Executive Summary

Fixed Income: T-bills were undersubscribed during the week, with the overall subscription rate coming in at 63.2%, compared to 53.1% recorded the previous week, due to a relatively tight money market during the week. Yields on the 91, 182 and 364-day papers remained unchanged from the previous week at 8.1%, 10.3% and 11.0%, respectively. According to the Kenya National Bureau of Statistics (KNBS) Q2’2017 Balance of Payments Report, the current account deficit expanded by 18.1%, to 6.2% of GDP in Q2’2017 from 5.3% of GDP in Q2’2016;

Equities: During the week, the equities market was on a downward trend with NASI, NSE 25 and NSE 20 losing 0.9%, 1.4% and 1.6%, respectively, taking their YTD performance to 20.5%, 19.3% and 15.9% for NASI, NSE 25 and NSE 20, respectively. Communications Authority of Kenya (CAK) released the Telecommunications Sector data for the fourth quarter of the financial year 2016/2017, highlighting an annual growth of 1.4 % in mobile subscriptions to 40.3 mn subscribers from 39.7 mn in Q4’2016z;

Private Equity: General Electric (GE) Health Care, a provider of medical technologies and services, has committed to contribute an undisclosed amount to an Egyptian based Rx Health Care Fund, that targets to raise USD 200 mn by the end of the year 2018. The fund aims to invest in specialised hospitals, medical diagnostics companies and pharmaceuticals companies, across North African countries of Egypt, Tunisia and Morocco, with a potential for expansion to the Sub-Saharan healthcare markets particularly Kenya, Nigeria and Ethiopia;

Real Estate: The real estate sector slowed down in the first seven months of 2017, as seen from the 18.4% decline in the value of building plans approved by the Nairobi City County between January and July 2017 according to the Kenya National Bureau of Statistics. The slowdown can mainly be attributed to (i) the wait and see approach adopted by risk averse investors during the electioneering period, and (ii) reduced credit to the private sector by banks as a result of enactment of the Banking Amendment Act 2015. Knight Frank’s Global Cities report 2018 indicates an increase in Mixed Use Developments in Nairobi driven by the need for a live-work-play environment;

Focus of the Week: We release our annual Kenya Retail Real Estate Report on 9^th October 2017, and according to the report, there has been an increase in the supply of retail space which has led to a decrease in the average rental yield by 0.4% points in the whole market to 8.3% in 2017 from 8.7% in 2016, and a 0.4% points decline in the Nairobi area yields to 9.6% from 10.0% over the same period. Occupancy rates declined by 2.7% points in the whole market to 80.2% from 82.9%, and 9.0% points in Nairobi to 80.3% in 2017 from 89.3% in 2016. Nairobi is sufficiently supplied with retail space factoring in the incoming supply in the next 2-3 years, but there could be certain nodes that investors can explore.

Company Updates

• Cytonn Real Estate, the development affiliate of Cytonn Investments, officially launched a Kshs 20.0 bn iconic mixed-use development named “Cytonn Towers”. The 35 floor triplex tower will be located in Kilimani and is designed as a live, work and play destination. The product was very well received, achieving 20.0% pre-sales on the residential units on the first day of sales. Commenting on the sales launch, Anne Nyambura, the Project Management Analyst said, “Kilimani is the perfect location for a mixed use development given the high density population with an attractive demographic and economic profile. Our pre-sales target for the residential component was 10.0% and we achieved twice the target on the first day of sales. We have received keen interest in the retail space from all the major retailers. The interest in buying commercial office space is strong. It is clear that the concept, which was based on rigorous research, has been very well received by the market.” See Event Note here,
• Our Investment Analyst, Caleb Mugendi, discussed the effects of the upcoming presidential poll re-run on the Kenyan economy and the real estate market. Watch Caleb on Ebru TV here,
• Our Investment Analyst, Caleb Mugendi, discussed equities market analysis and how the Nairobi Securities Exchange All Share Index (NASI) rally has been supported by performance of banking sector stocks and Safaricom. Watch Caleb on CNBC here
• Given the various ways in which businesses can raise capital, we focused on why companies should look at listing on the Nairobi Securities Exchange and the different types of listings available in the market. See article on Types of Listing
• We continue to showcase our real estate developments by our real estate development affiliate, Cytonn Real Estate, through weekly site visits. Watch progress videos and pictures on The Alma, Amara, The Ridge and Taraji Heights. The site visits target both investors looking to invest in real estate directly and those interested in high yield investment products to familiarize themselves with how we support our high yield returns. To deliver high yield returns, our cost of capital is priced off the loan markets where all-in pricing ranges from 16.0% to 21.0% and our yield on real estate developments ranges from 23.0% to 25.0%, hence our top-line gross spread is about 6%. If interested in attending the site visits, kindly register here
• We continue to see very strong interest in our Private Wealth Management training (largely covering financial planning), which is at no cost, and is held bi-weekly, but is open only to pre-screened participants. We also continue to see institutions and investment groups interested in the trainings for their teams, if interested in the training for your employees or investment group please get in touch with us through our Client Services team at clientservices@cytonn.com. 
• For recent news about the company, see our news section here
• We have 10 investment-ready projects, offering attractive development and buyer targeted returns of around 23.0% to 25.0% p.a. See further details here: Summary of investment-ready projects
• To invest in any of our current or upcoming real estate projects, please visit Cytonn Real Estate

