FNCE 424: REAL ESTATE FINANCE AND INVESTMENT

INTRODUCTION:
The Nature Real estate
Real estate:
RE is property. Property refers to anything that can be owned or possessed. Property can be
(1) a tangible asset, e.g., a building, or (2) an intangible asset, e.g., a lease agreement.

We use the term “real estate” in 3 ways: (1) we use it to refer to tangible assets, e.g., lands
and buildings, (2) we use it to denote the bundle of rights that give the owner of the rights to
use tangible assets, and (3) we use it to refer to the real estate industry or business activities.

RE as tangible assets
RE can be defined as the land and its permanent improvements. Land may include (a) the
surface of the earth, (b) rights to air space above the land up to a certain height, (c) rights to
the subsurface down to the center of the earth and to the minerals contained therein, and (d)
the improvements to the land, e.g., walkways and water drainage systems. The improvements
on the land, e.g., buildings, fences, and decks, are also parts of real estate.

RE as a bundle of rights
The bundle of rights is the services (benefits) that RE provides its users. For example, RE
provides owners with the rights to shelter, security, privacy, doing business, etc.

RE as an industry: career
The industry has a variety of professions: (1) brokerage, (2) leasing and property
management, (3) appraisal, (4) consulting and advising, (5) property development, (6)
construction, (7) financing, mortgage, and securitization, (8) investment, and (9)
governmental planning, taxation, and regulation.

Real Estate Finance Terminology

Real –The word real comes from the word realty which for centuries has been used to mean
land and all things that are permanently attached (immovable structures like Buildings and
other structures)
Personality-Include all movable things like automobiles, stocks of shares and bank accounts
Estate- Means all that a person owns including realty and personality. It is term that denotes
possessory or potentially possessory interest to occupy and use ( sell, use lease or even
exclude others from using) the property during the period in possession.
Real Estate-is a term used to refer to the Physical land and improvements constructed on it
including pavements, fencing and lighting plus others. All things attached to land are
included in the definition of the term. The ownership rights associated with the real estate is
referred to as the real property.
Property Rights-Is an expression that refers to the rights of a person to possession, use,
enjoyment and disposal of his or her property. The holder of the interest in real estate enjoys
some rights or degree of control or use , and to the extent that value can be ascertained,
interest may be sold, bought ,or use it as a collateral for a loan. One need not be the owner of

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a particular parcel of real estate to have rights to some of its benefits. A Lesse ‘Person who
leases’ land may have a right of possession and exclusive use of property for the period of the
lease. For this rights the lessee pays rentals for the term of the lease. Similarly, lender, or
mortgagee, has rights to repossess or bring about the sale of property if the
borrower(Mortgagor) defaults on the mortgage loan.The lender is said to possess a secured
interest on the property.

Real Estate Markets

Real estate markets participants are:
 Owner/User - These people are both owners as well as tenants. They purchase
houses or commercial property as an investment and also to live in or utilize as a
business
 Owner - These people are pure investors. They do not consume the real estate
that they purchase. Typically they rent out or lease the property to someone else.
 Renter - These people are pure consumers.
 Developers - These people prepare raw land for building which results in new
product for the market.
 Renovators - These people supply refurbished buildings to the market.
 Facilitators - This includes banks, Real Estate Brokers lawyers, and others that
facilitate the purchase and sale of real estate.

The owner/user, owner, and renter comprise the demand side of the market, while the
developers and renovators comprise the supply side. In order to apply simple supply and
demand analysis to real estate markets a number of modifications need to be made to
standard microeconomic assumptions and procedures. In particular, the unique
characteristics of the real estate market must be accommodated.

Characteristics of Real Estate market include:

a) Durability - Real estate is durable.
A building can last for decades or even centuries, and the land underneath it is practically
indestructible. Because of this, real estate markets are modeled as a stock/flow market.
About 98% of supply consists of the stock of existing houses, while about 2% consists of
the flow of new development. The stock of real estate supply in any period is determined by
the existing stock in the previous period, the rate of deterioration of the existing stock, the
rate of renovation of the existing stock, and the flow of new development in the current

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period. The effect of real estate market adjustments tend to be mitigated by the relatively
large stock of existing buildings.
b) Heterogeneous
Every piece of real estate is unique, in terms of its location, the building, and it’s
financing. This makes pricing difficult, increases search costs, creates information
asymmetry and greatly restricts substitutability. To get around this problem, economists
define supply in terms of service units, i.e. any physical unit can be deconstructed into the
services that it provides. Housing stock depreciates making it qualitatively different from a
new building. The market equilibrating process operates across multiple quality levels.
Further, the real estate market is typically divided into residential, commercial, and
industrial segments. It can be further divided into subcategories like recreational, income
generating, area, historical/protected, etc.
c) High Transaction costs
Buying and/or moving into a home costs much more than most types of transactions.
These costs include search costs, real estate fees, moving costs, legal fees, land transfer
taxes, and deed registration fees. Transaction costs for the seller typically range between
1.5 - 6% of the purchase price. But these costs vary from country to country.
d) Long time delays
The market adjustment process is subject to time delays due to the length of time it takes
to finance, design, and construct new supply, and also due to the relatively slow rate of
change of demand. Because of these lags there is a great potential for disequilibrium in the
short run. Adjustment mechanisms tend to be slow, relative to more fluid markets.
e) Both an investment good and consumption good
Real estate can be purchased with the expectation of attaining a return (an investment
good), or with the intention of using it (a consumption good), or both. These functions can
be separated (with market participants concentrating on one or the other function) or can
be combined (in the case of the person that lives in a house that they own). This dual
nature of the good means that it is not uncommon for people to over-invest in real estate,
i.e. to invest more money in an asset than it is worth on the open market.
f) Immobility
Real estate is geographically immobile (save for mobile homes, but the land underneath
them is still immobile). Consumers come to the good rather than the good going to the
consumer. Because of this, there can be no physical market-place. This spatial fixity means
that market adjustment must occur by people moving to dwelling units, rather than the
movement of the goods. For example, if tastes change and more people demand suburban

