real estate tax administration Reginald okumu

Real Estate Tax Administration: Strangling the goose that lays golden eggs

By Reginald Okumu

Real estate is the 4th largest sector of the economy. Between 2008 and 2014 the sector grew on average by 7.2% annually. In 2016, tax revenues recorded from the sector amounted to KShs 3.1bn. According to Kenya Revenue Authority (KRA) the sector’s tax revenue contribution did not reflect the growth and expansion of the economy. At the time approximately 20,000 landlords were in the tax net and complying. An amnesty programme that waived interest and penalties netted an additional KShs 130 million in tax revenue from the sector. Given that the sector is subject to various taxes and levies which include Income tax, value added tax, capital gains tax, stamp duty, rate and ground rent, the figures quoted pointed to possibly low compliance rates. Therefore something needed to be done.

To remedy the situation, the government introduced a raft of administrative measures targeting the landlords and tenants. The measures include introduction of withholding tax on rent, appointment of tenants and estate agents as collection agents and execution of a drive to increase the number of landlords in the tax net by 20,000. This article, will focus on the administrative measures and their impact on real estate investment.

All profit making entities including corporate landlords are required to pay an installment tax calculated at 25% of 110% of previous year’s profit. Installment tax, which has been in existence for many years is actually an advance corporate tax. It is usually paid in a maximum of five (5) installments. In working out this tax, the national government assumes that an entity will record at least 10% growth in profit every year. They therefore require a corporate landlord to pay this projected profit in advance in four (4) equal installments. The fifth installment will arise if a corporate landlord records a hire profit than projected, then the balance of the tax needs to be settled before the end of the first quarter of the following financial year. This methodology assumes that real estate investment is an all-round profitable business and there is no chance that a landlord will suffer losses. However like any other business, landlord do experience losses due to unfavorable economic conditions, high operating costs and voids.

Following the introduction of valued added tax on commercial rent, the Government in 2016 introduced withholding of Value Added Tax (WHVAT). Like installment tax, WHVAT is not a new tax but a reinforcement measure to ensure all VAT due to Government is remitted. To enforce the measure KRA appointed mostly the large tenants including state corporations, public agencies, banks, insurance companies and leading retailers as withholding agents. The appointed agents are required to withhold the VAT component which is 16% of invoiced rent and remit directly to KRA by the 20th of the following month. On withholding, the agents are required to issue the landlord with a withholding certificate. The withholding certificate issued by the tenant is used by the Landlord to claim back VAT to avoid double taxation. Unfortunately landlords do not have the option of paying for goods and services less VAT and issue the vendor with a withholding certificate just like their tenants issued them with one. Withholding of VAT has the effect of denying landlords actual cash for the period when it should have been collected to when it is remitted.

This year and specifically on January, 1st 2017, withholding tax on rent (WHTR), a new administrative measure on rental income passed when the amendments to the Finance Act of 2016 came in to effect. According to this law, tenants are obligated to deduct 10% of the rent payable to the landlord and pay directly to KRA by 20th day of the month. This means that landlords will every month receive 10% less of the rent they invoice their tenants. Withholding 10% of the rent affects both individual and corporate owners of commercial and residential property. However for corporate landlords who also pay installment tax this new measure amounts to double taxation as there is no recourse to reclaim while say paying installment tax.

Collectively the three measures highlighted above, have the two positive net effects and two major negative effects. On the positive side, the Government is on one hand able to receive all tax revenue due to it and on the other hand, tenants have an improved cash position by delaying remittance of the withheld amount by between 20 and 50 days. On the negative effects, less cash flow means landlords will be unable to respond to unexpected increase in expenses or take up opportunities as they arise. Some may even exit the sector. With low investments and reduced number of landlords, tax revenue from the sector will also decline. Though not intended, the reinforcement measures being implemented may end up strangling the goose that lays the golden eggs. The adage, “cash is king and is the lifeblood of any business” holds true for real estate investments as well.

It is generally accepted that tax is a necessary obligation of the citizens of any country. Therefore before I conclude, it is important that a clarification is made about the KShs 3.1 billion tax revenue that was collected in 2016. Real estate as a sectors has different tax points and therefore contributes significantly to the overall tax revenue. Accordingly a portion of the total revenue that is VAT and corporate tax collected is from and by business in the sector. The sector is also a huge employer and so a portion of the pay as you earn (PAYE) is from employees working in the sector. In addition more is collected from capital gains tax, stamp duty, rates (by County Governments) and ground rent. Therefore the KShs 3.1 billion collected in 2016 was only from one source and that is the approximately 20,000 landlords in the KRA database. There is certainly need to address the compliance issues by bringing more landlords in to the database.

