The UAE market may see a possible rebound in the fourth quarter of 2009 but it is dependent on the banking sector opening for business, according to a new report.

"We have a fundamentally bearish view on the direct real estate market, but an absolute potential upside in real estate stocks. Our view remains unchanged. This is a trading sector, with the market range bound over the next two quarters. There is the possibility of a rebound in the fourth quarter of 2009, but this is dependent on the moribund banking sector opening for business," Chet Riley, Equity Research, Middle East, Nomura International, said in a report on the UAE real estate.

There are some signs of life, however, with real estate agents indicating a higher level of "walk around demand" and mortgage financiers highlighting an increase in finance enquiries.

"These are encouraging signs, but the real estate agents are 'talking their book' and the financiers are 'protecting' theirs. Generally speaking, we think it takes around eight months from the 'tyre kicking' stage to the conversion stage, so we may see some stabilisation in the secondary markets soon, with perhaps some very modest improvement in the final quarter," Riley said.

Capital values and rental values appear to be falling at the same rate across the residential and commercial sectors, making yield analysis more difficult. In an efficient and traditional market, the capital value is generally a function of the rental value.

Investment returns are benchmarks of the passing rent divided by the capital value, but in the UAE and globally, the glut of capital and cheap money saw investment yields divorce themselves from rental returns. There is now a sharp retracement in both, so yields paradoxically are remaining relatively constant.

The issue is more acute in the commercial arena than the residential arena, where the traditional "buy to let" model is less common. Developers are trying to sell unoccupied space at nine per cent yields, probably developed at 12 per cent yields but are now being priced at 18 per cent by astute investors. This is an effective fall in value of 50 per cent and now entering the realm of reality.

The report predicts a 40-per cent average peak-to-trough fall across the direct market and across all sectors. "We think around 30 per cent has been taken, with a further 10 to 15 per cent still to come."

According to Nomura, the "fiscal rescue" package cannot come soon enough for some, and "we think master developers Nakheel and Dubai Properties are the obvious starting points." With a liquidity injection, unpaid (but billed) contractors fees will start to flow down the supply chain. Some developments are being completed on trust, but trust does not pay the bills and contractors are now in turn being squeezed by suppliers.

"The current situation is finely balanced, and we think the Dubai real estate and construction market is on the precipice. Clear and fair judgement is required by the regulators to stem a capital and human outflow."

Moreover, contractors are being squeezed by developers and the days of 20 per cent margins are over, with contracted work now being omitted and retendered. There is not much a contractor can do apart from protect their margins by rewriting contracts with suppliers, taking advantage of the sharp fall in commodity prices. However, some materials (such as pre-fabricated steel trusses) have a longer lead-time and less price elasticity than others such as bulk cement, so a contractor will be absorbing some of this cost.

In addition, banks are requiring (in some cases) the posting of 50 per cent to 100 per cent bonds – to be held in escrow – until completion. "We have heard of some developers squeezing banks to release bonds when contracts are cancelled. This may create a dangerous precedent, and could drive international contractors and consultancies abroad."

According to Nomura, listed entities are well run and will be among the survivors. Out of the current difficulties, opportunities may arise with survivors gaining access to distressed stock to bolster investment portfolios.

"The time is not yet right to start thinking of equity capital raising to set up (or buy into) distressed asset funds, but listed companies at least have the luxury of tapping equity markets if need be. The highly publicised strategy of Deyaar, with a multi-pronged approach to minimise its default rate, is imminently sensible and provides the sector with default leadership."

Creating a distressed asset fund could be very successful with a de-facto capital guarantee. It clears the balance sheet, allows for additional asset management fees and retains a stake for potential recovery in the workout of distressed assets.

Speculation continues on whether or not Union Properties and Deyaar will enter into merger discussions. Deyaar would benefit from Union Properties' superior investment and development portfolio, whereas Union Properties will gain access to a more cleaner balance sheet.

"We think the merger would favour Deyaar with a 1.5:1 conversion ratio, but could stretch to a 2:1 ratio if returns were sufficiently diluted. We see some obvious long-term benefits, but we also think there is short-term dilution."

Commercial vacancy rates across Dubai is rising, which is now estimated at 15 per cent, while six months ago they were between five and six per cent.

"This number can only get higher as there is a swathe of newly-completed buildings hitting the market particularly in the Tecom and Al Barsha areas. Developers are still asking for nine per cent net initial yields for the sale of as yet unoccupied units against development yields of 12 per cent.

"The smart money is unlikely to pay less than 15-20 per cent that is half the current asking price, and this is against a backdrop of falling rents. This would leave developers deeply in the red, but force sellers, without the capacity to warehouse inventory."


Opportunities on the way

There is approximately $11 billion (Dh40bn) of private equity money being hoarded in the region with $7bn raised in 2008, says the report.

However, there are few listed opportunities. Union Properties has prime assets, which may have to be sold to support the development programme – and income producing at least.

RAK Properties has Dh700m of cash in bank and no debt against a market cap of Dh950m and more assets on the balance sheet than the residual Dh250m.

"The capital is waiting in the wings, and we are not suggesting that it will be deployed in the real estate market; however, when it starts to move into the region, we think opportunities will start to appear."


Company debts

Company debt is trading at 15 per cent yields on average and collectively 80 cents in the dollar. And with share prices at all-time lows, convertibles might be increasingly attractive opportunities, investors share in the equity upside yet retain protection on the downside, and in the worst case gain control of the secured assets.

The Nakheel 12/09 $3.5 billion convertible sukuk is trading at 90 cents in the dollar (30 per cent annualised yield to maturity) having been as low as 60 cents, pre the $10bn Dubai "fiscal rescue" package. The Nakheel 05/10 bonds are trading at Dh0.62 and a yield to maturity of 53 per cent, that highlights the risk.

Nakheel is set to be a recipient of a government handout, which is now reflected in the pricing of the 2009 vintage, guaranteed by Dubai World. The Aldar 2011 convertible is trading at 86 cents.