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The rental element in Ijarah contract as applied at Oman Islamic banking

By Dr. Moilim El Azhar Mdawhoma
January 22, 2021 12:08 pm

Abstract

Rental calculation under Ijarah is a concern to many customers of Islamic banks in Oman, especially with respect to the part of it that is subject to revision from time to time, which stirs up customer’s apprehension towards the actual entire liability he owes the bank. The different calculation methods that are common in the Islamic banking literature have been studied and the applied ones in Oman have been discussed vis-à-vis the applicable Shari’a standards of AAOIFI.    

Keywords: rental, Ijarah, Islamic banks, Oman. 

  1. Introduction:

1.1 An Overview

People rent their homes for a number of reasons, including notably affordability, cost efficiency, flexibility, comfortability and others. Naturally, they often choose to be renters if they cannot afford to become homeowners –especially considering the huge down-payment that must be paid. But also, they may opt to rent if they seek certain benefits not readily available in the home they already own, such as amenities, larger or smart homes, and a better location, among others.

It is not surprising, however, that the demand for renting, given the above and other factors, is on the rise. But what is astonishing is that a substantial number of renters wish to remain renters forever, and others highly value the state of being renters. For instance, Freddie Mac’s 2019 housing survey revealed that approximately 40% of the renters have reported that they will likely never own a home –and 80% says renting is a better fit for their current lifestyle (1)

In the context of the Sultanate, the Omanis are among the leading nations in terms of owning their houses. This trend took a strong momentum since year 2014 when Oman ranked 16th in the world in home ownership rate, by 83% (2). This rate increased further in 2018, to become 98%, according to His Excellency Sheikh Saif Al Shabibi, thanks to 3 housing schemes adopted by the government, namely (a) the Housing Assistance Program, (b) the Housing Units Program and (c) the Housing Loan Program, in which the government spent so far more than OMR1 billion over the past years (3).

With this promising trend and strong demand, Islamic banks, particularly in Oman, do widely employ lease (“Ijarah”) financing. Even, at a point of time, this tool constituted the entire portfolio of some banks in the country, as they started operation via Ijarah, and thus built their financing business around this single contract. Actually, there is no single Islamic bank in Oman that does not operate Ijarah in its financial activities.

Like in normal lease contracts, the rent under Islamic Ijarah agreements is subject to change from time to time. Yet, many customers of these banks who are financed via a lease contract complain when they learn that their rental is changed –usually upward. The nature of such a change, the amount, and the frequency are sometime challenged as to their clarity to lessees. AAOIFI –one of the key regulators of the industry –tries to elaborate this point eloquently by urging more transparency, especially in respect to floating rental. It stipulates that the amount of the rental of the first period of the Ijarah contract shall be specified in lump sum, and that those for subsequent periods may be formulated with certain benchmarks. (4)

The dilemma is that most of Ijarah transactions at Islamic banks are financing ‘capital’ lease – from the point of view of the customer, as opposed to operating lease. So, in this form, the lessee agrees to pay high periodic rentals, over the normal (market) rate, with the expectation that he or she will eventually own the property upon settling the full amount. But, if the Bank retains the right to change the rental from time to time, then what is the point of agreeing with the customer on the overall rental amount? Is the rental just an indicative sum? Or that whatever change made in it will not affect the overall amount agreed upon with the customer as the aggregate payable amount?!  

1.2 Objective

So, this paper aims at highlighting the status-quo of the treatment of the rent in Islamic banking lease contracts in Oman and how it is calculated. It is hoped that familiarity with this treatment will enable current and potential customers, as well as the general public at large, to understand the different practices at Islamic banking, particularly in the jurisdiction of Oman. Such familiarity is likewise expected to shed more light on the difference between normal lease contracts and those of Islamic banking entities.   

1.3 Methodology

In writing this research, the description method has been employed to explain in-depth with the process and how the rental is charged under Ijarah contracts, of various types, including identified or forward, operating or financing, as operated by Islamic banks. The paper aims to investigate the background of rental and identify its methods of calculation. The focus will be on describing the phenomenon in order to have a proper understanding of rental treatment at Islamic banking in the Sultanate.

This said, the paper –in describing the issue, does not engage quantitative methods. It only endeavors to determine the characteristics of the rental in Islamic banking leases, and observe the trend, in order to validate the existing practices in the Omani Islamic banking sector. In doing so, the lease contracts of these banks have been examined in respect to the rental elements and the manner of calculating them. Accordingly, the methodology followed in writing this paper is the combination of both description and quality. Thus, this paper may be said to be a qualitative descriptive research. 

