Real Estate Joint Ventures with
Islamic Investors: Understanding the Keys to a Successful
Relationship
Craig Friedman and Imran
Ahmed, Arch Street Capital Advisors, L.L.C.
Since the reversal of the fantastic US
bull market run in the spring of 2000, real estate professionals
have witnessed a worldwide shift in investor sentiment in
favor of cash flowing real estate investments. This trend
is best evidenced through the exponential increase in cross-border
real estate demand and activity. Multiple sources of capital–
institutional investors, high net worth individuals, retail
investors and fund sponsors – including organizations
which pool real estate investment capital from many individuals
or smaller institutions are looking for real estate opportunities
in the US and Europe.
The surge in foreign investment in US
real estate has been dramatic – 2002 volume was up
356 percent over 2001 and indications are that 2003’s
volume will be even greater, with year over year volume
as of March 31, 2003 up 34 percent over the same period
of 2002. Nowhere has the increase in foreign investor demand
been more striking than in the capital influx from Middle
Eastern investors. Furthermore, the increase in Middle Eastern
investment capital for US real estate is being driven largely
by Islamic investors- i.e., individuals or entities investing
in accordance with the principles of Islamic law (also referred
to as Shari’a). Sponsors of Islamic real estate funds
have indicated that this increased level of investment appetite
is likely to continue in the near term. As an asset class,
Islamic investors view real estate as a vehicle that will
allow them to earn a risk adjusted yield premium relative
to the available alternatives. This outlook, coupled with
a projected fifteen percent annual growth rate in the Islamic
investment universe’s demand for real estate and an
increasingly positive view of the dollar’s prospects
for appreciation against the euro, make a strong case for
US real estate owners/operators and investment professionals
to take some time to understand the fundamentals in working
with this increasingly important investor base.
The Preference for
Joint Ventures
Islamic investors have frequently chosen to invest in joint
ventures along side established real estate owners/operators,
rather than owning 100 percent of real estate assets. There
are many advantages to the foreign investor in pursuing
this strategy:
1. the investor gets the opportunity to leverage the experience
and contacts of a local operator’s management team,
operating infrastructure and knowledge base;
2. the investor may require its joint venture partner to
make a meaningful equity co-investment, assuring an alignment
of interests (a) between owners and (b) between ownership
and property management;
3. the investor can avoid adding to its overhead burden
for administration of the investments by relying on its
joint venture partner’s personnel to carry out the
monitoring, reporting and other administrative functions;
and
4. partnering with a well-known operator may provide the
investor with name-brand recognition that immediately increases
its own credibility in the international real estate arena
and augments the likelihood of success for any retail syndication
of its investment.
For the US real estate owners/operators there are also many
benefits to a joint venture with an Islamic investor, however,
there needs to be a concerted effort by both parties to
clearly understand each others’ objectives and constraints.
The following sections outline potential issues that may
arise in a joint venture relationship and ways that some
of these issues may be mitigated.
Permitted Tenancies
Perhaps the most fundamental aspect of a Shari’a compliant
real estate investment is that the owned property or properties
must be leased to tenants that are not engaged in prohibited
activities. These activities include banking, mortgage lending
and consumer lending (including brokerage firms that extend
credit to clients); insurance; manufacturing and distributing
alcoholic beverages (including restaurants and retailers
that serve/sell alcohol); producing and distributing pork
related products (including restaurants and retailers that
serve/sell pork); manufacturing of firearms and munitions;
purveyors of pornography and profanity; gambling and gaming;
and tobacco and related products.
While this list may seem limiting at first,
there are asset classes which readily satisfy these tenancy
restrictions - multifamily and self-storage are two examples.
Other asset classes can also satisfy the tenancy tests,
provided that care is taken in tenant screening. These include
industrial, office, and retail properties with non-prohibited
uses. A simple rule for minimizing the potential for conflicts,
as it relates to leasing vacant space, is to focus on properties
with a single Shari’a-compliant tenant, or very few
such tenants, with lease terms that exceed the anticipated
life of the venture. By minimizing the anticipated lease
rollover, the partnership can avoid the tension that can
be created when the operating partner brings a non-compliant
tenant (e.g., a highly rated financial institution) to its
Islamic partner to fill a vacant space in a joint venture
property. Clear communication regarding the tenancy limitations
adopted by a particular Islamic investor, at the earliest
opportunity, will also assist in avoiding misunderstanding
or frustration later on.
Financing
After finding a property that meets Shari’a standards,
the next most important concern in forming a compliant real
estate joint venture is to structure financing that satisfies
Islamic principles. A prospective partner with an Islamic
investor must bear in mind that such an investor cannot
borrow funds through conventional means or pay interest
to a conventional lender. There exists, however, a widely
accepted body of Islamic Finance that can readily create
for the joint venture partners the same financing attributes
(in terms of loan to value, financing cost, loan assumability,
etc.) that can be achieved through a conventional financing.
