Housing Finance Islamic Alternatives
The term Musharakah means joint venture where profits are shared amongst the partners as agreed between them and losses have to be borne by each partner according to their investment.
Diminishing musyarakah or musyarakah mutanaiqisah is another form of musyarakah which was developed recently by the scholars. It is a musyarakah in which the Islamic bank agrees to transfer gradually to the other partner its (the Islamic bank’s) share in the musyarakah, so that the Islamic bank’s share declines and the other partner’s share increases until the latter becomes the sole proprietor of the venture. According to this concept, a financier and his client participate either in the joint ownership of a property or an equipment, or in a joint commercial enterprise. The share of the financier is further divided into a number of units and it is understood that the client will purchase the units of the share of the financier one by one periodically, thus increasing his own share until all the units of the financier are purchased by him so as to make him the sole owner of the property or the commercial enterprise.
In DIMINISHING MUSHARAKAH, a financer and a client participate in either ownership of a joint property, or in a joint commercial business, with the understanding that the client partner will buy the equity share of the financier partner over an agreed period of time until the title to the equity is completely transferred to the client by payments of installments to the financier for purchase over the agreed period. The buying and selling of equity is not stipulated in the partnership contract as it is not allowed - one partner is allowed to give only a promise to buy.
a) In DIMINISHING MUSHARAKAH, through contract partnership (shirkah al-aqd) the ratio of profit distribution for each partner can be disproportionate to the ratio of equity of both parties and has to be stipulated at the time of execution of a musharakah contract. However, any loss would necessarily have to be allocated in accordance with the ratio of equity at the time when the loss was incurred. In partnership by ownership (shirkah al-milk), the major objective of the relationship between the partners in a shared ownership in a property is not for the purpose of profit-earning through the business of buying and selling the property; therefore the ratio of profit distribution need not be stipulated in the arrangement.
b) In DIMINISHING MUSHARAKAH through partnership by contract, the lessee partner can promise to buy periodically the share of the financer partner according to the market value or at a price to be agreed at the time of sale of ownership Units of the asset. It is not permitted to stipulate that the ownership Units will be bought at a pre-agreed price or at their original or fair value, as that would constitute a guarantee of the share capital of one partner by the other partner; this is not allowed in a contractual partnership (shirkah al-aqd).
In DIMINISHING MUSHARAKAH through partnership by ownership (shirkah al-milk), on the other hand, one partner can purchase the ownership Units representing the share of the co-partner at a pre-agreed price. This is a very important difference between the two forms of DIMINISHING MUSHARAKAH, particularly in respect of Shari´ah compliance relating to both the procedure and the payment of price for the transfer of ownership by Islamic banks of their share in an asset to their clients. Islamic banks that provide housing finance on the basis of DIMINISHING MUSHARAKAH by way of shirkah al-milk (partnership by ownership), in order not to breach the Shari’ah rules, generally obtain a promise from their clients (or make a promise with the clients) that the clients will purchase the banks’ Units of shares in a particular property or asset at a pre-agreed price.
Composition of the DIMINISHING MUSHARAKAH Contract
A DIMINISHING MUSHARAKAH contract may consist of two or three sub-contracts, i.e.
(i) Partnership by ownership between two or more persons,
(ii) One partner leasing its share in the asset to the other partner(s), and
(iii) One partner selling its share to the other partner(s).
Contracts relevant to commercial assets that do not involve leasing involve two subcontracts – partnership and sale.
All the sub-contracts are considered permissible by the Muslim jurists when one contract is not dependent on another and particularly when sale/lease contracts are stipulated among the partners, i.e. where assets are sold/leased to partners. As regards the price of ownership Units periodically purchased by one partner from another, if the assets involve leasing, the purchase price can be pre-agreed.
After creating a joint ownership, the bank can sign a promise to sell the Units of the share of the bank’s ownership periodically to the client and, at the same time, undertake that when the client purchases a Unit of the bank’s share, the payments due on the remaining Units of the bank’s share will accordingly be reduced. Although the entrepreneur partner (the client) has an inherent motivation to acquire full ownership by purchasing shares from the financier (the bank), the majority of Shari´ah scholars and the AAOIFI Standard are not inclined to make the purchase binding on the client. Thus, while an Islamic bank will be making a binding promise to offer a specific part of its ownership of the project for sale on a specified future date, at a price that will be determined at the time of the actual sale (in the case of partnership by contract), the entrepreneur partner (the client) will voluntarily buy the share of the financing partner (the bank) at the price prevailing at the time of the sale, in the stock market or at a price determined by the free consent of the contracting parties.
Many see this as little different from a conventional mortgage, because, under both methods, monthly payments are made which may be similar in amount. However, unlike a conventional mortgage, where money is lent to help with the purchase of a property, the Bank makes its profit through the property's physical use via buyer occupation as a tenant. This is one of the fundamentals of Islamic finance whereby you can charge for the use of something physical, like a property, but you cannot charge for the use of money, because this is interest. The relationship between buyer and the Bank is also quite different.