Despite all efforts made to make the methodology of producing this paper as sound as possible, the inherent deficiencies of a descriptive research, such as potential biasness, the limitation of sampling, as well as the scope limitation of a descriptive research are still there. Nevertheless, all these deficiencies are typical in this sort of research, and it is hoped that the supporting evidence provided will help neutralizing those concerns.   

1.4 Scope

The scope of this research paper is to investigate how the rent is composed, calculated and then charged under Ijarah contracts as operated by Islamic banks in Oman. Hence, the paper will focus on the treatment of rental calculation, as opposed to the efficiency or fairness of the rental method adopted by the Islamic banking sector in Oman.    


2.Literature Review

2.1 Background 

Ijarah(5) is the Arabic synonym of a lease or a tenancy contract, where one contracting party exchanges (sells) the usufruct of an asset to a second party for a given period of time against rental payments. The rent is payable fully either on spot, or deferred, or in instalments, as may be agreed by the parties. The subject matter of the lease under the Shari’a must remain during the tenure of the lease, thus should not be consumable by virtue of the lease. This implies that fuel, money or food items are not leasable in the Shari’a since obtaining their usufructs will necessarily imply consuming them per se. 

Ijarah is one of the most applied contracts of Islamic banking, and perhaps one of the largest revenue generating devices to Islamic financial entities. Most mega projects in Islamic finance, like home financing, aircraft financing, Sukuk (Islamic bonds) are carried out through Ijarah. Other Islamic banking operations, like major construction, project financing, and Build-Operate-Transfer (B.O.T.) also employ, among others, Ijarah contract. Islamic financial entities greatly opt for this instrument since its return is relatively less risky, and yet many investors equally prefer it for the same reasons. 

Despite the above merits, Ijarah still retains some Shari’a challenges that are not yet resolved, even at the literature level (6). These challenges are valid regardless of the sort of Ijarah under consideration –whether Ijarah Mu’ayyanah or Ijarah Mawsufa Fil-Dhimmah. One such issue is the variable rental element and the way it is collected from the lessees. This part of the rental has not been attended eloquently enough, by regulatory references and standards, in a manner that eliminates disputation between Islamic banks and their customers. This has left Islamic financial entities and market players almost free to take the matter in their hands and try to come up with a Shari’a compliant –and yet –practical-business approach.

With the recent revision of lease contract under the International Financial Reporting Standards (IFRS), from an accounting stand (i.e. the IFRS-16, which supersede IAS 17 Leases, eliminating the classification of leases into either operating or finance, hence urging instead that all leases are to be treated similar to finance leases applying IAS 17) lease contracts, starting from 1 January, 2019, are ‘capitalised’ by recognising the present value of the lease payments and showing them either as Ijarah assets (right-of-use assets) or together with property, plant and equipment. If Ijarah payments are made over time, then the company shall recognise a financial liability representing its obligation to make future lease payments. (7) 

Traditionally, two Shari’a approaches, in calculating the variable rental of Ijarah, have been the most consistently followed by the mainstream of Islamic banking sector. The first, which is widely practiced, is to view a lease contract as a one broad agreement, similar to a master agreement, perhaps in the form of a memorandum of understanding or a letter of intents, where the whole period is divided into many rental periods and an offer and acceptance must be exchanged at the commencement of each new rental period. In such a structure, the next rent (mainly the variable portion) is, often, subject to change –usually, upward, on the commencement of every subsequent rental period. 

The 2nd approach, which perhaps was active in the early rise of Islamic banking, is to consider the whole Ijarah period as one within a single contract, although divided into many rental periods. This approach implies that nothing of the terms of the Ijarah is subject to change except the flexibility to vary the rental payment from time to time without affecting the overall rental amount payable by the lessee. This method seems to be derived under the perception that an Ijarah is but a sale contract, and thus the rent must be fixed in advance without variation. In the context of Murabaha, the AAOIFI states that: “It is not permitted under any circumstances to subject the determination of the price or the profit to unknown variations or variations that are determinable in the future, such as by concluding the sale and making the profit dependent on the rate of LIBOR that will prevail in the future. (8)” So, with the view that Ijarah is nothing but a sale contract, the rule of fixing the price (rent) was therefore perceived. 


