Aug 18, 2019

Kenya’s real estate sector has been one of the fastest-growing sectors of the economy over the last 5 years. Recently, the sector has experienced a lower rate of development, with the shortage of funding in the real estate sector being a contributing factor to the slow growth, with most developers relying on presales and debt. The slow uptake has reduced the presales capital available for developers to plough back into the project, with average uptake in the Nairobi Metropolitan Area declining from 23.3% in 2017 to 20.9% in 2018 as per our 2019 Residential Report. The decision to cap interest rates in the banking sector has led to banks reducing funding to the real estate sector, owing to the tighter credit conditions, given the inherent risks in funding long-term real estate projects, as evidenced by the increase in non-performing loans (NPLs) in the sector. The latest data from the Central Bank of Kenya reported a 48.0% increase in NPLs from 2017 to 2018, equivalent to Kshs 14.4 bn, thus bringing the total NPLs in the sector to Kshs 44.4 bn.  In this regard, we sought to dissect the real estate sector in Kenya, particularly on the funding side, and how industry players can find alternative ways of accessing capital. This focus addresses the topic as follows:

1. Overview of the real estate sector, where we highlight the developing trends in the real estate sector and introduce traditional investment strategy vs modern real estate investment strategy,
2. Traditional financing for real estate development, where we highlight traditional methods of financing real estate and the challenges in financing real estate development the traditional way,
3. Alternative financing for real estate development, where we highlight uses of alternative financing methods, merits of alternative sources of financing and factors limiting the adoption of alternative financing sources in the real estate industry,
4. Case Study – South Africa listed property market, and,
5. Steps to increasing access to real estate development funding.

Section I: Overview of the Real Estate Sector

The Kenyan real estate sector has witnessed tremendous growth over the last few years, supported by the growing population, expanding middle class, rapid rural-urban migration, and investments in infrastructure across Kenya. The real estate sector growth is expected to be bolstered by current trends such as government initiatives like Affordable Housing as one of its Big Four Agenda, continued investment in infrastructure and devolution. On the demand side, the government is working on uptake through the introduction of the housing scheme and the establishment of the Kenya Mortgage Refinance Company, which is expected to increase credit availability.

In 2018, the real estate sector recorded continued investment across all themes driven by;

1. The continued positioning of Nairobi as a regional hub that has led to the increased entry of multinationals creating demand for residential units, retail space, commercial offices, and hospitality spaces,
2. Kicking off the affordable housing initiative as part of the Kenyan Government’s Big 4 Agenda, which has gained momentum with the launching of projects such as the Pangani Estate in Nairobi, and,
3. An improving macroeconomic environment, with the country’s GDP growing by 6.3% in 2018, higher than the 4.9% recorded in 2017.

In terms of performance, however, the sector recorded an average total return of 11.2% in 2018, 2.9% points decline from 14.1% in 2017 as per our Cytonn Annual Markets Review 2018. This is attributable to a decline in effective demand for property amid the growing supply, evidenced by the 3.0% decline in the residential sector occupancy rates, and an oversupply in the commercial sector, currently at 2.0 mn SQFT and 5.2 mn SQFT for the retail and commercial office sector, respectively. However, it is important to note that the development returns for investment-grade real estate continue to average above 20.0% p.a.

The first way of investing in Real Estate is the traditional way and is what most people are conversant with. This is brick and mortar investment, where a developer, either an individual or an institution, purchase a parcel of land and develops a building, which they later rent out or sell to end-users. Some of the key challenges here include;

1. Little or no research and feasibility analysis – Investments of this type are usually speculative in nature, with investment done based on prediction of trends, which in most cases is not backed by data,
2. Low returns – As a result of the little research put into such investments, they usually give low returns, especially in instances where there is oversupply of similar units or developments, or shortage of demand for the real estate units,
3. Illiquidity – Exiting brick and mortar real estate is hard as there lacks an official platform for transactions.

Traditional / Conventional Transaction Scenario: A saver with money takes it to the bank and gets little to no return on their deposit. The bank, in turn, lends the money to, say, a developer and charges market rate cost of borrowing. The bank enjoys the difference between the cost of the deposit paid to the saver and the yield on loan received from the developer. This is illustrated below:

• Saver has Kshs 10.0 mn; he can go deposit it in a bank and get at best 7.0% per annum return on the deposit,
• Developer can then go to the bank and borrow the Kshs 10.0 mn from the bank. Remember the bank will be lending to the developer the same Kshs 10.0 mn that the bank got from the saver, but the all-in cost after all bank charges and loan fees comes to about 18.0% per annum,
• Developer will then use the money to develop a house and sell it for Kshs 12.5 mn, essentially making a gross return of 25.0%, or Kshs 2.5 mn on the Kshs 10.0 mn loan,
• Developer will then pay to the bank the Kshs 10.0 mn loan plus 18.0% total cost of loan, equal to Kshs 1.8 mn, so a total of Kshs 11.8 mn goes back to the bank, leaving the developer with Kshs. 0.7 mn of profit.

