Saudi Real Estate Sector

Saudi Real Estate Sector

Saudi Real Estate Sector – Poised for lift off

By Jitendra Garg MS (Finance), CFA

3rd April 2009

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Saudi Real Estate Sector

Table of Contents Overview ..............................................................................................................3 KSA Real-estate sector – changing times ahead................................................. 3 Growth Drivers of Saudi Real Estate Market...................................................... 4 Residential Sector- Middle income housing verge of a high growth rate .......... 8 Additional benefits to the Company ..................................................................11 Issues and Concerns .......................................................................................... 12 Outlook .............................................................................................................. 13

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Overview The Kingdom of Saudi Arabia (KSA) is by far the largest economy of the GCC and occupies ¾ of the Arabian Peninsula and holds 25% of the world’s confirmed oil reserves. The region has an oil-based economy, with oil-related activities accounting for 35–40% of real GDP and 85-90% of total exports revenue. Strong crude prices over the last five years have played a significant role in boosting the economic growth of the region which has registered a real GDP growth of more than 5% a year during the period 2003 to 2007 and same is expected to increase by 4.2% in 2008. Massive oil export revenues are funding high public spending in infrastructure and education and have helped the economy in maintaining a current account surplus of more than 25% a year between 2003 and 2007. However, after witnessing a super-spike period during mid-2008, oil prices fell sharply towards the end of the year to trade at less than US$35 per barrel and resulted in the collapse of five-years of bull-run in oil prices, which climbed from US$29 a barrel in early 2003 to a peak of US$147 a barrel in July 2008. It was the result of a growing realization that the global economy will face a sharp slowdown in 2009, leading to a huge drop in demand for oil.

KSA Real-estate sector – changing times ahead The focus of the KSA government to diversify from reliance on hydrocarbon sector; provided a direct impetus for the growth of real estate sector. Compared to other GCC states, the Saudi real estate market is at an early stage of development. It is however poised for lift-off, with demographic fundamentals and massive infrastructure investment providing the basis for growth and a positive outlook for most sectors of the real estate market. Key features of Saudi Real-estate market Ø Saudi Arabia is by far the largest real estate market in the Gulf, as well as being one of its fastest growing. Benefiting from its new era of leadership, the Saudi commercial real estate stock which includes office, hotel and retail space, is expected to virtually double in size to stand at nearly 30 million sq.m. by 2012. Ø The residential sector offers the greatest potential. With an estimated residential stock of 875 million sq.m. in 4 million dwellings, the Saudi residential market is more than ten times larger than any other Gulf market. Ø Saudi Arabian real estate market continues to maintain its charm even in times of global recession and declining property markets. The existence 3rd April 2009

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Ø

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of enduring demand fundamentals rather than mere speculation activity, heavily favours the growth of Saudi real estate market. A key characteristic of the Saudi real estate market is that the fundamental engine driving the demand is domestic population and economic growth, unlike other GCC economies where growth has been largely based on overseas residents and employers. A major opportunity arises in the provision of more affordable housing for a rapidly growing and youthful population. The current shortfall is estimated to be as high as 500,000 dwellings, which could rise to one million by 2012. Demand for office space has been rising in recent years with a large number of commercial projects initiated by the Government. Historically, villas were used as commercial space in top metros. The Government has since prohibited businesses from locating out of villas – provides further potential for increase in demand for office space. The retailing sector is also booming in the Kingdom. Given an official ban on cinema halls, retail malls are a key source of entertainment. The population visit malls for the purpose of, fun activities, socializing, and shopping. Additionally, a large young population has led to the modern retail trend finding faster adoption (i.e. higher brand consciousness and international awareness). In fact, given the harsh weather and landlocked cities like Riyadh, shopping is a key leisure activity. Saudi Arabia has by far the largest industrial market in the region, presenting significant opportunities, particularly in the logistics sector. This sector is currently underdeveloped but is expected to see rapid growth, with the creation of specialist logistics parks over the next five years. This will result in major opportunities for foreign developers and investors.

