While Shariah principles and Islamic finance products are more commonly talked about in banking and trading contexts, there is no reason real estate investors should remain ignorant of the financial system. After all, as a socially responsible investment method, Islamic finance has been gaining popularity across the globe.
With that in mind, below is your primer on this topic. We'll cover what Islamic finance is, its founding principles, and what investors need to know before navigating one of these transactions. Read on to learn more.
What is Islamic finance?
At its core, Islamic finance is a financial system that operates according to the principles of Sharia law, or Islamic law. As you might suspect, Islamic financing is most popular in predominantly Muslim countries, specifically countries in the Middle East like Saudi Arabia and the United Arab Emirates (UAE). In particular, Dubai, which is one of the world's wealthiest cities, is known for largely following Islamic banking and investment practices.
However, beyond where Sharia compliance is most common, it's also important to note that this financial system is gaining popularity in some of the world's largest capital markets. According to a 2020 report by the Islamic Corporation for the Development of the Private Sector (ICD), Islamic financing assets were worth $2,875 billion in 2019 and are projected to grow to $3,693 billion by 2024.
This rise in popularity is due in part to the fact that Islamic finance is largely thought to be a form of socially responsible investment. Since this financial sector must remain Sharia-compliant, one of the driving principles of the Islamic finance market is that it must do no harm.
What are the principles of the Islamic finance industry?
Now that you know more about Islamic finance, how it works, and where these financial transactions are most common, the next step is to take a closer look at some of the core Islamic finance principles. In light of that, we've taken the liberty of laying the basic tenants out for you below.
- Charging interest: Under Shariah principles, charging interest on a loan is a prohibited practice. It is believed to be a practice that unfairly exploits the borrower.
- Prohibited investments: Certain investments are also prohibited under Sharia law, including those that engage in forbidden activities, such as or the sale of alcohol or pork products.
- Speculation: Islamic law strictly forbids speculation, which means that those in the Islamic finance industry can not enter into any contracts where the ownership of goods depends on an uncertain event in the future.
- Degree of uncertainty: Shariah principles also prohibit investing in investment vehicles where there is believed to be an excessive degree of risk. Therefore, things like short-selling an asset or investing in derivatives are forbidden.
How is Islamic finance different from conventional finance?
As you may gather from looking at some of the basic Islamic finance principles, the Islamic finance market is very different from conventional banking. In particular, Islamic institutions have a few financing arrangements that do not exist in conventional finance. They are as follows:
- Profit and loss sharing (Mudarabah): In this form of partnership, the financier provides capital to an entrepreneur. The entrepreneur is then responsible for managing and investing the capital. Notably, any profits made from the investment are shared at an agreed-upon ratio between the two parties. However, any losses are solely the responsibility of the investor.
- Cost plus (Murabahah): In these types of Islamic finance transactions, money is lent for an agreed-upon price at an agreed-upon profit margin. Usually, these transactions are used for the purchase of a real asset like a house or a car and it utilizes the profit margin rather than a fixed rate of interest.
- Leasing (Ijarah): In this case, the lessee must make fixed payments to the lessor, who is the owner of the property. Once the debt is paid in full, the lessor must transfer ownership of the asset to the lessee.
- Equities: Typically, buying shares in a company is considered an acceptable form of investment, provided that the company does not engage in any prohibited activities, such as gambling or selling alcohol. Investing in private equity and investing in REITs (real estate investment trusts) are also acceptable practices
- Fixed-income investments: Additionally, Investments where the lender will receive a specified amount of income from the borrower are also considered acceptable. However, it is crucial that the amount of income be agreed upon upfront by both parties and no interest is charged during the course of the transaction.
What real estate investors need to know about Islamic finance transactions
The most important thing to know about the Islamic financial system is that only certain investment vehicles are acceptable under Sharia law. For example, while investing in most equities is acceptable, standard mortgage financing is not because interest is usually charged on a mortgage loan. With that in mind, if you're considering selling to someone who participates in Islamic banking, you may need to consider accepting one of the alternative financial products listed above instead of traditional real estate financing.
In addition, those who participate only in Islamic finance transactions usually use an Islamic financial institution for their banking. While Islamic banks are less common in the United States than they are in the Middle East, they do exist. To that end, you can expect a bank that is well-versed in Islamic financial products to be the lender.
The bottom line
At the end of the day, Islamic transactions are gaining in popularity across multiple capital markets, and this trend is only expected to continue as time goes on. For real estate investors, it would not hurt to familiarize yourself with the principles behind Islamic finance and the financial products that this financial sector has to offer. Not only are you widening your potential consumer base if you decide to do so, but you can also feel gratified knowing you've participated in a socially responsible investing method.