CHAPTER ONE
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.
2.3.1 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
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 Nairobi
stock exchange which are from nse.co.ke
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.
