|The Central Bank of Kenya|
The cost of borrowing in all banks is driven by the real interest rate which is fuelled or largely accommodates inflation. Inflation is the key driver of interest rates. The banks are highly supervised and are under the obligatory role of the Central bank of Kenya which determines the base lending rate accommodating all factors in the economy, based on this, the banks can then come up with their own mortgage rates or borrowing rates, a few basis points (spread) from the Central Bank lending rate.
In recent years, a number of countries experienced a rapid increase in housing market activity, which coincided with a period of low real and nominal interest rates. The link between the two is intuitive: low interest rates make credit cheaper and increase the demand for housing.
In more developed mortgage markets, consumers have easier access to credit and tend to be more leveraged. In the presence of financial frictions, the impact of changes in interest rates on consumers and therefore the housing market should become stronger when leverage is higher.
When interest rates are high, it means that fewer people and businesses can afford to borrow. This lowers the amount of credit available to fund purchases, slowing consumer demand. At the same time, it encourages more people to save (if they can) because they receive more on their savings rate. Higher interest rates also reduce the capital required to expand businesses, strangling supply. This reduction in liquidity usually slows the economy down. Low interest rates have the opposite effect on the economy.
Low mortgage interest rates have the same effect as lower housing prices, stimulating demand for real estate. Mortgage financing refers to a loan secured by collateral of some specified real estate property that the borrower is obliged to pay back with predetermined set of installments. The loan is usually for the purchase or construction of housing estates by individuals or companies.
Interest rates, especially the rates on interbank exchanges and Treasury bills, have as profound effect on the value of income producing real estate as on any investment vehicle. Because the influence of interest rates on an individual's ability to purchase residential properties (by increasing or decreasing the cost of mortgage capital) is so profound, many people incorrectly assume that the only deciding factor in real estate valuation is the mortgage rate. However, mortgage rates are only one interest-related factor influencing property values. Because interest rates also affect capital flows, the supply and demand for capital and investors' required rates of return on investment, interest rates will drive property prices in a variety of ways. Interest rates can significantly affect the cost of financing and mortgage rates, which in turn affects property-level costs and thus influences values. However, supply and demand for capital and competing investments have the greatest impact on required rates of return (RROR) and investment values.
As interbank exchange rates decrease, the cost of funds is reduced and funds flow into the system; conversely, when rates rise, the availability of funds decreases. As for real estate, the changes in interbank lending rates either add or reduce the amount of capital available for investment. The amount of capital and the cost of capital affect demand, but also supply capital available for real estate purchases and development. For example, when capital availability is tight, providers of capital tend to lend less as a percentage of intrinsic value, or not as far up the capital stack. This means that loans are done at lower loan to value ratios, thus reducing leveraged cash flows and property values.
Most retail investors, especially homeowners, focus on changing mortgage rates because they have a direct influence on real estate prices. However, interest rates also affect the availability of capital and the demand for investment. These capital flows influence the supply and demand for property and, as a result, they affect property prices. In addition, interest rates also affect returns on substitute investments, and prices change to stay in line with the inherent risk in real estate investments. These changes in required rates of return for real estate also vary during periods of destabilization in the credit markets. As investors foresee increased variability in future rates or increase in risk, risk premiums widen, putting increased downward pressure on property prices.
High interest rates in Kenya are hurting real estate investment. Interest is a cost to the developer of real estate as it is to the end buyer. The Central Bank of Kenya (CBK) increased the Central Bank Rate (CBR) from 8.5% to 10% in an effort to tame runaway inflation and stabilize the weakening shilling. Consequently commercial banks have increased their lending rates. While the intervention by the CBK targets to bring relief to the economy, the effects of high interest rates on real estate are yet to be felt. Real estate market is an imperfect market. Any changes in real estate market are felt several months later. This can be explained by the process and time it takes to deliver real estate.
High interest rates in Kenya mean that ongoing projects will cost more when finally delivered. This will be due to higher costs of material, labor and most importantly the cost of construction money. Halting or delaying work in progress would only escalate costs further. Developers will therefore want to pass the increased costs to buyers in the form of higher prices. Should they fail to do so, they will have to do with drastically reduced profits or suffer loses. New investors will shy away from real estate investments resulting in lower investment interest.