Ronald Reagan the 40th President of the United States was quoted stating that “businesses do not pay taxes, they only collect on behalf of Government”. The incentive for business to collect tax on behalf of government is that it gives them liquidity and interest free cash. Accordingly with stifling administrative tax measures, it is unlikely that landlord’s will relax and take in the reduced cash in-flow position. They are likely to institute mitigating measures which include increasing rent payable. The actual burden of these administrative measures, therefore is and will be borne by individual tenants and consumers through higher rents and prices of goods and services. It follows that if the tenants and consumers are unable to pay more, the sector will become less attractive to investors. It is therefore necessary that the government engages landlords and investors in the real estate sector and discuss how best to ensure that there is full compliance without depriving the sector of much needed cash in-flows. One such possible measure is to allow landlords to deduct the withheld 10% from installment tax.

Reginald Okumu is the Director in charge of Commercial Service at Ark Consultants Limited (www.arkconsultantsltd.com) an integrated real estate services provider. He has 20 years’ experience in valuation, sales, letting, estate management and real estate investment advisory.

3 bedroom apartment for sale Upper Hill

REAL ESTATE SECTOR IN KENYA: A REVIEW OF 2016 AND FORECAST FOR 2017 by Reginald Okumu

Kenya’s real estate market like any other in the world operates in cycles. Our cycles tend to start after a general election and end with the next general elections. 2017 will be an election year and the slowdown in uptake, drop in prices and the increasing number of vacancies is a telltale sign that the market is adopting a wait and see attitude.  For a better review of the property market in Kenya, we will look at each segment of the real estate market taking into consideration the drivers.

Kenya’s real estate market is well diversified in terms of income, geography and types. In terms of income, there is a clear segmentation of high, middle and low income. Kenya is a diverse country from the long coast line having prime beach properties, to the highlands dotted with large and small scale farms and arid and semi-arid lands to the north with hidden reserves in the forms of mineral and oil resources. The main property types include retail, office, residential, Industrial and special properties mainly found in cities, towns and urban centers.  The key drivers of the real estate market include demographics, income, availability and cost of credit, government policy, advertising, price, and changing lifestyles. For the purpose of this article, we will review the real estate market by highlighting how each type (retail, office, residential and industrial) performed in 2016.

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Apartment for Sale in Upper Hill Nairobi

 

 

 

 

 

 

 

 

The retail sector in Kenya, has been on an exponential growth with several malls opening up in various parts of the country. The growth in malls led to a debate mid this year, on what are the country’s priorities (should the country be building malls, schools, hospitals or factories). However, growth in the retail submarket was largely driven by increased urbanization (with devolution as a catalyst), a growing middle class with enhanced purchasing power and their changing consumer patterns as well formalization of retail activities. The increased demand for retail space made Kenya to be among the leading retail destinations in Africa. 2016 saw a slow-down in uptake of retail space without a corresponding reduction in supply.  Already two malls can be classified as dead malls, while a number are struggling to attract footfall. The major cause of the slowdown is attributable to financial and management challenges facing three major retailers in Kenya. Though there are new entrants both foreign and local, these challenges are likely to adversely affect the demand for retail space in 2017. However major opportunities exist for new entrants and much smaller players to open up retail stores in emerging towns and cities particularly those that house County Governments Head Quarters.
The office market in Kenya, like the retail sector has experienced increased supply and is currently estimated to be in surplus. A significant number of office buildings in key office nodes of Upper Hill and Westlands have very low occupancy rates. The demand for offices spaces is usually driven by growth of the services sector. The major players in the services sector include Government, Financial institutions, Professionals firms and NGO’s. For the last two years the education and health sectors have emerged as great consumers of office space with the opening of satellite college campuses and new hospital branches in major expansion drives. However, 2016 witnessed closures of some satellites campuses following orders from the Commission for University Education as well as the Ministry of Education. The NGO’s sector (mainly those focusing on the human rights and governance issues) have also reduced the sizes of their offices  after ceasing and or scaling down of operations as their relationship with the National Government deteriorates. In addition, with devolution, the National Government uptake of space has reduced as a significant part of the service delivery mandate is now with County Governments and State Agencies. Most of the State Agencies are well established in Nairobi, Mombasa and Kisumu. These events have greatly contributed to slow uptake of office space as well as increase in available stock. This coupled with a pipeline of new office developments, 2017 is likely to experience an increase in stock of office space. Rents and sale prices are also likely to remain stagnant or drop further as developers and property owners jostle for the few takers that will be in the market. 2017 being an election year, it is likely that new projects will be put on hold and any ongoing ones will be hoping for a post-election boost. 2017 is going to be very testing year for office developers and owners. Focus for office development in 2017 should be in the counties where demand is likely to pick up after elections.

