This article will consider the challenges addressed by banks in financing the development of commercial property in Dubai and also consider financing structures seen in the real estate finance sector. For the purpose of this article, we have not considered developments in Dubai International Financial Centre, where a different legal regime applies.
The United Arab Emirates (UAE), and Dubai in particular, is experiencing an unprecedented property boom. Major developers such as Nakheel, Emaar and Dubai Properties are changing the face of Dubai with developments such as The Palm, Jumeirah, Downtown Dubai and Business Bay respectively. Recent legal changes have been beneficial to the sector, now providing for non-UAE national persons and entities to own real estate in certain designated areas.
Although there have been many changes in laws relating to ownership of property, other aspects of the relevant legal framework have not evolved at the same pace, and further regulation would be beneficial in many areas. For example, the area of law dealing with taking security, insolvency and enforcement is relatively underdeveloped in the UAE compared with European jurisdictions, although not when compared to other regional countries.
Ownership of real estate in Dubai
The recent developments in real estate law in Dubai have been the subject of many articles and much discussion. In brief, the changes are as follows: Article 4 of Law (7) of 2006 concerning Real Property Registration in the Emirate of Dubai restricted the right to own real property in the Emirate of Dubai to UAE and GCC nationals, companies wholly owned by such nationals and also to joint public shareholding companies. However, Article 4 also granted non-nationals the right to either freehold ownership without restrictions or beneficiary rights or leasehold rights over real property for a period not exceeding 99 years in certain designated areas which have been approved by the Ruler of Dubai. Subsequently, regulation (3) of 2006 identified designated areas in Dubai and these include various Dubai Properties, Emaar and Nakheel developments.
Security over real property and relatedinterests
Owners of land in Dubai are generally able to provide a mortgage by way of a security interest over their land. The debtor will retain possession of the land and the mortgagee will receive the proprietary rights to it pursuant to a written mortgage deed. The mortgage is registered with the Lands Department and this affords priority to the mortgagee from the date of registration. Generally, only the interest of UAE-licensed financial institutions can be noted on the register.
It should also be possible to take an assignment of rights regarding leasehold interests in a building. In practice, security in respect of buildings themselves is limited to security over related insurances or, if the building generates income (such as a tenanted office building), security over the receivables (each by way of assignment).
Perfection of mortgages
Only a lender which has a valid trade licence and UAE banking licence may, where applicable, register itself as a secured creditor. It is generally not possible therefore for a non-licensed lender to register a mortgage in the UAE. There are also substantial official costs involved in registering and de-registering mortgages and this is often a major disincentive to the creation of this form of security.
Enforcement of mortgages
There are no statutory rights of enforcement or foreclosure remedies available under UAE law, which means that any enforcement must be undertaken through the courts (a mortgagee cannot exercise self help remedies and be a mortgagee inpossession).
If the court orders enforcement of the mortgage, it will organize the sale of the land by public auction. The sale proceeds will be distributed amongst the creditors in accordance with the order of priority set out under UAE law: (i) preferential debts, (ii) secured creditors (such as mortgages) followed by (iii) unsecured creditors (such as judgment creditors). Preferential debts include the following: judicial costs of preserving and selling the property, government taxes, employees' salaries, lessor's rental payments and amounts due to contractors.
The structures seen in commercial real estate finance in Dubai inevitably reflect the legal environment applicable to the real estate sector. Notwithstanding legislative changes, other than major corporate financings for the major developers, there is little appetite for lending in the sector amongst international banks. This is the case in real estate finance across the GCC.
Aside from any perceived commercial risks in relation to financing real estate development in Dubai, international banks are deterred by their inability to take mortgages without appointing a local agent and uncertainties in relation to taking and enforcing alternative forms of security. In addition, particularly in relation to greenfield developments, there may be little or no alternative security available.
The preference amongst local banks is to lend on a corporate basis (rather than to a special purpose company through which a developer may be developing a project) or otherwise lend to the special purpose company with the benefit of a parent company guarantee. In this way, the real credit is that of the corporate parent and repayment of the loan is not entirely dependent on the success of the project.
Parent company credit is not always acceptable to developers given the need for disclosure in their financial statements and the impact that such loans or guarantees may have on borrowing restrictions imposed in their other banking facilities. Sometimes a compromise is reached whereby a parent company will give a guarantee or other support until the relevant development is completed.
Other forms of security and protection
While mortgages are the banks' preferred alternative, the cost of registration does cause many borrowers to request that banks seek alternative forms of comfort or security. It is certainly the case that some real estate developers in Dubai have raised financing with the principal security for their lenders being merely the deposit of original title deeds with the security agent or a non-binding letter of comfort from the relevant parent company.
Other forms of security seen in the commercial real estate market in Dubai include:
- assignments of rights under leases;
- assignments of sale proceeds;
- assignments of rights in respect of bank accounts;
- assignments of insurances relating to the relevant property; and
- assignments of construction contracts.
There are practical and legal difficulties associated with perfecting and enforcing each form of assignment and banks will usually seek to mitigate the risks of having to try to enforce their security through appropriate covenants and other protective provisions in the relevant facility agreement. These provisions are no different from those seen in other markets and may include:
- a requirement that the borrower maintains its bank accounts with the facility or security agent, together with a right of set-off;
- a cash sweep whereby the borrower's cash flow in excess of an agreed amount is applied towards prepayment of the loan;
- approval rights over the terms of key contracts and the identity of counterparties, such as the management contract in relation to a hotel development;
- step-in rights in relation to key contracts;
- requirements in relation to insurances;
- a right to appoint a technical adviser to monitor construction progress on behalf of the banks;
- regular reporting on progress and financial performance; and
- comprehensive tests for the release of any completion support.