2.2 Types of Ijarah

Shari’a scholars classified Ijarah into (a) a sale of usufruct with respect to a specific asset, and (b) a sale of usufruct applicable to a described asset. This is what Sheikh Dr. Nazih Hammad explicated when he highlighted that in “the Ijarah applicable to an asset, the usufruct subject to the lease is associated with that asset –such as if a person rents a particular house or land or car, or hires a particular person to tailor clothes and so on. But the Ijarah applicable to the legal capacity, then the usufruct subject matter of the Ijarah is associated with the undertaking of the customer, like when a person rents a described beast for boarding or transport. (9)”   

Broadly speaking, Ijarah at Islamic banking takes 2 forms in view of 2 considerations –namely: availability and the end-purpose of the lease (10). From the consideration of readiness and availability, Ijarah is classified into (a) available, and (b) unavailable. As to the 2nd respect, Ijarah is grouped into (1) operating, and (2) to own –or “financing”.

2.2.1 Available: By this term, it is meant that the asset subject matter of the Ijarah is ready to use, in all material aspects, at the time of concluding the contract. This includes the fact that the landlord has the legal title or capacity to enter into the tenancy contract and that the underlying asset is free from occupancy and other aspects essentially evidencing its availability. The term that is often used to connote this sense is “identified” –or the Arabic synonym (“mua’yyanah”) –derived from the Arabic word “ain” (eye), meaning “seen. So, the lease asset is available evidently of being seen physically or identified conventionally, which tantamount to be seen by the to-be tenant.

2.2.2 Unavailable: Contrary to the foregoing category, is unavailable –a term refers to the fact that the asset subject matter of the Ijarah, is not yet, or at all, ready for use while concluding the Ijarah contract. This includes the scenario where the landlord does not have the legal title or capacity to enter into the tenancy contract, and/or that the underlying asset, despite the lessor having the legal power to conclude the contract –if any, is not free from occupancy and other aspects essentially evidencing its readiness. Like in the first scenario, the term that is commonly employed to indicate this direction is “prescribed” –or the Arabic classical term (“Mawsufa Fil-Dhimmah (11)”).

2.2.3 Operating: An operating lease is the sort where the lessee wishes to, or allows someone else to, use the underlying asset within the agreed period without the intention to own it. This kind of Ijarah is usually short term, typically one year or lesser. Long-term operating Ijarah, such as 99 years lease, on the other hand, are often viewed to tantamount to financing lease –for the purpose of enabling an Islamic bank to finance the underlying asset (12). A typical example of this is ‘Musataha’ contract, where the customer may have the right to use and operate an asset –usually a real estate –but not the right to own it. (Obviously, in such a case, the Ijarah term must be of equal or lesser maturity than the Musataha contract). Another characteristic of this kind of lease is that the rent tends to be almost at par and in line with the market rate –i.e. with zero opportunity cost.   

2.2.4 Financing: It is meant by financing lease –or lease-to-own, from customer’s viewpoint –an Ijarah where the purpose of the agreement is getting finance for the ownership transfer (13) to the customer –. This sort of Ijarah is often long term –typically averaging in the context of Oman around 10 years for corporate customers, and 20 years for retailers. Another feature of this sort of lease is that the rental is substantially higher than the prevailing market rate. The following characteristics, according to GAAP, must be established for a lease contract to be financing, else it will be deemed operating, namely: 

  • There is an ownership transfer to the lessee at the end of the lease;
  • The lease contains a bargain purchase option;
  • The lease life exceeds 75% of the asset’s economic life; or
  • The present value (PV) of the lease payments exceed 90% of the asset’s fair market value. (14)

2.3 Implications of Ijarah categories:

The grouping of Ijarah into different types, considering different scenarios, does give birth to 4 permutations, namely: (1) Available with Occupancy, (2) Unavailable with Occupancy, (3) Available with Ownership, (4) Unavailable with Ownership. Now, let’s analyze these classifications one by one:

2.3.1 Available + Occupancy:

This combination shows that the asset subject matter of the Ijarah is available before signing the contract and that the customer has selected it per se –and hence the term ‘Available’. It also means that the customer wants to sign Ijarah contract on such an asset only for the purpose of occupancy –and hence the term ‘Occupancy’, as opposed to having the intention to eventually own it.

2.3.2 Unavailable + Occupancy:

This combination indicates that the asset subject matter of the Ijarah is not yet available prior to signing the Ijarah contract, and accordingly the customer has not selected it per se –and hence the term ‘Unavailable’. It also means that the customer wants to sign Ijarah contract on such an asset only for the purpose of occupancy –and hence the term ‘Occupancy’.

