Thursday, October 13, 2011

The Relationship Between Real Estate and Stock markets in Kenya


This chapter provides an overview of the background that would enable an in depth analysis of the study phenomena. It also highlights the research objectives that further interrogate the underlying assumptions with a view of addressing the gaps.
Reilly and Brown (2005) defined investment as the current commitment of dollars for a period of time in order to derive future payments that will compensate the investor for the time the funds are committed, the expected rate of inflation and the uncertainty of the future payments.
The ultimate decision facing an investor is the make-up of his or her portfolio which will compensate them at the end of investment period. This challenge can only be overcome by adopting a strategic asset allocation decision which is the process of deciding how to distribute an investor’s wealth among different asset classes. By investing in different asset classes which possess different attributes and return relationship will enable an investor to minimize risks and yield a higher return. To undertake such a move an investor needs to examine how the two markets functions, that are establishing their relationship based on the correlation of the assets. By widening the pool of potential assets, investors can potentially increase returns while even reducing risks through the selection of complementary assets with low correlations among one another Wade (2007).
The focus of this research is to examine the correlation between assets returns of the Kenyan real estate and stock market. A correlation coefficient is a termed used to define a relative measure of relationship between two variables. Real estate continues to provide asset characteristics that can enhance the risk/return performance of a diversified investment portfolio. In particular, real estate investments can serve to provide:
Ø  Relatively predictable cash flow;
Ø  A hedge against price instability;
Ø  A low correlation to other asset classes; and
Ø  Reduced volatility of returns.
An examination of these characteristics reveals how real   state is potentially even better positioned in today’s investment environment.
Although stocks are unpredictable over the short term, they can deliver superior returns over the long haul. Investing in stock alongside real estate assets can be beneficial to an investor in the following ways.
Ø  Liquidity Preference- the fact that investors are certain of the possibility of selling out what they hold as and when they want.
Ø  Availability of information-More information are readily available pertaining to stock market
Ø  Tax benefits-Stocks hedge an investor against taxes.

