Wednesday, March 30, 2011

Forward ijara and property speculation

Emirates 24/7 is reporting that Dubai Bank is waiving the rental payments it demanded for construction projects that were delayed. In an earlier post, I included quotes form a paper by Dr. Abdul Sattar Abu Ghuddah on the forward ijara contract. I am more convinced that this was the contract used in the disputed contracts and that the issue was that rent began accruing on what the bank referred to as the "expected date of delivery". For the people affected by the delays and facing large payments for the rent that the bank claimed as due despite the delays, it is surely a relief.

However, I think that the issue does not really end here. The bank realized it was at fault for the cost of the delays by virtue of the specific contract used (based on my reading of Dr. Abu Ghuddah's position on forward ijara). However, I think it raises some more fundamental questions about what potential misuse could come from the forward ijara contract in the future with this new precedent. There is not yet any form of consensus about what happens when a project that is the subject of a forward ijara is delayed so that delivery does not take place on the specified date.

However, for purchasers of future apartments where the contracts are forward ijara, it is pretty much assured that they will assume that the rents will be waived by the developer. This reduces the costs to speculating on these types of developments; in a way, it's back to 2007. Their possible gain by buying an apartment with a small amount made as a down payment gives them the upside if the development is built on schedule. If things go awry, then they always have the option of walking away and losing their deposit (there may be additional penalties depending on the country). Even if they do not do so, they will be stuck with an underwater property and rental payments into the future. However, they will not have the additional rental fees assessed in a lump sum for any delays in the project.

Contracts will vary on the conventional side, but I assume they would have some grace period from when the contract is signed for a specified number of months. After that period, the principal and interest would be due in monthly installments whether or not the property is completed. If this occurs, it will make the forward ijara economically preferable to a conventional loan.

While this is generally a preferable outcome--making Islamic finance products more desirable--in this case, it would create additional incentives to speculate on real estate projects. If there were a delay (caused, perhaps by financial crisis or real estate panic), the buyer could sit on the unfinished property until it were ready and then decide whether to take possession or renege on the financing. During the intervening period, they would be granted a free ride, (free of payments and accruing interest) which would alter their economic decision about whether to wait for markets to recover.

Viewed from the ex ante position, this would alter the decision about whether to speculate on an "apartment in the sky" because the cost of it being unsuccessful would be reduced and the downside risk would be pushed out into the future a few years. Most investors, particularly in situations where real estate speculation occur, are quite myopic (with high discount rates). This could have a substantial impact on decision-making and might even attract people who didn't choose Islamic finance for the ethics but for the economic outcome. While not a bad thing for a generic Islamic finance product, in some situations, this could lead banks to over-extend again and face a crash.

1 comment:

Anonymous said...

It is shamefull that the reputed Bank was trying to swindle investors. Strange......