With the advancement in the real estate sector, as well as the various challenges facing the traditional funding methods in the sector, there has been a need to diversify the capital raising methods. This has given rise to innovative ways of funding.
Of these new real estate funding options, structured real estate investment solutions have gained the most traction. They are solutions that are packaged by investment professionals to enable an investor access a return, supported by the performance of real estate, in a form that meets an investor’s needs. Structured products tend to have the following characteristics;
They involve adding layers or features to traditional real estate, through a process called “structuring”,
They generally deliver higher returns to the investors, in comparison to traditional investments,
Like real estate, they tend to provide principal protection, coupled with an above-average yield return, and,
They are generally traded in the private markets to qualified or sophisticated investors through alternative investment managers such as private equity managers.
While structured products are geared towards providing favorable returns to the investors, they have also proven to be quite indispensable in the real estate sector, in that in the hunt for high yield, they are invested heavily in asset classes such as real estate, making them an easily accessible means of financing for developers. Another major advantage of structured funding is that it cuts out the middleman, in most cases financial institutions such as banks.
Some of the key financing options in structured financing are;
Mezzanine Funding – This is where an entity provides subordinated financing to a real estate development. The financing is junior to bank debt, hence gets paid only after the bank but senior to equity, and hence gets paid before equity investors.
Real Estate Structured Notes – This involves various options issued by a private firm, as a method of real estate financing. They include project notes, real estate-backed medium-term notes and other high yield loan notes, and,
Real Estate Investment Trusts – This involves purchasing units in a company that has converted the physical real estate asset into a liquid investable product. These can either be public markets tradable like REITs or privately placed.
Structured products and other alternative real estate funding options have proven to be useful in funding real estate. However, there is a heavy reliance in bank funding as opposed to funding from the capital markets, with 95% of business funding in Kenya being sourced from the banking industry, despite having one of the highest banking spreads globally, as compared to 40% in advanced markets. This slow uptake can be attributed to;Lack of sufficient market knowledge – There is insufficient knowledge of structured products in the industry, both on the supply side, with investment managers not bringing these products to the market, and on the demand side, with investors not being fully aware of the benefits they stand to get from structured products, thus opting for the traditional way of investing in real estate and; Lack of institutional development capacity – most of the real estate that is currently under development is not institutional-grade, and thus does not have the capacity to take up specialized funding such as that offered by structured products.
Case Study – South Africa listed property market
The South African listed property industry has experienced substantial growth over the past decade. The sector is dominated by a few large entities, with the biggest 10 accounting for about 80% of the sector’s market capitalisation. There are currently 27 entities listed as REITs on the JSE, with more attempts to bring new entities onto the Exchange. According to the South African REIT Association, REITs represent about ZAR 233 bn (Sh1.6 tn) worth of real estate assets.
South Africa is estimated to be the eighth-largest REIT market globally, with the US dominating the global REIT sector. Most South African REITs invest in commercial properties, such as shopping malls, warehouses, hotels, hospitals, and office buildings, with some investment in properties offshore.
Some of the factors that have led to the rapid development of the alternative funding sources in the South African industry are;
Presence of an already developed capital market – Even before the incorporation of alternative funding sources such as REITs and other structured products, the capital markets in the country were already well established. Not only did this make it easier for investment managers in structuring offerings for investors, given that they had built expertise, but it also boosted the uptake given that investors already had sufficient confidence in
the capital markets.
Diverse property offerings – The property sector in South Africa is well diversified, with large institutional developers in all the real estate subsectors, who have built a strong track record in real estate delivery, while at the same time giving attractive returns. This has had a snowball effect, by encouraging lenders and investors to commit capital to this sector, further spurring its growth.
Good Corporate Governance – Good regulation practices and corporate governance have acted as an incentive to both local and foreign investors, who have the assurance that their funds are being properly administrated and utilized.The success in the implementation of alternatives in the South African industry did not go without a host of challenges, such as; Fluctuation in the real estate industry, where the property market in South Africa took a hit following the 2008 global economic crisis, and; Competition with higher returns in Asia and other African markets.
