Stand-out performer: Despite short-term challenges, an expanding middle class and rapid economic growth provide strong fundamentals for growth

As one of the major markets of sub-Saharan Africa, Kenya is of increasing interest as a real estate investment destination. The 44.2m-person country and its 4.2m-strong capital Nairobi, act as a gateway to a regional East African market approaching some 150m people. Domestically, the economy has been outperforming much of the world, the population is expanding and incomes are on the rise.

Given these basic demand trends, it is hardly surprising that Kenya, like much of the sub-Saharan Africa region, is piquing the interests of a range of international funds and institutional investors. However, translating this interest into concrete large-scale capital inflows remains an issue. The market, like many others in Africa and beyond, is beset by a variety of short and long-term challenges that constrain investment.

Fundamental Demand Dynamics

Nevertheless, the long-term outlook for property in the country looks strong. Kenya is a significant player in a standout region, the only one in which the share of global foreign direct investment has increased in the last decade (17% in 2014). Indeed, it is part of a continental story in which infrastructure investment is expected to grow at 10% per annum in the next decade and the urban middle-class population is expected to reach 250m households by 2030.

Kenya’s domestic story is also compelling. The basic market of 44.2m people is expanding significantly. The country has experienced a strong population growth rate, standing at 1.93% in 2015. More importantly, the demographic structure of the country points towards a strong potential for economic and income growth.

Currently, more than 60% of the country’s population is under the age of 25. While this creates substantial dependency, with a heavy burden on public services and limited taxation revenue, the situation should be reversed in the coming decades.

Indeed, the Economist Intelligence Unit (EIU) estimated that Kenya will be one of the top-five economic beneficiaries from population growth globally. According to the EIU, the size of the labour force in the country is expected to increase from the current level of 18m to 48m by 2050. This growth alone should help contribute 1.7 percentage points to the economic growth rate and help the country maintain an average annual GDP increase of 4.7% over the next three and a half decades. This potential demographic impact is only bettered by Nigeria (1.9 percentage points on 4.9% growth) and Angola (two percentage points on 4.3% growth) in Africa, according to the EIU.

Even without this demographic dividend, Kenya’s economy is already performing strongly. In a low growth global environment the country recorded an economic growth rate of 5.6% in 2015. This is unlikely to tail off any time soon. The World Bank estimated GDP growth of 5.9% for 2016 and 6% for 2017.

Indeed, the country has established itself over the years as one of the stellar performers in the region, consistently outperforming the average annual economic growth rate for sub-Saharan Africa since 2009. This has had a positive impact on income in the country. In 2015, for example, Kenya moved from low-income status to join the ranks of the lower middle-income countries with, annual per capita incomes ranging from $1046 to $4125, according to the World Bank. Personal disposable income is also increasing, growing by approximately 13.8% in 2014, according to the Kenya National Bureau of Statistics.

Mature Returns

A maturing real estate market also bolsters these trends. Kenya, for example, was ranked as one of the top-10 improvers in real estate transparency in 2014, according to a global report compiled by Jones Lang LaSalle (JLL). The industry has become central to the country’s growth story, with the sector now contributing 9% to GDP.

Real estate has been a hot area in recent years. In the last half decade, property has outperformed traditional asset classes, generating average returns of 25% per year, compared to 10% for other asset classes, according to Cytonn Real Estate, a local property investment and development company.

Finance Vehicles

This improving reputation was cemented in the last quarter of 2015, with the launch of Kenya’s first real estate investment trust (REIT). The vehicle, worth KSh3.6bn ($35.1m), was listed by Stanlib Kenya. With an initial value of KSh20 ($0.20) per unit upon launch in December 2015, the REIT has had a mixed performance thus far. In late July 2016 the unit price had fallen to KSh18.1 ($0.18).

Nonetheless, Geoffrey Odundo, CEO of the Nairobi Securities Exchange, told the press in late 2015 that he expects more REITs to launch this year. Indeed, the authorities will hope that the country can follow the lead of South Africa. Its continental counterpart only introduced regulations regarding REITs in 2013, but by the last quarter of 2015 South Africa had a total of 33 domestic REITs and three foreign vehicles listed on the Johannesburg Stock Exchange, with a market capitalisation of more than $32bn. However, inflows are not limited to investment trusts.

The country has also seen some private equity activity in the property sector. For example, the British firm, Actis, has invested in the Garden City Mall and the Nairobi Business Park in the capital. The company raised KSh50bn ($487.9m) in 2016 to invest in private property ventures on the continent through the Actis Africa Real Estate Fund 3.

Short-Term Challenges

Such ventures point to the strength of investment opportunities across a range of property segments moving forward. However, in the short term there are a number of challenges that may slow the growth in funds and trusts entering the market. “So far, the impact [of REITs] is not very big,” Ronald Juxton, CEO of Goldman Group, a local real estate brokerage company, told OBG. “Institutional investors are totally out of the real estate market, especially the residential segment.” Even in South Africa, the emphasis of REITs has been on the income generating potential of commercial real estate.

