A 'Downward Spiral': Gulf Region Real Estate in the Era of Cheap OilPublished: March 11, 2009 in Knowledge@Wharton
In 2002, oil prices in the nations of the Gulf Cooperation Council (GCC) stood at $25 a barrel. By July 2008, that number had jumped to $147. The increase enabled the GCC's six member countries (Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates) to almost triple their gross domestic product -- from $350 billion to more than $1 trillion, according to the International Monetary Fund.
The increase in oil prices widened the fiscal surplus of GCC economies to a record high. From 2002 to 2008, an estimated $1.5 trillion in surplus was accumulated, leading GCC members to embark on a mission to diversify their economies. The focus was on developing and improving infrastructure overall, which had suffered from decades of under-investment. Government efforts concentrated on developing oil and gas, the power sector and transport infrastructure. The private sector, for its part, concentrated on residential, commercial and tourism real estate projects.
As Don De Marino, co-chairman of the National U.S.-Arab Chamber of Commerce, notes, "Real estate in the Gulf is fundamentally a private sector game. Actual recourse lending is pretty limited, so real estate investors who borrow from the banks do so personally. The rest of the investment funds come mostly from the earnings from other businesses."
Dubai-based developers Emaar and Nakheel led the region by launching the world's tallest tower, largest shopping mall and largest manmade island, along with a string of luxury hotels and residential developments. Other developers, such as Saudi Arabia's Kingdom Holding, jumped on the bandwagon by launching massive mixed development projects in Jeddah and Riyadh.
However, the oil boom -- and subsequent bust, with a decline to below $40 a barrel -- came at a price. The strong project pipeline caused a surge in the expatriate population, as people came to fill open jobs. This led to increased domestic demand and an acute housing shortage. Such factors, coupled with the weak U.S. dollar and high commodity prices, raised average inflation in the GCC to about 13% year-on-year in June 2008. The oil windfall expanded domestic credit growth but was intensified by the inflow of hot money. (All the GCC currencies, with the exception of Kuwait, are pegged to the U.S. dollar.) The large current account surpluses and high inflation resulted in speculative inflows looking for currency revaluation.
According to widespread press reports, the impact has been especially hard on Dubai. As Ashwin Verma, a partner at Black House Development Company, a New York-based real estate investment and development firm, notes: "Dubai went from a trading economy to a real estate economy. Unlike [oil-rich] Abu Dhabi, most of Dubai's GDP comes from real estate. Real estate is a game of credit and leverage. You can't make money in real estate without that."
Dubai is one of seven emirates and the most heavily-populated city of the United Arab Emirates. Abu Dhabi, a sister emirate and the largest by area, is the capital of the U.A.E.
Another 'World's Largest Mall'
The possibility of super profits in real estate attracted companies and individuals alike. The easy availability of liquidity enticed property developers to launch such highly-ambitious projects as an underwater hotel, a mile-high tower, a kilometer-high tower, a revolving high-rise apartment, yet another "world's largest mall," massive theme parks, a floating city and a twisted residential tower.
While the governments channeled most of the surpluses into their sovereign wealth funds, the government-linked companies and the private sector tapped international markets to finance domestic projects. Lulled by a false sense of security brought by bulging state coffers, these companies integrated leverage into their business model. They regularly went to the international debt markets to fund their construction plans. The generous mortgage finance and attractive rental yields due to the housing shortage sparked investors' interest in real estate, while the relaxation of strict foreign-ownership-of-property laws in countries such as the U.A.E., Bahrain and Oman added another impetus.
As the list of elaborate projects grew, so did the line of investors queuing overnight to book properties. Residential properties were sold even before they were built solely on the basis of blueprints, and strong demand led to massive speculation in the secondary markets for these off-plan properties. In some cases, properties were sold even before the developer had approval from the respective government departments. The hype brought international attention, and that, in turn, drove overseas investment.
Flipping of properties became the most profitable venture, sending property prices to dizzying heights. What was supposed to be an auxiliary support for economic diversification efforts become the main pillar of it. The construction contagion spread from one country to another as real estate and tourism development became the common denominator of the GCC diversification strategy.
In January 2008, the projects planned or underway totaled $1.6 trillion. This had increased to $2.54 trillion by January of 2009, with Saudi Arabia and the U.A.E making up 70% of the projects, mostly in the real estate, leisure and infrastructure sectors.
However, as the global credit crunch froze the international financial markets, the hot money evaporated. The drastic $100 slide in crude oil prices eroded investor confidence in the region. The tourist arrivals slowed to a trickle during the peak winter season as a recession engulfed major economies. In a spectacular swing, abundance of liquidity in the beginning of 2008 had vanished before the year end.