• • Cytonn Towers, where we are only selling residential units in the first phase, is currently 20.0% sold. See Cytonn Towers
  • The Alma, which is over 55.0% sold, has delivered an annualized return of 55.0% p.a. for investors who bought off-plan. See The Alma
  • Amara Ridge is currently 100.0% sold and has delivered over 20.0% p.a. returns to investors. See Amara Ridge
  • Situ Village is currently 15.0% sold. See Situ Village
  • The Ridge (Phase 1) is currently 31.0% sold. See The Ridge
  • Taraji Heights is currently 10.0% sold. See Taraji Heights
  • RiverRun Estates (Phase 1) is currently 8.7% sold after the recent launch. See RiverRun Estates

• With over 10 investment ready projects with over Kshs 82.0 billon of project value, we shall be very selective on new real estate projects going forward, only focussed on Joint Ventures and opportunities with deep value. We shall now be increasingly focused on private equity deals. Should you have any deals in banking, insurance, education, hospitality and technology sectors, kindly email a teaser to PE@cytonn.com
• We continue to beef up the team with ongoing hires: Careers at Cytonn

Fixed Income

During the week, T-bills were undersubscribed, with the overall subscription rate coming in at 63.2%, compared to 53.1% recorded the previous week, due to relatively tight money market liquidity experienced during the week. The subscription rates for the 91, 182 and 364-day papers came in at 121.8%, 22.2%, and 80.7% compared to 100.6%, 52.6% and 34.5%, respectively, the previous week. The seemingly high subscription rate on the 91- day T-bill is due to the fact that the government, in a bid to lengthen the maturity profile of its borrowing, aims to borrow less from the 91-day paper at Kshs 4.0 bn weekly as compared to the other two at Kshs 10.0 bn each. Yields on the 91, 182 and 364-day papers remained unchanged from the previous week at 8.1%, 10.3% and 11.0%, respectively. The overall acceptance rate came in at 87.0%, compared to 99.8% the previous week, with the government accepting a total of Kshs 13.2 bn of the Kshs 15.2 bn worth of bids received, against the Kshs 24.0 bn on offer in this auction. Despite this, the government is behind its domestic borrowing target for the current fiscal year, having borrowed Kshs 49.1 bn, against a target of Kshs 110.4 bn (assuming a pro-rated borrowing target throughout the financial year of Kshs 410.2 bn budgeted for the full financial year as per the Cabinet-approved 2017 Budget Review and Outlook Paper (BROP)).

Liquidity in the money market was relatively tight during the week, with a net liquidity injection of Kshs 2.2 bn, compared to a net withdrawal of Kshs 1.2 bn the previous week, with the bulk of the liquidity injection coming from government payments of Kshs 55.6 bn. There were high liquidity reductions through reverse repo maturities and payment of taxes by banks of Kshs 45.2 bn and Kshs 19.4 bn, respectively, and to counter the liquidity withdrawal, the CBK injected Kshs 25.3 bn through reverse repos. The tight liquidity in the market led to an increase in the average interbank rate to 8.1% from 7.1% recorded the previous week. The average volumes traded in the interbank market increased by 11.2% to Kshs 19.9 bn from Kshs 17.9 bn the previous week.

Below is a summary of the money market activity during the week:

According to Bloomberg, yields on the 5-year and 10-year Eurobonds declined by 10 bps to 4.0% and 6.3% from 4.1% and 6.2%, respectively, the previous week. Yields on these two bonds have been on a downward trend since July, and this can be attributed to the stability that has prevailed during the Kenyan General Election period. Since the mid-January 2016 peak, yields on the Kenya Eurobonds have declined by 4.8% points and 3.4% points for the 5-year and 10-year Eurobonds, respectively, due to stable macroeconomic conditions in the country. The declining Eurobond yields and stable rating by Standard & Poor (S&P), in spite of the political uncertainty around the presidential poll re-run, are indications that Kenya’s macro-economic environment remains stable and hence an attractive investment destination. However, concerns from Moody’s around Kenya’s rising debt to GDP levels may see Kenya receive a downgraded sovereign credit rating.

The Kenya Shilling remained relatively stable against the US Dollar (USD) during the week to close at Kshs 103.2, same as the previous week, due to dollar inflows from horticulture export earnings that offset demand from oil importers. On a year to date basis, the shilling has depreciated against the dollar by 0.7%. In our view, the shilling should remain relatively stable against the dollar in the short term, supported by (i) the weakening of the USD in the global markets, (ii) increased diaspora remittances that grew by 5.3% to USD 1.0 bn in 7 months to July 2017 from USD 987.2 mn over a similar period last year, and (iii) the CBK’s activity as they have sufficient forex reserves, currently at USD 7.4 bn (equivalent to 4.9 months of import cover). The key thing to watch is the current account deficit that worsened to 6.2% of GDP in Q2’2017, as compared to 5.3% of GDP in a similar period last year.

