Islamic Home Financing in Saudi Arabia

Transcription

1. Islamic Home Financing in Saudi Arabia By Edib Smolo ‫ & ٭‬Badr Kaseb Albadran ‫٭٭‬ Abstract Buying a home is a big commitment that consumes almost half of the salary monthly. Islamic banks in Saudi Arabia have developed several mechanisms to tackle the issue of home financing in ways in line with the Sharicah rulings. Some of the mechanisms are more commonly used than others and banks are trying to move towards more asset-based financing techniques that are believed to be more Islamic than debt-based. The recent ruling by the Islamic Fiqh Academy against organized tawarruq, which has been widely practiced in Saudi Arabia, will push Islamic banks to come up with new products. mushārakah & ijārah for house financing is one way out, a method that is gaining huge support, not only in Saudi Arabia, but all over the world. Joint ownership of a house is accepted by all schools of Islamic jurisprudence since the financier sells its share to the customer. In light of the above, this research aims at studying the current practices of Islamic home financing in Saudi Arabia and looks into the potential of the Saudi Arabian market for home financing. It is found that Saudi Arabian mortgage market is a time-bomb that will go off soon with huge potential for all the market players. Key words: Islamic banks, mortgage, home finance, Saudi Arabia JEL Classification: D1, G21, L85, R20, R21, 1.0 Introduction ‫٭‬ Paper presented at the International Seminar on “Muamalat, Islamic Economics and Finance (SMEKI 09),” October 20-21, 2009, Faculty of Islamic Studies, University Kebangsaan Malaysia, Malaysia. Corresponding author, Edib Smolo, is Associate Researcher at International Shari'ah Research Academy for Islamic Finance (ISRA), 2nd Floor, Annexe Block, Menara Tun Razak, Jalan Raja Laut, 50350 Kuala Lumpur, Malaysia (E-mail: edib@isra.my or hfz.edib@gmail.com). ‫٭٭‬ Badr Kaseb Albadran is a Ph.D. Student in Islamic Banking & Finance at Kulliyyah of Economics and Management Sciences, International Islamic University Malaysia (E-mail: albadr2020@gmail.com).
2. The Kingdom of Saudi Arabia is one of the biggest countries and economies in the Middle East region . With an area of about 2 million square km, Saudi Arabia is the largest country on the Arabian Peninsula. Its population is around 25 million, of which some 5 million are foreigners. The economy of Saudi Arabia is over-dependant on oil production, which accounts for roughly 75% of budget revenues, 45% of GDP, and 90% of export earnings. Although there are numbers of on-going projects that are trying to address a chronic need for homes, Saudi Arabia is still faced with a huge deficit of available homes, as the demand is currently far greater than the supply across all sectors and price levels. According to some estimates, Saudi Arabia is in need of about 1 million extra units (GulfNews.Com, 2009). In July 2008 the Shura Council approved the long-awaited mortgage law, but it is yet to be verified and implemented by the government. It is believed that this law, once in force, will increase the demand for housing by up to 50% (Al-Othman, Raghu, Elia, & Ramadoss, June, 2009, p. 2) and the yearly turnover of the house financing industry will be 150 to 180 billion Saudi Riyals (Merzaban, 2009). Saudi Arabia is considered fertile ground for the mortgage industry, and it offers much better prospects compared to other Gulf countries. This paper, which reviews the Islamic home financing mechanisms offered by the Islamic banks in Saudi Arabia, consists of five sections, including the introduction. Section Two briefly highlights the history of the creation of the Kingdom and its economy, especially the real estate and construction sector. The Islamic financial sector, including an overview of the main Islamic banks, is the subject matter of Section Three. The main focus of the paper, Islamic modes of home financing used by Islamic banks in Saudi Arabia, is discussed in detail in Section Four. Finally, Section Five contains concluding remarks and suggestions. 2.0 A Brief Overview of the Kingdom of Saudi Arabia 2
3. On September 23 , 1932, Abdul Aziz al-Saud founded the modern state of Saudi Arabia. Prior to this, on May 29, 1927, in the Treaty of Jeddah, the British had recognized the independence of Abdul Aziz’s territories, which were known as the Kingdom of Hijaz and Najd. This was the culmination of centuries of tribal feuding during which the al-Sauds had ruled at various times since the 18th century. Their ascendancy began in 1902 with the capture of Riyadh from the rival al-Rashid family, and this initiated a further 30 years of territorial consolidation and state building. King Abdul Aziz was succeeded by his son Saud, who undertook 11 years of economic and social reforms. After his abdication in 1964 his younger brother Faisal took over the throne. He continued to channel the growing oil revenues into development; starting in 1970 this was implemented through a structured program of five-year plans. King Faisal was assassinated in 1975, and King Khalid continued with the expansion of the Kingdom’s infrastructure. He built new roads, universities, industries, and even new cities. Having such a rapidly developing and increasingly wealthy economy, he shifted the emphasis to diversification. In 1982, King Khalid passed away and was succeeded by King Fahd. He named his brother, Abdullah bin Abdul Aziz, crown prince and deputy premier. It was under King Fahd that the historic Basic Law was introduced, defining the relationship between the monarch and citizens, as well as defining the government’s responsibilities. In 1995 King Fahd suffered a stroke, and Crown Prince Abdullah began playing a more important role in ruling the kingdom. Fahd passed away in August 2005, and was succeeded by Abdullah, who appointed the then Defense Minister Prince Sultan as Crown Prince. King Abdullah bin Abdul Aziz, also known as Custodian of the Two Holy Mosques, is assisted by the Crown Prince and rules by decree, advised by the Council of Ministers, consisting of the prime minister and 20 other ministers. 3
