The property market bust in most of the Middle East and North Africa (MENA) region exposed deep structural problems in the sector. If the leading real estate developers are to recover and deliver sustainable risk-adjusted returns to shareholders, executives will need to focus more on creating value than on simply erecting buildings. They will need to learn from their three most common mistakes—errors that became apparent during the downturn. First, developers grew in all directions with unfocused business models targeting a wide range of assets in different countries, as well as multiple segments and classes. Second, not having to worry about commercial capabilities and profits given the buoyant market, developers concentrated on iconic assets and rushed to deliver. Third, most regional players had volatile revenue streams and managed risk poorly—depending excessively on property sales, as opposed to recurring income from leasing and other operations.
Going forward, developers should adjust their strategies in four steps. They must first decide what kind of developer they want to be and where to operate on the real estate value chain. Second, developers should master their chosen markets, and understand all components of the real estate ecosystem so that they can identify and pursue attainable growth opportunities and create sustainable value. Third, developers should manage their exposure to market risk better by seeking more balanced revenue sources, and elaborating clearer investment and development guidelines. Finally, real estate players should start developing a set of core capabilities (e.g., opportunity identification, development, asset management) to deliver sustainable value. Real estate developers can prepare for the next property cycle by building key commercial capabilities and re configuring their market-facing approach. With the correct ingredients, property companies can better position themselves to capture emerging opportunities and enter undeserved parts of the market as the regional recovery accelerates. KEY HIGHLIGHTS : Real estate developers in the Middle East grew very fast into multiple real estate segments and adjacent businesses, often neglecting commercial capabilities and profits in favor of prestige projects, and failed to manage risk and revenue streams properly. Comparable developers in more mature markets have been growing at a more balanced pace, building a balanced business model with more recurring revenues focusing on specific segments and classes of the market in which they can excel. To position themselves for the upswing, developers need to choose where they want to be on the value chain, be firmly rooted in their target market, formulate robust risk and investment guidelines, and develop their capabilities to ensure value creation and success through differentiation. Rushing to Deliver, Neglecting Value Creation The intensity of the UAE real estate boom provided developers with only limited opportunities to build commercially driven capabilities, the essential source of competitive advantage. Most companies were not structured to allow them to maintain focus on commercial aspects of their activities throughout the development cycle, and many firms did not possess development and asset management capabilities sufficient for maximizing value creation. A number of real estate companies have gone through two cultural evolution phases since their inception. Design-driven organizations. The property development sector was initially defined by iconic properties that would shape the new urban skyline, and make names for companies, cities, and nations. In this initial stage, developers focused mainly on their architectural and design capabilities, placed less priority on costs and budgets, and ventured mainly into developing landmarks—the dream of every architect. Delivery-driven organizations. In their next organizational phase, and as markets started to cool down, real estate developers shifted their focus to delivery capabilities such as project management, procurement, and cost control. Governments, which had provided generous support, now wanted results and imposed challenging completion deadlines. Some developers also faced tighter-than-expected budgets. Within organizations, influence shifted away from the designers and architects (who valued aesthetics and functionality), to project managers, engineers, and accountants (whose mission was to deliver on time and on budget). Project directors, now in charge of delivery, started making significant trade-offs, sometimes putting delivery and cost before design, occasionally harming the ultimate product and its commercial potential. Some new delivery-driven organizations pushed “value engineering” too far, eliminating important aspects of the design on the basis of cost and delivery difficulties. This had a deleterious impact on some completed assets in the market and their potential for income generation. For example, a developer would cut corners on the recreational facilities for a five-star hotel, putting in a mediocre pool and a spa that was smaller than planned. Yet it was precisely the installation of such luxury features that would have allowed the hotel to charge top prices. Once the crisis hit, developers were unable to generate the returns that they had expected. Potential clients and buyers, some of whom had purchased properties in advance, were disappointed to receive a product different from that promised by glossy marketing brochures. Investors and financiers were similarly crestfallen, having extended backing on the understanding that the completed asset would be able to charge premium rates. Having Volatile Revenue Streams and Insufficient Risk Management Weak risk management capabilities also had a significant impact on the sector in general. UAE developers targeted quick, high-margin returns from developing and selling mostly residential assets. The result was that UAE developers became highly dependent on asset disposals, which are one-off transactions involving considerable risk. More than 90 percent of UAE developers’ revenues at the peak of the cycle in 2008 came from sales, while developers in more stable, more mature markets took in around 60 percent from selling assets . When the market fell, sales revenues dried up and some developers faced difficulties covering financing costs and other overhead expenses. Some UAE developers did start to show interest in income-producing assets just before the market began to slow. Property developers had not previously put much effort into continuous income streams from retail, commercial, or hospitality assets because of relatively lower returns. However, their interest in recurring income proved to be “too little, too late” in most cases. Furthermore, cheap financing, a seemingly ever rising market, and weak risk management capabilities left most UAE developers with high debtto-equity ratios. Industry averages are around 0.5, but most major UAE developers had significantly higher ratios. Immersed in a booming market, developers had no reason to consider more sophisticated financing schemes, which are typically used to balance financial risks and returns. The result, in some cases, was that developers were forced to seek debt restructuring. Know the Market; Identify Attainable Areas of Growth Developers have to acquire an intimate knowledge of their core market and a realistic sense of what opportunities are within reach. This knowledge will help them comprehend where they are in terms of the real estate cycle, the long-term waxing and waning of property prices, which in turn should allow them to calibrate their strategy and resource allocation accordingly . They should then follow three strategic imperatives in determining their geographic, property segment, and property class strategy: • Do not expand prematurely beyond the local market. • Start narrowing segment coverage and specialize in one or two segment types over the long term. Knowing the home market involves conducting periodic in-depth analyses that go well beyond monitoring market prices and volumes, but that also examine the underlying drivers of the real estate cycle, spanning demographic, economic, regulatory, and political dimensions. Demographic factors shape demand because of population growth, internal migration, household size, age distribution, and changes in family structure. Economic factors affect demand and supply because of household purchasing power, the macroeconomy (growth and inflation), fiscal and monetary policies (government spending on housing, liquidity, and the cost of borrowing), foreign investment, and the attractiveness of real estate compared to other asset classes. Regulatory factors also have an impact on demand and supply because legislation and regulations can either provide more transparency and confidence to investors or increase the number of players and buyers by allowing the entrance of foreigners. One such measure for buyers is Saudi Arabia’s mortgage law. Examples from the UAE include easier residency visas and ownership rights for expatriates, strata laws, escrow regulations, and leasehold laws, as well as regulations on sales and leasing pricing. Political factors such as domestic or regional instability can make developers shun troubled markets and induce buyers to put their money into more liquid investments. IN SUMMERY: The rise, and apparent fall, of the MENA real estate development sector is not the end, but the beginning of the story. For all the problems following the latest downturn, real estate remains one of the sectors with the highest expected growth within the MENA region, because property remains the preferred asset class for investors. Developers still have substantial opportunities to attract capital, create value, and win a bigger share of the pie. Moreover, there are still gaps in the market, with under served segments and classes in every geography. The cyclical nature of the property business means that the next surge, and the next bust, are both inevitable. For developers, now is the time to reconsider business models and value creation strategies. As the MENA region proceeds through the real estate cycle, wise developers will identify the core and differentiating capabilities they need to develop to be able to play and win in their respective markets. These capabilities will allow developers to grow successfully through the cycle’s coming phases.
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