In the Spotlight: Islamic Finance and Its Impact on Leasing Transactions in the U.S.

As a result of these restrictions, funds that are subject to Islamic law typically seek out safe havens for their investment in commercial real estate in the United States, such as multi-family housing, apartment buildings and self-storage facilities. To the extent that these funds venture into office, retail and industrial space, they usually prefer single-tenant buildings (or buildings with a limited number of tenants) where the existing tenants are not engaged in any of the prohibited activities. The restrictions imposed by Islamic law significantly limit the range of commercial real estate assets that are available to Islamic funds.

Even if an Islamic fund acquires an industrial, office or retail property occupied by a tenant who is engaged in a permissible activity, there are a number of other issues that may arise with respect to the lease. In particular, the Islamic fund may take issue with the assignment/sublease provision of the lease if it gives the tenant an unrestricted right to assign the lease or to sublet the space. Accordingly, the Islamic fund may seek an approval right over any assignment or sublease or may try to add a list of prohibited uses that restrict the types of activity that an assignee or a subtenant may perform in the premises. In many such cases, the willingness of an existing tenant to make such modifications to its lease will determine whether the transaction is able to go forward.

Prohibition Against Interest

As you may be aware, one of the fundamental rules of Islamic law is that the payment and the receipt of interest is prohibited. This rule can impact a number of other provisions in a lease, which may either derail the proposed transaction or require a lease amendment in order for the deal to proceed:

Default Rate

If a lease contains a provision that requires the tenant to pay the landlord past due rent, together with interest on such amount calculated at a punitive interest rate, the landlord may be in violation of the Shari'ah rules prohibiting the receipt of interest. The landlord can either live with the provision in the lease and just waive the penalty if and when the late payment of rent occurs, or the landlord can attempt to renegotiate the provision and insert a flat, stipulated sum as the penalty amount, so that it is not characterized as an interest payment.

Yield-Based Rent or Additional Rent

Some leases may bifurcate rent into: 1) base rent; and 2) additional rent. If the additional rent piece can be characterized as the payment of a return to the landlord to compensate the landlord for costs associated with the construction of the premises, the additional rent portion could be deemed the payment of interest to the landlord and the landlord might be subject to the claim that the landlord has violated the Shari'ah rules by accepting such additional payments. Accordingly, the landlord must be careful either to place all of its expected payment into the base rent number or to define additional rent in such a manner that it does not have the appearance of an interest-driven return on the landlord's original investment.

Major Indicia of Ownership

In the context of a single-tenant building (which may often be preferred by an Islamic fund because it limits the exposure to tenants violating the impermissible business activity restriction), the landlord must be careful to ensure that the tenant does not assume so many of the obligations relating to maintenance and casualty/condemnation that the tenant appears to have assumed most of the major risks of ownership. In such a circumstance, the landlord could be deemed to have merely provided financing to the tenant, with the rent payment being viewed as principal and interest payments relating to the financing. The landlord cannot afford the risk that the rent payments are recharacterized in this manner. For example, while it is acceptable to shift certain basic maintenance costs to the tenant, responsibility for capital repairs such as the roof or the foundations should probably remain with the landlord. Likewise, in the event of a major casualty or condemnation, it would be inappropriate to expect the tenant to make up any shortfall in the insurance or condemnation proceeds. Also, if the repairs will cause a significant disruption in the tenant's ability to use the premises for a period of time, the tenant should be entitled to some sort of rent abatement during that period, so that the burden of ownership is properly borne by the landlord.

Conclusion

It is safe to say that legal practitioners and property owners in the United States will continue in the next several years to encounter real estate investment funds originating in Islamic countries. Each such potential transaction involving investment in commercial real estate in the United States will raise to some degree the issues discussed above and the transaction will probably proceed more smoothly to a satisfactory conclusion if all sides to the transaction are aware of these restrictions and limitations.

David G. Williams is a partner in the Real Estate Practice Group at Seyfarth Shaw LLP (Atlanta office). His practice concentrates on real estate acquisitions, dispositions and financing, and the structuring of joint venture entities for real estate development and investment. Phone: 404-885-6682. E-mail: [email protected].

The flow of foreign investment money into real estate in the United States has certainly slowed over the last 18 months as commercial real estate markets have tried to adjust to the new reality of the current recession. However, as we all know, when commercial real estate markets in this country recover in the next several years, foreign funds will once again play a significant role in the recovery. For that reason, it is important for every owner of commercial real estate in the United States today to know something about Islamic finance. You may be selling your asset to a sovereign wealth fund or some other real estate investment fund originating in an Islamic country, or you may be forming a joint venture with such a fund as an equity partner to hold title to an asset. In either event, you are likely to come across investment money flowing into commercial real estate in the United States from an institution or entity subject to Islamic law. In the leasing context, there are a number of unique issues dictated by Islamic law (known as Shari'ah) that all owners and landlords of commercial real estate need to understand.