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Maisonette for Sale along Waiyaki Way

 

 

 

 

 

 

 

Residential sector performance is heavily dependent on household disposable income and availability of credit. On average Kenya’s household disposable income has been on upwards growth. This means households are able to spend more on shelter and other basic needs. On the other hand the price of (both rent and sale) has also been on upward trend mainly because the middle and low income segments of the residential market have been having a huge supply deficit. While the low income segment of the market still has a huge supply deficit, sections of middle income segment market are operating at surplus in both sale and rental sub-markets. In most towns hosting county headquarters, rental markets are yet to mature and a bigger chunk of the population are locals who commute from their ancestral homes. The capping of interest rates in 2016 gave mortgage holders a huge relief. On paper the capping of interest rates has reduced the cost of borrowing. On the other hand it has made mortgage lending less attractive for financial institutions as they can get better returns investing in government paper. The middle income residential sub-market which has in 2016 been very active on the supply side particularly in Nairobi and its environs, Mombasa and Kisumu are likely to witness reduced demand both rental and sales due to lay-offs and closures of businesses, reduced lending, relocation of some consular services by Diplomatic Missions as well as restrictions on issuance and renewals of work permits for expatriates.

Kenya’s industrial base has been shrinking over the years mainly due to a harsh operating environment. The major contributors to the harsh business environment include poor transport infrastructure, lack of reliable power, corruption and land issues. As a result, a number of manufacturing entities closed or relocated, while potential ones decided to invest elsewhere and settled for setting up marketing distribution operations in Kenya. Accordingly in 2016 the country experienced its fair share of factory closures and relocations. On a positive note, the government has made tremendous efforts to improve the business climate. These efforts include massive investment in road, railway and sea port construction and /or expansion; power generation including investment in clean energy such as geothermal, wind and solar energy; and reducing the bureaucracy in company registration. These efforts saw Kenya move up the world ease of doing business index. While setting up new factories and plants following government efforts, may be a long way out, an area that is likely to see significant growth in the industrial sub-market is warehousing and logistics areas. With improved network of roads and a revamped railway line new warehouses and logistic centers present a major real estate investment opportunity in 2017 and beyond.

The last sector is the omnibus special category that groups hotels (development in the hospitality industry) and service stations. The hotel industry particularly in the coastal region has been on a decline for the last several years. The major contributor has been declining security situation (threats of terrorism) which has kept tourists away, collapsed infrastructure, poorly maintained hotels and declining service standard. The decline in the coast region has been a boom of sorts for the hinterland. In Nairobi, Mount Kenya region, rift valley and the western Kenya, the hotel industry has been on upward trend mainly driven by growing numbers of high profile conferences and growth of domestic tourism. Like the hotel industry, Oil marketers have embarked on aggressive market expansion drives opening up new outlets and renovating old ones. Newly built roads, growing number of cars have given oil marketers new opportunities for growth. 2017 is likely to see a slowdown in new developments in this omnibus submarket. Movement activities are likely to reduce as the country nears the general elections even though a significant portion of elections campaign funds are likely to be spent on fuel, meals and accommodation.

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Redevelopment Site for Sale in Westlands

 

 

 

 

 

 

 

2016 was slow across all sectors other than service stations and the hotel industry with the exception of the coast region. Poor planning and reliance on speculation and dodgy market data saw office developer’s focus on saturated market segments and locations. The financial and management challenges facing three major retailers have placed investors in the retail sector in a state of panic while increased supply of middle income housing coupled with business closures has contributed on average to slow uptake of new units, drop in rentals rates and sale prices. In addition to the general elections in 2017, a major dark cloud hangs over investors in the real estate sector as Kenya Revenue Authority plans to enforce a new withholding tax measures targeting rental income. This measure will if implemented reduce cash flow (in a sector already riddled with delayed rent payment) and make it difficult for property owners to meet their financial obligations including debt servicing. A lot of what is to happen to the real estate market is dependent on the August 2017 general elections. However significant opportunities exist and those that can focus on areas that support political activities (which include lease of campaign offices, hire of meeting rooms, meals and hotel accommodation) have reason to be optimistic.

Reginald Okumu is the Director in charge of Commercial Service at Ark Consultants Limited (www.arkconsultantsltd.com) an integrated real estate services provider. He has 20 years’ experience in valuation, sales, letting, estate management and real estate investment advisory.

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Land Acquisition and Compensation by Reginald Okumu

Vision 2030 is a bold statement of where Kenya should be in just under 15 years. The document set ambitious targets and has proposed development projects to propel Kenya into a middle income country status by 2030. The statement has been backed by huge infrastructure developments, some of which are already complete and in use (Thika Road), others are in various stages of construction (Standard Gauge Railway) while others are still on the drawing board (Lamu Port). These massive infrastructure projects, have brought with them the need to acquire land for either expansion of existing facilities or construction of new ones.

The Constitution does not just recognize private property rights, it ensures they are well protected. The supreme law also recognises the superiority of public needs and has provided for situations where the public may need to acquire private land for public use. The repealed legal framework provided for acquisition with fair compensation (market value plus 15%). The current constitution has not retained this position but has gone ahead to stop parliament from passing laws that will allow for acquisition or deprivation of private property without compensation. The Land Act No 6 of 2012 has further clarified this constitutional provision by empowering the National Land Commission to come up with rules to guide acquisition and compensation. In addition, the Act is also very clear on the procedure to be followed by a public agency acquiring land for public use.

