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THE BANK OF AMERICA MERRILL LYNCH SECTOR VIEW ON UAE PROPERTY NOTES THAT DUBAI’S PRIME ASSET MARKET MAY HAVE REACHED A FLOOR

The BofA Merrill Lynch sector view on Dubai property sees an emerging floor for prime and retail assets despite structural hangovers and overcapacity. However, it also expects average residential prices to fall by 15 per cent this year.

“We see an emerging floor for prime assets, particularly in the retail sector, which has the smallest supply pipeline,” notes the report by Karthik Sankaran, Abdelrali El Jattari and Stephen Pettyfer, analysts of BofA Merrill Lynch. The experts state that demand is price elastic and cyclical growth in Dubai’s core retail, trade and tourism sectors are likely to resume despite quasi-sovereign debt issues.

Dubai has demonstrated a remarkable capacity to sustain premium rents and pricing power despite the perceived saturation. Nowhere is this more apparent than the fairly robust performance of retail assets. The retail will be the first real estate asset class to demonstrate medium-term growth. A modest 4 per cent decline in rental revenues is expected in 2010, but 3-4 per cent growth is also expected in 2011-12. Average mall rents, despite softening 18-25 per cent in 2009, still command US$900sqm pa. The report expects continued softening in smaller retail enclaves and older malls, due to rising competition from new-generation malls. Top destination malls still claim to have waiting lists, while recent supply has been absorbed without much strain, the view adds.

TRANSACTIONAL VOLUMES REMAIN WEAK The report notes that Dubai’s real estate market was built on ‘free-wheeling’ off-plan capital flows and needs transition towards end-user driven demand, in the medium term.There are formidable challenges also as neither regulation nor demographics are favourable for the creation of a true end-user market in the near term. The cost of ownership is simply too expensive to lure potential buyers; prices have yet to adjust to reflect excess inventory and transaction volumes remain sluggish.

NO DOUBLE DIP RECESSIONThere is little evidence of the feared ‘double dip’ recession and on the contrary there are signs of recovery.However, what is critical near term is the renewed government commitment to reduce the spectre of imminent default by rescheduling and repaying short-term debt. This, in itself, should rebuild confidence, which would aid the ongoing private sector recovery.

RESIDENTIAL PRICES TO FALLOn the residential sector, the cost of ownership is still prohibitive and regulatory environment remains unfavourable. Specifically to Dubai, which has been dependent historically on foreign capital flows, regulatory changes that would again permit property owners to gain long-term residency (withdrawn in 2008) would be a strong positive. More needs to be done to ‘triage’ and segregate viable projects from those that have little hope of completion.Further on the pricing environment the market has ‘conquered’ the first two phases of the down cycle; namely the exogenous liquidity and confidence shock in 4Q08 and the second round chain reaction in terms of employment contraction. However, a final leg-down is expected as the market has yet to fully price for excess inventory. The average residential prices will decline by 15 per cent in 2010.Residential rents have fallen almost 50 per cent from peak levels (30 per cent for prime villas and apartments) – in effect back to late 2006 levels. Rents are likely to remain more resilient than capital values and have plateaued in established neighbourhoods. Transaction volumes are still 60-70 per cent below peak levels according to brokers.

WHAT WILL SHAPE THE MEDIUM-TERM OUTLOOK?The biggest medium-term risk to the thesis of a ‘soft landing’ from this point is not merely oversupply, but the possibility of foreclosures and mass market auctions (so far non-existent) creating another round of distressed sales. Mass liquidation of unsold inventory is unlikely to be permitted.The sustainability of Dubai’s real estate market will depend on policy measures to convert transient expatriate employees into permanent residents and opening up long term capital market funding options for the real estate sector.The report visualises demand transitioning from primarily off-plan ‘bulk’ investors to end-users and buy-to-let investors who would place a greater premium on location and infrastructure factors over short-term capital gains and the ‘work in progress’ or ‘construction site’ status of several development zones, which were built speculatively.

NEAR-TERM: PRICE ADJUSTMENT INCOMPLETEThe number of residential units, four and five start hotel rooms and completed office space will go up in 2011. However, no additional mall space is expected for the next two years. The retail sector is likely to benefit from regional consumption flows.INWARD MIGRATION NOT A PANACEA The average residential prices are expected to fall by 15 per cent in 2010, following a 45 per cent decline from 3Q08 peak levels. “We see a rational unwinding and market segmentation over the medium term. We believe inward migration (from surrounding emirates) will support established residential locations, but this is not a panacea. Even if all qualifying expats from Abu Dhabi and Sharjah relocated to Dubai tomorrow, we estimate that there would still be 44,000 vacant units in 2010 rising to 73,000 by 2011. This would require a CAGR in population of 8% in 2009-11 to fill the empty space – a tall order. Clearly, inward migration should support rents in high-quality residential zones but is insufficient, on its own, to absorb surplus stock,” the report says.

HOSPITALITY PROFITABLE The report notes that tourist inflows more than doubled as well as the total four and five star room supply tripled during the period from 2000-08. Visitor arrivals in 2009 is estimated at 7-7.5m, (flat to -5% YoY), which would place Dubai in the top-10 most visited cities globally.In terms of performance, Dubai suffered the most significant decline across the region in 2009 with revenues per available room (REVPAR) down by 33 per cent to US$170 (vs 15-20 per cent across the region) and an occupancy rate of around 73.3 per cent versus 82.6 per cent in 2008. “At the trough, we believe occupancy levels hit 60-65 per cent in summer 2009,” says the report.However, REVPAR has started showing signs of stabilization in 2010, down just 2 per cent YoY in February 2010 with occupancy rising to 79 per cent YTD, concludes the report.