The Kenyan economy seems to be facing some challenges at the moment as can be seen from the lower than expected growth in Q2’2017 GDP of 5.0%, which was below 6.3% recorded in Q2’2016, as highlighted in our Kenya Q2’2017 GDP Growth and 2017 Outlook note. Also this week we saw Stanbic Bank’s Monthly Purchasing Manager’s Index (PMI) for September decline to 40.9 from 42.0 in August, an indication that the economy has not improved, and this was largely driven by (i) low private sector credit growth at 1.6% in August, and (ii) the prolonged election period. Furthermore, according to the Kenya National Bureau of Statistics (KNBS), in Q2’2017, the Balance of Payments position worsened due to widening current account deficit, which deteriorated to 6.2% of GDP from 5.3% recorded in Q2’2016, as the 15.5% increment in imports could not be offset by the minimal increase in the exports, which grew marginally by 2.9%. Diaspora remittances continue to increase as they registered a 5.1% growth to Kshs 47.6 bn from Kshs 45.3 bn recorded in Q2’2016. Lastly, the net public debt position grew by 27.8% to Kshs 2.3 tn in June from Kshs 1.7 tn in June 2016, mainly from commercial banks loans.

Standard & Poor’s, a global ratings agency, affirmed Kenya’s sovereign rating for short and long term foreign and local currency credit at B+ and B, respectively, also maintaining the outlook at stable based on an expectation of strong economic growth in the future. The agency maintained that the rating could be lowered should the political uncertainty brought about by the upcoming presidential poll re-run persist. This comes at a time when Moody’s spoke of a possible sovereign credit ratings downgrade based on Kenya’s debt to GDP ratio that hit 56.4%, and is expected to rise as the country keeps borrowing to finance the budget. We maintain that (i) we expect the economy to normalise once the country takes to the polls, the re-run is concluded, and uncertainty dissipates, with Kenya’s growth fundamentals remaining strong and intact, and (ii) the government should strive to manage the country’s debt levels going forward by enforcing efficient tax collection methods, involving private sector in development through more Public-Private Partnerships (PPPs) and reducing recurrent expenditure that currently accounts for 58.8% of the 2017/2018 budget, as mentioned in our note on Post-Election Areas of Focus.

Rates in the fixed income market have remained stable, and we expect this to continue in the short-term. However, a budget deficit that is likely to result from depressed revenue collection creates uncertainty in the interest rates environment as any additional borrowing in the domestic market to plug the deficit could lead to upward pressures on interest rates. Our view is that investors should be biased towards short-to medium term fixed income instruments to reduce duration risk.

Equities

During the week, the equities market was on a downward trend with NASI, NSE 25 and NSE 20 losing 0.9%, 1.4% and 1.6%, respectively, taking their YTD performance to 20.5%, 19.3% and 15.9% for NASI, NSE 25 and NSE 20, respectively. This week’s performance is attributable to losses by select large cap stocks such as Equity Group, KCB Group and Co-operative Bank, which lost 4.5%, 2.4% and 2.3%, respectively. Since the February 2015 peak, the market has lost 9.5% and 32.8% for NASI and NSE 20, respectively.

Equities turnover decreased by 33.4% to USD 15.7 mn from USD 23.6 mn the previous week. Foreign investors turned net buyers with a net inflow of USD 0.2 mn compared to a net outflow of USD 0.1 mn recorded the previous week. We expect the market to record subdued activity over the coming few weeks as market players remain cautious of the renewed political uncertainty in the country. Despite this, we expect the market to remain supported by improved investor sentiment once the country takes to the polls for the presidential elections scheduled for October 26^th.

The market is currently trading at a price to earnings ratio (P/E) of 12.9x, versus a historical average of 13.4x, and a dividend yield of 4.1%, compared to a historical average of 3.7%. Despite the valuations nearing the historical average, we believe there are pockets of value in the market, with the current P/E valuation being 23.8% below the most recent peak in February 2015. The current P/E valuation of 12.9x is 33.0% above the most recent trough valuation of 9.7x experienced in the first week of February 2017, and 55.2% above the previous trough valuation of 8.3x experienced in December 2011. The charts below indicate the historical P/E and dividend yields of the market.