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houses, people must find housing in the suburbs, because it is impossible to bring their
existing house and lot to the suburb (even a mobile home owner, who could move the
house, must still find a new lot). Spatial fixity combined with the close proximity of
housing units in urban areas suggests the potential for externalities inherent in a given
location.

Real Property Rights

One usually acquires a number of rights with acquisition of real property. These rights
empower owners to use or dispose of the property in any legal manner
They include:
1. The right of possession
This gives the owner the right to physically occupy the property and use it as he desires. This
right is however not unlimited. This is because property cannot be used as a nuisance. This
right means the owner can conduct certain activities on the property, subject to legal
restrictions such as building codes, zoning, easements, and covenants. The owner can decide
what to use it for, what not to use it for, whether to occupy the property or lease it out, when
to change uses, and when to make improvements or modifications. Generally, one may use
one’s property in any way that does not create a nuisance for others.

2. The right of control

This gives the owner the right to physically alter the property as well as the right to control
the property use. Control of the property is related to being able to use the property how you
want to and when you want to, subject to legal restrictions. The right to control property also
means being able to exclude others from using it or coming onto it. If people come on to
your property without permission, they are trespassing. This loss of control is most
commonly associated with the surface of the property , but in environmental contamination
cases it most typically involves allowing placement of toxic substances in the groundwater
under the surface of the property or in the air (which may then fall to the grounds of the
property manifesting itself in the form of soil contamination) without the owner’s permission.
This is commonly called toxic trespass, and there will be a lot more on this later. Another
form of loss of control is being unable to refinance a property you own in order to access
capital you have tied up in it. A version of this is where the owner incurs additional costs in
order to obtain financing.

3. The right of quiet enjoyment

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This right protects the owner from interference from the previous owners of the property.
This means different things if it is an owner-occupied house or an investment property. For
an owner occupant, enjoyment means to take advantage of the housing services generated by
the property. This means the ability to enjoy the land and any air, light, and water that comes
onto the property, its gardens and vegetation, and the warmth and comfort of the building and
all its rooms, vegetation, rooftop, clean air and groundwater, and other property components,
in a legal manner. In the event that any of these features of the property are impeded, a loss
has occurred. For commercial property or residential property for rent, enjoyment means to
derive profit from owning real estate. This would be in the form of monthly or annual cash
flows. The right to enjoy also includes having the asset appreciate in line with market
conditions.

4. The right of disposition

This enables the owner to transfer ownership in real property either during his lifetime or
upon his death. This right involves the right to give property away or transfer an interest of
less than full ownership to another person. This is the right to sell or bequeath the property
when you want to at a fair market price. If you cannot sell at a time of your choosing, within
normal market conditions, then this right has been taken away. This means you may not be
able to access the equity in your property and move onto other investments. Alternatively,
you may be required to act as a lender and extend financing to a future buyer rather than
cashing out of the property.
5. Surface Rights
The bundle of rights also has a vertical spatial component. Surface rights are the most widely
understood and include the right to use the surface of the property subject to zoning, building
codes, covenants, and easements. The real estate bundle of rights is usually thought to apply
most directly to the surface of the land. If someone deposits contamination on your soil
without your permission, you have lost control of this part of your real estate rights.
6. Air Rights
These are the rights above your land or building, extending up to the legal building limit or
height. In other words, if the zoning code allows you to build up to 150 feet, and your
existing building is only 50 feet tall, you have unused development rights up to the current
zoning building envelope as part of these air rights. According to Merriam-Webster’s
Dictionary of Law, an air right is a property right to the space above a surface or object (as a
building) that may be sold or leased for development purposes. Depending on where you live,
there may also be rights extending beyond the zoning building envelope toward the sky. In

