Peninsula Research - Gulf Real Estate Woes Not Just a ...

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PENINSULA RESEARCH

Gulf Real Estate Woes Not Just a Question of Supply: Part 1

Dr. Christopher Payne

www.peninsula-reh.com =

KEY FINDINGS:

• Real estate price declines across GCC countries and sectors have averaged around 30% in the past 4 to 5 years. The key driver of lower prices has been slower domestic demand, not excess supply additions.

• As a result of each government’s reliance on oil and gas as a source of revenue, falling oil prices led to large fiscal deficits. On average across the GCC, there was a swing from a surplus of +11% of GDP in 2013 to a maximum deficit of -12% of GDP in 2015/16.

• Although entirely necessary, fiscal controls in the form of tax and fee increases and spending cuts have taken significant spending power out of the economy. Average non-oil GDP growth in the GCC slowed from 6% in 2013 to 2% in 2018.



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PENINSULA RESEARCH

Gulf Real Estate Woes Not Just a Question of Supply: Part 1

Dr. Christopher Payne | January 2020

THE KEY TO THE REAL ESTATE MARKET IN THE GULF IS UNDERSTANDING WHAT’S DRIVING DEMAND It’s no secret that real estate prices have fallen by around 30% on average across the Gulf in the past four to five years. Whether residential or commercial in nature, there has been a noticeable lack of safe haven assets. Using data starting in 2016, Chart 1 below demonstrates the high correlation between the two largest GCC economies: the Kingdom of Saudi Arabia (KSA) and the United Arab Emirates (UAE). Strangely though, in much of the market commentary there has been distinct lack of attention paid to the fundamentals explaining recent price declines. Or, to be more exact, analysis has been very one-sided, focusing almost exclusively on additions to supply; when in reality, weak demand, driven by some very clearly discernible factors has been the primary problem. The goal of this briefing is to tell this demand story, by showing how GCC governments were required, when the oil bull market came to an end in late 2014, to cut spending and raise revenue; and how these fiscal controls slowed non-oil economic growth, placing downward pressure on the real estate market.

Sources: General Authority for Statistics KSA; Bank for International Settlements

OIL AND THE NON-OIL ECONOMY It’s widely understood that oil is the single most important driver of the Gulf economies; but what is perhaps less appreciated is how oil exports actually affect non-oil domestic spending and investment. Charts 2 and 3 below illustrate this link in the simplest possible way: while oil output made up, on average, 46% of total economic output in the Gulf in 2013 (the year from which the data is taken), oil and gas revenues (from direct sales and from dividends paid to governments by state-owned oil producers) accounted for, on average, 89% of government revenue.

Sources: Country National Statistics Agencies, IMF, Peninsula Research

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Chart 1: Various regional real estate indices, since 2016

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KSA Residential Index UAE Residential Index

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Chart 2: Oil and gas output as a % of total economic output, 2013

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Chart 3: Oil and gas revenues as a % of government revenues, 2013



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Of course, it’s not a coincidence that we have used 2013 to demonstrate the importance of oil; because with a barrel of Brent crude oil averaging $105, 2013 marked the last year of high oil prices. From late 2014 on, as Chart 4 shows, prices fell steeply, causing a headache for GCC governments that suddenly found themselves running fiscal deficits, where previously there had been large surpluses – as shown in Chart 5. With such large deficits, governments were forced to respond.

Sources: Country National Statistics Agencies, IMF, Peninsula Research, Federal Reserve Bank of St. Louis Before discussing the policy response, it is worth putting these ‘fiscal swings’ into perspective. Recessions invariably cause fiscal problems because government revenue is dependent on taxes and fees that tend to decrease as the economy slows. Less building activity, for instance, means less applications for building permits, and less fees collected. Likewise, slower economic growth implies lower profitability, which shrinks the corporate tax take. No country is immune from the effects of economic shocks on government finances. In 2007, for example, the UK posted a deficit of 2.6% of GDP1, safely within the 3% limit established by the EU’s Maastricht treaty. Yet, two years later, the deficit had ballooned to 10.1% of GDP2; primarily because the recession caused government revenue to fall. The UK’s deficit swing of 7.5 percentage points, from 2.6% of GDP to 10.1% of GDP, was extraordinary by historical standards, but is relatively mild compared to what GCC governments have had to contend with after 2014. As Chart 6 shows, the smallest deficit swing was over 10 percentage points (Bahrain); in four out of six countries, governments had to deal with swings of over 20 percentage points from top (2013) to bottom (in some cases 2015, in other cases 2016). On average the swing was -22 percentage points. All of this, as we have said, was a result of falling oil prices.

