SAUDI ARABIA REAL ESTATE SECTOR Fertile Ground for Real Estate Developers 19 october 2009 CONTENTS • Strong Fundamental Story: Saudi Arabia’s real estate sector benefits from a very strong fundamental story driven by a large, growing and young population. The current percentage of homeownership is low, EXECUTIVE SUMMARY 2 at c45%, with potential for significant growth. We estimate that yearly demand will increase at a rate I. MARKET OVERVIEW 3 faster than population growth, particularly once mortgages allow more people to own homes. Saudi II. STOCK OVERVIEW 8 Arabia escaped the worst of the world financial crisis, and we believe the overall economic environment is SAUDI REAL ESTATE (AKARIA) 9 solid. We consider it well-placed to benefit from strong economic (non-oil real) growth of 4.5% in 2010e DAR AL - ARKAN 24 and 4.6% in 2011e. IV. REAL ESTATE PRICES HAVE • Major Catalyst is Mortgage Law: All real estate stocks will benefit from the passing of a mortgage law, STABILISED 42 which we expect will happen in the next twelve months. Currently there is limited mortgage financing V. CONSTRUCTION COSTS HAVE available, as the lack of a regulatory framework is a major obstacle, particularly on MODERATED 44 enforcement/foreclosure. Companies like Dar Al-Arkan and Akaria are likely to benefit the most from the VI. OFFICE SPACE IN DEMAND, BUT new law, given their residential focus. We expect a very strong rally in the real estate sector when the law COULD BE REACHING RETAIL passes. OVERSUPPLY 45 VII. MORTGAGE & DEVELOPMENT • Initiating with ST/LT Buy on Akaria: Akaria is our favourite developer. It has a solid balance sheet with a FINANCING LIMITED 46 net cash position of SAR688 million, a growing recurring revenue base and potential for strong growth VIII. REGULATORY CHANGES from new development projects. Akaria's healthy mix of residential, commercial and retail properties are FAVOR INCUMBENTS 48 well-located. We particularly like its villas in the Diplomatic Quarter (which it is expanding) and its commercial space at the new Akaria Plaza in Riyadh’s Central Business District. Our LTFV of SAR33.50 per IX. DEVELOPMENT OF NEW share implies 27% upside potential. The company’s rental properties make up 40% of our value, its land CITIES 49 bank (13.8 million in total) makes up 31%, while cash and investments and the Binban project account for X. A PRIMER ON EMAAR the remaining 29%. ECONOMIC CITY AND KAEC 50 XI. DEMOGRAPHIC TRENDS • A Slightly More Cautious ST/LT Accumulate on Dar Al-Arkan: We also like Dar Al-Arkan due to i) its large land bank, which it has consistently traded at a profit, ii) its solid record of execution for its POINT TO GROWING DEMAND 55 development projects, and iii) its expanding rental portfolio. However, we are more cautious on the XII. CITY VIEWS 58 company due to lack of detailed information regarding its land bank; the operational risks we see attached APPENDIX I – MAJOR PROJECTS to its new project in Jeddah, Khozam Palace; and the financing of its SAR2.25 billion sukuk due in March IN RIYADH 65 2010 out of its cash flows, which we believe will limit the company's short-term ability to invest in land or APPENDIX II – MAJOR PROJECTS pay dividends. Our LTFV of SAR19.15 implies a 15% upside potential, and we initiate with a ST/LT IN JEDDAH 66 Accumulate recommendation. • A Primer on Emaar EC: We have included a primer on Emaar EC, although we have not decided to initiate on the stock at this time given a great deal of uncertainty over financing and the final masterplan. We believe the economic cities, including King Abdullah Economic City (KAEC), will be a major driver of construction activity within Saudi Arabia, and Emaar EC is well-placed to take advantage of public support for new economic development. However, the company, by itself, does not have enough money or financing to build KAEC on its own, and will likely have to resort to government support, either in the form of infrastructure investment or more direct financing that could dilute current shareholders’ stakes. While we believe KAEC will be successful over the long term, this may not result in stock outperformance. SECTOR NOTE Companies Analysed in this Report Company Rating LTFV Price* Upside Mkt. Cap EV ST / LT (SAR) (SAR) (SAR) (USD) (SAR) (USD) Jan Pawel Hasman Saudi Real Estate (Akaria) Buy / Buy 33.50 26.30 27% 3,156 842 2,504 668 +20 2 3332 1139 [email protected] Dar al-Arkan Acc. / Acc. 19.15 16.60 15% 17,928 4,781 25,775 6,873 Patrick Gaffney *Prices as at 18 October 2009 +20 2 3332 1080 Source: TASI, EFG-Hermes [email protected] KINDLY REFER TO THE IMPORTANT DISCLOSURES AND 1 DISCLAIMERS ON BACK PAGE FERTILE GROUND FOR REAL ESTATE DEVELOPERS 19 october 2009 SAUDI ARABIA REAL ESTATE SECTOR EXECUTIVE SUMMARY VERY STRONG