Ijarah

Ijarah is an Islamic contract of lease or hire under which an asset's owner lets another party enjoy its use, known as the usufruct, for a set term while that party pays rent at an agreed rate. Ownership of the asset, and the risks that come with ownership, stay with the lessor. The same word also covers the hire of a person's services for a wage, but in finance it almost always refers to the leasing of assets.

Ijarah is one of the most widely used contracts in Islamic finance. Banks use it to finance homes, vehicles, equipment and aircraft, and it is the basis of the most common form of sukuk.

Islamic law prohibits riba, a return on money lent. Rent is treated differently because the lessor is earning a return on a real asset it owns and is responsible for. The lessor bears the risk that the asset is destroyed, must handle major maintenance, and cannot charge rent for a period in which the asset cannot be used through no fault of the lessee. That link between return and ownership risk is what distinguishes ijarah from an interest-bearing loan.

In a typical bank-financed ijarah, the customer identifies an asset, the bank buys it and becomes the owner, and the bank leases it to the customer. The key conditions, reflected in AAOIFI's Sharia standard on ijarah, include:

• the asset and its permitted use must be clearly identified and lawful;
• the lease term and the rent must be specified to avoid gharar; rent may be fixed or set for successive periods by reference to a benchmark agreed in advance;
• the lessor bears ownership costs, such as major repairs and insurance, typically arranged through takaful, while the lessee bears ordinary maintenance and is liable for damage caused by misuse;
• rent becomes due only once the asset has been delivered and can be used.

• Operating ijarah: the asset returns to the lessor at the end of the term, as with an ordinary rental.
• Ijarah muntahia bittamleek (lease ending in ownership): the lessor promises, through a separate wa'd, to transfer the asset to the lessee at the end of the term by sale or gift. The promise must be separate from the lease so that two contracts are not combined into one.
• Forward ijarah (ijarah mawsufah fi al-dhimmah): a lease of an asset to be delivered in the future, often combined with istisna' to finance construction.

For home finance, many banks prefer musharakah mutanaqisah, a diminishing partnership in which the customer gradually buys the bank's share while paying rent on the remainder.

A company needs a machine costing 1,000,000. An Islamic bank buys the machine and leases it to the company for five years under ijarah muntahia bittamleek, with rent of 240,000 a year. Over five years the bank receives 1,200,000 in rent, recovering its cost plus a return. At the end of the term the bank sells the machine to the company for a nominal price under its earlier promise. If the machine is destroyed without the company's fault in year two, the lease ends and rent stops; the bank bears the loss, normally covered by takaful.

In an ijarah sukuk, an issuer sells assets such as buildings or aircraft to a special purpose vehicle, which issues certificates to investors and leases the assets back to the issuer. Rent paid by the issuer funds periodic distributions to sukuk holders. At maturity the issuer buys back the assets at a set price under a purchase undertaking, which funds the redemption. Whether investors have recourse to the assets themselves or only to the issuer distinguishes asset-backed sukuk from the more common asset-based structures.

An operating ijarah resembles an operating lease. An ijarah ending in ownership resembles a finance lease or hire purchase in economic terms, but differs on several points: the lessor must genuinely bear ownership risk, rent cannot be charged before delivery, late payment penalties cannot accrue to the lessor as income, and the transfer of ownership must be made under a separate promise. Accounting standards set by AAOIFI and by national regulators determine how ijarah appears in an Islamic bank's financial statements, which is not always the same as conventional lease accounting.