Building momentum: Rent and sales prices likely to rise rapidly due to supply constraints

Thanks to a shortage of supply, Mongolia’s real estate sector is likely to feature fast-rising rents, land values and sales prices for at least the next several years and perhaps more. The market is highly focused on the capital city, Ulaanbaatar, which is under pressure due to a speedy rate of urbanisation; supply constraints due to capacity, weather, geography and capital; and the rising wealth of its residents. Though some segments of the market, such as office space, may see an oversupply in the coming years, the definitive characteristic is likely to be a shortage of options. Property prices are expected to rise between 15% and 20% annually, according to market research from Trade and Development Bank (TDB).

MINING’S ROLE: The analysis starts with mining – almost all economic growth in the country is underpinned by minerals; the country is home to some of the world’s largest untapped reserves and situated next to China, the largest current consumer of natural resources, as well as Russia. While the lion’s share of the growth in the mining sector is yet to come, what has filtered through the economy already has left the government with more money to spend on wealth transfers to citizens.

The mining sector is also attracting diaspora Mongolians and expatriates to Ulaanbaatar to fill skilled, semi-skilled and management positions across the economy. Civil servants are seeing large salary boosts and in the private sector. And the resources-based growth attracts those who live outside the capital city to move there, in hopes of participating in the boom.

BUYING POWER: The residential sector is likely to be under the most pressure to grow at the fastest possible rate. Per capita GDP is forecast to triple by 2016, going from $2500 a year to $7500, according to TDB’s research. This great leap in buying power will add to an already short supply of homes in the capital city to create major hikes in sales prices. In many cases, sector operators in Ulaanbaatar expect that the result will be smaller household sizes – instead of families moving to nicer or larger spaces, they are likely to stop living as extended units as younger Mongolians look to establish households of their own.

INTERNAL MIGRATION: This is a familiar set of factors for resource-based economies early in the process of exploration and extraction, but in Mongolia there are some variables that are intensifying the effect. The capital city presents a unique narrative that argues for an even more intensified internal migration than is typical in most countries.

What is different here is the traditional lifestyle, as Mongolia is among the last countries to have a significant chunk of its population living nomadic or semi-nomadic lives. Mongolia’s herders raise sheep, goats, yaks, cattle and camels, but are finding it increasingly hard to manage. There have been more extremely cold winters in recent years than is typical, leaving some to wonder about whether climate change is a factor. When these extra-cold winters do come, much of the country’s livestock cannot survive until spring. Animals are a herder’s chief source of wealth and liquidity, and those who lost all or most of their animals often end up leaving the rural life in hopes of finding fast work in the city. They pitch their round, felt tents, called gers, on the outskirts of Ulaanbaatar where there are no services.

The primary problem cause by this is that those in these areas burn low-grade coal throughout the winter to stay warm and for cooking. The pollution makes Ulaanbaatar’s air among the dirtiest in winter, with levels of particulate matter in recent winters up to 14 times higher than recommended maximum levels from the World Health Organisation.

The herders still active have responded to the increased risk of animal deaths by keeping larger herds, on the assumption that more bodies means less likelihood of losing them all, and this is contributing to a self-reinforcing pattern.

More animals feeding on roughly the same amount of plant matter means less food for each, and a decreased ability to fatten up enough ahead of winter means more are at risk. It also means fewer plants survive, and with a smaller number of roots in the soil to hold water, desertification becomes a threat. That in turn leads to even more pressure on Ulaanbaatar and several second-tier cities to host the herders who are giving up the lifestyle.

EXACERBATING FACTORS: Weather conditions and economic growth combine to exacerbate the housing shortage, and the domestic construction industry lacks the capacity to quickly address this gap. Building more homes is no simple matter – most construction materials must be imported, and transportation links are clogged and unable to handle a surge in deliveries. Land is scarce; Ulaanbaatar is surrounded by mountains to the north and south, providing additional upward pressure on land prices.