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some cases, unused development rights, a form of air rights, can be transferred to others for
monetary gain. At some point, you get into common property in the atmosphere because
planes travel overhead, as do satellites, without being thought of as violating air rights. Also,
in order to maximize use and enjoyment, it is logical that the property owner also has the
right to have the air near the windows and doors of the building as clear as the environment
around them. Thus, if a company deposits air pollution on your property, it is a violation of
your air rights. If the contaminants arrive without your permission, it is a form of toxic
trespass.
7. Subsurface Rights
This includes the water, groundwater, and mineral rights under your land. Technically, the
subsurface estate extends from the surface to the center of the earth. In urban areas, the
subsurface estate is not an issue for mining or groundwater contamination because mining is
not permitted by zoning code, and the groundwater under these properties is rarely used for
drinking, which is typically provided by municipal drinking water sources piped in from
elsewhere. In some rural areas, however, mining rights are very valuable for water, oil, gas,
salt, minerals, metals, or otherwise. If someone allows hazardous material from their property
to encroach on subsurface water or into air pockets underneath your property without your
permission, it is toxic trespass. In an urban area, this may get into a basement and present a
fire hazard. It would also be of concern to a lender and make it much less unlikely you could
get a mortgage secured by the real estate. In rural areas, the same issues apply, but with the
added risk of contamination of the drinking water from wells, and its attendant health risks.
8. Special Cases for Adjacent or Common Property
Your property may have a right to use other commonly held property or adjacent body of
water. You may have a share of a community that owns common property, say a beachfront
area. Also, if you have water frontage on a river, lake, or ocean, you probably own a right up
to the mean high tide or high waterline.You may have a right to exclude strangers from your
property, but they may typically walk on the beach below the mean high waterline without it
being deemed trespassing. The locational premium of the property, which is capitalized into
market value, may be intricately tied to the property owner being able to use the water source
for recreation, fishing, or a related purpose.If the adjacent body of water is polluted or only
partially useable, then the resultant loss of value to the adjacent property is a form of
loss.Take, for example, property along a large river that has been polluted with fuel oil from a
pipeline rupture. The property owners bought this property because they enjoyed fishing,
boating, swimming, and wildlife Once the contamination passed by their property, it
deposited several inches of congealed fuel oil on “their” beaches and swamp grass. Small

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animals and fish died, and the land was tainted. However, most of the affected land was
below the mean high tide and was technically owned by the state.

Classification of Estate
Based on Rights-Estate in possession verse Estate not in possession
 An estate in possession (present estate in land) entitles its owners to immediate enjoyment
of rights to the estate.
 An estate not in possession ( a future estate in land) does not convey in rights of the estate
until some future time. Usually contingent to occurrence of some events for instance, the
heir to the current landowner whose right to ownership awaits the death of the land owner
Based on possession and use-Freehold verses Leasehold
 Freehold estate is an estate in possession that last indefinitely.
 A leasehold estate expires on definite date. Implies the right to possess and use the
property by another for a period of time
Types of Freehold Estates
 Fee simple estate-This represent the most complete form of ownership of real estate. The
holder is free to divide up the estate and sell them up, lease or borrow money against it
subject to the law of the state. However the use of a fee simple estate may be controlled
by deed restrictions(private contractual agreements imposed by the former owners) to use
or not use the property in certain ways.
 Life Estate-It is a freehold estate that last only as long as the owner of the estate or the
life of some other persons.Upon the death of the person, the property reverts to the
original grantor (transferor of property), their heirs or any other designated person.
Types of Leasehold Estate
 Estate for years-This is created by the lease that specifies the duration for the tenancy.
The lease agreement must specify the lease termination date which can be as long as 99
years.Lease and all the transactions in real estate is written and contains the rights and
duties of the landlord and tenant and other provisions related. The difference, fair market
value less the lease rentals, if positive represent the value to the lessee which may be sold
or even borrowed against.
 Estate from year to year-Also known as periodic tenancy, it is an estate that continue for
successive period until either party gives proper notice of the intent to terminate at the
end of one or more subsequent periods.A period usually coincides with the rent payment
period.
Estates Not yet in Possession (Future Estates)

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 Estates not in possession or future estates are estates which do not convey the right to
enjoy the property until sometimes in the future. The two most important types of future
estates, are the reversion and the remainder.
Reversion
A reversion exists when the holder of an estate in land (the grantor) conveys to another
person (a grantee) a present estate in the property that has fewer ownership rights than the
grantor’s own estate and retains for the grantor or the grantor’s heirs the right to take
back, at some time in the future, the full estate that the grantor enjoyed before the
conveyance. In this case, the grantor is said to have a reversionary fee interest in the
property held by the grantee. A reversionary interest can be sold or mortgaged because it
is an actual interest in the property.
Remainder
A remainder exists when the grantor of a present estate with fewer ownership rights than
the grantor’s own estate conveys to a third person the reversionary interest the grantor or
the grantor’s heirs would otherwise have in the property upon termination of the grantee’s
estate. A remainder is the future estate for the third person. Like a reversion, a remainder
is a mortgage able interest in property.
Other Terms used
 Interest-Is the right or claim on the real property, its revenue or production, Interests are
created by the owner and conveyed to another party.
 Encumbrances-Involves pledging property as a condition for obtaining a loan (Mortgage
loan) the lender receives a secured interest on the property but not possession or use.
 Easement-Is non-possessory interest in land. It is the right to use the land that is not
owned or leased by some else for some special purpose. It entails a limited user privileges
associate with ownership.
Title
It is an abstract term linking the individual or entity who owns the property to the property
itself. It is used in reference to documents, records and acts/ behavior that prove ownership.
An abstract is an historical summary of publicly recorded documents that affect the title. The
quality of a title conveyed from seller to buyer depends upon the effect these documents has
upon the seller’s rightful possession of his property. A title is conveyed from one person
( seller or grantor) to another (buyer or guarantee) by means of a written instrument called
the deed. To be valid the deed must be in written and must meet certain legal requirements of
the country (state, if the country is federal) in which the property is located. A good and
marketable title contains the following elements;

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  Must be valid and free from any litigation
 Free from reasonable doubt
 Reasonably sold or mortgaged
 Easement, leases or mortgage do not make a property automatically unmarketable
however the deed should indicate if such situations exists so that the purchaser can make
a rational decision on purchase in terms of the appropriate price given the available risks.