Growth Drivers of Saudi Real Estate Market 1. Demography is Destiny Rapid growth in population Social, economic and real estate developments in Saudi Arabia are being strongly impacted by the dramatically changing demographic profile of the Kingdom. Saudi Arabia is not only the largest of the GCC countries (accounting for over 60% of the region’s population), it also continues to experience one of the world’s steepest rises in population; increasing from 7.3 million in 1975 to over 25 million in 2008, and fast growth continues as the total population recorded 8year CAGR (2000-08) of 2.4%.. Although an annual 3rd April 2009

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growth rate of 4.1% during 1975-2004 is estimated to drop to 2.3% in the period of 2004-2015, it is still expected to be higher than 2.0% growth in Arab countries and 1.3% in developing countries over the period of 2004-2015. . By 2015, UN estimates Saudi’s total population to reach over 29mn (nearly double its population in 1990). It is also generating enormous pressures on the country’s residential market and open up the Kingdom for vast array of growth opportunities in all segments of real estate. Favourable Demographic structure The Kingdom's The Kingdom's Population by Age and Nationality population (In mid-2007) (in thousand) breakdown by age Age Category Saudis Non-Saudis Total % of Total groups in mid-2007 0-14 6597.1 1295.6 7892.7 32.6 indicates that children 15-39 7647.6 3523.2 11170.8 46.1 of age groups from 0 40-64 2836.8 1608.4 4504.2 18.6 to 14 years old 65 & above 609.9 124 674.9 2.8 accounted for 7.89 Total 100.0 3446.7 1732.4 24242.6 million, or 32.6 percent of the total Source: Annual Report 2007 SAMA population, the youth (from 15 to 39 years) 11.17 million or 46.1 percent, while the age groups of 40 years and over stood at 5.18 million, or 21.4 percent of the total population. The population pyramid is highly skewed towards the youth with over 78% of the population below the age of 40. Interestingly, Saudi has the highest percentage of population below the age of 40 across the GCC. A large number of young Saudi’s are now entering adulthood and setting up families. This will have a major impact on the economy, and will boost demand for modern retailing and residential units indicating superior prospects for the real estate sector. 2. “10x10” Vision is taking Shape Reforms boosting Economic Competitiveness The government is proactively seeking to achieve rapid and sustainable economic growth. A key objective is to become among the world’s 10 most competitive nations by 2010 – its “10x10 Vision” – through opening up its market, inviting inward investment, improving the business environment and capitalizing on the Kingdom’s competitive strengths as the global capital of energy with a youthful population. A massive investment in infrastructure & industry is required to execute this vision which will boost the income level & thus will again boost the consumption capacity indicates huge potential for commercial, retail and housing sector growth.

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Relaxing FI norms and increase in FDI To achieve this goal, government access to the World Trade Organization (WTO) and reduced the corporate tax on foreign-owned firms (down from 45% to 20%). Apart from it, Saudi Arabia also removed the minimum capital investment requirements on foreign investors and a new government procurement law was also passed under which 100% foreign-owned companies could bid for government contracts. All these measures, has dramatically increased foreign direct investment, which is increased almost ten-fold from USD 183 million in 2000 to USD 17.5 billion in 2007 respectively, accompanied by equally impressive growth in domestic investment. This huge inflow will further boost the capital formation which again lead to higher income & thus will boost the real estate sector.

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3. Negative real interest rates scenario make real estate compelling Interest rates in Interest Rate Trend for 3-month Currency the region are at Deposits decreasing trend & 4.5 interest rates on 3saudi Riyal US Dollar 4 month SAR and 3.5 3 US dollar deposits 2.5 touched the four 2 1.5 years low of 1.45% 1 and 1.21% respectively in Jan. 2009. Low interest rates in the region Source: Monthly Bulletin, SAMA work as catalyst for real estate sector growth & provide an excellent opportunity to the genuine buyers to buy a house or an office which they can ill afford. It will also benefit the real estate developers by reducing the cost of financing and improving their margins. Apart from it, inflation hit a 27-year high of 10.5% in April-08 as rents climbed 20.4% due to the lack of residential supply and individuals forced to rent. General cost of living index in the region is still very much higher than the prevailing nominal interest rates taking the real interest rates in the negative zone. With negative real interest rates; consumers have less of an incentive to save/deposit their funds and a greater incentive to invest in real estate to benefit from attractive rental yields and gain though capital appreciation home prices.

