12 January 2012

Kenya: Is a Property Bubble Imminent?

Economist Walter Bagehot defined the process of a financial crisis as "quiescence, improvement, confidence, prosperity, excitement, overtrading, convulsion, pressure, stagnation, ending again in quiescence". This would aptly describe Kenya's property sector and what is likely to happen unless urgent measures are taken to forestall a likely bubble.

The property market has grown considerably in the last decade. Property consultants, Knight Frank's 2011 Africa Property Report reported robust activity in all market segments, with many projects already completed. Others such as Renaissance Capital's proposed Tatu City and Centum Investments' "diplomatic hub" are in the pipeline. To capitalise on the boon, various companies quickly created real estate departments while some NSE-listed agricultural companies began to diversify into property development, saying their land would be worth 10 times the current share price if it were converted to real estate. This unfolded amid allegations that a good portion of the finances flowing into the sector was actually proceeds from piracy in neighbouring Somalia.

According to real estate analysts, the growth has mainly been driven by urbanisation, a strong economy and growing middle-class, stable legal environment, significant credit expansion, and increased spending on infrastructure by government. However, the market faced difficulties in 2011 due to high inflation, a weak shilling, high cost of land, and cases of fraud.

The high inflation last year caused steep import prices. Consequently, the shilling weakened, falling to a historic low of 107 to the dollar in October. The cost of construction materials rose by about 40% and forced developers to spend more on projects. This hurt the property market and is prompting commercial banks to cut lending, fearing a slowdown in the uptake of properties especially in the upmarket segment.

How and whether the growth can be sustained are now major worries for investors and Kenya's government.

According to the Depository Corporation Survey, the real estate sector received a large portion of the credit that was released in the last few years, as lenders saw it as a safe and profitable investment. Research analyst at NIC Securities, Samora Kariuki, says a lot of this credit was disbursed on the premise that higher property and land prices (often posted as collateral) ensure that borrowers are always in positive equity and can therefore borrow more money, which ends up being a perpetual cycle.

'Of concern is that of late, credit to the real estate sector has been growing significantly. In fact, as of the third quarter of 2011, it accounted for 12% of all private sector credit. In addition, personal loans account for just over a quarter of all private sector credit. The Central Bank of Kenya is fuzzy about its lending classification as I am of the opinion that a number of personal loans are actually taken to invest in property,' says Kariuki.

If this is the case, then credit to the real estate sector could account for over a quarter of all private sector credit.

Says Kariuki: 'This does not bode well for the economy as credit-based asset prices are driving economic growth rather than improvements in productivity that would drive better wages. You then get a disconnect between income growth and asset price growth, which will have to correct in the near future most likely through a correction in asset prices (house prices to fall) because wages are sticky downwards.'

Marlborough Properties Limited owns luxury apartments in Nairobi, has three other projects planned, and

is confident it will acquire financing. The company's director, Nick Stock says developers with viable business models and proper corporate governance structures should not have problems getting credit. However, because the country entered 2012 from a weaker than expected economic position, the uptake of property could be slow and new projects costly.

'Most of our finishes are imported goods. We managed to procure nearly all of these before the shilling went into serious decline. Had we been procuring these items today, our selling prices would need to be considerably higher. Our mitigation in the future will be our "buy well" procurement policy, combined with currency hedging,' says Stock.

The building industry is beset with many challenges, especially in supply chain and regulation. The cost of inputs is exorbitant and especially serviced land.

'This makes it hard to deliver homes efficiently. Where such problems exist, developers will add a cushion - or "risk premium" - on home prices to protect against things that are likely to go wrong,' says Laila Macharia, the founder of the Kenya Private Developers Association and chief executive of Scion Real.

Macharia believes the best incentive the government can provide is to improve on the overall investment climate, which would facilitate faster delivery of affordable housing.

"If professionals are better regulated, developers won't have to consult several of them for the same service. If contractors are more organised, projects will complete faster. If power and fuel prices come down and roads are fixed, the cost of building supplies will stabilise. If corruption is eradicated from municipalities and land registries, developers will be able to complete their approvals more quickly. If there is legal reform, developers will be able to enforce their contracts. All these will convert into savings for the developer and ultimately for home buyers,' says Macharia.

