lender, exploiting the borrower’s expense. Money is viewed merely as a unit of value and cannot therefore be an income producing asset. Therefore, deriving income solely from money is forbidden. In contrast, the raison d’être of Islamic finance is to provide an arrangement in order that both financier and the party receiving finance (i.e. the buyer) are equally compensated, with the aim of advancing the socio-economic welfare of an Islamic community.
So how can finance be accessed in the absence of interest payments? Equity financing is permitted under Shariah, provided the companies involved abstain from engaging in prohibited activities such as alcohol production/consumption, gambling, and pornography. In non-Shariah finance, other positions in the cap stack are interest bearing (i.e. senior and junior forms of debt). Shariah finance, however, while strictly non-interest bearing, offers economically similar products in the form of Murabaha financing.
The transaction requires a small amount of financial engineering. In a Murabaha arrangement, the financier purchases a target asset and, in parallel, negotiates a sale price with the potential buyer, which includes an agreed-upon profit for the financier (i.e. a mark-up). The purchase can occur either outright or through a series of deferred payments.
But to purchase an illiquid asset such as an investment property is a reasonably intensive process, and so executing two simultaneous real estate transactions (the parallel purchase and sale) in order to facilitate Murabaha would be cumbersome and costly. However, Murabaha allows for another, unrelated asset to be substituted in favour of the acquisition target – this method is known as Tawarruq or Commodity Murabaha.
Many Shariah compliant financiers therefore use a highly liquid and tradable commodity (usually a precious metal) that represents the acquisition target in a financing agreement. The financier sells a liquid commodity (let’s say gold) to the buyer plus a mark-up which represents the cost of financing, and then the buyer sells the gold back to the financier for cash. The cash proceeds to the buyer can then be used to facilitate a real estate acquisition. Following this, a series of deferred payments to fulfil the original sale of the commodity to the buyer (including the mark-up) are arranged. It is the mark-up that takes the place of interest payments in a conventional bridge loan. The rights over the real estate asset can be assigned to the financier in order that they are secured, as they would be in a conventional asset-backed loan.
In simple steps, the process is as follows:
- Commodity Selection: Instead of directly dealing with the property, the financier selects a commodity (often a widely traded and readily available one) as a substitute for the property. This commodity serves as the underlying asset for the Murabaha transaction.
- Financier Purchase: To facilitate the transaction, a financial institution acts as an intermediary. The financier purchases the commodity on the open market at the current market price, effectively becoming the owner of the commodity.
- Commodity resale: The financier adds a mutually agreed-upon profit margin (mark-up) to the cost of the commodity. This profit margin is disclosed to the customer upfront.
- Commodity sale and property purchase: After the commodity is sold to the buyer, the buyer sells it back to the financier for cash. The cash proceeds are used to complete the purchase of the property from the seller, but with rights over the property assigned to the financier in order that they are secured.
- Deferred Repayment: The customer repays the financier in regular instalments, covering both the principal amount (original cost of the commodity) and the profit margin, typically in a bullet format for a bridge loan. The instalments are predetermined and fixed – they cannot be floating.
Through this method, the Murabaha method adheres strictly to Shariah principles, ensuring that the transaction is free from any interest (riba). The profit earned by the financier is based on the agreed mark-up, making it Shariah-compliant. By utilizing the Murabaha method with a commodity purchase, individuals and businesses can acquire property while adhering to Islamic principles of finance. It provides an alternative financing option for those seeking to avoid conventional interest-based transactions and promotes the spirit of ethical and Shariah-compliant investing and ownership.