Keep in mind that in the world of Islamic finance we have asset backed loans, which means the value of the loan will be directly correlated with the value of the real estate. In Dubai we have witnessed the phenomenal growth of commercial and residential real estate, which was financed based on projections of an unlimited number of visitors and businesses. The more people migrated to this fantastic location the higher the value of the residential property values. They also spent no expense when it came to designing and building world record standards in architectural designs. They were sadly mistaken as the global financial crises brought about a dramatic slow down in the flow of tourists and commerce, which subsequently lead to the decline in real estate values. That in turn lead to a series of margin calls at the banks, since the loan balances exceeded the declining market value of the property. To compound matters even further the cashflow of the developers was strained to the point where they did not have enough to cover the payments to the banks, which lead to their subsequent defaults. Then the rulers of the country stepped forward and rescued the situation by restructuring the outstanding balances. The lesson to be learned from this scenario is about the diversification of revenue streams. Such as creating industries that derive a steady income, as oppose to focusing on strictly seasonal tourism.
In an attempt to learn from our neighbors in the GCC, we in the Kingdom of Saudi Arabia have endeavored to build industrial zones and economic cities. The overall aim is to create consistent rental revenues along with vitalizing the consumption of electricity, water, and all the various facets of the economy. The projections for industrial growth fuels the rise of real estate valuations. The economy is growing more diversified away from its core strengths, referring specifically to the oil industry and the consistent flow of Islamic Tourists. The projects literally mesmerize investors, land owners, and real estate developers who are excited about the prospects for the future. The financiers of these infrastructure projects are working around the clock trying to supply the liquidity.
Recent events in the region have us financiers pondering the impact of certain catalysts that can potentially deflate real estate values. The first being severe floods, and the second being delays in construction projects. When the property is located in the midst of a flood zone, one can only assume that property values will decline rapidly. This is compounded by the lack of utilization of flood insurance. If the banks are using Last In First Out (LIFO) otherwise known as Mark to Market, then they will experience a dramatic decline in the valuations of the property. Normally flood insurance would cover the value of the property thus insuring the financier and the property owner. However, once the property is deemed in a flood zone its future rental revenue will be discounted dramatically. Unless they build a citywide drainage system, those specific locations will be uninsurable. Which will eventually lead to a lack of finance for that location. It is imperative that cities that recently suffered floods in Australia, Germany, and Saudi Arabia take immediate action to install state of the art drainage systems in order to save their respective economies. Its simply an issue of mitigating risk at the insurance company.
Another catalyst that can deflate real estate values is the delays in huge construction projects. We are referring so the growing pains of the city as it impacts the existing businesses and residents. Stop and consider the impact of having a construction site near your show room, restaurant, or hotel. The usual flow of customers can not or will not tolerate the traffic jam or the unsightly construction crew. As customer dissatisfaction grows, they tend to find alternative venues to spend their disposable income, which results in the bankruptcies of the respective businesses. Compound the situation even further with the delays in construction that leave cranes and piles of dirt to serve as landmarks when giving tourists directions. The entire community is holding on to the hope that the contractors will attain the finance to get the construction finished.
Those businesses that are adversely affected by the huge construction projects around their locations are not an isolated part of the economy. They are not an acceptable loss in the grand scheme of growth. The fact of the matter is that they each have existing bank relationships. They have outstanding debts in the form of overdrafts and loans. If they go out of business due to the infrastructural blockade of on going projects at their respective locations, then the bank loses money. The non performing loan NPL requirement is currently at 150% for KSA Banks. Delays in construction lead to customers avoiding certain retail outlets, which in turn leads to bankruptcies. Then the money supply suffers a spiraling deflation of liquidity. If we look into the reasons for the delays of the construction we find a barrage of excuses, such as a lack of finance for construction projects due to delays from bureaucratic ministries. Our problems can be resolved with a city wide drainage system, and more timely financing for the huge infrastructure projects. Both solutions can be resolved through Lean Management Tools. Enhancing efficiency and eliminating waste, while staying focused on customer satisfaction.
Khalid I. Natto ([email protected]) is chairman & CEO of The KIN Consortium.