Given the surge in prices of ultra-luxury real estate in Dubai, it is of little surprise that listings have accelerated, even though we know from experience that most of these deals tend to take place off-market. The fact that listings in this space have more than doubled (in the backdrop of a historically strong dollar) is sparking a reality check as interest rates march upwards. Despite the inelasticity that this sector has to interest rates, the obvious issue remains demand and supply.
Adam Smith’s theory said that the price of a good (or asset) was given by the number of factor inputs (land, labour, financing costs, and materials) that went to produce it. When land, being the critical factor here, is available in high quantity, the price should be relatively affordable. However, as the theory of economics in real estate evolved, participants had to factor in the time taken to construct, as well as the quality of existing stock available.
In the last decade, yet another critical variable has been the quantity of money being made available at low rates, and the resultant margins that accrue when such developments are built. The global housing market crash of 2008, and the subsequent revival of asset prices, was where interest rates were effectively set at zero, implying that the manufacturing process of such assets were done in an environment where there was a little opportunity cost to the investment.
A year for luxury
This led to an increasing concentration of assets being made and purchased at the top end of the spectrum. In 2021, ultra-luxury real estate, sales accounted for the highest percentage of global housing sales ever since such data was tracked in 1969. This is of no surprise, but as we scrutinize market trends, we observe that as interest rates and inflation start to bite into ‘real profits’, the price of the existing stock starts to fall, as investors start to re-allocate towards higher income yielding investments.
We have already started to witness this in Dubai and the UAE, where mega-IPOs have drawn in record subscriptions. At base, given the historical and present monetary policy, prices of certain segments of real estate have become more correlated to the money supply rather than ‘replacement value theory’, which is the only benchmark that anchors prices in the medium to long term. If we imagine institutional developers building homes in the luxury segment by availing of cheap financing, the obvious imperative is the expected profit margins rather than the resultant rental yields, as the latter is far too low in this sector, to begin with.
Margin of safety
With both interest rates and factor input costs rising, such developments start to look riskier, with the margin of safety starting to evaporate. On the pricing side, as the supply of existing and near-ready units increase, buyers are left with an increasing array of choice, thereby negating any ‘rush to judgment’ effect dominating the landscape over the last year. Akin to a candle burning on both sides, the only conclusion to expect prices at this end will start to taper and course-correct (a phenomenon that is already in the early stages of being played out),
Notice that the narrative is not about excess supply, but rather the prospects of easy financing coming to an end. This heralds a paradigm shift towards more income-generating assets, a phenomenon that investors are being forced to grapple with for the first time in more than a decade-and-a-half. The need for opulence and large spaces will always be a factor as the wealth effect starts to accrue. Moreover, as Dubai continues its march towards being a global destination, luxury real estate is unlikely to go through a contractionary price cycle that was evidenced in 2008-10.
What is increasingly likely is that family offices and institutional investors will bring a sense of balance by building and retaining assets that have income-generating opportunities with a significant margin of safety given the inflationary and interest rate headwinds. This capital re-allocation heralds new opportunities for new homeowners as well as passive investors in other segments of the real estate sector.