Methods of Assurance
A buyer can be assured that a title is good and marketable in three major ways;
i). The seller can provide a warranty deed instrument as part of the deed. The warranties
can be classified into;
-General warranty deed which indicate that the property is free from any encumbrances
other than those listed in the deed. The covenant included is that the grantor has a good
and valid title to the property, that there will be compensation of the grantee incase of loss
in situation where another has superior claim on property, covenant against encumbrances
etc
-Special Warranty Deed which has some content of the general warranty but limits the
application of defects and encumbrances that the grantor held the title to the property
-Quitclaim Deed offers the grantee the least protection. It conveys the grantee rights,
interest and title that the grantor may have in property with no warranty in terms of the
nature of the rights, interests or of the quality of the guarantor’s title to property. The
quitclaim deed simply says grantor “quits’ whatever claims he or she has in the property.
ii). Search of the relevant recorded documents-To establish whether there is reason or
question on the quality of the title. This is usually done by a lawyer through the Abstract
and opinion method involving two steps:-
 Locating and examining all documents in the public records that have affected the
title of the property in question
 Arrive at an expert opinion on the character of the title and give judgment on the
title quality.
iii). Title Insurance-Insurance may be purchased to cover for the unexpected problems in the
title. Among many others the title insurance protects the policy holder against losses that
may show up at any future time due to the defect of title not disclosed or hidden. Types of
insurance taken include the following:-
a. Owner’s Policy-Insures the interest of the new property owner. This policy is payable
to the owner (or his or her heirs).

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 b. The lender (or Mortgagee) Policy –Insures the interest of the mortgagee. This is
payable by the mortgagee.
Both policies are paid for within a one time premium.

Limitations of Property Rights

Government Restrictions-Land use regulations are mostly common at the local level.The
polices take into account protection of health, safety, environment and the general welfare of
the society. The restrictions include the following:-
 Maximum Height of buildings
 Parking requirement
 Building codes-permits, inspection
 Water and sewage system
 Environmental restrictions
 Pollution of air and water
 Development of wetlands
Land use regulations are most prominent at the state and local level. The right to regulate
emanates from the “police powers of the state,” which are based on the protection of the
health, safety, and general welfare of its citizens (societal considerations). As the population
in an area grows, it may apply to the state to become incorporated as a city, township, or
municipality. At this point, the state usually delegates some areas of land use regulation.
Incorporated areas then may modify and expand land use controls and develop restrictions on
land use. These items are usually enumerated in zoning ordinances and building codes.
Common restrictions used to implement controls include zoning ordinances, allowable uses,
height restrictions, parking requirements, and building codes, permits, and inspections. The
state usually retains control over water or riparian rights, mineral rights, eminent domain, and
the like, while the federal government regulates housing and loan discrimination, interstate
land sales and securities, and environmental restrictions (pollution of water and air, and
endangered species, as well as effects of property use and development on wet lands).
Private Restrictions-Based on personal objective to restrict property use by all owners e.g
 Prohibiting sale of alcohol in the property
 Prohibiting subdivision of property/minimum size prescribed
 Minimum quality buildings
 Landscaping
In some cases, property owners may choose to incorporate certain deed restrictions that limit
the use of property by all subsequent owners of that property. Property owners may use such

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restrictions to achieve personal or business objectives. One example of a personal objective
would be to add a deed restriction explicitly prohibiting the sale or consumption of alcoholic
beverages on the property forever. In the event that this restriction is violated, the restriction
may stipulate that title will revert to the owner who incorporated the restriction, or to his
heirs. An example of a business objective that is commonly achieved through deed
restrictions may involve subdivision of a large tract of land into smaller individual tracts to be
sold to builders and developers. In order to assure the initial buyers of the subdivided tracts
that subsequent buyers will build improvements that conform in quality and use, the owner of
the initial larger tract may deed restrict each of the subdivided tracts. Such restrictions may
require a minimum and/or maximum building size, minimum quality building materials,
landscaping, and the like, thereby providing all owners with some assurance of conformity
and general standards in design and building quality. However, resolution of any future
violations of deed restrictions may prove to be problematic, particularly after a long period of
time. In the first example, the original property owner or all of his heirs would have to bring
an action against the current owner to regain title to the property if the deed restriction
prohibiting the sale of alcohol were to be violated. In the case of the subdivision, usually a
property owners association representing owners of the subdivided properties would have to
bring legal action against the property owner who is in violation. In this instance, the court
may require the owner in violation to cure the problem or pay the owners association for any
loss in property value as opposed to forcing the sale of the property.

BUILDING SOCIETIES AND REAL ESTATE FINANCING

Definition
This is a cooperative whose members pool their resources in order to offer financial and
lending services, such as mortgages. It is similar to a bank or credit union in that they are
owned entirely by their members. Building societies emerged in the U.K. during the 19th
century, and are similar to savings and loans institutions in the United States. These
societies offer mortgages and demand-deposit accounts and are often backed by insurance
companies. Building Societies are licensed under the Building Societies Act. Currently
there is no licensed Building Society in Kenya according to the Central Bank.

Commercial Banks and Mortgage Finance Institutions are licensed and regulated
pursuant to the provisions of the Banking Act and the Regulations and Prudential
Guidelines issued there under. They are the dominant players in the Kenyan Banking

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system and closer attention is paid to them while conducting off-site and on-site
surveillance to ensure that they are in compliance with the laws and regulations.