Prohibited Activities

Under Islamic law, Islamic funds are prohibited from owning real property that is used for certain so-called impermissible business activities. For example, prohibited uses include manufacturing or distributing alcohol or tobacco, gambling and gaming, pornography and profanity, manufacturing of firearms and munitions, producing or distributing pork-related products and the development or sale of interest-based financial products (including most Western banking, consumer finance and insurance companies).

As a result of these restrictions, funds that are subject to Islamic law typically seek out safe havens for their investment in commercial real estate in the United States, such as multi-family housing, apartment buildings and self-storage facilities. To the extent that these funds venture into office, retail and industrial space, they usually prefer single-tenant buildings (or buildings with a limited number of tenants) where the existing tenants are not engaged in any of the prohibited activities. The restrictions imposed by Islamic law significantly limit the range of commercial real estate assets that are available to Islamic funds.

Even if an Islamic fund acquires an industrial, office or retail property occupied by a tenant who is engaged in a permissible activity, there are a number of other issues that may arise with respect to the lease. In particular, the Islamic fund may take issue with the assignment/sublease provision of the lease if it gives the tenant an unrestricted right to assign the lease or to sublet the space. Accordingly, the Islamic fund may seek an approval right over any assignment or sublease or may try to add a list of prohibited uses that restrict the types of activity that an assignee or a subtenant may perform in the premises. In many such cases, the willingness of an existing tenant to make such modifications to its lease will determine whether the transaction is able to go forward.

Prohibition Against Interest

As you may be aware, one of the fundamental rules of Islamic law is that the payment and the receipt of interest is prohibited. This rule can impact a number of other provisions in a lease, which may either derail the proposed transaction or require a lease amendment in order for the deal to proceed:

Default Rate

If a lease contains a provision that requires the tenant to pay the landlord past due rent, together with interest on such amount calculated at a punitive interest rate, the landlord may be in violation of the Shari'ah rules prohibiting the receipt of interest. The landlord can either live with the provision in the lease and just waive the penalty if and when the late payment of rent occurs, or the landlord can attempt to renegotiate the provision and insert a flat, stipulated sum as the penalty amount, so that it is not characterized as an interest payment.

Yield-Based Rent or Additional Rent

Some leases may bifurcate rent into: 1) base rent; and 2) additional rent. If the additional rent piece can be characterized as the payment of a return to the landlord to compensate the landlord for costs associated with the construction of the premises, the additional rent portion could be deemed the payment of interest to the landlord and the landlord might be subject to the claim that the landlord has violated the Shari'ah rules by accepting such additional payments. Accordingly, the landlord must be careful either to place all of its expected payment into the base rent number or to define additional rent in such a manner that it does not have the appearance of an interest-driven return on the landlord's original investment.

Major Indicia of Ownership

In the context of a single-tenant building (which may often be preferred by an Islamic fund because it limits the exposure to tenants violating the impermissible business activity restriction), the landlord must be careful to ensure that the tenant does not assume so many of the obligations relating to maintenance and casualty/condemnation that the tenant appears to have assumed most of the major risks of ownership. In such a circumstance, the landlord could be deemed to have merely provided financing to the tenant, with the rent payment being viewed as principal and interest payments relating to the financing. The landlord cannot afford the risk that the rent payments are recharacterized in this manner. For example, while it is acceptable to shift certain basic maintenance costs to the tenant, responsibility for capital repairs such as the roof or the foundations should probably remain with the landlord. Likewise, in the event of a major casualty or condemnation, it would be inappropriate to expect the tenant to make up any shortfall in the insurance or condemnation proceeds. Also, if the repairs will cause a significant disruption in the tenant's ability to use the premises for a period of time, the tenant should be entitled to some sort of rent abatement during that period, so that the burden of ownership is properly borne by the landlord.

Conclusion

It is safe to say that legal practitioners and property owners in the United States will continue in the next several years to encounter real estate investment funds originating in Islamic countries. Each such potential transaction involving investment in commercial real estate in the United States will raise to some degree the issues discussed above and the transaction will probably proceed more smoothly to a satisfactory conclusion if all sides to the transaction are aware of these restrictions and limitations.

David G. Williams is a partner in the Real Estate Practice Group at Seyfarth Shaw LLP (Atlanta office). His practice concentrates on real estate acquisitions, dispositions and financing, and the structuring of joint venture entities for real estate development and investment. Phone: 404-885-6682. E-mail: [email protected].