Demand in Dubai's construction sector has soared in light of international events and higher tourism numbers

During the last real estate boom in 2006, Dubai was home to 30,000 cranes, 24% of the world’s total. Although many of these came to a halt as the local economy was hit by the global financial crisis, the city looks set to reclaim its title as the crane capital of the world, according to Simon Gray, the managing director of Chesterton MENA.

It is not difficult to see why. Dubai’s real estate market has been brought back to life, residential sales prices have risen steeply and once-pessimistic developers have revived mothballed projects. Add to this Dubai’s victory in securing the right to host the World Expo in 2020 – an announcement that will bring with it a raft of infrastructure projects and investments – and it is easy to see why the local construction industry is in a buoyant mood.

Positive Signs

There are several positive signs for the future of the sector. The construction industry’s share in the economy of Dubai stood at about 8% in 2013, substantially below the 2008 level of 14%. This is largely seen as a positive sign that the sector has recovered without falling prey to the excesses that led to a hard landing in 2008 and the years that followed. The industry is regaining confidence as contractors get their cash flows in order and are awarded more jobs. The banking sector, itself badly hit by its exposure to the real estate and construction industry, has now offered a vote of confidence – in December 2013 construction loans increased by 40.1%, the biggest rise since June 2009.

Most importantly, the pipeline of work has begun to swell. According to EC Harris, a built-asset consultancy firm, the volume of announced and planned projects in the UAE as a whole was valued at $315bn for 2014. When projects currently under construction are included, the figure for the full year could reach $730bn. As such, the order books of major contractors should be filling up for some time to come.

Expo 2020

The most important catalyst for future growth will be the Expo 2020, which is expected to draw 25m visitors to Dubai during the six-month hosting period. Furthermore, in the six years leading up to 2020 an additional 277,000 jobs will be created to help prepare for the event.

The authorities believe the Expo will have a beneficial economic and demographic impact. For example, urban planners have forecast a mid-range population growth scenario of 4.5% per year leading up to 2020, meaning a population of 2.8m. In a high-growth scenario, the emirate’s population could reach 3.4m by 2020. This suggests that there will be substantial demand for residential and commercial real estate as well as infrastructure development. Indeed, the government has already calculated that these development plans will necessitate a 25, 000-ha land release, bringing the total area of developed land in the emirate to 118,000 ha.

Expo 2020 infrastructure alone will cost more than $9bn, even before taking into account supporting projects aimed at meeting this growing demand. The Expo site in Jebel Ali, covering 438 ha and designed to host up to 300,000 visitors at peak times, will cost between $2bn and $4bn. Infrastructure development, including the $1.36bn expansion of the metro’s red line to the exhibition site, has been allocated a further $2bn-4bn. These projects alone will offer an enormous stimulus to the construction industry.

One of the biggest beneficiaries of the Expo announcement will be the city’s tourism industry. Consequently, there is likely to be a substantial pipeline of construction projects in the hospitality segment of the market. Tourism represented 20% of Dubai’s GDP in 2013 and is set to grow at a rate between 7% and 9% until 2020. As such, the supply of hotel rooms is expected to nearly double by the time the Expo commences.

Spare Rooms

By the end of 2013, the market already had over 87,000 rooms in 611 graded hotel establishments, according to a report by Jones Lang LaSalle. The four- and five-star segment dominates the market, accounting for 69% of the current inventory. However, the market will require additional volume closer to 2020, while the focus of developers may shift. “Many developers are moving into hotel apartments and serviced apartments as many view this segment to be considerably less volatile over a long-term investment horizon,” Saeed Mohammed Al Qatami, the CEO of real estate developer and services company Deyaar, told OBG.

Even without the demands of hosting Expo 2020, Dubai has set ambitious tourism targets for the next decade. According to the Department of Tourism and Commerce Marketing (DTCM) targets, which are part of the Tourism Vision 2020 plan, Dubai hopes to attract 20m tourists per year by 2020, a 100% increase on the 2010 level. With 11m visitors entering the emirate in 2013 and a major spike in entrants expected for the Expo, policy planners are focused on accommodating rising numbers of tourists.

“Winning the right to host World Expo 2020 only escalates the scale and urgency of what remains to be accomplished,” Helal Saeed Almarri, the director-general of DTCM, told the local press in early 2014.

The government has already taken significant steps to support the construction. Moreover, there are plans to supply land grants to developers for three-and four-star hotels, as well as to reduce the approval process for hotel construction to two months. An exemption is also planned for three- and four-star hotels from the 10% municipal fee levied on occupancy for a defined period after opening.