The istisna is a contract of sale of specified items to be manufactured or constructed with an obligation on the part of the manufacturer or contractor to deliver them to the customer on completion. The Hanafi jurists approved the legality of istisna as an independent type of contract on the basis of istihsan or Islamic equity due to the needs of the buyers to obtain the goods according to their specifications and needs. Modern scholars adopted this view to accommodate the needs of the contemporary developments of modern financial transactions among the Muslims, and to realise the general principles of the Shariah. As a special type of contract, several conditions must be fulfiled in order to consider a contract of istisna as valid to avoid prohibited elements in Shariah either in the subject matter or the nature of obligations and liabilities of the parties. The viability of istisna as an instrument of modern financing could be further enhanced by the operation of parallel istisna. However, strict conditions must be observed in order to avoid the element of riba.
Definition of Istisna
Literally, the word istisna is a derivative from the root word sanaor to manufacture or to construct something. Istisna is an orderor request to manufacture something, whereby the requestorinvited, induced or caused another to make or manufacture somegoods for him.
Technically, it is a contract to purchase for a definite price something that may be manufactured later on according to agreed specifications between the parties. In other words, it is a contract of sale of specified items to be manufactured or constructed with an obligation on the part of the manufacturer or contractor to deliver them to the customer on completion.
As stated earlier, istisna is actually an exception to the general condition in a sale that the goods intended to be sold must be in the physical or constructive possession of the seller.
TYPES OF ISTISNA
There are two types of istisna :
Ordinary istisna: This is the common type of istisna as discussed above which means an agreement between the buyer/ requestor and the seller/manufacturer to manufacture a specified thing with specific specifications to be delivered in the future.
Parallel istisna or to contract two independent but interrelated contracts of istisna. The first contract, for example, is between a bank as a seller/manufacturer who undertakes to manufacture a specified good, and a customer as the buyer to whom the goods will be delivered. In the second contract, the bank as a buyer would request another company/ producer to manufacture the same goods specified in the first istisna. The second istisna is independent of the first istisna, whereby no liability arising from the first istisna contract shall be imposed on the parties of another istisna. Thus, the manufacturer in the second istisna, for example, is not liable to the end buyer (the bank’s customer) in the first istisna. The parties are only responsible to those with whom they entered into a contract.
MECHANISM OF ISTISNA
The effect of istisna is the establishment of the right of the buyer/ requestor over the subject matter (the manufactured goods) and the establishment of the right of the seller/manufacturer over the agreed price.
Thus, istisna is actually a sale contract whereby the subject matter could be delivered in future and the price could be paid according to the terms of agreement between the parties. This flexible feature of istisna could provide a tool for financing projects to be constructed in the future. For example if the government wants to construct a highway, it may enter into a contract of istisna with a contractor. The price of the istisna in this instance might be the right of the construction company to manage the highway and collect the tolls for a specified period, known as BOT (build operate-transfer).
Another important mechanism of istisna is that it is possible for the manufacturer to actually manufacture or construct the products required or to ask another party to manufacture the products on his behalf. His obligation is to deliver the products with the agreed specifications and the actual work can be done by him or by another party, through the operation of parallel istisna. Istisna therefore provides a proper Shariah-compliant instrument for financing, especially for the house financing sector, particularly for houses under construction. In this instance, the bank as the financier has two options:
1) Either to contract an istisna as a buyer with the developer who constructs the house and upon completion and delivery of the house, sells it to its customer at a higher price; or
2) To enter into contract in its capacity as a seller with the customer, for example, to build a house, and then to have a parallel istisna with the housing developer according to the specifications required by the customer in the first istisna. On completion of the project, the developer will deliver the house to the financier and the financier will, in turn, hand over
the property to the buyer (customer).
In both cases, the bank may calculate its cost and fix the price of istisna with the client in a manner which would allow the bank to gain reasonable profit over the cost. The payment of installments by the client may start at any point as agreed by the parties even before the house is completed and continues until the whole amount is settled. For security purposes, the bank may keep the title deeds of the house or any other type of guarantee agreed by both parties, until the last installment is paid by the client.
Ijara is a contract that results in the transfer of the right to use (usufruct). However, the ownership of the asset remains with the owner/lessor. In ijara, the lessor must be the absolute owner of the rented item or the agent of the owner or his natural or legal guardian. The item given for rent and the amount of rent should be fully and precisely known to both parties. In addition, it is necessary to make known the use of the item hired, so as to avoid disputes between the contracting parties. In the ijara of services, the benefit should be made known by a statement of the nature and method of service offered.
In terms of the types of ijara, there are two types, the operating ijara and the ijara muntahiah bittamlik. The later is the most popular type of ijara at present.
Ijara or leasing is a form of contract allowed by Islam based on the textual evidences of al-Qur’an and Sunnah. Not everyone has the means to purchase or own certain assets which he needs so as to utilise and benefit from them. Therefore, Islam has permitted the contract of leasing in order to facilitate public needs and to provide facilities in life. Islamic law permits the leasing of certain assets whose benefit can be obtained by the lessee against the payment of some agreed rental.