The construction season is limited by the weather, as using cement-based materials at or below the freezing point makes for short-lived buildings. Continuing construction throughout the winter requires a great deal more money to heat the building. Labour costs are rising on account of Mongolia’s small population and pool of workers. Money itself is an issue – Mongolia is also scrambling to raise cash on international markets to pay for infrastructure and develop its mines. All of these bottlenecks, some of which are common symptoms of Dutch Disease and others unique to Mongolia, combine to make the housing shortage difficult to address.

SIZE AND SCOPE: Ulaanbaatar was home to around 1.3m of Mongolia’s 2.8m people as of late 2012. Mountains to the north and south of the city box it in, so it has grown horizontally. An east-west axis, Peace Boulevard, is effectively the only artery in the city. There are no highways or other roads that cross it from one end to another. Soviet city planners designed it with 250,000 people in mind, so it has grown far beyond its limits.

Space on the roads is as hard to come by as in its apartment blocks: according to research by M.A.D. Mongolia, a real estate and economic research firm based in Ulaanbaatar, there are 170,000 cars in the city and 125,000 property titles.

There are nine administrative districts in the capital, with the centre, Sukhbaatar, home to the parliament, as well as government buildings and all but one of the country’s grade-A office towers. Chingeltei, directly west, is considered the downtown shopping and residential district, which spreads along Peace Avenue and is highlighted by the State Department Store, a landmark that is now in private hands but remains an upscale retail option.

The other districts comprising the core of Ulaanbaatar are Bayangol, Songino Khairkhan, Bayanzurkh and Khan Uul. Baganuur and Bagakhangai are satellites to the east and south-east, and Nalaikh has its own administration but remains technically a part of the city. Prices have been on a steady climb in recent years save for in 2009, when the global financial crisis drove commodity prices down and took the Mongolian economy with it. Within Ulaanbaatar’s downtown core, the “First 40,000’’ are the oldest flats in the city from the Soviet period. These are considered the most desirable living spaces in thanks to their location, build quality, high ceilings and relatively spacious layouts. To the west, around the State Department Store, are another 50,000 units that are considered a second tier in the city centre.

SPREADING OUT: On the outskirts of the city, save for on the southern side, are the ger districts. On the southern side is an area called Zaisan, where many of Ulaanbaatar’s wealthy have built villas on foothills. Most of the structures here were built illegally, as some of the villas fall within the area of the Bogd Khan National Park. No retail services are available, but the area is desirable because it affords the wealthier residents a spot separate from the ger districts to the north, east and west.

Some of the streets leading south from the city core to Zaisan are emerging as high-value areas, such as Olympic Street, where embassies and diplomatic residences are clustered. One of the most anticipated projects in the residential sector is Olympic Residence, a luxury condominium expected to be complete by the fourth quarter of 2013.

Mongolia’s barren landscape and bitterly cold weather leave little opportunity for second-tier cities to emerge. The north-south railroad line that is part of the Trans-Siberian Railroad is a logical place for other cities to spring up, and that is where Darkhan, to the north of the capital; Erdenet, near a copper mine to the north and west; and several others have emerged. In the south, in the Gobi Desert, Dalanzadgad, Khan-Bogd and Sainshand are cities set to receive more attention thanks to the mining sector and national industrial development plans that are a by-product of it (see analysis).

LAND ACCESS: Land is governed by the 2002 Law of Mongolia on Land. Only Mongolian citizens can own land; however, the law provides legal distinctions for ownership, possession and use. Ownership rights are currently limited to urban areas: Ulaanbaatar, provincial capitals, and the capitals of the sub-provincial administrative districts, called soums. Foreigners and commercial entities cannot own land but can own the structures on them, lease property and acquire usage rights. Terms may range from one to 90 years.

The majority of land remains owned by the state. Private citizens have the right to a plot in exchange for paying fees that generally amount to less than 5% of the actual cost of the land. In Ulaanbaatar, this can be up to 700 sq metres, and via this process the ger districts have grown. Elsewhere in the country the amount of land citizens are entitled to at this low cost is larger. The fees are in part set by the cost of the land, which, for 700 sq metres in the capital city, was in 2011 valued at about $8000, according to R2 Research, an Ulaanbaatar-based team of foreign investors and data providers.

