The Gulf's property problems will take years to fix - but bold -investors with reliable local partners are unwilling to wait, finds Shayla Walmsley

Dubai's approach to property - which is summarised by Jones Lang Lasalle as ‘build it and they'll come' - looks a little less convincing than it once did. Dubai had been the regional outrider. Now it looks more like a regional example of hubris.

The problem is oversupply. In regional terms, it is most acute in Dubai, where Moody's forecasts a contraction of up to 50% across all segments. But the most recent Moody's report on the Gulf property market added negative factors such as tightened funding across the Gulf Cooperation Council (GCC) states - the result of bank over-exposure to real estate debt - and a trend towards cash preservation.

Compared with office, which is suffering across the GCC, the performance of residential is variable. Last September, the Bahraini government announced that it would spend $1.3bn (€0.93bn) over two years to plug a long-term undersupply of subsidised housing. But when the 23,000 apartments come on stream in that market in 2012, rental prices will be driven down.

Unsurprisingly, the fall in residential prices has affected the United Arab Emirates (UAE) the worst - residential prices in Dubai have fallen 60% from their peak in 2008.

Yet there are opportunities for overseas investors in the regional residential market. Take the joint-venture agreement signed last year between Pramerica and state-owned Mubadala for a regional real estate unit whose first project will be worker housing in Abu Dhabi. Demographics are driving the project: the emirate expects to double its resident population to 3m within two decades.

"It's a major difference, bringing institutional quality product to the region," says Pramerica Real Estate Investors (PREI) managing director Mark Chamieh. "It will look like a local joint venture with global quality assets. As in other emerging markets, the investment opportunities are linked to a growing middle class with strong consumption.

"Housing in Abu Dhabi is aimed at wealthy locals and expats with significant disposable incomes. At the same time, the government has a grand vision of economic diversification and it needs workers who are not to be found in the local population. Hence the rationale for key-worker housing. There are a lot of high-end apartments but little housing to take care of plant workers, nurses, and hotel workers. There are huge opportunities there."

Even so, local variations add up to regional pessimism on residential. Moody's analyst -Martin Kohlhase points out that there is already a GCC-wide overhang, with more coming onto the market against low expected population growth rates - possibly even low single-digit growth rates - for the foreseeable future.

"The overhang is unlikely to clear soon," he says. "That means there will be relatively depressed prices in the short term."

Indeed, the supply keeps coming. Residential aimed at wealthy GCC tourists in al Ain, for example - all 1,222 units of it - is targeted for a forecast increase in demand towards 2015 driven by the tourism sector, according to local property firm Asteco.

In fact, the tourism sector is the one area where investors do not necessarily fear to tread. Accor, a French hotel group, will open five Ibis hotels, including three in Bahrain, Saudi Arabia and Syria, by 2014 to make a total of 54 across the region. Four of them will open in 2012.

Yet even this sector is not without its supply-created problems. The state-owned developer Nakheel - Dubai's largest - recently announced that it was scrapping plans to build the Trump hotel and tower on the Palm Jumeirah following restructuring and a government bailout. It will build a shopping centre instead.

Not all suffering is equal
Despite the pall settling on the regional property market, there are arguably bright spots. Moody's maintains a negative outlook on the GCC property market overall because of similar features in Doha, Abu Dhabi and Bahrain. Yet the Saudi and Kuwaiti property markets "look slightly more positive".

Saudi Arabia also has a relatively young population large enough to cope with an under-supplied residential market, especially in large cities. Despite a secondary price correction, prime prices have held in cities such as Riyadh, Mecca and Jeddah.

According to a recent note from DTZ, Qatar will stabilise across asset classes. A slight increase in demand has been driven by economic fundamentals, with double-digit GDP growth across 2010. As GCC states go, Qatar came out of the economic crisis relatively unscathed. Yet demand for office in 2010 was low, despite 63% of registered demand coming from government and public sector bodies, holding down vacancy rates.

"From a regional perspective, Dubai is more advanced - as a market, it's a few years ahead of Qatar, so it suffered more in the economic downturn and has more supply in the market," says Mark Proudley, associate director for Qatar at DTZ. "Qatar hasn't had the same levels of oversupply and speculation from outside the region that Dubai had. Investors in the Qatari market tend to be long-term investors."

Regionally speaking, where there is infrastructure, there is hope. "Infrastructure spending by GCC governments has been maintained through the financial crisis," says Kohlhase. "Governments have accumulated sufficient rainy weather funds in times of high oil prices, which allows them to spend."

In Qatar, you could point to the knock-on effects of public expenditure on major infrastructure projects, such as the new Doha International Airport. The Saudi government will commit $400bn (€290bn) to infrastructure over five years.

Market maturity
Across the Gulf states a two-tier property market is emerging. Proudley also notes greater differential pricing as rates fall in secondary. "There is greater bandwidth between good-quality and poor-quality assets in Qatar - and in Dubai even more so," he says. "The market is developing and maturing." In short, falling rental is shifting the balance of power towards tenants, who are opting for prime whereas once they would have settled on secondary.

