By Axel Jacob

How Islamic finance models have created a bit of a mortgage bubble in Dubai!

Real property can be mortgaged for finance purposes - that statement in its simplicity is true for the UAE as for the rest of the world. As a security interest the mortgage is being registered in the property register in favour of the lender and by virtue of that registration secures his interests above the interests of all other creditors of the owner. A mortgage can be followed by a second and even a third or fourth mortgage if a careless or risk ignorant mortgage provider accepts it. Secondary mortgages fortunately are not yet a common terminology within the real estate environment in the Gulf. The trouble with them is that obviously as a security they lack the same value as a primary mortgage and depend on what’s left once the first mortgage is fully satisfied. Whilst the worldwide financial crisis was partly caused by such multiple mortgages that had no real value, in the UAE so far it was said that no mortgage bubble existed here. That picture may cautiously have to be replaced.

Another circumstance supports this view although it is not fully grasped and understood by the majority of small real estate investors who are using the services of an Islamic finance provider such as Tamweel or Amlak: The Dubai Mortgage law may know and provide for conventional mortgages, which require registration of the lender in the property register, but by far the majority of real estate finance deals is based on Islamic finance principles. In most cases an ijara-agreement was concluded, a so called forward lease agreement, by virtue of which the bank provides the funds and takes over the contract with the developer directly and agrees on a long term lease with the buyer, who will only have to start paying the lease rates upon hand over. Important to note is that in such a structure the bank formally becomes the owner of the property for the duration of the finance arrangement and therefore, there is no need to register a conventional mortgage in the property register. At the end of the lease period the property is formally transferred to the buyer by virtue of a separate sale & purchase agreement.

Whilst the original purpose of this structure is to circumvent the Islamic prohibition of interest for money lending, the formal appearance of the bank as owner of the property leads to a slightly different distribution of the commercial risks involved. However, that does not mean that for the buyer who signed up for an ijara there is an easy way out in case he miscalculated his investment. He will remain liable towards the bank under the ijara-agreement. But the bank to a certain extent becomes more of a partner in the investment rather than a mere finance provider as it does in a conventional mortgage structure.

Many such an agreement have been concluded at the peak of the Dubai real estate boom, including deals for secondary and tertiary buyers which had to pay huge premiums to previous buyers in order to take over the contracts. These peak prices including the premiums often were financed up to 90-95%. The Dubai real estate crisis has now created a bit of its own “mortgage bubble”, where such properties are today worth only 50% of their financed prices. Banks are now facing the problem of having securities that do not match the volume of the financial transaction. Should the buyer cease to be able to pay the lease rates the bank faces potential losses. Such situations are not uncommon these days as many small buyers are currently struggling after having lost a job. Currently realizable rental yields may not cover the lease rates; a sale of the property in current market conditions will manifest the loss.

The only chance to avoid losses lies in holding the property with a long term strategy. This elementary truth is valid for both – buyers and banks who should accept their relationship as rather a partnership. It will be worthwhile for both to sit together and jointly search for solutions if the buyer faces financial difficulties. It cannot be in the interest of the bank when the buyer gives up. Therefore, the banks should be open to accommodate certain concessions such as a payment holiday or even to re-negotiate the lease conditions altogether. For distressed buyers it will be highly advisable to seek such constructive talks with their banks.

Axel Jacob