Islamic financiers bank on adding non-Shariah clients

Islamic property funders compete with mainstream banks on deals, reports Alex Catalano

Islamic banking is one of the fastest-growing parts of the world’s financial system, accounting for an estimated $1.6trn of assets in 2014. However, in Europe and North America, it is still at an embryonic stage.

According to the EU, the UK is the most advanced Islamic finance market in the west and a “key destination for foreign, Shariah-compliant institutions”.

Real estate is a core area for Islamic finance, particularly in the UK. There have been high-profile Shariah-compliant fundings of major London property projects: Chelsea Barracks, King’s Reach Tower on the South Bank, The Shard, the Olympic Village and most recently, Battersea Power Station.

These required big slugs of capital and have involved equity investors from the Middle East and South-East Asia, who have used their relationship banks – big, international ones – to arrange financings.

However, in the UK, there is also a healthy business providing more standardised Shariah-compliant funding for smaller projects, in the £3m-100m range, with the bulk of this coming from Islamic banks.

Abdulaziz Al Duweesh, Gatehouse
Abdulaziz Al Duweesh, Gatehouse

There are six fully-fledged Islamic banks, authorised by the Prudential Regulatory Authority, and four are notably active in financing real estate: Gatehouse (see panel), Bank of London and Middle East (see panel), Qatar Islamic Bank subsidiary QIB (UK), and ABC International, an Arab Banking Corporation subsidiary.

“With rare exceptions such as Battersea Power Station and the Shard, the vast majority of the deals we see done in the London market are low cap and use the murabaha plain and simple, and documented in a simple manner,” says Norton Rose partner Lucy Wolley-Dod (see Islamic finance panel).

Islamic financiers have been noticeably active in areas that conventional banks have tended to shun since the financial crash: development, healthcare, retirement villages and student housing.

Abdulaziz Al Duweesh, Gatehouse’s chief investment officer, says: “The market is quite sophisticated by now in terms of Shariah financing and investments. It’s been there quite some time. All our transaction documents are similar to the Loan Market Association standard of any conventional bank. From an obligors’ perspective, it doesn’t require them to be Shariah-compliant to negotiate the financing document.”

Indeed, much property financing by the likes of Gatehouse and BLME is provided to conventional sponsors who do not require Islamic compliance – clients such as Resolution Properties and retirement village specialist Audley.

Alice Myers, head of property at BLME, says: “Our competitors are conventional banks. On the private client side, it is more driven by the need for banking services that are Shariah-compliant. For the rest of the book, it is simply finance that is required, so we have to compete.

“We’re happy to look at all sorts of situations as long as we’re comfortable that they make sense economically and there isn’t a Shariah restriction on the type of asset used. It’s quite rare for us to see Shariah compliance being what scuppers a deal. With most of the transactions we don’t choose to go ahead with, it is because they are too risky, too big or too small,” she adds.

 Pricing is no different

The pricing of this smaller-scale, more standardised finance is no different to a conventional loan, the banks stress.

Says Al Duweesh: “We have non-Shariah-compliant clients who want the best terms and execution. The economics are exactly the same; the main difference is that we document the financing in the way that complies with Shariah requirements.”

Commodity murabahas are the usual format used (see panel). This structure is now relatively mature in the UK, with standardised documents that are similar to the Loan Market Association’s conventional loan documents, but tailored to ensure Shariah compliance.

Myers says BLME uses warrants basedon Shariah-compliant metals trading “that allows us to produce the same cash flow as a loan. We can knit them together in different patterns to obtain fixed or floating-rate scenarios. You can facilitate development finance with multiple drawings, or take on break up-deals, where someone is buying a whole block at a discount, breaking it up and selling the bits – it’s very flexible.”

Marrying up conventional bank and Islamic finance for a deal, whether both senior or senior and mezzanine, is also quite straightforward. The two sit together, with the funders entering into a common terms (intercreditor) agreement, which governs how security and cashflows are shared, agency provisions and other terms.

Shariah structures form the foundation for Islamic property finance

Islamic financiers cannot fund activities prohibited under Shariah law. These mainly involve tobacco, pornography, alcohol, pork, gambling, arms and conventional financial services. Thus, property such as restaurants, hotels, supermarkets, casinos, banks and insurance premises are largely ruled out.

