Dubai, unlike other sovereigns in the Gulf Cooperation Countries (GCC), is not an oil economy and has instead made its name as an international business hub in the region. As with most service-led economies, the real estate sector has become an important contributor--representing about 7% of nominal GDP, alongside construction activities also at about 7%--and a barometer of investor sentiment in Dubai. The real estate sector has proven to be volatile, subject to the indirect economic effects of swings in oil prices but also somewhat to geopolitical risk. The Dubai property market's long decline since a peak in second-half 2014 has prompted speculation about when it will reach bottom and begin to rebound. We expect property prices to stabilize by 2020, but do not see any meaningful recovery in 2021. Here, we outline our base case and stress scenarios for real estate prices and their potential ratings impact on different asset classes in Dubai.

We expect the Dubai residential real estate market to fare no better in 2019 than in 2018, in the base case scenario that S&P Global Ratings uses in its ratings analysis on entities in the emirate. Since their last peak in 2014, prices and rents have fallen 25%-33% in nominal terms (according to Asteco). S&P Global Ratings expects prices to fall by another 5%-10% in 2019, coming close to levels seen at the bottom of the last cycle in 2010 (see table 1). While we expect prices to largely stabilize in 2020, we don't see a meaningful recovery in 2021. Relative to the previous recovery cycle, we believe it will take longer time for prices to display a meaningful recovery.

Table 1

The recovery in real estate prices that started in 2012 was supported by a strong oil price (the Brent crude oil price hovered around $100 a barrel in 2011-2014), which supported economic activity in the region and spurred real estate investment. In addition, since 2009, global interest rates have been historically low, which supported demand for real estate as an asset class and benefited many global cities including Dubai. However, our latest base case is for Brent to remain flat at $55 in 2019 and 2020 (see "S&P Global Ratings Lowers Brent And WTI Oil Price Assumptions For 2019 Through 2020; Natural Gas Price Assumptions Are Unchanged," published on Jan. 3, 2019, on RatingsDirect). Furthermore, global interest rates are also relatively higher now, marking the end to accommodative monetary policies. Plus, we believe fewer ongoing developments will be stopped or delayed than in past downturns because the current downturn has been slower and more gradual, thanks to increased regulation of the sector that requires prefunding of construction and a relatively high presales for ongoing developments. We think this means it will take longer for the market to reach equilibrium, in other words, a slower and more gradual decline and subsequent recovery.

Despite significant additional supply to the market in 2019 and 2020 from existing projects, several factors should help to stabilize the real estate market next year:

• We see very few, if any, major new project launches in 2019 and 2020, as developers pull back supply in response to lower margins due to falling prices.
• Improved affordability following price falls and bargain hunting by bulk buyers.
• Resurgence of Asian, especially Chinese, investors' interest in Dubai residential real estate.
• Relaxed regulations about the foreign ownership of businesses located outside of free zones supporting demand.
• The UAE central bank's removal of the 20% cap on bank real estate lending as a percentage of total deposits, together with relatively low interest rates.
• Increased economic activity related to Dubai Expo 2020, which is expected to attract about 25 million visitors to the emirate.
• Relaxed visa rules, such as long-term residency visas for foreign investors who invest UAE dirham (AED) 5 million-10 million ($1.4 million-$2.8 million) in real estate projects.
• Reduction of government fees to 2.5% from 5% of the annual rent of commercial establishments.

Further Downside Possible If Developers Continue To Launch New Projects In 2019-2020

While not our base case scenario, a stress scenario could arise if supply isn't reigned in, especially if government and royal family-related developers (Emaar Properties PJSC, BBB-/Stable/--; Meraas; Dubai Properties; and Nakheel), with attractive land banks and economies of scale, continue to launch new development. In such a scenario, we think residential real estate prices could decline by 10%-15% in 2019 and a further 5-10% in 2020. In this case, we see no upside for Dubai residential real estate prices in 2021, as we expect it will take a while for the market to absorb oversupply. Developers' margins have declined significantly already over the past two years. Emaar Development Dubai's margins fell to 37% for the nine months ended Sept. 30, 2018, from 48% at year-end 2014; Damac Real Estate Development Ltd.'s (BB-/Stable/--) margins fell to 25% from 47% over the same period, reflecting the gradual price decline seen over the past three years.