2.3.3 Available + Ownership:

This combination illustrates that the asset subject matter of the Ijarah is ready for use starting from the date of signing the Ijarah contract –and hence the term ‘Available’. It also means that the end-purpose of the customer for signing the Ijarah contract on such an asset is to transfer the title ownership to the lessee –and hence comes the term ‘Ownership’.

2.3.4 Unavailable + Ownership:

This combination connotes that the asset subject matter of the Ijarah is not yet ready for use at the time of concluding the Ijarah contract –and hence the term ‘Unavailable’. It also means that the end-purpose of the customer for signing the Ijarah contract on the underlying asset is to have the title ownership –and hence comes the term ‘Ownership’.

Now, these four combinations are put into a matrix as follows:    

Table (1)* 

Ijarah Divided


Available(spot)Unavailable(forward)
Occupancy(rent-to-use)12
Ownership(rent-to-own)34

* Source: writer’s own illustration.

The first foregoing category –Available + Occupancy is slightly active in some Islamic banks, usually applies on the vacant premises of the bank. An example of this is the head office of a number of banks, such as Bank Muscat –where its Islamic window –Meethaq –operates, typically when the office is designed like a mall-sort, with many offices to rent. However, because traditional landlords can better compete banks, and the customer may have many and better options than that of the bank, this type of Ijarah is not heavily operated. 

The second arrangement –Unavailable + Occupancy –is almost not operated completely by Islamic banks. It is rarely seen that a customer approaches an Islamic bank to be financed under Ijarah for a property that does not exist, and yet he does not plan to take its title ownership. One explanation for this is the arguments we stated above that landlords can give the customers better offers.

The last 2 categories –Available + Ownership, and Unavailable + Ownership –are perhaps the most applied sort of Ijarah at Islamic banks across the globe, including Oman in particular. The customer approaches the bank to get finance for a property which he eventually wishes to own. The desired property may be readily available at the time of placing the request to the bank for financing, or rather available only in the mind of the customer or on a paper as a structure.

2.4 Rental related challenges

In practices, as highlighted above, majority of Ijarah transactions at Islamic banks are financing ‘capital’ lease –from the viewpoint of the customer, as opposed to operating lease. So, in this form, the customer agrees to pay high periodic rents, over the normal rate, with the expectation that he or she will own the property once he pays the entire amount. Here, those periodic rentals are the sums for the entire lease contract which are then distributed to a given period, covering the principal amount, the profit portion of the financing as well as any additional expenses may be incurred by the Bank. The whole arrangement aims to ensure that by the maturity of the contract, the Bank gets back its financing amount along with the profit margin it would have got had it rather invests the amount in other areas –“the opportunity cost”. 

The unanswered questions in eloquent way are that if the Bank will retain the right to change the rent from time to time, while the customer expects to pay no more than the overall agreed amount, then what is the meaning of their agreement? Is the customer right to understand that whatever change is caused, it will not affect that overall sum agreed as the aggregate amount payable by him? And what is the Shari’a stand on such an understanding?

2.5 Shari’a & Regulatory Rental

2.5.1 Rent Under the Shari’a

It is a matter of consensus among Shari’a scholars that a lease contract is but a sale contract (15) of usufruct. In that perspective, the rent is nothing but the price of that sort of sale. To this, Ad-Dharir, defined Ijarah as “a sort of sale where the usufructs or utility rights of a property are the object sold; however, it is given a special name (16) [i.e. Ijarah or lease]” (17). This being the case, therefore, the rent must be known in advance by the lessee and lessor, as a price in a sale would have to be clearly known in advance by the seller and buyer. To this, AAOIFI’s stipulation holds that “The rental must be specified, either as a lump sum covering the duration of the Ijarah contract, or by instalments for parts of the duration. (18)” In his elaboration of the consensus of Shari’a jurists on the rental, Dr. Al-Quradaghi further added that the “Fuqaha agree that the rental must be known; so, if it is in currency, the amount must be spelled out, such as: a hundred thousand, and the denomination must be clear, such as: dinars, or riyals or dollar. Then if the currency of the country is given, such as Qatari Riyal, then that is it –no more. However, if the country has two known currencies, the currency must be specified, such as the USA Dollar, the Canadian Dollar, or the Qatari Riyal and the Saudi Riyal… (19)” 

