By Michele Lerner

For decades, investment bankers have educated themselves and their employees about Islamic law, known as shariah, in order to design investment vehicles that can be profitable yet consistent with the values of more than 1 billion Muslims across the world. Now Muslim investors are discovering the potential benefits of investing in shariah-compliant REITs.

The Malaysian government approved the world’s first Islamic REIT, the Al-Aqar KPJ REIT, on May 15, 2006. Launched by KPJ Healthcare Bhd, this REIT had an IPO of more than $130 million U.S. with a focus on hospitals. The REIT will buy hospital buildings from the Johor Corporate Group in Malaysia for RM 300.2 million.

The Malaysian Securities Commission (SC) issued guidelines for Islamic REITs in November 2005. Presently, Malaysia is the only government to establish such guidelines for REITs.

Shariah governs all aspects of life for Muslims, providing guidance and principles by which they make moral and economic decisions. While many Americans are familiar with Muslim prohibitions on eating pork and drinking alcohol, there are many other elements of shariah that guide Muslims’ investment decisions, leading to the development of Islamic-compliant investments vehicle.

Of particular importance in the financial world is the prohibition against interest, known as riba, which is considered usury under Islamic law. Interest is considered unearned income and unjust, according to an article on “Principles of Shariah in Islamic Finance and Their Application for Western Investors” in the Patton Boggs Middle East and North Africa Business Guide, 2004/2005.

“There are several aspects of developing an Islamic-compliant investment,” says Laine Kenan, executive director of Arcapita, Inc., a bank that specializes in Islamic-compliant investments. “It’s important to understand that they are a socially correct investment fund similar to a green fund or a Thrivent fund. These funds choose to invest in businesses that are consistent with certain social principles,” he says. “In the case of Islamic investments, this means not buying casinos or leasing to bars, etc.”

Kenan explains that the economic contracts and investment structure of Islamic-compliant investment funds must be approved by a board of shariah consultants who are religious scholars.

“In addition to the social concerns, the financial structure of Islamic investments is also more complicated, because straight lending and borrowing are not permitted under Islamic law,” Kenan says. “Generally, these investments are structured as a series of lease mechanisms with third-party financing. Islamic real estate investment funds recharacterize conventional mortgage financing into a lease structure, so that lease payments are made against the assets rather than interest payments.”

Combining REIT and Islamic Requirements

Structuring an investment to comply with both REIT requirements and the obligations of Islamic law may seem restrictive, but the two sets of rules are quite compatible.

“The intersection of REIT rules and Islamic restrictions is actually pretty consistent,” says Art Pasternak, a partner with Gibson, Dunn and Crutcher. “The only difference in an Islamic-compliant REIT is the use of the ijara (lease financing). With an ijara, the REIT would lease property from the title holder and pay money upfront for the purchase price. Economically, the REIT is the same as the owner, and for tax purposes the REIT owns the property. However, because this is styled as a lease and treated as a lease for Islamic purposes, the REIT can be shariah compliant.”

In addition to the limits on how an Islamic REIT can be structured, the REITs are restricted in the properties in which they can invest. At Arcapita, where many private Islamic real estate funds have been developed, investments have included industrial buildings, storage facilities, senior housing, residential developments and condominium conversions.

“While hotels can be problematic because they often include a bar, some limited service lodgings can be acceptable,” Kenan says. “We have not invested in offices at all, because of the restriction on finance tenants such as banks, which are not allowed because of the prohibition on interest.”

According to the Patton Boggs article, “in some cases a shariah board may determine that, where income derived from haram (illegitimate) sources is a negligible part of the larger investment, the offensive portion can be cleansed by payment of a financial penalty or a charitable contribution.”

Adhering to the rules of shariah primarily requires following guidelines when establishing an investment fund, with a nominal amount of oversight required once the fund is established.

“We work with a panel of Islamic consultants, similar to working with an auditor, to either structure around shariah restrictions or to avoid certain businesses entirely,” Kenan says.

Favorable Attributes

While investing in a shariah-compliant REIT or other Islamic-compliant investment vehicle may not have substantial appeal to non-Muslims, these investments have significant attraction for Muslim investors.

“There’s certainly no particular downside to non-Islamic investors choosing to invest in an Islamic-compliant REIT,” Pasternak says. “There are no significant additional costs to setting up a REIT to be Islamic-compliant. It’s a good investment regardless of the Islamic structuring.”

Pasternak points out that, in part because of oil prices, “There’s a substantial amount of money to invest among Muslims both in the U.S. and overseas. We’ve mostly seen foreign investors choosing Islamic-compliant investments, but there are also a fair amount of Muslims in the United States who are interested in these investments. There has been plenty of discussion among investors and investment bankers about the fact that the money is in the Middle East.”

Two Islamic REIT applications have been filed since the SC released Islamic-compliant REIT guidelines in November 2005. According to The Star online newspaper on Nov. 22, 2005, the SC “said in a statement [that] Malaysia was the first jurisdiction in the global Islamic financial sector to issue such guidelines and had set a global benchmark for the development of Islamic REITs.”

“There is very high interest in Islamic-structured investments, including REITs. Part of it is the generally high interest in real estate,” Kenan says. “The investors we work with are the ultra-wealthy merchant class who would rather make an investment that is Islamically structured rather than an alternative investment. We work extremely hard to make sure there is no economic drag just because the fund is Islamic-compliant.”

According to Kenan, “For a long time the approach to this type of investment was to be Islamic compliant first, then work on the investment aspect. Now this pattern has turned around to look for a good investment, simultaneously with how the investment can be shariah compliant.”

Arcapita has successfully launched several private Islamic-compliant REITs, but Kenan is not aware of any public Islamic-compliant REITs in the United States.

“One challenge of developing an Islamic-compliant public REIT in the U.S. is that the rules are not always completely clear for overseas investors, that is, Muslims from outside the U.S. that might be interested in this type of investment,” Pasternak says. “There is already an enormous amount of Islamic investment in real estate in the United States through private corporations, limited liability companies and private REITs. I would expect an increasing level of demand for REITs because of the money out there and the increasing level of sophistication of investors.”

Dr. Alexander Ressos, an international finance lawyer, lecturer at the University of Applied Sciences in Frankfurt, Germany, and legal counsel in Dubai, shares Pasternak’s optimism about the future of Islamic REITs.

“It is my personal view that REITs have a promising future in general and that, in particular, shariah-compliant Islamic REITs will outperform other real estate funds and other Islamic investment alternatives,” Ressos says.  “While tax aspects do not matter in zero-tax environments, I personally expect that Islamic REITs will attract a great proportion of Islamic real estate investment due to other key factors, such as benefits from large-scale real estate projects, facilitating sale-leaseback financing and increased transparency (operations, audited financials). They might also give a larger proportion of the population in the Middle East access to an interesting investment opportunity particularly acceptable for cultural, moral and religious reasons.”