The lack of liquidity forced developers to put many projects on hold, and speculators were left with inflated assets that could not be sold, as banks tightened mortgage lending criteria. Most of the projects have either been cancelled or put on hold for lack of funding. In Dubai, construction cranes -- once jokingly called the national bird -- have mostly been idle. According to Proleads, a firm that tracks construction projects, about 150 projects in the GCC were on hold in January this year, about 88 of them in the U.A.E. alone.
Given what he calls "some consistent overbuilding in the Gulf," the "current very steep decline in oil prices is playing havoc with virtually all real estate projects," says De Marino. "If there is a bright spot, it's that the banks are not sitting with the properties. But clearly the downside is the private cash tied up. The fact is that no one locally saw just how rapidly oil prices would collapse."
Of course, the overbuilding and speculation are not confined to the Gulf. "Every country and city in the world is in the same spot -- Miami, China, even New York," notes Verma. "However, Dubai is not supply-constrained like New York or London, so prices can fall much further."
Heading for the Exits
In explaining why the problem is magnified in the region, Verma points to three factors. "As the real estate sector unwinds, there are fewer jobs, and people are forced to leave because they cannot stay without a job. Fewer people means less demand for real estate and fewer shoppers at the mall. It becomes an obvious downward spiral."
In addition, he says, "bankruptcy and debt laws in Dubai are very harsh. It makes sense in markets [not characterized] by the wide adoption of credit for growth. However, so many buyers have [been using] credit without knowing the legal implications of default. Now that they know, people are leaving, which once again translates to fewer buyers, less shoppers -- again, a downward spiral."
Finally, he notes, "monetary policy is important. In the U.S., the government can print trillions of dollars and amortize over the largest economy in the world. They can slash interest rates to practically zero to reduce debt and the cost of servicing debt. In Dubai, they can't. That's why they need Abu Dhabi [to help]. They can't lower interest rates. In fact, interest rates are going up, further squeezing borrowers and stifling any remaining growth. This further increases [the number of] defaulters, again driving people out."
Many leading contractors and developers have laid off employees and adopted a wait-and-see approach to future projects. The retrenchments may have significant repercussions on domestic demand.
In 2007, Dubai's construction and real estate sectors employed about 50% of the total workforce. Moreover, OPEC's December cut of 4.2 million barrels a day will also affect the GCC countries. The cuts translate to about a 10% contraction in the oil sector of Saudi Arabia, Kuwait and the U.A.E. Meanwhile, the Algerian oil minister has said that OPEC may announce further production cuts to support the prices on March 15. Lower oil prices, reduced oil production, outflow of expatriates and falling demand for goods and services are expected to slow GDP growth to a bare minimum.
Meanwhile, the huge amount of wealth destroyed by the crash in the GCC stock market has hurt investor sentiments. The GCC stock markets collectively lost more than $600 billion in market capitalization last year. According to the IMF's most recent forecast, the GCC economy is expected to expand by 3.5% in 2009 compared to 6.8% last year. After years of heady growth, reality is returning to the GCC real estate market. Recent surveys indicate average home prices in the GCC falling by 10% to 40% from their peak prices -- with Dubai being the most affected. Moreover, many GCC companies in real estate and financial services face severe headwinds when it comes to repayment or rollover of an estimated $40 billion of debt due this year, given the absence of liquidity and investor appetite.
Going forward, governments are expected to replace the private sector as the leading entity to announce new mega projects. Unlike during the 1970s oil boom, GCC governments have spent only one third of their oil wealth and can pursue countercyclical fiscal measures to rescue their economies. The region's countries are better equipped to weather a low-revenue scenario due to their huge foreign asset positions and low public debt. The extent of spending in each country will be dependent on oil prices, as countries have different breakeven points.
Nevertheless, the emphasis has shifted from real estate to investment in human capital and infrastructure to improve non-oil-sector growth over the long term, including technological universities, mass rapid transport systems and value-added industries. Abu Dhabi has unveiled a 131-km metro line while Saudi Arabia, Oman, and Qatar are going ahead with power, petrochemical and transport projects. A recent Gulf Construction Survey indicated this shift. According to the survey, two thirds of senior executives from construction companies predict that the operations will move away from Dubai to Abu Dhabi, Qatar and Saudi Arabia.
Still, some investors are cautiously optimistic. "Dubai is a model for the region; as Dubai goes, so goes the perception of commerce and trust in commerce in the region," says Verma. "Dubai is built on entrepreneurship and innovation. These may sound like buzzwords, but it's actually true. They just had the world -- and investors -- build them a first-class city and infrastructure. So they will use this as a base to recreate themselves."