Land on the secondary market was selling for between $333 and $1500 per sq metre. For large-scale developments mandating sizeable plots, developers are not typically reliant on government land sales but instead look for private land owners. Annual government auctions are another method to acquire land, but in these cases restrictions on what can be built typically come as part of the package.

One of the difficulties in moving ger-dwellers into formal housing is the cost of the land this demographic now owns thanks to the current system in place, as part of the government’s plan involves buying these plots and building apartment blocks on them. R2’s estimates of the cost if the government attempted to buy the land from those owners is between $81,000 and $136,000 per plot. However, land values are rising, and ger dwellers have other disincentives to selling. Some operate shops on that land, or other small-scale commercial ventures.

There are also homes being built on the individual plots – brick structures that residents typically construct over the course of several years, starting with the basic structure and adding to it as cash comes available. These are typically summer residences, as in winter a ger is cheaper to heat using coal-burning stoves. Ger-district land owners are encouraged to build on this land in part by the Ulaanbaatar city government, which has advocated solving the sewage and pollution problem by extending infrastructure to the ger districts, whether such a move is financially feasible or not (see analysis).

RESIDENTIAL MARKET: As of late 2011 low- to middle-income residential properties in the capital were selling for between $1500 and $3000 per sq metre, with higher-end properties in a range from $2500 to $10,000 per sq metre, according to R2.

From 2000 to 2010, every region’s population in Mongolia shrank, save for that of Ulaanbaatar and Dalanzadgad, a town located in the southern Gobi Desert, according to the Ministry of Roads and Transportation. The latter is a frontier-like with few multi-story buildings and large sprawling ger districts, and is set to see almost as much pressure as Ulaanbaatar, thanks to its proximity to the country’s flagship mining projects Oyu Tolgoi and Tavan Tolgoi. For the capital, research from R2 Research estimated that this migration means another 175,000 dwellings would be required, if all current residents were to live connected to heating, sewer and water services.

Though most of those in ger districts now lack the money to purchase or rent an on-the-grid flat, this is certain to change as the country gets richer. Mongolia’s population is young and transitioning from extended-family households to nuclear ones. The average apartment size in the core is around 65 sq metres, and the average family unit living in them is between six and seven people.

THE FULL SPECTRUM: Developers in Mongolia are typically the country’s biggest conglomerates, which operate across several economic sectors, and a few large-scale builders. The market is an immature and developing one, with thus far little interest in building low-cost or middle-income housing.

High-end projects such as Olympic Residence or the mixed-use Blue Sky tower have generated talk and interest but in the end appeal to a very small market, said Christopher de Gruben, the managing partner of M.A.D. Mongolia. According to M.A.D.’s Mongolia’s research, there are 300 to 500 high-net-worth individuals in Mongolia, but more than 1000 housing units under construction with an anticipated sales price of $1m or more. “The strong demand is the emerging middle class,’’ de Gruben said. “They are working for the mining industry or for multinationals. You have 600,000 people in that position and they are desperately looking for housing.’’ POTENTIAL MODEL: Demand is so great that some firms are offering access to housing as a part of incentive packages for employees. For example, MCS Properties Holding, an arm of one of the country’s largest conglomerate, MCS Group, is currently constructing Viva City, a residential area along one of the roads between Ulaanbaatar’s city centre and airport, and MCS Group’s employees were given the first crack at buying. “MCS has about 8000 staff, mostly between 25 and 30 years old,’’ the company’s vice president for finance and investment, Ya. Purevsuren, told OBG. “Their biggest problem is housing.’’ Viva City’s plan includes 64 buildings housing around 1600 apartments. They come at 20 sq metres, 30 sq metres or 40 sq metres. Moving walls are used to save space, and the units are fully furnished, again to maximise space. In each building the ground floor is earmarked for retail space – supermarkets, barbers, restaurants, pubs, fitness clubs and other neighbourhood retail uses. Because the project is aimed at meeting the needs of employees, MCS offered units first to them, and as of October 2012 about 650 had been bought, Purevsuren said. The units are selling for approximately $1000 per sq metre, and that implies a thin margin for MCS – construction costs in Mongolia are estimated anywhere between about $600 and $900 per sq metre. Purevsuren told OBG MCS’s cost was $900, however, that includes an estimate of around $75 per sq metre for delivering the units fully furnished.