According to both individual and collective diligences by Shari’a scholars and councils, the rental, under the Shari’a, does not have to take only one form –a static form throughout the Ijarah term. Rather, these diligences have concluded that it is permitted by the Shari’a that the rental may be subject to change. To this, AAOIFI states that: “In case the rental is subject to changes (floating rental), it is necessary that the amount of the rental of the first period of the Ijarah contract be specified in lump sum. It is then permissible that the rentals for subsequent periods be determined according to a certain benchmark. Such benchmark must be based on a clear formula which is not subject to dispute, because it becomes the determining factor for the rentals of the remaining periods. This benchmark should be subject to a ceiling, on both maximum and minimum levels. (20)” 

In the same token, the Islamic Fiqh Council of the Muslim World League in its 22nd session held in Makkah, during the period from 10-14 May 2015, stated that: “Secondly: It is allowed to conclude a lease with a variable rental linked to a stable benchmark known to the two parties, to which a maximum and a minimum limits are set, provided that the rent for the first period is specified at the time of the contract, and that the rental of each period is determined at its beginning. (21)” The Council went on to explicate the difference between a lease contract and a sale one on the ground that in a lease contract the ambiguity is tolerated, which may not be the case in a sale contract. The justification of this double-standard, according to the Council, is because a lease contract is based on selling a usufruct in the future that are gradually renewed, unlike in a sale contract that falls on an existing asset. Unlike a sale contract, an Ijarah contract can be deferred to a future date, according to the majority of Shari’a scholars “because transferring the usufruct of a property in case of Ijarah cannot be done immediately at the time the contract is concluded.” (22) 

Another troublesome issue in relation to rental is the Shari’a legality to revise the already agreed rental. The debate on changing the rent is not confined only to having floating rent, but also on changing the already fixed rent. Obviously, if the change means reduction, then most of Shari’a scholars may not have any Shari’a objection. However, if the nature of change is upward, do the Shari’a scholars support it? The answer to this is almost yes, provided that the period for which the rent is to be raised has not already elapsed. The AAOIFI appears to side with this view, when it states that: “The amendment of future rentals is permissible by the agreement of both parties, i.e. the periods for which the lessee has not yet received any benefit. (23)” The logic behind this restriction is the fact that the rental period that has elapsed has become a debt –and hence cannot be increased, while the periods that have not matured yet have therefore not caused their respective rentals to be a liability –from a Shari’a perspective. 

Some Islamic banking practices, however, find an acceptable Shari’a compliant way through this restraint. They suggest, for example, to increase future rentals in order to offset the amount that could not be charged for the already passed period. This approach, however, is only conceivable with Ijarah, as it would be unthinkable to be applied with Murabaha dealings, and also with service Ijarah operation, like travel finance, marriage finance, and medical finance.     

One last Shari’a issue on the rental is the entitlement of it once received by the lessor. Under the Shari’a, rent is payable to the lessor upon the contract, but it is entitled to him if, only if, the consideration –the subject matter of the lease –is received in full by the lessee. This receipt, according to Shari’a scholars, can be in actual –represented by actual use, or constructive –by enabling the tenant to make use of the asset. However, in case the lessee could not use the asset, for no reasons attributable to him, then the rentals already paid to the lessor must be treated differently. To this, AAOIFI holds that: “If the leased asset is destroyed or if the continuity of the lease contract becomes impossible up to the expiry period without the cause being attributable to the lessee in either case, then the rental is adjusted based on the prevailing market value. That is, the difference between the prevailing rate of rental and the rental specified in the contract must be refunded to the lessee if the latter rental is higher than the former. This is to avoid loss to the lessee, who agreed to pay a higher rental amount compared to the prevailing rate of rental in consideration of lessor’s promise to pass the title to him upon the expiry of the lease term (24).

2.5.2 Rental Under the IBRF

The Islamic Banking Regulatory Framework (“IBRF”) issued by the Central Bank of Oman has enforced the Shari’a stipulations on rentals. It commenced with the applicability of the rent, associating it with the delivery of the leased asset. However, it rules that if the subject matter of the Ijarah is not delivered, then “lease rentals shall not become due and payable” (25). This qualification of the liability to deliverability could be misunderstood or misinterpreted as to mean that in whatever circumstances the rent is not payable until and unless the underlying asset is delivered to the lessee. One such a circumstance is having a contractual stipulation assented by the lessee that the rental shall be paid in advance. Then, by virtue of such a stipulation, the rental is payable even before the delivery of the asset. This is typical under Ijarah Mawsufah Fil-Dhimma (or forward lease) whereby the leased asset often does not exist at the time of concluding the contract, while the lessor (the bank) may want to reduce its risk exposure by engaging the customer to contribute as well –and possibly using that contribution to finance the construction under the Istisna’ contract. 

