The trouble with bubbles

After the collapse of one of the most spectacular – and foolish – property booms in history, Perhaps the panic wave that hit the world’s stock markets, and the nervousness over whether it might be repeated in China, was not the most appropriate response

Nathan North, Mladen Petrov

What does a real estate bubble look like? It’s hard to say. Alan Greenspan, the former chairman of the Federal Reserve, for example, believes one can see them only in retrospect. Looking back to autumn 2007, when the first signs of the credit crunch appeared, it is remarkable how almost every analyst and politician at the time reassured us that it wouldn’t significantly affect the US economy. When it later became clear that this wasn’t the case, the mantra was then amended to: “This should only affect the US and other Anglo-Saxon markets.” And when this also turned out to be wishful thinking, many people in this part of the world then claimed that this was just a “US and Western European” problem and that the CEE region would be insulated from it. In hindsight, it is easy to laugh grimly at such a misreading of what became a very global crisis. But despite the apparent lessons to be learned from speculative booms, they have not been enough to prevent another major property bubble forming and bursting – this time in Dubai. Furthermore, some prophets of doom are now warning that the same thing could occur with China’s burgeoning real estate market.

Nevertheless, it may be worthwhile examining these cases, not just so that we can understand what might have happened or could happen, or to brace ourselves for similar calamities in our region, but because there may in fact be some positive fallout for the CEE markets – or so Holger Schmidtmayr, CEO of Austrian property developer and investor Sparkassen conjectured on a rival website to ours recently. He predicted that Middle Eastern investors, having had their fingers burnt in Dubai, might now start to look elsewhere to put their money – somewhere more stable, based on a real economy and with good returns. And the CEE region would seem to fit the bill perfectly.

The biggest and the silliest

Late last November, the emirate’s largest developer, Dubai World, suspended the repayment of USD 35 bln of debts for six months. The announcement led to stock markets plunging across the world and to fears that the recession would be ‘double-dipped’. Real estate prices had already fallen due to the global downturn by around 50 pct in 2009 up to that point, but now analysts  at UBS are estimating that the depreciation will be as much as 75 pct. The Burj Khalifa, at 818m the tallest building in the world, as well as a plethora of other spectacular projects, including the World Islands (artificial archipelagos in the shape of palms and a map of the world), will be left behind as reminders of one of the most impressive and ridiculous property booms the world has ever seen.

So how did this all happen? Michael Atwell, Cushman & Wakefield’s head of Middle East Operations and based in Dubai, explains : “There was a substantial amount of development in Dubai leading up to the bursting of the bubble, especially in offices and the residential sector. This was fuelled by rising prices, as large international investors sought to buy projects from developers – often off-plan. However, the question had to be asked: who was actually going to occupy these buildings?”

Buying for selling

The problem in a nut-shell was that there was a huge supply of new real estate, but a lack of end-users. One common misconception about Dubai that seemed to help fuel this boom was that the country’s economy was based on oil money – but this is to confuse the emirate with other, genuinely oil-rich Gulf states. Last year, revenues from oil and gas accounted for less than 6 pct of Dubai’s economy. In fact, it wasn’t oil that was driving the Dubai economy at all, but debt, with a number of large international and local banks happily providing the credit. Properties were being bought purely for trading, rather than with eventual tenants or residents in mind; and when the global recession came along, the whole process unravelled.

Jeroen van der Toolen, the managing director of developer Ghelamco Poland, from his own experience of the state, describes the situation: “When you are driving in Dubai in the evening, you won’t see any lights on in all the apartment blocks. This is a market with no end-users. It is not a place with a population of millions – all the people flying in are visitors – it has no normal economy. Companies and ex-pats have moved to Dubai just to be part of the real estate boom, but when it was over there was no longer any reason for many experts to live there. If there is no end-user, you don’t have a proper basis for business.”

Nothing to do with us

Could the bursting of the Dubai bubble have any consequences for the CEE real estate market? Well, we are unlikely to see a repeat of these events in our part of the world, where the property and financial markets are much more mature and transparent, and based on real economies with substantial populations of end-users. As Michael Atwell explains: “Historically, the CEE region has developed over a longer period and matured gradually over the last 10-15 years. It is also much more transparent than the UAE, and it is a very well-planned market. This is simply not the case in Dubai, and so there should be no direct comparison.”

Middle Eastern investors are already present in the CEE region as shareholders of a number of companies. An anonymous source we spoke to told us that his Arab-owned company has been engaged for some time in buying up small shopping centres in towns across the west of Poland. But are we likely to experience a new wave of Middle Eastern investors, for example, sovereign wealth funds who have turned their backs on Dubai? According to Jeroen van der Toolen, there is little chance of this: “Wealth funds invest wherever there are opportunities, but recently returns from the real estate market in the CEE region have not been good enough, so almost nothing was invested there by the funds. Instead, they preferred Dubai and other Middle East and African countries. They tend to buy US government bonds, companies – such as in the car industry – and shares, which at the moment are offering better returns than the 6-7 pct yields on real estate in CEE countries. There is a Middle Eastern presence here, but it is very small. The people we have met are more interested in co-developing, and not so much in buying the end project.”

Michael Atwell of Cushman & Wakefield is in agreement with this analysis: “It is unlikely that they will be directing their attention towards a particular region such as the CEE, where, for example, there are still massive differences between the sectors and the cities. The funds are likely to act on a case-by-case basis. They are not as opportunistic as they have been and so are not looking for high-risk investments.” However, he goes on to add that: “The CEE region may offer some excellent opportunities for Middle Eastern investors – it is high quality product, secure rents at market sustainable levels, quality covenants and attractive yields that these investors are seeking.”