RESIDENTIAL MARKET DRIVEN BY DEMOGRAPHICS Long-term trends are very positive for the Kingdom of Saudi Arabia's (KSA) residential market. The major characteristics of the residential market are i) a young and growing population that is ii) increasingly urban and iii) characterised by a low home ownership percentage. We believe the market will also benefit from iv) a shrinking household size, as young people increasingly move out of their parents' home when they marry. We estimate annual demand of 160,000 new units each year, with unmet demand of up to 50,000 units. OUR SHORT-TERM VIEW ON THE MARKET IS CAUTIOUSLY OPTIMISTIC We believe new residential housing targeted at the middle-income segment has strong promise in the Saudi Arabian market, given powerful pent-up demand and a growing number of young people that would like to own their own homes. We believe prices have been fairly stable over the past year, but we expect them to start to increase again in 2010e and 2011e, particularly if liquidity comes back to the market either through higher oil prices, stock market performance or mortgages. The secondary property market is very small, which means that developers and the government are the main recourse for buyers and will therefore benefit from the expected positive growth trends. Additionally, while a large number of projects have been announced, we believe a number have been delayed owing to the financial crisis and new regulations. This is likely to benefit those developers able to launch within the next year. Dar Al-Arkan, with its Al Qasr project, which launched this year, and Shams Alriyadh project, launching next, should benefit the most from strong demand in the near term. THE STOCKS HAVE NOT DONE WELL Since the beginning of 2008, all Saudi real estate stocks have fallen. The decline accelerated after the world financial crisis in August, with a mild recovery in November and December before stocks fell again at the beginning of 2009. Although stock performance has improved since spring 2009, all are well below their early 2008 prices and all except Jabel Omar are down 40% or more. WE INITIATE ON AKARIA AND DAR AL-ARKAN - PREFER AKARIA We are buyers of both Akaria and Dar Al-Arkan, but we prefer Akaria because of its steady recurring revenue streams and stronger balance sheet. While Dar Al-Arkan has a better track record for development and the ability to grow, it is heavily dependent on buying and selling land profitably, while Akaria’s business model is simpler and steadier. Also, we believe Dar Al-Arkan's inability to roll over its SAR2.25 billion sukuk, due to be repaid in March 2010e, has hurt its short-term ability to grow or pay dividends. Both companies trade with a high correlation to the wider KSA market, particularly Akaria, so any changes in sentiment for the overall market are likely to affect both companies significantly. NEW MORTGAGE LAW SHOULD LIFT ALL BOATS Historically, very limited financing has been made available to homebuyers. While banks have offered mortgage-like products for some time, many are fearful of expanding without final government approval of mortgage loans. We expect the mortgage law, which has been delayed by almost a year due to the financial crisis, will benefit all real estate companies, but particularly those like Dar Al-Arkan and Akaria that target the middle-income segment of the population. CREDIT COULD LIMIT GROWTH AT DEVELOPERS Real estate companies generally have limited access to credit from banks or from the bond market. While some have been more successful than others, namely Dar Al-Arkan, we believe banks are very risk averse when it comes to real estate companies. This negatively impacts the companies, especially when combined with the difficulty of selling off-plan. This is probably a bigger concern for Dar Al-Arkan given its heavily leveraged business model, but even Akaria’s growth plans, which we believe will need financing could be limited. We expect this will reverse in the medium term, say towards the end of 2010e, particularly if a mortgage law is passed and demand picks up. KINDLY REFER TO THE 2 IMPORTANT DISCLOSURES AND DISCLAIMERS ON BACK PAGE FERTILE GROUND FOR REAL ESTATE DEVELOPERS 19 october 2009 SAUDI ARABIA REAL ESTATE SECTOR I. MARKET OVERVIEW ECONOMIC GROWTH REMAINS ROBUST DESPITE CRISIS Our economist believes that Saudi Arabia is in one of the strongest positions, both in the MENA region and globally, to withstand the current economic crisis and continue to support growth. We believe the government's investment programme will remain intact and will be the main driver of economic growth, as a result we expect economic activity to remain solid, resulting in real non-oil GDP growth remaining above 4.0% in both 2009e and 2010e.