UAE. Dubai’s real estate market is underpinned by strong fundamentals. Demand is outstripping supply, and rental yields are high. According to Colliers International, property prices in freehold areas in Dubai rose by 42% during the first three months of this year. Even though fundamentals are positive, there are signs of overheating. We believe that this is particularly true when it comes to off plan (properties currently under construction) rather than completed properties. These signs of overheating are strongly related to the ultra loose monetary conditions which distort economic incentives and encourage risk-taking behaviour.
In March, Standard Chartered Bank recommended tightening monetary policy as a way of preventing speculation on the housing market. This is still necessary but no longer sufficient. Given the signs of overheating in off plan properties, policy response would now have to go beyond prevention, and directly address speculative activity.
Dubai’s authorities are already responding by improving regulation. The introduction of a property court is such an example. More is needed, and an additional option would be the introduction of a capital gains tax for any re-sale of properties which takes place in less than a year from purchase. In addition, the authorities can regulate the payment plans offered by developers. This would discourage short term speculative behaviour which can be destabilising, whilst at the same time encourage long term investors who are ready to take advantage of the long term positive fundamentals of Dubai’s economy in general and the housing market in particular.
Dubai’s economy is booming and the Emirate is attracting foreign human capital to its growing sectors. As Dubai establishes itself as the third largest re-export hub in the world, the trade and re-export sectors are growing rapidly. According to the latest Dubai Chamber of Commerce and Industry figures, total direct trade (imports and exports) increased by 52.3% year on year and re-exports were up by 73.4% in Q1 2008. The numbers of industrial licences approved by the government of Dubai soared by 66% during that same period.
The favourable economic environment is making Dubai an attractive destination. Population is growing. According to government statistics, compounded annual growth rate (CAGR) of Dubai’s population between Q1 2007 and Q1 2008 was 7.6%. This number represents 110,000 new comers a year. Assuming that the average expatriate household is 2.5 persons, similar to EU households, 44,000 units should be ready and available each year just to keep up with population growth. Currently, the overwhelming majority of new residential supply is on the high end segment, specifically apartments. But the market for villas and the middle class segment are still vastly undersupplied and this will be the case for years to come. As far as fundamentals are concerned, both the economy and the housing market are in good shape.
The signs of speculation
Because of strong fundamentals, the long term outlook for the housing market is positive. But that does not mean that there will be no cycles along this positive trend. There are currently some strong signs of speculative activity taking place in off plan properties. Investors are willing to leverage up at a considerable cost in order to take short term positions, “flipping” their properties before their instalments are due. Standard Chartered has constructed an econometric model that can help explain property prices. The most interesting finding of this model is that completed properties do not trade at a premium to off plan properties. This is yet another sign of speculative activity taking place in off plan properties.
It is important to understand some aspects of the property market’s micro structure. When developers launch properties, usually before construction even begins, they only release a limited number to the market. These properties are then traded on the secondary market. At a later stage, developers release another tranche to the market. There are now several cases of properties in which the primary prices of newly launched tranches, is actually higher than the prevailing prices in the secondary market. In other words, it is cheaper to buy the same properties that were launched a few months before from the secondary market, than buy at the launch of new tranches in the primary market. Yet, investors rush to launches and properties sell at these premiums very fast.
This is because developers generally offer better and enticing payment structures, allowing the buyer to put 5% to 10% down as a deposit, with further payments made regularly until completion and delivery. When investors buy from the developer, they only pay a small initial amount. Buying in the secondary market means the buyer has to take over the payment plan of the first buyer, which makes the initial payment higher. These premiums are not negligible. Standard Chartered estimates, for example, that in many cases the premium can be higher than 50%. We see this as the price investors are willing to pay in order to leverage up.
The desire to leverage up in the off plan housing market and the premia it has invoked is a significant sign of speculative activity. If a property goes up in value by 10%, and an investor has only paid 10% of the price as deposit, the return the investor makes is actually 100%. It is very common to see investors taking positions in the market with the intention to flip it before further payments are due. In many cases, investors have no intention whatsoever to actually own a property. Their presence in the market is simply a short term position based on leverage in order to make a quick and substantial profit.
In order to assess property prices in more detail, we have constructed an econometric model. The model takes into consideration the location of properties, whether the property is a villa or an apartment, what floor the apartments are on, and whether these properties are off plan or completed. According to our model, there is a premium of AED 1,950 per square foot (psf) for villas, and for apartments the price increases by AED70 psf the higher the floor. The model also shows a significant premium for two iconic locations, the Palm and the Burj where the premium is AED 1,110 psf and AED 3,965 psf respectively. The model can explain 79% of the variation in property prices in Dubai. Another interesting finding from the model is that there is no premium for completed properties. Once we adjust for location, type of property and floor level, whether the property is off plan or completed makes no significant difference on prices per square foot. When comparing like for like, completed properties trade at a similar price as off plan properties.