While the law is very clear, public agencies in urban areas have been taking advantage of property owners and developers by acquiring portions of their property without compensation. This is through what they call the surrender condition given to property owners when they place request for development permission. What makes this situation worse is that those with freehold title are being forced to surrender them for inferior interest like leaseholds (by the way if you have a freehold title you are exempt from applying for change of user, that is why it is called a freehold. What you are not exempt from is seeking development approval. This is requirement you adhere to before undertaking any development on land with a freehold title). This provision as is, appears harmless, but in effect, the property owner on acceptance ends up losing portions of land which is usually a strip with a depth of measuring anything from 3 meters to 10 meters of prime space. In the case of a freehold title one loses the reversionary interest and therefore “reversionary  value”. Developers particularly those with plans to develop do not seem to have much choice as it is usually a take or leave condition (where leaving means you cannot proceed with your development plans). Also given that the cost of this “surrendered land” is usually passed on to the unsuspecting buyers may be a good reason why property owners do not mind the condition.

It is difficult to trace the rationale behind this condition but a logical explanation is that County Governments (to be more specific Nairobi City County) found a way of acquiring land without a paying a single penny for it. This action amounts to a great injustice and all those who were forced to surrender parts of their land should be compensated unless they have willingly donated a portion of land to the County or National Government. In addition to this strategy by the County Government being illegal, there is a major drawback in that not everyone owning land along a stretch of road plans to redevelop their land and even if they do, there are time differences. This further delays provision of services.

Due to this, a scenario is playing out in Upper Hill Area (and it has extended to other parts of the City) where Kenya Urban Roads Authority (KURA) has embarked on expansion of existing roads. The problem is they are operating on the assumption (thanks to Nairobi County Government’s poor record keeping, they do not have a comprehensive list of ”surrendered” portions of land) that everyone “surrendered” portions of land to allow for road expansion. So while road construction is going on, the land to build the road is not available. Even where it was “surrendered” the boundaries were not resurveyed and the titles amended. The ignorance (or fear or both) of the property owners is working to the advantage of KURA and the road contractors as even those who have not surrendered portions of their land are preparing to move their boundary walls at their own cost to accommodate “development”.

That existing roads in Upper Hill and every part of the City need expansion is not in doubt, but due process must be followed. The Upper Hill land owners need the roads, but they should also be compensated (just like those in other parts of the country who received compensation for SGR and such other projects. It is common knowledge that completion of Langata Road expansion was delayed because a land owner had to be fully compensated and more recently a property owner was awarded KShs 1bn compensation for the southern by pass to proceed) for the portions of land that was reverting to public use.

Upper Hill as a commercial area was not an afterthought as its planning can be traced back to the 1948 Nairobi Master Plan, the 1973 Nairobi Metropolitan Growth Plan and Hill Area Zoning Plan of 1992. For Road expansion to commence, enough funds not only for road construction but also for land acquisition compensation must have been budgeted for and set aside.

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Photo by Kenguy (From Google)

KURA which is undertaking the project should familiarise itself with the Constitution and the Land Act No.6 of 2012 and get to know that, what they are doing is building roads on private property. If the owners of the plots were to one day erect barriers on these roads and mark them private, the public will have no recourse. Public funds will have been used to build private roads. The framers of the constitution were aware of the tricks that may be used to deprive people their property rights. They were wise enough to stop parliament from passing laws that would lead to such deprivation. If parliament is barred, it follows that public entities cannot administratively introduce conditions (such as surrendering 20% of the land for utilities) that lead to the same deprivation. The National Land Commission should as a matter of priority issue Land Acquisition guidelines and stop this abuse of power by County Governments and other public agencies. Such guidelines will provide a clear and objective way for public agencies and private entities to engage. It is also necessary for organisations like COFEK to take up this matter as consumers of real estate suffer the most through high property prices as developers pass on the cost of surrendered portions off to buyers. For your information, you are not greedy when you ask for what is rightfully yours. You do not need to apply for change of user if you have a freehold title or surrender it for a leasehold. Also you do not have to surrender a portion of your land for road expansion or utility provision without compensation.

Reginald Okumu is the Director in charge of Commercial Services at Ark Consultants Limited and has over twenty years’ experience in Corporate Real Estate and Consulting.

