“Although demand is more difficult to predict and dependent on a number of variables, we estimate 30,000 units have been added to Dubai’s housing stock in 2008 and will be followed by 30,000 in 2009 and 2010 respectively, which is more in line with government planning forecasts. In Abu Dhabi, we forecast around 18,000 units to come on stream in 2009 and 2010 against a current estimated shortage of 28,000 units,” Nomura Securities’ analyst Chet Riley wrote in a report on the UAE real estate market.
“We believe that the fundamental valuation of property should be relatively straightforward as it is just a measure between the demand and supply of rentable [commercial] or live-able [residential] space.
“Construction pipelines are quite visible and measurable and have a long gestation period, so the supply-side can be tracked – in fact, some agencies make a living out of it.”
According to the report, residential demand relies on population growth, the development of mortgage markets and the availability of credit. However, speculation only adds liquidity and not demand, so the key driver for residential is the end-user market.
The report said there are pockets of value in the listed sector. “We regard the relatively ‘underdeveloped’ Abu Dhabi as having better prospects... but there appears to be a wider, possibly unwarranted, disconnect from equity market valuations that are starting to appear oversold to us.
“The preference is towards early cycle developers with committed sales and unencumbered balance sheets – or at least access to committed facilities – and low or no gearing. We believe there has not been enough of a sector shake-out yet to sort the ‘men from the boys’ and sector consolidation appears inevitable.”
According to Riley, the market has relied too heavily on the easily “funded off plan” sales market where speculators provided the working capital. But this passed the refinancing risk with each speculative “flip”, which has unwound sharply. Regionally, developers now face the situation where speculators can’t sell or can’t meet the final instalments as developments complete. The end-user market is being crimped by onerous (or no) bank lending terms, with banks trying to conserve already limited liquidity pools and reduce sector exposure.
On the home financing front, the UAE mortgage market has historically been thin, says the report, but banks leveraged their lending exposure with a classic triple exposure [bridge financing the development start up, financing the contractor’s bond and financing the end-user], clipping the ticket at each pass of the finance chain.
The “halcyon” days are over and the banking system has choked the desperately needed liquidity with developers now forced to provide incentives to gap bridge finance loans to clear inventory backlogs.
“The public sector has the tacit support of federal governments and the ability to tap equity capital markets if need be.”
Companies are being forced to evolve rapidly, said Riley. “We see the warehousing of unsold inventory for delivery into the rental market as a greater, but now unavoidable, challenge. The occupier market is rapidly weakening and capital markets may take years to recover [after all Singapore and Hong Kong are still below 1996 levels]. Lower rents and occupancy, coupled with higher financing costs, will weaken revenue accounts, with payback in rental significantly longer than the payback in sales.
“In terms of business evolution, we believe the next logical step would be to carve property assets into funds, but this assumes the demand exists. This would recycle equity to the group and ultimately the shareholders, but until this happens, capital is locked into lower returning investment portfolios.”
Liquidity, beyond monetary measures, is mostly about confidence. The whole world appears to be in recession and capital-rich countries have also discovered that their accumulated wealth is not enough to keep them unaffected. The collapse of housing bubbles is now a global event. Therefore, it is a question of normalisation after a long period of excesses.
Meanwhile, Dubai, which first opened the doors to foreign investment, has led the way in terms of real estate regulation and other emirates are now following the lead. Abu Dhabi and Ajman have both announced the formation of separate real estate regulatory agencies, which will run in parallel with the Dubai’s Rera, which is the only formal regulatory body in the country.
This is the first stage of “regulatory harmonisation” and a key step towards developing a de-facto UAE regulatory system, which is required if the country is to attract, or more importantly retain, foreign real estate investors. These regulatory frameworks are designed to protect parties on both sides of the real estate transaction [sales and leasing] with policies framed to further regulate development activities [and obligations], mortgage and tenancy registration, escrow accounts to ring fence development proceeds and so forth. The aim is to add transparency to an opaque market and will generally include the monitoring of developments, the provision of rental indices, adjudication and dispute resolution and the monitoring of media advertising [ie. sales of developments].
“We believe increasing the regulatory system and transparency will ultimately shore up market credibility and confidence around securing the purchase of property rights,” said Riley.
“However, sustainable coordination is required – this is coming, but the UAE is not there yet. Until such time, regulatory arbitrage risk remains, where the regulatory burden in one emirate [Dubai] is greater than the rest and too much regulation, too soon, in the current climate may add to an already weak outlook.”
Unfortunately, as developers look increasingly likely to default on commitments, the level of disputes that require arbitration is likely to continue to grow.
Regulatory authorities may lack the vested power to act and this could undermine progress further, the report said.
Cash dividends unlikely
Developers are now being caught in a liquidity trap as the global liquidity dries up. The most common funding structure in the UAE is to accept a down payment and then instalments over the construction period with a bullet payment (of up to 80 per cent) at practical completion, but these vary significantly based on the developer and development type, with less reputable developers (non-public listed), probably having to give away more incentives to attract buyers and compensate for the additional risk.
However, during the run-up in property prices over the past three years, the trend has been towards over-development (as a sector) coupled with increased sales competition that created favourable payment terms for purchasers.
“This is fine when credit and bridge finance is available, but developers are now being caught in a liquidity trap. Contractors require payment on completed work certificates [which are being held up] and purchasers can’t raise the finance to service the outstanding instalments. So developers must focus on the ‘stringent control’ of their receivables and payables, with payables on a shorter duration than receivables,” the report said.
Thought most UAE realty firms do not disclose dividend policies, dividend policy is simply the trade-off between retained earnings on the one hand and the paying out of cash or issuing new shares on the other.
“We think there is a high risk of dividend cuts (if shareholders allow it) or an increase in stock dividends, where there is no transfer of economic benefit. A lot depends on board recommendations and if they want to cash out existing shareholders or maintain cash.”
According to the report, there will be no transfer of economic benefit from companies to stock holders with stock dividends. From a corporate perspective however, cash balances are held intact.
“This cash is more valuable to management, than to shareholders wrapped up as part of a potential liquidation value. Shareholder approval will be required, but chief financial officers may try to bypass cash dividends by issuing stock (or a combination of a stock and less cash) over the coming year, the Nomura report said.
Uplift in equity valuation
The year 2009 will see a 25 per cent uplift in equity valuations as against a forecast of 35 per cent rise in emerging markets, according to Nomura.
“Our house view is for a global 25 per cent uplift in equity valuations for 2009 compared with a forecast for emerging markets of a 35-per cent rise. We think international emerging market money may seep back in a rather hierarchical manner, firstly in Turkey, then Russia, then possibly the Gulf Co-operation Council (GCC) – although we see less risk in investing in the GCC region, backed by oil reserves.”
The report, however, says the UAE market is further characterised by a high proportion of local retail investors [90 per cent] who were (probably) also participating in the speculative off-plan real estate market, so we regard this as a “double whammy” of wealth destruction to pass through the domestic system. The report has taken a generally favourable outlook on aggregate emerging markets, which are currently showing the highest levels of equity market risk premiums over the past 10 years.
According to the report, emerging market risk premium is close to 600 basis points above the developed market. Historically, the point at which a premium such as this is reached tends to be followed by relative outperformance over next 12 months.
“This is based on forward P/Es based on consensus estimates, which we think are inflated [we are 40 per cent below consensus earnings on our coverage universe]. While fundamental valuations look inexpensive, there are limited near-term catalysts to boost market confidence.”