Apparently, what the IBRF means by the stipulation is that the rental become absolutely due and payable in all respects upon full delivery of the leased asset. As such, the terms “due” and “payable” were used to refer to a situation where there would be no counterclaim whatsoever by the lessee against the rentals he pays. It also may be said that the IBRF envisages Ijarah to be operated with the anticipation that the underlying asset will be delivered immediately or shortly after concluding the agreement. Those Ijarah whose assets are to be delivered after the elapse of a considerable long time were perhaps viewed as would have an Istisna’ contract or a grace period therein. 

Another Shari’a related feature addressed by the IBRF is the determination of the rental in a clear manner. It permits agreeing to pay the rental in advance but in an unambiguous way. More interestingly, the IBRF gives room for the two parties to set the rental in absolute term for the entire period, or for a specific period (26). This implies that the two approaches of viewing the Ijarah contract –whether a one-term contract or a master agreement –is accommodated by this clause. In addition to the clarity of the rental, the IBRF empowers the lessor to impose a late payment charge. However, the way the IBRF put it indicates that the fee is not a penalty, rather a self-imposed charity on the part of the lessee (27). That means, it is not the Islamic bank –as a lessor –that actually penalizes the lessee; rather it is the customer who undertook to donate through the bank. This is very similar to an undertaking by someone self-imposingly to donate in the form of a penance –which is acceptable under the Shari’a, evidently from the Quranic verse that read: {Then let them complete The rites prescribed For them, perform their vows, And (again) circumambulate The Ancient House.}, [Surat, al-Hajj, Verse: 29]. 

The IBRF touched the accounting and financial reporting, by highlighting the different treatment under the AAOIFI and IFRS. The former looks to the rental as expense on the lessee and income to the lessor, whereas the later treats it as finance lease regardless of the form of Ijarah agreement –whether capital or operating lease. It seems the IBRF does not object either approach of recording the rental is followed by the Bank (28), as the two approaches emanate from two different considerations, especially since IFRS views the lessee more than the lessor. However, the recent enforcement of the IFRS with respect to recording the rental entails that the two approaches will have no practical impact; for the lessor will still book the rental as income and the lessee as cost, and yet the lessee will disregard the nature of the lease if the Ijarah is a long term one. 

Finally, the IBRF attended the rentals on the risk exposure under the capital adequacy requirements. It considered first the credit risk of the failure of lessee to honour the rentals, but highlighted the mitigation of repossession of the asset by the bank, despite some concerns with such a recourse, especially in the case of movable assets and residential properties. Also, the IBRF foresaw a market risk exposure under Ijarah Muntahiyal Biltamleek (IBM) when the lessee backs off from the deal, and the lessor may have to reimburse the lessee the rentals representing the capital payments (29). This sort of risk, nevertheless, seems to be well taken care by the remedies opted by these financiers in the jurisdiction of Oman. For instance, almost all Islamic banking Ijarah are carried out with a binding promise to lease from the Bank. Similarly, the leased asset is almost always mortgaged to the lessor. This said, if the applicable contract is a stand-alone Ijarah –whereby the property is entirely under the ownership of the bank, then the repossession –so to speak –is resorted to. However, if the applicable contract is an Ijarah-plus, like Diminishing Musharaka (or “DM”), then the outstanding rental payments is deemed due and payable at once.                          

2.6 Rental Calculation Method

Ijarah in Islamic banking evolved over time in consideration of developments taking place in relation to business, insurance, regulations, accounting reporting and Shari’a requirements. Accordingly, different methods are applied in calculating the rental on either operating lease or capital lease. All these methods want to satisfy one thing, that is, the lessor (here, Islamic bank) is able of collecting back the entire principal amount disbursed to acquire the underlying asset, any additional cost incurred by the bank, including maintenance, insurance, tax, etc., as well as making profit that will make the opportunity loss in the underlying transaction equal to zero.   

Among the methods of rental calculation, according to Dr. Mundhir Qahf, commonly used are the followings (30)

2.6.1 Charging an equal fixed amount stipulated in the contract for all instalments whereby each instalment consists of one increasing portion –representing the principal amount, and one reducing portion –representing the rent calculated on the outstanding principal amount; or 

2.6.2 Charging a reducing rental stated in the contract consisting of one fixed portion –representing a percentage of the principal amount (such as 10% -if the lease contract will mature in 10 years), and one reducing portion –representing the rental calculated on the outstanding principal amount; or

2.6.3 Charging a reducing rental consisting of one fixed portion and one reducing portion –undecided in the contract whose calculation method is determined in the contract, such as at the rate of 2 + LIBOUR, where its sum is known before the commencement of each rental period.  