Demand in Dubai remains strong for good-quality space in single-ownership developments, such as the Central Business District (finance) and TECOM (oil and gas). Otherwise, Dubai office rents dropped by 50% during Q4 2010, with vacancy rates at 41% and forecast to reach 45% over the next year, according to JLL. The report forecasts the completion of an additional 12m ft2 of commercial space in the same period.

For the remaining overhang, JLL urges government intervention towards "demolition or adaptive reuse". Given that occupation has increased by 70% since 2008, but office stock has increased by 140%, that could mean a lot of demolition.

The problem is, there is no distress in the region. As a result of the boom, most property in Abu Dhabi was high end, says Chamieh. "Now some of it is being repositioned. We're looking both at repositioned and at new product — but the majority will be new developments rather than repositioned assets. Because there is such wealth in Abu Dhabi, land prices don't react a great deal to corrections. People don't need to sell: they just hold on to assets in the belief that the market will come back."

In Dubai, it is a question of waiting for the overhang to clear. Given that is unlikely, the outlook from Moody's is, unsurprisingly, negative until the end of 2011 - for the GCC in broad terms, and Dubai in particular. "We don't believe underlying growth will be sufficient to create demand," says Kohlhase.

Mike Atwell, head of Cushman & Wakefield's Middle East operations, likewise does not expect a recovery within the next two or three years, at least for office. "It is a slower recovery, a stabilising recovery. There is no expectation that the economy will take off suddenly in the next two or three years."

DTZ believes that in Qatar demand, not supply, will drive future development. One could extrapolate this across the region, with a greater focus on identifying target markets, and delivering products with credible quality and pricing. "We are beginning to see that more landlords adapt to these changing market conditions by adjusting prices to meet market demand in order to achieve and maintain high levels of occupancy," according to the Asteco report.

Write the rulebook
Another longer-term trend - interrupted by economic crisis - has been towards making the market more transparent. Dubai has made legislative progress towards increasing transparency in the property market in a bid to attract institutional investment. Yet despite a recognition that transparency needs to happen, the region still has some way to go.

"With Dubai, there's an element of inertia," says JLL research director Jeremy Kelly. "It showed a strong improvement in terms of developing a framework to improve transparency. But it's taking a while for market practice to change - for the practice to catch up with the regulation."

As examples, he cites Dubai and Abu Dhabi as serious about improving transparency but a note of reality has come into it. Over the past 18 months or two years, the emphasis has been on survival. The long-term trend is towards transparency but it has arrested over the past two years.

Lack of clarity on legal title to property in Abu Dhabi will likely continue to stifle demand to some extent. Where there have been legislative improvements, they have tended to focus on developers and the development sector. Investor protection rules introduced in Dubai last year, for example, were aimed at developers selling off-plan developments on sites they did not own, requiring them to secure 20% of funding in advance. A separate requirement linked investor payments to construction phases, which in practice is designed to ensure that investors would be protected from developers shunting additional risk onto them.

Among largely cosmetic measures, there have been significant legislative developments. The Real Estate Regulatory Agency (RERA) recently introduced guidelines on Dubai's Strata law, which covers jointly owned assets. According to RERA, the guidelines are designed "immediately to transform the nature of ownership of a major slice of Dubai's total property stock" and to "strengthen, extend, and clarify the rights of owners".

Still, investors stay clear
In the meantime, will institutional investors come to the rescue without a comprehensive framework? Hardly. Until even they pulled out of the market, cash buyers accounted for 80% of Dubai transactions - a significant fall in rental values (with little chance of stable cash flow) adds little to the market's institutional appeal.

Meanwhile, the GCC's cash-rich institutional investors, notably sovereign wealth funds, are looking towards the west to asset sub-classes with current traction among European pension funds.

London-based Gatehouse bank last year made its first acquisition on behalf of GCC investors - two UK student accommodation properties worth £29.2m (€32.9m). It is not an overwhelmingly exclusive category, of course: Pramerica's recent transaction in Abu Dhabi is a joint venture with Mubadala, a subsidiary of the sovereign wealth fund. "There's more interest from capital wanting to stay in the region as Middle East markets mature," says Chamieh. But Mubadala is also investing in Taiwan and Russia.

According to Atwell, institutional investors are looking for long leases, with high-quality tenants. "They're looking for security of income in high-quality assets, and that is difficult to find," he says. "In Europe, five-year leases might be the norm; in Dubai, you're looking at one-, two- or three-year leases."

In the meantime there is an outside chance of political upheaval. In the past, whenever the oil price fell below $50 a barrel, an overly exuberant analyst was likely to forecast the imminent demise of one or other of the Gulf potentates. Now they are talking about political contagion from North Africa. Although the Egyptian capital Cairo is more likely than revolution to fly towards the Gulf, Banque Saudi Fransi pointed out in a recent note that Egyptian unrest created indirect exposure to negative investor sentiment, with foreign investors liquidating regional positions.

Otherwise, the problem for institutional investors is that this is an emerging market with associated regulatory risks offering, according to Moody's, single-digit returns against expectations of above 10%. In other words, prices would have to fall further or the economic recovery would have to be more pronounced to restore the demand-supply balance and provide attractive returns to institutional investors.