United Arab Emirates: 05/06/2006

Negative real interest rates sustain Dubai property boom

Underpinning the Dubai property boom is the highly beneficial economic phenomenon of negative real interest rates, which makes real estate a strong investment. While investment continues to operate in such an environment then the Dubai property boom is unlikely to suffer anything more than short-term fluctuations.

To step back a moment: what are negative real interest rates? Basically this means that local inflation exceeds the cost of borrowing so that in essence borrowing is for free.

This is not sustainable in the long-run, but negative real interest rates are like a rocket propellant for real estate booms and have often been cited by development economists as a prime factor in explaining why a boom has happened.

In Dubai the local inflation rate is running at around 20 per cent, according to the recent Gulf News/YouGov survey and was 18-22 per cent last year on the reckoning of the National Bank of Dubai. Strong increases in rental costs, energy costs as well as services like education and healthcare are behind this high inflation rate.

Double-digit negative rates

At the same time UAE interest rates are tied to US rates set by the Federal Reserve. Thus mortgage finance presently costs between 6.75 per cent and 7.5 per cent in Dubai. So the real interest rate for Dubai property is negative into the double digits.

To look at this phenomenon from another angle: debt taken out today will be devalued by around 20 per cent in a year's time; and the cost of repayments will be 20% lower in real terms.

In reality it does not work quite like that for many middle income families. The Gulf News/YouGov survey highlighted a seven per cent rise in salaries, much lower than the general inflation rate, with a squeeze on real incomes.

However, this does not remove the attractiveness of buying property in a high inflation environment with negative real interest rates. Indeed, the surging cost of rentals and the pressure on middle class incomes will improve the case for buying; basically mortgage payments will be pegged to interest rates while rents will suffer the impact of local inflation.

To rent or buy?

It is back to the old argument about whether it is better to buy or rent, and clearly in an environment of negative real interest rates the pendulum swings even further in the direction of buying. For the annual rent rises are going to be that much sharper and the impact on mortgage payment rises than much smaller.

Home buyers need to remember that buying a house or apartment is a long-term investment, generally financed over a set number of years, and so the impact of economic forces like negative interest rates and inflation are crucial to their future experience.

On the downside inflation can also be protective of the nominal value of an investment, and if the housing market crashes at a time of high general inflation then unit prices tend to stay unchanged. This was the scenario observed in the mid to late 1970s in the UK when high inflation ravaged the economy but left house prices static, although falling in real terms.

For anyone taking a mortgage against a property it is comforting to know that it is unlikely that the value of the home will fall in nominal terms, so that the property value will always exceed the amount borrowed, and this is likely under inflationary circumstances, though the cost of borrowing will probably go up.