The Relationship Between Real Estate and Stock markets in Kenya

2011-10-13T04:43:00.000-07:00

CHAPTER ONE

This chapter provides anoverview of the background that would enable an in depth analysis of the studyphenomena. It also highlights the research objectives that further interrogatethe underlying assumptions with a view of addressing the gaps.

1.2 Background Information

Reilly and Brown (2005) defined investment as the current commitment ofdollars for a period of time in order to derive future payments that willcompensate the investor for the time the funds are committed, the expected rateof inflation and the uncertainty of the future payments.

The ultimate decision facing an investor is the make-up of his or herportfolio which will compensate them at the end of investment period. Thischallenge can only be overcome by adopting a strategic asset allocationdecision which is the process of deciding how to distribute an investor’swealth among different asset classes. By investing in different asset classeswhich possess different attributes and return relationship will enable aninvestor to minimize risks and yield a higher return. To undertake such a movean investor needs to examine how the two markets functions, that areestablishing their relationship based on the correlation of the assets. Bywidening the pool of potential assets, investors can potentially increasereturns while even reducing risks through the selection of complementary assetswith low correlations among one another Wade (2007).

The focus of this research is to examine the correlation between assetsreturns of the Kenyan real estate and stock market. A correlation coefficientis a termed used to define a relative measure of relationship between twovariables. Real estate continues to provide assetcharacteristics that can enhance the risk/return performance of a diversifiedinvestment portfolio. In particular, real estate investments can serve toprovide:

Ø Relatively predictable cashflow;

Ø A hedge against priceinstability;

Ø A low correlation to otherasset classes; and

Ø Reduced volatility ofreturns.

An examination of thesecharacteristics reveals how real stateis potentially even better positioned in today’s investment environment.

Although stocks are unpredictable over the short term, they can deliversuperior returns over the long haul. Investing in stock alongside real estateassets can be beneficial to an investor in the following ways.

Ø Liquidity Preference- the factthat investors are certain of the possibility of selling out what they hold asand when they want.

Ø Availability ofinformation-More information are readily available pertaining to stock market

Ø Tax benefits-Stocks hedgean investor against taxes.

1.3 Statement of the problem

Investments in the Kenyan markethas been affected by different business cycles with ups and down in the performanceof assets in different markets. The investors in the stock markets are facedwith a plunge as the market is currently bearish. The real estate on the otherhand is at vibrating reflecting a bubble in the real estate industry whichmight not be sustainable in the long run.

The majority ofKenyan households hold neither common stock nor other risky financialsecurities. Others invest in stocks almost exclusively or invest in real estatemarkets alone. The extent to which risky asset holdings are diversified alsovaries greatly to holdings concentrated in a few individual stocks. The idea ofholding a portfolio rather than a single asset has been the focus offinancial theory since its introduction by Markowitz in 1952.

The problem that this research seeks to address is the asset allocationdecision making process based on the returns relations of the stock and realestate market. As this a challenges faced by both existing and potentialinvestors in the Kenyan market. It also needs to clarify whether theperformance of stock market is attributed to the real estate boom and theeffect of consolidating the two assets in a mix portfolio.

1.4 Research Objectives

The purpose of this studyis to research on the relationship between the real estate market and the stockmarket. It seeks to achieve the following objectives;

Ø To identify whether theaverage quarterly returns on Kenya’sReal estate and Stock market are correlated.

Ø To analyze whether the Realestate market boom has an effect on the plunge of the Stock market in Kenya.

Ø To examine whetherdiversifying in the two markets can hedge the investor against risks or pricevolatility.

1.5 Research Questions

Ø Are the average quarterly returns on Kenyareal estate and stock markets correlated?

Ø Does the overheating Realestate market affect the Stock market performance?

Ø What is the effect ofallocating Real estate assets and the Stock assets in a portfolio mix?

1.6 Justification of the study

The aim of this study is to examine the relationship between the realestate market and the stock market in Kenya and examine the correlationbetween them. The information gathered in this study will be of importance toinvestors, the government and its agencies, the scholars and the general publicin understanding the two markets.

Investors will be able to make informed investment decisions andstrategies their asset allocation mix on the two markets based on theircorrelation. This will enable them hedge against risks and maximize theirreturns.

Through examining the return relationship between these two markets,this paper will investigate the diversification effect between them, and hopeto assist the potential investors who anticipate on optimizing their portfolioreturns.

This study will also be a useful tool to regulators and policy makers inKenyain designing policies which favors the performance of the two markets.Government agencies and other private regulation companies will able to usethis information as a guide on how to improve the integration and financialdeepening of the two markets.

The study will also help future researchers in widening the scope of thestudy and increasing their knowledge through discovery.