So, can Kenyans actually afford to buy the now over-priced houses or is a bubble eminent? Does the 'middle-class' that real estate investors target when buying/developing houses to sell or let at higher prices, actually exist?

Not really, says Kariuki in an article posted on his blog. He opines that the middle-class that real estate analysts and the media have in mind is very different from the middle-class that actually exists.

'The middle-class they have in mind are the people who earn more than Kshs100 000 per month, have a car and take their kids to private schools...On the ground the middle-class is in stark contrast to what they envision, and would not offer the captive market for the exorbitantly priced houses in the leafy suburbs. Instead, they will ensure that a developer who puts up apartments in Kikuyu, Kinoo, Kahawa Sukari and Ruiru will have a captive market for his rental income...Our short economic history shows that the companies and businesses who have taken time to understand the "middle-class" have thrived,' says Kariuki.

The mortgage market in Kenya - the World Bank says it's the third most developed in sub-Saharan Africa after South Africa and Namibia - has big challenges that have locked out the majority of citizens from accessing the necessary financing to buy properties. The challenges include the lack of access to long-term funds and credit risk information, low incomes, difficulties with registration of property, and high interest rates.

'The cost of homes and of housing finance is too high. The legal system is not strong enough to make both the lender and the borrower confident,' says Macharia, adding that the recommendations included in the World Bank's report for Kenya's mortgage market would go a long way in providing more inclusive financing to potential home owners.

The World Bank's report recommended collaborative efforts between the private sector and government to expand the stock of mortgageable properties, provide affordable finance, improve risk management, and to develop a secondary mortgage market.

Nevertheless, there have been considerable gains in housing finance over the years in both value and number of loans. Stock and other investors in the sector are confident that the growth will continue locally and in the East African region.

'The mortgage market is set for tremendous growth over the next decade, both in Kenya and the region. The key factor is the rates of interest charged. However, treasury would need to progressively lower interest rates. Reduced rates will stimulate economic growth, wealth creation and increasing home ownership,' says Stock.

Globally, the key signals as to whether or not a bubble is forming in a market are increasing cases of fraud; investors owning a high proportion of properties; large number of holiday homes being built - indicating that there would not be enough buyers to take up the properties, and weak re-sale markets.

In Kenya, there are increased cases of fraud in land and property purchases. In November 2011, the government demolished real estate projects worth millions of shillings in Syokimau in Nairobi City, saying the homes stand on fraudulently acquired public land.

'If there were no gullible investors stuck on the premise that house prices only know one direction (up, up and up), then there would be no room for fraud. You rarely hear of fraud in pyrethrum markets or cassava markets. I think the rising cases of fraud in real estate are a pointer that a bubble could be forming,' says Kariuki.

Analyst at Standard Investment Bank, Denis Migoi says it is clear that certain markets in Kenya are showing signs of being overpriced when compared to historic ratios between housing prices and income levels.

'If high mortgage rates persist, unemployment rates go up, and demand for housing weakens, then a bubble is imminent. When the price of a product is decreasing and consumers know that they can buy the product in a few months at a cheaper price, then they will wait to buy. This "waiting" is poison for any industry,' says Migoi.

Despite the challenges, the prospects for the real estate sector in the long-term appear promising. For those investors who are eyeing the market now, it would be advisable to conduct thorough due diligence.

'Foreigners interested in investing in property should continue to do so if they carry out a proper due diligence on titles and ensure that the registered owner has a legitimate title. The fact that the tenure of the properties that they may hold is restricted to not more than a 99-year lease should not be a barrier to investment. It is expected that parliament will soon put in place legislation to deal with extension of leases,' says Rachael Mbai, partner at law firm Kaplan & Stratton.

Perhaps Kenya's economy can turnaround quickly. The International Monetary Fund in its latest economic update said that for the country to set the foundation for a more prosperous future, it must successfully tackle three main issues for 2012: weather the impact of the unfolding Euro crisis, conduct successful national elections, and continue to implement the new constitution, which contains ambitious governance reforms that would greatly improve the investment climate.

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