This article is the latest in a series of articles focused on basic Islamic finance concepts and structures. This article will focus on Musharakah transactions.
What is Musharakah?
Musharakah is a partnership arrangement whereby the musharakah partners (a financier and a customer) share in the profits of the partnership at predetermined rates. A diminishing Musharakah is a form of Musharakah where the financier's participation diminishes over time as the customer's participation increases.
What makes this different to a conventional loan? Similar to a conventional loan used by a customer on a property acquisition, a diminishing Musharakah financing involves the financier contributing towards part of the purchase price of an asset jointly with the customer. It however, differs from the standard security position in a conventional loan, as, in a Musharakah financing, it is the financier rather than the customer who will hold the legal title to the property involved in a property acquisition financing. The respective ownership percentages of the financier and the customer in the asset/property will be determined in the Musharakah agreement. Over time, the customer will buy out the financier's percentage of ownership until it reduces to zero. At this point, legal title will transfer from the financier to the customer.
How is it structured?
The financier will purchase an asset (for example, a property) from a seller at a price agreed between the seller and the customer.
Both the financier and the customer contribute towards the purchase price at pre-agreed amounts. This will determine the respective percentages of ownership in the asset of the financier and the customer. The respective ownership percentages will be set out in the Musharakah agreement.
The customer will make payments to increase its percentage of ownership in the asset, thereby decreasing the financier's percentage of ownership, until the asset is 100% owned by the customer.
Where the asset is property, the financier will typically lease the property to the customer, who will make lease payments to the financier.
When is Musharakah most often used?
Musharakah is particularly well suited to real estate transactions, such as investment projects and property purchases.
Security position
How are these structures of financing secured? The financier will hold legal title in the asset until such time that the customer purchases the entirety of the financier's ownership percentage in the asset. This may then be supported by other security in favour of the financier, including security over insurance or profit reserve amounts.
For further advice on Islamic finance, please feel free to get in touch with Jonathan Grosvenor and Lilli Sutherland.