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A REVIEW OF FUSION’S REAL ESTATE DEVELOPMENT TRUST, BY REGINALD OKUMU 11TH JULY, 2016

 A REVIEW OF FUSION’S REAL ESTATE DEVELOPMENT TRUST, BY REGINALD OKUMU 11TH JULY, 2016

Kenya joined the list of countries that boast of having Real Estate Investment Trusts (REITs) in November, 2015 when the Stanlib’s Fahari I-REIT was listed on the Nairobi Securities Exchange. In a couple of weeks, Kenya will be celebrating its first D-REIT assuming the offer by Fusion Capital is successful. According to the Information Memorandum (IM) issued on 20th June, 2016, Fusion Capital the promoter of Fusion Real Estate Development Trust (FRED Commercial) is aiming to raise KShs 2,300,000,000/= through sale of 100,000,000 units. Each unit is being sold at KShs 23/=. The proceeds of the sale will be used to acquire a six acre plot in Meru town and develop on it a mixed used development. The development to be known as Greenwood City will comprise a retail center (291, 391 square feet approximately), six storey office block (172, 989 Square feet) and 53 apartments (with a total built up area of 84,800 square feet approximately). The offer is restricted and only Professional Investors can purchase. The Minimum units a professional investor can purchase is 218,000 translating to a minimum spend of KShs 5,014,000/=. The offer closes on 15th July, 2016.

To effectively review a D-REIT one has to take into account various factors. However for the purpose of this article, we will look at the structure of the D-REIT, its management team (both at  construction and management phases), make a comparison between the proposed D-REIT returns and returns from alternative investments namely a high yielding government bond and review treatment of demand risk.

The major difference between a REIT and any other company whose business is to invest and manage real estate lies in their tax treatment. REITS are exempt from corporate tax a special treatment not available to conventional companies. FRED Commercial is structured as an incorporated common law trust which makes it qualify for exemption under Kenya’s income tax laws. However the law does not exempt companies that are wholly owned by a REIT. According to the IM issued by the promoters of FRED Commercial, the proceeds of the offer will be used to acquire Meru Greenwood Park Limited a Special Purpose Vehicle which is the developer of Greenwood City currently under construction.

From a tax perspective FRED Commercial is tax exempt a position confirmed following issuance of a tax exemption certificate by Kenya Revenue Authority. On the other hand Meru Greenwood Park Limited is a company incorporated under the Companies Act and is not tax exempt. This, means that the income generated from Greenwood City, will be taxed before it is passed on to the trust.  In the review of Stanlib’s Fahari I-REIT, I had pointed out that the decision to acquire companies that own the underlying real estate asset is aimed at avoiding stamp duty which amounts to 4% of the assessed market value of the property. While this is true, investors need to weigh whether it is better to invest in a trust that will pay stamp duty, a one off payment or invest in a trust that will own shares in a company that pays corporation tax every year. As

currently structured investors are better off putting their money in a conventional real estate company as they will save on CMA approval fees, payments to Trustees, REIT Manager and a host of other players that are riding on this REIT.

A D-REIT’s offer, comes with a promise that the underlying real estate assets will be soundly conceived, professionally designed, skillfully constructed and expertly managed. Real estate developments are complex undertakings requiring specialist team to manage the construction phase, competent contractor to construct and an equally qualified team to manage the development once complete. The Construction phase of Green Wood City is under a reputable team of Architects and Engineers. Equally a professional estate management firm has been hired to handle marketing and management of the development. Investors can take comfort that at least on paper, three key stages of development that is design, construction and management of Greenwood City seem to have been assigned to the right professionals.

FRED Commercial target to sell the completed project to yield investors. The option chosen is to first lease the retail and office parts of the development for a year before selling. However the 53 residential units will be sold outright. The projected period of construction is 24 months and it is assumed that the retail center and office building will be fully let on completion. One of the major risks identified by promoters and which does not seem to have been factored is demand risk. Meru town, the 6th largest urban center in Kenya is certainly a promising real estate frontier market. However the unanswered question is whether the town with a population of 30,000 (or is it 70,000) can absorb 291,000 square feet of retail space and 172,989 square feet of high grade office development in one phase. The economic review of Meru town including the excerpts of the feasibility study quoted in the memorandum do not demonstrate a strong demand for retail as well as high grade office space. The demand for retail space is driven by growth in purchasing power (disposable income) and consumer patterns in the catchment area. For retailers to take up space, they need to be convinced that the catchment area is big and wealthy enough to patronize their establishments. On the office side, demand is driven by growth in services such as banking, insurance, administration (National and County Government) and consultancy. For a yield investor (and for such a scale, the field is limited to Pension Funds, Insurance Companies and an I-REIT) the quality of tenants (for retail the tenant mix), occupancy rates, rents receivable and covenant strengths will form key part of issues to consider when purchasing the development from the D-REIT. On the residential side, the lease market in Meru town is not developed. Accordingly the likely purchasers of the residential units are those of Meru ancestry who are currently residing in other towns both in Kenya and abroad. While this is a great potential market (due cultural affinity and emotional attachment), consideration needs to be given as those purchasing will not be the occupiers of the units and will thus require the units bought to be leased out tenants whether on short lets or long leases. No information about how much rent they are likely to earn has been provided to assist the REITs investors gauge whether the return on the residential units are attractive to potential buyers (yield investors) of the same. At 21% construction rate, it is not clear how many shops and offices have been taken up as well as the number of those who have so far booked the residential units. From this perspective and considering demand factors, the ongoing development is highly speculative for the targeted yield investors.

