Reflections On Dubai Real Estate Market

REFLECTIONS ON THE ECONOMICS OF REAL ESTATE IN DUBAI by Ohan Balian

Presented on February 17, 2005

at

The Executive Office Economic Intelligence Unit Dubai, United Arab Emirates

TABLE OF CONTENTS

1. INTRODUCTION...........................................................3 1.1 PROBLEM

STATEMENT.............................................................. 3

2. GROWTH PATTERNS ....................................................4 2.1 1995-2004.....................................................................4 2.2 EXPLANATIONS.....................................................................5 2.2.1 9/11 and Oil Price Increases...................................................5 2.2.2 Dutch Disease ........................................................................5

3. MARKET ASSESSMENT.................................................6 3.1 PRICE-BUBBLES ................................................................... 6 3.1.1 Definition................................................................................6 3.1.2 Formation of bubbles..............................................................6 3.1.3 Bubbles in Dubai.....................................................................7 3.2 COMPETITION ................................... .................................. 9 3.2.1 Property markets vs. Stock markets ......................................9 3.2.2 GCC markets.........................................................................10 3.3 MARKET REGULATIONS ................................................... ......10

4. FUTURE OUTLOOK ....................................................12 5. POLICY RECOMMENDATIONS .....................................14 6. CONCLUSION ............................................................16 REFERENCES AND BIBLIOGRAPHY..................................17

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REFLECTIONS ON THE ECONOMICS OF REAL ESTATE IN DUBAI by Ohan Balian

1. INTRODUCTION 1.1 Problem statement In recent years, property prices in Dubai have increased dramatically. This price increase can be explained either by economic factors (demand and supply) or by speculative factors induced by expectations, or both. The problem is that the Dubai real estate market is a relatively new market with many imperfections and hence, speculative factors tend to play a much more critical role in creating price-bubbles – i.e. price increases triggered by expectations for more than complementing capital gains. But property prices cannot increase out of bounds indefinitely, and at some point they need to resume their ‘fair’ values – i.e. property values determined by economic fundamentals. The real danger is that if the price-bubble bursts, it will have severe repercussions on both the macroeconomy and the financial sector, possibly causing a recession. Consumer spending will fall because people DRAFT-NOT FOR QUOTATION (Economics of the Real Estate Sector in Dubai – Ohan Balian)

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will feel that they are poorer (a wealth effect), and the capacity of the financial sector to lend will be diminished upon borrowers not being able to repay their mortgage loans (a lending effect).

2. GROWTH PATTERNS 2.1 1995-2004 Table 1.1 Selected Statistics on Dubai Real Estate Sector, 1995-2004.

GDP ($m) Share of Real Estate1 in GDP ($m and %) Employment in Real Estate2 Completed Buildings3 Housing Units

1 995

1 996

1 997

1 998

1 999

2 000

2 001

2 002

2 003

2004 *

11,2 39

12,1 92

13,4 06

13,5 90

15,2 07

16,9 85

17,5 52

18,1 13

19,66 0

20,50 0

2,12 5 (17%)

2,31 6 (19%)

2,39 8 (18%)

2,56 1 (19%)

2,80 7 (18%)

2,99 7 (17%)

3,13 4 (18%)

3,27 0 (18%)

3,320 (17%)

4,500 (22%)

80,0 00

82,0 00

85,0 00

86,0 00

92,0 00

100, 000

113, 000

120, 000

131,0 00

145,0 00

1,22 6

1,16 9

1,24 8

1,58 1

1,83 0

1,91 7

2,44 5

2,25 9

2,389

2,684

98,0 00

100, 000

110, 000

128, 000

140, 000

145, 000

160, 000

172, 000

183,0 00

192,0 00

Sources: Ministry of Planning, Dubai Municipality, Dubai Chamber of Commerce and Industry, Dubai Development Statistics, and other government agencies. Notes: * Preliminary Estimates 1. Real Estate and Construction. 2. Includes construction, sales, finance, and design. 3. Residential, multi-storey residential/commercial, and recreational, industrial and services buildings.