Potential Impact On Corporate Ratings Under the Stress Case

A stress case could occur if developers launch new development at lower margins or on a speculative basis, with small deposits and long-term payment plans. This will increasingly put the development risk and the burden of funding on developers' balance sheets. If the real estate downturn turns out to be longer and deeper than we currently anticipate, ratings on property developers could lead to higher leverage and a risk of further downgrades.

We expect stand-alone creditworthiness for real estate investment companies such as MAF, DIFC, and Emaar Malls to remain more sheltered from the downturn than the developers due to their more stable rental models, together with very high asset quality.

Government-related entities

In our view, credit conditions in Dubai deteriorated in 2018, reducing the government's ability to provide extraordinary financial support to its government-related entities (GREs) if needed (see "Government Companies DEWA And DIFCI Downgraded On Weakened Economy In Dubai," published on Sept. 4, 2018). The negative outlook on Dubai Electricity and Water Authority (DEWA; BBB/Negative/--) partly reflects our concern that a real estate downturn beyond our base case could put increased pressure on government finances. About 70% of Dubai government revenues are from nontax sources, with part coming from land transfer and mortgage registration fees, housing and municipality fees, alongside immigration and visa, as well as tourism, aviation, and automobile registration fees. The Dubai government also receives real estate-related income in the form of dividends from the key developers it controls such as Emaar Properties PJSC (BBB-/Stable/--) and Nakheel. Our stress scenario assumes that demand for real estate could remain weaker for a longer period, dampening economic activity in the emirate. Under the base case, we expect real economic growth in Dubai of 3.5% in 2019, compared with our estimate of 3.2% in 2018.

Banks

In our view, risks related to the real estate sectors in our base case scenario are well reflected in the ratings on banks in Dubai. They assume that banks' exposure to the sector doesn't increase significantly following the recent end to the 20% cap on real estate exposures by the central bank.

We estimate banks' exposure to real estate developments at about 20% of total loans on Sept. 30, 2018, at AED305 billion. Our data include both exposure to construction (about 25% of the exposures) and the real estate sector (about 75% of the exposures). Taking the opportunity of the transition to IFRS 9, we believe that banks have recognized some potential asset quality issues. Moreover, although real estate developers' operating margins have dropped, we understand that they are relatively hefty, giving them some leeway to withstand the drop in prices. If the correction in real estate prices accelerates beyond our base case, some developers might start experiencing repayment difficulties, which could ultimately weigh on banks' cost of risk.

The market is still dominated by cash buyers. Reportedly, mortgages finance about only 20% of transactions. The Central Bank of the UAE doesn't disclose the exact amount of banks' mortgage lending exposures. We estimate banks' total stock of mortgage loans was AED99 billion on Sept. 30, 2018, assuming it represents around 30% of total retail lending. We view positively regulations, enforced in 2013, which cap the loan-to-value ratio for first-time buyers at 75% for foreigners and 80% for nationals for transactions below AED5 million. The cap is lower for second-time buyers or if the property value is higher than AED5 million. For off-plan sales, the cap is set at 50%, although we understand that they represent a small share of the overall mortgage book. Banks usually ask for additional financial guarantees on mortgages to prevent clients from willingly defaulting on their mortgage in case of volatility in real estate prices. As such, they expose themselves to the risks of unemployment rather than asset value depreciation. This risk is very minimal for nationals working for the public sector. For foreigners, in case of default, banks generally try to have a recourse to their savings and end-of-service benefits, in addition to seizing and liquidating the property, which can be a lengthy process. While given current market conditions, we think that risks are well reflected in our ratings. If real estate prices decline more than we currently expect or if job losses increase significantly, pressure on the ratings might emerge as banks' asset quality deteriorates beyond our current expectations and their cost of risk increases.

Banks in the UAE tend to generally display a good level of profitability and capitalization, giving them a good margin to absorb a moderate increase in risks. The average Tier 1 capital ratio for rated UAE-based banks stood at about 16% and their average return on assets was 1.6% at year-end 2018.