One consideration affecting the trend of the calculation method of the rental is lack of knowledge of future expenses that may be incurred by the lessor, such as insurance and maintenance, etc. Therefore, this has given rise to having a variable element of the rental to take care of those variable factors. Another consideration is the maturity of the contract, whether short term Ijarah –like most of the cases in operating leases, or long term Ijarah –like most of capital leases. Under the former, the rental calculation approach is simple and straightforward. It just calculates the principal amount, adding to it the profit amount and annualize the process. Putting it differently, the total rental is the total financing amount, time the annualized profit, or: FA + (FA × profit × tenure). But, most of Ijarah contracts at Islamic banks are long term in nature, as they aim of transferring the underlying property to the customer.     

Accordingly, a variable element of the rental must be introduced to the rental formula in order to take care of any additional expenses that may be incurred by the lessor –the bank, but unknown to both the bank and the customer at the time of signing the Ijarah contract. Such additional costs may include, among others, property tax, insurance, and major maintenance expenses.

One of the most elaborative method whereby the rent is calculated, considering such variables, is the method produced by Dar Al Shari’a, in its documentation of MISCO financial syndication.(31) The method has considered two rentals: the first rental and the subsequent rentals. Accordingly, the first rental is calculated as follows: 

RP1 = rVR + AR + AC + OC, where RP1 is the Rental Payment for 1st period, rVR is Relevant Variable Rental, AR is Additional Rental, AC is Applicable Component, and OC stands for Other Component). The second rental is calculated as follows: 

RP2 = rVR + rSR+ AC + OC, where the relevant Supplementary Rental or rSR is now introduced to the equation. The subsequent rentals are calculated as follows:

RPS = rFR+rVR + rSR+ AC + OC, where the relevant Fixed Rental is now introduced.

Despite the fact that the calculation method of Dar al-Shari’a may be said to be more innovative and transparent, it nevertheless seems to complicate the matter more than simplifying it, despite the efforts made to avoid this. For instance, one may likely confuse Supplementary Rental (SR) from Additional Rental (AR) for their synonymy. Similarly, with the fact that the above individual components of the rental are again calculated based on further equations and formula, this calculation method may potentially clatter the mind of an ordinary customer. Take, as example, the fact that the Variable Rental has to consider OBA for LC/LG, the Additional Rental has to take into account the formula for the Advance Amount, and the Rental Payment needs to count the equation calculating the Rental Payment Capex or RPCAPEX, and so on and forth. This said, the said calculation method retains its value to corporate customers, sophisticated retailers as well as academics.

A more simplified, yet comprehensive, rental calculation method is to perhaps reduce the computation formula to: Fixed Rental (FR) and Variable Rental (VR) and then elaborate the latter to consider: change in the (a) interest benchmark in the economy –sometimes referred to as Base Rate, and (b) expenses related to property tax, structural maintenance, insurance, and any other pertinent payments, usually covered under the Service Agency Agreement.    

2.7 Rental between market contracts and Islamic banking contracts

Many current and potential customers –nay, Shari’a scholars –argue that the rentals being charged by Islamic banks are considerably high, and hence view this as, at least, potentially Shari’a incompliance. Their argument is driven by the fact that in Islam, fairness is a strategic value, on both moral and legal grounds (32), and yet when Islamic banking imposes higher rentals than the rental rate prevailing in the real estate market, surely an element of injustice is there.

However, it may be said that the real estate does not have one single market for which the rental may be viewed as a standard. Rather, different players in this market have their different rates. For example, hotels –which lease out their rooms for rentals –are one player, and hence this may be considered as one market. The same may equally apply to estate agents, as well as with Islamic banks –all of which have their respective rental rates –given their different markets. As such, the rental rate charged by hotels, for instance, may be different –more likely higher than that of property dealers, which in turn could be different from that of Islamic banking. Furthermore, the type of lease contracts being operated in Shari’a compliant banking is more of long term, with the mutual understanding that the lessee will eventually own the underlying asset. 