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4. Gross Fixed Capital formation – KSA early on the curve Gross fixed capital formation Trend of GFC/GDP & Growth in GFCF (GFCF) as a GFCF/GDP Growth Rate in GFCF percentage of GDP refers as a 24.00 barometer of the % 14.00 level of development in 4.00 an economy. In 2003 2004 2005 2006 2007 KSA, just 20% of the Kingdom’s Source: Annual Report 2007, SAMA GDP in 2007 was channeled into fixed capital formation. This is the lower in the region with regional peers ranging from Kuwait (19.7%) to Qatar (35.5%). Historically, developed countries such as the US and UK have had their GFCFs as a percentage of GDP steady at the 16%-19% levels. The EU and OECD countries were marginally higher at 20.8% and 21.8% in 2005. China and India on the other hand have witnessed a sharp increase in their GFCF from 36.5% and 22.3% of GDP in 2000 to 43.8% (2004) and 33.8% (2005) respectively. This rapid growth reflects the significant infrastructural development initiatives underway in the two largest emerging economies. The ratio in the kingdom tends to be skewed lower due to the buoyant oil prices that are driving GDP. However, reality is that the remainder 80% is available to be channeled into real estate and infrastructure development and there in lies the opportunity. This shows that KSA is at the nascent stages of development and there is huge potential for the real estate sector in the Kingdom. With hydrocarbon led revenues continuing to dominate the Saudi GDP (estimated at 54.1% of GDP in 2007) there are significant opportunities for growth in the sector as the Government’s plan to diversify the economy away from hydrocarbon revenues, and huge construction projects gets rolled out. Saudi Arabia has showed an encouraging increase during 2005-07. The government’s continued investment focus on prioritized areas of economy (real estate expected to be amongst the list) indicates the growth in real estate sector to sustain even in times of global recession. 5. Commercial real estate still has upside Commercial rentals in the region have registered a high growth of 15.2% p.a. over the last 5 years. However, absolute rentals remain comparatively low with rentals for prime office space in Doha and Dubai at a steep premium of 190% and 168% respectively to Riyadh. It indicates that prices are among the lowest 3rd April 2009

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in the region; suggesting that the recent history of significant price rises should not, in isolation, give cause for concern and still there is a potential for real estate prices in commercial sector to go upside.

Residential Sector- Middle income housing verge of a high growth rate Housing sector accounts for more than 70% of real estate activity. It is currently estimated that there are over 4 million units in the Kingdom. According to the eighth National Development Plan (2005-2009), the real estate sector is expected to grow at an annual rate of 6.3% and the demand for housing is expected to increase at an average of 200,000 units per year. Saudi Arabia has a fast growing and relatively young population, along with a declining average household size. These factors are driving demand for additional residential dwellings in all major urban areas. A major opportunity arises in the provision of affordable housing for the fast growing middle income segments of the market. Some of the factors which will ensures better opportunity in middle income housing are as follows: Active City Building and Rapid Urbanisation The majority of the Kingdom’s population is city dwellers, and the country contains four out of the five largest cities in the GCC region. Its urban population has grown by over nine million between 1990 and 2008 as Saudi cities continue to accommodate more than ½ million new urban dwellers a year. Most urban growth is occurring in Riyadh, the capital, and in urban clusters along the Red Sea Coast (Jeddah, Makkah and Madinah) and Eastern Province (Dammam/Al-Khobar). Trend of Urban Population Year (Period) Saudi Arabia Arab Countries Developing Countries The world 1975 58.3 41.8 26.5 37.2 2005 81 55.1 42.7 48.6 2015 83.2 58.8 47.9 52.8 Source: Annual Report 2007, SAMA

According to Table, there has occurred a continuous increase in the ratio of the Kingdom's urban population to total population. It rose from 58.3 percent in 1975 (against the world average of 37.2 percent) to 81.0 percent of the total population in 2005 (against the world average of 48.6 percent). It is estimated that the ratio of cities’ inhabitants to total population will reach 83.2 percent in 2015, which is considered high compared to the world average of 52.8 percent.

