Dubai or Not Dubai?

blitt bob knakal 10 Dubai or Not Dubai?In the 1989 movie Field of Dreams, an Iowa corn farmer, played by Kevin Costner, hears voices in his head. The voices encourage him to build a baseball diamond in the middle of a cornfield. Those voices repeatedly tell him, “If you build it, they will come.” Apparently, these same voices were in the heads of the leaders in Dubai, but instead of building a baseball park in the middle of a cornfield, they decided to build tens of billions of dollars worth of condos, offices, malls and even casinos.

Unfortunately, this emirate is one of the few in the region without much oil; therefore, the resources to build their dreams were almost exclusively borrowed. And, more unfortunately, after they built it, very few have come.

Fiscal problems in Dubai dominated the headlines last week as the emerging emirate announced that it needed to halt payments on some of its sovereign debt for six months. Dubai itself demonstrates just how quickly countries can veer off the road to recovery and into trouble. More importantly, for investors across the globe, their debt debacle is stoking new fears that heavily indebted nations could potentially default on their government debt.

No one disputes that many countries gorged on cheap, readily available debt during the boom years, but the clear poster child for this trend was Dubai. Although the city-state is one of the few members of the United Arab Emirates (there are seven member emirates) that has little oil wealth of its own, it does act as the emirates’ trading, tourist and financial hub. It had always been assumed that, in the case of financial stress, the U.A.E.’s richest oil state and capital, Abu Dhabi, would bail out its free-spending neighbor. Abu Dhabi’s initial refusal to assist Dubai was a reminder that policy makers might not be willing or able to solve all of the world’s credit problems with easy money, and has raised fresh worries among investors about sovereign support for Dubai’s debt-laden corporate entities. Alternatively, new credit worries could lead central banks to become even looser with money, encouraging another round of risk-taking.

Dubai World, the corporate face of the emirate, is at the heart of Dubai’s debt woes. It is a conglomerate that, for years, has led the emirates’ high-profile domestic and overseas investment ambitions. Going back to the 1980s, Dubai initiated a building boom to transform an underdeveloped region into a modern landscape of dazzling residential and commercial skyscrapers and beach-side luxury hotels. To implement this strategy, the government turned, in large part, to Dubai World, which turned to international debt markets for the capital to make things happen. Almost 50 percent of Dubai’s $60 billion to $80 billion (depending on which report you read) in debt is related to Dubai World and its entities.

The real estate development arm of Dubai World is Nakheel, most famously known for building the city’s iconic palm-shaped island developments. In 2007, Dubai’s property markets were in full swing, and dredging had actually begun on two additional palm-shaped developments. In early 2008, sales began for the first phase of this massive project, which added 500 miles of new beachfront property to the landscape, with the potential to house 400,000 people. Initially, demand was very strong, and units were being flipped regularly, as monthly appreciation was enormous.

Those of us in New York are probably most familiar with Dubai World’s investment arm, Istithmar, which had purchased several large office properties in Manhattan. Among these were 230 Park Avenue, which they purchased in November of 2005 for $705 million. This property was sold about a year later for $1.15 billion. Istithmar also purchased the Knickerbocker Hotel at Six Times Square, which they intended to convert into a luxury hotel. It also purchased 280 Park Avenue, which it subsequently sold for more than $1.2 billion, and the leasehold on 450 Lexington Avenue, for which they paid about $600 million. Hotel acquisitions other than the Knickerbocker included the W Hotel Union Square and a majority share of the Mandarin Oriental in the Time Warner Center. Istithmar also purchased high-end retailer Barneys New York for nearly $1 billion, well above initial estimates and due to a bidding war in which they prevailed.

Subsequent transactions displayed a diversification far beyond the company’s core business. In August of 2007, at the height of the market in Las Vegas, Dubai World purchased a 50 percent interest entering into a joint venture with MGM Mirage in its $8.5 billion CityCenter project, which was under way and in need of an equity injection.

In addition to its real estate investment and development initiatives, Dubai World also operates many ports in Dubai and around the region. If you remember, in 2006, the company was caught in the middle of a political maelstrom in Washington after agreeing to purchase a British competitor that operated ports in, among other places, the U.S. The result was that they agreed to forgo the U.S. assets because of security concerns.

Aside from these investments in the U.S., Dubai World invested heavily in companies and projects across Asia, building ports in Pakistan and India and taking equity positions in Chinese banks. They also deployed capital worldwide, including investments in golf courses in Scotland and South Africa. It also purchased the most famous ocean liner in the world, the QE2, which it planned to make into a tourist attraction at the Palm Jumeirah.