Sources: Country National Statistics Agencies, IMF

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Chart 5: Deficits and surpluses,as a % of GDP

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Chart 6: Negative swing, percentage points of GDP, 2013

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Negative swing, percentage points of GDP, 2013 to 2015/16



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EXPLAINING THE NEED FOR FISCAL CONTROL Budget deficits of over 10% of GDP, let alone 20%-plus, are unsustainable, and no responsible government can ignore them. The case of Saudi Arabia provides a good example of why not, and why the Saudi government responded in the fashion it did, i.e. with Vision 2030. Coming into 2014, the Kingdom had very little public debt; total sovereign debt in 2013 was only 3% of gross domestic product. Yet, from 2015 through 2018, the Saudi Government needed to fund over 1.2 trillion Riyals (or U.S.$ 320 billion) of cumulative deficit. Rather than just printing the cash (the route taken in countries like Venezuela, where successive governments seem content to stoke hyperinflation, and rapidly destroy savings), the government drew down its savings and issued dollar-denominated debt; in a ratio of roughly 60% deposit draw-down to 40% debt issuance.3 Of course, Saudi Arabia has large savings, and a very comfortable debt position (thus its sovereign debt is rated A- by Standard and Poor’s). But annual deficits of 10%-plus of GDP soon take their toll. 1.2 trillion Riyals of funding meant that by the end of 2018, Saudi Arabia’s public debt had risen to 19% of GDP; and it’s savings held at SAMA, the Central Bank, had fallen by 60%.4 That kind of funding requirement is not sustainable; and drawing down savings to such a large extent, certainly not desirable. Chart 7 shows how, across the entire GCC, debt levels rose as a percentage of GDP as a result of persistent deficits. While the moves have been large, it’s also clear from the chart, and a definite positive for the region, that no government has resorted to money printing.

Sources: Country national statistics, IMF

Some countries are obviously in a stronger position than others, and certainly the countries where public debt is less than 50% of GDP can be considered sound. That said, Chart 7 does raise the question as to what is a reasonable level of debt-to-GDP; is greater than 60% too much, or is the threshold 100%? The answer, in short, is relative to the interest rates being paid on the debt. Take Japan, a country with public debt at a staggering 238% of GDP at the end of 20185. With interest rates of around 0.9% across its debt6, its financing bill is an entirely manageable 2.1% of GDP. Yet, when Greece was paying a weighted average interest rate of 5% on its debt, 180% debt-to-GDP implied an interest bill of 9% of GDP7. Just to achieve a deficit of 5% of GDP, the remainder of Greece’s budget (known as the primary budget) had to be in a surplus of 4% of GDP, something that was almost impossible to achieve. It’s little wonder that Greece had to seek international help. What matters is the interest rate that lenders are willing to accept in taking on the risk of a particular creditor. So long as a lender is convinced that a government is in control of its finances and has a realistic and achievable plan to maintain fiscal restraint, then interest rates will stay low and the government will stay clear of a fiscal trap.

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Chart 7: Government debt as a % of GDP

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There is nothing wrong with smoothing out the economic cycle by running budget deficits, and in certain circumstances these deficits can be very large. But what matters is a government’s response and its willingness to properly manage the situation. When, after 2015, GCC governments began to introduce fiscal balance measures, they were signalling a clear and unambiguous intention to not let matters spiral out of control.