Looking at an Alternative Financing Transaction, the facts remain essentially the same, except that the intermediary is not a bank but an investment vehicle; the saver with money takes it to an investment professional, through an Investment Vehicle, who gives the money directly to the developer. The developer will still pay the usual cost of borrowing, but instead of paying it to the bank, it will be paid to the Investment Vehicle, which will pass the returns to the saver. By structuring out the bank, the saver has been able to increase the returns from the typical rate of return given on deposits, to the typical rate of borrowing paid by developers. This is illustrated below:

• The saver has changed to an investor and channels his Kshs 10.0 mn to an Investment Vehicle managed by an investment professional,
• The developer can then borrow the Kshs 10.0 mn from the Investment Vehicle and pay the same 18% per annum they would have paid to the bank in the conventional scenario,
• The developer will then use the money to develop a house and sell it for Kshs 12.5 mn, essentially making a gross return of 25.0% or Kshs 2.5 million on the Kshs 10.0 mn loan,
• The developer will then pay to the Investment Vehicle the Kshs 10.0 mn loan plus 18.0% total cost of loan, or Kshs 1.8 mn, which will be paid to Mr. Investor,
• As a result, a total of Kshs 11.8 mn goes to the saver turned investor, leaving the developer with Kshs 0.7 mn of profit.

The difference between the Traditional Transaction and the Alternative Transaction is that the parties with money have come up with a private Investment Vehicle to be able to transact directly, by structuring out the bank. For the party with money, they get a much higher return, and for the party needing the money, the developer, they are able to transact very quickly and move faster than other developers relying only on conventional bank funding. This is the key essence of the Alternative Transaction: using highly customized features, it brings two parties together to transact through innovative features and delivers to them superior results than they would not otherwise get in conventional channels.

Section II: Traditional Financing for Real Estate Development

Traditionally, the two main ways of funding real estate development are through debt and equity.

1. Debt Financing

This has been the most common source of real estate funding, and is where a developer gets capital from a financier, and pays it back at a fixed rate, regardless of whether their investment yields return or not. Some of the common debt sources include;

1. Bank debt – This is where a developer obtains development capital from a bank or an institutionalized lender. The interest rates are usually determined by market forces, but in some instances, such as is the case in Kenya, can be controlled by regulatory authorities. The tenors of these loans vary in length, dependent on the profile of the project being funded. These loans are heavily collateralised and involve a lengthy due diligence process.
2. Private Lenders – Such capital is advanced by anyone with access to capital and a willingness to invest it. Usually, such lenders are not institutionalized or licensed to lend money, but rather do so with the intentions of earning a return. One of the benefits of such capital is that the lenders’ terms are typically easier to meet. The biggest disadvantage, however, is that the size of loans tends to be much smaller.

2. Equity

1. Presales Financing – This is whereby project developers can cover their capital requirements by selling their projects early on. This model of real estate development has garnered the interest of investors since it allows them to take advantage of capital appreciation of these properties that are sold off-plan.
2. Joint Ventures – This refers to a business arrangement in which two or more parties come together to undertake a project by pooling their resources together. Normally, real estate joint ventures combine the real estate development expertise and financing capability of a developer with the landowner’s contribution in the form of land.

Though the above methods of financing have worked for the real estate sector, they have not been short of challenges, in turn preventing the sector from growing to its full potential in terms of scale, as well as limiting the returns to real estate investors, as highlighted below:

1. Shortage of foreign financing and investment capital – In the traditional way of investing in real estate, the returns are low. This, coupled with the small scale in which these investments are done, discourages foreign investors from advancing funding. The long processes involved in the due diligence stage also drive away those who are seeking funding, with most opting to source for financing from other easier sources.
2. Difficulty in securing bank funding – Banks and other financial institutions have been very averse to offering credit, especially to the real estate sector, since they consider it a high-risk segment. This is attributable to the slow uptake of developed housing units. This, in addition to the interest rate cap that has tightened bank lending to the private sector, has seen the real estate sector struggle to secure bank funding.
3. When foreign financing is available, it tends to be expensive and of short tenor – Foreign investors, when choosing to invest in Africa, demand high returns, compared to what they would get in their local markets. Such funds also tend to have a shorter tenor, which does not give the developers sufficient time to yield returns from the real estate investment in order to pay back.
4. High degree of risk perception depending on firm/company – Most financiers usually require a long track record of delivery of real estate, which tends to isolate upcoming developers.
5. Unreliability of presales for funding – While presales are considered a cheap source of funding, they tend to be unreliable due to the possibility of defaults or delayed payments which in turn would result in project delays if relied upon.
6. Access to limited amounts of capital – Banks only provide a certain percentage of construction funding usually 50% - 70% of construction funding, thus developers have to look for alternative funding sources. Furthermore, bank debt is usually charged on the property title and thus a borrower cannot seek funding from other banks.