During the week, the Communications Authority of Kenya (CAK) released the Telecommunications Sector statistics for the fourth quarter of the financial year 2016/17; the fourth quarter ended in June 2017. Key highlights include:

• Mobile subscriptions increased by 0.6 mn new subscriptions, representing a 1.4% y/y growth to 40.3 mn subscriptions, from 39.7 mn registered in Q4’2016. However, mobile penetration declined marginally by 1.3% points to 88.7% from 90.0% registered in Q4’2016. This is attributed to the review of the base population upwards to 45.4 mn from 44.2 mn as per the Economic Survey 2017,
• The minutes of use per subscriber per month in the industry grew by 2.8% to 88.4 minutes from 86.0 minutes registered in a similar quarter last year,
• The total number of Short Messaging Service (SMS) sent during the quarter increased by 25.9% to 14.6 bn messages from 11.6 bn registered in Q4’2016. On a quarterly basis, the number of SMS’s sent grew by 14.1% from 12.8 bn recorded previous quarter, which could be attributed to introduction of SMS tariffs by service providers to encourage SMS usage,
• Internet subscriptions recorded a 10.5% growth to 29.6 mn subscribers from 26.8 mn registered in Q4’2016. The growth was driven by a 15.3% increase in mobile data subscriptions to 29.4 mn at the end of the quarter, which accounted for approximately 99.0% of the total subscriptions. The increase of mobile data subscriptions could be attributed to a sustained decline in the price of smartphones costs as well the widespread availability of the handsets. Internet penetration increased by 4.0% points to 64.8% from 60.8% recorded in Q4’2016,
• The number of internet broadband subscriptions increased by 42.6% to 15.4 mn from 10.8 mn recorded in Q4’2016. On a quarterly basis, the internet broadband subscriptions grew by 12.4% from 13.7 mn recorded previous quarter; this is attributed to the affordability of smartphones in the country as well as affordable internet bundles offered by various internet service operators. The broadband penetration closed at 34.2%, up from 24.6% recorded in Q4’2016. Important to note is that; internet broadband subscriptions include those subscriptions to homes and offices, while internet subscriptions refer to those offered by mobile operators,
• The number of mobile money subscriptions increased by 6.8% to 28.1 mn subscriptions from 26.3 mn in Q4’2016, while the number of active mobile money transfer agents increased by 13.8% to 180,657 compared to 158,727 agents in Q4’2016,
• The volume of mobile money transactions (deposits and withdrawals) registered a 27.9% growth to 480.6 mn with Kshs 1.2 tn transferred during the period. The person-to-person transfers amounted to Kshs 541.8 bn with the rest being used to pay for goods and services,
• The mobile money segment continues to experience increased competition evidenced by a marginal reduction in Safaricom’s market share by value of transactions to 74.2% in Q4’2017, from 76.1% in Q3’2017.

Key highlights from the report in comparison to the previous quarter and a similar quarter last year are summarized in the table below:

Given the rapid population growth of 2.6% and technological advancements, which in turn has resulted in continuous strong growth of the telecommunications sector over the years, we are of the view that the industry still presents a good investment opportunity for both the short and long term investors.

Insurance Regulatory Authority (IRA) Q2’2017 Report

IRA released Q2’2017 numbers for the insurance industry with the market recording growth in total gross insurance premiums by 12.4% y/y to Kshs 119.2 bn from Kshs 106.0 bn in Q2’2016, compared to an 8.6% y/y growth registered the previous year. Below is a summary of the key metrics:

Key highlights of the performance in Q2’2017 compared to Q2’2016 include:

• Operating revenue grew by 6.7% to Kshs 93.7 bn from Kshs 87.8 bn, driven by net premium income growth of 10.4% to Kshs 96.0 bn from Kshs 87.0 bn. Just as is the case with most African countries with low insurance penetration rates, the non-life segment remained dominant contributing 64.2% (Kshs. 74.5 bn), while long-term business contributed 35.8% (Kshs. 42.7 bn) of the total premiums during the period,
• Operating expenses grew by 7.9% to Kshs 84.3 bn in Q2’2017 driven by (i) an 8.2% increase in claims incurred and benefits paid to Kshs 54.6 bn from Kshs 50.5 bn, and (ii) a 7.5% increase in commissions and management expenses to Kshs 29.7 bn from Kshs 27.6 bn,
• The sector recorded a marginal improvement in operational efficiency with the loss ratio declining to 56.9% from 58.0% and the expense ratio also declining slightly to 30.9% from 31.8% attributed to a faster growth in premiums compared to expenses. This led to the combined ratio declining to 87.8% from 89.8%,
• Total assets held by the insurance sector increased by 12.5% to Kshs 564.4 bn from Kshs 501.6 bn in Q2’16 driven by a 12.4% growth in investments to Kshs 450.7 bn from Kshs 400.8 bn,
• Shareholders’ funds grew by 6.5% to Kshs 141.3 bn from Kshs 132.7 bn in Q2’2016, attributed to capital restructuring following the changes in regulatory capital requirements.

The current insurance business model is not profitable as depicted by the high expense and loss ratios. However, we expect increased product innovation and operational efficiency to drive profitability and thus growth of the sector amidst the heightened regulation. The Insurance Regulatory Authority (IRA) is at the forefront of this initiative, pushing for (i) the observance of prudential guidelines, (ii) better corporate governance of insurance companies, (iii) increased transparency in financial reporting, and (iv) use of a risk-based approach to capitalization, with varying risk charges on respective investment options.

