Shaky foundations

Prepayment for any products or services has always warranted a discount. Pay for a flight or hotel room up front, and you expect to get a cheaper price.

Business-to-business transactions invite even deeper discounts for companies prepared to stump up cash in advance.

The reason is simple: prepayment means positive cash flow, which can be worth a considerable percentage of any transaction.

Buying property off plan is the ultimate prepayment scheme and, like all others, it comes with a discount. The reason for the discount is two-fold. First, the developer selling property benefits from positive cash flow. In some cases, sufficient property can be sold to completely finance the building project.

Secondly, there is risk involved for the buyer, and this is built into the price.

The early days of the Dubai real estate boom, when non-Emiratis were first allowed to buy property, was a time of extreme risk. The legal system had not even been changed before developers were selling forms of ownership.

I can recall people being given contracts all but scribbled on the back of a fag packet that promised the bearer that they would own a certain property when the law allowed them to do so.

His Highness Sheikh Mohammed, who was Dubai's Crown Prince at the time, had given his word the law would change, and for early investors - typically buying from government-owned developers - that word was good enough.

These early investors were right. They took the risk and netted massive rewards. Villas selling for $1.5 million when Palm Island was first announced are now being advertised for closer to $15 million.

The developers also won. Dubai government-owned Nakheel's business was almost entirely founded on the cash generated from selling the first Palm Island properties off plan. Emaar, also partially owned by the Dubai government, had earlier pulled the same trick with the city's first freehold developments for expats: Emirates Hills and Emirates Lakes.

Fast-forward six years and, while the law has been considerably tightened regarding foreign ownership, new risks have emerged in the off plan market.

Several tiers of operators have emerged. Developers such as Nakheel and Emaar have been upgraded to master developers. Smaller developers, some of which have become giants in their own right, buy plots from the master developers on which to build their own skyscrapers or villa complexes.

Investors or private home buyers can buy from master developers, sub developers, or real estate brokers that buy and sell ownership rights in the same way as futures traders sell ownership of coffee beans.

And the vast majority of speculators have as much intention of ending up holding keys to a home as traders intend to own tonnes of coffee beans. They are buying and selling paper, not property.

This house or cards has been underpinned by real estate values running ahead of the cost of building property, and the willingness of people to pay ever-higher prices for it.

But these foundations are being attacked from several directions.

Construction costs rose at about twice the rate of inflation in 2007, up around 20% according to research from international consultancy EC Harris. The price of steel reinforcement rose by 46% and structural steel gained 38%, while cement prices ended the year 30% higher.

The cost of steel in the UAE has continued to soar - up 35 percent since the start of the year. And there are shortages of many raw materials used in construction, causing costly delays to projects.

Staff costs are rising due to inflation and competition for workers. Gulf currencies, which are pegged to the US dollar, are weakening. The Indian rupee, the Euro and the British pound are all strengthening, making the GCC a less attractive place to work for citizens of countries that typically provide all the labour for the construction industry.

Money is also getting more expensive in the wake of the global credit crunch. Central banks across the Gulf have been cutting base rates in line with cuts at the US Federal Reserve, but these rates have not been passed on to businesses as banks shy away from making risky loans.

Selling bonds - effectively borrowing from the private sector and wealthy individuals - has become common to finance projects. But confidence is ebbing away and these bonds will need to offer higher and higher guaranteed rates of return to attract buyers. The money to developers is again more expensive.

But the bunker buster that could blow the foundations of the off plan market apart is consumer confidence. Until last month, investors were unconcerned about holding the ownership rights to a property that would be built in the future.

Supply was low, demand was high, and real estate prices looked like going up forever.

But now there are stories that properties will not be built. There are stories that developers would rather compensate people holding ownership rights, than build the properties that they have bought.

Damac Properties' Palm Springs development was the first cancelled project to break into the open. The shockwaves were felt as far away as London, where investors threatened to sue the developer unless the properties they had paid for were built.

Palm Springs should have been completed by the end of last year, but Damac postponed construction of the homes, and finally cancelled it completely in March. They offered to buy back the ownership rights to the properties at a premium of 6 percent per annum for every year since investors bought it.

An investment of $1 million when the project was launched five years previously would only be bought back for $1.33 million - hardly the return that the rest of the Dubai property boom was delivering over that period.

Damac claimed the cancellation was due to planning changes imposed on it by Nakheel, the master developer of Palm Jebel Ali on which Palm Springs was due to sit. Nakheel denies responsibility.

It is possible that Damac has fallen into a negative equity trap where the revenue it raised from the sale off plan of the Palm Springs development is no longer sufficient to build the project at a profit.

Five years on from the launch of Palm Springs, it is cheaper to buy back the ownership rights at 33 percent more than they sold them for than to build the properties.

UAE daily Emirates Business on Tuesday unearthed two other developers that claim to be in a similar situation. Al Arefi Marina at Dubai Marina and the A1 Tower at Jumeirah Village South, have been put on hold or cancelled, according to the paper, although the developers responsible for the projects have not made the decision on whether to buy back ownership rights, or continue to build what might be loss-making towers.

If buy-backs become common, billions could be wiped off the value of ownership rights overnight. Owners would be faced with a terrifying choice: sell at a discount rate back to the developer - perhaps 30 percent below today's values - or press for the development to be completed, which might bankrupt the developer leaving the owner with nothing.

The rising costs afflicting the construction and development industries show no signs of abating. The only release valve might be a sharp economic slowdown, which would be as likely to send weaker developers bust as spiralling inflation.

The risks therefore are growing, while the potential rewards are shrinking in buying property off plan. The attraction of prepayment is vanishing for buyers, while becoming ever more critical to the survival of sellers.

The days of multi-billion projects being sold off-plan within hours of their launch could be over. Expect buyers to show considerably more caution in the future.

Rob Corder is the Editorial Director of ITP Publishing Group.

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