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2.2 Explanations 2.2.1 9/11 and Oil Price Increases The economic boom in the real estate sector in Dubai, and to some extent in the Middle East, can be partly explained by massive capital inflows after September 11, 2001 as Arab funds were more closely scrutinized in the US and Europe. Almost $150billion flowed into the region since 2003, with about half of it going to the UAE. A second contributing factor is the increase in oil prices since the Iraq war which has increased oil revenues. 2.2.2 Dutch Disease When capital inflows which are not related to the endogenous productive capacity of the domestic economy increase, the economywide wage rate also increases. To maintain the same level of profits, producers raise prices. They can raise prices in the non-tradable service sector, but they cannot raise prices in the tradable manufacturing sector because prices in the latter sector are determined in world markets. In the case of Dubai, this phenomenon, known as Dutch Disease, has shifted resources from tradables into non-tradable service sectors as evidenced by the dramatic increases in tourism, trade, and the real estate sector.

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3. MARKET ASSESSMENT 3.1 Price-bubbles 3.1.1 Definition A price bubble is defined as an increase in property prices caused by speculative demand in anticipation of capital gains. Thus, an increase in prices caused by economic factors such as rising income, low interest rates, growing population and supply shortages, is not a bubble. This distinction is important because if the increase in prices has been caused by any one or all of the latter factors, then prices would be less likely to collapse, but rather fall gradually in a downturn. Policies and regulations can be more effective in cushioning the effects of a gradual price fall. 3.1.2 Formation of bubbles Property bubbles are formed when property prices get out of line with their ‘fair’ or underlying values. The ‘fair’ value of a property is based on the rate of return to be derived from renting the property (or the implicit rent saved in the case of an owner-occupier). One way of determining whether prices are overvalued or undervalued is the P/e ratio, where P is the price of the property, and e is the ‘fair’ value. In other words, we look at property prices relative to rents. For example, if the average annual market rent for a $300,000 three bedroom apartment is $12,000 then the P/e ratio is 25. When consumers are paying high prices, they are implicitly assuming that rents will increase. If DRAFT-NOT FOR QUOTATION (Economics of the Real Estate Sector in Dubai – Ohan Balian)

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rents do not increase, then it means that house prices are overvalued and will be adjusted accordingly. In other words, when the P/e ratio increases, it implies that prices are rising faster than rents because consumers expect to reap capital gains. This underscores the fallacy that increases in population and supply shortages also lead to price increases. True, but not to bubbles; if this were the case, then rents will also increase at the same rate as prices increase, leaving the ratio unchanged. 3.1.3 Bubbles in Dubai The real estate sector in Dubai employs about 20% of the total labor force (construction, sales, finance). Most of the increase in real estate demand in recent years has been generated by speculators who seek short-run profits. However, there is also a real demand-based growth, emanating, in turn, from the growth prospects of Dubai, the creation of new free zones, and the increasing population. One estimate puts the tangible demand for housing at 300,000 units by the year 2010. This strength in demand has led to rising premiums paid above the original price, sometimes by as much as 40%, especially on offplan options. Foreigners purchasing a second vacationing home also contributed to the real demand growth. By definition, supply in the short-run is fixed because of construction lags; the short- run supply curve is inelastic. However, there has been rapid growth in both residential and commercial construction in DRAFT-NOT FOR QUOTATION (Economics of the Real Estate Sector in Dubai – Ohan Balian)

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2004. Currently, there are about 50,000 units under construction compared to an annual average of 8,000 units during the 2000-2003 period. One developer alone, Emaar Properties, is expected to build 15,000 units per year, and by 2010 total investment in construction is expected to reach $50 billion. In other words, supply has been increasing steadily to meet the increase in real demand. There have been some indications of supply shortages at the high end of the market. P

P SRSS0

LRSS0

SRSS1 P1

PL

P0

P0

D0

LRSS1

D1

D0

D1

Q Q0

Q1

Q2

SHORT RUN Inelastic Supply

Q Q0

Q1

Q2

LONG RUN Elastic Supply

As demand in the short run increases from D0 to D1, prices along the short-run supply schedule SRSS0 increase from P0 to P1 (higher than in the long-run where, due to a supply shift, the price increase is only to PL). Beyond the short-run, supply will tend to increase. Unless the price increase is large, prices will be higher than at the initial equilibrium.