In spite of the affirmation ratings from various global rating companies as highlighted in our Cytonn Weekly #27/2017, Global ratings agency Moody’s has placed KCB Bank, Equity Bank and Co-op Bank on review for a possible downgrade of their ‘B1’ global scale long-term local currency deposit ratings and ‘b1’ baseline credit assessment (BCA). This rating action is driven by the agency’s view of a potential weakening in the Kenyan Government’s credit profile as captured by Moody’s recent decision to place Kenya’s ‘B1’ Government ratings on review for downgrade. Ratings are essential for a well-functioning market as they facilitate best pricing and timing of public offerings, as companies with good ratings get public recognition thus can easily attract investors.

Despite the elaborate process and timing put in place to bring Chase Bank Limited out of the receivership on October 7, the lender’s receivership will be extended following an application by a depositor for an extension of the lender’s receivership. The Central Bank of Kenya (CBK) has, therefore, frozen the receivership pending the hearing of the case, which is set for November 14, 2017. The lender will remain under statutory management by The Central Bank of Kenya (CBK) and Kenya Deposit Insurance Corporation (KDIC). This comes even after the State Bank of Mauritius (SBM) expressed its interest in carving out some assets and liabilities in the lender. Chase Bank was one of 3 local banks that faced closure, the others being Imperial Bank, another mid-sized lender, and Dubai Bank, a smaller lender. We are of the view that the reopening of Imperial Bank after Chase Bank will improve confidence in the banking industry.

In an effort to keep our rankings of companies on the Cytonn Corporate Governance Ranking (Cytonn CGR) Report up-to-date, we continually update the rankings whenever there are changes on any of the 24 metrics that we track, and how this affects the company ranking. This week, Centum Investment appointed Mrs. Susan Wakhungu Githuku as an independent non-executive director. The following directors retired from the Board of the company; Dr. James McFie, Mr. Khan and Mr. Henry Njoroge. Centum’s overall score improved to 66.7% from 64.6% due to an improvement in gender diversity score to 44.4% from 27.3%. Centum therefore improved its ranking to position 23 from position 29.

Below is our Equities Universe of Coverage:

We remain "neutral with a bias to positive" for investors with short to medium-term investments horizon and are "positive" for investors with a long-term investment horizon.

Private Equity

General Electric (GE) Health Care, a provider of medical technologies and services, headquartered in Chicago, Illinois, USA, has committed to contribute an undisclosed amount to Egyptian based Rx Health Care Fund that targets to raise USD 200.0 mn by the end of the year 2018. Rx Health Care, a private equity fund, targets to have its first close at USD 100.0 mn before the end of the year 2017. This is a boost to the fund which had received a commitment of USD 20.0 mn from African Development Bank in October 2016. The newly established fund aims to invest in specialised hospitals, medical diagnostics companies and pharmaceuticals companies, across North African countries of Egypt, Tunisia and Morocco, with a potential for expansion to the Sub-Saharan healthcare markets particularly Kenya, Nigeria and Ethiopia. The opportunity in the health sector is being driven by (i) expanding demand for healthcare services from Africa’s growing middle class, and (ii) increased demand of quality, affordable and sustainable healthcare. In November 2016, we also witnessed UK based venture capital firm, LeapFrog, acquire an undisclosed majority stake in Goodlife pharmacy valued at USD 22.0 mn from Nairobi based Private equity firm Catalyst Principal Partners.

Private equity investments in the Sub-Sahara African Region remains robust as evidenced by the increased deal flow in a number of sectors that support growth. The increasing investor interest in private equity investment in sub-Sahara Africa is attributed to (i) rapid urbanization, a resilient and adapting middle class and increased consumerism, (ii) the attractive valuations in the private markets compared to the public markets, (iii) the attractive valuations in Sub Saharan Africa’s markets compared to global markets, and (iv) better economic projections in Sub Sahara Africa compared to global markets. We remain bullish on PE as an asset class in Sub-Sahara Africa. Going forward, the increasing investor interest and stable macro-economic environment will continue to boost deal flow into the mark.

Real Estate

The real estate sector has continued to record a slowdown in activity as a result of a challenging economic environment in 2017. KNBS released their August issue of The Leading Economic Indicators (LEI), highlighting that the value of building plans approved by Nairobi City County between January and July 2017 decreased by 18.4% to Kshs 149.5 bn from Kshs 183.2 bn between January and July 2016. The value of residential approvals during the same period declined by 17.4% to Kshs 88.5 bn in 2017 from Kshs 107.2 bn in 2016, while the value of commercial approvals declined by 15.1% to Kshs 61.0 bn from Kshs 76.1 bn during the same period in 2017 and 2016, respectively. We attribute the decline mainly to (i) the wait and see attitude adopted by investors during the electioneering period, and (ii) reduced credit to the private sector by banks as a result of the enactment of the Banking Amendment Act 2015 that has seen credit growth decrease to 1.6% in August 2017 compared to 5.4% in August 2016, and a 4-year average of 15.3%.

