Factors that investors look for in a property deal

16 April, 2024 / Articles

Investment is the act of foregoing consumption of money from one's wealth today to enhance future consumption capabilities created by an increase in the value of wealth. Investors can choose to grow their wealth through either real or financial investment asset classes. On the one hand, a real investment refers to a tangible asset class such as machinery and equipment, real estate among others. On the other hand, financial investment asset class refers to intangible assets such as corporate stocks or bonds which exist in contractual agreements put either in electronic or papers forms.

In this article, we focus on real estate in Kenya, a tangible investment asset class, that has outperformed the other asset classes generating returns of on average 25.0% over the last five years against average returns of 16.2% for equities and 12.9% for the 5-year government bond over the same period. We start by looking at the reasons why investors should consider having real estate in their investment portfolio then cover the different real estate property themes and thus, options for investment in real estate and conclude with the factors that investors look at when evaluating real estate deals. Other than the high returns observed, real estate provides additional benefits to investors such as;

(i)Diversification; Investment performance in real estate has low correlation to that of stocks and bonds which are very sensitive to economic factors such as interest rates and therefore, offer lower risk while providing satisfactory returns to investors.

(ii)Tangible asset; the physical nature of real estate makes it easy for valuation and establishment of the real value of the asset class compared to the valuation of intangible assets which often arise from value approximations. 

(iii)High demand; the country is characterized by housing deficit estimated at 2.0 million units, high urbanization rate that is 2.4% above the global average and high annual population growth rate of 2.6% compared to global average of 1.1%%. Therefore, the market status creates high demand for real estate products, thus, creating a unique opportunity for investments in the sector.

(iv)Hedge against inflation; An investor can hedge their invested funds against inflation based on the fact that as inflation increases, the value and rental income from the real estate asset also increases.

Real Estate investments exist in two main forms; direct and indirect real estate investment platforms. On the one hand, direct real estate investment refers to a case in which an investor either purchases a real estate unit, such as residential or commercial office, from a developer or source for a construction professional to carry out the full development of the real estate units. On the other hand, indirect real estate refers to a case in which an investor purchases into and owns a percentage of shares in a consolidated fund that is invested into real estate portfolios such as Real Estate Investment Trusts (REITs) and real estate company shares. In the case, of direct real estate investments, both individual and institutional investors have continued to explore various investment opportunities offered by real estate platform which cut across four property themes such as;

(i) Residential Units: In this case, investors place their funds in housing units constructed in order generate rental income by leasing space for dwelling purposes such as apartments or single dwelling units (villas and bungalows).

(ii) Commercial Units: In this case, investment can be made into real estate property which constitutes of one or a combination of offices, warehousing or retail units intended for business usage that can be sold or leased out for by the owner.

(iii) Hospitality Units: In this particular case, an investment is made into a property which constitutes of hotels or serviced apartment units that generate revenue through the provision of accommodation and meals at a fee.

(iii) Land; In this case, investors buy land parcels that come with or without value addition with the options of keeping the units for capital appreciation and consequently sell at a later date or erect a building. 

However, before making any investment commitments in real estate themes, investors look into a number of factors which provide pointers on expected real estate investment performance such as;

(i) Investment Returns; investment returns from real estate are measured in;

  1. Annual rental yield; This measures the rate of annual rental income earned from a real estate property. It is computed by dividing the annual rental income generated from the property by the current price of the property and worked as a percentage. The required rate of return varies depending on the property theme with a good rental yield for residential being 5.0% to 7.0% and commercial real estate (office, retail and industrial) being 9.0% to 12.0%.
  2. Annualized price appreciation; this measures the annual upward change in the value of a real estate asset. It is computed by dividing the difference between the current and the initial offer price of the property by the initial offer price of the property. The arrived at fraction is then divided by the number of years since the initial offer was made to the market and resulting figure expressed as a percentage.
  3. Return On Investment (ROI); this provides a measurement for earning power of an asset. ROI is computed diving the total present value of positive cash (income)from investment into the property less the total present value on negative cash flows (costs) divided by the total present value on negative cash flows (costs), and the arrived as fraction expressed as a percentage. Notably, the higher the ROI from the real estate property, the more desirable the investment opportunity in the property.
  4. Internal Rate of Return(IRR): This measures the discount rate at which the net present value on negative cash flows (costs) of investment equals the present value of positive cash (income) from the investment property. Therefore, the higher the project's internal rate of return, the more desirable it is to undertake investment in the property. It is important to note that, if the event that the investor borrows the funds to be injected into the investment property, the internal rate of return must be higher than the cost of the funds borrowed to realize positive cash flow from the property.

(ii) Occupancy Rate; This is measured by the proportion of leased out space to the net total leasable space in the real estate property which is then worked out as a percentage. Therefore, as more tenants take up the available space in a particular real estate property, the occupancy levels of such property increases. Higher occupancy for a property compared to the market average implies higher demand for the property unit for rental purposes.

(iii) Annual demand; this is measured by the annualized rate of percentage sales of the real estate property. In order to arrive at the annual demand, divide the number of units sold to date by the total number of units in the real estate property. Notably, Cytonn Q3' 2017 market review shows that the average annual uptake for detached housing units recorded an uptake of 23.2% compared to apartments which recorded slightly higher average annual uptake of 24.0%. The difference can be attributed to higher demand of apartments given the lower cost of construction per square meter for apartments compared to detached units which lead to lower offer prices for apartments.

(iv) Geographic location; in order to identify the best location for real estate investment, an investor needs to evaluate the potential performance viability of a given geographical location based on the area's ease of accessibility and availability of quality infrastructure provides by road networks, electricity supply, and sewer line connections. Additionally, the investor needs to assess the existence of social amenities (such as shopping centres, schools, and hospitals), zoning regulations applied by the county government and the investment returns characteristics of the location. Notably, areas with relaxed zoning regulations, high-quality infrastructure and social amenities are likely to be characterized by high investment returns on real estate property.

 (v) Capital Requirement; An investor should also consider available investment budget in their real estate property investment decisions. Notably, compared to a financial investments asset such as shares, real estate is largely capital-intensive investment platform due to larger costs input which goes into building materials and professional fees.

Key property performance pointers observed above provide quantifiable guidance through which the investor can determine the viability of the real estate property to meet the set financial goals. Therefore, any individual who seeks to invest in real estate property should research on the property performance indicators to determine whether to commit or forego any real estate investment deal or forego any real estate investment deal.

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