Today, the Lease structure and its variants
are widely accepted by a host of institutions including
Fannie Mae, Freddie Mac, portfolio and securitization lenders,
insurance companies and dedicated mezzanine lenders as a
bona-fide means of property financing, and have been endorsed
by the major credit rating agencies. While there had been
an initial inclination to charge a structural premium for
the financing, a growing awareness and increased competition
within the financial community has resulted in the incremental
costs being limited to minimal additional legal documentation
and entity formation expenses. Despite a widespread acceptance
of the Lease structure, it is important to note that putting
an Islamic financing in place with an institution familiar
with the structure is significantly less cumbersome than
pursuing such a transaction with an institution unfamiliar
with the concept. Likewise, assuming an existing financing
in the context of an acquisition is generally an arduous
process, particularly in cases where lenders and servicers
do not have prior exposure to the Ijara structure and experience
in dealing with Islamic investors.
From the perspective of a US real estate
owner/operator looking to enter into a joint venture relationship
with an Islamic investor, there are additional implications
pertaining to the financing that are important to understand
in an effort to avoid later issues. An example is the Islamic
investor’s need to distance itself from traditional
borrowing in light of the prohibition on interest. Islamic
investors are not in a position to sign financing term sheets
and commitment letters; however, they are able to sign a
letter of acknowledgement to the potential partner assuming
the obligation for their pro-rata share of any transaction
related expenses in the context of the Ijara agreement.
Likewise, Islamic investors cannot be party to non-recourse
carve out obligations associated with the financing; the
direct burden of these obligations is on the joint venture
partner who can, under certain circumstances, be indemnified
or otherwise compensated. Additionally, the prohibition
on interest necessitates the use of either non-interest
bearing accounts for all joint venture related activity
or the investment in Shari’a compliant Murabahah Funds,
which are short term liquidity management vehicles utilized
by Islamic investors, now being offered through the Islamic
finance subsidiaries of certain global financial institutions.
USA Patriot Act
and OFAC Lists
Due to the enactment of Title III of the Uniting and Strengthening
America by Providing Appropriate Tools Required to Intercept
and Obstruct Terrorism (“USA Patriot Act”) on
October 26, 2001, and money laundering lists maintained
by the Office of Foreign Assets Control (“OFAC”)
of the United States Department of the Treasury, foreign
investors in general, and Islamic investors in particular,
have come under increased scrutiny when conducting business
in the US. Though a majority of Islamic investors conduct
their US based investment activity through holding companies
incorporated in tax efficient jurisdictions such as the
Cayman Islands, US based joint venture partners and financing
providers have an affirmative know-your-customer (“KYC”)
obligation, which extends beyond the holding companies to
the ultimate beneficial ownership. This obligation is further
complicated by the fact that a number of Islamic investors
syndicate their investments either prior to, or shortly
after, closing a transaction.
Fortunately, both potential joint venture
partners and financing providers can mitigate related concerns
by conducting business with reputable Islamic investors
supervised by regulatory agencies that have established
procedures for due diligence that are comparable to the
requirements of the USA Patriot Act. Generally, US partners,
financing providers and the rating agencies will accept
certification attesting to the initial and on-going compliance
with the USA Patriot Act and OFAC lists from a regulated
Islamic institution as the placement agent and responsible
intermediary for an investment syndicated to multiple Islamic
investors. This certification satisfies the intent of the
USA Patriot Act and reduces what might otherwise become
a prohibitive burden on the Islamic investor, its US partner
and the financing provider.
Public Company Partners
Islamic investors frequently seek joint venture relationships
with US public company (i.e., REIT) partners. Having a public
joint venture partner provides the investor with the additional
benefit of doing business with an entity that is subject
to several levels of external scrutiny and oversight: (1)
stock exchange regulators, (2) auditors (frequently Big
4); (3) equity analysts; (4) credit committees at its leading
lending relationships; and (5) in many cases, credit rating
agencies.
Despite these benefits, a US REIT partner
will need to provide an Islamic investor with comfort on
several important issues, unique to public real estate companies,
relating primarily to compatibility and alignment of interests.
In particular, the US partner should carefully review with
the Islamic investor its previous experience in joint venture
relationships with capital partners. In addition to discussing
this experience from an economic perspective (how actual
returns compared to projections, etc.) the US public company
partner should provide examples of how it may have altered
a business practice or company custom to accommodate the
specific needs of its partner – in this way demonstrating
its flexibility in meeting the Islamic investor’s
somewhat unique requirements.