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Much depends on the supply response. Policy makers usually do not pay much attention to supply factors as compared to demand factors. Note that prices in the real estate sector may also be increasing because of the strength of the euro or a rise in world commodity prices. To the extent that intermediate inputs in construction are imported from abroad, the increase in the price of construction materials raises building costs further – imported cost-push inflation of sorts. 3.2 Competition 3.2.1 Property markets vs. Stock markets An interesting development in the region, and in particular in Dubai, has been the simultaneous growth of both the property sector and the stock market. The UAE stock exchange has grown by 47 % in 2004. In other parts of the world, such as in the US and Europe, the growth of the real estate sector has been at the expense of the stock market; as stock prices have plunged in recent years, investors and consumers alike have shifted into the real estate sector. Several studies, most notably by Case, Quigley and Shiller, have shown that wealth effects in property market busts are much more severe than in stock market crashes because typically, property is acquired with borrowed money. In the case of Dubai, however, the rise in the stock market will help mitigate such an adverse wealth effect if the property bubble were to burst.

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3.2.2 GCC markets Since September 11, the flow of funds to the Middle East led to governments in the region, especially in Saudi Arabia, increasing their expenditures and creating several large infrastructure projects. The extent to which GCC countries have been able to attract funds rather than to provide refuge for funds, depended, to a large extent, on the creation of enabling environments. The UAE, and especially Dubai, has been exemplary in this regard. The Palm Islands, the ‘World’ project, Dubai Land, are fine examples. Bahrain, Qatar, Kuwait, and Saudi Arabia have also displayed solid rates of growth in their real estate sectors. However, these countries have different real estate rules and regulations which can affect competition. One important objective of this regional market should be the standardization and harmonization of property market rules and regulations to increase transparency and generate more cohesive rates of growth. 3.3 Market Regulations Market regulations are important because they cushion adverse effects of property busts and constrain speculative behavior. The freehold property market in Dubai is relatively new with many market imperfections. Property markets are inherently imperfect because of imperfect information, high transaction costs, and supply lags. While it is important to devise rules and regulations, it is important to see to it DRAFT-NOT FOR QUOTATION (Economics of the Real Estate Sector in Dubai – Ohan Balian)

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that as a consequence, more distortions are not created. For example, to this day, the UAE has no Federal Property Law and foreigners can buy freehold property ( guarantees are offered by developers, and approved by the local government). In other words, freehold is not illegal, but neither it is explicitly legal. The terms of an agreement between the seller and the buyer are included in the contract which seems ‘acceptable’, but a clear property law should be enacted to reduce uncertainty and eliminate any doubts of property rights. An important set of regulations governs the ability of lenders to make out loans. The Central Bank of the UAE (CBU) has devised rules that limit direct bank lending to the construction sector to 20% of a bank’s customer deposits. This regulation has been enacted to prevent excessive lending and secure the financial viability of the banks. However, real estate lending to speculators and homeowners alike is not tightly controlled which may cause severe problems in a downturn, especially in the financial sector as banks lose their ability to make out additional loans as borrowers begin to default on their payments. It appears that the Dubai financial sector needs to be monitored more closely and that stricter regulations should be in place to control lending.