CHAPTER TWO

2.0 Introduction

This section provides a review ofthe commercial real estate market and the stock market in Kenya and the previous studieswhich have been conducted on the relationship between the two markets. It aimsat comparing and contrasting the different authors’ views on the relationbetween the two markets, relating this research study to conclusions drawn,highlighting any gaps and summarizing on the specific gap that this researchstudy hopes to contribute to.

2.1 The Real Estate market

Real estateby definition represents capital investment in concrete and fixed assets. Itincludes land plus anything permanently fixed to it, including buildings andother items attached to the structure. Examples of real estate includeundeveloped land, houses, townhomes, office buildings, retail storebuildings and factories (Brown, 1990).

A survey conducted by Hass Consultants in association with CFC Stanbicbank in the year 2010 revealed that the Kenyan real estate sector has beenvibrant for the past decade between the years 2000 to 2010. Themarket’s resilience is in sharp contrast to international property markets; ithas also survived the local and international recession unscathed. The reportalso revealed that capital gains from Kenyan properties far outstrip gains fromUS and UKproperties. There has been also an increase in rental prices which are unlikelyto return to the past levels in the short run. This has eventually made the Kenyareal estate market to be the winner in theinternational property investment amidst the indebtedness in the Westerncountries (Mwithiga, 2010).

The property market in Kenyahas grown rapidly and become an important source of economic growth. Over thelast ten years between the years 2000 to 2010, those who invested in realestate earned higher returns compared to those who traded at the Nairobi StockExchange (NSE), meaning that for profitable long-term investments, the propertysector holds key (Jivanjee,2010). TheKenyan banks have realized this lucrative sector and are offering mortgageproducts to attract Kenyans. Many middle class Kenyans now prefer to purchasetheir own homes rather than be tenants (Mwithiga, 2010).

Figure 1: The real estate movement trend in Kenya from theyear 2000-2010;

*Source: The quarterly publication of The Hass Property Index (2011).

2.2 The Stock Market

Yang and Ye (2010) defines a stock market, also known as an equitymarket, as a place where shares are issued and investors can buy and sellstocks and other securities. The markets can be either a physical place such asexchanges or over-the-counter markets that take place over computers andtelephone lines. It is one of the most popular and prestigious financialmarkets because not only it is the most important sources for companies toraise capital, but also it provides investors an opportunity to receivedividends and benefit from capital gains.

The stock market is partof the broader market referred to as the financial market (Reilly, 1997). Thegrowth of related financial services sector such as unit trusts investmentsclubs, pension and provident fund schemes have extensively contributed towardsthe deepening of the stock market. It should be appreciated that in as much asan economy can have savings, there is usually lack of established mechanismsfor channeling those savings into activities that create wealth. Thereforeencouraging a culture of saving in less developed financial markets may firsttrack economic growth (Kithinj and Ngugi 2008).

Stockmarkets provide investors with an efficient mechanism to liquidate their long-term investments. The very fact that investors arecertain 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 thepurchase of assets. Andritzky (2007) and Filer, Hanousek and Campos (2000) alsoargue that stock markets are very important in contributing to the financial liberalization throughproviding a means of diversifying risk for capital raisers and investors. Theinteractions of buyers and sellers in a stock market determine the price oftraded assets, this feature of the stock market that signals on how funds inthe economy should be allocated among financial assets (Fabozzi, 1995).

The prices of stocks around theworld do not move together in an exact manner. This is because the economicsystems in which stock markets are located have dissimilar environments interms of taxation, industrial growth, political stability and monetary policiesamong other factors. Stock markets may experience a general increase in pricelevel referred to as a bull market or general decrease in price level referredto as bear market. Stagnant prices or sudden big price movements downward isreferred to as a stock market crash.

Kenya’s capitalmarket has been described as narrow and shallow. The stock market and private bondmarket has been rising at less than 1% of growth financing. There have beensignificant focus on the capital market with for example the institutionaldevelopment of the stock market and the introduction of the new instruments(Ngugi, Amanja and Isaya 2009).

The Kenya stock market has encountereda significant decline as Nyaga, partners limited and Francis Thuo stockbrokerages 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 orcontractstraded during a given period,for a securityor an entire exchange.The volume of shares traded is the total number of shares traded on the StockExchange on a particular day, which together with the total value of all sharestraded, (that is turnover) gives a measure of the amount of business activityon the Stock Exchange (Odera,2005). Lo and Jiang (2000) argue that apart from onlyutilizing stock price and indexes as the only fundamental building block of anytheory of market integrations, investors need also to take into considerationof stock turnover as a parameter in gauging the performance of the stockmarket.

2.3.2 Property price Index

Armonat and Pfnuer (2004) stated that the common sources of marketinformation on real estate performance are real estate indices. An index is astatistical measure of changes in a representative group of individual datapoints. This paper will use the property index as thebasis for measuring real estate returns. The property index will use aggregatedprices on a quarterly basis rather than the market value at a particular pointin time. Gelner (1993) concluded that such temporal aggregation contributes toboth a lower return volatility and a lower beta with the stock market.

