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Sun 20 May 2007 06:00 PM

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Reality check

Just how truly robust the real estate sector in the gulf is clearly evident on the astronomical projects currently at hand. Barry Mansfield looks on the future of real estate in the GCC region.

Depending on who, you believe, somewhere between 15% to 25% of the 125,000 construction cranes currently operating in the world today are located in Dubai. There are two possible interpretations of this astonishing development: It could be a property bubble of epic proportions, or it may be emblematic of a new Middle East that challenges its long-standing role as a financial recycling machine. Either outcome could have profound consequences for world financial markets and the global economy.

Dubai represents the public face of the GCC's red-hot property sector. It may be a speculator's dream, but for overseas institutional investors the market's staggering price appreciation in recent years - combined with its rudimentary regulatory framework - is giving rise to a ‘wait and see' approach, according to analysts.

Nevertheless, it is hoped that upcoming changes to regulation and a greater balance between supply and demand will help the market to achieve improved stability, inspiring the confidence of major institutions including banks, fund managers and insurance companies.

"The institutional investors have the real buying power in terms of real estate all over the world and are one of the key drivers of more established property markets such as the US and the UK," explains Tom O'Grady, real estate partner at the Dubai office of global legal services organisation DLA Piper.

"To sustain Dubai's commercial property market in the longer term I think it will be extremely beneficial to attract this kind of investment."

In recent months, legal experts have also praised the implementation of various initiatives by Dubai Lands Department aimed at tightening up the emirate's fledgling property law, lending greater reassurance to both private and institutional investors that the region is a safe place to do business.

The scale of development in Dubai is sure to invite comparisons with Shanghai Pudong, China's massive urban development project of the 1990s. When Pudong emerged from the rice fields, few would have believed that anything could ever surpass it. However, according to industry sources, 26.8 million sq ft of office space is expected to come on line in Dubai in 2007 alone - six times the peak rate of completions in Pudong in 1999 and nearly equal to the total stock of 30 million sq ft of office space in downtown Minneapolis in the United States.

Based on current projections, a further 42 million sq ft should come on line in Dubai in 2008 - the equivalent of adding the office space of a downtown San Francisco. There is one notable and critically important difference between these two urban development projects: Pudong has an indigenous support base of 1.3 billion Chinese citizens. Dubai's current population is 1.3 million. Even counting the entire native population of the UAE, the support base is still only around four million domestic citizens. This means a region with less than 0.5% the population of China is outbuilding the biggest construction boom in modern Chinese history.

It would be unwise to assume that a property bubble must be the inevitable consequence of all this activity; construction and economic development go hand in hand, after all. The problems arise when building cycles go to extremes - fuelled by speculation, or funded by the easy money of state-directed lending.

While the world's spotlight has been on Dubai, Bahrain has now taken the lead in the area of commercial property, with The Lagoon Bahrain - the region's first freehold commercial development on Bahrain's US$1bn Amway Islands - offering premium opportunities for new concept food and beverage outlets and boutique retail. The kilometre-long waterside, retail and dining destination sits in the company of London's Covent Garden and Cockle Bay Wharf in Sydney, with top-flight stores and restaurants open throughout the day and into night from September 2007.

In tandem, Bahrain has stepped up efforts to build its tourism infrastructure with construction underway on theme parks, entertainment venues, hotels and property, and many more plans are said to be in the pipeline. The 2004 addition of Bahrain to the Formula One Grand Prix circuit gave tourism in the country a great boost. In fact, Bahrain has recently been hailed as a ‘boomtown' after achieving the highest tourism growth in the GCC in the first quarter of 2006 - followed up by healthy summer figures; tourist arrivals in Bahrain soared by 30% in the first quarter, way ahead of its nearest rival Dubai, which achieved 7% growth, according to UN World Tourism Organisation figures. Occupancy in five-star hotels also increased by a remarkable 20% from last year, says Five Star Hotel Owners Committee chairman Abdulrahman Morshed.

ADIH chief executive officer Rashad Janahi says that over 60% of available reservations for The Lagoon Bahrain had been snapped up within three months of the launch. "The speed with which investors reserved this project consolidates our belief that the freehold real estate market in Bahrain and indeed throughout the Gulf is here to stay," said Mr Janahi. "Tourism-driven retail and hospitality developments throughout the Gulf are continuing to drive the economy. New shopping centres, leisure attractions and hotels are enticing ever-increasing numbers of holidaymakers both from throughout the world and within the Gulf, driving more investment as a result."

Growth in the real estate sector, suggests ADIH real estate executive director Nicholas Fraser, has been further spurred with the shift from the residential market towards commercial property development: "One reason that Dubai is the biggest destination brand in the Gulf is due to its introduction of the residential real estate freehold concept, where individuals could own their properties for a period of years," he says. "Dubai not only introduced this before other cities, it also allowed a much easier flow of expatriate visitors and residents than its regional counterparts."

Bahrain has achieved impressive growth in the first quarter of 2007, with the volume of dealings in the property market increasing by 17% from the same quarter last year to reach US$441.7m. In a statement carried by the daily Akhbar al Khaleej, the survey and land registration bureau chief Shaikh Salman bin Abdullah al Khalifa said he believed the property market indicator has been steadily growing, thanks to the flexibility of Bahrain's property market laws and regulations. He also pointed out that the rate of dealings of non-citizens formed 16% compared to 12% last year.