Real estate investors are interested in returns. Accordingly investors will put their funds in instruments that will give the greatest return from the available comparable alternatives. From the IM, the gross target IRR is 20.8% while the net is 18.25%. While these calculated rates are higher than a comparable return from a high yielding government bond (currently at 13.2%), the assumption of 100% occupancy raises a big question mark on how this IRR was arrived at. Given my earlier remarks regarding uptake (meaning lower than projected incomes as well longer time to achieve required occupancy) and now the question mark on 100% occupancy rate assumption, one can safely conclude that the actual IRR will be much lower than quoted.

The investing community in Kenya is a yearning for a great real estate investment opportunity. A REIT offers such an exciting promise given the poor performance by quoted conventional real estate companies. In addition, choice of a D-REIT by Fusion Capital is wise as it differentiates it from the earlier issued Stanlib’s Fahari I-REIT. The Promoters of FRED Commercial have done a commendable job fronting the REIT. They should also be commended for appointing a professional team to oversee the construction and management of the underlying asset. While commendations are in order, prudence dictates that this project be undertaken in phases. Phasing would enable the promoters test this frontier market and gauge demand. There are clear issues regarding the structuring of the D-REIT and the assumptions in arriving at the target IRR. On structuring the promoters have missed the main objective of providing tax exempt earnings for the investors. For investors to enjoy the benefits of putting their money in a REIT, FRED Commercial needs to directly own Greenwood City. The calculations on the IRR also needs review by restating and making reasonable assumptions on occupancy and rental rates.

Reginald Okumu is the Director in charge of Commercial Service at Ark Consultants Limited an integrated real estate services provider. He has over 15 years’ experience in valuation, sales, letting, estate management and real estate investment advisory.

 

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Kenya Property Listings

Is There Opportunity For More Shopping Malls in Nairobi? By Reginald Okumu, Director Ark Consultants Limited, May, 2016

Over the last several months there has been talk in newspapers, board rooms, clubs and even professional circles that the office, retail and residential property submarkets are over supplied. While data is scarce on this subject, a real estate market report released last month was quoted as stating that shopping malls are operating at an average of 40% occupancy. A week later an executive of an Asset Management Company was quoted stating that after the completion of the approximately 620,000 square feet Two Rivers Mall in Runda, Nairobi will not need any other Mall. Accordingly anyone thinking of putting up a Mall should therefore consider other cities and towns. This article is not questioning the veracity of the Market report that put the average occupancy rate at 40% but the seemingly alarmist conclusion that Nairobi the 12th most populous city in Africa does not need any more Malls as it is oversupplied. To explore this subject further, this article will define a shopping center, trace the origins of shopping centers, look at the key issues to consider when developing a shopping center and address the nagging question of whether shopping centers have a future in Kenya.

According to the International Council of Shopping Centers (ICSC), “a shopping center is a group of retail and other commercial establishments that is planned, developed, owned and managed as a single property with onsite parking.  While this definition is appropriate it leaves out a critical social and economic role that shopping centers have come to play in any society or economy. Various scholars and authors, have identified different types of shopping centers. For our purpose we will stick with the broader ICSC categorization which has three types namely Malls or Shopping Malls, Open air Centers and Hybrid Centers and superimpose other classifications:

  • Malls or Shopping Malls: These are closed shopping centers with shopping streets and alleys. They have a Gross Leasing Area (GLA) of between 400,000 and 800,000 square feet (Regional Malls) and over 800,000 square feet for Super Regional Malls. Two Rivers at 620,000 square feet when opened, Garden City and Sarit Center each at 500,000 will fall into the category of a regional mall.

 

  • Open Air Centers: These are characterized by store following one another in a strip. They have a common parking lot located at the front of the stores but do not have closed streets. Open Air Centers have GLA of between 125,000 and 400,000 square feet and take different shapes the common ones being L, U and Z. The simple I shaped is used in residential and community centers. Under this category, we have neighborhood centers, Community Centers, Power Centers, Theme Festivals Centers, outlet Centers (these house mostly manufacturers and retailers and do not have anchor tenants) and Lifestyle Centers which are usually located around high earning residential areas and try to combine shopping and lifestyle needs of the catchment area. Westgate Mall, Garden City Village Market, The Junction Mall, The Hub and Galleria Mall will fall under this category.

 

  • Hybrid Centers which are a combination of Malls and Open Air Centers. They are the new trend in shopping centers. Unlike the name suggests, they are smaller than shopping malls and open air centers though they combine the offerings of these two types. From a planning perspective small sized shopping centers meet very little resistance from communities, can be put up much faster and cost less to build. They are also able to attract high rents.