Rosen (2007) in his work onvaluation of US commercial real estate stated that the prevalent method forvaluing 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 givencharacteristics . Wheaton, Baranski andTempleton (2009) in their study of 100 years of commercial real estate pricesin Manhattanutilize property index in determining the returns of the real estate assets.

2.3.3 Stock market index

Odera (2005) defined stock marketindices as an aggregate measure that provides information to investors on themarket performance by characterizing the development of global markets andspecified market segments. Odera (2005) further statedthat Indexnumbers are applied in the measurement of movements at the stock market. AnIndex number effectively summarizes hundreds of price movements. There are bothprice and volume index. Influential globalfinancial indices such as the Global DOW and the National Association ofSecurities Dealers Automated Quotations System, (NASDAQ) Composite track theperformance of selected large and powerful companies in order to evaluate andpredict economic trends.

Among the main measures of stockmarket performance include; stock market indexing, market capitalization andstock turnover. Stock market indexing is one of the most widely used measuresof stock performance. Investors hold portfolios of many assets but it iscumbersome to follow progress on each security in the portfolio. Thus it isprudent to observe the entire market under the notion that their portfoliomoved in the same direction as the aggregate market. The market index such asthe NSE index is used to observe total returns for an aggregate market andthese computed returns are to judge performance of individual portfolios. Thestock composite index is found to be significant in explaining housing pricemovements, which are also affected by inflation rate and hot money inflows(zhang,).Quan and Titman (1999) argue that a number of earlier researchers haveutilized stock price indices in determining the return of the stock marketassets.

2.3.4 Rental income

Real estate asset price theorystarts 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 analysisof expected monetary benefits that are associated with the acquisition anddevelopment/ownership of a property in order to assess investment profitabilityand feasibility.

2.4 Markets Correlation

Correlation is the word given to the extent to which assets movetogether; this is measured with statistical formulae. Correlations can rangefrom -1 (perfectly negatively correlated) through to +1 perfectly positivelycorrelated (Pearson, 1896).

If asset B tends to move in the opposite direction to asset A then thesetwo assets are said to have “negative correlation”, and they can be highlyeffective at canceling out each other’s volatility. If the assets both trend upwards over thelonger term a combination of them will have a return equal to the average ofthe two assets’ returns but with substantially reduced risk. The mostdiversified portfolio consists of securities with the greatest negativecorrelation (Markowitz, 1952).

2.5 Portfolio Analysis

The correlation coefficient betweentwo financial assets plays a major role in determining the effectiveness ofdiversifying a portfolio. A portfolio is the totalcollection of all investments held by an individual or institution, includingstocks, bonds, real estate, options, futures, and alternative investments, suchas gold or limited partnerships. Most portfolios are diversified to protectagainst the risk of single securities or class of securities (Markowitz, 1952). Hence, portfolio analysis consists ofanalyzing the portfolio as a whole rather than relying exclusively on security analysis (Markowitz, 1952).Portfoliotheory tells us that if you manage to combine assets whose returns show lowcorrelation 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’sportfolio includes riskier assets, as long as those riskier yet higher yieldinginvestments are balanced with others in a well-diversified portfolio.Theoretically, “buy and hold investors” may minimize those down days if theyinvest in assets whose returns have low (or possibly negative) correlation witheach other (Suna, 2007).

Peng (2001) concluded thatdiversification is most effective when the correlation between the assets is –1and it is least effective when the correlation is +1. As a result, investorswho want to reduce the risk of their portfolio as much as possible need to lookfor 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 correlationwith SP stock (Standard and Poor’s) to be -0.6.They concluded that real estateoffers diversification benefits to institutional investors because of its lowcorrelation with commonly used stock price index.

2.6 Review of the Relationship between the two markets

Much of the earlier work conducted by many scholars covered extensive investigation on the relationshipbetween the real estate market and the stock market. Their investigation on therelationship between the stock and real estate market yielded a variety ofresults. Some scholars evident a positive relationship between the two assetsmarket while others argue that the two markets are segmented.

Bai (2008) argued that the real estate and stock market of Chinaare highly correlated and the volatilities of real estate market had aspillover effect on the stock market. Chen (2001) utilized a seasonal data fromTaiwanto analyse the relationship between stock price and real estate price and founda positive relationship with an increase in stock prices affecting the realestate market. Hui and Yue (2006) point out that there is a strong positivecorrelation between the Shanghai and the HongKong housing price and the Shanghaiequity market composite index and the Hong Sheng Index. Okunev (2002) found apositive correlation between Australia’sreal estate market and stock market. Zhao (2007) investigated the volatilityrelationship between the price of national real estate market and stock marketin for a period of seven years and found a significant correlation betweenthem.