Islamic law also prohibits the paying or receiving of interest and Islamic scholars must pass Islamic financing structures and assets before they are marketed.

The interpretation of Shariah prohibitions varies; a non-compliant activity may be allowed if it is a small part of a property’s floorspace, or non-compliant revenue — generated by, say, a hotel restaurant serving alcohol — can be segregated. Revenue could also be cleansed by swapping it, for example, for compliant income with a joint-venture partner or paying it to an Islamic charity.

The main financing structures used are:

Commodity murabaha: This cost-plus financing is most like a conventional term loan or revolving facility and is commonly used by lenders to advance funds for property investment and development.
The client mandates the financier to buy Shariah-compliant assets — typically metals or shares — to be paid for on a deferred basis. The financier buys and sells the assets immediately at market value for spot delivery, providing the client with the capital.
The client repays this principal, plus a mark-up reflecting financing costs. This often consists of the profit rate (equal to a benchmark Libor plus margin), plus any arrangement fees and amortisation.

The client mandates the financier to buy Shariah-compliant assets — typically metals or shares — to be paid for on a deferred basis. The financier buys and sells the assets immediately at market value for spot delivery, providing the client with the capital.

The client repays this principal, plus a mark-up reflecting financing costs. This often consists of the profit rate (equal to a benchmark Libor plus margin), plus any arrangement fees and amortisation.

Ijara: resembles a standard finance lease. The financier buys the asset and leases it to the client for a fixed period; the rent is structured with a profit component and the lessee undertakes to buy the property at maturity.

Sukuk: an Islamic bond, where payments to investors come directly from Shariah-compliant collateral, such as real estate; typical interest-bearing bonds are not Shariah-compliant.

Property-backed ijara sukuks have been issued in Europe. The German state of Saxony-Anhalt issued the first one, in 2004, for €100m, listed in Luxembourg. A 100-year master lease on Ministry of Finance properties was sold to a special-purpose vehicle and the assets leased back for five years. The sukuk’s certificate holders receive a variable rent, benchmarked to six-month Euribor plus 1bps.

The UK government followed suit in 2014 with a £200m, five-year sukuk. It was 10 times oversubscribed, paying a profit of 2.036%, the same as the equivalent five-year UK government bond yield. Here, the proceeds were used to acquire a 99-year lease on three government buildings and lease them back for five years.

Shariah-compliant CMBS vehicle rolls out from Gatehouse

Gatehouse Bank opened its London doors in 2008; the Shariah-compliant investment bank, owned by Kuwaiti firm Securities House, not only provides financing, but is also active in the capital markets and invests as a principal.

Its expertise in structuring Islamic products and advising investors, plus its connections with Middle Eastern and South East Asian capital, has attracted global asset manager Threadneedle to take a 2% stake in Gatehouse.

Gatehouse recently launched a Shariah-compliant €100m securitisation, which it calls a commercial rental-backed security. It is an ijara sukuk structured to mimic a two-tranche, fixed-rate CMBS. A special-purpose vehicle will issue the certificates and the proceeds will be used to buy a Parisian office property, whose rent will pay the certificate holders.

This structure makes it easier to enforce security if the asset runs into trouble — a problem with continental CMBS, where mortgage enforcement can take years. Here, as the issuer owns the asset, it can more easily enforce the lease, which will be a UK one. Mount Street is advising the bank.

Natale Giostra, Gatehouse
Natale Giostra, Gatehouse

Gatehouse formed its four-strong real estate financing team, headed by Natale Giostra, last year. So far its lending has been mainly in the UK, but the bank plans to have 40% of the exposure to Euros: in Ireland, Benelux, France, Germany, Spain and Italy. Giostra aims to build a £1bn book.

Gatehouse competes with standard banks. Gatehouse chief investment officer Abdulaziz Al Duweesh says: “We are a relatively small bank and our primary focus is property. We think we are very good at structuring financing to best help clients accomplish their business plan. Our financing of the Holiday Inn in west London is a good example.”