Transport Infrastructure

This should support a substantial hotel-building programme. Even so, the hotel industry will not be the only beneficiary of Dubai’s ambitious growth plans and Expo award. The emirate’s transportation sector is also primed for substantial investment. “Connectivity to the Expo site is of course a major priority and is a collaborative effort between the Roads and Transport Authority (RTA), Dubai Municipality, Dubai Airports and other key Expo stakeholders,” Almarri told local press. The two major projects preoccupying planners over the next decade will be the expansion of Al Maktoum International Airport in the south of the city, close to Jebel Ali and the Expo site, and the expansion of the city’s metro network. The former will require an investment of $32bn, bringing the annual capacity up from the current level of 5m passengers to 120m passengers per year by 2022. This could be extended further to a capacity of 200m passengers per year by 2050. To be built in a period of six to eight years over two phases, the project should bring a host of small and large contracts to the construction market and supplement the expansion plans at Dubai’s current main airport, Dubai International, where capacity will be increased to 100m passengers per year by 2020.

The other planned major infrastructural project in the transport field will be the metro network expansion. Expected to begin in 2015, the RTA will oversee an extension to both the red and green lines. The former will connect to the Expo through a dedicated station at the site. The RTA is currently studying four options for the 15-km red line extension, which will be completed by 2019. This is part of plans to add more than 35 km of track and 33 stations to the metro network as a whole.

The terms and details of financing for this programme have not yet been finalised. However, the RTA is considering public-private partnership (PPP) options. The existing network is run under a contract management arrangement with the British firm Serco. Any move towards a PPP model is unlikely to include infrastructure development, but rather bring in private capital for the rolling stock and operating systems. Khaled Adel Al Monayyer, the manager of the Commercial and Investment Department at the RTA, told OBG, “Infrastructure is a huge risk that private investors do not want to take. They get the return from the rolling stock.”

PPP Model

Nonetheless, Dubai is continuing with its plans to introduce the PPP model as a means of bringing expertise and capital to the development of the city. A draft PPP law is expected to be released in early 2015 and will be the second of its kind in the Gulf. Such a move could have a substantial impact on the construction industry moving forward. “It will be extremely important for the economy of Dubai in terms of private sector investment,” Al Monayyer told OBG. One area where the model could be adopted in the near future is in residential and mixed-use developments tied to the city’s public transit system.

Transit Projects

The RTA is now looking to promote transit-oriented development (TOD) projects throughout the city. The term, which refers to the concept of constructing housing density around transport stations, was first coined in the US and helped promote public transit and reduce car usage in North America. While the US market norms of building within 800 metres of a transit station may not be appropriate considering the often overbearing heat in Dubai, the TOD concept should help meet the increasing housing needs of the city.

The first project in this regard will be around the Union Square station. In December 2013 the RTA announced that it is looking to develop 19,000 sq metres in the vicinity of the station on a PPP basis.

Mattar Al Tayer, the chairman of the board and the executive director of the RTA, told the local press, “The project focuses on providing [a] high-class residential and office environment characterised by pedestrian-friendly roads, green spaces, vital utilities, retail outlets among others. The high population density in the project will contribute to supporting RTA’s drive towards encouraging the residents to use public transport means, besides providing an enjoyable avenue for residents and visitors alike.” The RTA has engaged consultancy EY to work on a study for the project, with a final report due by end-2014. The project, which is known as the Union Oasis, is expected to be tendered in the first quarter of 2015, followed by six months for financial close and then a 24-month construction period.

Although the precise financial arrangements have not yet been established, they will be run on a revenue-sharing basis. In many ways, the agreement will therefore be like a simple lease. The RTA will take a fixed sum from the private developer within a certain revenue band. If revenue exceeds a certain ceiling, the RTA will be entitled to an additional share. The model should not only support the development of public transit in the emirate, but also support housing supply, in addition to boosting private-sector investment from the construction industry.

Other Projects

Whether they are built on a PPP basis, by government-owned developers, or else by private firms, these mixed-use developments are likely to remain a staple of the construction industry in the coming years. As of April 2014, mixed-use projects accounted for 36% of the construction spend throughout the federation of the UAE, according to regional projects data tracker MEED Projects. Such developments had the biggest share in the total spend, followed by commercial projects. “Lifestyle sectors – retail, hospitality and high-end residential – are the most active construction segments,” Christopher Seymour, head of property for the UAE at ARCADIS, told OBG.