“We are not making money on the apartments but on the commercial area,’’ he said. MCS plans to sell 70% of those spaces and rent 30%, at rates close to $25 per sq metre per month.

A NEW MORTGAGE SYSTEM: In order to expedite sales MCS has imported a model seen elsewhere in Asia but for the first time in Mongolia, in which a developer and bank work together to offer mortgages to potential buyers. MCS has paired with Golomt Bank, and rates are generally at around 12% for 15 years, according to Purevsuren. That compares with a typical mortgage rate of around 17% to 18%. “People are realising mortgages are hard to get,’’ Purevsuren told OBG. “Mortgages are a huge constraint in this market.’’ For many a monthly payment is affordable – typically about $300 a month. A downpayment is the challenge, in particular because Mongolian banks tend to mandate a minimum up-front contribution worth about 30% of the value of the property.

PREMIUM SEGMENT: The project has proved popular, and MCS is building along a similar model near Tavan Tolgoi, the coal deposits in the Gobi Desert, to house mine workers. The company may repeat the model elsewhere, but perhaps looking outside Ulaanbaatar. Even with low-cost housing considered the market segment most underserved, MCS’s focus remains elsewhere. It would rather build for higher-income segments of the population in order to chase larger profit margins – it considers the premium market to be a price point between luxury and middle class and is focusing efforts there.

In addition to low profit margins on middle-class and low-cost housing, this volume-based approach requires finding more land, and in Ulaanbaatar that is difficult because of the geography of the city and the immaturity of the real estate market. “You need to have a lot of land to do middle-class developments,’’ Purevsuren said. “For Viva City we worked with the land owner by making him a subcontractor.’’ STATE EFFORTS: Constraints for developers will not stop demand from rising, however. In addition to the extra wages Mongolia’s emerging middle class is turning into savings and potential downpayments, the government is determined to increase the number of potential buyers by providing mortgages at concessionary rates. The idea is to coax ger dwellers into registered flats so the amount of pollution hanging over Ulaanbaatar can be reduced.

On a commercial basis, mortgages range from three to 10 years in maturity and with interest rates as of mid-2012 between 15% and 18%. The government would like to add concessionary rates through several programmes and government agencies, such as State Bank, which is publicly owned and was set to be privatised but may be kept and directed to lend at single-digit rates. The state-owned Development Bank of Mongolia has contributed funds to State Bank to that end. Another agency created to support a more robust mortgage market and push rates down is the Mongolian Mortgage Corporation, more commonly known as MIK. It was formed in 2006 with investment from 10 commercial banks, and its role is to securitise mortgages, reducing risk for commercial lenders and allowing them to buy MIK bonds as a long-term asset to serve as a maturity match for long-term loans. MIK has an agreement with the Development Credit authority of the US Agency for International Development to guarantee half the value of mortgages MIK acquires. State support for MIK includes placing its bonds on the list of securities that qualify as collateral in the eyes of the central bank, meaning MIK bonds can count towards a bank’s core capitalisation, leaving more of its other assets available to be deployed. By mid-2012 MIK had issued MNT6.3bn ($4.4m) in bonds tied to mortgages, most of which had been bought by the banks that underwrote the mortgages to start.

BUILDING PLAN: The government has also come up with a building plan to construct 100,000 homes. It aims to build 75,000 units in the capital and 25,000 in other locations. Further details are unclear. The capital requirements to do so have been pegged at $6.2bn at minimum start and, depending on land acquisition costs and the per-metre construction price, rising to nearly double that. That implies spending at least the equivalent of Mongolia’s GDP, and probably more. For a country that may need to spend about that amount on railroad infrastructure in order to fulfil its mining sector aspirations, the cost total and the limited access to capital raises serious questions about the feasibility of building 100,000 homes without major private sector involvement. “It’s a political promise more than anything else,’’ said de Gruben.