Last November, the bank provided Al Dau Development, part of Egypt’s Sami Saad Holding, with a £22.5m refinancing for the hotel, in Acton. The sponsor did not require Shariah compliancy. The hotel had been operating for over 10 years under a different brand; Gatehouse came into the picture after it had been refurbished, extended to 225 rooms, and rebranded. These changes meant it was difficult for conventional banks to be comfortable lending on the asset. Al Duweesh says: “Our take was that the hotel had traded very well for 10 years. We thought it was the right play to change the brand and believed operating performance could improve.”

Gatehouse refinanced the Holiday Inn in West London
Gatehouse refinanced the Holiday Inn in West London

The bank also finances development, up to 20% of its book.

While all of Gatehouse’s business so far has been senior finance, it recently won a mandate from a US investor to provide $100m of mezzanine in the UK, Ireland, Germany, France, Belgium, the Netherlands, Luxembourg, Italy and Spain. This fund, which Gatehouse is co-sponsoring, will provide Islamic financings at loan-to-value ratios of up to 85%, for three to five-year terms and is targeting 6-10% net internal rates of return.

This will allow the bank to do deals with higher loan-to-value levels and derisk its balance sheet. Again, Shariah compliance was not required by the investor, a US investment manager looking to expand its US financing business with a European partner. The fact that Gatehouse was willing to keep the senior rather than sell it on was an advantage.

In the longer term, Gatehouse would like to develop this Shariah-compliant finance fund management business; on the equity side, the bank co-invests and has $2.2bn under management in Europe and the US.

BLME is independent Euro Islamic leader

BLME, Europe’s biggest independent Islamic bank, has been financing real estate since 2008. “The bank is still young,“ says Alice Myers, BLME’s head of property finance.

Alice Myers, BLME
Alice Myers, BLME

BLME, which is listed on Dubai’s NASDAQ, funds residential and commercial, in the £3m-25m range, typically for three years.

“We are active across most sectors, from student accommodation and age-restricted housing to mixed-used schemes,” Myers says. “In the past two years we’ve developed a specialism in development finance.”

The bank’s biggest financings are mixed- use projects, including Brewery Square, a £40m regeneration scheme in central Dorchester, where work has just started on the second phase, and 145 Kensington Church Street in London — “classic retail on bottom, residential on top”.

“Shariah restrictions mean City offices can be slightly more difficult, because they are likely to be let to conventional banks or insurance companies. So we tend to finance West End or regional ones,” says Myers.

BLME’s book is geographically diverse: Notes Myers: “It’s not just London. One of our oldest clients is south-west specialist Acorn Property Group, which we are on the fifth scheme with.

“Our appetite is very much for senior, particularly for development, as once you’re subordinated, you have less control. We’re pretty conservative.” Loan-to-value ratios on most of its financings are in the 50-65% range.

BLME also participates in Shariah-compliant syndications, such as the financing of King’s Reach Tower on London’s South Bank, and clubs. “You could club with conventional banks, it just involves more documentation and a slightly different structure,” says Myers. “We are involved in a capital stack with conventional bank product and conventional mezzanine, behind Shariah-compliant senior.”

BLME also looks at continental European deals; the bank’s private client side will follow them there. “On the commercial side it’s in the less sunny bits of Europe, particularly since yields are still very attractive, especially with Euro interest rates,” says Myers.

Islamic finance feeds into US CMBS pool

Shariah-compliant financings have been part of US CMBS pools. Wells Fargo’s and RBS’s 2013, $1.1bn conduit CMBS WFRBS Commercial Mortgage Trust contained the $99.9m Brennan Industrial Portfolio III Loan, secured by 25 industrial buildings.

This was structured with 25 separate special-purpose vehicles and the sponsor, a joint venture between Brennan Investment Group and Gatehouse Bank, leased the properties to a master lessee indirectly owned by Islamic investors. The rent payable under the master lease is intended to cover the debt service payments on the mortgage loan.

Goldman Sachs’ GS Mortgage Securities Corp. II 2014-GC20 used a similar structure. It included a 10-year, $80m mortgage on Houston office block Three Westlake Park, owned by Falcon Real Estate Investment Management and let to Conoco Phillips, which generates around $7.1m of net cash annually.

Again, the structure used a master lease to an affiliate, which pays enough rent to satisfy the loan’s servicing requirement and fund reserve accounts: in this case, $3.7m for the first five years, which are interest-only.