4. The Saudi monarchy is central to the government of the kingdom . The Basic Law stipulates that the kingdom is ruled by the direct heirs of the first king, Abdul Aziz alSaud, and that the laws and constitution are based on the Qur’an, with the legal system based on Islamic law (Sharicah). 2.1 Economy According to CBS News website, Saudi Arabia possesses 25% of the world's proven petroleum reserves, ranks as the largest exporter of petroleum, and plays a leading role in OPEC. Furthermore, the petroleum sector accounts for roughly 75% of budget revenues, 45% of GDP, and 90% of export earnings. Oxford Business Group (2009), in its Report on Saudi Arabia, stated that the private sector grew by 5.9% in 2007 and took a 46.1% overall share of the economy. It is no surprise then that the driving force behind the country’s economic development is the oil, given the size of its reserves. Since the economy is dependent on oil, the authorities are aware of the need for economic diversification. With an increasingly young population, the creation of employment is a central concern. Furthermore, housing development is taking place as the supply of homes is far less than the demand. On the other hand, in order to encourage economic diversification the government started to promote private sector participation and market liberalization. As result, in 1999, the Supreme Economic Council (SEC) was created to officially lead the process of privatization. Furthermore, the major steps have been taken to open up markets, encourage both inside and outside investment, and boost the role of the stock market. This became evident from its lobbying efforts for World Trade Organization (WTO) accession, as it successfully became the 149th member in November 2005. Despite the global economic crisis, the Kingdom of Saudi Arabia continued to register a reasonable growth, with a large budgetary surplus for the sixth consecutive year and a rise in imports. Its real GDP grew by 4.4 percent in 2008. All of these 4
5. reflect a healthy and confident domestic economy with strong consumption and investment demand . However, the Kingdom is facing a new challenge in the form of rising inflation rates. Its consumer price index (CPI) reached a 30-year high in July 2008, peaking at 11.08% (Hawa & Singh, 2008). The strong macro-environment, cheap credit, and the rise of food and rental prices contributed to inflation. Nevertheless, it went down to 5.2 percent in April 2009 – according to IMF. 2.2 Real Estate and Construction Due to the strong economic growth, robust demand and an extremely large young population looking to become future homeowners, the real estate sector in Saudi Arabia is promising great growth in the years to come. When it comes to residential and office space, the demand is currently far greater than the supply across all sectors and price levels. With a mismatch between inflation and salaries, Saudi Arabia is experiencing an acute need for affordable housing. This problem is partially being addressed by the government with its plan to deliver 35,000 low-cost housing units over the next two years (Oxford Business Group, 2009). However, this is far short of the estimated need of about 1 million extra units (GulfNews.Com, 2009). The long-awaited mortgage law, approved by the Shura Council in July 2008, would establish a housing finance market, which will certainly unleash latent demand for housing onto the market. According to a report by the Kuwait Financial Centre, there will be an increase in demand for housing by up to 50% once this mortgage law is in place (Al-Othman, et al., June, 2009, p. 2). The lack of mortgage lending, according to this report, is the main cause for a dramatic fall in residential real estate capital build-up (p. 4). Sharicah-compliant home financing credit has begun to be offered by major banks in anticipation of the law's implementation. It is believed that this mortgage law would allow wider access to property ownership upon government approval. The Strategic Mortgage Finance Group estimates a yearly turnover of 150 to 180 billion Saudi Riyals for the house financing industry once the mortgage law is 5
6. implemented (Merzaban, 2009). It is also expected that Saudi Arabia, due to the longterm growth of population trends and the housing shortage, offers better long-term prospects for the mortgage industry compared to other Gulf countries (National, 2009). With a lot of mega-projects and the development of four enormous economic cities― King Abdullah Economic City (KAEC), Prince Abdulaziz bin Mosaed Economic City (PABMEC), Jazan Economic City (JEC) and Knowledge Economic City (KEC)―coupled with a large population of young people who are potential home buyers, the growth of the real estate and construction sector is guaranteed. During the 1980s almost all housing and real estate development was government sponsored. Now the situation is changing fast, and the private sector is taking over the market. More than 50 companies were licensed to sell and develop real estate in the Kingdom in 2007 alone. Apart from the banks that provide home financing, there is also Saudi Home Loans, a venture backed by Dar al-Arkan Real Estate Development, Saudi Arabia’s largest developer by market value (National, 2009). 3.0 Islamic Financial Services Saudi Arabia is the largest market for Islamic finance. Islamic banks are operating side by side with conventional banks, and most, if not all, of the conventional banks have opened Islamic windows offering Islamic products (Ahmed, 2006; Molyneux & Iqbal, 2005). The popularity of Islamic finance is on the rise, and Islamic banking is expected to grow at more than 20% y-o-y in assets (Hawa & Singh, 2008, p. 15). However, there is a dire need for a better regulatory regime as well as greater financial expertise in the field of Islamic finance in order for the sector to develop further, not only in the Kingdom but also in the region (Ahmed, 2006). Saudi banks, in general, are among the most liquid and capitalized banks in the developing world (Ahmed, 2006, p. 102). Saudi Arabia’s financial sector in general and Islamic banks in particular are supervised by the Saudi Arabian Monetary Authority 6
