Reflections on Dubai Real Estate Market

8/14/2019 Reflections on Dubai Real Estate Market

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REFLECTIONS O N THE ECONOMICS O F

REAL ESTATE IN D UBAI

by

Ohan Balian

Presented on

February 17, 2005

at

The Executive Office

Economic Intelligence Unit

Dubai, United Arab Emirates


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REFLECTIONS ON THE ECONOMICS OF

REAL ESTATE IN DUBAIby

Ohan Balian

1. INTRODUCTION

1.1 Problem statement

In recent years, property prices in Dubai have increased dramat-

ically. This price increase can be explained either by economic factors

(demand and supply) or by speculative factors induced by expecta-

tions, or both. The problem is that the Dubai real estate market is a rel-

atively 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 comple-

menting 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 re-

percussions on both the macroeconomy and the financial sector, pos-

sibly causing a recession. Consumer spending will fall because people

DRAFT-NOT FOR QUOTATION (Economics of the Real Estate Sector in Dubai Ohan

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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.

Sources: Ministry of Planning, Dubai Municipality, Dubai Chamber of Commerce andIndustry, Dubai Development Statistics, and other government agencies.

Notes:* Preliminary Estimates1. Real Estate and Construction.2. Includes construction, sales, finance, and design.3. Residential, multi-storey residential/commercial, and recreational, industrial andservices buildings.


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1995 1996 1997 1998 1999 2000 2001 2002 2003 2004*GDP ($m) 11,2

3912,1

9213,4

0613,5

9015,2

0716,9

8517,5

5218,1

1319,66

020,50

0Share of Real Es-tate 1 inGDP($m and%)

2,125

(17%)

2,316

(19%)

2,398

(18%)

2,561

(19%)

2,807

(18%)

2,997

(17%)

3,134

(18%)

3,270

(18%)

3,320(17%)

4,500(22%)

Employ-ment inReal Es-

tate2

80,000

82,000

85,000

86,000

92,000

100,000

113,000

120,000

131,000

145,000

Com-pletedBuilding-s 3

1,226

1,169

1,248

1,581

1,830

1,917

2,445

2,259

2,389 2,684

HousingUnits 98,0

00100,000

110,000

128,000

140,000

145,000

160,000

172,000

183,000

192,000

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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 economy-

wide wage rate also increases. To maintain the same level of profits,

producers raise prices. They can raise prices in the non-tradable ser-

vice sector, but they cannot raise prices in the tradable manufacturing

sector because prices in the latter sector are determined in world mar-

kets. 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 apart-

ment 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


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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 in-

creases, it implies that prices are rising faster than rents because con-

sumers expect to reap capital gains. This underscores the fallacy that

increases in population and supply shortages also lead to price in-

creases. 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 un-

changed.

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 estim-

ate 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 off-

plan 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 construc-

tion lags; the short- run supply curve is inelastic. However, there has

been rapid growth in both residential and commercial construction in


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2004. Currently, there are about 50,000 units under construction com-

pared to an annual average of 8,000 units during the 2000-2003 peri-

od. One developer alone, Emaar Properties, is expected to build 15,000

units per year, and by 2010 total investment in construction is expec-

ted 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.

As demand in the short run increases from D 0 to D 1 , prices along

the short-run supply schedule SRSS 0 increase from P 0 to P 1 (higher than

in the long-run where, due to a supply shift, the price increase is only

to P L). Beyond the short-run, supply will tend to increase. Unless the

price increase is large, prices will be higher than at the initial equilibri-

um.


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Q

D0

SRSS 0

P0

D1

Q0

SRSS1

P1

Q2

Q1

SHORT RUNInelastic Supply

Q

LONG RUNElastic Supply

P0

D0

D1

LRSS0

LRSS1

PL

Q0

Q2

Q1

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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 ap-

proved 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 ac-

ceptable, but a clear property law should be enacted to reduce uncer-

tainty 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

banks 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 exo-

genous. The endogenous variables arise from within the economic sys-

tem, 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 spec-

ulators, 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 de-

creasing, then prices will correspondingly be pulled down. If rents are

increasing, then prices will be pulled up. In Dubai, rents have been in-

creasing 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


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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 sub-

sequent 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 Dubais real estate market.

Another helpful valuation method is the P/Y ratio, where Y is av-

erage disposable income. This ratio measures the long-term affordabil-

ity of property i.e. one looks at average property prices relative to av-

erage 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 affordable 1 .

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. This1 Some analysts use average median incomes instead of average householdincomes to smooth out distortions caused by purchases made by the superrich.DRAFT-NOT FOR QUOTATION (Economics of the Real Estate Sector in Dubai Ohan

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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, com-

merce, 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 Dubais GDP.

Finally, Dubais population is expected to grow to 2 million by

2010 which will create 300,000 units over a five year period. Demo-

graphic factors do not increase prices in the long-run since, as we have

already shown, the long run supply curve for housing is perfectly elast-

ic.

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, some-

what 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


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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 de-

creased 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 con-

traction. Finally, fiscal policy in the form of tax relief and other tax be-

nefits 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 increas-

ing over the last couple of years, they are still undervalued using ac-

ceptable 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 Mat-

rix (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 funda-

mental economic identities. This SAM can then be used in economic

planning to identify bottlenecks and hopefully generate a highly sus-

tainable rate of growth of the Dubai economy.


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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, UnitedArab Emirates.

Case, K. E., J. M. Quigley and R. J. Shiller (2003), Home-buyers, Hous-ing, 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, Number1, pp 1-26.

Dubai Chamber of Commerce and Industry DCCI (2005), Various stat-istical 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 , Washing-

ton 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 ImpactedHouses: Broker Disclosure Behavior and Perceived Market Effects


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in an Unregulated Environment, Journal of Real Estate Practiceand Education , Volume 4, Issue 1, pp 35-49.

Leamer, Edward (2002), Bubble TroubleYour Home Has a PE Ratio Too. Working Paper, UCLA Anderson School of Business.

Leung, C. (2004), Macroeconomics and Housing: A Review of the Lit-erature, Journal of Housing Economics , Volume 13, Issue 4, pp249-267.

Strategy Magazine (January 2005), Regional Real Estate Market To Re-main Strong in 2005, Canada.


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Reflections on Dubai Real Estate Market