Dubai's Real Estate: Towards a Stable Market

Property in Dubai has fallen in price for seven consecutive quarters, writes Hugo Cox in the Financial Times. Prime prices in July were 10 percent below levels from two years ago. In the second quarter of this year, home sales slumped almost a third compared to the previous year.

"Over the past 18 months, the market lost between 6 percent and 15 percent, depending on where you look," says David Godchaux, who runs Core Real Estate, a Dubai-based agency. 

This plummet was forecasted by Standard & Poor's property report released last year. S&P's rating analysts said the pressures on the real estate sector are threefold.

First, declining oil prices have hindered the recruitment and expansion plans of oil exposed companies. Consequently, non-oil private companies' businesses activities have also slowed, with job creation much lower than last year and even going into neutral in the Emirate.

Secondly, the U.S dollar, to which the UAE dirham is effectively pegged, has remained persistently strong over the past 12 months. This made UAE real estate more expensive for international investors holding non-U.S. dollar liquidities.

Finally, foreseen pressures on tourism, the cornerstone of Dubai's economy, in addition to tourists' diminishing purchasing power, has made it perplexing for foreign national to invest in the Dubai market, as we have seen most recently with the British pound post-Brexit.

Consequently, S&P degraded the bond ratings of three major UAE developers; Emaar properties, Damac properties and Aldar properties. The ratings for Emaar and Damac dropped to "stable", while Aldar ratings dropped to "positive". 

Despite these negative insights, real estate investors remain optimistic about the future of Dubai's real estate sector. According to JLL's head of research Craig Plumb, Dubai is well on the way to market recovery and believes that now is the perfect time to invest in the market. While investors may not see a high rental yield or strong capital appreciation in the short term, the long term suggests otherwise. With the UAE central bank imposing precocious measures to secure the market from vulnerabilities and to prevent the formation of a bubble in the near future, the market is now more stable than ever, he recommends.

As part of ongoing governmental efforts to stabilise the market, mortgage caps were introduced and transaction fees were enhanced. Regulation continues to expand in the UAE as new property laws (which include escrow accounts, regulations on off-plan sales, and mortgage limits) came into effect in the past few months and are likely to enhance regulatory oversight. This is predicted to provide transparency to international investors and improve market sentiment and investor confidence in the region.

Additionally, the lifting of geopolitical restrictions, such as US sanctions on Russia and Iran, could benefit the recovery of the UAE property market according to  Maria Morris, who runs Knight Frank's Dubai prime business.

One of Dubai's leading real estate companies, Wasl asset management group, has deemed this decline in value a 'healthy correction'. The company's CEO, His Excellency Hesham Al Qassim, explains: "Following the recovery period that was seen by the real estate sector from 2012 until mid-2015, this year the industry is undergoing a correction phase while maintaining sustainable growth."

Moreover, Expo 2020 is expected to have a significant impact on Dubai's real estate sector. Mathew Green, UAE-based head of research and consulting at CBRE, the world's largest commercial real-estate investment firm says "Dubai Expo 2020 will help generate further sustained investment into the Emirate's infrastructure facilities, which will ultimately make it an even more attractive destination for foreign capital". The event is expected to attract 25 million visitors and boost the economy by 28 billion Euros while expanding the tourism sector around 70%, and hotel revenues by 30%.

Despite all of this, one thing remains certain: Dubai's current real estate market provides ample opportunities for risk-averse investors considering investing in a buoyant market.

Spatial Economics: The Rise of Dubai's Commercial Real Estate Market

                          

Before oil was first discovered in Dubai in the late 1960's, the city was a flourishing port for pearl and gold trade, as well as other commercial activities, serving as a major regional hub. After the oil boom of 1973, two years subsequent to the establishment of the United Arab Emirates, the newly-formed federation saw a large inflow of foreign skilled labour, skyrocketing the population of Dubai from 59,000 to 280,000. Expatriates, who comprised 72% of the population at the time, mainly migrated from Europe, North Africa, as well as Southern Asia[1] . 