Abdulrahman Morshed is keen to point out that cultural factors and local conditions, including differences in climate, have played an important role in Bahrain's success story. "Bahrain weather-wise is slightly better than Saudi Arabia and Kuwait and so for a change families came here to enjoy their summer holidays," he says.

Another factor would be the fact that businesses in Bahrain, compared to its neighbouring countries, remain active even during the summer. "People here continue what they are doing in the summer," says Morshed. "Things do not die down because it is summer and the five-star hotels reducing their rates from US$143 to US$100 has helped in the growth."

Three years ago the case for buying property in the region was overwhelming, both for investment and for living. Since then prices and rentals have soared; those who purchased real estate back then seem happy with the choices they made. However, prices today are higher and the rental outlook less certain. So where is the property market heading?

Those waiting for a property crash in Dubai could be just as disappointed as the speculators who bought late into the off-plan apartment scene. Rental yields are still double what is commonly found in similar, though more mature, global property markets. Actual property prices are still more than 50% cheaper in many cases. Furthermore, Dubai inflation levels are currently very high and even wage packets for non-nationals are increasing. Hence, if house prices are static in nominal terms then they are falling in real terms, allowing for the effect of inflation.

Even though the bonanza for speculators looks to be over, Dubai rentals will eventually climb again, while mortgage payments should remain fairly steady, and high general inflation in the GCC due to the oil boom should take property prices higher in the longer term.

The day will dawn when the main urban centres of the GCC are priced at levels similar to other global hub cities, and this will of course be much higher in real terms than it is today.

There are many other, more complex reasons as to why a long-term bullish outlook for real estate in the region looks justified. Bubble or no bubble, the Dubai-led Gulf building boom is hardly an isolated development. Throughout the GCC region, it has been accompanied by expanded infrastructure efforts, rapidly growing commitments to education and medicine, increased industrialisation, and the growth of domestic capital market activity.

These trends are emblematic of a new and important development in the Middle East that distinguishes the current period of elevated oil prices from the oil shocks of the past - a massive push toward internal development that goes well beyond tourism. Of course, the ‘Dubai factor' simply was not present in the two oil shocks of the 1970s or in the brief surge in oil prices in 1990. The absence of domestic spending commitments meant that the inflow of elevated oil revenues passed quickly through a revolving door - reinvested in world financial markets, especially dollar-based assets. The trend of so-called petrodollar recycling became synonymous for the oil shock.

Of course, this time the shock is very different. Internal absorption is now very much in focus for oil-producing countries in the Middle East. As oil prices have surged in recent years, imports of goods and services of the world's major oil producers more than doubled from around US$170bn in 1999 to US$355bn in 2005. At the same time, according to IMF estimates, primary government expenditures - a good proxy for publicly sponsored infrastructure and social spending initiatives - accounted for fully 15% of GDP growth in 2005 in the GCC (Gulf Cooperation Council, which includes Saudi Arabia, Kuwait, the UAE, Bahrain, Qatar and Oman); by contrast, this share was ‘zero' in 2002.

Moreover, holders of the public purse in the GCC are mindful of the policy mistakes of the past, when mean-reverting oil prices led to substantial government budget deficits for those who had been too aggressive in opening up the spending spigot.

For the developing economies of the GCC, the IMF is estimating central government surpluses of a little more than 8% of GDP in 2007 - about the same as in 2006 but a swing of around 11 percentage points of GDP from the 3% average deficits of 2002-03. This more prudent response is a very encouraging sign that the GCC region could avoid the boom-bust cycles of the 1980s and thereby set the stage for more sustainable state-led spending initiatives in the years ahead.

Notwithstanding the push toward internal absorption, Middle East oil-producing states have not turned their backs on dollar-denominated assets. Due largely to dollar-pegged currencies, GCC monetary authorities still need to invest a large portion of their outsize portfolio of official foreign exchange reserves in dollar-based assets. However, the combination of new domestic spending programmes and reserve diversification strategies challenges the traditional view that petrodollar recycling is an automatic outgrowth of rising oil prices.

There is an added and important twist in the current climate: The United States Patriot Act now makes it much more difficult for Middle East portfolio investors to transfer funds into the US. At the same time, the controversy over the purchase of US assets by Dubai Ports World, together with US congressional efforts currently underway to extend restrictions on foreign direct investment into the US - the so-called CFIUS approval process - also discourages the dollar-centric buying of Middle East investors.

An offset comes from the sharp corrections in local stock markets since late 2005 - underscoring the risks of the domestic capital markets option for non-dollar diversifications strategies. However, should these markets begin to recover, it seems reasonable to predict that local buying will intensify rather quickly - diverting assets away from lower-return alternatives in the US and elsewhere in the developed world.

In short, there are many reasons to believe that in the current period of sharply elevated oil prices, the petrodollar recycling story may be far less compelling than it used to be.

This conclusion has important implications for world financial markets. Most importantly, it challenges consensus views that high oil prices create a natural bid for dollar-denominated assets. In a climate where dollar risk remains an ongoing concern, this could be an especially important point for the currency debate. In light of recent dollar-diversification concerns expressed by reserve managers in the Middle East - especially those in the UAE, Qatar, Iran, and Syria - the possibility should not be dismissed out of hand.

The examples of Dubai, Bahrain and Abu Dhabi underscore a critical difference between then and now. Even if a bubble emerges in the short-term, there will be no turning back for the new Middle East. It is high time that investors broadened their horizons.