While a clear definition and classification of shopping centers exist, the term “shopping mall” is commonly used in Kenya to describe any newly built shopping center irrespective of size and offerings. We will therefore use these terms interchangeably.

st.petersburgGostiny Dvor, In St. Petersburg

Shopping Centers as we know them are not a recent phenomenon. From literature, their origins can be traced to the Al-Hamidiyah Souq in Damascus or the Grand Bazaar of Istanbul which are identified as the medieval predecessors of shopping Malls. The first planned shopping Mall was the Gostiny Dvor built in 1785 in St. Petersburg. It housed 100 stores on 53,000 square meters. However the most acknowledged and cited milestone of shopping center development is the Southdale Center in Twin Cities, Minnesota, United States of America (USA).

This completely closed regional sized shopping mall was built according to the plans of the Austrian born Architect Victor Gruen. Southdale, the first modern shopping mall opened its doors to customers in 1956.  The success of this mall led to the growth and spread of shopping Malls in the USA. By 1992, there were 38,000 shopping centers with sales space of 4,586 billion square feet and a turnover of US $ 717 billion. The US Census Bureau puts the number of shopping centers as 107, 773 in 2010 of which 1500 are regional and super regional sized shopping centers.

moroccoThe Aquarium at Mall of Morocco, Kodadi Photography

From the USA, shopping malls spread across the world to Europe, South America, Australia, Asia and Africa. Africa portfolio of early shopping Malls include Gateway Mall in Durban South Africa, built in 2001, Mall of Arabia in Egypt built in 2010 and Morocco Mall in Casablanca Morocco measuring 250,000 square meters built in 2011. Morocco Mall has 350 plus shops. One of its key features is a 1,000,000 liter cylinder shaped aquarium with a 360 degrees view of the sea life that contains 40 species of fish. Among the first generally acknowledged shopping centers in Kenya include The Mall and Sarit Center in Westlands and Yaya Center in Kilimani.

Having a clear understanding that a shopping mall is just a shopping center, we can now evaluate whether, Nairobi still needs more malls. The appropriate framework to evaluate is one that looks at what happens before (pre) and after (post) construction of any shopping center.

Pre-Construction refers to the activities that are undertaken before construction of the shopping center. There are many activities undertaken but the key ones are:

  • Feasibility Studies: A feasibility Study is a decision making aid. While it gives no guarantee that a shopping center will be successful when complete, it however helps clarify the opportunity, identifies challenges to be encountered during and after construction. A good feasibility study addresses legal, social, economic, environmental and physical issues. A key feature of the feasibility is the answer to the question whether the shopping center will be marketable (i.e. are there tenants to take up space in the proposed development). Unfortunately there are number of shopping centers undertaken without feasibility studies while others have questionable ones done to support or justify a prior made decision. The other challenge is that most of the developers and investors lack the requisite knowledge to test the underlying assumptions and capacity to interrogate a feasibility report. They are easily overwhelmed by the numbers and buzz words (IRR, NPV, payback period, profitability Index, Occupancy Rates, Gross Leasing Area, pro forma financial statements and so on) used by consultants and accept recommendations some of which are based on dodgy market research, massaged figures, down played risk, exaggerated demand and over looked competition. Ideally a feasibility study should be carried out by a qualified independent consultant and not the Architect, Project Manager, Identified Facility Manager or related party whose independence can easily be questioned.
  • Design: Shopping Center design is a relatively new and evolving typology. In designing, the Design Team led by the Architect must address the needs of the Developer, Tenants and Customers. The developer is most concerned with cost and durability. The Tenant is most concerned with shopping center layout, shop design, flexibility and size. The customer is concerned about access, parking, movement, security and aesthetics. A review of shopping Centers, reveal that they are mainly designed to meet the developer and Architect’s fantasies. They are costly, have less functionality and easily breakdown leading to high maintenance costs.

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Mall of Africa Layout from Google

Alterations after completion are often cumbersome and expensive. Customers are ignored as the shopping centers are poorly located (on the wrong side of the road) access is difficult (it takes long to enter a shopping centers due screening (which creates a feeling of invasion of privacy) and is common to encounter traffic snarl up where shopping malls are located and parking is largely inadequate particularly in the evening and on weekends. Tenants get shops that are either too big or too small, layout of shops are not appealing to shoppers (demand shoppers, comparative shoppers and impulse buyers) and locations that provide poor visibility and are not ideal for retail businesses.

  • Tenant Mix: This refers to a blend of shopping center occupants based on a pre-determined criteria usually from market research.  Tenant mix is essentially an exercise in positioning of the shopping center. Tenants comprise retailers, service and entertainment providers. They represent the income source of the shopping center on one hand and attract customers on the other. There are three types of tenants. Anchor tenant who occupy large retail areas for a small rent but generate the most customer traffic. Preferential Tenants represent brand names around which the shopping center offering is built. The last type of shopping center tenant is the Filling-Up Tenants who operate small trade areas, pay high rents and generate little customer traffic.  The tenant mix is important as it affects consumer preference. The tenant mix is what causes the customers to visit the shopping center and it must fit the targeted income group. In other words the income groups in the catchment area must be able to buy at the shopping center. So it does not make sense to put a shopping mall on Thika Road with tenant mix suitable for shoppers who reside in Karen.

