By Dr Hisham Dafterdar
The aim of this case study is to present a dramatically different outcome of a much lauded mode of development financing based on a diminishing musharakah (partnership) model. Diminishing musharakah is shariah mode of financing that awqaf often considers for developing its idle assets. Diminishing musharakah calls for a strategic cooperation between awqaf and the private sector who can bring in capital and entrepreneurship. Private developers are attracted to awqaf projects because of the business opportunities they represent. A socially connected project with a cash-flow has a special appeal to the private sector.
In this study, I offer my own observations focusing on issues and concerns that impact on development financing that entail partnerships between awqaf and the private sector. This case study is based on a real life project that utilized a diminishing musharakah mode of financing. The name of the parties involved, the type, scope and location of the project have been changed for reasons of privacy and confidentiality.
My hope in writing this case study is to shed some light on some of the risk issues and constraints that are associated with awqaf/private sector partnerships in general, and the goal conflict, information asymmetry and opportunistic behavior that may emerge from a diminishing musharakah structure. Lessons learned from this study may be applied by awqaf institutions especially those who have undeveloped land but are cash-strapped.
Awqaf Foundation is a medium sized charity based in the Emirate of Ajman, UAE. This organisation has the primary objective of improving the health and wellbeing of the poor and needy with special focus on orphaned children. Awqaf Foundation has under its purview a plot of waqf land measuring 28,145mÂ² in newly developing suburb about 20 kms from the city center. The site is accessible by good roads and is serviced by public utilities. The market value of the land was estimated by two independent real estate valuers at US$20.00 million. Awqaf Foundation wanted to develop the site so that it becomes a source of revenue for its activities.
The feasibility study showed that the best use of the land is to construct a commercial shopping complex. The project will serve the residents by offering shopping and entertainment facilities, and will contribute to the social development of the new community. The feasibility study also showed that in order to finance, develop and operate the project, the involvement of a private sector company that can bring in capital and operational expertise is needed for the project to succeed. Being a waqf, the land cannot be sold or mortgaged. Therefore, the feasibility study recommended a partnership structure based on diminishing musharaka. The project implementation period is expected to be 2.5 years including site preparation, construction and furnishing.
The project entails the construction of a shopping mall of three levels with escalators between floors, comprising a supermarket as an anchor store, retail outlets, restaurants, food court and cafes, and an entertainment zone. There will also be a mosque, ablution area. The mall will be surrounded by a parking lot of 500 parking spots.
The total cost of the project was estimated at US$ 60.00 million, contributed as follows:
Awqaf contribution land – $20.0 million 33.33 %
Project construction cost – $40.0 million 66.67 %
Total project cost $60.0 million 100.00%
Awqaf Foundation entered into diminishing musharakah (reducing partnership) agreement with a private developer to build and operate the project. The partnership was based on the parties initial respective contributions, i.e. one third (1/3) for awqaf and two thirds (2/3) for the private developer.
The diminishing musharakah contract was signed between the parties according to the following terms:
- The ownership of the land remains with awqaf while the developer’s ownership is restricted to the building.
- The scope of the project, the design and amount to be paid for the cost of construction are agreed upon between the two parties.
- The Awqaf Foundation reserved the right to approve all tenancies before any leases are signed for retail space. The reason was that awqaf wanted to ensure that all businesses in the mall are halal businesses.
- The developer makes a binding promise to sell its ownership share of the project to Awqaf Foundation in periodic instalments, thereby gradually reducing its share in the project.
- The net profit (or loss) will be accounted for on quarterly basis.
- At the end of each accounting period the net profit (or loss) will be divided pro-rata between Awqaf and the developer based on their respective shares as at the beginning of that accounting period.
- Awqaf’s share of the profit will be deposited into an escrow account and is applied in whole or in part to buy a gradually increasing undefined shares in the building.
- All disputes arising from or related to the contract shall be decided by arbitration.
Both Awqaf and the developer had agreed on the diminishing musharakah mode of financing because:-
- From the Awqaf standpoint, diminishing musharakah involves no cash outlay on the part of awqaf, and provides timely liquidation of the developer’s ownership share in the project in favor of awqaf.
- From the developer’s stance, diminishing musharakah provides the financier with an exit strategy by gradual withdrawal from the investment after recuperating the invested capital and the expected profit.
Project risks, mitigation strategy and impact
The project was exposed to a number of financial and non-financial risks. Risks came in many different shapes and sizes and affected both awqaf and the developer, quantitatively and qualitatively. Many of the project-related risks were identified at the outset and mitigation measures were put in place to avoid or minimize their consequences. These risks included the following:
Cost overrun risk:
This risk relates to cost estimation errors, increase in the cost of building materials and other cost increases such as increase in customs duty, rates and taxes.