7. (SAMA), which was established in 1952 and acts as the central bank. Although Sharicah is the law of the land, Saudi Arabia does not have an Islamic banking law (Ahmed, 2006, p. 103). Despite the fact that the Islamic financial sector is not free from problems, some of them being a lack of human resources and a need for regulatory reform, it is built upon strong local demand and should see a path to robust success. Regional financial institutions have shown great interest in entering the Saudi market, especially in the wake of the forthcoming mortgage law. The following are the major players in the market: i. Al Rajhi Bank Al Rajhi Bank is the largest Islamic bank in the world. Al Rajhi is also the largest lender and the largest listed retail bank in Saudi Arabia (Hawa & Singh, 2008) with total assets of SR 124 billion (US$33 bn), a paid up capital of US$4 billion and an employee base of over 8,000 associates. It was found in 1957, and in 1978 it became known as Al Rajhi Trading and Exchange Corporation. In the same year it was also established as a Saudi shareholding company. Its headquarters is in Riyadh and it has a vast network of over 500 branches in the Kingdom. As one of the leading and most progressive banks in Saudi Arabia, Al Rajhi Bank recorded net income growth of SR 1,602 million (equivalent to US$427.2 million) in the first quarter of 2008. In 2006, Al Rajhi Bank ventured into the Malaysian market after being the first foreign bank to be awarded a full-banking license by the Bank Negara Malaysia. Al Rajhi Bank currently has 19 branches in Malaysia with plans to increase this number in the future (Al-Rajhi). One of the existing opportunities for Al Rajhi Bank lies in mortgage financing (Hawa & Singh, 2008). 7
8. ii . The National Commercial Bank (NCB) The National Commercial Bank, better known by its acronym NCB, is the most prominent bank and was the first local bank established in Saudi Arabia by Royal Decree in 1953. The initial paid-up capital for NCB was SR 30 million (US$ 8 million). The NCB is the largest Bank in terms of capital in the Arab world. Total assets equaled SR 221,802 million (US$ 59,147 million) while the net profit was SR 2,031 million (US$542 million) as of the end of 2008. As of the end of 2008, the NCB operated 275 branches throughout the Kingdom, dedicated exclusively to Islamic Banking services with 2.2 million customers and 5,380 employees. At the same time, the NCB operates 2 international branches located in Beirut and Bahrain, and has 3 representative offices in London, Seoul, and Singapore. Since it started operation in the 90's, the NCB has been one of the pioneers in Islamic Banking, providing a wide range of innovative Islamic alternatives for various traditional services and products (NCB, 2008). iii. Riyad Bank Riyad Bank is the largest listed Saudi bank with significant government ownership (51.3%). It has the third-largest branch network (201) in the country and offices in London, Houston, and Singapore. Riyad Bank plays an important role in the Saudi economy with strong asset growth of 22.5% in financial year 2008 (Hawa & Singh, 2008). Riyad Bank’s net income for the year 2008 was SR 2,639 million. Total assets of the bank reached SR 160 billion and shareholder’s equity reached SR 25.7 billion as at end of December 2008. Customer deposits rose to SR 105 billion and loans grew to SR 96.4 billion in the same period (RiyadBank.com). 8
9. iv . Arab National Bank (ANB) Arab National Bank (ANB) is one of the top ten banks in the Middle East. It was launched in mid 1979 and now operates through its 168 local branches and one branch in London, UK since 1991. ANB provides commercial and Islamic products to the retail and corporate sectors both domestically and internationally. The bank has 3,600 employees and capital of USD 1.73 billion (Arab). According to Hawa and Singh (2008, p. 55) the ANB’s strategic partnerships with leading real estate and insurance companies in relatively underpenetrated sectors of mortgages and insurance places it in a potentially strong position to exploit new sectors. v. Banque Saudi Fransi (BSF) Banque Saudi Fransi (BSF) is one of the leading corporate banks of Saudi Arabia established in 1977 with its headquarter in Riyadh. It is affiliated with Calyon of France, which is rated among the world's top ten banks by total equity. It has 75 branches with 2,345 employees as of 31st December 2008. For the year 2008, BSF earned a net profit of SR 2,806 million that is 3.5% increase compared to SR 2,711 million earned in 2007. In the area of Islamic banking services, BSF had made considerable improvement in the development of products and services as well as in providing alternative products to companies and individuals (BSF). vi. Saudi British Bank (SABB) Established in 1978, SABB started operation on 01 July 1978 when it took over the operations of The British Bank of the Middle East in the Kingdom of Saudi Arabia. Its assets value was SR 131.7 billion (US$ 26.2 billion) and its profit was SR 2,920 million (US$ 779 million) at year-end 2008. SAAB paid capital of SR 7,500 million is 60% owned by Saudi nationals and 40% owned by HSBC Holdings BV (a wholly owned subsidiary of HSBC Holdings plc). SABB operates through 84 branches and has 3,232 employees (SABB). 9
10. 10 2 % to 5% Late payment Penalties Early settlement after one year Source: Various websites and reports. 4M 200K Yes 1700 1500 23-70 land 18 Max. Amount Min. Amount Insurance Estimation fee Management fee Age any time 2% to 5% 5M 150K Yes 1000 1475 22-60 any time 2% to 5% 4M 150K Yes 1500 1500 21-60 5% to 10% 180/300 10 Max. Tenor (Months) Max. age of house (Years) 0% to 15% 5% to 5.25% Profit Margin 0% to 10% 5K 1 Year Yes 4.75% to 5.99% 300 25 5K 1 Year Yes 4.25% to 4.75% 300 10 5K 1 Years Yes Min. Salary Min. Yrs of Services Joint Loan Down Payment Ijārah Murābahah Murābahah /Ijārah Products offered 5M 150K Yes 1500 1000 20-60 2% to 5% for each late installment after one year 10% 240/360 26 4.25% to 6.5% 5K 6 months Yes Murābahah /Ijārah SABB Riyad Bank SAMBA ANB Bank NCB Albilad BSF any time NO any time 2% to 5% any time NO any time 2% to 5% Murābahah/ Murābahah Ijārah/Istisna’/ Ijārah Murābahah /Ijārah Mushārakah 5K 5K 5K 2K 1 Year 1 Year 1 Years 6 months Yes Yes suspend Yes 4.75% to 4.5% to 4.75% to 5.5% 4.75% 5.5% 4.9% 300 240 300 300 15 20 10 20 10% For Land & 15% No 10% 10% for Home 1.5M 3M 3M 5M 150K 100K 150K 30K Yes Yes Yes No 2000 2000 1500 2000 1500 0 500 0 22-60 21-60 25-60 18-60 RAJHI Table 1: Home Financing Programs Comparison