Given that completed properties can generate income, one would expect their prices to be higher. For example, let us compare two identical properties; one completed and one that will be completed in one year.
The floor area of each of these properties is 1k square feet, and the annual rent for the completed property is AED200,000. This generation of income should be reflected in the price. The price of the finished property should be higher by AED200 psf. The econometric model states that this is not the case.
This is another indication of speculative activity in off plan properties. This speculative activity has eliminated the premium that completed properties once enjoyed. Buying a completed property for short term speculation is difficult, given that the full price for the property needs to be paid to the seller. It is much easier when one only needs to pay 10% of the price for an off plan property. It is not only cheaper, but by leveraging up the potential profit also increases. The problem is that with leverage, potential losses also rise, but the risk of a loss is not on investors’ minds at the moment. The market is dominated by a one way bet mentality.
Learning from the experiences of others
These patterns in Dubai’s property market are not unique. Even a mature housing market like the one in the US can go through similar cycles. Two recent examples are the experiences of Hawaii and Las Vegas.
At the peak of the housing boom in the United States in 2004, when borrowing costs were the lowest in four decades, Las Vegas was a hotbed for investors. An estimated 7,000 people were moving to Las Vegas each month. The city was growing and so was the construction of new homes. Property values rose 44% in the third quarter of 2004, mostly driven by speculators. According to Fannie Mae, almost half of Las Vegas home sales in 2005 and 2006 were to people who intended to resell quickly for profit. Developers tried to regulate the market themselves by prohibiting buyers from renting or selling houses for at least a year after buying, but there was no strong response by the state government. Speculation continued, and prices eventually collapsed. To this day, the housing market in Las Vegas is one of the hardest hit markets in the US.
Hawaii, which saw property prices doubling between 2002 and 2007, is looking at ways to slow down the market. One of the ways to reduce speculation is by introducing a new tax on top of the existing capital gains tax of 7.25%. The new tax would invoke an additional 60% capital gains tax on property held less than six months prior to sale, 30% on property held 6-12 months, and 15% on property held 12 to 24 months.
Prevention and cure
Dubai now needs direct measures to tackle short term speculation, according to Standard Chartered. Introducing a capital gains tax on properties could be such a measure. The tax will aim to discourage short term speculative transactions and at the same time allow long term investors to benefit from strong economic and housing market fundamentals.
In order to be a deterrent, the tax needs to be high enough, for example in excess of 50%, and should only be applied to the properties that are being bought and sold within a period of twelve months. Sellers that keep their properties for more than 12 months before selling should be exempt from this tax.
In addition to the capital gains tax, the authorities can also consider regulating the current payment plans developers offer to buyers. Initial deposits, for example, can be raised to 20% of the purchase price from 5%10% with potential buyers also having to provide proof that they are able to finance the remaining 80% of the property price either through existing funds or an approved mortgage agreement. This will ensure that buyers can afford to pay the full price of the property and are not simply paying a 10% deposit for a short term profit with having neither the intention nor the ability to actually purchase the property.
Several of Dubai’s developers are acting responsibly, and are trying hard to impose stipulations on the resale of property to control speculation. For example, one of the largest property developers in the UAE, has recently issued restrictions on the sale of off plan property only. Properties can only be transferred three times and the first buyer cannot transfer or sell the property to a third party until after 30% to 40% of the value of the property is paid. The second buyer can then resell after 60% to 80% of the value is paid and the third buyer can only resell after 80% to 100% of the value is paid.
However, buyers avoid the restrictions by signing a memorandum of understanding (MoU) through a power of attorney agreeing on the sale price with the actual transfer of the property occurring once the time limit expires. In effect, this is leading to the creation of a forward speculative market for off plan properties. The problem with such initiatives by individual developers is that they are not institutionalized and they can be evaded by investors quite easily. A government initiative with a carefully implemented capital gains tax and regulated payment plans are more likely to succeed than uncoordinated initiatives by individual developers.
Off plan property prices cannot be fully justified by the positive fundamentals. There are signs of excessive short term speculative activity which is based on leverage and can prove to be destabilizing. The challenge facing authorities is to penalize short term speculators, without affecting long term investors that position themselves to benefit from the long term positive prospects of Dubai’s property market.
Two possible ways to achieve this is by changing the payment structures and also taxing capital gains made on properties that are being bought and sold within a period of twelve months, with investors that buy and hold for longer than 12 months being exempt.