Currently there are there are 43 licensed commercial banks and 1 mortgage finance
company. Out of the 44 institutions, 31 are locally owned and 13 are foreign owned.
The locally owned financial institutions comprise 3 banks with significant shareholding
by the Government and State Corporations, 27 commercial banks and 1 mortgage
finance institution. The ownership structure of the commercial banks and mortgage
finance company is as depicted in the chart below:

Construction Loan is any loan where the proceeds are used to finance construction of
some kind. Almost all lenders are concerned that the money lent is repaid, so underwriting
of construction loans usually focuses on how that might occur.
In the most basic situation, that of an individual building a home for themselves, a
business building a property for business use, or an investor building a property to rent
out, the fundamental guideline is for the lender to consider whether once the loan has been
fully extended and converted into a mortgage and the building is occupied, whether the
individual, business, or investor can afford to pay back the loan on a monthly basis.

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 Real Estate Financing
Real estate is usually acquired with some form of financing. This may be debt financing from
a lender or equity financing from a limited partner. In general, financing allows the
borrower/investor/owner to leverage the amount of financial equity they have in the property,
hence increasing the rate of return. Thus, the vast majority of potential real estate buyers use
financing, sometimes referred to as “other people’s money.” Real estate that cannot be
financed is a typical and would have a smaller pool of potential buyers. Inability to obtain
financing is a form of loss of control of the property. There are different ways of real estate
financing: governmental and commercial sources and institutions. A home buyer or builder
can obtain financial aid from savings and loan associations, commercial banks, savings
banks, mortgage bankers and brokers, life insurance companies, credit unions, governmental
agencies, individual investors, and builders.
Savings and Loan Association
The purpose of these institutions is to make mortgage loans on residential property. These
organizations, which also are known as savings associations, building and loan associations,
are the primary source of financial assistance to a large segment of homeowners. As home-
financing institutions, they give primary attention to single-family residences and are
equipped to make loans in this area.
Characteristics of a savings and loan association
 It is generally a locally owned and privately managed home-financing institution.
 It receives individuals' savings and uses these funds to make long-term amortized
loans to home purchasers.
 It makes loans for the construction, purchase, repair, or refinancing of houses.
 It is state or government registered.

Commercial bank
Due to changes in banking laws and policies, commercial banks are increasingly active in
home financing. In acquiring mortgages on real estate, these institutions follow two main
practices:
First, some of the banks maintain active and well-organized departments whose primary
function is to compete actively for real estate loans. In areas lacking specialized real estate
financial institutions, these banks become the source for residential and farm mortgage
loans.
Second, the banks acquire mortgages by simply purchasing them from mortgage bankers

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 or dealers.
In addition, dealer service companies, which were originally used to obtain car loans for
permanent lenders such as commercial banks, wanted to broaden their activity beyond their
local area. In recent years, however, such companies have concentrated on acquiring mobile
home loans in volume for both commercial banks and savings and loan associations.
Service companies obtain these loans from retail dealers, usually on a nonrecourse basis.
Almost all bank/service company agreements contain a credit insurance policy that protects
the lender if the consumer defaults.
Savings banks
These depository financial institutions are government registered, primarily accept
consumer deposits, and make home mortgage loans.

Mortgage Broker/Bankers
Mortgage bankers are companies or individuals, who originate mortgage loans, sell them to
other investors, service the monthly payments, and may act as agents to dispense funds for
taxes and insurance.
Mortgage brokers present the consumer home buyer with the best loan from a variety of loan
sources. Their income comes from the lender making the loan, just like with any other bank.
Because they can tap a variety of lenders, they can shop on behalf of the borrower and
achieve the best available terms. Despite legislation enacted that could favor the major banks,
mortgage bankers and brokers keep the market competitive so the largest lenders must
continue to compete on price and service.

Life insurance companies

Life insurance companies are another source of financial assistance. These companies lend
on real estate as one form of investment and adjust their portfolios from time to time to
reflect changing economic conditions. Individuals seeking a loan from an insurance
company can deal directly with a local branch office or with a local real estate broker who
acts as loan correspondent for one or more insurance companies.

Credit unions/ SACCOs

These cooperative financial institutions are organized by people who share a common bond
— for example, employees of a company, a labor union, or a religious group. Some credit
unions offer home loans in addition to other financial services.

Real Estate Investment Trusts (REITs)

Real estate investment trusts (REITs), which began when the Real Estate Investment Trust

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Act became effective January 1, 1961 in USA, are available. REITs, like savings and loan
associations, are committed to real estate lending and can and do serve the national real
estate market, although some specialization has occurred in their activities.

Other sources
Creative real estate investing
Individual investors constitute a fairly large but somewhat declining source of money for
home mortgage loans. Experienced observers claim that these lenders prefer shorter term
obligations and usually restrict their loans to less than two-thirds of the value of the
residential property. Likewise, building contractors sometimes accept second mortgages in
part payment of the construction price of a home if the purchaser is unable to raise the total
amount of down payment above the first mortgage money offered.

Construction Lending
Often financial help requested by small builders can be assessed in same way as any other
business i.e. looking at past performance, examining stake, liquidity and
profitability, and judging future plans, gearing and cash flows.

However, o n e need to think about key risks in both the development and completion
stages. This sector is also prone to economic cycles.

