Sorouh says ar-riba-derci
Concerns have been raised over the Shariah-compliance of many Islamic securities. Sorouh’s Dh4.016bn issue is the sector's best example yet of how to wave goodbye to riba when borrowing. By Mark Kolmar.
In August, Sorouh Real Estate priced a multi-tranche sukuk issue totalling Dh4.016bn (US$1.09bn). The most senior, class A tranche (rated Aa3/A by Moody's/Standard & Poor's) of Dh2,761m was priced at 200bp over one-month Eibor; class B (A3/BBB–) of Dh251m at 250bp over, and class C (Baa3/BBB–) of Dh1,004m at 350bp over.
A proposed deeply subordinated, unrated class D tranche of Dh1,004m was not issued. All have scheduled maturity dates in January 2012 and legal final maturities in January 2015. Citi, First Gulf, National Bank of Abu Dhabi and Noor Islamic were bookrunners and lead managers.
Away from the standard figures of totals, tenors and tranches, however, Sorouh's deal stands out from most Islamic deals in being a fully structured securitisation that also sees it comply with Shariah asset ownership principles to an extent that most deals in the sector have failed to do. Khalid Howladar, senior credit officer, covering asset-backed and sukuk finance at Moody's, describes it as the current "poster-child of sukuk securitisation".
A fundamental shift in the sukuk market began in February this year when the Accounting & Auditing Organization for Islamic Financial Institutions (AAOIFI) ruled that 85% of securities labelled as Islamic did not comply with Shariah's ban on riba (interest). Howladar refers to the "confusing use of the term 'asset-based'" in most deals, which is used to describe a slightly softer link to assets than "asset-backed" but in fact the investor has no legal claim on the assets, making the parent borrower ultimately responsible for covering payments.
The result is a deal that, from a credit risk perspective, bears little difference to an unsecured bond, and a borrower-dependent profit stream that bears little difference to interest.
"While we're not Shariah scholars, it's clear that the majority of sukuk comply with the form, not the substance, of asset ownership," Howladar says. "While certain scholars are unhappy with this, the fact is that the key people, investors and borrowers, are still applying the 'asset-based' structures."
To be Shariah-compliant, the lender must take legal ownership of the assets from the borrower. By taking on all rights and obligations attached to the assets, and their profit/loss risk, the investor is genuinely the owner of assets, making money solely from their profitability, and losing money if the assets' value declines.
Previous sukuk have essentially seen investors simply lending money to the borrower, with a set of assets nominally referred to as representing the principal paid, but having no impact on the payment of profit. The supposedly new ruling, which is actually just a move to enforce in practice what the spirit of the regulations had been all along, makes Islamic financing ideally suited to securitisations – both essentially demand packaging assets into an investable entity separated from the parent borrower.
Sorouh's sukuk is backed by a securitisation of land and associated rights to payment from 109 plot sale and purchase agreements (PSPAs). Sorouh is a master developer at the first stage of the property production line, granted land, freehold, by the Abu Dhabi government. It then sells the land in packages to sub-developers, which in turn sell individual units to end-users.
With high demand for property in the UAE, end-users typically agree to buy property ahead of construction, thus beginning phased payments to sub-developers from early in the process, but avoiding a large initial deposit. This in turn allows sub-developers to agree to buy land ahead of delivery, on a similar basis of phased payments. This creates a window for the master developer, where it has agreed, and is now legally bound, to hand over units of land to sub-developers in perhaps four or five years time, but can monetise them in the interim to attract a lump sum of revenue, providing they have bought them back in time to hand over to the sub-developers.
The land in Sorouh's securitisation is pledged to 62 sub-developer obligors, whose payments will fund the returns to sukuk holders. The majority are Gulf real estate developers, although individuals make up 18.2% of the pool. As the assets' revenue source is phased purchase payments, rather than lease payments (ie, there is no yield), both the principal and profit payments to sukuk holders are being funded by principal payments from the sub-developers to Sorouh. Thus, there is a heavy (42%) over-collateralisation between the notional sum of payments from the sub-developers and the three rated tranches of the funding.
The necessary separation of assets and borrower is achieved through a dual-SPV structure, comprising a propco, Sorouh Abu Dhabi Real Estate LLC (SADRE), and an issuer/trustee, Sun Finance Ltd. SADRE, acting as asset manager (mudareb) buys the assets from Sorouh using an inter-company loan from the issuer, funded through the sukuk proceeds, and using the assets as collateral.