Steps in increasing access to real estate development funding
Increasing the access to funding for real estate development can be achieved through;
The development of structured products in the Kenyan market – These products have been a welcome alternative to banks for businesses seeking capital for growth, and the same can be applied to real estate financing. In developing markets such as Kenya, capital markets remain underdeveloped; hence businesses are forced to source up to 95% of funding from banks, while only 5% from capital markets. As such, real estate development and investment is not being provided with adequate access to this source of capital, which is provided at competitive rates can increase the development of affordable housing.
Tax amendments to level the playing field – Structured Products and Non-bank funding need to be given favorable tax treatment as all other funding methods, which will provide an incentive to capital providers to invest in the real estate sector. This is expected to spur development of alternative sources of funding at competitive rates available for the real estate development.
A review of I-REITs – There is need to conduct a review on REITs, given that we only have one REIT on the stock exchange, and trading at 40% below its listing price due to negative investor sentiments.
Reduce minimum amount investable in all REITs – In order to attract capital into capital market vehicles such as Real Estate Investment Trusts (REIT’s) for real estate development, the minimum investment amount needs to be amended. The current regulations, which define the minimum subscription amount per investor at Sh5m for a Development REIT (D-REIT), is too high to attract significant interest from investors. An amount of Sh1m would ensure the investor is sophisticated while also allowing a larger pool of investors to participate.
Expand trustees of a collective investment scheme – Collective Investment Scheme Trustees should not only be banks but should also include companies licensed by the CMA. For capital markets to fund real estate development, the players will need to accumulate capital in a fund overseen by trustees. The Capital Markets (Collective Investment Scheme) Regulations (2001) limit approved trustees to banks or financial institutions. Kenya has only 4 banks certified as CIS trustees, and thus we need to go the way of more developed countries and increase the pool to include other appropriate players.
Expand tax relief for regular savings towards home purchase– Savings into Collective Investment Schemes regulated by the Capital Markets Authority (CMA) should qualify as HOSP (Home Ownership Savings Plan). Savings in CMA approved products such as Money Market Funds currently don’t qualify as HOSP. Therefore, savers only have the option of banks, which pay low interest. There is need to expand the meaning of ‘approved institution’ that hold deposits intended for HOSP to include Fund Managers, thus enabling the potential homeowners making savings through the Collective Investment Scheme (CIS) to enjoy the tax relief provided under HOSP.
HOSP Guidelines should include Capital Markets Authority (CMA) investment guidelines in addition to the Central Bank of Kenya (CBK) – HOSP guidelines only recognize investment guidelines per CBK. If Fund Managers were included, the guidelines would be as per CMA. So that an investor has a choice whether to save through a bank or an investment savings product. To include investment guidelines provided by the CMA regulations, in addition to the prudential guidelines issued by CBK to regulate investment of deposits under a registered HOSP.
Allowing specialized collective investment schemes – There is currently no provision to register a CIS that invests in a single asset class, specific sector, or is formed for a specific purpose, thus limiting the financing available to real estate from Collective Investment Schemes. The Capital Markets regulations for Collective Investment Schemes do not allow a sector-specific fund to be formed for example a technology, financial services, or real estate fund.
Real estate development is crucial in any developing economy. According to the National Housing Corporation, Kenya has a cumulative housing deficit of 2m units growing by 200,000 units per year being driven mainly by rapid population growth of 2.6% p.a. compared to the global average of 1.2%; and, a high urbanization rate of 4.4% against a global average of 2.1%. Supply, on the other hand, has been constrained with the Ministry of Housing estimating the total annual supply to be at 50,000 units. Alternative sources of funding are critical to helping meet the housing demand and real estate needs of the country and help provide affordable housing.