Given soaring prices for ultra-luxury real estate in Dubai, it’s no surprise that listings have accelerated, although we know from experience that most of these deals tend to take place off-market. The fact that listings in this space have more than doubled (against the backdrop of a historically strong dollar) triggers a reality check as interest rates rise. Despite the inelasticity of this sector to interest rates, the obvious problem remains supply and demand.
According to Adam Smith’s theory, the price of a good (or asset) was given by the number of inputs (land, labor, financing costs and materials) needed to produce it. When land, the critical factor here, is available in large quantities, the price should be relatively affordable. However, as the economic theory of real estate evolved, participants needed to consider the time required for construction, as well as the quality of the existing stock available.
Over the past decade, another critical variable has been the amount of money made available at low rates and the resulting margins that accumulate when such developments are built. The global housing market crash of 2008 and the subsequent recovery in asset prices was the reason interest rates were set at zero, implying that the process of making these assets took place in a environment where the opportunity cost of investment was low.
A year for luxury
This has led to a growing concentration of manufactured and purchased assets at the higher end of the spectrum. In 2021, ultra-luxury real estate sales accounted for the highest percentage of global home sales since this data was tracked in 1969. Not surprisingly, but looking at market trends, we see that when interest rates and inflation begin to bite into “real earnings,” the price of existing stocks begins to decline, as investors begin to reallocate to higher income investments.
We have already started to see this in Dubai and the United Arab Emirates, where mega IPOs have attracted record subscriptions. Basically, given historical and current monetary policy, the prices of certain segments of real estate have become more correlated to the money supply rather than to the “replacement value theory”, which is the only reference which anchors prices in the medium and long term. If one imagines that institutional developers are building luxury housing using cheap finance, the obvious imperative is the expected profit margins rather than the resulting rental yields, the latter being far too low in this sector, to begin with.
With interest rates and input costs rising, such moves are beginning to look riskier, with the margin of safety beginning to evaporate. On the pricing side, as the supply of existing and near-ready units grows, buyers find themselves with an increasing array of choices, negating any “judgment rush” effect that has dominated the landscape over the past the last year. Similar to a candle lit on both sides, the only conclusion to expect is that prices will begin to decline and correct (a phenomenon that is already in its infancy),
Note that the story is not about the oversupply, but rather about the prospects for easy funding coming to an end. This heralds a paradigm shift towards more income-generating assets, something investors are forced to contend with for the first time in over a decade and a half. The need for opulence and wide open spaces will always be a factor as the wealth effect begins to build. Moreover, as Dubai continues its march towards a global destination, luxury real estate is unlikely to go through a contraction price cycle that was evident in 2008-10.
Family offices and institutional investors are increasingly likely to bring a sense of balance by building and holding assets that offer income-generating opportunities with a significant margin of safety given inflationary headwinds. and interest rates. This reallocation of capital heralds new opportunities for new owners as well as passive investors in other segments of the real estate industry.