FISCAL CONTROLS AND NON-OIL ECONOMIC GROWTH Every country in the GCC has been faced with the same need to introduce extensive fiscal controls in order to address its deficits. However, in Charts 8 and 9, we focus attention on the UAE and Saudi Arabia, the two largest GCC economies. Chart 8 shows total government tax and fee revenue as a percentage of non-oil GDP each year from 2014 to 2018, Chart 9 total government spending as a percentage of non-oil GDP. (Note: in both Charts, the UAE line reflects the combined budgets of the Emirates of Abu Dhabi and Dubai.) What both charts clearly show is the concerted effort in both countries to close the deficit. The increase in the tax and fee take in Saudi Arabia from 8% to 15% of non-oil GDP is particularly noticeable, as is the reduction in spending as a percentage of non-oil GDP in both the UAE and Saudi Arabia. (Note: in Abu Dhabi, spending as a percentage of non-oil GDP fell from 80% to 59% over the same period). On average, across the GCC, the deficit in 2018 was -1% of GDP having been -12% of GDP in 2015/16.

Sources: Country national statistics, IMF, Peninsula Research estimates

Chart 9 also, however, shows something else; that both countries began a slight course-correction after the first wave of spending control; Saudi Arabia in 2017 and the UAE in 2018. Essentially, seeing the effect of fiscal policy on the domestic economy, both countries relaxed austerity measures. Neither country reversed course; instead it was appreciated that too much fiscal control could weaken domestic demand to the point where policies undermined growth and, thereby, efforts to lower the deficit as a percentage of GDP. This is the moment at which to re-connect to the larger point we are making in this briefing; specifically, that the primary source of slower non-oil economic growth in the GCC has been the need to implement fiscal controls, and the effects of increasing revenue and scaling back spending on domestic demand. Chart 10 shows how the non-oil economies of all the GCC countries have slowed, from an average growth rate of 6% in 2013 to 2% in 2018. This slowdown has coincided with attempts to raise revenue and cut spending as a percentage of GDP, which has had the unwanted side-effect of reducing domestic spending power.

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Chart 8: Government tax and fees revenue as a % of non-oil

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Chart 9: Government spending as a % of non-oil GDP, 2013 to 2018

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Sources: Country national statistics, IMF, Peninsula Research

REAL ESTATE PRICES AND A SLOW NON-OIL ECONOMY Over the very long term, an increasing population coupled with finite space will lead to rising land values. But over an economic cycle (or even over a 30 to 40-year period) prices can move up or down for other reasons, such as changing credit and banking policy, shifts in preferences to smaller household size, and the opening up of domestic markets to foreign investment. The UK, for instance, is often held up as an example of a country with a chronic lack of new housing supply. Yet, of the 38 years (out of the 44) from 1974 to 2018 during which UK average house prices have risen, the annual increase in dwellings has outstripped population growth in 32, or 81%, of them.8 Prices have been driven by a variety of demand factors such as buy-to-let and general ownership preferences, all enabled by a liberalized banking system. Non-oil economic growth rates in the GCC provide a window into patterns and trends in household income and spending, and business investment. Rising incomes correlate with rising affordability and therefore increased real estate demand; and business investment correlates with the demand for more commercial space. But, beyond that, in the GCC, where so much of the population is made up of expats, the workforce itself (and its requirement for dwellings) can vary dramatically year by year depending on the state of the economy. Unsurprisingly, in our research, we have identified a high correlation between non-oil GDP growth and population changes in the UAE – a finding which we discuss in detail in Part 2 of this briefing. Chart 11 below couldn’t be clearer: demonstrating a high correlation (r=0.8) between UAE real estate prices and non-oil GDP growth. This is the real picture of what has been happening in real estate markets in the region. The explanation has less to do with annual supply additions than commonly understood, and more, instead, to do with weak demand. After all, history has shown time and time again that a buoyant market can absorb huge quantities of new supply. Equally, history has shown that enthused demand can be no more than a willow-the-wisp: here today, gone tomorrow.

The UAE is, of course, entirely normal in this regard; data from the UK (Chart 12), shows a similar correlation (r=0.7) between GDP growth and real estate prices. As we will show time and time again in our research, Middle Eastern real estate markets are, not surprisingly, subject to the same fundamental forces as any other real estate markets when looked at through the right lens.