Also important to address is the REIT’s
ability to satisfy the Islamic investor’s holding
period requirements. Generally speaking, funds formed by
Islamic Fund sponsors have a finite life of between five
and seven years, with a strong expectation that the Fund’s
affairs will be wound up and investors’ capital will
be returned within that stated time period. REITs, on the
other hand, can face several important impediments to sale
that an Islamic investor will need to receive comfort on:
1) REITs go through periods (like recent quarters) where
reinvestment opportunities are scarce and REITs resist selling
properties to avoid potential earnings dilution; 2) REIT
partners may not be anxious to dispose of assets that they
believe are “core” to their presence in a market
or which justify the existence of a regional or local office;
and 3) REIT partners may be hesitant to sell when doing
so will likely require giving up lucrative property management
and leasing contracts on the assets. Assurances of a REIT
management team’s willingness to periodically evaluate
sales of joint venture assets, coupled with a demonstrated
history of pruning the REIT’s own portfolio, can be
helpful in assuaging investor concerns.
Frequently, however, a well-defined exit
mechanism, controlled by the investor, is the only way to
satisfy investor concerns. A compromise position on control
over timing of sales may involve providing the REIT partner
with an acquisition window towards the end of the joint
venture’s intended life. During this window, the REIT
may have a preemptive right to acquire the joint venture
assets subject to investor protections in the form of market
value and minimum return threshold tests.
Bridging the Time
Zone Gap
US owners of real estate often voice concern regarding the
ability of a joint venture partner located 14 hours away
by plane and between seven and eight hours apart in time
zones, to be sufficiently responsive on partnership matters.
Most frequently, this responsiveness issue is relevant when
addressing the resolution of major decisions – e.g.,
active negotiations with a major tenant, a lender on a refinancing,
a new joint venture acquisition or an asset disposition.
While it is true that time zone differences
and physical distance can be inconvenient, advanced planning
and consideration from both parties should prevent serious
conflicts. Successful partnerships generally foresee tenant
leasing issues and refinancing opportunities well in advance
and can establish guidelines that allow the operating partner
to conduct business on behalf of the joint venture, with
minimal day-to-day input from the capital partner.
Similarly, negotiations over an asset
disposition can be left to the operating partner so long
as the joint venture has spent time in advance agreeing
upon an acceptable form of contract, establishing a range
of pricing and timing for sale that is satisfactory to the
partners.
Similar strategies have proven effective
as it relates to acquisitions in which the operating partner
is charged with responsibility for sourcing acquisitions
that fall within certain pre-established criteria. The operating
partner provides the capital partner with periodic updates
in the form of an acquisition pipeline report that discusses
in detail the size, material terms and timing of transactions
being pursued and provides the capital partner with feedback
on transactions that were either lost or abandoned prior
to consummation. These reports provide a good framework
for weekly or semi-weekly discussion (depending upon how
active the acquisition program is) so that each party feels
informed and knowledgeable about the opinions and preferences
of the other. The ability to respond quickly to partnership
issues is greatly enhanced by physical and time zone proximity.
It is frequently comforting to the US partner to know that
there is an investor representative within the country available
for face to face meetings with financing providers, property
sellers, brokers, lawyers, accountants, etc. as business
needs may dictate.
Conclusion
To be successful, a joint venture relationship between an
Islamic investor and a US real estate owner must be based
on a deep and thoughtful understanding of each partner’s
needs. Both parties to the transaction should develop a
general understanding of the counterparties’ practices
in order to establish a framework in which the partnership
can effectively operate. US owners that are considering
joining with an Islamic investor would benefit from spending
some time considering the issues identified in this article.
H
The authors would like to thank Isam
Salah and Scott Arnold of King & Spalding, LLP, Harvey
Uris of Skadden, Arps, Slate, Meagher, and Flom, and Jennifer
Keith of Arch Street Capital Advisors, L.L.C., for their
insights and assistance in the writing of this article.
Craig Friedman is a Partner at Arch
Street Capital Advisors, L.L.C., a real estate advisory
and asset management firm based in Greenwich, Connecticut,
specializing in advising Middle Eastern investors with their
US and European real estate investment strategies. Mr. Friedman
has over ten years of real estate investment advisory and
capital markets experience. Prior to co-founding Arch Street
Capital Advisors, L.L.C., Mr. Friedman was a senior originator
with Deutsche Bank’s real estate investment banking
group, having started and being responsible for the firms’
global real estate joint venture advisory business. Mr.
Friedman has been a repeat guest lecturer at New York University’s
Masters Degree in Real Estate Program. Mr. Friedman holds
a BS from Binghamton University and a JD from Fordham University.
Imran Ahmed is a Partner at Arch
Street Capital Advisors, L.L.C., a real estate advisory
and asset management firm based in Greenwich, Connecticut,
specializing in advising Middle Eastern investors with their
US and European real estate investment strategies. Mr. Ahmed
has been involved with real estate industry for over ten
years, with experience in real estate investment advisory,
finance, development, construction and design. Prior to
co-founding Arch Street Capital Advisors, L.L.C., Mr. Ahmed
was a senior member of the real estate investment banking
group at Deutsche Bank, having been involved with more than
$10 billion of real estate advisory and capital markets
transactions with a particular focus on real estate related
structured financial products. Mr. Ahmed holds a BS and
BA from Cornell University, a MA from Massachusetts Institute
of Technology and a MBA from Harvard Business School.