Dubai’s high-end real estate sector is once more feeding the construction industry. According to the “GCC Powers of Construction 2014” report by Deloitte, $12bn worth of stalled projects have been restarted over the last 18 months. The government has also intervened to help kickstart what was an ailing real estate sector. In September 2011 the Real Estate Investment Promotion and Management Centre of the Dubai Land Department launched the Tanmia programme, an initiative to match potential investors with abandoned real estate projects. By September 2014, the initiative had helped relaunch 37 projects worth a combined value of $2.5bn.

“There remain a great number of stalled projects sitting idle in the local market which could offer respectable returns on investment for private developers,” Irfan Godil, the CEO of Texture Holdings, told OBG. Alongside the reinvigoration of the real estate market, megaprojects are beginning to come back onto the agenda. One such project is the Dh2bn ($544.4m) Dubai Water Canal, which has been revived and is now scheduled for completion in 2016. The project involves drilling a canal from Dubai Creek to the Gulf, as well as plans for marine transit stations, hotels, parks, footpaths and luxury housing. The contract for the Dh802m ($218.3m) third phase of the project was awarded to the Dubai-based Belhasa Six Construct in June 2014.

Flagship Project

The local developer Nakheel has also brought one of its flagship projects back to the market with the October 2013 launch of Deira Islands. Originally conceived as Palm Deira, one of three palm projects by the company, the relaunched project is expected to see the development of four linked islands with 40 km of coastline, apartments, retail space and tourism resorts. When completed, the 4.5m-sq-metre project will have 50,000 hotel rooms and be home to 280,000 residents.

Dubailand, a district of entertainment venues, theme parks and residential developments in the east of the city, is another significant example of project revival in recent years. Although the concept being developed by Dubai Properties Group was put on hold during the economic downturn, with US entertainment firms such as DreamWorks and Universal Studios pulling out, a number of residential developments within the district have been relaunched in the last two years. With good access to both Dubai International Airport and Al Maktoum International Airport, Dubailand is likely to be of great interest to secondary developers, particularly as it is within a master development. As such, infrastructure costs may be an issue, as there has been some uncertainty as to whether the government or the developer will bear responsibility for certain infrastructure costs.

Beyond these showpiece real estate developments, infrastructure projects in the country also bring the promise of major construction contracts. The value of infrastructure contracts awarded in the UAE in 2014 is expected to increase by more than five times, to $15.2bn. While much of this, particularly outside the transport field, will be awarded by Abu Dhabi’s energy sector, there are substantial opportunities in Dubai beyond the metro and the airport. For example, the government currently has ambitious plans to construct a 1000-MW combined solar park. If completed, the $3bn project would be the biggest of its kind in the world, according to Deloitte.

Challlenges

The large inventory of projects that have been brought to the market in the last 24 months should swing the pendulum back in favour of contractors. However, the uptick in the local sector also brings with it a number of challenges. The improved conditions in the region’s premier construction market, for instance, are generating additional interest from foreign firms.

“Competition among subcontractors in the construction industry has continued to grow as more regional players enter the market, but many lack the technical sophistication to service the larger segments of the market,” Talal Saeed, a managing partner at Dubai-based interior design and construction company Fino International, told OBG. Whether all these players can compete for large contracts may be questionable, but the general interest in Dubai is ensuring that the tendering process remains highly competitive. The additional competition in the market is therefore creating price pressures within certain segments. “Rates and fees for engineering and project consulting firms have fallen to their lowest levels in over a decade as a result of heightened competition from new market entrants,” Mohammed Sadiyyah, an area general manager at Consultant Khatib & Alami, told OBG.

Across all market segments, participants are adjusting to a new reality of price pressure during an upward movement in the cycle. “We haven’t really seen margins in the construction sector improve,” Zeina Tabari, the chief corporate affairs officer at contractor Drake & Scull, told OBG. “We don’t believe we’re going to get back to the margins of 2007.” At the height of the previous real estate cycle, contractors enjoyed gross margins well beyond 15% in some cases, a situation that is unlikely to return. However, Tabari concedes that margins are now higher than the norm after the real estate collapse.

Mature Market

However, not everybody is as concerned about the pressure on contractors. “The construction market has matured a bit now and it doesn’t allow super profits,” said Seymour. Despite some pressure on contractors, tender prices have been rising moderately for the last three years. According to a report by EC Harris, tender prices are forecast to increase 3.7% in 2014, following similar growth of 2.9% and 3.2% in 2012 and 2013, respectively. This comes at a time when material costs have been falling. The company’s Construction Cost Index estimates that construction prices in the UAE will rise approximately 6% in 2015.