Chart 1

Chart 2

Insurers

At year-end 2017, the 62 insurance companies operating in the UAE had total exposure to the UAE real estate sector of about AED5.1 billion, representing on average about 8%-9% of their total invested assets. However, the 30 national UAE insurers, holding about 60% of total assets in the industry, had, with on average about 17% of their invested assets, a significantly larger exposure to the real estate sector in 2017 than branches of foreign insurers operating in the UAE. This means that national companies are much more sensitive to price declines in the real estate sector.

While most UAE insurers are still very well capitalized, we believe that further anticipated declines in real estate prices, in combination with more volatile returns from equity investments, ongoing highly competitive market conditions, and tougher regulations may weigh on the credit quality of some companies in the market over the next 12-24 months. This applies particularly to insurers with significant exposure to real estate investments. In order to mitigate declines in land prices, a smaller number of insurers have decided to develop real estate in hope of achieving a better investment return. This will not only deliver even more units to the market, but also in some cases will constrain the credit quality of these insurers due to their significant exposure to illiquid real estate assets.

Corporates: Developers will continue to experience margin erosion

The declines in real estate prices over the last several years as well as our expectation of further weakening in 2019 led to higher leverage and exhausted or reduced the financial cushion Dubai real estate developers previously had. We recently lowered the long-term issuer credit rating on Damac Real Estate Development Ltd. to 'BB-' from 'BB', reflecting our expectation of weakening credit metrics over the next two years as the Dubai residential price decline lowers presales, operating margins and profitability (See "Dubai-Based Damac Real Estate Development Downgraded To 'BB-' On Weak Market Prospects; Outlook Stable," Feb. 18, 2019).

On June 27, 2018, we revised to negative the outlook on the 'BB+' rating on Dubai Investments Park Development Company LLC on the back of increased leverage on its parent Dubai Investments (DI). This was a culmination of a purchase of a stake in Emicool and weak real estate markets, which not only hurt DI's development business but also its building materials and contracting businesses. DI was unable to presell real estate developments under construction as expected (see "Dubai Investments Park Development Company Affirmed At 'BB+'; Outlook Revised To Negative On Weakening Parent Financials," published on June 27, 2018, and "Dubai Investments Park Development Company 'BB+' Rating Affirmed On Expected Leverage Decline; Outlook Remains Negative," Dec. 24, 2018).

Our ratings, especially on developers, generally factor in the significant market-derived volatility in Dubai. In addition, market regulation introduced since the last downturn in 2009-2011 and the developer's relative success and discipline in terms of presale policy and payment terms have helped cushion the impact of market conditions and helped them maintain their ratings in 2015-2018. However, oversupply and intensified competition means all players are now forced to offer generous payment plans, including payments of up to eight years after handover. Margins are decreasing on the back of the drop in prices and incentives offered, and S&P Global Ratings expects them to drop further in 2019 and 2020. As a result, buffers built into our ratings metrics have diminished (see chart 3). Importantly, we see the risk of continued margin erosion over the next one to two years, in line with price declines. Emaar Properties, the only Dubai-based developer not to have been subject to a negative rating action during the current cycle, benefits from significant EBITDA contribution from its portfolio of high-quality rental assets that provide relative cash flow stability and mitigates development risk. We expect new unit sales and new project launches to drop further in 2019, particularly for private developers with lower margins than the government-sponsored developers (see chart 4).

Chart 3

Chart 4

Under our base case, we expect the ratings on Dubai real estate investment companies (that generate rental income) to remain resilient. These companies came into the current market slowdown with significant rating buffers including competitive advantages like desirable locations, very high asset quality, supportive lease structures, brand reputation, prudent cost structures, and strong balance sheets. We are now seeing softening rental prices, but all of our rated real estate companies, Majid Al Futtaim Holding LLC (BBB/Stable/A-2), DIFC Investments LLC (BBB-/Stable/--), Emaar Malls PJSC (BBB-/Stable/--), and Dubai Investments Park Development Company LLC (BB+/Negative/--) have secured lease structures with long-lease tenures and more than 90% occupancy across portfolios.

