Ensuring a return in optimism is not misplaced

Recently, a colleague was approached by an employer of a large development company who jocularly stated that, since Dubai thrives on speculation, investors will follow the recommendations from companies like Phidar, so, we should write something positive. I often hear similar comments. A modest degree of speculation is acceptable, even healthy. However, the degree of speculation observed during past market booms does not constitute a thriving market. In reality, this level of speculation increased volatility and destabilised the market.

In response to our last report, I was asked, “What is market stability?” Since we reference this concept regularly, the question is fair.

Market stability is associated with less frequent and less volatile cycles. A stable market usually gives stakeholders access to accurate information that allows them to plan accordingly. In real estate, this equates to information on housing demand so the developers can create a supply pipeline that meets demand.

Positive net impact

During the last market crisis of 200811, investors would often comment on their personal losses incurred. My response was to question the net impact of all investment in Dubai property.

In most cases, as long as the investor entered the market before 2007, there was a positive net impact. (Of course, many did lose money, especially those that started investing during or after 2007, which often included working professionals.)

Seasoned real estate investors still made profits, even when valuing the portfolios at the trough rates of 2011, even accounting for the losses incurred from off-plan investment in properties that were never built or perpetually stalled. So, why should we avoid volatility?

Volatility is a common measure of risk. If investment risk is defined as the uncertainty of achieving expected returns, then higher volatility equals higher risk, which should require a higher return.

Simply put: high risk demands high returns. So, higher risk pushes up the required return (yield requirement), which pushes down real estate values. Risk reduces property values.

Sub-prime mortgage crisis

The risk-reward relationship seems obvious, in theory. In practice, investors often underestimate or are unaware of current risk, until it is too late. In mature markets, real estate is typically a lower risk, yielding asset with a long hold period. Occupier demand and new supply are driven by long term, macro socioeconomic trends. Except the sub-prime mortgage crisis, which incidentally illustrates the dangers of underestimating risk, real estate has been a boring asset class.

Compared to other investment options like stock markets and private equity, real estate investment risks should be much easier to assess and manage.

Employment

The challenge with a primarily expatriate labour market is that housing demand is tightly coupled with employment. If an expat is fired or made redundant, in most circumstances, he/ she must leave the country almost immediately.

This has a swift and direct impact on housing demand. Conversely, if the economy starts to boom, then job growth increases, and population can grow rapidly within a short time frame. Considering the supply pipeline usually requires at least two to three years to complete product and catch up with demand, this can lead to rapid rent inflation. Combine that demand function with a highly competitive development industry and the result is volatility. The structure of the labour market structure implies that some volatility is inherent, but it can be reduced. The solution is better information on the economy, capital flows, employment, population, house prices, and rents.

Of course, the information would need to be published in regular intervals and contain verifiable data. This is something we illustrated in our recent report — unsubstantiated optimism actually leads to worse crises.

Self-reinforcing cycle

Attempts to prop up or reignite a market with unsubstantiated positive signals can create bigger problems later. And the key word is: unsubstantiated. But substantiating claims and analysis requires good information.

Simply “thinking positive” is not a valid market strategy. In the short term, it can create a self-reinforcing cycle, but eventually it will harm a market.

Analysts and their reports should remain objective because it contributes to the long term health of the market. Optimism creates crises, but objectivity builds markets.

The writer is Managing Director of Phidar Advisory.