What about the international banks that have been exposed to the Dubai bubble – couldn’t these provide another new source of investment in CEE property? “In the longer term, maybe the bubble will have a positive effect in the CEE region and other markets, because they have seen that the Middle East isn’t a safe investment. So it’s possible that they might buy into investment companies and funds in our region,” – is Jeroen van der Toolen’s lukewarm assessment of the prospects for this happening. “I can’t see any new sources of investment this year making a significant impact. The main ones won’t change. Allianz, for example, has decided to allocate EUR 3 bln for real estate investment. It’s not that there is no money coming from China or the Middle East, but it is simply insignificant. Maybe in two years Chinese money will finally start coming this way,” he concludes.

Further east

Which brings us to the situation in China. Are we also faced with the chilling prospect of a real estate bubble forming in the world’s most populous nation? What would be the implications for the world economy if China, the key engine of global growth, turns out to be the next Dubai?

While economists and real estate analysts argue about the existence of a bubble on the Chinese residential market, the signs are all there: rapid economic growth, increasing incomes, ongoing migration to the largest cities and easy access to credit. Property prices in the key cities such as Beijing and Shanghai kept on rising in 2009, which comes as no surprise. Firmly believing that property prices would continue rising steadily, the Chinese, or at least those who can afford it, are now on the market, looking to buy more flats.According to a study by Goldman Sachs, residential prices in Shanghai and Beijing have respectively grown by 30 and 80 pct in recent years. Nevertheless, according to the government, home prices nationwide rose 5.7 pct in 2009.

The impressive pace of development and the rapidly changing skylines of China’s major cities is the logical result of easy access to credit. In 2009 alone, development companies borrowed USD 1.4 tln. This comes at a certain price. According to data provided by CB Richard Ellis, in Q3 2009 the vacancy rate in Beijing stood at 22.4 pct. This is expected to grow as new buildings enter the market. In 2010, a total of 1.2 mln sqm of offices could be completed, increasing the total stock of office space in the capital to almost 10.5 mln sqm. Despite the fact that the vacancy rate in the CBD of the capital reached 35 pct in 2009, the city council is still planning to enlarge this zone of the city by adding new buildings. Financial Street Holding, a development company whose majority stake owner is the city of Beijing, is this year to start construction work on office projects that will bring an additional 1 mln sqm of space to the market.

Smelling the overheated coffee

The Chinese government is already putting the brakes on. In December the government announced that it is to use taxes and interest rates to stabilize the property market and thus prevent any eventual bubble. Meanwhile, according to various media reports, state-owned banks have been instructed to severely curtail their lending or even refrain from it altogether. The goal is clear: to prevent the Chinese economy from overheating. “One of the main problem areas is the booming real estate market,” writes UniCredit Bank in its analysis of the Chinese market. “Housing prices in some cities are rising too fast, which deserves the close attention of the central government,” Chinese prime minister Wen Jiabao has stated. Since the beginning of 2010, the People’s Bank of China has already raised interest rates on short-dated central bank bills twice.

A tale of two Chinas

“It’s about time,” comments John Stinson, DTZ’s regional director for sales and investments in the Asian Pacific capital markets. “There is a lot of panic and bad press about China today, but the strong fundamentals of the economy are still there. The demand is there too. The government wants to keep housing affordable for its citizens; and last, but not least, there is still room for growth. There are two Chinas, really: the developed coastal cities and the inland. The government now wants to make the rest of the country a success story too.”

Arthur Kroeber, Beijing-based analysts quoted by ‘The Washington Post’, insist that China’s economy is “not even close” to being a bubble. “At some point the music will stop,” Mr Kroeber remarks, adding that this is unlikely happen for at least 15 years, when the urbanization process is expected to slow down.

What does preventing overheating mean in terms of GDP growth? In Q4 2009, the Chinese economy expanded by 10.7 pct – the strongest growth since the end of 2007. While the government’s goal of always having two digit GDP growth is now being adjusted to the current conditions, GDP growth will still remain somewhere around 8-10 pct.

The figures also show that China, unlike the US, is still some distance from entering a banking crisis. Admittedly, the total credit for the property sector in China has reached 40 pct of the country’s GDP product; but in 2007 the same figure was 80 pct in the US. At the same time, Chinese banks have much smaller exposure to real estate, which represents 20 pct of their assets, while buyers are burdened with less debt than homeowners abroad. The value of mortgages issued in the period 2002-2008 totalled 40 pct of the value of housing sold across the country.

One of the recent changes in legislation, however, also raises the question of what might happen to the Chinese real estate market and the global implications of a potential, but still rather theoretical, collapse in the property market. Since October 1st 2009, domestic insurance companies, the largest industry in China, have been able to invest directly in Chinese real estate. Conservatively estimating that 5 pct of the total assets will be invested in direct property, DTZ predicts than an additional USD 28 bln will be channelled into the real estate investment market in the course of the next three to five years. By comparison, between 2001 and 2008, USD 27.5 bln was invested in Chinese real estate. By 2020, the insurance companies are expected to emerge as the dominant force in the Chinese real estate investment market with a combined property of USD 131 bln, DTZ predicts.

When East meets West

“Inevitably, this amount of money available to spend will affect property prices in China, but one should remember that initially insurers are likely to adopt a risk-averse strategy, investing mainly in prime locations in China’s three largest cities,” argues DTZ’s John Stinson. Since, due to some shortages in the supply of prime products, not every investor is likely to find the property they are looking for (preferably portfolios of properties rather than individual opportunities) in China. Therefore, increased investment into Western and Eastern Europe, as growth plateaus out in gateway Asia cities, is likely to take place. This is the good news for Europe and the CEE region. The investors – sovereign wealth funds, government linked companies, funds  – are already seeking out such opportunities. “There is a total focus on Europe and the UK,” confirms John Stinson. ν