Saturday, June 24, 2006

The Economics of Key Money

Recently, the Gulf News has been running articles about 'key money.'

I once looked at a café, and the asking price was itemized into decor, goodwill, and key money. At the time, I'd never heard of key money, but I've certainly learned about it since.

In Dubai, there is a Rent Commission, and landlords cannot raise the rent by an excessive amount. The problem, of course, is that the Rent Commission's definition of 'excessive' tends to vary widely from year to year. Currently, the Dubai Rent Commission defines 'excessive' as 'more than 15%.' Before 2003 (I was told) 'excessive' meant 'more than 10% every two years.' At the time I was looking at the shop (2005), excessive seemed to mean 'more than 100%.' And the landlord did indeed raise the rent on the shop by exactly 100%, which the Rent Commission allowed. They said, given the Dubai economy, 100% was not 'excessive.' Which meant the buyer should not have paid any key money.

But before 2004, key money made perfect sense. For example, flats in my building rented for a wide range of prices. As a long-standing tenant, I was paying about €500 per month, the same price as when I'd moved in; new tenants were paying about €750 (and tenants without residence visas, legally barred from leasing residential flats, were sub-leasing from entrepreneurs who were charging them more than €1,500 per month).

For the last 10 years, Farook, relying on the old definition of excessive as '10% every two years' made his living off key money (not in my building, but in several other apartment buildings in Dubai). He'd find some long-standing tenants who had to move for some reason, and would take over their lease. The old tenants were very happy with Farook, since they were legally obligated to pay out the full lease (having written post-dated cheques for the full amount), and Farook relieved them of that responsibility. He usually gave them a little key money, as well.

Then Farook would charge the new tenants 'key money' (and also sub-lease the flat to them for a price midway between the old price and the current rent). Farook's customers would be very happy, since they would be saving quite a bit on the rent.

And Farook would be very happy.

Basic economic theory says that this phenomenon must occur whenever there are any rent controls: people like Farook (and many others) will figure out how to take advantage of the controls. Here in the UAE, it's called 'key money.' Elsewhere, I'm not sure what it's called. (I once tried to find someone like Farook in New York City, where 30 year residents may be paying less than $100 in a building where new tenants have to pay $3,000, but didn't have any luck, and couldn't find anything where the rent was less than my salary.)

Lately, the key money business in Dubai has become much more difficult, since rents have increased drastically, and are allowed to rise (for now) 15% a year, and people can't see paying key money when they can rent for the same price directly from the landlord without it.

So Farook has had to adapt.

He tried to sell me a school in Sharjah for about €4,500,000 (the school cannot be sold to ex-pats, so that would have been €4,500,000 pure profit, split between Farook, some of his cousins, and a few Citizens). Then he offered to sell me a software business for about €200,000. The fact that I don't actually have €200,000 (let alone €4,500,000) seems to be beyond his grasp, since he thinks all Westerners must necessarily be in a position to consider Croesus a pauper. I was courteous enough to read the contract for the 'software company.' Actually, it was a fake cleaning company, where I was to put in all the capital, and the capital would then be distributed among Farook, another khandoura-clad ex-pat, and the requisite Citizen to give the enterprise legitimacy. This was all clearly spelled out in the English contract, since they'd been trying to sell the company to some Arabs before they thought of me (and they hadn't bothered to switch the English contract for an Arabic one). Sadly, Farook failed to separate me from my tiny mite.

Another profitable enterprise Farook is currently pursuing is collecting key money for some unadvertised flats only he knows about. Because no one knows about them, these flats are renting for much less than the normal Dubai rent. But Farook has been in Dubai a long time, and knows where to find such bargains. In this case, the bargains are located in Sharjah, where rents are about 50% of what they are in Dubai. Farook's customers think they're getting a Dubai flat for a 25% discount (well, he's not going to let them sub-lease it without a profit, is he?), and they are happy to pay key money. Until they realize they've been had, by which time it's too late.

One thing I find strange is that Farook doesn't seem to be doing much in the new, freehold areas.

This time last year, small villas were renting for about €1,000 a month. With the 15% limit on increases, landlords cannot legally raise the rent above €1,150; however, new tenants are offering as much as €2,000. Which means some old tenants and entrepreneurs will be trying to collect key money. But, at least as far as he's confided to me, Farook is not among them.


Blogger James said...

There are many forms of rental regulations which all get labelled as rent controls so one needs to get specific about what law they are talking about when they discuss so-called rent control laws.

3:03 am  

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