Hence, in consideration of the fact that the Islamic banking is a market on its own, thus differs from other players dealing in the real estate sector, and that the lessee will end up owning the leased asset –unlike in other types of lease arrangements –including hotels and property dealing, the rental under Islamic banking Ijarah is justly higher. This is in addition to the fact that the lessee’s interest is protected in the understanding that should the contract fail to survive till maturity for reasons not attributable to the lessee, the property dealing rate shall apply, which may imply reimbursement to him.    

    
3. Analysis & Results

As we have seen, the rental rate charged by Islamic banks under Ijarah contract, is being challenged by the existing and potential customers of these banks. Their argument is that the rental rate imposed by these banks is higher than the rate prevailing in the market as operated by real estate brokers and individual property owners. Some Shari’a scholars also support the challenge –but on the Shari’a ground of the ambiguity of the rental structure as well as on the fairness of the same in lieu of market rental rate. 

Islamic banks at the end of the day will appear to remain financial intermediaries –taking deposits from depositors and then extending these deposits to fund-users through different Shari’a compliant instruments. In this structure, Islamic banks tend to take into account the same factors typically considers by a bank. These factors include notably risk pricing, the cost of capital, the return on equity, the opportunity cost, and provisions –just to name. It is these factors that apparently causing conversion of the practices of Islamic banking and conventional one.   

In respect to the calculation methods applied by Islamic banks in the sultanate to compute Ijarah rental, the practice varies from one bank to another. For example, some banks opted very simple and straightforward approach, whereby the entire rental is calculated and then provided to the customer in the form of schedule of payments, usually in equal monthly instalments. Some other practices provide formulas via which the rental computation may be carried out even by the customer. Despite these different methods, Islamic banks in Oman tend to converge in terms of charging the principal amount, usually termed as fixed element, and any associated expenses as well as the profit element, which often classified as variable element. This part of the rental is sometime defined as to cover kinds of rentals labelled differently, including ‘complementary rental’ and others.

Another area of conversion amongst Islamic banking practices in Oman in calculating the rental is building part of the rental into the service agency agreement. Almost without fail, Islamic banks engaged the lessee as an agent to manage the essential maintenance services besides his obligation to look after the operational maintenance. In some practices, even the lessee is assigned as agent to undertake the construction activities for the property to be leased to him –to avoid the limitation imposed by AAOIFI Shari’a Standard where the lessee can’t be appointed by the Islamic bank (lessor) as the Sa’ni under the Istisna’ (33)

The use of benchmark in calculating the variable rental is very common under the Ijarah contracts applied by Islamic banks in Oman. The AAOIFI’s requisite of setting an upper limit and lower limit on the variable element seems to be in operation (34). Nevertheless, it is not international benchmarks, like LIBOUR, or even a national ones, that are being adopted. Rather, most of Islamic banks in Oman employ the capped and floored rate of their own treasuries as the applicable yardstick. The SSBs of these banks seem to view the index used in this context as in conformity to the AAOIFI’s requirement of being “based on a clear formula which is not subject to dispute.” This become more practical as evidenced by the failure of indices like LIBOUR, for example, to be truly stable following the outbreak of the COVID-19 and the associated financial disturbance. 

Lastly, some Islamic banks in Oman introduce the concept of “Base Rate” into the rental formula to attend, among other things, changes in the overall interest rate in the economy. This, from a business viewpoint, is a wise approach to give banks flexibility to manoeuvre situations where the overall interest in the economy goes up. With, or without, it, Shari’a compliant banks operating in Oman do converge to, more or less, using the same approach in calculating the rental, by considering the same key elements into their different formula.    


4. Conclusions & Recommendations

  • Ijarah seems an essential contract of all Islamic banks operating in Oman, and even in some banks it represents as much as 70% of their overall portfolio. 
  • Out of the 4 classifications of Ijarah –(a) Available with Occupancy, (b) Unavailable with Occupancy, (c) Available with Ownership, (d) Unavailable with Ownership, it is the last two categories, i.e. (c) and (d) that are mostly applied by Islamic banks in the jurisdiction of Oman. 
  • The rental calculation method adopted by Islamic banks in Oman does not follow a standardized formula, unlike, for example, the price calculation method in Murabaha, where almost all Islamic banks count (a) the principal amount, (b) the profit margin, and (c) any associated expenses –like shipment, transportation, storage, etc. 
  • Retail customers, in particular, being financed under Ijarah may need a very simplified and easy-to-understand and transparent rental calculation method. This is partly because such a mode is new to them, and their unfamiliarity with it is well established.   

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