Boom town

Diversification is key. However smug an investor who owned nothing but high-tech stocks would have been in the late 1990s, he was in for a nasty shock when the bubble burst. The same is true for an economy. In the early 17th century, Holland became the most important producer of tulip bulbs in all of Europe; but this was scant consolation when the market crashed, taking the Dutch economy with it.

This is a lesson that some have learned better than others. While more than 90 percent of Kuwait's export dollars still come from the oil industry, the late ruler of Dubai, Sheikh Rashid bin Saeed al-Maktoum, realized in the 1960s that the city's economy couldn't rely on “black gold” forever; sooner or later, the wells would run dry. Under his direction, the city began to plough the economy's oil money into its infrastructure, investing in developments such as the world's largest man-made cargo harbor at Jebel Abi.

Dubai's economy has diversified further in recent years, with its rulers openly declaring their ambition to create “the Singapore of the Middle East.” The government has encouraged foreign companies to relocate to the city through the creation of de-regulated economic “free zones” such as Dubai Media City and Dubai Internet City. The 7.2 million square meter Dubai Silicon Oasis technology park was launched in 2002 in the hope of creating a Middle Eastern version of California's Silicon Valley, while Emirates has grown into one of the world's largest airlines. Most recently, the city launched the Dubai International Finance Centre (DIFC) in the hope of creating a regional economic financial hub on par with New York, London and Hong Kong. Thus far, the effort seems to have paid off: in 2004, 93 percent of the city's gross domestic product came from sources unrelated to the oil industry, and since 1998 the emirate's GDP has grown at an annual rate of 14 percent.

“There's a vast need for affordable housing…but we are aiming for the more affordable mid-market, and building one bedroom units rather than 2,000 square foot ones.”

Both a driver and a side effect of this rapid expansion has been the city's fast growing real estate market. The arrival of multinational companies has created demand for prime office space, while their employees require homes and leisure facilities. What's more, thanks to annual population growth of around 7 percent, the city has a characteristic that makes it the holy grail for real estate investors: inbuilt scarcity.

THE FLOODGATES OPEN
This is not to say that it's always been an easy market in which to operate. “We started looking at Dubai in 2001,” explains W. Jonathan Wride, a managing director of private equity firm Capital Partners.“We did some research and really liked the market, but at the time, it didn't allow foreign ownership. We would have had to lease the land—that obviously wasn't of interest to us as a US fund.”

In 2001 the law had been changed to allow foreigners to lease real estate for 99 years: prior to that, only UAE and GCC nationals had been permitted to own property in the city. Wride and other Western investors had to lobby the government personally to persuade them that leaseholds wouldn't be enough to attract foreign direct investment. The authorities eventually concurred: in May 2002, the crown prince Sheikh Mohammed bin Rashid Al Maktoum issued a decree allowing foreigners to buy property in selected areas of the city on a freehold basis. “It's a really probusiness government that understands the necessity of attracting Western investment,” says Wride. “They realize that to do that they have to change certain things.”

Sheikh Mohammed's decree sparked a boom in residential real estate big enough to make today's US property market look half hearted. Expatriates make up more than 80 percent of Dubai's population. Immigrants from the Philippines and the Indian subcontinent have traditionally taken the emirate's low paid jobs; while at the other end of the economic ladder, a growing number of Westerners and Iranians have been attracted by the city's combination of low tax, high growth, and economic and social freedom. In 2004 the city's population grew by almost 100,000.

Yet until the 2002 decree, this huge foreign-born population were unable to own their own homes. The change meant that the amount of money available to buy residential property rocketed overnight—and prices, unsurprisingly, rocketed with it. By early 2004, residential property prices were growing at an annual rate of 10 percent; in the first six months of 2005, the average prices of villas, scarce due to land shortages, grew by as much as 22 percent. To meet the demand, new projects began popping up in the city, in the nearby desert and even on land reclaimed from the sea.

That's not to say that there haven't been hiccups along the way; at certain times, prices in some sectors have fallen equally rapidly, such as the seven percent decline in apartment prices during the first half of last year. But the overall trend has been remorselessly upwards: in October 2005, Dubai Property magazine predicted annual price increases of seven percent to 10 percent for both villas and apartments.

Andy McTiernan, the magazine's editor, has been watching the market for three years and though growth is still strong today, he suggests that things have begun to calm down. “Originally people were speculating,” he says. “You saw Saudis buying 40 apartments one day, and flipping them the next for a premium of up to 30 percent. The speculation era petered out in early 2005 once lots of new projects became a reality. Now the secondary market is developing, those quick flip returns aren't available.”

THE NEW WORLD
The relatively recent introduction of foreign ownership laws is not the only thing that makes Dubai different from the type of market many real estate investors are used to. The government also has a degree of influence that makes the French look like free-market fundamentalists. The Dubai government launched the region's two largest real estate developers, Emaar Properties and Al Nakheel Properties, in 1997. It still owns a 32 percent stake in the former, while the latter is operated by the goverment's Corporate Office. Although various private sector competitors such as Damac Properties and ETA Star Properties have since joined the freehold sector, the emirate's government still exercises significant influence over the local market.