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4. FUTURE OUTLOOK To predict the future of the real estate sector in Dubai, one has to look at a wide range of variables, some are endogenous, others exogenous. The endogenous variables arise from within the economic system, the exogenous variables are determined independently of local supply and demand considerations. The most important endogenous variables are prices, rents, and income; the exogenous variables are the world price of oil and the rate of population growth. The first question we may want to ask is: “ are current property prices overvalued or undervalued?” If we can somehow eliminate speculators, then we will be able to predict the future more accurately. To do this, we look at the P/e ratio more closely. The Fundamental Law of Economics tells us that prices must reflect ‘fair’ values. If rents are decreasing, then prices will correspondingly be pulled down. If rents are increasing, then prices will be pulled up. In Dubai, rents have been increasing in recent years. Property prices should therefore increase to depress the rental income(e) to a level which is more consistent with the cost of funds (the rate of interest). Let the rate of interest on bank deposits be 2% and let the yield on property be 10%. Then, this implies that property prices are undervalued. Why should an investment in property yield you 10% a year while a bank deposit yields only 2% ? The price of the property should rise to depress the rental return to a level more consistent with the cost of funds (the rate of interest). If the DRAFT-NOT FOR QUOTATION (Economics of the Real Estate Sector in Dubai – Ohan Balian)

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preceding numbers reflect the current state of affairs in Dubai, then property prices are undervalued even though they have been rising sharply. The future outlook also depends on expectations of future prices, which, in turn, are fed by past experience. Case and Shiller have shown that there is positive serial correlation between prices in consecutive time periods – i.e. changes in property prices in one direction in one period tend to be followed by changes in the same direction in the subsequent period. This means that people have adaptive expectations property prices are expected to rise because they have risen in the past. This is an important source for speculative demand, which is clearly prevalent in Dubai’s real estate market. Another helpful valuation method is the P/Y ratio, where Y is average disposable income. This ratio measures the long-term affordability of property – i.e. one looks at average property prices relative to average disposable income. If this ratio is low, then people will be able to purchase property for longer periods to come. In Dubai, the dramatic increase in disposable incomes over the last decade clearly shows that this ratio is low – i.e. houses are still affordable1. Looking at the exogenous variables, the high price of oil has clearly increased capital inflows, raising the economy-wide wage rate, which, in turn, has been raising prices in non-tradable sectors. This 1

Some analysts use average median incomes instead of average household incomes to smooth out distortions caused by purchases made by the super rich. DRAFT-NOT FOR QUOTATION (Economics of the Real Estate Sector in Dubai – Ohan Balian)

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trend has fueled an impressive rate of growth throughout the Dubai economy not only in the real estate sector but also in trade, commerce, tourism and other sectors. Interestingly, a fall in the price of oil need not cause major problems since the oil sector contributes only about 7% to Dubai’s GDP. Finally, Dubai’s population is expected to grow to 2 million by 2010 which will create 300,000 units over a five year period. Demographic factors do not increase prices in the long-run since, as we have already shown, the long run supply curve for housing is perfectly elastic.

5. POLICY RECOMMENDATIONS We need to be careful not to interfere in the market by too much. One limitation in the making of policy recommendations is the absence of accurate and timely data on the real estate sector in Dubai. This makes the calculation of ratios, such as those presented above, somewhat murky, and hence, the government needs to compile quarterly, preferably monthly, data on the real sector at the micro level. This, in turn, requires coordination and collaboration with various government agencies and ministries. The conduct of monetary policy should not be influenced solely by fears of higher inflation leading to the maintenance of low interest rates. To some extent, interest rates have been rising in international DRAFT-NOT FOR QUOTATION (Economics of the Real Estate Sector in Dubai – Ohan Balian)

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markets which tend to increase mortgage rates. This may be a healthy development because one would not want to increase mortgage debt to unsustainable levels. If mortgage rates are high, then, as already pointed out, a burst in the bubble will cause adverse wealth effects, spending (both consumption and investment) will fall, and GDP will fall further due to multiplier effects. Monetary policy should be conducted in such a way that the ‘excess liquidity’ caused by capital inflows does not spillover to other sectors – i.e. it does not causes price increases in manufacturing, trade, commerce, and tourism. Another tentative recommendation is that excess borrowing for speculative purposes should be discouraged by limiting the size of a home loan - say to 15% of the purchase price. This limit can be decreased when the economy expands, and increased when the economy contracts, thus extracting and injecting liquidity as required. In choosing between fixed and variable mortgage rates, fixed rates render the economy much more sensitive to interest rate changes, and hence could have much more harmful effects in a contraction. Finally, fiscal policy in the form of tax relief and other tax benefits lead to higher property prices. These should be carefully drafted to maintain the right balance.