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The continued rise in the ratio is suggestive of the expected expansion in the demand for public utility services and housing in the Kingdom's cities during the coming period. Thus, continuing urbanisation will be a major driver of real estate growth. As well the rapid expansion of its existing cities (notably Riyadh and Jeddah), six Special Economic Cities (SEC’s) are being developed, which by 2020 are expected to account for up to 30% of the Saudi economy and house 4–5 million people. This shows the high potential for growth of residential market & huge demand for middle income housing sector in the region. Low penetration in house ownership and increasing supply shortages The housing market in Saudi Arabia faces an acute supply shortage, especially of affordable housing for those on middle incomes. The total stock of residential units across Saudi Arabia was approximately 3.95 million (as at the beginning of 2008). This represents a significant under-supply in relation to the current demand with this under-supply estimated to be as high as 500,000 dwellings. The current housing shortage looks set to worsen over the next few years. The small amount of stock (380,000) set to enter the market between 2008 and 2012, compares to an estimated growth in the number of households across the Kingdom of circa one million over the same period. In addition to the growth of the population, according to the eighth National Development Plan, home ownership fell from 65% to 55% from 2000-2004. Presently, it is estimated that home ownership has further declined significantly and 40% of total households and only less than 10% of the overall population owning their own home. The government has taken this issue seriously and realized the importance / need for housing and has implemented a vision for it. The Governmental housing plan is reflected in KSA’s Eighth Development Plan (2005-09) which targets the construction of one million housing units and the new housing strategy aims at increase the house ownership from currently 40 percent to 80 percent by 2020. The Government’s development plan encompasses 280mn sqm of residential land plots to be provided in urban areas and the private sector constructing about 875,000 residential units (of which 225,000 units will be supported by the Government). It indicates that there is a huge potential in the middle income housing sector in the upcoming years. Decreasing size of household Size of the average household is changing and there is a gradual trend towards the western family life style of smaller (nuclear) family units. This is one of the by-products of urban migration. Furthermore, the young population would marry and form new households. The current average household size in KSA is estimated to be 5.62 and it is estimated, the total household size to decline to 3rd April 2009

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5.2 by 2015 and if the expatriate non-Saudi household size to remain constant at 4.1, the household size of Saudi families would decline from approximately 6 at present to 5.8 by 2015. The declining household size will fuel demand for housing, creating demand for a large number of household units. Simultaneously the lower average household size and an improved affordability factor will also accelerate the growth within the apartment segment. Apart from it, to address the short term short fall serious efforts will need to be made to accelerate the development of residential dwellings within some of the major projects (particularly in the Special Economic Cities).

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R iya ls

Increasing Per Capita Income The income growth is Trend of Per Capita Income & its Growth a critical determinant Per Capita Income Riyals Growth Rate (%) factor for affordability 25.00 70000 of houses. An 60000 20.00 increasing trend in the 50000 Saudi per capita 15.00 40000 Income has been seen 30000 10.00 since 2004. The per 20000 capita GDP in KSA 5.00 10000 has grown at a CAGR 0 0.00 of 12% for the period 2004 2005 2006 2007 2003-07. Annual per capita income in the Source: Annual report 2007, SAMA Kingdom rose by 4.6 percent to Rls 59,016 in 2007 against an increase of 10.2 percent in the preceding year. This growth is expected to continue in double digits with CAGR of 11% forecasted for 2007-10E according to IMF estimates. The past four years have shown a continuous increase in the per capita income. Although GDP per capita is not a perfect measure, it does in part reflect the earning power of an economy, which in turn affects the asset prices including real estate and changes in the life style of the people. The income growth will, increase the quality of life, expand the housing ownership (new and exciting) and make positive impact on affordability of houses by middle income people. Low penetration in Mortgage Financing and Improved Housing Finance Schemes The mortgage finance market may prove a major driver for real estate demand in the Kingdom. Globally, mortgage to GDP ratios vary from 100% in Denmark to 5% in UAE. Comparatively KSA mortgage to GDP stands at 3rd April 2009

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approximately around 1%. The high contribution of hydrocarbon revenues (due to buoyant oil prices) distorts the mortgage to GDP ratios. Accordingly, KSA also present below the mortgage per capita for the region. Note that KSA remains highly under-leveraged compared to regional peers. According to the Arabian News Property Survey 2008, nearly 80% of investors would opt for a mortgage while purchasing a property in the Middle East. The constraining factor in KSA housing market has been the lack of a well-defined mortgage law. A much awaited new legislation is expected to be released very shortly and it is expected that the draft proposal is currently being reviewed by the Government. It is expected that the Government will expedite the proposed mortgage law soon, which will unlock significant demand. The law is designed to allow much wider access to property ownership in a country where currently 43% of the population owns their own home. The new law is expected to result in: ● Entry of new players into the market, increasing the range of funding options available to purchasers of residential dwellings ● The establishment of new standards for home finances ● Introduce new capital market instruments ● Stimulate further Islamic financing through new Shariah compliant products ● Provide large companies with ability to offer tradable financing bonds ● Encourage the regulation and greater transparency in the brokerage sector ● Introduce securitized mortgage products ● Create a secondary mortgage market Apart from it, Saudi banks and financing companies have introduced housing Shariah-compliant loan programs to finance home purchases that extend up to 25 years in advance of the approval of the mortgage law. This will again expected to boost the demand in housing sector in upcoming period.

