Any attempt to assess property value in Dubai is a high risk activity that can be classed alongside deep sea diving and BASE jumping. Nevertheless, it is fairly exciting.
One way of finding out whether properties are valued fairly is to get into real estate mathematics. I truly detested math in school but it is a useful tool to arrive at some sort of conclusion.
The focus in this article is on the income-based valuation approach. The idea is to convert income into value and use the result as a measure of the fair market value of the property.
If the actual selling price is higher than the fair market value, the property is over valued and vice versa. If the selling price approximates the fair market value, the property is fairly valued.
The calculation is deceptively simple; just divide next year's Net Operating Income (Income) of the property by the Market Capitalisation Rate (also called Capitalisation Rate or Cap Rate) as set out below:
Fair market value = Net Operating Income, divided by, Market Capitalisation Rate.
The Cap Rate is the investors required rate of return less the expected annual growth of the Income. Let's take an example. Suppose an apartment is currently selling for Dh1 million.
If the income is Dh60,000 and we assume a Cap Rate of 10 per cent, the fair market value value is Dh600,000. Here, the property seems over valued.
All other things remaining the same:
- If the income increases, the fair market value rises and vice versa
- If the required rate increases, the fair market value heads south and vice versa
- If the growth rate declines, the fair market value dips and vice versa.
Some notes
The income is not the annual rent. The income is the rent less all operating expenses except interest, income tax and depreciation. Therefore, you deduct salaries, repairs, insurance, municipality taxes, admin expenses etc.
For simplicity's sake, we can assume growth at equal to or slightly higher than the expected annual inflation rate (3 per cent).
The mother of all issues is that of the Cap Rate. Theoretically, the Cap Rate is the required rate of return less the growth in income.
The required rate is what a mythical creature called a rational investor would expect given the risk of investing in a specific property.
Typically, Cap Rates vary depending on the property type and location. An investor may expect a 15 per cent return in a poorly maintained property with high tenant turnover and defaulting tenants. This higher rate translates to a lower fair market value.
On the other hand, the same investor may expect only 8 per cent in a brand new apartment building in a good location with upper middle class tenants (i.e., people who drive 2005 E Class Mercs), resulting in a higher value.
How to get the Cap Rates? The most reliable rates are the market derived rates.
In the US, agencies such as Korpacz regularly publish Cap Rates for each property type (residential, office, retail, industrial etc) and for each metro. These rates are calculated from actual past transactions in that area.
In Dubai, we don't have that luxury. But I'm not stumped; we can use the Weighed Average Cost of Capital (WACC) method. Here, the Cap Rate is calculated by assuming certain financing mix for the investor and a cost for the debt and equity components.
Suppose Investor A has a 60:40 debt equity mix, can get a bank loan for 7 per cent and has a cost of equity of 10 per cent, his WACC is 8.2 per cent.
What's the score?
So, armed with a growth rate of 3 per cent and a Cap Rate of 8.2 per cent, have a look at the accompanying table.
I've not run the numbers for incomplete properties such as Palm Jumeirah, Jumeirah Islands or Burj Dubai as future rentals are highly uncertain. Readers are welcome to try this and kill the boredom of the summer.
Warning to users
Before you pounce for the phone to call your broker, a few important caveats.
The table does not imply (e.g.) that all Al Sahab or Ranches units are good buys; only the one analysed here and even this is as of June 30 and is based on a bunch of key factors and assumptions.
For example, the annual rent may increase or decrease significantly, and resale prices may take a beating or zoom.
Most importantly, the fair market value depends on the Cap Rate/WACC which is highly influenced by each investor's funding mix.
Typically, since equity is costlier than debt, zero debt translates to a higher WACC and lower fair market value. Hence, Investor A's great good buy may be another's staggeringly overvalued property.
To wrap up, it doesn't hurt to do a quick Cap Rate calculation before making the buy decision.
This is vastly superior to merely relying on the agent's solemn guarantee that you've made the wisest decision of your life.
The writer works as financial analysis manager at Nakheel LLC. The views expressed in this article are his own and do not necessarily reflect the views of Nakheel or this newspaper.
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