Main areas Construction Lending

Contracto
rs
This is a person contracted to carry out building work on someone else’s land. Banks is
asked to lend to contractor to enable commencement of building work, pending
receipt of certified stage payments.

Estate
Development
The builder will construct a property or properties on his own land for sale on
completion. Bank could be asked to lend for land purchase and building costs, with
repayment to come from sales, secured by a legal mortgage on the site.To control
exposure, bank will usually insist site developed in stages, so that proceeds of one stage

15
are coming in before the next stage starts.

Property Investment and Development Advances:

The builder or developer buys a house or group of houses, vacant or tenanted. Some will
be renovated for sale at a profit and others will provide rental income.As security, bank
takes mortgages over all the properties and looks to rent or sale proceeds for repayment of
the advance.

Lending to Contractors
Lender investigates details of the specific contracts. Reliance could be placed on
level of security available but difficulties can arise due to inadequate capital
resources or by inexperience.It’s vital that borrower has capacity and ability to complete
the contract. In evaluating contract, lender needs to examine carefully clauses that cover
the following:
Variations: although contract price will be open to adjustment in variations, these could
mean that additional finance is required.
Fluctuations in cost: Particularly in longer-term contracts where builders can be
vulnerable to increases in materials costs and wages during the contractual period.
Penalties: borrower must have capability and ability to maintain a strict
schedule.
Time extensions: to permit extensions due to extraordinary events, such as force
majeure etc
Interim payments: Intervals at which work will be inspected by architect and certificates
issued in respect of completed work.
Retention funds: Usually 5% or 10% of contract price.
Period of final measurement: frequently 6 months after completion of work. the
architect or quantity surveyor is required to inspect the work, verify previous
measurements and amount certified for payment.
Defect liability period: often 6 months, to allow latent defects to show through any
defect must be rectified at builders’ expense.
Nominated sub-contractors and suppliers: Have right to go to employer if
payment is not received from builder when due. Employer will deduct such payments
from funds due to contractor.
Amount: lender must be certain that amount requested will, when added to borrower’s
capital, be sufficient for the contract to be completed.

16
The contractor should have his own plant and machinery and therefore, should only
need to borrow sufficient working capital to pay for labour and raw materials until
payment is received.
As security, an assignment of contract monies should bet taken. If contract is not
satisfactorily completed, then no monies will be forthcoming, so you would
normally seek additional security.

Advances to
estatedevelopment
Bank need be satisfied that customer has building capacity and experience, as
well as administrative ability, to complete the development fully.
Matters to be checked;
Has full planning permission been obtained? Bank needs a copy.
Has reputable estate agent confirmed saleability of proposed properties at intended
prices?
Are costings viable, and do they contain a margin for time and cost excesses?
How much will land cost?
Must road and sewers be completed before building is allowed to start? Are bonds
required for them?
What profit is expected? Rule of thumb, it should roughly equal cost of
land.

Banks will be reluctant to lend more than security valuation over site, except in
case of established, undoubted customers who can provide extra security from
outside the development.

How much to lend approach

How much does customer need to borrow to build all planned houses, and to pay all
creditors before house sale proceeds commence to arrive?

Compare anticipated total + borrowing to customer’s contribution and new worth of

business.

Calculate security valuation of site on basis of 50% of land cost and current value, plus
50% of roads and sewers costs plus 66% of building costs.

17
 If there is insufficient security value here to cover amount needed in (a) consider
building houses in phases, the proceeds of one phase partly financing the next.

Building loan is advanced in stages-foundations, elevation (walls built), roofing and

internal work against bank manager’s site visit and valuation or against architect’s
certificates.

Insurance could be required on all aspect of development, including key man

cover.
Property Investment Advances.
Property lending can be safe and remunerative to lenders, but lenders need to be aware of
market conditions and likely prospects and changes. This is because property market tend
to be cyclical, with period of shortages and oversupply of certain type of buildings.
Purchase of tenanted properties: If customers wish to borrow to invest in tenanted
properties, loan repayment will come from rental income.

Points to be
examined.
Margin: recommended margin should be at least 15% between rental income and out-
going for interest and capital repayments. Lower margin may be acceptable for good
customer if tenants are first class and long standing and there are other sources of income.
Tenancy/lease agreements: should be for longer than anticipated term of bank
borrowing and tenants should be good quality.
Security cover: Bank seeks full security cover. Tenanted properties may be
valued conservatively at three time’s annual rental.Vacant, immediately saleable
properties could attract a security valuation of up to 80% of recent professional
valuation. Take additional security if you think it is necessary in light of valuation.

Purchase of vacant properties for later sale.

Borrowings are bridging loans but open bridge particularly if renovation is needed
before resale.

Points to be
satisfied

18
Capability: Developer must be capable of carrying out work within budget
and time. Planning permission: may be required for proposed renovation.
Planning permission: may be required for proposed renovation amount: Must
not exceed 66% of anticipated sale proceeds, to allow for interest, delays in
completing renovations, market price changes, and selling costs.
Security: first mortgages security is required, with a wide margin over amount of loan,
even before renovations.

Risks in Property Finance

Letting risk: It might not be possible to let building at all. if the market is depressed or,
if its let, it might have to be to tenants, which would not be attractive to an institution.
Construction risk: There might be cost overruns which may even go higher if original
builder is fired and someone new has to be brought in. Although there is a contingency
built into the project, this covers only minor mishaps.
Disposal risk: Institutions may decide to reduce/hold their property portfolios and not be
in market for this type of property. They may require higher yield.