This risk was mitigated by careful calculation of all costs at current market prices, conservative estimates and by taking 10% contingency provision (price and physical). In addition, the construction contract was based on fixed-price turnkey terms and conditions that exclude price escalation due to currency fluctuations and other factors.
Time Delays Risk
Time delay risks relate to failure to complete the project within the dates stated in the schedule. This risk involved several activities as detailed below:
- Incomplete design and construction documents
- Appointing incompetent professional teams or sub-contractors based on the sole criteria of selecting the lowest bidder without considering quality just because their offer is the lowest.
- The design is not continuously monitored to ensure its adherence to the budget and program.
- Client delay in making payments on time to contractors and others.
Most, if not all of these risks were mitigated through careful selection of the project team. An experienced project manager was engaged to oversee the execution of the project and ensure that all of the project requirements are met and implemented on time. In addition, the construction contract included penalty clauses for undue delays.
There are rules and regulations that are set by the local government that need to be abided by in order to avoid penalties or major disruptions to the project.
All licenses and work permits were obtained based on approved plans and drawings. In addition, a reputable engineering consultant was engaged to ensure that none of the building codes and ordinances are skipped or infringed.
Foreign exchange and economic conditions Risk:
This includes currency fluctuations and deteriorating economic conditions.
There is no foreign exchange risk. The UAE dirham is considered to be among the most stable currencies in the world. It has been pegged to the United States dollar since 1973. The exchange rate is US$1.00 = AED 3.67. This stability is expected to continue. The UAE enjoys a robust and resilient economy having a credit rating of AA by all major rating agencies.
Damage by accident, earthquake or fire risk
This risk relates to partial or total loss or damage by reason of accident, fire, flood, earthquake and other natural or man caused disasters.
This risk was mitigated by adequate and comprehensive insurance cover. During the construction phase, the contractor was required to insure all works until completion. In addition, the building was designed to withstand tremors up to 8.0 of the Richter scale.
Project environmental risk relates to any potential harm on the environment or health caused by the project during the construction phase or arising out of operation, by effluents, emissions, wastes, etc.
The project is considered to be environmentally safe and that there will be no harmful emission of toxic gases or other pollutants that may have an adverse effect on the surrounding atmosphere, the project will also not affect any known historical, religious or archaeological sites. In addition, a public liability insurance policy was taken to cover most of these risks.
Project operational phase
The construction phase was completed without any major issues. Except for some disputes about the design and minor delays, the project was delivered on time and within budget. The project was accepted by the partners and their respective shares 1/3rd for Awqaf and 2/3rd for the developer – were confirmed as per their respective contributions.
After completion of the project, the relationship between the partners began to change from being collaborative and conciliatory during the construction phase to adversarial and conflicting during the operational phase.
The first problem was about the tenancy mix. The new suburb was thinly populated and the demand for retail space was very weak. The developer could not lock in an anchor tenant like supermarket or a department store or international tenants like BHS or Zara, who are key to attracting other businesses. The second problem was that Awqaf had vetoed applications from some businesses that were considered to be repugnant to shariah such as amusement and leisure businesses, cinemas, arcade games, pawnshops and conventional banks. The third problem was the lease terms which included high rental rates, common area charges, and share of the municipal and real-estate taxes and insurance.
Partners in conflict
For approximately two years, less than ten tenants negotiated rental agreements, and the mall was operating at a loss. This situation caused a conflict and soured the relationship between Awqaf Foundation and the private developer. The developer as the majority partner had to bear the bigger share of the loss and blamed Awqaf Foundation for its restrictive rental covenants. Awqaf Foundation on its part felt that it has entered into a dark tunnel, that the project instead of being a source of revenue became a financial burden.
Going to arbitration
The dispute escalated to the point that both parties had to invoke the arbitration clause in the contract. The arbitrators advised the partners to engage a specialized commercial property management firm to lease and manage the mall. The consultant advised the partners to consider offering lease incentives such as rent-free periods, reduced rentals and fit-outs. This strategy succeeded in attracting few more tenants, but the rental revenue did not cover all the expenses. The developer, in order to stem the loss sought to exit from this partnership by offering to sell his share in the partnership. Awqaf Foundation were given the right of first refusal, and refused. However, Awqaf Foundation agreed that the developer may sell his share to a third party subject to their approval. The terms of the offer were too vague to be considered by any serious buyer.
Gradually, with the ongoing development and population growth in the area, more businesses were attracted to the mall. About ninety percent of the shop units were leased, and the project started to net positive results after three years from opening. All prior years losses were recouped, and the net profit was divided between the two partners proportionate to their original ratios.
