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Sat 27 Dec 2008 04:00 AM

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Bolt from the Blue

Poor financial ratings and the credit crunch are coming to bear on Oman's much-hyped megacity, Blue City.

Poor financial ratings and the credit crunch are coming to bear on Oman's much-hyped megacity. Can Blue City hold its appeal for investors or is Oman's latest stab at economic diversity threatened with failure?

It's one of the biggest real estate developments in the Middle East and will create 200,000 jobs when it's completed, at a cost of $20bn, in 15 years.

Blue City, or Al Madina A'Zarqa, Oman's planned megacity, is a sprawling metropolis stretching across 16km of the country's rugged coastline, and a clear signifier of the economy's push away from oil and into tourism and real estate.

In keeping with tradition for a Middle Eastern project on this scale, Blue City has received its fair share of publicity and grandiose descriptions since its launch in 2005. In October, Richard Russell, the chief executive of Blue City Company 1 - the company overseeing the first phase of development - branded it an "iconic city" with an "innovative design".

"This confirms the evolution of Oman in the global real estate arena," he said boldly. Project chairman Anees Issa Al Zadjali followed suit, calling the development "a dynamic and sustainable city of the future".

But no amount of florid talk can now disguise the seismic shift in the economic climate since Blue City was unveiled three years ago. Projects across the Gulf are being delayed as investment capital evaporates in the wake of a cooling global economy; while developers that had banked on off-plan sales to fund ambitious construction schemes are reporting cash woes as speculators flee due to dropping property values.

Like the rest of the Middle East, Oman is rapidly discovering its real estate projects are not immune to the liquidity freeze. Last month, rating agency Moody's downgraded $399m worth of bonds for Blue City to junk status, dropping from Baa3 to Ba1.

The agency reasoned that sluggish sales and a "less-favourable macroeconomic environment" could jeopardise the project to the point where; "the borrower may find it difficult to continue funding the construction in the longer term."

Partly to blame is the more cautious spending trend of European speculators, suggests Khalid Howladar, a senior credit officer for structured and Islamic finance at Moody's, Dubai.

"The payment plan structure is catering towards speculators, and speculators need a liquid market," he says. "Most of the people who have bought in Blue City are foreign investors and not locals. Investors are being hammered in their home markets so they have much less spending money for buying speculative property overseas."

Located on a natural peninsula an hour from Oman's capital, Muscat, the 32 sq km waterfront city is being built along the Al Sawadi coast, adjacent to the Gulf of Oman. Phase one, a 2.5 sq km development, comprises around 5000 apartments and 500 villas. Initial sales began in December 2007, with one-bedroom apartments priced at about $179,400 and two-bedroom apartments at around $291,200. Three-bedroom villas are being sold from around $535,600.

The project is set to include three five-star hotels, an 18-hole golf course, shops, schools, mosques and police stations. Slated for completion in 2012, the phase one site is expected to create around 7000 jobs.

Oman, like all GCC countries, is searching for oil-free ways to drive economic growth. In a report published by American bank Merrill Lynch last month, Oman's GDP growth was forecast to slip to 3.3 percent in 2009 - down from 6.4 percent this year - partly due to slipping oil prices. Overall GCC growth is now expected to be 3.5 percent, down from an earlier projection in October of 4.5 percent, the report said.

The need for Oman to expand its economy is arguably more pressing than most. The Sultanate has significantly less oil than other Gulf states, such as the UAE and Saudi Arabia.

The International Monetary Fund (IMF) said in October that Oman's fiscal budget will fall into the red when oil drops below $77, making it the GCC's most exposed country to falling oil prices. Real estate, by contrast, accounted for just 3.8 percent of Oman's economy in 2007. At the time of writing, oil was just under $39.

Oman has other drivers for diversity, namely its young population. Some 70 percent of Oman's population is below 20 years old, and many will require jobs in a few years.

"There is always a need to diversify for true sustainable growth and if you're looking at the future it is key - especially for the likes of Oman where you have such a young population," says Mary Nicola, an economist at Standard Chartered, Dubai.

"If you look at the oil sector, it doesn't employ very much. It's a capital-intensive industry rather than a labour-intensive one. So obviously a country like Oman needs to diversify because you have more people coming into the labour force and you have to provide jobs for them.Moody's Howladar helped rate part of the $925m of debt raised to finance the first phase of development at Blue City, back in March 2007. Some 15 investors, primarily big banks, backed the scheme through the purchase of these bonds.

Back then, banks were lured by the easy debt on the money markets and willing to invest in real estate projects promising sky-high returns. Now, with the global market looking considerably less rosy, banks, or the bondholders, will be the losers if Blue City stutters due to lack of demand.

"It's long way off and we are not at this stage yet, but if the company cannot repay the bonds, the bondholders would suffer a loss," says Christophe De Noaillat, senior vice president in structured finance at Moody's, London and lead analyst for Blue City.

Last month, the Moody's downgrade was made in light of poor sales at the project. As of August, the company charged with delivering the first phase of the project, Blue City Company 1, has posted $30.6m of sales, against a target of $101m. In July, fellow agency Fitch Ratings put $526m of debt on ‘ratings watch negative', again citing lacklustre sales.

Sales at Blue City started in December 2007 during one of the biggest real estate booms the Gulf has seen. "If you couldn't sell your units in a boom, what likelihood is there that you can sell them out in a recession? Going forward it doesn't look good for the project for the next couple of years at least," says Howladar.

According to Howladar, a key mistake made by Blue City and in other local developments was building a top-end project aimed at the wealthy. The GCC has long had a shortage of affordable housing, with much of the residential property built or planned in the Gulf out of reach to low and middle income earners.

"The big flaw was catering to investment and speculative demand versus genuine owner occupier and middle income demand," he says. "The GCC is saturated in real estate projects, but there are those on middle to lower incomes who are desperate for housing."

Of real concern to analysts at Moody's is the risk of exposure in the project. The insurance against Blue City Company 1 defaulting on paying back the bonds is not unconditional, meaning the insurance company is likely to contest any claim, explains De Noaillat.

"This is clearly what insurance companies can do; this is the assumption we have to make. That is a duty to their shareholders, not to pay all claims."

Howladar agrees. "Any insurer will try and dispute the claim and wriggle out of it. It's a large exposure; $399m. You can imagine them trying to find a way not to pay [and] that is why there is a risk of exposure to the project.

"If, for whatever reason the insurance doesn't pay, then you are exposed to the project despite the insurance you thought you had."

Weighted in Blue City's favour, however, is its value to Oman's economy in terms of labour capital. Should the project stall, says Nicola at Standard Chartered, the government would be likely to extend a helping hand to ensure the development - and its potential 200,000 jobs - stays afloat.

"A lot of these projects are going to be prioritised on the basis of what is important for the long-term future of the country," she says. "The Economic City in Saudi is important for the long-term future of the Kingdom, because it intends to provide a lot of jobs. For the same reasons, the Blue City project could be prioritised for its labour potential."

Oman's diversification into real estate is still in its embryonic stages and is not yet a key driver of the economy. Economists and analysts agree that any further setbacks to Blue City would not hamstring Oman's economy, but would certainly cast a gloomy cloud over future large-scale property developments in the region.

"You are catering to speculative demand," Howladar notes. "That speculation has now gone as those people have lost money in falling markets. That whole demographic which was an unhealthy one, is gone."

The long-term health of Oman's economy is partly vested in whether the government can make a successful push away from oil. Blue City is a litmus test for this experiment, and time will tell whether the results are worth duplicating.

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