Trends In Real Estate Market Segments

Residential

We expect residential real estate prices in Dubai to continue falling this year as they have in 2018. Prices dropped 8%-9% in 2018, according to JLL and about 10%-13% according to Asteco. Residential prices have declined gradually since peaking in second-half 2014, in tandem with lower oil prices, but the trend did not reverse when oil prices recovered and stabilized in 2018, perhaps due to supply and demand imbalances or due to heightened geopolitical risk. The number of units under construction has surged in the last two years, with developers offering aggressive sales incentives, such as payments of up to eight years after handover, registration fee waivers, and service charge discounts. This means a significant amount of new stock will come to market in the next two to three years, constraining a recovery in property and rental prices.

The city's property developers delivered 23,000 units in 2018, up 35% from 17,000 in 2017, according to JLL. The overall supply of residential units grew by about 5% (see chart 5). JLL estimates 62,000 units are expected to be delivered in 2019, although historical realization rates have been less than 50% of their initial estimates. If 31,000 units are delivered in 2019, residential supply will grow by about 6%, broadly in line with population growth data from the Dubai Statistics Center. However, we believe that the population is evolving toward lower-income residents who are less inclined and able to buy a home. Negative trends in mobile subscriber numbers and port throughput also point to a potential weakening in residential property demand. About 75% of real estate transactions in Dubai (excluding land transactions) are conducted in cash, suggesting higher contributions from high-net-worth individuals, with about 20% financed through mortgages and 5% "others," according to the Dubai Land Department.

Chart 5

Commercial real estate

The office market continues to struggle, despite low additions to supply, due to structural changes in the segment. We don't believe that office rents have bottomed out yet. While the new supply coming to the market is reportedly is limited, the emerging popularity of coworking spaces is acting as a disruptor for those offering traditional office space. Vacancy rates have increased to 11% in 2018 from 8% in 2017, while average rents fell about 17%, according to JLL. We expect rental declines to continue in 2019, though less intensely. The easing of licensing regulations to allow for dual licensing, which is now a possibility in Dubai and Abu Dhabi, may lead certain businesses to consolidate office space to save rent. However, such measures increase the attractiveness of the UAE to international businesses and may lead to higher foreign investments in the long term.

Hotels

Oversupply continues to trouble the Dubai hotel industry, although 2020 brings some hope for recovery due to the Expo. We expect to see lower average daily rates (ADRs) as supply continues to increase faster than demand. JLL estimates that 24,600 new hotel rooms will come onto the market until 2020. Increased competition and a squeeze on profitability are likely to keep the hotel sector under wraps in 2019. Assuming visitor traffic due to the Expo reaches the target of 25 million, hotels are expected to have a good year in 2020.

Retail

We also expect to see the Dubai retail real estate sector feel the squeeze due to a sluggish economy, which doesn't encourage spending; growth in online shopping, and more cost-sensitive tourists. The growth of e-commerce poses a threat to brick-and-mortar retail, something the major players (Emaar Malls and MAF) are addressing by establishing their own presence in this field by investing in e-commerce portals or last-mile services integrating the two business models. We expect occupancy and rentals to deteriorate, especially because gross leasable area of about 1.3 million square meters is to be delivered through 2020, according to JLL. Increased tourist arrivals and economic activity on the back of the Expo is expected to ease the pressures temporarily in 2020.

Related Research

S&P Global Ratings research

• Dubai-Based Damac Real Estate Development Downgraded To 'BB-' On Weak Market Prospects; Outlook Stable, Feb. 18, 2019
• Dubai Investments Park Development Company Affirmed At 'BB+'; Outlook Revised To Negative On Weakening Parent Financials," June 27, 2018
• Dubai Investments Park Development Company 'BB+' Rating Affirmed On Expected Leverage Decline; Outlook Remains Negative, Dec. 24, 2018
• Government Companies DEWA And DIFCI Downgraded On Weakened Economy In Dubai, Sept. 4, 2018
• S&P Global Ratings Lowers Brent And WTI Oil Price Assumptions For 2019 Through 2020; Natural Gas Price Assumptions Are Unchanged, Jan. 3, 2019

Other research

• Property Review: UAE Real Estate Report Q4 2018, Asteco
• The UAE Real Estate Market: A Year in Review 2018, JLL