Lower interest rates allow more people to be able to qualify to purchase a home, thus more people can afford to purchase. At the same time, because more people are able to purchase homes, it reduces the amount of homes on the market (reduces the supply) which in turn pushes up the cost. Conversely, when interest rates are high, fewer buyers are able to qualify for a loan which increases supply. Over supply tends to push prices lower.
It is not a secret that today, the real estate market in Kenya is facing several challenges even after continuous growth in the last few years. Property prices around the country and especially in Nairobi have reached levels that are out of the range for the majority of the population. Easier access to mortgage facilities would have been the possible solution that could boost further the real estate market as cash buyers become less day after day.
For the last six months though, we kept on listening and hoping that the CBK will reduce the CBR. This would have led to cheaper finance, and hopefully an increase in the mortgage sector in Kenya which today accounts for just 21000 active mortgages. What happened was exactly the opposite.
The real estate market is at a very critical point. Developers continue to build countrywide, offering an increasing supply of expensive housing and commercial options, while at the same time, the market seems unlikely to support this growth. The cost of building has seriously increased in the last six months. This is due to the shilling losing against the USD and the British pound, leading to higher costs in importation, while existing loans are now more expensive by at least 1.5%.
Same time, access to cash becomes more difficult as interest rates go up. Large sums of money involved via Chamas as well as private investments in real estate assets and other investments face challenges when it comes to liquid them. This is due to lack of cash in the market.
On top of that, Kenya’s building, construction and real estate sectors are facing rough times as bad loans from banks soar. According to an industry status report from Central Bank of Kenya (CBK- May 2015), the two fast-growing sectors in Kenya, building - real estate and construction experienced the highest rise in non- performing loans (NPL) during the first quarter of the year (2015). The sectors which experienced the highest increase in NPLs between January to March were building, construction and real estate whose NPLs increased by 28 percent and 20.4 percent respectively according to the CBK. The real estate sector saw bad loans during the period rise from 129 million U.S. dollars to 155 million dollars. However, it is the building and construction sector that accumulated more bad loans, which surged from 103 million dollars to 134 million dollars. The regulator blamed the rise in bad loans to high lending rates offered by commercial banks, which stand at an average of 16 percent. Imagine what is about to happen now that the interest rates have increased more.
The increase of the CBK usually leads to a slowdown in economic growth due to reduced credit to the private sector affecting most of the country’s economic sectors.
So far, the market reacted negatively to the rate increase with the shilling depreciating further against the USD and the British pound. The shilling extended further losses against the US Dollar (USD). The USDKES shed 0.34% to register at 98.53.The Kenyan Shilling registered a new low against the Sterling Pound shedding 0.15% to a new low of 156.23 on Friday June the 19th 2015.
The fundamentals of the shilling remain weak among them being a widening current account deficit estimated at 9% of GDP for the FY2015/2016, an increasing fiscal deficit at 5% of GDP and the reduced inflows from tourism and other foreign exchange earners. The key factors supporting the currency are low inflation rates and the high forex reserves held by Central Bank, but this has been depleted slightly over the last few months.
The increase of the Central Bank Rate (CBR), will most probably affect several key economic factors. The yields on government securities are expected to increase and this will negatively impact the valuation of Market-to-Market bond portfolios. Higher interest rates lead to less cash via finance and that has a direct impact on the country’s economic growth. Real estate usually is negatively affected when interest rates go up.
In the last few years, real estate and construction have been the leading sectors of the Kenyan economy. Anyone who had a chance to directly or not to get involved with the industry did it without having a plan of what to expect. Life time savings have been invested in real estate, people sold assets to invest in real estate, others borrowed money but they really did not know what is going to happen. For some people, all these sounds a bit complicated or Chinese, and maybe they are.
The key question is; should someone who does not have any investment or relative education background invest his own or his/her family lifetime savings, or even worst, borrow to invest in a market that he/she cannot follow up or even understand how it moves? How is a market that is based on private investors and Chamas going to react to all these challenges? Who is going to take the blame if something will go wrong and the poor will become poorer?
So far there is no reason for panicking. It is as though a good timing for everybody to sit back and analyze its position and exposure in the market. Everyone should realize what is happening and start reading more than just the impressive headlines. Before it is too late, one should prepared to have a plan B if things will not change.
By Kosta Kioleoglou REValuer,(Tegova)
Civil Engineer Msc – DBM
Founder and CEO of Capital Plus ltd
Chief Strategist (CSO) for the East African Region
Director of Engineering – Property Appraisal & Valuations
for Taylor Scott International PTE.