19
20
REAL ESTATE INVESTMENT TRUSTS ( REITS)
Introduction
A real estate investment trust is an investment fund designed to invest in various real estate
properties. It is similar to a stock or bond mutual fund, except that the money provided by the
investors is invested in property and buildings rather than in stocks and bonds. Real estate
investment trusts, known as REITs, are entities that invest in different kinds of real estate or real
estate related assets, including shopping centers, office buildings, hotels, and mortgages secured
by real estate.

In other words, REIT is a trust company that invests its assets in real estate. On investing in one
REIT unit an investor buys a portion of a managed pool of real estate. The pool of real estate
then generates income through renting, leasing and selling of property and distributes it directly
to the REIT holder regularly.Broadly speaking, REITS are regulated investment vehicles that
enable collective investment in real estate. Investors, both retail and corporate, are allowed to
pool their funds under the umbrella of the REIT and then engage in real estate projects.

A real estate investment trust is a trust that qualify under certain tax provisions to be a pass
through entity that distributes to its shareholders substantially all of its earning in addition to
capital gains. The trust does not pay tax on earnings but the distributed earnings do represent
divisible income which can be taxed accordingly.

The Case for Reits

1. REITS are relatively high-yield instruments and must pay out at least 90% of their
taxable profit as dividend to shareholders. Hence investors benefit from distribution of
earnings generated by REIT,

2. Buying a share in REIT entails the purchase of physical assets with long expected life
span and potential for income through rent and property appreciation. this therefore
creates a bit of safety net for investors as they will always stake claim on property
underlying the trust while enjoying the benefits of their income from REIT,

3. An average investor benefits from ability to invest in real estate without having to spend
the normally associated large capital and labour requirement/involvement in the property
development. Since the resources would be pooled from wider spectrum of investors, a

21
 large number of investment properties would be purchased. This would entail regular
flow of income to investors; and,

4. The high rate of distribution means that the tax on the individual is generally at the
personal level.

The Case against Reits

1. Since REITS involve investments in large capital, an investor wishing to divest would not
easily do so because real estates cannot easily be liquidated for cash unlike shares which
generally sell in small units,
2. It is difficult to decide on the right REIT as it entails studying a number of factors
particularly in the area of management, and the track records of the managers and their
team; and,

3. The REIT returns can be affected when the tenants fail to pay rent and hence a diversified
investment by location and type of property may be critical in deciding which REIT
would be ideal.

Types of Reits
There are several types of REITs.

1. Construction and development trusts lend the money required by builders during the
initial construction of a building.
2. Mortgage trusts provide the long-term or Short term, variable or Fixed rate financing for
properties. Specifically, they acquire long-term mortgages on properties once
construction is completed.
3. Equity trusts own various income-producing properties, such as office buildings,
shopping centers, or apartment houses. Therefore, an investor who buys shares in an
equity real estate investment trust is buying part of a portfolio of income-producing
properties. REITs have experienced periods of great popularity and significant depression
in line with changes in the aggregate economy and the money market. Although they are
subject to cyclical risks depending on the economic environment, they offer small
investors a way to participate in real estate investments. The equity oriented real estate
investment has provided investors with opportunities to(1) invest funds in diversified
22
 portfolio of real estate under professional management and (2) to own equity shares that
trade on organized exchanges, thus providing more liquidity than if a property were
acquired outright.

Direct Real Estate Investment

Residential
The most common type of direct real estate investment is the purchase of a home, which is the
largest investment most people ever make. The purchase of a home is considered an investment
because the buyer pays a sum of money either all at once or over a number of years through a
mortgage. For most people, those unable to pay cash for a house, the financial commitment
includes a down payment (typically 10 to 20 percent of the purchase price) and specific mortgage
payments over a 20- to 30-year period that include reducing the loan’s principal and paying
interest on the outstanding balance. Subsequently, a homeowner hopes to sell the house for its
cost plus a gain.

Raw Land
Another direct real estate investment is the purchase of raw land with the intention of selling it in
the future at a profit. During the time you own the land, you have negative cash flows caused by
mortgage payments, property maintenance, and taxes. An obvious risk is the possible difficulty
of selling it for an uncertain price. Raw land generally has low liquidity compared to most stocks
and bonds. An alternative to buying and selling the raw land is the development of the land.

Land Development
Land development can involve buying raw land, dividing it into individual lots, and building
houses on it. Alternatively, buying land and building a shopping mall would also be considered
land development. This is a feasible form of investment but requires a substantial commitment of
capital, time, and expertise. Although the risks can be high because of the commitment of time
and capital, the rates of return from a successful housing or commercial development can be
significant.

Rental Property
Many investors with an interest in real estate investing acquire apartment buildings or houses
with low down payments, with the intention of deriving enough income from the rents to pay the
expenses of the structure, including the mortgage payments. For the first few years following the
23
purchase, the investor generally has no reported income from the building because of tax-
deductible expenses, including the interest component of the mortgage payment and depreciation
on the structure. Subsequently, rental property provides a cash flow and an opportunity to profit
from the sale of the property.

