The Real Estate Conundrum

Published on 18th November 2008

The global financial crisis has sparked off a debate over whether the impending world recession and the resultant limited availability of credit are going to impinge on the Mauritian real estate sector and consequently affect the construction industry. Some anticipate only a slower growth in property value while others believe that the risk of recession is certainly there as Mauritius does not have a diversified property market.


Two recent press reports threw light on this conundrum. The first one mentioned that the crisis did not have a curb on Integrated Resorts Scheme (IRS) projects. Conversely, the second one announced a slowdown in construction projects, quoting the administrator of the Building and Civil Engineering Contractors Association as saying that “some IRS promoters have reduced the scope of their investments”.


Once a taboo, the IRS is now lauded by the authorities, so much that they appear sensitive to negative comments on this sector. True, IRS activities contribute to some extent to the economy in terms of job creation, foreign direct investment and revenue for government. But they cannot be a key performance indicator. In a country with very limited land resources, it is not a sensible policy to make the real estate sector become a crucial generator of economic growth.


The world recession will definitely impact on the sale of IRS villas as foreign buyers diminish. Moreover, the sharp depreciation of the rand and of the pound sterling against the rupee dents the country’s competitiveness in its two main markets, South Africa and England. The downside risks to property growth are reflected in the fall of IRS-related stocks listed on the Port Louis Stock Exchange: the prices of Ciel Investment, Deep River Beau Champ and Médine S.E. have tumbled by a further 24% since the financial crisis unfolded on 15 September.


The opening of the Mauritian property market to foreigners four years ago has put buyers into a feeding frenzy. Some say that the market is not really in a bubble or rather is still in the early stage of a boom, and it has yet to burst. The truth is that nobody can tell how far into a bubble the market really is, because property valuations are done roughly and real estate indices are lacking.


The Central Statistics Office computes a construction price index (CPI) which measures the change in the level of construction prices for residential buildings only. The index shows overall increases of 9.8% for July, 10.7% for August and 11.7% for September compared to the corresponding months of 2007. With such high rates, it is difficult to overlook an industry buzzing with activity.


However, the CPI does not have a good record in predicting important turns in the business cycle. In 2000, when economic growth rebounded strongly to 9.3%, the index rose by only 1.4%. In 2005, when the economy slowed down to 2.3%, the index shot up by 7.7%. Besides, the real estate market has a low correlation with the real economy simply because returns are based on appraisal value.


One can certainly make money in property investment in Mauritius. Most property funds that have been set up are captive as the promoters already had the properties. These funds are just another way of raising money. The question is how adequate a return an investor will get that compensates for the risk incurred.


The risks involve the liquidity nature of the property investments, the volatility of the demand, the location, the valuers, the tenants and the management of the property. One may find four good properties in Mauritius, but they are not enough to build a diversified property portfolio that will generate great returns. When rental income is assessed against appraisal value, rental yields are found to be quite low and even close to zero in real terms. Hence, developers have to bank on capital appreciation.


Investors need to think in terms of risk premium. Rental yields are unattractive compared with risk-free after-tax 7-year government bond yields. No one would invest in commercial real estate at an internal rate of return (IRR) of 10%. To raise the IRR, developers inject a dose of leveraging through debt financing. But going beyond 70% leverage carries a lot of risk.


There is a flip side to leverage when bubbles pop. We can define a bubble as activities that spring up on the back of loose monetary policy. Monetary pumping gives rise to misallocation of resources which manifests itself through a relative increase in non-productive activities.


Surely, just as constructing buildings does not cause economic collapse, so there are linkages between construction booms and financial busts when monetary expansion, overinvestment and speculation constitute the nexus of capital intensive activities. The interest rate (the relative price between consumption goods and capital goods) is what makes the construction business a speculative activity. Changes in the interest rate can have Cantillon effects, named after the French economist Richard Cantillon, on real estate projects.


The governor of the Bank of Mauritius prides himself on having successively cut the benchmark interest rate, from 9.25% to 7.75%. One of the Cantillon effects is that a lower rate of interest tends to increase the value of land as it reduces the opportunity cost or full price of owning land. It will also stimulate the demand for land and result in a rise in land prices. However, since the deciding factor with land is location, a change in interest rate has differential effects on land prices.


As the worldwide crisis prompts multinationals to outsource their business in cheaper locations, developers in Mauritius will build speculative office buildings which are investments that rely on an uncertain flow of rental income. Profit calculations cannot show for sure whether interest rates will remain low. Overbuilding is a problem of too much financing at too low a rate. Highly leveraged building projects are a natural response to government-sponsored, not market, interest-rate signals: the latter distort the structure of production into bad investments and improperly allocated labour, at a time when liquidity should flow into productive activities.


By Eric Ng Ping Cheun

Director, PluriConseil Ltd


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