On the other hand Sheng, Li and Liu (2005) had conducted a correlationanalysis in China with the Shanghai real estate priceindex and Shanghai Stock Exchange index (SSE index) and confirmed a week linkbetween them. Liow (1998) observed that the commercial real estate and propertystock market moved apart in Singapore.Okunev and Wilson (1997) used a co-integration and linear regression analysisin 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 anon-linear and insignificant result.

2.7 Market Developments

2.7.1 Equitymarket

Kenya has a slow tremendouschange in the secondary market for equity. Its equity market is not comparablewith the world’s most advanced secondary markets within a year or two. The keyingredients that underlie market quality in advanced equity market are: exchangesbased on open electronic limit order book, nationwide integrated market with alarge number of informed traders and fluency of short or long positions andpresence of no counterparty risk and more securities options. All this lacks inthe Kenya Equity market making it shallow and narrow as compared to that ofdeveloped markets (Ngugi et al, 2009).

The Kenyan equity markets’ capitalization, turnoverand the number of listed companies are low compared to big emerging marketssuch as South Africa and the developed markets such as the US and China. Theautomatisation of trading systems, regional integration and increased primary marketactivity are expected to boost size and liquidity in the future.

The table below shows how distinctly the Kenya Equitymarket is shallow and narrow as compared to those of developed markets.

Figure 2: Equity marketsIndicators for the year ended 2010

Country	Stock exchange	Market Capitalization(USD)	Traded Volume(USD)	Equity Turnover(USD)
United States of America.	New York	15970 Billions	19813 Billions	180.652Billions
United Kingdom	London	3613 Billions	2741 Billions	56.639Billions
China	Shanghai	2717 Billions	4496 Billions	76.051Billions
Kenya	Nairobi	0.013533Billions	0.083001Billion	0.001445Billions

*Source: World Federation of Exchanges (WFE) Monthly Statistics.Except for Nairobistock exchange which are from nse.co.ke

2.7.2 RealEstate market

Comparedwith U.S. and otherdeveloped markets, Kenya'sreal estate industry is less experienced and immature. The Kenya realestate market lacks the following forms of Real estate investments.

Ø Aggregation vehicles-Aggregateinvestors and serve the purpose of giving investors collective access to realestate investments. Which comprises;

a) RealEstate Limited Partnerships (RELPs)

b) Real Estate Investment Trusts (REITs)

Undertakinginvestments through REITS provides investors with an opportunityto take part in large-scale commercial real estate projects without having toinvest large amounts of money in illiquid investments.

Themost common way in which investors in Kenya held real estate assets ismajorly through mortgage financing.

Ø Free and clear equity-refers to full ownershiprights for an indefinite period of time, giving the owner the right e.g. to leasethe property to tenants and resellthe 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 estateownership rights if the loan terms are not met.

Wangechi(2010) stated that housing finance companies in Kenya finds the local real estatemarket conducive enough to flourish hence the rising demand for home loans andmortgage loans.

The Kenya markets lacks a national property indexuntil the year 2009 when it was announced that it would be unveiled probablythis year,2011.Aron(2009) stated that Kenya'sfirst 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 forthe investors to benchmark the performance of the real estate market.

2.8 Conclusion

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

CHAPTER THREE

3.1 Introduction

This chapter outlines how the research study will be conducted. Itincludes the research design adopted, the target population, sampling methodsand techniques, data collection and analysis.

3.2 Research Design

The research design is the conceptual structure within which research isconducted. It consists of the blueprint for the collection, measurement andanalysis of data. As such the design includes an outline of the framework ofstudy, availability of various data, and observations. It means the exactnature of the research work in a systematic manner (Kothari, 2004).

This research study will use descriptive research design. This designuses description as a tool to organize data into patterns that emerge duringanalysis.

3.3 Target Population

The target population of the study includes Kenya private propertydevelopers within Nairobi and the Nairobi Stock exchange equity turnover.

3.4 Data Collection

The study will use Secondary data collection methods using observationguide for quarterly property index from property developers and the equity turnoverfrom Nairobi Stock Exchange. It will sample quarterly reports for both marketsfor a period of six years (2005-2011).

3.5 Data Analysis

According to Baily (2006), data analysis procedure includes the processof packaging the collected information, putting it in order and structuring itsmain components in a way that the findings can be easily and effectivelycommunicated.

The study will utilize quantitative techniques; simple regressionanalysis as a statistical tool for investigating the relationship between thetwo variables (Real estate market and the stock market).The data will be editedfor any errors before they are entered into a computer based program, analyzingthe components of correlation and regression will be done using software knownas Mint lab. The analyzed data will be presented in a variety of ways forexample by use of graphs, charts, tables, pie charts, histograms andpercentages.

DOWNLOAD PDF VERSION

The Research Corner

The Relationship Between Real Estate and Stock markets in Kenya