This removes recourse to Sorouh to an extent that would not be possible if only the issuer/trustee was an SPV and Sorouh itself still held the assets – with the dual-SPVs, Sorouh could become insolvent and the propco would remain to receive sub-developer payments and pass them on, through the issuer, to sukuk holders.
Although the dual-SPV model thus maintains the financial structures linking investor to assets in the event of Sorouh's removal, as property manager/servicer Sorouh retains responsibility for providing the shared infrastructure elements of the developments: roads, sewage, pipes, cooling etc. If the shared infrastructure is not delivered on time, sub-developers can stop paying.
Sorouh is also a relatively new entity, established by government in June 2005 to develop new areas of Abu Dhabi, and as such is unrated and relatively untested. Thus, security is not only necessary in the event of Sorouh insolvency, but beneficial in any case due to the inexperience of the primary project manager/servicer.
To provide this security, Abu Dhabi Commercial Properties (ADCP) has been added as back-up property manager/servicer. ADCP is wholly owned by Aa3 rated (Moody's) Abu Dhabi Commercial Bank, which is 64.8% owned by the Abu Dhabi government. If Sorouh were to default, ADCP would collect payments from sub-developers, enforce contracts with sub-contractors, pull reserve funds together and, if the sub-developers were to default, resell the land.
Also, while Sorouh is responsible for delivering infrastructure, and is liable for non-timely delivery, potentially to the extent of cancelling the PSPAs and refunding the sub-developers, it has taken a number of steps to protect against this responsibility affecting payments to sukuk holders
The first is designed to protect the ability to pay for the infrastructure: the construction contracts are fixed-price and pre-funded. Of the sukuk proceeds due to Sorouh, Dh1.735bn will not reach it, but instead will be paid directly into an escrowed infrastructure reserve account, which will be controlled by the propco and used explicitly for funding the fixed-price construction contracts.
With costs projected at Dh1.137bn assuming completion by Q4 2009, the fund inherently includes a Dh598m contingency reserve, and should the reserve also run down, Sorouh would make up any shortfall. Once the verification agent (again ADCP) has certified that pre-set milestones are met, the propco's cash manager (HSBC) will release funds to Sorouh to pay third-party contractors.
In the event of Sorouh insolvency, the propco, assisted by ADCP and HSBC, is allowed to pay third-party contractors directly. Only if the infrastructure fund, including contingency reserve, is exhausted and Sorouh is insolvent, is the revenue from the assets used to pay for infrastructure. Payments to sukuk holders would in this case be hit, starting with the most junior tranche.
The second step protects against refunds to sub-developers affecting payments to sukuk holders if Sorouh does fail to provide the infrastructure, and is inherent in the dual-SPV structure: Sorouh remains liable for non-timely delivery, but the propco holds the assets. Refunds to sub-developers would thus come from Sorouh's own corporate reserves, and cannot be taken from funds held by the propco that have accrued from the assets.
The remaining steps protect against Sorouh failing its infrastructure responsibilities in the first place. Of these, the first is that Sorouh is yet to agree a construction delivery date on 98 out of the 109 contracts. These dates will be set once the respective sub-developers have submitted development plans, which Sorouh has absolute discretion to approve or reject.
Second, even given Sorouh's control over its own target dates, all the new delivery dates must be a minimum of 32 months after sukuk close, guaranteeing the first 32 months of payment (scheduled maturity is only 41 months). Third, the PSPAs stipulate two six-month grace periods on delivery dates: one on the individual dates set within each contract, and one on the planned master site opening date of June 30 2010.
Aside from deal-specific covenants, market conditions provide a disincentive for the sub-developers to cancel the contracts and seek a refund, even if Sorouh does miss delivery dates. Given a loan to value of 49% for the sub-developers and sharply rising property prices, a significant downturn in the property market would be required to pitch the sub-developers into negative equity. While the value of the land remains above the initial agreed price, there is no benefit in cancelling the original PSPA, even if Sorouh's infrastructure commitments are behind schedule.
Successfully separated from Sorouh, the securitised assets and cashflow have a number of attractive components for investors. The payment terms of the underlying PSPAs are relatively short, allowing payments over 40 months, and with an average life of 21 months, thus limiting long-term exposure to the property market and credit risk of the sub-developers.