However, Kenya is also hampered by a number of short-term factors that are not conducive to the launch of new REIT products. First, there has been a poor run for the country’s stock market in 2016, with the bourse losing an estimated KSh55bn ($536.6m) of its value in the first six months of the year. The country’s currency has also weakened somewhat, experiencing a 12% depreciation against the dollar in 2015. Finally, the run up to the August 2017 general elections also heightens uncertainty over broader risk.

During such times, the preference is to hang onto cash rather than invest in real assets, according to Juxton. “We will not see many projects in the next 12 months, and even banks will be cutting down on lending to individuals,” he told OBG.

Residential Market

As such, activity in the market is likely to slow down in terms of both developments and transactions. In the residential market this period of caution will simply reinforce what has been a slow sales market. “In the past two years, we have seen a reduction in prices. Mixed-use projects, in particular, are getting harder to sell,” Juxton told OBG. “We also have a glut in the higher-end residential market. We have oversupply at the moment.”

For the residential market as a whole, the picture is mixed. The Kenya Bankers Association Housing price index (KBA-HPI) points to a slow market. The index shows that house values have increased by less than 1.5% in each quarter in the year to March 2016. While prices were almost completely flat at 0.2% growth in the second quarter of 2015, they increased by 1.4% in the first quarter of 2016.

This represents a curious anomaly in the general long-term trend. Indeed, since the turn of the millennium, property prices have increased by 357%, according to Hass Consult. Moreover, in the last half decade, property values have grown between 4.7% and 10% on an annual basis. However, recent growth has also been rather uneven. According to Knight Frank, the UK-based commercial property consultant, luxury residential property in Nairobi actually saw a 3.5% increase in selling prices in the first three quarters of 2015. This is more in line with the general trend in property over the last three years.

Furthermore, many within the industry are yet to witness a complete slowdown in transaction activity. For example, Jumia House, an online real estate listings platform, reports sizable churn in their listings, with up to 30% of rental listings changing each month, and as many as 15% of sales listings.

Nairobi and its environs dominate the residential market. The capital and its satellite towns account for some 72% of all listings on Jumia House, for example. The other major markets include Mombasa and Eldoret. In the Nairobi area, the price of a two-bed unit ranges from approximately KSh4m ($39,028) in the outer suburbs up to KSh14m ($136,598) in the city. Indeed, in the city itself, two-bed units usually sell for a minimum of KSh7m ($68,299).

Formal Affordability

This points to a larger and longer-term problem with the country’s property market. The current formal, developer-led sector represents just a small portion of the overall market and has little ability to cater to the substantial demand dynamics in the real estate segment. “Less than 1% of the population would be able to afford properties in the formal sector,” Juxton told OBG.

As such, there is a significant mismatch between the formal supply hitting the market and the nature of demand in the country. This has led to a situation of disparity. “There’s an emphasis on the high-end properties rather than the low end,” Ngumi Gituro, product manager at Jumia House, told OBG.

According to the company’s calculations, any residential property leasing for less than KSh70,000 per month ($683) is considered affordable. However, while the highest demand comes for units below that figure, approximately 60% of properties are listed above that price. The formal market is, thus, responding to a small segment of the wider residential market. Housing supply in the market is relatively meagre. Private sector developers are expected to bring approximately 45,000 units to the market in 2017, according to Juxton. This is similar to 2015, when approximately 44,000 units entered the market. In the high-end, luxury segment, a total of 3000 new units were forecast for 2016.

Low-Income Housing Supply

In terms of low income affordable units, the supply is somewhat constrained. The National Housing Corporation (NHC), the government body that is responsible for housing programmes and policies, for example, currently has just eight projects – totalling 531 units on its books — either ongoing or out for tender. While it has a further 9965 housing units in the pipeline, this falls a long way short of demand requirements.

The NHC estimates that a total of 50,000 units are brought to the Kenyan market each year, while the urban housing need across the country stands at between 200,000 and 250,000 new units per year. Importantly, these figures do not even take account rural areas, where housing requirements are twice the size of those in towns and cities.

Input Pricing

Supply side management is hampered by the high costs of development in the country. For both government agencies and private developers, the ability to build affordable units is constrained. Prefabricated structures can be constructed for as little as $90 per sq metre, while the NHC prices its units on average from $250 to $300 per sq metre. Even at this lower end, building a unit at cost would remain unaffordable for a substantial share of the Kenyan population. According to the Mortgage Company, a Kenyan real estate consultancy firm, only 20% of Kenyans can afford a residential unit priced at $10,000.

In addition to affordability, developers in the country have been facing another challenge when it comes to changing the way the local population perceives and accepts low-cost housing. Indeed, the uptake of some construction materials, which are primarily used in prefabricated structures and sustainable buildings, has been slower compared to traditional building materials, due to their unfamiliarity.

Land

The cost of development is not just confined to construction prices. One of the biggest challenges to the goal of affordability is land pricing in the market. “Land [pricing] is based on speculation and not on proper evaluation,” Juxton told OBG. “Land that can be developed for major projects is also very limited.” This is particularly the case in prime residential areas of the capital, such as Kilimani, Kileleshewa and Westlands.

