Over the last two years, there has been a lot of discussion over the introduction of the cap on interest rates in Kenya and its effects on the real estate sector. Development and finance companies in the sector, such as Housing Finance, as well as construction companies, have come forward to blame the capping for declining profits. This was further supported by the decline in mortgages from 24458 accounts in 2015 to 24085 accounts by the end of 2016, soon after the implementation of the cap on rates. While it is a component that is constraining the real estate sector, we are of the opinion that the cap has not contributed much to the problems facing the real estate sector in Kenya.
The introduction of the cap law was introduced following concern from the public over the high cost of credit in Kenya, which hindered access to credit. From the year 2006 to 2015 however, the mortgage market had only 24000 accounts indicating that the banks were not willing to finance the property market even with huge spreads and big profit margins, which reflected the risks of financing property purchases in the country. With the implementation of the law, it was expected that the cost of credit would lower and increase access to finance, however, this was not the case in many sectors of the economy. As reported, the cap, saw a 1.5 percent decrease in mortgage accounts in commercial banks. Despite the decline, the value of mortgages increased from Ksh 203 billion to 219 billion.
Kenya has historically recorded low levels of mortgage. Today, Kenya’s outstanding mortgage debt to GDP ratio is still low compared to countries like South Africa, and Namibia where the ratios are above 20 percent. This is despite the fact that Kenya’s mortgage market is the third most developed in Sub-Saharan Africa, with assets equivalent to over 2.5 percent of the country’s GDP, according to World Bank. It is estimated that the residential real estate mortgage finance market stands at Ksh 200 billion. The news is not surprising as the Kenyan market has long been dominated by SACCOs. According to a World Bank report of late 2017, these institutions fund 90 percent of financed housing in the country and there are over 100000 housing loans outstanding. The sector provides the funds through packaged development loans at more affordable rates, rarely exceeding 14 percent, even before the interest rate regime was enforced.
Therefore, despite an expanding real estate sector and high expectations from the property sector over the past decade, banks have kept asking for large spreads to reflect lack of trust in the market due to lack of supporting incomes for applicants, and poor/lack of credit history that increase the risk of possible borrowers’ default, coupled with continuously increasing number of non-performing loans and the slowdown of the real estate market. In 2015, the housing price index rose by 4.2 percent in the first three quarters of the year, and by the end of 2017, the ratio of non-performing loans to gross mortgages was 10 percent, 3 percent points higher above the industry’s NPLs to gross loans ratio. It is also in the same time period where the banking sector was fragile after the shutdown of 2 major banks in 2015 and early 2016.
Knowledge of the real estate market indicates that the fundamental principles of real estate — and the availability of equity, debt, and economic strength— have a much greater impact on the valuation and performance of property than interest rates. And at present, banks still have a low appetite for real estate loans. The market for commercial mortgages is new and nearly non – existent. Because housing finance in Kenya remains below its potential, the government recently announced the establishment of the state-owned Kenya Mortgage Refinance Company (KMRC). Once KMRC has started operations, it will raise market debt, including mortgage-backed bonds, to lend to banks and financial cooperatives using their mortgage loan agreements with customers as security, thus help lenders who are afraid to write housing loans.
Another key variable is the supply-demand dynamics. Supply gluts and/or falling demand can lead to a rise in cap rates and fall of prices regardless of the business pursuits. Type of available properties, affordability, and future expectations also play a key role. Inflation represents the last of the variables as real estate may offer protection against rising inflation, mainly in the form of higher cash flow from rents or income. Expectancies are that after interest rates rise, banks could have drastically increased lending incentives and make access to finance easier. The resulting flood of debt will more than offset any negative impact of higher interest costs on cap rates and asset values. However, when the flow of debt eventually comes to an end, the process reverses, and the contraction of debt is felt in real estate. This sudden plunge in values grinds transactions to a halt, as long-term investors know that once the debt adjustment process is over, the cost of capital — and hence real estate values — will return to normal. As transactions cease, and loans default, sales only occur at temporarily depressed values to opportunistic equity buyers. These low value marks further discourage lending, and fuel a feedback loop. Given real estate’s high overall leverage, even a modest cyclical pullback in outstanding debt is simply too large to be absorbed without an intense impact on liquidity and pricing.
This phenomenon emphasizes that the flow of debt funds— more than interest rates — is the dominant determinant of real estate pricing, on the grounds that even very low prices cannot compensate for the entire absence debt in terms of the WACC. Higher interest rates can facilitate access to financing, but make the average borrower’s credit costs unaffordable. In reality, Kenya’s growth in real estate has not been sustainable. Despite the substantial call for affordable housing, the professionals, investors, and developers of the market focused on high-end and expensive real estate.
Looking at the future, it will be important to learn from past cycles and how the variables move. By doing so, it will become apparent that interest rates, property market values, and sustainability are not nearly as correlated as it would be assumed.
This article is written by Buildafrique Consulting Group; a multi-disciplinary consulting group of four (4) specialized companies, that offers End-to-End Real Estate and Development Solutions to Investors, Developers, and Prospective Home Owners in Kenya and the Regions.
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