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6. CONCLUSION We have seen that although property prices have been increasing over the last couple of years, they are still undervalued using acceptable valuation methods. The challenge is to reduce the incentive of speculators to generate a sustainable rate of growth. Demand has been increasing rapidly but present construction activities and future plans suggest that the increased demand can well be met by increases in supply. Even the traditional assumption of a fixed land supply does not hold well in Dubai given the “The Palm Islands” project, claiming a land area from the sea. A distinctive feature of the Dubai economy is that all sectors have been growing in tandem, which is a healthy sign of sustainable economic development. The Freehold Property Law must be clarified and the banking sector should be monitored more closely. However, the absence of accurate and timely data on the real estate sector in particular, and on the economy in general, constitute a real constraint on the implementation of monetary and fiscal policy. One very helpful device will be the construction of a Social Accounting Matrix (SAM) which captures the inter-sectoral and inter-institutional transactions in the Dubai economy. The compilation of such a SAM will identify data deficiencies and shortcomings since it is based on fundamental economic identities. This SAM can then be used in economic planning to identify bottlenecks and hopefully generate a highly sustainable rate of growth of the Dubai economy. DRAFT-NOT FOR QUOTATION (Economics of the Real Estate Sector in Dubai – Ohan Balian)

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REFERENCES AND BIBLIOGRAPHY AME Info (February 2005), “ The Dubai Economic Miracle. Can it Last?”, UAE. AME Info (January 2004), “ Where Next for Dubai Real Estate?”, UAE. AME Info (July 2003), “ How Will Dubai Freehold Property Prices Move ? ”, UAE. AME Info (March 2002), “ The Time to Buy Real Estate in Dubai”, United Arab Emirates. Case, K. E., J. M. Quigley and R. J. Shiller (2003), “ Home-buyers, Housing, and the Macroeconomy”, Prepared for the Reserve Bank of Australia Conference on Asset Prices and Monetary Policy, Sydney, Australia. Central Bank of the UAE (2005), Various statistical sources. Clapp, J. M. and C. Giaccotto (2002), “Evaluation House Price Forecasts”, Journal of Real Estate Research, Volume 24, Number 1, pp 1-26. Dubai Chamber of Commerce and Industry DCCI (2005), Various statistical sources. Dubai Municipality (2005), Various statistical sources. Economist, The ( May 2003), ‘A Survey: House of Cards”, London, U.K. IMF (2004), UAE: 2004 Article IV Consultation – Staff Report, Washington D.C. Krainer, John (2002), “House Price Dynamics and the Business Cycle”, Federal Reserve Bank of San Francisco (FRBSF), CA. Larsen, J. E. and J. W. Coleman (2004), “Psychologically Impacted Houses: Broker Disclosure Behavior and Perceived Market Effects DRAFT-NOT FOR QUOTATION (Economics of the Real Estate Sector in Dubai – Ohan Balian)

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in an Unregulated Environment”, Journal of Real Estate Practice and Education, Volume 4, Issue 1, pp 35-49. Leamer, Edward (2002), “Bubble Trouble—Your Home Has a PE Ratio Too.” Working Paper, UCLA Anderson School of Business. Leung, C. (2004), “ Macroeconomics and Housing: A Review of the Literature”, Journal of Housing Economics, Volume 13, Issue 4, pp 249-267. Strategy Magazine (January 2005), “ Regional Real Estate Market To Remain Strong in 2005”, Canada.

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