Salient Features of the Ijara Contract
The following summarises the salient features of the ijara contract:
o The lessor must be the absolute owner of the rented item or the agent of the owner or his natural or legal guardian.
o The considerations given for rent and the amount of rent should be fully and precisely known to both parties.
o In a contract of hire, it is necessary to make known the use of the item hired, so as to avoid later disputes between the contracting parties.
o In all kinds of ijara, the period of lease must be fixed and the purpose for which it is rented should be specified.
o In the ijara of services, the benefit should be made known by a statement of the nature and method of service offered.
o It is the responsibility of the lessor to maintain the property leased in such a way as to retain the benefit of the property.
o If the lessee intentionally damages the property hired, the lessor has the right to terminate the lease agreement and seek compensation.
o The lessee is allowed to sub-let immovable property provided that there is no restriction from doing so in the agreement of the contract.
o The hired item should be treated as a trust in the hands of the user.
Ijara Muntahiah Bittamlik (Leasing Ending With Ownership )
There are many types of ijara muntahia bittamlik, some of which have been developed through practice. In fact, ijara muntahia bittamlik can be categorised into major and secondary types. It should be noted that all of these types aim at transferring the legal title of the leased asset to the lessee. The mode of financing using different types of ijara muntahiah bittamlik is becoming a popular financing tool in many products offered by Islamic banks nowadays. The following are the various forms of the contract of ijara muntahia bittamlik and their related juristic characterization in light of the conditions stipulated in the contract:
Ijara Muntahia Bittamlik through Gift (Transfer of Legal Title for No Consideration)
It is a form of lease whereby the legal title is transferred to the lessee for no consideration by entering into a gift contract in fulfillment of a prior promise upon the settlement of the last lease instalment or by means of issuing a gift deed made conditional upon the settlement of all ijara instalments. The legal title is then automatically transferred without the need to enter into a new contract and without any extra payment other than the amounts paid by the lessee in the settlement of ijara installments.
Ijara Muntahia Bittamlik through Transfer of Legal Title (Sale at the End of Lease Period for a Token Consideration)
This agreement includes:
a) An executable ijara contract whereby the rent and ijara period are determined. If the ijara period expires, then the ijara contract will be nullified.
b) A promise to enter into a sale contract to be concluded at the end of the ijara period, if the lessee wishes so and has paid the agreed consideration. This type of ijara is permitted as there is no limit to the consideration to be paid in a bargained sale. The consideration may be equal to the value of the asset or otherwise, and it would be sufficient if a mutual agreement is reached on the consideration.
It should be noted that the transfer of a legal title at the end of the period of ijara muntahia bittamlik either for a token consideration or otherwise is based on the assumption that the lessor earns a rent higher than that which is paid for a similar asset such that in both cases, he will recover the cost of the asset through the ijara instalments. This is why the lessor would agree to the transfer of the title of the leased asset for a token consideration or otherwise.
Ijara Muntahia Bittamlik through Transfer of Legal Title (Sale at the End of Lease Period for an Amount Specified in the Lease)
This agreement, like the earlier one, is also a contract that includes an ijara contract and a promise to enter into a sale contract. The sale contract, includes an amount for the sold asset to be paid by the lessee (the buyer) after the expiry of the ijara period. Thus, upon the lessee’s paying the agreed consideration, the leased asset becomes sold and its title transferred to the lessee (the buyer) who will be entitled to the right of benefit and disposal of the asset in any of the legitimate forms of disposal.
Ijara Muntahia Bittamlik through Transfer of Legal Title (Sale) Prior to End of Lease Term for a Price Equivalent to Remaining Ijara Installments
This agreement is an Ijara contract and all the Shariah rules relating to ijara are applicable to it. The agreement also includes a promise made by the lessor that he will transfer the title of the leased asset to the lessee at any time the lessee wishes to do so during the ijara period and at a price equivalent to the remaining instalment of ijara, when there is a desire to purchase.
Ijara Muntahia Bittamlik through Gradual Transfer of Legal Title of Leased Asset
This agreement includes an ijara contract with a promise made by the lessor that he will gradually transfer the legal title of the leased asset to the lessee until the lessee has full legal title of the leased asset. This would involve determining the price of the leased asset which is to be divided over the period of the ijara contract so that the lessee is able to acquire a share of the leased asset for a proportionate consideration of the total price until the full title of the leased asset is transferred to the lessee at the end of the ijara contract period. It should be noted that, in this arrangement, there should be a sale contract for each share sold to the lessee. In addition, the amount of rent should decrease as the lessee acquires a greater share of the leased asset. If, for any reason, the ijara contract is revoked prior to the transfer of title to the lessee, then the title of the leased asset will be shared by both the lessor and the lessee to whom partial title of the leased asset has been transferred. This gives justice to the lessee whose aim is to acquire title of the leased asset through payment of a rent in excess of the fair rental amount.