A change in positions
The lure of profits and the capital appreciation of the project, led to a change in the positions of the two partners and sparked new disagreements and arguments. This time it was Awqaf Foundation who wanted to end the partnership and offered to buy out the developer’s share in the project. Awqaf took the position that the partnership is a diminishing musharakah and therefore has the right to accelerate the exit of the diminishing partner. The developer on his part rejected the offer and argued that the promise to sell his share (the building) is not binding according to Shariah and is legally non-enforceable. The developer’s argument was based on the premise that a forward or future sale is not permitted from a Shariah perspective, especially that no consideration (i.e. sale price) was stated in the contract and the construction cost does not reflect current market value.
Back to arbitration
The arbitrators considered the case and ruled as follows:
- Since the buy/sell condition in the contract is not made in absolute terms and since there is no defined consideration, the buy/sell condition can only be construed as a promise to buy/sell.
- A promise creates a moral obligation but cannot be enforced legally or under Shariah.
- Under the prevailing property law in the country, the building is an immovable property and therefore is considered as land improvement. This means that the building becomes part of the land, and together they form a homogenous capital.
- In conclusion, the arbitrators opined that notwithstanding the terms of the diminishing musharakah, the partnership should continue and neither partner can force the dissolution of the partnership.
Based on the arbitratorsâ€™ decision, the diminishing partnership was transformed into permanent partnership. This made the developer effectively a majority owner of the waqf (land and building) with a controlling interest of 66.6 percent.
Issues and constraints
No mode of financing comes without a dose of pain. In a diminishing musharakah contract, the problem revolves mainly around the sale provision. The ownership of the building by the developer will be liquidated progressively in favor of Awqaf Foundation until Awqaf eventually owns the entire project. From a Shariah and legal perspectives, the sale provision does not constitute a sale contract. A sale contract should stipulate the price and the time period for settlement. In a diminishing musharakah neither of these two elements can be stated in definite terms. It is unjust to fix the future price of the building before it is constructed. The sale or part sale can only be effected at the prices prevailing at the time of the actual sale. This would entail market valuation on each settlement date. Therefore, the sale provision in diminishing musharakah can be nothing but a non-binding, non-enforceable promise.
Other issues of concern include the following:
- The profit to be realized from the project cannot be accurately estimated. Therefore awqaf’s share may differ from what was expected and this could affect its revenues.
- The developer/financier cannot ascertain the period until full recovery of principal and profit.
- Any financing mode for which a repayment period is not known, is considered flawed from a commercial standpoint.
- There is no justification under Shariah for imposing penalty fees for early (or late) settlement.
- Most scholars consider that the sale provision in a diminishing musharakah agreement a promise to sell that creates a moral obligation but is not binding. The developer (building owner) may not want to fulfil the promise to sell if the value of his share in the project is appreciating and the profit potential is higher than expected. In this case the diminishing partnership becomes a de facto permanent partnership.
- One of the unique risks of this mode is that if the project location has to be acquired or removed by government for a public purpose, awqaf as the land owner may receive compensation or a substitute location, while disputes are likely to arise regarding adequate compensation to the building owner.
- Most real estate laws consider any building or structure with embedded foundation in the land as land improvements, and hence become part of the land. Therefore, in this case Awqaf and the developer become partners in both the land and the building. This is tantamount to the developer becoming the part owner of the waqf property. Some scholars consider this situation to be an infringement of Shariah, while others allow it under the rules of istibdal where awqaf substitutes an undefined part of the land for an undefined part of the building.
The development of awqaf assets offer an opportunity to advance awqaf missions and enhance operational capabilities, but the risk elements increase uncertainty of success. Diminishing musharakah is a mode of financing based on profit and loss sharing. Therefore the tenor, i.e. the duration of the agreement, cannot be reliably determined. The ambiguity of the buy/sell provision in the contract is a cause of conflict between the partners and has the potential to change the nature of the relationship between them.
This case raises ethical questions. A contract is in essence an exchange of promises which the parties commit to. The diminishing musharakah agreement was signed with the reciprocal understanding and commitment of the two parties to all its clauses. However, while the parties agreed to the same terms on paper, they had different expectations about how the agreement will benefit them in practice. The attitudes and behaviors of the partners had changed as the conditions on the ground changed.
Awqaf and the private sector have different goals and metrics that drive them. Awqaf’s commercial strategies are more about development and social impact. The private developer, on the other hand, is focused on maximizing profits and does not want to be distracted with a social mission. Awqaf properties cannot be used as collateral. The security taken by the financiers is largely confined to the assets they finance and not to the inalienable waqf assets. This security becomes difficult to call upon when a tangible asset becomes an inseparable part of another tangible asset. It’s like trying to unscramble scrambled eggs.
On structuring a diminishing musharakah agreement, questions arise about a number of factors. The cost of contracting with the wrong private developer is high especially when there are risks awqaf weren’t aware of, or when there is a serious lack of understanding of the other partner’s motives and concerns, and when the agreement is poorly worded.