 Investments in the Kenyan market has been affected by different business cycles with ups and down in the performance of assets in different markets. The investors in the stock markets are faced with a plunge as the market is currently bearish. The real estate on the other hand is at vibrating reflecting a bubble in the real estate industry which might not be sustainable in the long run.
The majority of Kenyan households hold neither common stock nor other risky financial securities. Others invest in stocks almost exclusively or invest in real estate markets alone. The extent to which risky asset holdings are diversified also varies greatly to holdings concentrated in a few individual stocks. The idea of holding a portfolio rather than a single asset has been the focus of financial theory since its introduction by Markowitz in 1952.
The problem that this research seeks to address is the asset allocation decision making process based on the returns relations of the stock and real estate market. As this a challenges faced by both existing and potential investors in the Kenyan market. It also needs to clarify whether the performance of stock market is attributed to the real estate boom and the effect of consolidating the two assets in a mix portfolio.
The purpose of this study is to research on the relationship between the real estate market and the stock market. It seeks to achieve the following objectives;
Ø  To identify whether the average quarterly returns on Kenya’s Real estate and Stock market are correlated.
Ø  To analyze whether the Real estate market boom has an effect on the plunge of the Stock market in Kenya.
Ø  To examine whether diversifying in the two markets can hedge the investor against risks or price volatility.
Ø  Are the average quarterly returns on Kenya real estate and stock markets correlated?
Ø  Does the overheating Real estate market affect the Stock market performance?
Ø  What is the effect of allocating Real estate assets and the Stock assets in a portfolio mix?
The aim of this study is to examine the relationship between the real estate market and the stock market in Kenya and examine the correlation between them. The information gathered in this study will be of importance to investors, the government and its agencies, the scholars and the general public in understanding the two markets.
Investors will be able to make informed investment decisions and strategies their asset allocation mix on the two markets based on their correlation. This will enable them hedge against risks and maximize their returns.
Through examining the return relationship between these two markets, this paper will investigate the diversification effect between them, and hope to assist the potential investors who anticipate on optimizing their portfolio returns.
This study will also be a useful tool to regulators and policy makers in Kenya in designing policies which favors the performance of the two markets. Government agencies and other private regulation companies will able to use this information as a guide on how to improve the integration and financial deepening of the two markets.
The study will also help future researchers in widening the scope of the study and increasing their knowledge through discovery.
This section provides a review of the commercial real estate market and the stock market in Kenya and the previous studies which have been conducted on the relationship between the two markets. It aims at comparing and contrasting the different authors’ views on the relation between the two markets, relating this research study to conclusions drawn, highlighting any gaps and summarizing on the specific gap that this research study hopes to contribute to.
Real estate by definition represents capital investment in concrete and fixed assets. It includes land plus anything permanently fixed to it, including buildings and other items attached to the structure. Examples of real estate include undeveloped land, houses, townhomes, office buildings, retail store buildings and factories (Brown, 1990). 
A survey conducted by Hass Consultants in association with CFC Stanbic bank in the year 2010 revealed that the Kenyan real estate sector has been vibrant for the past decade between the years 2000 to 2010. The market’s resilience is in sharp contrast to international property markets; it has also survived the local and international recession unscathed. The report also revealed that capital gains from Kenyan properties far outstrip gains from US and UK properties. There has been also an increase in rental prices which are unlikely to return to the past levels in the short run. This has eventually made the Kenya real estate market to be the winner in the international property investment amidst the indebtedness in the Western countries (Mwithiga, 2010).
The property market in Kenya has grown rapidly and become an important source of economic growth. Over the last ten years between the years 2000 to 2010, those who invested in real estate earned higher returns compared to those who traded at the Nairobi Stock Exchange (NSE), meaning that for profitable long-term investments, the property sector holds key (Jivanjee,2010). The Kenyan banks have realized this lucrative sector and are offering mortgage products to attract Kenyans. Many middle class Kenyans now prefer to purchase their own homes rather than be tenants (Mwithiga, 2010).
 Figure 1: The real estate movement trend in Kenya from the year 2000-2010;
*Source: The quarterly publication of The Hass Property Index (2011).
Yang and Ye (2010) defines a stock market, also known as an equity market, as a place where shares are issued and investors can buy and sell stocks and other securities. The markets can be either a physical place such as exchanges or over-the-counter markets that take place over computers and telephone lines. It is one of the most popular and prestigious financial markets because not only it is the most important sources for companies to raise capital, but also it provides investors an opportunity to receive dividends and benefit from capital gains.
The stock market is part of the broader market referred to as the financial market (Reilly, 1997). The growth of related financial services sector such as unit trusts investments clubs, pension and provident fund schemes have extensively contributed towards the deepening of the stock market. It should be appreciated that in as much as an economy can have savings, there is usually lack of established mechanisms for channeling those savings into activities that create wealth. Therefore encouraging a culture of saving in less developed financial markets may first track economic growth (Kithinj and Ngugi 2008).
Stock markets provide investors with an efficient mechanism to liquidate their long-term investments. The very fact that investors are certain of the possibility of selling out what they hold as and when they want, is a major incentive for investment as it guarantees mobility of capital in the purchase of assets. Andritzky (2007) and Filer, Hanousek and Campos (2000) also argue that stock markets are very important in contributing  to the  financial  liberalization through providing a means of diversifying risk for capital raisers and investors. The interactions of buyers and sellers in a stock market determine the price of traded assets, this feature of the stock market that signals on how funds in the economy should be allocated among financial assets (Fabozzi, 1995).
The prices of stocks around the world do not move together in an exact manner. This is because the economic systems in which stock markets are located have dissimilar environments in terms of taxation, industrial growth, political stability and monetary policies among other factors. Stock markets may experience a general increase in price level referred to as a bull market or general decrease in price level referred to as bear market. Stagnant prices or sudden big price movements downward is referred to as a stock market crash.
Kenya’s capital market has been described as narrow and shallow. The stock market and private bond market has been rising at less than 1% of growth financing. There have been significant focus on the capital market with for example the institutional development of the stock market and the introduction of the new instruments (Ngugi, Amanja and Isaya 2009).
The Kenya stock market has encountered a significant decline as Nyaga, partners limited and Francis Thuo stock brokerages firms are at the edge of bankruptcy, causing concerns in investors’ confidence in the stock market.
2.3 Market indicators for the real estate and stock markets