11. 3 .1 Banking Control Law According to the Article 10 of the Banking Control Law issued by the Saudi Arabian Monetary Agency (SAMA) the banks are not allowed to undertake any of the following activities (SAMA, 1966): 1. To engage, whether for its own account or on a commission basis, in the wholesale or retail trade including the import or export trade. 2. To have any direct interest, whether as a stock-holder, partner, owner, or otherwise, in any commercial, industrial, agricultural or other undertaking exceeding the limits referred to in para 4 of this Article, except when such interest results from the satisfaction of debts due to the bank, provided that all such interests shall be disposed of within a period of two years or within any such longer period as may be determined in consultation with the Agency. 3. To purchase, without the approval of the Agency, stocks and shares of any bank conducting its business in the Kingdom. 4. To own stocks of any other joint-stock company incorporated in the Kingdom, in excess of ten percent of the paid up capital of such a company provided that the nominal value of these shares shall not exceed twenty percent of the bank's paidup capital and reserves; the above limits may, when necessary, be increased by the Agency. 5. To acquire or lease real estate except in so far as may be necessary for the purpose of conducting its banking business, housing of its employees or for their recreation or in satisfaction of debts due to the Bank. In cases where a bank acquires real estate in satisfaction of debts due to it and such real estate is not necessary for the Bank's own banking business or housing of its employees or for their recreation, it shall dispose of it within three years of its acquisition or, in exceptional and justifiable circumstances, within such period or 11
12. periods as may be approved by the Agency and subject to such conditions as it may deem fit to prescribe . As an exception to the provisions of para 5 of this Article, the bank may, in special and justifiable circumstances and with the approval of the agency, acquire real estate, the value of which shall not exceed 20 percent of its paid-up capital and reserves. From this law we can see clearly that SAMA does not differentiate between Islamic and conventional banks. Both of them are governed by the same law and regulation. However, the last paragraph of the article mentions an exception in special and justifiable circumstances with an approval of the agency for every purchase. This approval usually takes from one to two months. Because it is not practical for the banks to wait for the approval they started establishing Special Purpose Vehicles (SPVs) to facilitate the transactions. 4.0 Islamic Home Financing Instruments in Saudi Arabia Saudi Arabia is one of the biggest and the most important real estate markets in the Middle East. About thirty five years ago the government lunched the real estate development fund, to finance all Saudi citizens for building their own houses, and to be repaid without any extra fees. That program was excellent during the initial ten years, but later the repayment ratio was very law and the number of defaults increased. As result of this, the waiting time for loan approval increased from few months to more than fifteen years. At that time, the banks were not interested in long-term house financing until January 2006 when the central bank of Saudi Arabia, Saudi Arabian Monetary Authority (SAMA), issued a new regulation and restriction on consumption loans with two aims: to minimize the number of consumption loans on one side and to encourage the house 12
13. financing on the other . This resulted in banks starting to develop and improve the house financing products. Access to affordable medium- to long-term finance is an important aspect of achieving sustained growth in the consumer real estate sector (Zubairi, 2006, p. 91). While on the one hand, the government of Saudi Arabia is trying to meet the increasing demand for homes, it is still lacking far behind in reaching its goal. Furthermore, non-existence of the mortgage law creates additional burden on the real estate sector development. On the other hand, the banks in Saudi Arabia, assuming a soon approval of the long awaited mortgage law, have taken preemptive steps in developing and providing Islamic home financial products in the Kingdom. The models for Islamic home financing currently used by Islamic banks in Saudi Arabia are murābahah, ijārah, mushārakah & ijārah and istisnāc. Different models are used for different purposes. For example, completed houses can be financed under murābahah, ijārah and mushārakah & ijārah structures, while incomplete houses or under construction can be financed under istisnāc structure. The detailed discussion on these structures is the subject matter of the following paragraphs. 4.1 Murābahah (cost plus profit) Murābahah simply means an increase or growth from the Arabic verb rabaha or rabiha )َ‫)ربَح‬ َ which also may imply profit (Wehr, 1980).1 In other words murābahah is a ‘cost-plus financing’ (Thani, Mohamed Abdullah, & Hassan, 2003, p. 57), ‘markup sale’ (Rosly, 2005, p. 87) or resale based on profit margin above the cost. This is a sale contract whereby a product is sold at a price equivalent to the cost price of that product plus profit margin. For example, if the cost price of a product is RM1,000 and the profit margin is RM200, then the price of that product, under murābahah principle, would be RM1,200. The verb ‫ح‬ ََ ‫ ََر َب‬or ‫ح‬ ََ ‫( َر ِب‬rabaha or rabiha) means to gain, profit, to win while َ‫( ِربْح‬ribh) pl. َ‫( اَ ْر َباح‬arbāh) means gain, profit, benefit, interest; pl. proceeds, returns, revenues, dividends, etc. See: (Wehr, 1980). 1 13