Section III: Alternative Financing for Real Estate Development

With the advancement in the real estate sector, as well as the various challenges facing the traditional funding methods for real estate, there has been a need to diversify the capital raising methods. This has given rise to innovative ways of funding real estate. Of these new real estate funding options, structured real estate investment solutions have gained the most traction. Structured real estate investments are solutions that are packaged by investment professionals to enable an investor access a return, supported by the performance of real estate, in a form that meets an investor’s needs. Structured products tend to have the following characteristics;

1. They involve adding layers or features to traditional real estate, through a process called “structuring”,
2. They generally deliver higher returns to the investors, in comparison to traditional investments,
3. Like real estate, they tend to provide principal protection, coupled with an above-average yield return, and,
4. They are generally traded in the private markets to qualified or sophisticated investors through alternative investment managers such as private equity managers.

While structured products are geared towards providing favorable returns to the investors, they have also proven to be quite indispensable in the real estate sector, in that in the hunt for high yield, they are invested heavily in asset classes such as real estate, making them an easily accessible means of financing for real estate developers. Another major advantage of structured funding is that it cuts out the middleman, in most cases financial institutions such as banks.

Some of the key financing options in structured financing are;

1. Mezzanine Funding – This is where an entity provides subordinated financing to a real estate development. The financing is junior to bank debt, hence gets paid only after the bank but senior to equity, and hence gets paid before equity investors.
2. Real Estate Structured Notes – This involves various options issued by a private firm, as a method of real estate financing. They include project notes, real estate-backed medium-term notes and other high yield loan notes, and,
3. Real Estate Investment Trusts - This involves purchasing units in a company that has converted the physical real estate asset into a liquid investable product. This can either be public markets tradable like REITs or privately placed.

Structured products and other alternative real estate funding options have proven to be useful in funding real estate. However, there is a heavy reliance in bank funding as opposed to funding from the capital markets, with 95% of business funding in Kenya being sourced from the banking industry, despite having one of the highest banking spreads globally, as compared to 40% in advanced markets. This slow uptake can be attributed to; 

1. Lack of sufficient market knowledge – There is insufficient knowledge of structured products in the industry, both on the supply side, with investment managers not bringing these products to the market, and on the demand side, with investors not being fully aware of the benefits they stand to get from structured products, thus opting for the traditional way of investing in real estate,
2. Lack of institutional development capacity – most of the real estate that is currently under development is not institutional-grade, and thus does not have the capacity to take up specialized funding such as that offered by structured products.

Section IV: Case Study – South Africa Listed Property Market

The South African listed property industry has experienced substantial growth over the past decade. The sector is dominated by a few large entities, with the biggest 10 accounting for about 80% of the sector’s market capitalisation. There are currently 27 entities listed as REITs on the JSE, with more attempts to bring new entities onto the exchange. According to the South African REIT Association, REITs represent about ZAR 233 bn (Kshs 1.6 tn) worth of real estate assets. South Africa is estimated to be the eighth-largest REIT market globally, with the US dominating the global REIT sector. Most South African REITs invest in commercial properties, such as shopping malls, warehouses, hotels, hospitals, and office buildings, with some investment in properties offshore.

Some of the factors that have led to the rapid development of the alternative funding sources in the South African industry are;

1. Presence of an already developed capital market – Even before the incorporation of alternative funding sources such as REITs and other structured products, the capital markets in the country were already well established. Not only did this make it easier for investment managers in structuring offerings for investors, given that they had built expertise, but it also boosted the uptake given that investors already had sufficient confidence in the capital markets.
2. Diverse property offerings – The property sector in South Africa is well diversified, with large institutional developers in all the real estate subsectors, who have built a strong track record in real estate delivery, while at the same time giving attractive returns. This has had a snowball effect, by encouraging lenders and investors to commit capital to this sector, further spurring the growth of this sector.
3. Good Corporate Governance – Good regulation practices and corporate governance have acted as an incentive to both local and foreign investors, who have the assurance that their funds are being properly administrated and utilized.