In the seven years leading up to the beginning of 2015, land prices increased by more than 535%, with land in the prime area of Upper Hill costing KSh470m ($4.6m) per acre, according to Hass Consult. By the first quarter of 2016 land in the same area cost KSh511m ($5m) per acre. Given these constraints, many developers are now looking to satellite towns outside the main urban areas to build more price competitive offerings. This move has led to a slight softening of 0.2% in the price of land in certain prime inner city locations, according to Hass Consult.

Mortgages

While lending to the real estate and construction sectors increased by 25.6% and 30.1%, respectively, between June 2011 and September 2015, the cost of financing remains an impediment to affordability. This is not only the case on the supply side, in terms of borrowing by developers, but also on the demand side in terms of loans to potential home owners. Indeed, Kenya’s mortgage market is failing to bridge the affordability gap for most potential buyers. There are some 12m bank accounts in the country, giving a broad sense of the scope of the formal market. Of this, between 4m and 6m would be eligible for a mortgage, according to Juxton. However, by the end of 2014 there were only 22,000 mortgages in the market.

Although uptake has been on the rise, with an 11% increase in 2014 alone, mortgages are largely failing to help Kenyans get onto the property ladder. According to a study by Cytonn Real Estate, mortgages remained unaffordable for Kenyans across all neighbourhoods of Nairobi. The company calculated that the median house price per sq metre in Nairobi is KSh97,295 ($949), which would require a monthly mortgage repayment of KShS135,635 ($1323). Based on mortgage repayments comprising 40% of income, a median Nairobi mortgage would require a household income of KSh358,070 ($3493). However, the median household income in Nairobi is KSh200,000 ($1951) per month, according to Cytonn. The major problem is the cost of a mortgage. Loans in the local market are charged at anywhere between 12% and 21.4%. This is not only the result of the general inflationary environment in the country and government monetary policy, but also a consequence of the risks attached to the portfolio. Indeed, in the first quarter of 2016 real estate accounted for 42% of non-performing loans across the commercial banking sector. The government has made efforts to combat these issues with the introduction of subsidised mortgages for civil servants in 2015. Such loans will have interest rates capped at 5% and be available over a 20-year tenor. Peter Wairegi, CEO of resorts and cities developer Longonot Gate & Makuyu Ridge, told OBG, “The recent interest rate cap should be helpful for mortgage borrowers, but educational training is still needed to improve awareness of financing options.”

Rental Market

Given the question of affordability and the levels of distress in the sector, it is perhaps unsurprising that the market is dominated by either self-builds or rental. Some investors, such as the US-based International Green Structures, are looking to introduce pre-fabricated affordable housing into the market, focusing on community organisations such as savings and credit associations.

However, in large urban areas the rental market predominates. “Kenya remains mainly a rental market because most people do not have the cash flow to buy or to get a mortgage,” Gituro told OBG. This is particularly true for the younger generation up to the age of 35, who account for a substantial proportion of demand (45% according to Jumia). Overall, 60% of the listings on Jumia are rentals.

Rental rates are highly competitive compared to monthly mortgage repayment requirements. According to Cytonn Real Estate, the rental affordability index tracks much higher than the mortgage affordability index, indicating that rents are affordable to Kenyans in most areas of the capital and its satellite towns.

In the lower- to middle-income segment of the market, a two bed rental property would lease for KSh25,000 ($244) to KSh40,000 ($390) per month in desirable areas of Nairobi and its environs, according to Juxton of Goldman Group. In the upper- middle-income segment, rental rates for a three-bedroom would range between KSh90,000 ($878) and KSh120,000 ($1170) in good neighbourhoods of the capital. This represents a substantial softening at the top of the market. According to Juxton, the same properties would have leased in a range between KSh110,000 ($1073) and KSh140,000 ($1366) three years ago.“Rents are vibrant, but rents are too high in Nairobi,” Juxton told OBG.

The leasing market can be broken into two, with the lower-middle-income segment outperforming the upper-middle-income segment. Indeed, with high demand in the lower-income segments, investors can see strong returns here. Rental rates in this segment have been on the rise, with rental yields as high as 30%. This compares to declining yields of 10% to 15% in the upper-middle-income segment of the leasing market. While these may look appealing on paper, commercial lending rates that hover around the 18% mark in the local market render the low double-digit yields in the upper-middle-income segment less attractive. “In terms of recouping rental yields, the upper- middle-income leasing market is not great,” Juxton told OBG.

Outlook

While there is undoubted potential in Kenya, the ability to tap into it is somewhat constrained. Affordability remains a concern and, therefore, in the volume-driven segment of the residential market build to let is a key model. At the higher end of the residential market, which represents a small fragment of the overall picture, the dramatic growth of the past five years appears to be slowing down. Indeed, across all segments, investors are likely to adopt a wait-and-see approach, as the country enters election season. Moving beyond that, Kenya’s strong growth fundamentals are likely to bring more foreign capital into the market.