14. Most of the Islamic banks across the globe use mur ābahah as an Islamic mode of finance although in its origins murābahah is quite different from it. Originally, murābahah represents a particular type of sale that has nothing to do with financing. The only distinguishable feature of murābahah sale is that the seller discloses the cost to the purchaser and the additional profit margin that he is going to charge. Murābahah is used for sale of completed properties. There are several conditions laid down by the jurists for the validity of murābahah sale.2 Among others for sale to be valid under the murābahah structure the subject matter of the sale must be existing at the time of the sale and the institution (bank) must possess the property before selling it to the customer. This means that the property must be owned by the bank prior to the sale. The ownership of the property can be held directly by the bank or indirectly through special-purpose-vehicle (SPV) or through its agent. Since the price of murābahah is usually payable at the future date the bank would like to secure its interest. For that reason it may ask the buyer to provide the bank with some kind of security. Islamic law allows for the property to be mortgaged during the financing period. It also allows for the third party to provide a guarantee on the financing. In case of murābahah the price is set upfront and cannot be changed at any time. This implies that in the case of default and/or late payments the buyer may not be asked to pay extra amount as a penalty for that. The only case when he can be asked to pay penalties is if he signed a late penalty clause that is going to be used for charitable purposes. This is a type of precautionary steps as to avoid late payments. However, this additional payment cannot be used as part of the bank’s profit as it is only for charitable purposes. 2 For detailed discussion on the conditions for murabahah sale see: (Usmani, 2002). 14
15. On the other hand , in case the buyer wants to settle his/her debt earlier, the scholars have allowed Islamic financial institution to provide some rebates to the buyer. However, this is totally left to the bank’s discretion and cannot be stipulated as a condition of the murābahah contract. Furthermore, in case of loss or damage to the property while in the possession by the buyer, the outstanding amount due to the bank should be paid by the buyer. This outstanding amount is the unpaid part of the murābahah sale that was already undertaken some time ago. However, if the loss or damage occurs and the title of the ownership is still with the bank (directly or indirectly) the cost will be borne by the bank itself. Murābahah is the oldest model and still the most widely used in Saudi banks. Figure 1 below show the murābahah model structure in brief. Due to the law restriction some of the Islamic as well as conventional banks established a special purpose vehicle (SPV) in order to own and manage all real estate transactions and ownership responsibilities. The murābahah model structure with SPV is shown in Figure 2 below. 15
16. 4 .2 Ijārah muntahiya bi al-tamlīk (lease & own) Literally, the term ijārah means ‘to give something on rent’ (Usmani, 2002, p. 69). The term ijārah comes from the Arabic verb ‫ اَ َج ََر‬which means to reward, recompense, remunerate, to let for rent, hire out, lease, etc (Wehr, 1980, p. 5). From this verb we get a noun َ ‫ اَجْ ر‬pl. ‫ ا ُ ُجور‬meaning wages, pay, honorarium, rate, fee, etc. Therefore, ‫( اِجا َ َرة‬ijārah) simply means rent, letting, leasing, hiring out, letting on lease (Wehr, 1980, p. 5). Technically, it refers to the sale of usufructs and/or services (Mohamed, 2005, p. 19). Ijārah could be also defined as "a contract of hire or lease for a service or for a use of certain moveable and immovable property for a consideration" (Buang, 2000, p. 139). Besides the general ijārah contract, Islamic banks have developed another mode of financing which could be seen as derivative of ijārah contract called ijārah wa iqtinā or ijārah muntahiya bi al-tamlīk (leasing ending with ownership or hire purchase). Ijārah wa iqtinā is the alternative for the conventional lease-purchase contract developed by Islamic banks. The mechanism of ijārah wa iqtinā is more or less the same as the mechanism of ijārah explained above. The only difference is that the former includes the promise by the lessor to transfer the ownership of the leased asset to the lessee after the leased period is over. This promise is only binding on the lessor, as lessee has the option to buy or not to buy the leased asset at the end of leased period. The lessee can also return the asset to the lessor. In any case, the promise must be one-sided as the promise from both sides would render this contract as invalid according to the principles of Sharicah. 16
17. Under this mode , the bank will calculate the total rental taking into consideration both the cost and the profit margin. This total rental will then be divided into installments to be paid during the specific period. The transfer of ownership through ijārah wa iqtinā can be done in three ways. Firstly, the property can be given to the lessee as the gift (hibah) from lessor. In this way there is transfer of ownership without consideration or price. Secondly, at the end of the leasing period the transfer of ownership title is done for a certain price, normally at a nominal value of the property. Finally, the transfer of title can be transferred to the lessee even prior to the end of leasing period for a price that is equivalent to the remaining of ijārah installments. In ijārah, the Islamic financial institutions purchase the house (selected by the customer) and then lease it to the customer at the agreed rental price. The property is also mortgaged in order to protect the bank’s interests. In order for ijārah contract to be valid, from Sharicah point of view, it has to fulfill necessary conditions stipulated by Sharicah. Basic conditions are listed down as follows:3 i) The contract should be clear to both parties ii) It should be mutually agreed. iii) The subject of the lease contract should be durable, non consumable asset. iv) Prior to the ijārah contract, the acquisition of either the asset which is to be leased or the usufruct of that asset should take place (AAOIFI, 2004, p. 139). v) The responsibilities and benefits of both parties should be clearly stated. vi) The period of lease should be for a known period and against known price. Some argue that the rental must be money (Khoja, 2002, p. 68). vii) The leased asset cannot be used for any other purposes other then those stipulated in the contract. If no purpose is specified then the lessee can use this asset for any purpose it is normally used. 3 The following conditions are mentioned in several sources. For detail discussion on the issue see (Usmani, 2002, pp. 70-71). See also: (Ahmad, 1993, p. 45), (Abū-Sulaymān, 2000, pp. 34-35) and (Khoja, 2002, pp. 67-71). 17