The success in the implementation of alternatives in the South African industry did not go without a host of challenges, such as;

1. Fluctuation in the real estate industry, where the property market in South Africa took a hit following the 2008 global economic crisis, and,
2. Competition with higher returns in Asia and other African markets.

Section V: Steps in Increasing Access to Real Estate Development Funding

Increasing the access to funding for real estate development can be achieved through;

1. The Development Of Structured Products In The Kenyan Market - These products have been a welcome alternative to banks for businesses seeking capital for growth, and the same can be applied to real estate financing. In developing markets such as Kenya, capital markets remain underdeveloped, hence businesses are forced to source up to 95% of funding from banks, while only 5% from capital markets. As such, real estate development and investment is not being provided with adequate access to this source of capital, which is provided at competitive rates can increase the development of affordable housing,
2. Tax Amendments to Level the playing field – Structured Products and Non-bank funding need to be given favorable tax treatment as all other funding methods, which will provide an incentive to capital providers to invest in the real estate sector. This is expected to spur development of alternative sources of funding at competitive rates available for the real estate development,
3. A Review of I-REITs - There is need to conduct a review on REITs, given that we only have one REIT on the stock exchange, and trading at 40% below its listing price due to negative investor sentiments,
4. Reduce Minimum Amount Investable in all Real Estate Investment Trusts (REIT) - In order to attract capital into capital market vehicles such as Real Estate Investment Trusts (REIT’s) for real estate development, the minimum investment amount needs to be amended. The current regulations, which define the minimum subscription amount per investor at Kshs 5.0 mn for a Development REIT (D-REIT) is too high to attract significant interest from investors. An amount of Kshs 1.0 mn ensures the investor is sophisticated while also allowing a larger pool of investors to participate.
5. Expand Trustees of a Collective Investment Scheme - Collective Investment Scheme Trustees should not only be banks but also include companies licensed by the CMA. For capital markets to fund real estate development, the players will need to accumulate capital in a fund overseen by trustees. The Capital Markets (Collective Investment Scheme) Regulations (2001) limit approved trustees to banks or financial institutions. Kenya has only 4 banks certified as CIS trustees, and thus we need to go the way of more developed countries and increase the pool to include other appropriate players.
6. Expand Tax Relief for Regular Savings Towards Home Purchase- Savings into Collective Investment Schemes regulated by the Capital Markets Authority (CMA) should qualify as HOSP (Home Ownership Savings Plan). Savings in CMA approved products, such as Money Market Funds currently don’t qualify as HOSP. Therefore, savers only have the option of banks, which pay low interest. There is need to expand the meaning of "approved institution" that hold deposits intended for the Home Ownership Savings Plan (HOSP) to include Fund Managers, thus enabling the potential homeowners making savings through the CIS to enjoy the tax relief provided under HOSP.
7. HOSP Guidelines should include Capital Markets Authority (CMA) investment guidelines in addition to the Central Bank of Kenya (CBK) - HOSP guidelines only recognize investment guidelines per CBK. If Fund Managers are included, the guidelines would be as per CMA. So that an investor has a choice whether to save through a bank or an investment savings product. To include investment guidelines provided by the CMA regulations, in addition to the prudential guidelines issued by CBK to regulate investment of deposits under a registered HOSP.
8. Allowing Specialized Collective Investment Schemes- There is currently no provision to register a Collective Investment Scheme (CIS) that invests in a single asset class, specific sector, or is formed for a specific purpose, thus limiting the financing available to real estate from Collective Investment Schemes. The Capital Markets regulations for Collective Investment Schemes do not allow a sector-specific fund to be formed e.g. a technology, financial services, or real estate fund.

Real Estate development is crucial in any developing economy, According to the National Housing Corporation, Kenya has a cumulative housing deficit of 2.0 mn units growing by 200,000 units per year being driven mainly by (i) rapid population growth of 2.6% p.a. compared to the global average of 1.2%, and, (ii) a high urbanization rate of 4.4% against a global average of 2.1%. Supply, on the other hand, has been constrained with the Ministry of Housing estimating the total annual supply to be at 50,000 units. Alternative sources of funding are critical to helping meet the housing demand and real estate needs of the country and help provide affordable housing.

 

Disclaimer: The views expressed in this publication are those of the writers where particulars are not warranted. This publication is meant for general information only and is not a warranty, representation, advice or solicitation of any nature. Readers are advised in all circumstances to seek the advice of a registered investment advisor.