In the residential sector this week, the State Department of Housing and Urban Development has reached out to private contractors to partner in the construction of 8,000 houses on a pilot scheme on 55-acres of land in Mavoko, Machakos County. The partnership involves the government providing land while the contractor will assume design, procurement, construction, commissioning and handing the houses over to the buyers. The entire project is estimated to cost Kshs 21.0 bn, translating to an approximate Kshs 2.6 mn cost per house once complete. To save on costs and time, the contractor is expected to use modern building technology for the affordable mass housing project. Details remain limited with regard to the sizes of the house and the projected selling price. While this is a move in the right direction in terms of addressing the housing deficit, in the past Public Private Partnerships (PPPs) have failed to materialize due to political interference, disparities and lack of clarity in terms of revenue sharing and the long-term nature of such projects mostly exceeding 10-years, while most private investors aim to exit investments in 3-5 years. Should the project be successful, it will play a role in addressing the housing need estimated to be at 2 mn units and growing at 206,000 units annually, according to the African Development Bank. In addition, it will address the main limitations to affordable housing which include (i) high land costs driven by speculation, with prices rising at a 5-year CAGR of 19.4%, and (ii) high construction costs, which account for approximately 70.0% of development costs. In our view, however, more needs to be done to address other challenges that hinder affordable housing development, which include:

1. Access to Funding - Financing for development is not only expensive, but also difficult to access. In addition, enactment of the Banking Amendment Act 2015 has resulted in a decline in private sector growth to 1.6% in August 2017 from 5.4% growth in August 2016 and 21.0% growth in August 2015, and,
2. Developing Infrastructure – Developers have to incur costs of servicing land through roads, water supply and sewer systems, and thus these costs are passed on to buyers.

Development of Mixed Use Developments (MUDs) is rapidly increasing, according to Knight Frank Global Cities Report 2018, driven by population growth and lack of infrastructure to support the same, creating the need for integrated live-work-play developments. For developers, integrating office, residential, retail and hotel uses for example, has advantages such as (i) creation of multiple revenue streams thus diversifying risk, (ii) creation of a symbiotic relationship between the various aspects of the development, thus having a better chance of performance of the entire development, and (iii) higher returns compared to single use developments for example, while the average office occupancy in Kilimani in 2017 is 90.5% with a rental yield of 9.3%, the average occupancy of mixed use developments with retail and office space in the same market is 95.0%, realizing an 11.0% rental yield. In our view, however, the success of MUDs is dependent on the mix and the execution. Developers therefore have to conduct adequate market research to determine the optimum mix for optimum returns.

Some of the notable current and proposed MUDs in Nairobi include:

Research: Cytonn Research

In the hospitality arena, Kenya’s hotel industry has been on an upward trend between January and July 2017 boosted by the recovery of the tourism industry. According to LEI by KNBS, August 2017 release, the total number of visitors arriving through Jomo Kenyatta International Airport (JKIA) and Moi International Airport (MIA) increased by 12.6% to 543,154 between January and July 2017 from 482,470 during the same period in 2016. Overall, the number of visitors has increased by 32.1% between January and July 2017. In Nairobi alone, this is reflected through increased hotel occupancy during the same period by 17.3% points to 56.5% occupancy in July 2017 from 39.2% occupancy in January 2017, according to STR Global Hospitality Group. We attribute the growth to;

1. Aggressive Marketing - This has helped restore confidence among key international markets such as Europe, USA and the new emerging markets in Africa and Asia as well as the domestic market. According to the World Travel and Tourism Council’s (WTTC) 2017 report, the Kenyan government increased spending on the sector by 93.4% from Kshs 31.9 bn in 2010 to Kshs 61.7bn in 2016,
2. Improved Security Status - Following previous attacks by terrorists, the government has put in place security measures for the safety and security of tourists during their stay in the country,
3. Growth in Meetings, Incentives, Conferences and Exhibitions (MICE) Tourism - According to the economic survey by the KNBS 2017, the number of foreign and local delegates increased by 36.1% to 268,401 in 2016 from 196,253 in 2015 showing the growth in conference tourism, and,
4. Increased Domestic Tourism – According to WTTC, domestic travel spending generated 60.8% of direct travel and tourism contribution to the Kenyan GDP in 2016 compared to 39.2% from international tourism receipts.

The hotel sector however got a setback in August 2017 as average occupancy declined to 35.8% in Nairobi. This is attributed to concerns over security during the elections period. Hoteliers have, nevertheless, showed optimism in the sector in the long-term through continued investment in the sector. Global hotel chain Hilton announced a Kshs 5.0 bn investment to renovate and rebrand 29 hotels in Africa, among them, the 109-room Amber Hotel along Ngong Road. The hotel will then rebrand to ‘DoubleTree’ and will continue to be operated by the owners under a franchise agreement. Other hotels that have also begun expansion or refurbishment in Kenya include; the Nairobi Serena Hotel, who as from December 2016, embarked on undertaking expansion and refurbishment budgeted at Kshs 2.4 bn and the upcoming extension of the Ole Sereni Hotel, which is intended to rise to a total of 13 floors and with a total of 148 rooms. These developments aim at ensuring the hotels remain relevant in the market, maintain their market share, and also address the increasing demand for accommodation both leisure and business travellers.