2.3.1 Stock Turnover

By definition stock turnover is the number of shares, bonds or contracts traded during a given period, for a security or an entire exchange. The volume of shares traded is the total number of shares traded on the Stock Exchange on a particular day, which together with the total value of all shares traded, (that is turnover) gives a measure of the amount of business activity on the Stock Exchange (Odera,2005).  Lo and Jiang (2000) argue that apart from only utilizing stock price and indexes as the only fundamental building block of any theory of market integrations, investors need also to take into consideration of stock turnover as a parameter in gauging the performance of the stock market.

2.3.2 Property price Index

Armonat and Pfnuer (2004) stated that the common sources of market information on real estate performance are real estate indices. An index is a statistical measure of changes in a representative group of individual data points. This paper will use the property index as the basis for measuring real estate returns. The property index will use aggregated prices on a quarterly basis rather than the market value at a particular point in time. Gelner (1993) concluded that such temporal aggregation contributes to both a lower return volatility and a lower beta with the stock market.
Rosen (2007) in his work on valuation of US commercial real estate stated that the prevalent method for valuing real estate, based on the work of Rosen (1974) and Rosen and Topel (1988), is to construct a hedonic price index of a property with given characteristics . Wheaton, Baranski and Templeton (2009) in their study of 100 years of commercial real estate prices in Manhattan utilize property index in determining the returns of the real estate assets.

2.3.3 Stock market index

Odera (2005) defined stock market indices as an aggregate measure that provides information to investors on the market performance by characterizing the development of global markets and specified market segments. Odera (2005) further stated that Index numbers are applied in the measurement of movements at the stock market. An Index number effectively summarizes hundreds of price movements. There are both price and volume index. Influential global financial indices such as the Global DOW and the National Association of Securities Dealers Automated Quotations System, (NASDAQ) Composite track the performance of selected large and powerful companies in order to evaluate and predict economic trends.
Among the main measures of stock market performance include; stock market indexing, market capitalization and stock turnover. Stock market indexing is one of the most widely used measures of stock performance. Investors hold portfolios of many assets but it is cumbersome to follow progress on each security in the portfolio. Thus it is prudent to observe the entire market under the notion that their portfolio moved in the same direction as the aggregate market. The market index such as the NSE index is used to observe total returns for an aggregate market and these computed returns are to judge performance of individual portfolios. The stock composite index is found to be significant in explaining housing price movements, which are also affected by inflation rate and hot money inflows (zhang,).Quan and Titman (1999) argue that a number of earlier researchers have utilized stock price indices in determining the return of the stock market assets.

