1 Investing in Real Estate

Housing demand in Kenya is estimated at 150,000 units per year and it is steadily rising to 200,000 units. Our building industry currently delivers 35,000 units per year, a paltry 20% leaving a deficit of 80%. This means that demand for housing is insatiable and will increase exponentially in the years to come. Over the last 10 years, residential real estate values in Nairobi have increased 3 to 4 fold while residential plots have increased 5-8 fold. If you had bought a house ten years ago, you would be three to four times richer. If you had bought land same time and held onto it for speculation purposes, today you can sell it for five to eight times the price you bought it. No inflation can rob you of your new riches.

This monumental growth is replicated for industrial as well as commercial properties especially along the major corridors of Nairobi such as Mombasa Road, Ngong Road, Waiyaki Way, and the satellite commercial centers such as Upper Hill.

The good thing with real estate is that its demand is a derived one. This means that if the population rises, more real estate is needed to house the increased population. Right now as we plan to improve tourism, agriculture, trade, manufacturing, BPO and financial services as provided in the Vision 2030, real estate are marked as the flagship projects. We need more resort cities, hotels, ports, markets, industrial and BPO parks.

As you consider venturing into real estate, you should note that the prices of building materials are also on the rise. The cost of finance has also gone up with interest rates rising and the shilling depreciating against the dollar. The cost of land is also quite high as investors shift from the poorly performing equity markets to real estate. It is therefore important to carefully consider your project and compare it with various development options. Some of the investment tools you can use include; payback period, return on investment, net present value, internal rate of return and profitability index which I have explained in this link.

2 The Place of Feasibility Study

The place of a feasibility study is in the heart of every investment decision. The surest way to know the rent a property can fetch is by putting it up for rent in the market. If you want to know how much a property can sell for, put it up for sale. In the case of a development project, the scenario is a little different. The market can easily change by the time the project is delivered and this means every project carries some amount of risk.

A feasibility study therefore allows the investor to design a winning project by testing it, re-designing it and re-testing it before he/she can implement it. In the long run the feasibility study will save the investor money, time and effort. One of my clients had to abandon a project, which appeared lucrative, and opted to sell the land after running some of the analytical tools that I discuss below.

A feasibility study comes in two stages: pre-feasibility stage and feasibility stage. This is explained below.

i) Pre-feasibility Study

Under a pre-feasibility study, the consultant carries out an inspection of the site and proceeds to carry out a market survey to determine the various possible alternative development options that can be put up on the site. These are then interrogated and ranked, before a recommendation of the highest and best use is proposed. The pre-feasibility report informs the design concept for the project and feeds into the feasibility study.

ii) Feasibility Study

This is the actual feasibility study and a costly one. It involves many professionals such as the projects manager, architect, engineers, quantity surveyor, valuer, land surveyor, etc. With the collective input of these professionals and informed by the pre-feasibility report, the project can be conceived and costs estimated with reasonable degree of accuracy. The valuer or appraiser would then be able to determine the viability of the project.

iii) Common Objectives of Feasibility Study

  • To provide an overview of the real estate market; neighborhood characteristics, growth and future outlook.
  • To consider and recommend the highest and best use of a site in terms of permitted planning parameters – user, plot ratio, site coverage and minimum plot size. A project should be economically, socially and environmentally sound.
  • To estimate the cost of the project.
  • To estimate the income level of the project and thus return on investment.
  • To estimate the net present value of the project and thus its viability.
  • To determine the internal rate of return – IRR of the project and to compare it with the industry benchmark and alternative investment vehicles.
  • To determine the projects pay-back period and to compare it with the industry benchmark and alternative investment vehicles.
  • To provide further recommendations that would increase the project’s potential.

Investment objective are normally defined by the investor and one project may be feasible to one investor and not feasible to another. The standard measure is however the industry benchmark, though this must not be used to condemn a project with a positive net present value.

Investment objective are normally defined by the investor. It is not uncommon that one project may be viable to one investor and not viable to another investor. The standard measure is usually the industry benchmark, though this must not be used to condemn a project with a positive net present value.

3 Tools for gauging the viability of a project

i) Pay Back Period (PBP)

This is the most basic tool applied by investors to compare projects, or development options. It requires no special skills or industry knowledge to apply. Pay Back Period is the amount of time taken to recoup your invested capital in the project. It is presented as a ratio of the total investment cost to its annual income which is assumed fixed over the life of the project.

  • PBP = (Cost of Project/Annual income) Years.

For example if you invest 10m in a project which earns you 600,000/- per annum with 10% outgoings, your PBP will be computed as follows:

  • PBP = (10,000,000/(600,000-60,000)) Years.
  • PBP = 18.52 years

This can then be compared with other investment options and the industry benchmark. A shorter PBP is an indicator that the project is better.

ii) Return on Investment (ROI)

Return on Investment measures the profitability of the project. Again this is a basic tool applied by investors to compare projects, or development options. It is presented as a percentage of the annual income to the total investment cost.

  • ROI = (Annual Income/Cost of Project) x 100%.

In the above example, the ROI is computed as follows:

  • ROI = ((600,000-60,000)/10,000,000) x 100 %.
  • ROI = 5.40%

Again this can be compared with other investment options and the industry benchmark. A positive return implies the project is viable. A higher ROI is an indicator that the project is better. However conversely, a higher ROI is also an indicator that the project is riskier.

iii) Net Present Value (NPV)

This is a relatively complex computation applied by an expert to determine the viability of a project. Unlike the other tools above, this reflects the real world scenario; that income is not static – rents rise with time and that a project has life – beginning and end. Under the NPV computation, all positive and negative cash flows are projected over the life of the project and discounted to the present and summed up. A positive value implies the project is viable while a negative one implies the project is not feasible. The expert applying this must be conversant with the market of the real estate class .

In the above example, we introduce project life as 5 years and rent growth at 5% per annum. NPV can be computed as in the table below:

Year/Description

Cash Flows

PV @6% NPV
Implement (-) Dispose of (+) Income (+) Expense (-) Net Income

0

(10,000,000)

(10,000,000)

1.00

(10,000,000)

1

600,000

(60,000)

540,000

0.94

507,600

2

660,000

(66,000)

594,000

0.89

528,660

3

726,000

(72,600)

653,400

0.84

548,856

4

798,600

(79,860)

718,740

0.79

567,805

5

14,500,000

878,460

(87,846)

15,290,614

0.75

11,467,961

NPV

7,796,754

3,620,881

The above project with a positive NPV indicates the project is viable. However the figure 3,620,881 lacks comparability element as it is just a number.

iv) Internal Rate of Return (IRR)

Internal Rate of Return refers to the rate of return at the point where the Net Present Value – NPV is zero. This is a fairly complex mathematical concept that involves calculus and guesswork as may be necessary in the application. And not to dampen your hope, it can be computed using computer software or spreadsheets. In the above example, I used Microsoft excel to compute the IRR which is I obtained as13.34%.

You can therefor compare various project IRRs. The higher the IRR the better the investment

v) Profitability Index (PI)

Profitability Index is also referred to as the Cost/Benefit ratio. It is the present value of all anticipated benefits from an investment divided by the present value of capital outlay – cost.

  • PI = Present value of anticipated investment returns/present value of capital outlay

Again, in the above example (note NPV in 3), this is computed as follows:

  • PI = (507,600+528,660+548,856+567,805+11,467,961)/10,000,000
  • PI = 1.36

PI higher than 1.0 indicates that the project is feasible. This is a useful tool in comparing investment options. PI of 1.0 is an indicator that the rate of return is the same as the IRR.

One thought on “Investing

  • January 21, 2012 at 1:52 pm
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