When the global recession began to be felt tangibly around the world, Dubai World’s far-reaching investments proved not to be immune. The New York office buildings and hotels purchased by Istithmar have been significantly hurt by the value reductions seen in the Manhattan market. Given the high price paid for Barneys, a restructuring of that company is currently being explored. Additionally, this past summer, MGM Mirage said it was writing down the value of CityCenter by about $2.34 billion, which devalued Dubai World’s stake by about $1.17 billion.

In late 2008, just as Dubai’s chairman, Sultan Ahmad bin Sulayem, was hosting a $20 million party with 2,000 guests to promote the Palm Island development, property prices there were already falling. Dubai World started cutting jobs in its property divisions. In June of this year, it began corporate restructuring, which resulted in the consolidating of units and the shedding of many more jobs.

Now that the local property market in Dubai has gone from boom to bust, Dubai is left with an oversupply of real estate that few want to buy or rent. Even after hundreds of projects were put on hold or canceled this year, the new construction (almost all of which is speculative) that is in the pipeline, which is scheduled to actually be completed, is expected to double Dubai’s supply of office space by 2011. The vacancy rate in completed office buildings is currently 59 percent. Rental prices at the end of the third quarter were down 58 percent from a year ago. The residential market is not faring much better, as vacancies are rising, absorption has slowed to a crawl and apartment prices and rents have plummeted.
Last Wednesday’s announcement regarding the need for six-month debt-payment relief did, indeed, shake markets, taking investors and analysts by surprise. Notwithstanding the circumstances referenced above, the announcement was unexpected and has investors worried about hidden debt bombs in other countries and institutions. This is a tangible concern.

If we look at the potential ramifications of Dubai’s troubles, we must keep in mind that the emirate is relatively small. While its total debt, estimated to be in the $60 billion to $80 billion range, is large in relation to its $75 billion G.D.P., it is very small in a global context. It is estimated that foreign banks have $130 billion of total exposure to the U.A.E., which is a negligible 0.4 percent of foreign banks’ total cross-border exposure. The regional impact will depend on how Dubai World’s crisis develops.

For now, most of the pain will be felt by the holders of the Islamic bonds of Nakheel. In mid-December, $3.52 billion in these bonds will mature. This was one of the largest Islamic group of bonds issued, and it was absorbed quickly by both Western and regional investors. The market was so bullish on Dubai’s ability to repay the obligations that, early last week, the bonds were trading at a 10 percent premium to par. Toward the end of last week, the price has fallen to as low as 38 cents on the dollar and finished the week at 57 cents.

A problem now is that the circumstances behind Dubai’s moves are not transparent, making it difficult to gauge the exact risk to the bonds in question, and Dubai’s own general creditworthiness.

This is vividly evident in the credit-derivatives market, as credit-default-swap premiums on sovereign debt have escalated, not only on Dubai’s debt but also on the debt of other highly leveraged nations. When Dubai announced its debt standstill on Wednesday, the cost of insuring against a Dubai debt default more than doubled, from 318 basis points to 570. It is expected that these premiums will normalize if it appears the central bank will step in.

While Dubai’s default is not likely to cause a banking crisis, it could well create a broader crisis of investor confidence in overly leveraged economies. Other emerging markets may suffer, as they have always seemed a bit more vulnerable because their financial markets are not as deep and sophisticated as those in the West. Investors remain cautious about the developing world’s ability to handle a crisis. Dubai’s circumstances are clearly left-over business from the mid-decade mania rather than a signal of new economic trouble. However, a growing concern today is whether sovereign debt may now represent another after-shock of the global financial crisis.

Ironically, Dubai’s debt problem is likely to reinforce the policies of the world’s central bankers, especially those at the Fed, to keep the money spigots wide open to prevent any new credit concerns. In the short term, this should help gold and other riskier assets. However, in the long term, it may feed new asset bubbles and lead to future credit problems.

The effects on our New York commercial real estate market could be positive. Pressure will exist on the Fed to keep monetary policy loose, keeping our interest rates low. This should keep mortgage lending rates at their present levels for the foreseeable future. Additionally, concerns about the safety of emerging markets could and should redirect investment dollars into more stable markets like the U.S. As New York is the leading destination for this foreign capital, we should be a beneficiary of distress elsewhere.

Robert Knakal is the chairman and founding partner of Massey Knakal Realty Services and has brokered the sale of more than 1,000 properties in his career.

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