Other highlights in the real estate sector this week include;

1. International retailers Carrefour will open a 3^rd outlet next month at Nairobi’s Thika Road Mall (TRM), taking over space vacated by struggling rival Nakumatt Holdings. At TRM the outlet will cover over 5,000 SQM of retail space, adding to its two existing outlets at Two Rivers Mall, along Limuru Road, which is 7,200 SQM and The Hub in Karen, which is 5,000 SQM.
2. Retailers have rolled out digitalization projects aiming to improve clients experience at their outlets. This week the Hub Karen Mall rolled out a new service that will see customers pay to park on the go via M-Pesa, eliminating the need for customers to queue at the pay station, as part of its drive to enhance the customer experience at the mall. Naivas Supermarket in partnership with Interswitch East Africa launched its Digital Retail Strategy, with the roll out of its payment network ‘Naivas Pay’, at their Westlands and Ciata Mall on Kiambu Road. The new service will allow customers to pay directly from their Bank account via mobile, internet, and card at the till thus eliminating costly point of sale services, boosting revenue by at least 7.0%.

We expect the real estate industry activities to remain on a slow towards the end of 2017, but will pick up in 2018 should peaceful elections be held. This will be driven by the demand as seen through the high population and urbanization growth at 2.7% and 4.4%, respectively, and real estate’s high returns of on average 25.0% p.a. in the last 5 \-years and 25.8% recorded in 2016.

Focus of the Week: Kenya Retail Sector Real Estate Report - 2017

Last year we released Kenya’s Retail Real Estate Sector Report 2016 entitled “Investors Perspective on the Kenyan Retail Sector”. According to the report, the retail sector in Kenya was an attractive investment opportunity with average rental yields of 8.7% country wide and 10.0% in Nairobi driven by a growing middle class seeking aspirational lifestyles, increasing GDP growth which has averaged at more than 5.1% p.a. over the last five years and increased infrastructural developments opening up new areas for development and increasing ease of movement. This year, we update the report with findings from research conducted in 8 nodes in Nairobi as well as key urban centers in Kenya including Eldoret, Kisumu, Mombasa and the Mt. Kenya Region, consisting of Nyeri, Meru and Nanyuki Towns. In the report we cover the current state of the retail market in terms of supply, demand, drivers, challenges and performance in 2017, which we compare with 2016’s performance, to gauge trends and hence outlook. In this focus we will cover the main highlights from the report starting with an introduction, performance of the retail real estate theme in Nairobi and in Kenya by nodes and by the type of malls, retailers’ sentiments on the market before concluding with an outlook for the sector.

Introduction

2017 has been a turbulent year for the retail sector in Kenya due to several reasons:

1. A tough operating environment characterized by low credit,
2. The wait and see attitude adopted by investors as a result of the 2017 General Elections,
3. Increased supply of retail space, which grew by 41.6% y/y in Nairobi alone from 3.9 mn SQFT in 2016 to 5.6 mn SQFT in 2017, and is expected to grow further by a 3-year CAGR of 7.3% to 6.9 mn SQFT in 2020. The significant 41.6% growth is mainly due to bullish outlook by developers on the retail sector leading to development of malls such as Two Rivers which opened in February 2017,
4. Increased competition with new entrants such as Carrefour and Choppies, and,
5. Internal challenges facing retailers on financing and supply chain management, especially Nakumatt and Uchumi.

The above challenges have led to a decline in performance of the sector with average rents declining by 9.0% countrywide from an average of Kshs 154.9 per SQFT in 2016 to Kshs 141.0 per SQFT in 2017 and occupancy decline of 2.7% points from 82.9% to 80.2% resulting in an 0.4% points decline in yields from 8.7% in 2016 to 8.3% in 2017 for the entire the country and 0.4% points decline for Nairobi from 10.0% in 2016 to 9.6% in 2017.

Going forward we expect:

1. Reduced development activity especially in Nairobi County following the increase in supply,
2. Increased dominance by foreign retailers who are making inroads due to stronger financial muscle, better governance and management systems, lower costs of goods and government incentives such as tax holidays to increase foreign direct investments. For instance, Carrefour has taken up the space vacated by Nakumatt in Thika Road Mall and Choppies is set to be the anchor in the upcoming Kiambu Mall and to take up space in Spur Mall in Ruiru, and,
3. Paradigm shift from anchor tenancy after Nakumatt’s challenges - developers may offer less space to anchors to mitigate overreliance on one brand or have other retailers other than supermarkets, such as fast foods, as anchors provided they can attract the relevant foot fall.

Performance

In performance, we will cover the general market performance in the country, performance in Nairobi by nodes and by mall classification then conclude with the performance of key urban cities in the country.

In 2017, the retail sector’s performance softened with rental yields declining by 0.4% points to 8.3% in 2017 from 8.7% in 2016, attributable to a decline in occupancy rates which declined by 2.7% points to 80.2% from 82.9%, respectively.

