Beware, the property bubble is about to burst

Property investors in Nairobi and other cities are blowing large bubbles but the burst won’t be long.

Having learnt from the recent real estate market crash in the US where I lost millions of shillings in equity, I am now investing in emerging markets.

My advice is, buyer beware.

In Nairobi’s commercial real estate, if your capitalisation rate is less than 12 per cent, you are losing.

If for example, your Net Operating Income on a rental property cannot add up to Ksh300 million ($3.726 million) in 15 years on say an apartment complex that cost say Ksh180 million ($2.23 million) to build, you are in the wrong business.

If your Debt Service Coverage Ratio is less than 1.5, you are slowly strangling your financial prowess.

And if your equity build up is more than 15 per cent annually in an economy with a 40 per cent unemployment rate, the bubble is about to burst.

A market bubble is created when demand exceeds supply and suppliers become greedy.

This is already happening in Kenya.

Real estate goes through four cycles— buyers’ market phase one, buyers’ market phase two, sellers’ market phase one and sellers’ market phase two.

The buyers’ market phase one is when property is so cheap that anybody with a little saved up can afford one.

There is a huge supply while demand is sluggish.

Rent becomes higher than the mortgage hence properties have tremendous cash flow.

However, it is expensive to borrow as lenders follow stringent rules.

In buyers’ market phase two, rents shoot as demand for rentals rises. These two phases are the best to invest in real estate.

In the third phase, most people start feeling the need to buy instead of renting.

Landlords get greedy and increase rents arbitrarily.

Developers become more creative in building, lenders become greedier and come up with unsustainable mortgage programmes while citizens become more unrealistic and start purchasing what they cannot afford.

In phase four, fuel is poured onto the fire and everybody contributes into building a financial house of cards.

When the market bubble bursts, the local banking and mortgage industry will be hit first

In the past 10 years, several banks have hurriedly set up mortgage departments in order to cash in on the rising demand for housing, without regard to the fundamentals of mortgage lending.

For example, several banks now have products for Kenyans living in the diaspora who wish to invest at home, but they lack solid ground to reclaim their money if the market withers.

One bank is lending at 80 per cent Loan to Value for commercial properties to borrowers with a six-month- old bank account.

A mortgage banker from a leading institution in the country recently told me that all his bank requires from borrowers abroad is proof of employment and a bank statement

This sounded ridiculous and reminded me of more than 50 per cent of the banks that collapsed in the first three years of the Great Depression in the US.

The mortgage industry in Kenya is too young to take such aggressive risks.

Another batch of players leading the country’s finance to the slaughterhouse is speculators.

In real estate more than any other market, savvy speculators can make lots of money.

However, profits breed new speculators who have no knowledge or need to learn how the game is played.

All they care about is buy high, sell higher. They speculate in both developing and rehabilitating.

Though rehabilitating, is not a big phenomenon, developing, subdividing and change of use are.

For example, an apartment complex owner could subdivide and change use to single condominiums to rake in bigger profits.

Developers also change land use from farmland to residential, subdivide it into smaller plots, and sell them at inflated prices.

These are the dominos that are being played and the market is becoming dangerously shaky.

Based on these factors, my estimate is that we are in phase two of the sellers’ market. If I were investing in Kenya at the moment, I would diversify. Again, buyers beware!

Mishael Ondieki is a real estate investor in the US. He specialises in real estate syndication and emerging markets. He can be reached at Ondieki1@yahoo.com