Islamic financing structures
Islamic financing structures are quite common in the real estate finance sector in Dubai.
The most common form of Islamic financing structure that is used in relation to real estate finance in Dubai is the Ijara structure. An Ijara is used for both retail and corporate real estate finance and is a hybrid between an operating lease and a finance/capital lease. Under this structure, the financier usually retains ownership of the property throughout the period of the Ijara and title to the real estate may be provided to the lessee at the end of the Ijara.
Certain key issues exist in relation to using an Ijara financing structure in order to ensure that the structure is Shari'a-compliant. One issue is that the obligation to insure and undertake any major maintenance to the leased asset must remain with the lessor. In addition, the lessee is only responsible for payment of rent whilst the use of the asset continues, so an issue arises where the lessee is no longer able to use the leased asset, for example due to its total destruction, as the obligation to make lease payments will cease.
Other Shari'a-compliant structures have been used for sukuks and bank financings in the Dubai real estate sector, but the Ijara structure was recently used in Nakheel Development Limited's landmark $3.52 billion sukuk which was listed on the Dubai International Financial Exchange in December 2006. Nakheel Development Limited used the proceeds of the sukuk issue to purchase a long-term leasehold interest in part of the land at Dubai Waterfront from an entity within the Nakheel group. This land was then leased under an Ijara to another Nakheel group entity, with the rentals being used to make coupon payments to the sukuk holders. The seller of the land invested the proceeds in the capital of Nakheel PJSC, the main holding company of the Nakheel Group and the proceeds were intended to be used for the financing of Nakheel's projects which include iconic developments known well beyond Dubai, such as The Palm Jumeirah.
It is important to note that under the sukuk structure, sukuk holders have an ownership interest in the underlying sukuk asset (the leased land). As a result of the recent changes to the property law in Dubai, and with Nakheel's land being in designated areas, there was no issue with sukuk holders from outside the GCC having an interest in the land. The issuer, Nakheel Development Limited, itself was a free zone entity owned by a charitable trust.
The Ijara structure used in the Nakheel sukuk involved the following principal documents:
(i) Purchase agreement
Pursuant to a purchase agreement, Nakheel Development Limited acquired a long-term leasehold interest over certain land, buildings and other property at Dubai Waterfront for a term of 50 years.
(ii) Lease agreement (Ijara)
The lease agreement provided for the lease of the property during six consecutive periods of six months by Nakheel Development Limited to an entity within the Nakheel Group. This agreement contained the main covenants and events of default.
(iii) Servicing agency agreement
Under Shari'a law, a lessor has certain obligations which it cannot pass to the lessee under the Ijara. These include the obligation to insure the lease asset, the responsibility to pay property taxes (other than those imposed by law against a lessee or tenant) and any major maintenance and structural repair of the property. These obligations can however be passed by the lessor to an agent. Accordingly, Nakheel Development Limited passed the risk of performance of these obligations on to a separate Nakheel entity.
To the extent the servicing agent claims any costs and expenses under the servicing agency agreement, the lease rentals will be increased by an equal amount. Any increased lease rental is set-off against the costs and expenses claimed under the servicing agency agreement.
(iv) Purchase undertaking
The purchase undertaking is the key document from a credit perspective because it allows for the sukuk holders to be paid on early termination or at the term of the Ijara.
Under the purchase undertaking, the counterparty agreed to purchase Nakheel Development Limited's interest in the leased assets at a specified price on a specified date following the issue of a notice served either upon the occurrence of an event of default or immediately before the scheduled redemption date of the sukuk.
Conventional financing documentation
It remains the case that most real estate developments in Dubai that have relied on third-party funding have borrowed under conventional loan facilities from banks. Often these transactions are not public and banks will lend to developers with whom they have an existing relationship on a bilateral basis using a bank's own in-house documentation. However, some deals usually the syndicated financings are reported in the local press and these include financings for developments such as those at Dubai Festival City, Wafi Mall (including Dubai's new Raffles Hotel) and a corporate financing for Sama Dubai, a subsidiary of Dubai Holding.
The larger, syndicated deals tend to be documented using a facility agreement prepared on the basis of one of the primary documents recommended by the London-based Loan Market Association (LMA). This document will be amended to reflect the relevant security structure and other protective covenants agreed between the banks and the borrower. In addition, as the LMA-recommended forms are prepared for use with English incorporated investment grade borrowers, other changes to the documentation will be appropriate to reflect that the relevant borrower for a real estate financing in Dubai is likely to be incorporated in Dubai, the governing law is often Dubai law and it is often the case that the borrower or its guarantor will not be the equivalent of investment grade.
It is likely that the current financing practices will continue to be commonplace in the Dubai commercial real estate sector, with the market witnessing a combination of conventional and Islamic financing, both in the bank and capital markets.
However, we believe that the market will mature and additional financing structures and sources of funds will be tapped by developers in the next year or so. These structures include the use of securitization, where a developer can raise funding for itself on the basis of existing rental income. In addition, there has been a growth in the real estate fund market in recent years and we expect this to continue and structures to become more sophisticated.
On the legislative front, additional regulations are likely to be issued that clarify or derive from the recent changes in real estate law. However, it is unlikely that any of these changes will affect the real estate finance market or financing structures seen in that market.
We do not foresee changes in laws relating to security or insolvency in the next 12 months.
Partner, Banking and Finance
Clifford Chance, Dubai
Telephone: +971 4 3620 609
Lawyer, Banking and Finance
Clifford Chance, Dubai
Telephone: +971 4 362 0444
Lawyer, Real Estate
Clifford Chance, Dubai
Telephone: +971 4 3620 673