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Picture the scene. You're the investment director at a prominent family office with a diversified real estate portfolio and have agreed heads of terms to acquire a sought-after regional logistics asset for £40m which benefits from a long lease to a well-known online retail giant. The Propco is incorporated and debt terms are in. An Islamic bank has offered to provide a £26m facility with a three-year term at an annual fixed profit rate of 3.20%.
The terms are attractive and align with your financial model, but you notice references in the terms sheet to 'purchase contracts' and 'commodities' and need further details before proceeding.
The concept of a purchase contract forms the cornerstone of all commodity murabaha facilities. Taking our opening scene and working it through, a purchase contract will comprise:
The Propco will then instruct the Islamic bank to on-sell those same commodities (sometimes by engaging a separate entity as its on-selling agent) on Propco's behalf to another broker on the LME for the original £26m.
The result? The Propco has £26m to part-fund its purchase of the asset and owes the Islamic bank £28.5m, repayable over three years. The difference of £2.5m? That's an amount equal to the fixed annual profit rate of 3.20% on the £26m over three years.
The economic effect is similar to a conventional loan but the crucial difference lies in how the debt obligation arises. Islamic law considers money as merely a means to achieve an objective and not the objective itself. As it has no intrinsic value, one cannot charge or receive money on money and real economy transactions are encouraged.
That rules out the payment or receipt of interest. How is the outcome of the purchase contract and on-sale any different? Well, proponents cite that whilst not perfect, the fixed rate product meets current standards issued by the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) and the commodity trade is sufficiently 'arm's length' as it involves:
Okay, let's revisit our opening scenario for a moment. You're now onboard with the concept of purchase contracts and the rationale for the commodity trade. Before signing the terms sheet however, you'd like some comfort that there is an equivalent concept of IPDs in such facilities.
You pick up the phone to the relationship director at the Islamic bank and she explains three options in broad terms:
A fixed rate product, like the one agreed with you, comprises one purchase contract for the duration of the three-year term under which the Propco required to repay a fixed portion of the facility on pre-agreed instalment dates (similar to IPDs) every 1, 3 or 6 months. She points you to the relevant section of the terms sheet which specifies, in your case, quarterly fixed profit payments.
Floating rate products have typically comprised a series of shorter, back-to-back, purchase contracts. She explains that if the commercial terms dictated a three-month floating rate facility, each purchase contract would, unsurprisingly, be for a term of three months. The profit element of each contract would be benchmarked against three-month LIBOR and a fixed margin. On a profit-only facility, the principal amount of each maturing purchase contract (in our case, £26m) would be refinanced by the next until the facility matures or is otherwise settled (say, from the sale or refinance of the asset). The profit element of each purchase contract would however be payable by the Propco each quarter in advance.
Importantly, she caveats this by mentioning that AAOIFI have issued Standard 59 which means that floating rate commodity murabaha facilities can’t operate in the same way as they did before 31 December 2019. The UK market is still adapting to the implementation of Standard 59 with no immediate changes to floating rate products in the offing, though its adoption in the UAE has led to some innovative structures taking shape in that region.
A variety of hybrid and developer-specific products are also available, where profit accrues during the development phase and is paid in instalments once the asset becomes income producing.
That concludes our first instalment of Murabaha Monthly, which I hope you have found to be a practical and useful introduction to the concept of purchase contracts. Next month, we'll revisit our opening scenario.
This time, two years will have passed and you will consider selling the asset in line with your investment strategy to maximise investor returns. You will want to know what an early payment scenario means for the purchase contract – can it simply be terminated prior to maturity? Stay tuned to find out!
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