18. viii ) The lessor will be solely responsible for any loss or damage to the leased asset throughout the lease period unless the loss or damage is caused by the lessee's negligence. ix) A jointly owned asset can be leased to either partner or third party. In latter case, the rental will be shared between the partners. All these rules are related to the ordinary ijārah. When it comes to the hire and purchase contract, the Council of the Islamic Fiqh Academy, during the Twelfth Session held in Riyadh form 25th Jumuād Thānī to 1st Rajab 1421H (23-28/9/2000), in its Resolution No. 110 (4/12) said that the following criteria should be met for ijārah muntahiya bi al-tamlīk to be permissible: (i) the contract of lease and contract of sale should be independent from each other, i.e. there should be two separate contracts; (ii) there should be genuine desire for parties to conclude the lease contract. The lease contract should not be used as a legal device for the sale contract; (iii) any damage to the leased property should be responsibility of the owner and not the lessee, unless the damage is caused by misuse of the lessee; (iv) insurance, if any, should be borne by the owner alone and it should be carried out through Islamic insurance (takāful); (v) Sharicah rulings related to ijārah should be applied for the period of lease contract, while the Sharicah rulings regarding ownership and sale should be applied when the property is transferred to the lessee; (vi) the maintenance cost, except operational costs, should be borne by lessee during the lease period (OIC Fiqh Academy, 2000, pp. 253-254). 18
19. The following are the steps (see Figure 3) involved in the of ijārah wa iqtinā operation (Khoja, 2002, p. 76): 1. Asset purchase contract: Upon receiving the demand from a client the bank buys the asset from the vendor. 2. Delivery and receipt of the asset: The vendor delivers the asset to the bank or any other party designated by the bank. The client will notify the bank upon the receipt of the asset. 3. The lease contract: The bank will start leasing the asset to the client with the promise (by the bank) to transfer the asset to the client either as the gift or at nominal price. Throughout the period the client will pay the rental to the bank. 4. Transfer of ownership: Once the client has paid the entire installments due and the lease period is over the bank will transfer the ownership of the asset to the lessee as a gift or through the sale. The lessee becomes legal owner of the asset. 19
20. 4 .3 Mushārakah & Ijārah Mushārakah & ijārah (partnership & leasing which ends in transferring of ownership to one party - the client) is a hybrid product of Islamic banks relatively new in Saudi Arabia. It is the second widely used mode of finance, but still in its pioneer stage. It is a combination of joint venture and leasing, whereby the ownership is transferred directly after the client pays all the rentals without any extra payment or special arrangement at the end of the rental period. The literal meaning of the word mushārakah is sharing. Under Islamic law, mushārakah refers to a joint partnership where two or more persons combine either their capital or labour, forming a business in which all partners share the profit according to a specific ratio, while the loss is shared according to the ratio of the contribution (Usmani, 2002, p. 87). The mushārakah & ijārah model can be easily implemented for various financing purposes. However, it is most commonly used for home financing. Basic steps involved in the mushārakah & ijārah structure for home financing are: i) First Step a. Customer identifies the property that he/she wants to purchase and approaches the bank for financing facility. b. Customer and bank will enter into a mushārakah arrangement where the purpose of this partnership is to acquire a property. c. The initial deposit/down payment made by the customer at this stage will be his contribution towards the mushārakah venture while the bank’s contribution will be equal to the remaining financing amount. ii) Second Step a. The bank subsequently leases his part of the acquired property to the customer for a maximum period of 25 years, if the customer agrees to that. Otherwise, it can be sold in the market and both of them will share the profit/loose according to their percentage of ownership. 20
21. b . The rental paid by the customer consists of two parts: the minimum return or the baseline (3%) plus the Consumer Price Index (CPI) on the day before signing the contract. c. The first 10 years there will be no changes in the rental, but on the following periods: (11y - 15y), (16y – 20y) and (21y – 25y) there will be a review to the new official CPI and will be adjusted accordingly but not less than the 3% baseline. iii) Third Step a. After paying all the rentals, the property will directly be fully owned by the customer and the ownership title will be transferred to him/her without any additional compensation. b. With this the mushārakah & ijārah will be terminated. The above mentioned steps are illustrated in the Figure 4 below. 21