Soaring oil prices during the early 2000's reinforced momentum to hire large numbers of skilled office workers. From about 61,000 office workers in serviced office buildings in the 1990's, the number of such workers escalated to 123,000 by 2006. The 123,000 workers in 2006 were occupying roughly 15 million square feet (SF) of space in dozens of serviced office towers typically 40 levels high spanning along the world-renowned Shiek Zayed road in the centre of Dubai. The average rent in these buildings was $20/square foot (SF) per year[2].

Figure 1. Office Demand in the Dubai Real Estate Market

The growth in demand is pictured in figure 1. This growth in space demand was caused by the increasing need of work space by office workers. In the early 2000's, the need for space grew drastically due to technological change, such as the increase in popularity of the personal computer and fax machine, resulting in more space necessary per worker [3]. The growth in office demand is represented in Figure 1. by the movement to the right of the demand curve, for example, from a previous time when there were 61,000 workers  (in the 1990s) to the time when there were 123,000 in 2006. To illustrate further, if the need for office workers in downtown Dubai increased further to 180,000 workers, the demand in the market would support an additional 7 million SF of space (a total of 22 million SF would be needed) at the same $20 rent. 

On the other hand, the supply function of real estate is said to be 'kinked'. The supply function is depicted as a vertical line at the current quantity of space supply in the market, which is seen in figure 2. at 10 million SF. This is primarily because the space market is highly inelastic. In other words, if the need for office space falls, the available office space can not be reduced. This can be attributed to the fact that the built space is extremely durable; buildings typically last decades, and refurbishing them is expensive and time-consuming. As a matter of fact, about 98% of supply consists of existing space, while only 2% consists of the flow of new development[4]. The kink in the supply function occurs at the current quantity of built space at a rent level that equates to the long-run marginal cost of supplying additional space to the market. In this case, the marginal cost is simply the cost of developing new buildings, and can be expressed as: 

QS= f(L,N,M,P)

Where the quantity supplied (Qs) is a function of; 
L: the cost of land acquisition
N: the cost of labour employed
M: the cost of building materials
P: a suitable profit margin for developers[5]. 

Hypothetically speaking, for the market to reach equilibrium i.e. for supply to meet the increase in demand, the current rent needs to cover the replacement cost. The replacement cost level of rent  is the level of rent that is sufficient to stimulate profitable new development in the market[6].  If rents are above the replacement cost in a market, then developers can profitably undertake new development in that market, therefore, increasing the amount of space available in the market.

Figure 2. Supply function of Real Estate 

To put things into perspective, let's assume that it would have cost $200/SF to develop an office building in Dubai in 2006 (including site acquisition costs, construction and development costs, plus a sufficient profit margin), and investors were willing to pay $10 to purchase an office property for each dollar of current annual net rent the property could produce. If a building could charge $20 annual rent for office space, and expect that space to be rented continuously, then the building would be worth $200/SF (10 x 20= 200).  In this example, the net rent that equates to the marginal cost of adding office supply into the Dubai market is $20. Therefore, $20 is the replacement cost rent level. If you look closely at figure 2, you will notice the kink point at the $20 rent level. Beyond that point, the supply function has risen indicating that the development cost of new buildings is greater, as more stock of supply is added into the market. 


References 

[1] European University Institute (EUI) and Gulf Research Center (GRC) (2015) Demography, migration, and the labour market in the UAE. Available at: http://cadmus.eui.eu/bitstream/handle/1814/36375/GLMM_ExpNote_07_2015.pdf?sequence=1. 

[2] Knight Frank (2016) The Future of Real Estate In The World’s Leading Cities- Global Cities: The 2016 Report. Available at: http://www.knightfrank.com/resources/global-cities/2016/all/global-cities-the-2016-report.pdf.

[3] Dixon, T. and Thompson, B. (2005) Connectivity, technological change and commercial property in the new economy: A new research agenda.

[4] EdInformatics (1999) Real estate economics. Available at: http://edinformatics.com/real_estate/real_estate_economics.htm. 

[5]  Fallis, G. (1985) Housing economics. Toronto: Butterworths.

[6] Miller, D. and Geltner, N. (2006) Commercial real estate analysis and investments. Mason, OH: South-Western.