The activities that are undertaken before construction if poorly handled can lead to failure or early death of a mall. Most of these activities cannot be undone once construction starts and is complete (you cannot change the overall design though you can review the tenant mix). So when you see a shopping center opening and having 40% occupancy (which basically puts it in the category of dead or dying shopping center) then some if not all of these key pre construction issues were not well looked into. A dead shopping center is a shopping center that has occupancy rate of less than 40% or is unable to attract traffic.

Post Construction: This refer to the activities that take place once the shopping center is complete. There are several key activities generally grouped under management. These are Stakeholder management, Facility Management, Financial Management and promotion and marketing

  • Stakeholder Management: On completion of the shopping center, the key stake holders whose needs must be addressed include investors (owners), tenants, service providers, customers, Financiers and neighboring community including regulatory authorities. Stakeholder management is a high level function that requires the manager to delicately balance the various and sometimes openly competing interests. It is an exercise in managing expectations. A well-managed shopping center gives returns (income and capital) to the investors, addresses in a timely manner tenants concerns, make the customers feel welcomed, comfortable and safe, supervises suppliers and maintains a healthy relationship with the surrounding community and regulatory authorities.
  • Facility Management: These include activities like security, cleaning, electrical and mechanical services, civil works, traffic management and health and safety issues these are daily and sometimes routine activities in a shopping center.
  • Financial Management: These includes preparation and monitoring of budgets, cash and credit management, financing capital and recurrent expenses and risk management
  • Marketing: The main function of marketing is to promote the mall and encourage customers from the catchment area to patronize the shopping center. Various activities which include celebrity visits, food festivals, book fairs, exhibitions, religious and cultural celebrations, fashion shows can be held regularly at the shopping centers. Marketing also aims at keeping the shopping center attractive to tenants. Continuous market research within the catchment area is necessary to note any changes in consumer behavior, demographics and household incomes as well to monitor activities of any competitors existing and potential. The results of the market research should then inform a review of tenant mix and overall shopping center management.

Post construction challenges can be isolated as management gaps. These can be addressed through management changes, strategic planning, training, staffing and increased use of technology. Excellent facilities management skills are easily available locally and this what Investors are getting in the name of shopping mall management. Investors in shopping centers have been slow to recognize and provide resources for the critical roles of finance professionals and marketers to draw customers and deal with competitors. As soon as these critical skills are incorporated into shopping center management then we will be able to experience improved occupancy rates and better returns and prolonged life spans.

Having discussed the above, it will be an anticlimax to end this article without commenting on the future of shopping centers in Kenya. The Market report referred to earlier, the newspaper articles and comments by various corporate executives give an impression that shopping centers in Kenya face an uncertain future. This scenario is not unique to Kenya as a similar debate is raging in the USA which has enjoyed over six decades of “Mall culture”. At the height of the “Mall Revolution” approximately 140 Malls were being built in the USA annually. When the Mall of Africa was opened in Durban in 2001, Market analysts were apprehensive as already there was retail space surplus. Several more Malls bigger than the Mall of Africa have since been built. In America a number of malls have closed over the last several years mainly driven by the economic meltdown, changing consumer preference (resurgence of down town shopping, populations moving back to the City Center from the suburbs as well as e-commerce) which has led major retailers like Sears, JC Penney and Walmart to close down stores. Sears alone has closed over 300 stores over the last 3 years and more closure are on the way. These closure have led to the chorus that end of Malls in nigh. However the war is not yet lost as Mall owners and developers are looking for new anchors to replace the disappearing retailers. Potential anchors include Movie Theatres, Emerging Department Stores.

dubaimall

Dubai Mall (From Google)

Unlike America, the shopping culture Kenya and Africa is just picking up driven by a middle class with high growing purchasing power and pent up appetite for consumer goods. The movement to suburbs is accelerating due to congestion and high property prices within the city as well as improved infrastructure and security in the out skirts of the city.

Countries in Africa are also growing at an average of 5%. According to the World Bank, Kenya’s economy is projected to grow at 5.9% this year and 6.1% in 2017. In addition we are yet to experience true shopping malls (our shopping centers fall in the category of closed and open air shopping centers). What is clear is that most of Africa and Kenya included may not enjoy shopping malls for as long as America and rest of the developed world have due to forces of convergence. However, the key point to take home is that real Shopping Malls are on the way and when they do arrive, we will have a whole new shopping mall experience. There is room for more shopping malls. All that investors and developers need to do is just address the pre and post shopping centers construction issues.