Dubai’s booming property market and the possibility of another bubble has received much speculation from analysts across the UAE and the wider region. Soaring property prices have heightened worries about the risk of a speculative asset bubble, following the 2008 crash that caused prices to plunge by more than 50 per cent.
To understand whether or not a property bubble is on the horizon again, we need a framework to analyse property prices that will help real estate players direct their attention to the most important issues and to make better investment decisions. For authorities, these considerations may help them in their efforts to avoid a repeat of past boom-and-bust episodes.
Core financial principles are key to this analysis. The fundamental value of a real estate asset is the present discounted value of all the future cash it is expected to generate. For a property, cash is derived from rents.
In a bubble, asset prices are much higher than asset fundamentals can justify. But future rents and fundamental values are not directly observable and require estimation — making the analysis particularly difficult.
From June 2011 to June 2014, property prices in Dubai increased by 77 per cent. During the same period, rent prices rose by 46 per cent. Even though the increase in sales prices was accompanied by rising rents, property prices increased at a faster rate than rents.
If property sale prices increase at a rate faster than rents, future rents must also be expected to grow at a faster rate than before — in order for prices to reflect sound fundamentals. From a demand perspective, the higher current demand for space could very well signal even higher future demand.
Moreover, higher current rents may also indicate higher future rental growth.
The crucial issue on the demand side is the extent to which the factors driving higher demand today are likely to persist well into the future. The World Expo in 2020 will attract more tourists to Dubai but what will happen after the event? Will the increase in tourists be sustained?
Real estate assets are long-lived, and an increase in future rents must reflect far into the future.
Perhaps a more significant risk to a sustained higher future growth in rents is related to property supply. As property prices (and rents) have increased, we have witnessed many new developments being planned.
When completed, this infrastructure will add to the supply in the emirate, resulting in downward pressure on rents. Furthermore, such projects are often undertaken by a variety of developers and are uncoordinated.
The resulting increase in supply may outstrip the future demand for Dubai property, and future rents may decline or grow too slowly to justify the high property prices. Prices may end up falling, spurred by lower than expected rental values.
The latest data is already reflecting this trend and the last quarter of 2014 has seen zero increase in Dubai’s property prices and rents. Real estate prices have flatlined in the last three months as more residential units come on the market.
So what is the solution to prevent this disequilibrium?
Developers should not build and add to the supply of space at a rate that outstrips property demand in Dubai. A number of large projects are suitable for phasing, which allows additions to the supply of space to take place gradually and at a time when it is clear that the increase will be sustained.
It is also important to remember that Dubai offers a relatively safe market for investors, and as such property here commands a risk premium lower than that associated with assets in other Middle East countries. Such safe haven effects in house prices have been documented for other major cities such as London, and likely to be playing a role in the recent appreciation in Dubai property prices. In addition, interest rates are at historically low levels across the major developed economies.
While the recent increases in property prices can also be justified based on fundamentally lower interest rates and risk premium, the major risk is that the conditions that have led to reduced discount rates may reverse. Interest rates may rise.
Other countries in the region may become more stable. Investors may become less risk tolerant. These are primarily global risks arising from the actions of international monetary authorities and global investors, and beyond the direct control of the Dubai Government.
To avoid a bubble, Dubai must focus on the market for space — both the demand for use of the space and additions to the supply of space.
Large real estate developments financed with high leverage ratios should also raise alarm bells. High leverage will pose significant challenges as discount rates increase and real estate prices decline, even if the market for the use of space remains healthy and rental values are sustained.
Asset values lower than outstanding debt make it difficult or even impossible to refinance outstanding loans. Any resulting defaults will adversely affect the value of other real estate assets.
To mitigate the risk of such a scenario, significant equity capital must be used in the acquisition of real estate assets and for the financing of real estate investments.
The writer is a Professor of Finance at London Business School.