2.3.4 Rental income

Real estate asset price theory starts with the rent “fundamental” determined in Ricardian monocentric models (e.g., Muth 1969). This model deals mostly with the determination of equilibrium rent (or property income) across urban locations.
Property investment analysis involves the analysis of expected monetary benefits that are associated with the acquisition and development/ownership of a property in order to assess investment profitability and feasibility.
Correlation is the word given to the extent to which assets move together; this is measured with statistical formulae. Correlations can range from -1 (perfectly negatively correlated) through to +1 perfectly positively correlated (Pearson, 1896).
If asset B tends to move in the opposite direction to asset A then these two assets are said to have “negative correlation”, and they can be highly effective at canceling out each other’s volatility.  If the assets both trend upwards over the longer term a combination of them will have a return equal to the average of the two assets’ returns but with substantially reduced risk. The most diversified portfolio consists of securities with the greatest negative correlation (Markowitz, 1952).
The correlation coefficient between two financial assets plays a major role in determining the effectiveness of diversifying a portfolio. A portfolio is the total collection of all investments held by an individual or institution, including stocks, bonds, real estate, options, futures, and alternative investments, such as gold or limited partnerships. Most portfolios are diversified to protect against the risk of single securities or class of securities (Markowitz, 1952). Hence, portfolio analysis consists of analyzing the portfolio as a whole rather than relying exclusively on security analysis (Markowitz, 1952). Portfolio theory tells us that if you manage to combine assets whose returns show low correlation with each other, you may be able to minimize risk while maximizing returns. This means that it is possible to be a “prudent investor” even if one’s portfolio includes riskier assets, as long as those riskier yet higher yielding investments are balanced with others in a well-diversified portfolio. Theoretically, “buy and hold investors” may minimize those down days if they invest in assets whose returns have low (or possibly negative) correlation with each other (Suna, 2007).
Peng (2001) concluded that diversification is most effective when the correlation between the assets is –1 and it is least effective when the correlation is +1. As a result, investors who want to reduce the risk of their portfolio as much as possible need to look for pairs of assets that have a correlation close to –1.Ibbotson and Siegel (1984) using U.S. annual data from 1947 to 1982 found real estate’s correlation with SP stock (Standard and Poor’s) to be -0.6.They concluded that real estate offers diversification benefits to institutional investors because of its low correlation with commonly used stock price index.
Much of the earlier work conducted by many scholars covered extensive investigation on the relationship between the real estate market and the stock market. Their investigation on the relationship between the stock and real estate market yielded a variety of results. Some scholars evident a positive relationship between the two assets market while others argue that the two markets are segmented.
Bai (2008) argued that the real estate and stock market of China are highly correlated and the volatilities of real estate market had a spillover effect on the stock market. Chen (2001) utilized a seasonal data from Taiwan to analyse the relationship between stock price and real estate price and found a positive relationship with an increase in stock prices affecting the real estate market. Hui and Yue (2006) point out that there is a strong positive correlation between the Shanghai and the Hong Kong housing price and the Shanghai equity market composite index and the Hong Sheng Index. Okunev (2002) found a positive correlation between Australia’s real estate market and stock market. Zhao (2007) investigated the volatility relationship between the price of national real estate market and stock market in for a period of seven years and found a significant correlation between them.
On the other hand Sheng, Li and Liu (2005) had conducted a correlation analysis in China with the Shanghai real estate price index and Shanghai Stock Exchange index (SSE index) and confirmed a week link between them. Liow (1998) observed that the commercial real estate and property stock market moved apart in Singapore. Okunev and Wilson (1997) used a co-integration and linear regression analysis in the US to test whether or not there existed a relationship between the  real estate investment trusts indices (REIT ) and the Standard and Poor’s composite price index(S&P500), and got a non-linear and insignificant result.

2.7.1 Equity market

Kenya has a slow tremendous change in the secondary market for equity. Its equity market is not comparable with the world’s most advanced secondary markets within a year or two. The key ingredients that underlie market quality in advanced equity market are: exchanges based on open electronic limit order book, nationwide integrated market with a large number of informed traders and fluency of short or long positions and presence of no counterparty risk and more securities options. All this lacks in the Kenya Equity market making it shallow and narrow as compared to that of developed markets (Ngugi et al, 2009).
The Kenyan equity markets’ capitalization, turnover and the number of listed companies are low compared to big emerging markets such as South Africa and the developed markets such as the US and China. The automatisation of trading systems, regional integration and increased primary market activity are expected to boost size and liquidity in the future.
The table below shows how distinctly the Kenya Equity market is shallow and narrow as compared to those of developed markets.
 Figure 2: Equity markets Indicators for the year ended 2010
Stock exchange
Market Capitalization(USD)
Traded Volume(USD)
Equity Turnover(USD)      