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Chart 10: Annual non-oil real GDP growth, 2013 to 2018

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Sources: Bank for International Settlements, UAE Federal and Competitive Statistics Authority, UK Office of National Statistics

Of course, we’re not claiming that new supply additions do not have an impact. Indeed, however highly correlated, differences in the performance of residential, retail and office assets over the cycle are likely highly related to relative differences in vacancy/occupancy rates. Moreover, our own econometric models indicate that the annual variability of the UAE’s real estate price index is better explained when we incorporate supply additions as an additional explanatory variable. Even so, the prime determinant of real estate prices in the recent cycle has been demand, evidenced by slowing non-oil GDP growth. Given the high elasticity of the expat population, it is hardly surprising that real estate prices have been on a downward trend. The key question for real estate investors, which will be considered in a future briefing, is where the GCC countries are in relation to their fiscal balance programs. Once we see revenue collection and government spending as a percentage of non-oil GDP flatten out, we expect to see green shoots in real estate markets.

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Chart 11: UAE Residential annual real estate prices and non-oil GDP growth

UAE Real Estate prices (left-hand scale) UAE real non-oil GDP growth (right-hand scale)

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ABOUT THE AUTHOR Dr Christopher Payne is Chief Economist at Peninsula Real Estate. Formerly, he was the chief economic advisor at the Dubai International Financial Centre; and head of research at the Kuwait Institute of Banking Studies. He has also worked at Bloomberg LP, JP Morgan and PriceWaterhouseCoopers (where he qualified as a Chartered Accountant). He has 25 years of experience covering developed and emerging markets, and holds a Bachelor’s degree from Cambridge University, England, and a Doctorate from the London School of Economics.

ABOUT PENINSULA REAL ESTATE Peninsula is an investment and research company that is identifying trends, opportunities and challenges in the MENA real estate market.

DISCLAIMER This report has been issued by Peninsula Real Estate Management Limited (“Peninsula”) for informational purposes only. It does not purport to be a complete analysis of the topics discussed, which are inherently unpredictable. It has been based on sources Peninsula believes to be reliable. Peninsula has not independently verified those sources and makes no guarantee, representation or warranty as to its accuracy or completeness. Peninsula accepts no responsibility or liability in respect thereof or for any reliance placed by any person on such information. All opinions and views expressed in the report reflect our judgment at this date and are subject to change without notice. Statements that are forward-looking involve known and unknown risks and uncertainties that may cause future realities to be materially different from those implied by such forward-looking statements. No investment or other business decisions should be made based on the views expressed in this report. This document may not be reproduced or circulated without the prior written consent of Peninsula.

Peninsula Real Estate Management Limited +971 2 671 1773 | [email protected] 8th Floor, Al Sila Tower, ADGM Square, Abu Dhabi, UAE

1 Eurostat Database, https://ec.europa.eu/eurostat/home? 2 Ibid. 3 International Monetary Fund, “Saudi Arabia Article IV Consultation Report”, 2017, 2018, 2019, https://www.imf.org/en/Countries/SAU 4 Ibid. 5 Trading Economics, Japan General Government Gross Debt to GDP, https://tradingeconomics.com/japan/government-debt-to-gdp 6 Japan Ministry of Finance, Interest Rate Weighted Average of General Bonds, https://www.mof.go.jp/english/jgbs/reference/Others/outstanding03.htm 7 Eurostat Database op. cit.; George Alogoskoufis, “Greece’s Sovereign Debt Crisis: Retrospect and Prospect, 2012”, p. 39, http://eprints.lse.ac.uk/42848/1/GreeSE%20No54.pdf 8 GOV.UK, Statistical data set, Table 102, https://www.gov.uk/government/statistical-data-sets/live-tables-on-dwelling-stock-including-vacants; UK Office of National Statistics, Great Britain population mid-year estimate, https://www.ons.gov.uk/peoplepopulationandcommunity/populationandmigration/populationestimates/timeseries/gbpop/pop


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