Dubai also differs from the West in the scale and extravagance of its developments. Emaar's projects include the world's largest marina; the Arabian Ranches, a development of luxury villas surrounding an equestrian center and polo grounds; and Burj Dubai, a tower, which at over 700 meters tall, will be the world's tallest upon completion. (The developers are rumored to have kept the exact height under wraps, to ensure that rivals do not beat them to the finish line.)

Al Nakheel has gone one step further and actually created new islands. “The Palm Islands” will consist of three tree-shaped archipelagos in the Persian Gulf, described by their developers as “the eighth wonder of the world.” Nearby will be the three hundred islands that make up “The World,” a development of estate homes and resorts on a complex of islands that, from above, will resemble a map of the Earth. The English pop singer Rod Stewart is rumored to have bought Britain.

One group that has backed investments at the luxury end of the market is Abraaj Capital, one of the region's largest private equity firms. The firm closed a $113 million real estate fund in December 2004 with the intention of investing in property throughout the Middle East.

Emaar's projects include the world's largest marina; the Arabian Ranches, a development of luxury villas surrounding an equestrian center and polo grounds; and Burj Dubai, a tower, which at over 700 meters tall, will be the world's tallest upon completion.

Stefan Hickmott, a vice president with the firm, notes that there are still legal obstacles to foreign-registered funds wishing to invest directly in UAE real estate. Abraaj's first investment in the country's property market thus took a more roundabout form, when it acquired a 34.5 percent stake in the Sharjah-based developer Emirates International Holdings at a cost of 86.3 million dirhams ($23.2 million). The company's portfolio includes three developments in Dubai: the Palazzo Versace Dubai hotel, the D1 residential tower and the Emirates Financial Tower in DIFC.

“As the market matures, and laws change and things like REITs come about, it'll make foreign ownership much more favorable,” he explains. “But because it's starting from scratch at the moment, the opportunities are very much in building new developments.” However, legal hurdles are not the only reason why the firm is currently focusing on development projects. “We don't want to do plain vanilla investments,” Hickmott adds. “We don't think that's the best way to go for our LPs, as it could leave them exposed to an economic downturn.”

Some commentators suggest that the profusion of luxury developments in Dubai have left those lower down the income scale rather badly served. The scarcity of residential property has led rents to spiral alongside prices, with average rates climbing 37 percent during the first three quarters of 2005. In November the Crown Prince placed a 15 percent cap on rental increases for any individual tenant. Nonetheless, many lower- and middle-income workers can no longer afford to live in the city and are forced to commute from the neighbouring emirate of Sharjah, some 45 minutes along the coast.

“Developers are building luxury apartments to maintain their margins,” explains Jacques Bernard, a managing director with Bahrain's Unicorn Investment Bank (UIB). “It's hard to do loweror middle-class accommodation due to the cost of land. Lots of the luxury apartments will be empty, because they don't fit the demand for lower-class spaces.”

One group hoping to help capitalize on this market gap is Capital Partners. The firm has funded Riverwalk, a five million square foot mixed-use development in the telecommunications free zone Dubai Internet City, which is built around a series of manmade canals. The project will includes offices, a Marriott hotel and retail space.

Wride says that the firm was attracted by the demand for high quality offices, citing the waiting list of 200 companies for space in Dubai Internet City. He adds that, unlike many other development projects, Riverwalk's residential space will not target the top end of the market. “There's a vast need for affordable housing,” he says. “We can't get it down to that level because of the severe price of land, but we are aiming for the more affordable mid-market, and building one bedroom units rather than 2,000 square foot ones.”

THE FUTURE
The relatively small size of the market, the high price of what little land is available and the legal obstacles to ownership have all conspired to ensure that, while high returns are on offer, the consensus among opportunity funds working in the region seems to be that focusing entirely on the Dubai property market would be a mistake. Abraaj's real estate mandate covers the whole of the Middle East, while Capital Partners is also looking at opportunities in the services and high-tech sectors.

Bernard suggests that UIB may steer clear of Dubai altogether. “Our feeling is it's pretty saturated, and the market is softening,” he says. “There used to be great turnover, but now residential is at its peak.” Yet he remains optimistic about the market's future. “When we do see a correction it'll be a healthy one. It may fall for a few months, but it'll come back.”

Abraaj's Hickmott is even more positive. “There may be an adjustment, but I don't think there'll be a correction,” he says. “Dubai is still showing strong signs in terms of demand growth, and it's only the plain vanilla projects which don't have a competitive advantage that are taking longer to sell.”

Nonetheless, both suggest that other markets in the region may present more interesting possibilities in the immediate future. Other emirates, such as Ras Al Khaimah and Ajman, have followed in Dubai's footsteps in allowing foreigners to own freehold properties. Bernard says that he expects UIB's new fund to focus its attention on Abu Dhabi and Sharjah, as well as on markets outside the UAE including the Saudi residential, Kuwaiti retail and Omani leisure sectors.

Dubai may have led the way—there are certainly few areas in the GCC that can compete with the city's development—but it seems others are certainly following in its path.