The first thing to consider when structuring financing for any property development is that real estate does not exist in isolation to other investment classes in the market. Which means that, essentially every shilling spent on real estate could be spent on buying shares, bonds and/or T-Bills, farming, land for farming and so on. Essentially, what is it that I am foregoing in making an investment in real estate? Understanding this is key because it leads to appreciating the opportunity cost deep-rooted in real estate investment in relation to the other asset classes. What is an asset class? According to the Financial Times, an asset class refers to a broad group of investments that tend to react similarly in different market conditions. The main classes include stocks, bonds and money market vehicles. Which leads to the next question: how is one able to compare real estate returns across these different asset classes in order to be in a position to say: let me pick real estate because it gives me the best balance in reward for the risk entailed in comparison to the rest?
This approach, the quantitative appraisal of the opportunities and the risks inherent in any RE investment, is key to ensuring that your hard earned savings/equity as a developer (budding or experienced) is generating income at a rate that is competitive with the other asset classes when you consider the risk/volatility of each against the rewards.
Assessing Risks and Rewards
How do you assess the risks and rewards in an investment? Financial professionals in real estate have instruments they use to calculate the performance of an investment, including real estate. These are referred to as performance metrics. The metrics that are used mostly include the internal rate of return (IRR), Profit on Cost and Profit on Value. In the environment of uncertainty that is the Kenyan real estate market, is not only ideal but necessary even if you’re building one house. These metrics, based upon market extracted data of costs and values – which have to be corroborated and factual- will help guide any investor into making the right decision as to not only whether the real estate investment is worthwhile or not, but also how much to invest when and how. These metrics can help investors point out any future uncertainties in the market that they should be wary of.
IRR is one of the performance metrics and it is defined in real estate as the rate at which a project’s cash outflows match its inflows having taken into account the time value of money which is, essentially, the depreciation of money over the lifetime of the project given a basic opportunity cost metric.
Cash flows and Exposure to Risks
Which brings me to my second point. Because real estate is such a capital-intensive investment, not only does it require large sums of money to be paid out, but they are to be paid out over long periods of time in which there are likely to be no cash inflows from the investment unless you engage in pre-sales, for example. As a result, most people opt to borrow portions from banks and other lending institutions such as private equity.
One of the tools financiers use to measure their exposure and thus the risk of an investment is through the use of Loan-to-Value (LTV) ratio. LTV is the proportion of the loan to the value of the investment. As an investor, the concept of leveraging is one often only seen from a profits point of view. Often, the assumption is that a higher loan to value ratio (LTV) reduces the investor’s exposure and is therefore more attractive to the investor as he reaps positive returns for every shilling invested which is often very little in relation to the lending party. (LTC ratios of 80-90% are common even 100%) However, the reverse is also true. Should the project post losses for whatever reason, the investor stands to lose a lot more for every shilling invested, an effect that can easily bankrupt any investor and cause massive losses for all those involved including the lending party who will then come for any assets signed up as collateral including the development itself which unless its posting profits, will drain the lending party going forward.
LTC, on the other hand, is a measure of how much debt an investor takes on the cost of the project. Between the LTV and the LTC ratios, the LTC is a more critical metric, as it is the basic measure of how much debt versus equity that the investor takes on. For example, when we say 85% LTC ratio, it implies that 85% of the cost of the development is funded by a lending institution whereas 15% is funded from other sources such as equity. An investor can have other sources, for instance, mezzanine finance or top-up finance as it’s more commonly referred to in Kenya
The higher the LTC, the higher the amount of accrued interest. Interest rates are at a predetermined rate, and they can be fixed or varied depending on the lender. A higher LTC and a higher amount of accrued interest, therefore, means that investors are more susceptible to shocks if they can’t meet the cash flows or if they have a tight cash inflow during the lifetime of the project. So, even when building/buying your family home, this is key because one has to be able to finance the loan/mortgage without breaking the bank, an issue that is prevalent in the Kenyan society.
This cannot be overstated, understanding the debt to equity ratios and their effects on the cash flows and, therefore, the profitability of the project is paramount. In Kenya, the interest rate varies significantly and, unfortunately, a lot of it is based on market forces and control is often not in our hands, which means that projects are sensitive and exposed to these varying rates. Without scenario testing to see what these effects are on the project, you will be literally diving through a series of moving rings of fire, with no fire extinguisher nearby, and a touch of petrol on your pants.
The Property Investment Experts
The consultants who are known to do this sort of analysis – that including market research and data collection – are known as Property Development Managers, although some Construction Project Managers have taken up this role. They are few and hard to come by in Kenya although this is changing as Kenyan investors wake up to the complexity of real estate investments. These professionals are prevalent in all other mature real estate markets in the world. Investing in professional consultants as mentioned above is key in today’s real estate market, and the power of real estate to be a force for good and bad cannot be overemphasized. If you are in doubt, ask an American or a European (particularly a Greek if you can find one).
In summary, real estate investment is about striking a balance between what you get out and what you put in and the varying and increasingly complex amount of inputs required to understand what every shilling invested gets you as a return relative to the other asset classes, is key to securing finance from lenders who are getting more and more cautious, and weary, when it comes to real estate investment in Kenya.
Mumo Kianga BArch (Hons), MSc Real Estate, Henley Business School (Hons) avid runner and I bleed Kenyan.