22. Although this model is considered to be closer to the Sharicah teachings yet it is relatively less practiced by Islamic banks all over the globe in general and Saudi Arabia in particular . Certainly, after few years of lunching this product the customers still prefer murābahah model, mainly because of the changing nature of the rate & the ownership. 4.4 Istisnāc Literally istisnāc ‫ َإستِصناع‬comes from the Arabic verb sanaca َ‫صنَ َع‬ َ which means to manufacture, to produce, or to construct something. Therefore, istisnāc means manufacturing or production. Technically, it represents a contract to purchase a product that is to be manufactured later on according to the agreed price and specifications between parties. In istisnāc model, the customer asks the bank to finance the construction of the house. Once the project and the client are approved, the bank will appoint the builder or constructor to build the house either directly or indirectly through its agent or SPV. Once the construction is done, the bank will sell the house to the customer either through murābahah, ijārah wa iqtina’, or mushārakah & ijārah models. The price of the house will be equal to the cost incurred by the bank plus the premium agreed mutually between the bank and the customer. Istisnāc model could be used for building any residences such as: villa, apartment, duplex or condominium. This product allows the client to own the suitable residence through various options: 1. The bank builds the estate completely for the client on a land owned by the client himself or owned by a third party 2. The bank builds the estate completely for the client on a land owned by the bank. 3. The bank completes the construction of an estate (partial istisnāc) 22
23. The down payment is credited into the client ’s current account before signing the contract to make sure that the client is capable of making the initial payment. The amount is withdrawn after the contract has been signed. The estate and the land are valued through two estate offices selected by the bank. It is acceptable to have two clients as joint-venture in a contract with the bank. The client is exempted from the 10% initial down payment if he is the owner of the land. The time plan for the construction is specified in the contract. Depending on the size, design, and evaluation of the project the construction time falls between 8 to 24 months. The client decides on the architectural design and on the contractor. However, the contractor must be approved by the bank in terms of trustworthiness. 4.4.1 The Main Conditions in the Contracts between Bank and the Architect He must be present at the project site for a period not less than 4 days in a week for an hour a day. In addition, he must be present when the dispensation of cement takes place. The bank should arrange a meeting every day with the architect to analyze the progression of the construction work as to make sure the work is going as planned. The first party (bank) has the right to request for compensation from the second party (architect) for whatever damage the architect may be responsible for. If the second party has caused any delay in any stage of the construction plan, the first party is allowed to charge a fine of about 1500 Saudi Riyals for every day delayed. The first party has the right to terminate the contract during any stage of the construction given that a formal letter is forwarded a week prior to the termination and given that the bank pays the architect his due salary for the effort made so far. 4.4.2 The Main Conditions in the Contracts between Bank and the Contractor The second party is to give the first party a 10% charge of the value of the contract until the completion of the project where the second party completes all tasks. The first party pays the second party a deposit specified by the managing 23
24. architect when the contract has been signed and approved . With the consent of both parties, it is possible to make any amendments or add/reduce tasks within an agreed percentage at the time of signing the contract. If the second party is not able to complete the tasks given within the timeframe specified in the contract, the first party has the right to fine 1500 Saudi Riyals for every day delayed whereby the fines are not to exceed 5% of the value of the contract. The second party is also required to provide a (5) year guarantee certificate that guarantees any defaults or errors made as a result of mistakes made during the construction period, with a promise to fix any problems that might appear after the project is completed. 4.4.3 Relationships between Bank, Customer, and Contractors Generally three parties are needed to accomplish the construction of the project as per contract. They are bank, customer, and contractor. Firstly, customer goes to the bank and applies for the construction of a specific project. After evaluating the customer’s status and project’s viability, the bank signs a contract with the customer(s). This is stated as istisnāc contract between the bank as main contractor (Sānic) ‫ صانِع‬and the customer as project owner (Mustasnic)َ ‫ ُمستَصنِع‬. Secondly, bank again signs a contract with sub-contractor as an executor (Sānic al-Munaffidh)َ ‫ الصانِع َال ُمنَ ِفذ‬. This is called as a parallel contract (Aqd Istisnāc Muwāzī)َ ‫ عَقد َإستِصناع َ ُموازي‬. Thirdly, they build up a relationship between subcontractor and customer. This relationship is significant in the sense to eliminate all kinds of gharar (uncertainty) or wrong construction. For example, customer can follow up and supervise during the time of construction of the building as to make sure that it is going on accordingly. In brief, process is depicted in the Figure 5 below: 24
25. Its application by Islamic banks is limited due to the legal restrictions faced by the banks . The further legal amendments are needed in order to facilitate the development of Islamic financial industry in the Kingdom. 4.5 Property Power The most innovative and active player in the house financing in Saudi Arabia is Alrajhi Bank. In the anticipation of the approval of the very long-awaited mortgage law Alrajhi bank launched a new product this October that is very similar to the mortgage lending. Property Power is a cash financing product; through Tawarruq Fiqhi using Saudi stock market shares as the underlying assets. It is applied through the power of any valuable property owned by the customer and transferred to the bank as collateral until the full repayment of the contract is completed. The Basic steps involved in the Property Power structure are: a. The customer applies to the financer. b. The financer approved the customer credit ability. c. The financer evaluates the property in the market and gives a credit limit of 70% of its market value. d. The customer transfers the property title to the bank as a mortgage until paying back all the debt. 25
