How to handle default in Ijarah financing for leasehold properties

In-Depth Analysis

After a gap of a few weeks, the author endeavors to wrap up the long debate on Ijarah or leasing by picking the last few points. This is considered to be the last Ijarah article and the promise is to start a fresh subject from next week. The explanation covers how the default in the Ijarah of a leasehold property works in Islamic finance. Shariah principles consider usufruct as a commodity which can be bought and sold freely. It is easy to understand how the usufruct of a freehold property is managed in the operating as well as financial lease transactions over which there has been a good discussion. The title to the freehold property is held with the owner who is acting as the lessor — as such it is straightforward to manage the default. However, the basis of financing a leasehold property by an Islamic bank is not the title but the long-term usufruct it has acquired from the developer. Another difference between freehold and leasehold properties is that the value of the former may be going up in a given market but the value of the latter is designed to decline in the same market since the number of years the leasehold property was held at the time of purchase is eroding with the passage of time. Another important aspect in leasehold properties is the risk of relieving the land by the state at a notice in the case of land coming in the way of projects of public interest such as rail, roads, hospitals, schools/universities and such. Generally, such repossession is carried out by the state against compensation to the holder of the ownership to the usufruct. For example, Obaid utilized a financial leasing facility from an Islamic bank for a period of 15 years for a villa to be constructed over a 99-year leasehold land. But by the time Obaid got possession of the newly constructed villa, the remaining lease of the land is reduced to 95 years. If Obaid successfully completes the repayment of the Ijarah financing to the Islamic bank, the bank will transfer to Obaid the ownership of the villa along with the remaining usufruct of 80 years for the land over which the villa has been built. Let us assume that Obaid continues to pay the lease rent in the initial period of five years but defaults in the sixth year and is unable to regularize the situation. Here, the Islamic bank will be obliged to take action to protect its interest which shall be to terminate the lease and ask Obaid to purchase the property by virtue of the put option accorded by Obaid to the Islamic bank at the time of signing the set of Ijarah documents. The sale price by the Islamic bank to Obaid in this case shall constitute the outstanding principal amount of the Ijarah financing called the fixed element together with the unpaid variable element (see article 72 for both). If Obaid is able to pay this amount, the Islamic bank shall transfer to Obaid the usufruct having the remaining number of years in the leasehold land which shall be 90 years. However, if Obaid is unable to respond to the put option, the Islamic bank shall ask Obaid to vacate the villa if he is residing there so that it can be sold by the Islamic bank in the market. If the bank is able to secure a buyer who is agreeable to pay an amount which is less than the amount required by the bank to square up the outstanding Ijarah position on its books, Obaid shall be responsible to pay the shortfall. The new buyer shall get the transfer of the usufruct to the land with the number of years remaining in the leasehold term. The Islamic bank will be in a tight situation since it has to be mindful of the number of years passed in the leasehold term accorded by the state, thereby affecting the property value. This is the reason that Islamic banks seek a higher downpayment by the customer while financing the leasehold property compared with freehold property. If the Islamic bank is not able to find buyers due to the remaining number of years being unattractive, it may seek the state to prematurely renew the land lease for another 99 years. And if no buyer can be found at all, the last option is to enter into a rescheduling of the Ijarah financing for a longer period to bring down the rental so that Obaid can pay it.