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Covid-19 scourge disrupting how real estate is estimated

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Apartment blocks. FILE PHOTO | NMG

Summary

  • A July 2019 research note by Cytonn Investment puts supply glut in the commercial office sector at 5.2 million square feet as at 2018 (it is probably higher than that by now).
  • An October 2019 note showed that the retail sector, on the other hand, had a supply of 12.5 million square feet of mall space in 2019, with an occupancy rate of 75 percent (which also meant a glut of three million square feet).

A couple of days back, I had a conversation with a friend who runs a technology startup and had decided to scale back on the floor space the company needed by nearly 60 percent.

The decision was driven by a very simple trigger: they had realised that staff could still effectively deliver while working from home, and there was little commercial reason to continue paying for full floor space utilisation.

This story is replicated all-over, as such are the decisions that service companies, especially small and medium entities, have had to make as part of the Covid-19 coping mechanism.

This development exacerbates an already depressed real estate market that has, over the past two years, continued to struggle under the weight of glut, low occupancy rates and poor price discovery.

A July 2019 research note by Cytonn Investment puts supply glut in the commercial office sector at 5.2 million square feet as at 2018 (it is probably higher than that by now).

An October 2019 note showed that the retail sector, on the other hand, had a supply of 12.5 million square feet of mall space in 2019, with an occupancy rate of 75 percent (which also meant a glut of three million square feet).

The oversupply also meant rentals and sale prices were already softening even before the pandemic started. And with the virus now rearing an ugly head, the situation couldn’t be any more dire. In fact, the pandemic will now fundamentally change how real estate is valued by reinforcing the (discounted) cashflow approach.

Supported by bubbly (zero cost) hot money, real estate valuation has been somewhat of a guesswork in this market, and has remained so for some time.

Take the case of an upmarket apartment with a market price of, for illustration purposes, Sh15 million. If a buyer financed it via a 20-year bank loan at market interest rates of between 12 to 13 percent over the life of the facility, there will be a sizeable gap between rentable rates and monthly loan repayment to the extent that the borrower, if they chose to rent it out, will still have to top up bank repayments from their pockets.

Which effectively points to over-valuation anyway. But thanks to Covid-19, the market could be up for a reset to cash flow valuations.

The premise of discounting cash flows is very simple: a shilling is worth more today than tomorrow (this you can measure by using a basket of goods). In other words, the value of an asset is simply the sum of all future cash flows that are discounted for risk (and inflation).

Which is why you probably need to subject any piece of plot you are being shown in Kitengela or Riat (or anywhere else) to a cashflow test before investing.

The likelihood and timing of future cash flows derived out of an asset influences the price an investor would pay today. If the cash flows are more certain and there is a 100 percent chance of occurring, then the discounting will be at lower rates (and the converse is true).

This is why a government-issued Treasury Bond attracts no discount while you will most certainly discount a debt instrument issued by a mid-sized company.

For real estate, there is a likelihood that companies could opt to permanently cut-back on office space requirements while those dealing in goods are already adopting electronic commerce (which is changing the way we shop).

This has introduced an element of uncertainty on real estate cash flows, which means elevated discounts. Consequently, the old guesswork valuation approach may just be facing a disruption.

@GeorgeBodo