However, while contractors are conscious of the 7.5% drop in tender prices in 2011 alone, the general trend in markets across the region is margin pressure. According to Global Investment House, gross margins across the GCC contracting sector declined to 11% in the first quarter of 2014, down from 11.5% in the same quarter of 2013. The research firm thus concluded that the regional sector “would continue to witness declining margins as rising construction costs and stiff competition eat into the profits of GCC contractors”.

Construction Costs

While contractors have not had to worry about rising material costs, inflationary pressures are still having an impact on input expenses. Cost-of-living adjustments and a shortage of workers are pushing up labour costs for contracting firms. “When considering the amount of public infrastructure and mega-projects currently in the pipeline, the labour market could be under significant pressure at times as it attempts to keep pace with demand,” Al Qatami told OBG.

In April 2014 a survey commissioned by Dubai International Academic City (DIAC) and carried out by Deloitte found that the emirate is likely to have a shortage of 500,000 workers by 2015. “As the construction industry continues to rebound across the region, there is a GCC-wide shortage of engineers forming which will likely require firms to begin pushing their recruitment efforts further afield to the Philippines, India and other countries,” Sadiyyah told OBG. These developments are likely to make labour costs rise even higher. According to EC Harris, labour rates increased by 3% in 2013 and are forecast to grow by a further 6% in 2014.

This has been causing a range of difficulties for contractors, especially considering that labour costs, unlike material costs, are not usually covered under escalation clauses in contracts. “The challenge with the construction industry is always labour costs, not procurement. However, material prices can always be hedged, which assists you in managing your risk,” Tabari said. “Procurement affects sectors differently, from civil to engineering to oil and gas.” In the civil engineering sub-sector, for example, procurement costs would usually constitute about 20% of the total costs of a project, according to Tabari. Further to this, most contracts in the Dubai market are laid out as a lump sum and as a result, do not account for sharp changes in market conditions, placing more risk on the contractors’ books.

Construction Financing

Aside from the rising labour costs that are squeezing margins, the biggest challenge for contractors is managing cash flows. While the banking sector has begun lending to the construction industry and preferred developers once more, revenue collection remains an issue. This is partly a legacy of the financial crisis, with some contractors still awaiting payment for work on projects that were foreclosed, although this is becoming less of an issue. Industry estimates suggest that fewer than 2% of private developers still have outstanding debt issues with contractors. However, despite the uptick in work and capital flowing into real estate and infrastructure, the prevalence of late payments remains a concern. The market norm for payment terms is usually 90-120 days, but there is no penalty for late payment. With revenue collection still an issue, contractors are having to turn to term loans and bank overdraft facilities to fund their work.

“The payment situation for contractors hasn’t improved since the beginning of 2013,” Taher Safieddine, an analyst at SHUAA Capital, told Bloomberg in August 2014. “Working capital is continuously under pressure, which is forcing contractors to go to the banks to cover the shortfall.”

Local contractor Arabtec, for instance, reported that money owed by clients increased to Dh8.8bn ($2.4bn) in the first six months of 2014, up from Dh7.2bn ($1.96bn) at the end of 2013. The company’s debt climbed by Dh329m ($253.7m) in the second quarter of the year to Dh1.29bn ($351.1m). Another large contractor, Drake & Scull, has taken two term loans worth Dh199m ($54.17m) to meet the rapid growth in its backlog and address the issue of delayed payments, according to Bloomberg.

Nonetheless, while there will be significant implications for profitability and project delivery as a result of the additional cost of borrowing, the general outlook for large-scale contractors remains positive. In the first quarter of 2014, for example, Arabtec saw profits increase by 120.7% year-on-year, while in the same period its net profit margin grew to 6.4% from 4% in the first quarter of 2013.

Outlook

While Arabtec has been one of the leading drivers of growth across the regional construction sector, reporting a gross margin of 15.3% in the first quarter of 2014, its performance is still a reflection of a buoyant local industry. The pipeline of projects across a range of segments – from residential real estate and hotels to transport infrastructure – should offer plenty of tenders for contractors as well as support a growing pipeline of work.

While cost pressures are affecting the market, margins have improved and are putting the sector on a more sustainable path. The focus for the sector over the coming years will be on building developments to accommodate the visitors expected in 2020. Even beyond the Expo, the fundamentals of the market look solid for a sustained period of growth.