The performance of the sector across the key cities is as summarized below:

Source: Cytonn Research

Nairobi Retail Market Performance

YTD 2017, Nairobi’s performance has softened across all submarkets driven by increased supply, which led to a decline in occupancy levels. On average, occupancy levels have declined by 9.0% points y/y from an average of 89.3% to an average of 80.3% with Nairobi Eastlands having the largest decline in occupancy levels at 23.3% points followed by Mombasa Road and Thika Road with 14.6% points and 14.0% points declines in occupancy levels, respectively. These nodes got significant amount of retail spaces between 2016 and 2017 with malls such as K – Mall and Southfield in Nairobi Eastlands adding 220,000 SQFT, Next Gen Mall adding 490,000 SQFT of retail space in Mombasa Road and Unicity adding 115,000 SQFT on Thika Road. Consequently, yields declined by 0.4% points y/y as shown in the table below:

Source: Cytonn Research

Regional Performance

Similar to Nairobi, performance across all the key urban cities in Kenya we sampled softened with Nairobi and Mt. Kenya Region having the largest declines with occupancy rents declining by 9.0% and 10.0%, respectively. The yields in these zones declined by 0.4% and 1.0%, respectively. Mombasa recorded a slight increase in occupancy rates of 6.1% resulting in a 0.1% points increase in yields. Eldoret’s performance remained largely unchanged though it was still the worst performing node with average rental yields of 6.6% mainly due to low rental rates as shown below:

Source: Cytonn Research

Performance by Class Type

To analyze the performance of malls by Class we classified malls into three bands as below:

• Regional Centers/Destination Malls: They are largest malls, with a Gross Lettable Area (GLA) of 400,000 - 800,000 SQFT and characteristically have two or more anchor tenants eg, Two Rivers Mall, Next Gen Mall and Garden City
• Community Centers: These are the second largest mall types, occupying spaces of between 125,001 - 400,000 SQFT and characteristically have zero to two anchor tenants, eg, Galleria, Village Market and Westgate
• Neighborhood Centers: They have the minimum mall space, with a Gross Lettable Area (GLA) of 20,000 SQFT and characteristically having a maximum of one or even no anchor tenant eg Cross Roads Mall, Lavington Mall and K-Mall

On performance by class, destination malls had the highest yields with a market average of 10.3%, which was a 1.4% points decline from the 2016 average. This was mainly as a result of a 16.8% decline in occupancy levels brought about by increased supply following the opening of Two Rivers Mall in February 2017, which added 620,000 SQFT of retail space.

Source: Cytonn Research

Retail Opportunity in Kenya

To determine the investment opportunity for development of malls in Nairobi and the other key cities, we analyzed the regions based on rental yields, incomes using GDP per Capita and supply – current supply and incoming supply.

In Nairobi, all the nodes had sufficient retail space supply and returns had softened due to a decrease in occupancy levels and we thus came to the conclusion that the city has sufficient retail supply with opportunity being in other regions. We analyzed the investment opportunity in Key cities using the metrics above and Mombasa emerged the best investment opportunity mainly due to low supply both current and incoming and relatively higher GDP per capita.

Methodology Used:

• Rental yield – measures the expected return from development hence the higher the better. Carried 20% of the weight. Areas with a high yield of more than 9% were given a score of 3, a yield of 6.5-9% was given a 2 while less than 6.5% was given a 1
• Contribution to total mall space – Gives an indication of the current development potential of an area. The less supply the better. Carried 30% of the weight; a large market share indicates that the area has enough malls. Less than 10% market share shows potential, hence given a 3 with a market share of 10-20% getting a score of two, a market share of more than 20% gets 1 point
• GDP Per Capita -It shows the ability of the population to spend. The higher the better. Carried a 20% weight, hence, areas with a high GDP Per Capita, of more than USD 1,100 were given a 4, USD 801-1100 was given a 3, USD 501-800 a 2 and less than USD 500 a 1
• Contribution to upcoming supply - Gives an indication of the future development potential of an area. Carried 30% of the weight with a large deal pipeline of more than 10%, indicating that the area may have enough mall space in the next 3 years, lack of a deal pipeline was also an indication that investors are not willing to venture there hence also got a 1. Less than 6% was given a 3 as it indicates potential, while a region contributing between 6.1%-10.0% got a score of 2

Source: Cytonn Research

To understand the weighting metric used, and for a comprehensive analysis on the ranking and methodology behind it, see our  Cytonn Real Estate Retail Market Report

Retailer Sentiments

Additionally, we also carried out a survey among retail investors in a bid to seek their insights on the current retail sector scene in Kenya and where it is most likely headed, their perspectives were as follows:

From the table above, five out of the six sentiments are positive with one being neutral indicating that retailers have positive sentiment on the state of the retail market. We expect growth and stability in the sector driven by favorable demographics, proper implementation of the strategic initiatives and the abilities of the retail sector players being able to mitigate the challenges facing the retail sector.

Conclusion

The sector is likely to experience a shakeup with the leading retail outlet in Kenya, Nakumatt, exiting its flagship stores and thus leaving some malls as an anchor tenant. This is likely to be an opportunity for more foreign retailers to come into the country, thus changing the landscape of how the sector has been operating.