26. e . The customer applies for Tawarruq product. f. The financer buys shares from the Saudi stock market and fully owns it in his portfolio. g. The financer sells those shares to the customer on deferred basis. h. The customer has the right to keep those shares or to sell them either directly or to appoint the financer to sell it on his behalf in the market and transfer the proceeds to his account with a profit or loss depending on the market situation. The above mentioned steps are illustrated in the Figure 6 below: All these steps are done in less than three days with a fixed profit of 6%, the maximum tenure is ten years and the minimum financing amount is SR100,000. That is an example of Tawarruq Fiqhi that is very rarely to be found in any Islamic bank nowadays. 5.0 Conclusion The paper argues that the Islamic home financing in Saudi Arabia is going to see a tremendous development in the years to come. With a huge population, robust demand 26
27. for real estate properties and the mortgage law around the corner the true potentials of home financing in Saudi Arabia are yet to be reached . Consequently, Islamic home financing, supported by many initiatives by the government, is about to flourish in the country where the demand for Shari’ah-compliant products is very high. There are several Shari’ah-compliant products available in the market such as murābahah, ijārah, mushārakah & ijārah and istisnāc. While the murābahah, ijārah and mushārakah & ijarah can be applied for the completed projects and are relatively easy to implement, the istisnāc financing mechanism is slightly more complicated. All in all Saudi Arabia is ‘a promised land’ for the real estate industry but its potentials are to be realized only after the introduction of the long-awaited mortgage law. Nevertheless, huge potentials of the market will push the market players to be more innovative and proactive in the structuring and developing new products to cater the market needs. 27
28. Appendix – 1 : Major developments scheduled for completion – residential segment Project Developer Location Value$ Mn Year Details Residential/Resort Districts Emaar, The Economic City King Abdullah Economic City 145 2009 616 apartments Al-Qasr Mixed-Use Development Dar Al Arkan Riyadh 350 2009 200 Villas 3800 Apartments Jalmudah Apartment Buildings RCJ&Y Jubail Industrial City 70 2010 6 four storey buildings Esmeralda Suburb Emaar, The Economic City King Abdullah Economic City 500 2010 200 Villas Residential/Resort Districts Emaar, The Economic City King Abdullah Economic City 120 2010 134 Villas Residential Development: Phase II RCJ&Y Jubail Industrial City 150 2010 412 Units Jubail Residential Development: Phase II RCJ&Y Jubail Industrial City 100 2010 193 Units Yanbu Residential Development RCJ&Y Jubail Industrial City 100 2010 240 Units Al Ghadeer Village Emaar Properties Al Khobar 600 2010 226 Villas Al Tilal Dar Al Arkan Medina 65 2010 499 Villas – Phase I 1589 Villas – Phase II 1840 Units – Phase III Al Basateen Residential Suburb Kinan International Real Estate Development Co. Yanbu 93 2010 200 Villas – Phase I 40 Villas – Phase II Al Nada Village Dar Al Arkan Al Khobar 700 2010 242 Villas Staff Housing Development Ministry of Education Dammam 133 2011 197 Villas Al Muhamadiyah Tanmiyat Group Jizan 300 2011 2770 Units Jeddah Lamar Development Zahran Real Estate Jeddah 160 2011 2 Towers – 60 & 68 Storeys Housing Development King Fahd University for Petroleum & Minerals Dammam 50 2011 100 Villas King Abdulaziz University: Housing Project Jabal Omar* Ministry of Education Jeddah 801 2011 1260 Units Jabal Omar Development Company Makkah 2700 2011 4235 Units Olaya Towers GOSI Riyadh 268 2011 2 Towers – 34 & 36 Storeys Mixed Use Tower KM Properties Jeddah 300 2011 1 Tower – 30 Storey The Seafront Project Seafront Company Al Khobar Jeddah Residential Tower Al Rajhi Development/ Tameer Holding Jeddah 100 80 2011 2011 1 Tower – 57 Storey Source: MEEDProjects. This is Appendix 3 reproduced from Al-Othman et al. (June, 2009). Saudi Arabia Residential Real Estate Outlook (Research). Kuwait: Kuwait Financial Centre “Markaz”, p. 14. 28
29. Appendix – 2: Saudi Arabia: Selected Economic Indicators, 2005–09 2005 2006 2007 2008 Proj. 2009 (Percentage change) Production and prices Real GDP Real oil GDP Real non-oil GDP Nominal GDP (in billions of U.S. dollars) Consumer price index 5.6 6.2 5.2 316 0.6 3.2 -0.8 5.1 357 2.3 3.3 0.5 4.7 384 4.1 4.4 4.8 4.3 469 9.9 -0.9 -10.3 3.3 377 4.5 62.6 55.9 29.6 33.0 -58.3 17.6 3.1 40.6 35.0 40.2 0.4 -63.6 8.5 1.1 (In percent of GDP) Fiscal and Financial variables Central Government revenue Of which: oil revenue Central Government expenditure Fiscal balance (deficit -) Non-oil primary balance Change in broad money (in percent) Interest rates (in percent) 1/ 48.0 42.7 29.6 18.4 -46.2 11.6 3.8 50.8 45.3 29.8 21.0 -48.2 19.3 5.0 44.7 39.1 32.4 12.3 -55.8 19.6 4.8 (In billion U.S. dollars) External sector Exports Of which: Oil and refined products Imports Current account Currrent account (in percent of GDP) SAMA’s net foreign assets SAMA's net foreign assets (in months of imports) of goods and services) Real effective exchange rate (percent change) 180.8 161.8 211.3 188.5 233.5 313.9 205.6 281.4 -82.7 101.6 93.5 134.2 24.3 28.6 301.3 438.5 -54.6 90.1 28.5 150.5 -63.9 99.1 27.8 221.4 15.7 18.1 20.1 31.6 32.4 -2.7 -1.6 -2.8 2.3 … Sources: IMF Public Information Notice, Data provided by the authorities; and IMF staff estimates and projections. 1/ Three-month Saudi Arabian riyal deposits. Period average at June 25, 2009. 29 188.0 159.1 -89.5 14.1 3.7 475.1
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