United States of America.
New York
15970 Billions
19813 Billions
United Kingdom
3613 Billions
2741 Billions
2717 Billions
4496 Billions
*Source: World Federation of Exchanges (WFE) Monthly Statistics. Except for Nairobi stock exchange which are from

2.7.2 Real Estate market

Compared with U.S. and other developed markets, Kenya's real estate industry is less experienced and immature. The Kenya real estate market lacks the following forms of Real estate investments.
Ø  Aggregation vehicles-Aggregate investors and serve the purpose of giving investors collective access to real estate investments. Which comprises;
       a) Real Estate Limited Partnerships (RELPs)
       b) Real Estate Investment Trusts (REITs)
Undertaking investments through REITS provides investors with an opportunity to take part in large-scale commercial real estate projects without having to invest large amounts of money in illiquid investments.
The most common way in which investors in Kenya held real estate assets is majorly through mortgage financing.
Ø  Free and clear equity-refers to full ownership rights for an indefinite period of time, giving the owner the right e.g. to lease the property to tenants and resell the property at will.
Ø  Leveraged equity-Refers to the ownership rights but subject to debt (promissory note) and a pledge (mortgage) to hand over the real estate ownership rights if the loan terms are not met.
Wangechi (2010) stated that housing finance companies in Kenya finds the local real estate market conducive enough to flourish hence the rising demand for home loans and mortgage loans.
The Kenya markets lacks a national property index until the year 2009 when it was announced that it would be unveiled probably this year,2011.Aron(2009) stated that Kenya's first property index is nearly complete, the Kenya Real Estate Index (KREX) , will be used to determine the level of transactions in the real estate sector. The lack of standard property index in the country has made it difficult for the investors to benchmark the performance of the real estate market.

Although extensive research has been conducted on the relationship between real estate and stocks markets in developed markets such as the United States, United Kingdom and China, little is known about the Kenyan market which is still immature and less experienced.  The studies have revolved primarily around stock market price indexes and rental income for the real estate market.  Explaining the relationship between the two markets by reference to the stock price index and rental income may not be conclusive as there are other parameters that need to be transposed into the analysis for example; by use of stock turnover and the property index which has experienced little focus. Also by conducting the study in an emerging market the research aims to provide information to interest the investors who wish to explore the two markets.

CHAPTER THREE                     

This chapter outlines how the research study will be conducted. It includes the research design adopted, the target population, sampling methods and techniques, data collection and analysis.
The research design is the conceptual structure within which research is conducted. It consists of the blueprint for the collection, measurement and analysis of data. As such the design includes an outline of the framework of study, availability of various data, and observations. It means the exact nature of the research work in a systematic manner (Kothari, 2004).
This research study will use descriptive research design. This design uses description as a tool to organize data into patterns that emerge during analysis.
The target population of the study includes Kenya private property developers within Nairobi and the Nairobi Stock exchange equity turnover.
The study will use Secondary data collection methods using observation guide for quarterly property index from property developers and the equity turnover from Nairobi Stock Exchange. It will sample quarterly reports for both markets for a period of six years (2005-2011).

According to Baily (2006), data analysis procedure includes the process of packaging the collected information, putting it in order and structuring its main components in a way that the findings can be easily and effectively communicated.
The study will utilize quantitative techniques; simple regression analysis as a statistical tool for investigating the relationship between the two variables (Real estate market and the stock market).The data will be edited for any errors before they are entered into a computer based program, analyzing the components of correlation and regression will be done using software known as Mint lab. The analyzed data will be presented in a variety of ways for example by use of graphs, charts, tables, pie charts, histograms and percentages.