The multi-tranche structure creates a payment waterfall that provides top level investors with a potentially swift return; given no defaults from sub-developers, the class A certificates amortise within 18 months. All payments are made monthly: senior expenses and transaction running costs, including hedges, are paid off first, then the first 2.5% of the payments due to sukuk holders is paid to each tranche, proportional to each tranche's total size, and the remaining 97.5% is then paid sequentially in order of seniority.
There are also two six-month reserve accounts in addition to the infrastructure fund to protect payments to investors, again funded by sukuk-sale proceeds diverted from Sorouh. An Dh84,285,263 liquidity reserve can fill the shortfall in profit payments if insufficient funds are available on the monthly profit distribution date. The reserve is dynamically sized to cover six months profit payments, and hence drops over the course of the certificates' life.
This reserve is in addition to the projected, but optional, principal amortisation payments (they only have to be paid as and when excess is available) significantly exceeding the compulsory profit payments (propco defaults if these are missed), allowing the principal amortisation payments to be diverted to pay profit if necessary without touching the reserve.
The propco's control over funds also avoids any risk of commingling if Sorouh were collecting funds and making payments alongside the rest of its corporate activities. A Dh6.85m senior expenses reserve will cover the senior expenses of either property manager/servicer, or propco and issuer in the event of property manager/servicer or propco default respectively.
A cumulative cap hedge with Citi protects the propco against significant Eibor rises by maxing out its contribution to the Eibor portion of profit payments at Dh330m. If cumulative Eibor payments across all tranches reach this figure, Citi will cover the remaining Eibor portion of all profit payments.
Ignoring Islamic/conventional market delineations, the deal is also unique in the region. It is the first true-sale securitisation of such assets anywhere in MENA, mixing elements of ABS, CMBS and project finance. It is also the first wholly dirham-denominated securitisation in the UAE, and the largest offered to market investors.
The certificates were placed entirely with Middle Eastern investors. Ever since concerns, now declining but late enough not to have affected Sorouh, over dollar de-pegging emerged earlier in the year, investors have been looking to diversify the currency base of their dollar-heavy portfolios.
Sorouh would be unlikely to have attracted more than Dh4bn on an unsecured basis, and certainly not at the pricing achieved (unrated Sorouh would have been considered a significantly riskier prospect thant the Aa3/Baa3 rated securitised assets; Moody's gave credit enhancement for structural features of about 45%, compared with some 10% typically.
The success has piqued the interest of other players. A number of the region's other large real estate developers have been talking to the ratings agencies about doing similar deals, although with their own tweaks.
One such alteration that is popular is to securitise not the sub-developer payments, but the end-user payments – another prepayment cash flow that can be monetised over the short term. Many of the early entrants to the market are looking at doing this as they have begun to cut out the middleman sub-developers, allowing end-users to buy directly.
This method, however, brings the disadvantage of securitising cashflows more exposed to the increasingly concerning level of speculation taking place among property buyers in the region, and the associated volatility, over-valuation and fear of sudden correction that accompanies it.
A HSBC study puts sukuk sales down 50% so far in 2008. There have been suggestions that the slowdown is the result of the February edict from AAOIFI creating uncertainty in the market, with investors staying away from products they now consider themselves to not fully understand.
Howladar suggests that the decline is more likely to be simply connected to the global uncertainty affecting all sectors, saying: "The sukuk market does not exist in an isolated bubble. Borrowers don't want to lock themselves into lending rates that are being priced in the current wider spread climate."
While some smaller investors have undoubtedly entered into sukuk without due care and attention to the small print, believing themselves to own the assets involved when they do not, the major investors could not have misunderstand previous sukuk without a mass, deliberate mis-selling of products, of which there is no suggestion or evidence. Investors were simply happy with unsecured bonds with a face of asset-base and Shariah-compliance.
Sorouh's true-sale, non-recourse securitisation's success suggests quite the opposite of investor uncertainty over sukuk's make-up – investors were aware of the sukuk's unsecure nature, and in tighter times they've stopped buying them. If the market is going to pick up in the current cautious conditions, borrowers may to have to follow Sorouh's example by stopping issuing Islamic bonds, and starting issuing sukuk.