Additional benefits to the Company Product Diversification Currently, company has strong presence in three sectors- Asset management, Brokerage Services and Corporate Finance. Company decision to enter in realestate sector will provide a reasonable amount of diversification to the company revenues; as cash flows of real estate sectors are not perfectly correlated with the cash flows of existing business segments. In normal scenario; it is also seen that in medium term stock prices not moves in tandem with real estate prices; thus it may help company to maintain stability in cash flows.

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Increase in Cash Flows In present scenario, world economy is facing a deep downturn. Due to suck out of liquidity, dull performances of stock markets & decrease in demand for goods and services have adversely affected the M & A activities and fund raising activities. Apart from it, trading volumes have also come down. All these have increased pressure on margins of the company and further deterioration in economy may put downward pressure on revenues. Entry in real-estate sector will increase the cash flows of the company. Increase in market presence and liquidity Entry in this business segment will reduce the volatility of cash flows and thus will reduce the business risk of the company. Increase in business operations will also increase the overall market share of the company and thus its market presence. Increase in market presence would lead to increased liquidity and marketability in company stock. Decrease in cost of capital Increase in business operations & cash flows will decrease the financial risk of the company as company having greater cash flows is less susceptible to shortterm fluctuations as compare to company having lesser cash flows. This decrease in financial risk would further lead to decrease in cost of debt and equity and thus will reduce the cost of capital of the company.

Issues and Concerns Despite Saudi Arabia’s significant growth potential, a number of challenges to realizing its full potential remain. The government has recognized the challenges and has made progress in tackling issues such as modest transparency, delays in implementing legislative reforms and opportunities to increase foreign ownership. The government is also tackling issues such as bureaucracy and labour shortages which have resulted in extended delays in developing real estate projects in the past. Some other factors that need to be considered are: Unsustainable Growth in Cost of land and housing prices The price of raw land has abnormally gone up by 20-25% on an annual basis over the past three years followed by more or less similar increase in housing prices. It was due to increase in demand for land, ample liquidity and searching for a safe heaven by investors following the collapse in Saudi stock market in 2006. Such growth in prices is unsustainable in long run and correction in prices may take place in upcoming year as a result of the marked expansion in 3rd April 2009

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construction of residential buildings by the public and private sectors in addition to the potential decline of most of the economic activities affected by the global economic crisis which is expected to alleviate the increasing demand. This is supported by the cost of construction that is expected to continue decreasing as a result of a decline in construction inputs such as steel and cement, which recorded a marked decline recently in view of fierce competition among local manufactures. Unrelated business segment need high level of efforts Currently, company deals in asset management of financial asset, brokerage services and corporate finance. Entry in new business segments need higher level of management commitment and competency & greater management efforts to get success; as on failure of which may leave the desired result unachievable. Increase in Construction costs - labor A problem facing the industry is the difficulty in getting adequate labor. Labor costs would increase, given lack of skilled labor in certain sectors in the Kingdom. Efficient human resources are often not willing to relocate to Saudi for employment given the significant demand for similar skill sets both in the region as also the traditional labor markets of the Indian subcontinent. This is creating a shortage in talent, resulting in an increase in labor costs. This bottleneck is being faced across industries. For example, research study reveal that wages to drivers of cement trucks have risen over 100% in just a year in certain parts of the Kingdom. This may put downward pressure on margins.

Outlook The first half of 2008 that witnessed high oil prices and in turn windfall oil revenues for the KSA is estimated to have experienced property prices rising in the range of 40% to 80% in the Kingdom’s capital city of Riyadh. Besides the strong domestic demand in the country, the heightened real estate activity was further catalyzed by the participation of investors from other Gulf states. The momentum of rising real estate prices during early 2008, started to slow down as the year end approached and is expected to consolidate at relatively lower levels in 2009. However, the residential segment is expected to continue to present under supply situation for the near future. Saudi Arabia is witnessing an escalating demand from young middle income group. Thus, if Saudi is to meet such demand it will need to build 1.5mn new homes by 2015 and it will be up to the financial institutions (both governmental and private sector) to provide the finance that makes this expansion possible. Overall, the Kingdom’s real 3rd April 2009

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estate sector is expected to continue its growth trajectory between an average annual rate of 5% to 7% till 2012. The rising trend may slow down in near future but will continue its upward journey.

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