With the supply-demand imbalance set to grow, and few domestic players eyeing the market, housing below the premium price point may be an area in which foreign investment is primed to succeed. Mongolia’s legal environment for foreign investment has been shaky in 2012, with the government introducing restrictions and looking to boost tax revenues from foreign participants. The new foreign investment law, the Strategic Entities Foreign Investment Law, was passed in May. It complicated the legal regime and reduced profit potential for foreign investors in several sectors of the economy, however, real estate was not one of the ones singled out.

Since the law was introduced there have been no new foreign investments proposed that would serve as a test case for how the law is applied, and supporting regulations have not been introduced. As of October 2012 the government was pledging to review the law and perhaps ease some of its key restrictions, such as mandating a Mongolian majority partner for investments valued at more than MNT100bn ($70m) in the mining, financial and media sectors.

HOSPITALITY: The legal regime is expected to become clearer in 2013, once some of these uncertainties are addressed. Regardless of how clear, foreign investors are likely to require a local partner, Purevsuren said. One of the most prominent examples of this has been the relationship between MCS and Hong Kong-based hotelier Shangri-La. Construction began in 2005 on a hotel on Sukhbaatar Square that was eventually repurposed as Central Tower, the prime grade-A office space in the city. The partnership is now building a Shangri-La Hotel on a site a few blocks to the south of the square. This is one of the most anticipated real estate projects in the capital. It is projected to be the city’s tallest building, and part of a wave of arrivals of international hotel brands. It will feature several floors of mall space.

As of late 2012, however, with work progressing on the tower that will comprise phase 1, its developers were considering clawing back their ambitions, thanks to the uncertain investment climate and a slowdown in coal demand from China signalling headwinds for the Mongolian economy. “We are rethinking our projections and reducing our assumptions,’’ Purevsuren said. “The payback period is likely to be longer, and financing could be more expensive,” and may mean building just one tower instead of two.

An additional 1200-1400 hotel rooms are expected to come available in the next several years, however these projects had been announced in advance of what has, in 2012, become a pronounced slump in demand for coal from China. Coal is for now the bulk of Mongolia’s exports, so the investment thesis for any project in Mongolia must heed its prospects for exports to China. The slowdown in demand – even if based on short-term factors and not on long-term ones – has tempered expectations for the hotel market in Ulaanbaatar. A further constraint is the airport’s capacity to process foreign arrivals. A new airport is in the works, but is still at an early stage.

OUTLOOK: The market for grade-A office space has been swinging between under- and over-supplied in recent years, as waves of new corporate arrivals snap up what is available, a new tower comes to market and overshoots supply, and then the cycle is repeated. About three-quarters of grade-A space is found in the central business district, with Jiguur Grand Plaza, to the west, the only source of grade-A space outside it. All of what exists has been built since the mid-2000s, and the project pipeline includes new towers to come. R2 Research pegged combined grade-A and B supply at roughly 350,000 sq metres. Prices are roughly between $2000 and $6000 per sq metre for purchase. Rental prices doubled from 2009 to 2011, going from a range of $15-35 to a range of $ 30-65, according to R2 calculations.

Prices for retail space range between $2000 and $7000 per sq metre per month. The range of prices reflects in part the lack of centralised data to inform values. “Developers are not required to report sales, so there’s no way to really know sales and occupancy rates,’’ said J. Onon of the Mortgage Insurance Corporation, a government body responsible for providing liquidity in the mortgage market through securitising existing mortgages. “And therefore prices are not underpinned by values. This is a completely market-driven market, with each deal idiosyncratic.’’ Retail space scheduled soon includes concourse shopping in the Shangri-La under construction, as well as several other indoor venues. In the long term, retail shopping is envisioned as an increasingly indoor experience given the cold winters. City planners also envision underground retail if Ulaanbaatar builds a metro system, which could be connected to the metro stations. That mimics what has been done in other cold-weather cities, such as Toronto. For now, however, with the focus on the city centre due to traffic concerns, storefront retail operations, in particular close to the State Department Store, are likely to remain coveted and an important source of space.