Most of the investments alternatives we have described thus far are traded on securities markets
and except for real estate have good liquidity. In contrast, the investments we discuss in this
section have very poor liquidity and financial institutions do not typically acquire them because
of the illiquidity and high transaction costs compared to stocks and bonds. Many of these assets
are sold at auctions, causing expected prices to vary substantially. In addition, transaction costs
are high because there is generally no national market for these investments, so local dealers
must be compensated for the added carrying costs and the cost of searching for buyers or sellers.
Therefore, many financial theorists view the following low-liquidity investments more as
hobbies than investments, even though studies have indicated that some of these assets have
experienced substantial rates of return.

Real Estate Investment Trust in Kenya-In the last decade or so, the Kenyan economy has
experienced significant growth in most key sectors. This growth has been attributed to a vibrant
private sector and the ever increasing appetite for foreign investments in Africa. Kenya has been
regarded as the preferred hub for multinationals and other international organisations with
operations in East and Central Africa.

The Kenyan Government, in response to this, has invested heavily in infrastructure development.
In addition, the Government has taken steps to improve the legal and regulatory framework in
key sectors of the economy.

Presently, Kenya does not have a formal framework that allows for efficient financing of large
real estate developments, other than the usual mortgage financing. Real estate developers
have resulted to entering into joint ventures of various forms, in order to efficiently finance their
development projects. However, as these joint ventures are not specifically designed for real
estate projects, they create significant limitations for developers and potential investors. These
limitations include tax inefficiencies and increased development costs. In addition, it is not
uncommon to have disputes between the joint venture partners. The disputes lead to delays in
delivery of the real estate products and also negative publicity of the real estate project.
24
In recognition of the significant growth in real estate sector of the economy and the need to
provide a framework for financing real estate investment projects in Kenya, the Kenyan
Government proposes to introduce a framework for real estate investment trusts (“REITS”) in
Kenya. In line with this, the Capital Markets Authority (“CMA”) has been mandated to develop
REIT regulations. In addition, the Finance Bill 2011 proposed various amendments to the
Income Tax Act that are meant to lay a suitable tax regime for REITS in Kenya.

Proposed Reit Regulatory Framework

In the last quarter of 2011, the CMA engaged various stakeholders in consultations on the REIT
framework, culminating in the preparation of a discussion paper setting out key elements of the
proposed framework. These key elements will still undergo further consultation before an
agreement is reached and draft REIT regulations are published.

Stakeholders have proposed the establishment of two types of REITS, namely, the Income
REITS and the Development REITS. The key distinction between these two REITS is as
follows:

 Income REITS would generally be permitted to invest in income generating real estate
products, in the form of rent receivables and similar income.
 Development REITS would generally be permitted to invest in property development and
construction projects.

There have been proposals to have Development REITS converted into Income REITS once the
development has been completed.

Stakeholders also noted that there has been increased consumer demand for Islamic investment
products. In line with this, stakeholders proposed for a framework that establishes REITS that are
compliant with Sharia law.

Proposed Tax Treatment of Reits

The Finance Bill 2011 proposed various amendments to the Income Tax Act. These
amendments sought to have income generated by REITS exempt from income tax (presently
30%). It’s important to note that the proposals to amend the Income Tax Act have been made
prior to the creation of the REIT regulations.

25
It has been suggested that ideally, the exemption from payment of income tax should only apply
to income that has been distributed to unit holders and not all the income generated by the REIT.
This proposal is meant to incentivise REITS to distribute as much income as possible to the unit
holders.

However, it would appear that the income tax exemption for REITS will not be automatic and
each REIT would have to apply to the Commissioner of Income Tax for exemption from income
tax. Proposals have been put forth to have the income tax exemptions as automatic provided the
REIT has been registered by the Capital Markets Authority.

New rules governing implementation of Real Estate Investment Trust (REITs) will be gazetted
before the March 4 General Election. The CMA has developed a draft policy and regulatory
framework to that effect of which it finalization will include the listing of REIT’s in the stock
exchange.

26
VALUATION OF PROPERTIES
Real Estate as an Investment
Characteristics of an Investment
An ideal investment has a number of qualities which an investor needs to identify with any form
of investments he wishes to take. The qualities are:
 Security of capital-Relates to ease of converting the investment into cash at ease in future
with no cost. Compared with Government securities (Treasury bills and bonds), the income
from real estates is less secured and less regular arising from the defaults in rent payments as
well as the voids ,real estates do not offer the same security of capital due to management
costs, default of rent payment etc
 Liquidity of capital-Is the ease and speed of converting the investment into cash. Real
estates are not liquid because it takes both time and money to convert into cash. They
therefore offer two methods of raising cash namely; selling the property or to use it as a
security for a loan.
 Cost of transfers-Management costs e.g an office block or block of flats calls for
considerable amount of management. Investment should be compared based on the amount
of skill of management time required. Investments which require more management time
should produce higher returns to pay for the time and effort. Thus real estates require long
leases with proper requirements which reduce on the costs of management.
 Taxation-Real estates are subject to taxation in Kenya as opposed to other investments
which are tax exempt. The tax would be paid at the time of sale(capital gain tax) or paid on
annual income(income tax)
 Divisibility-Government control affects the use of land.

Opportunities for Investment

Investors have a number of opportunities open to them both as an alternative investment and
sources from which to obtain money for investments. These include:
 Commercial banks,
 Mortgage institutions/building societies,
 Stocks of shares, Insurance companies,
 Retained funds/savings; and,
 Co-operatives
OUTGOINGS

27
Outgoings are the periodic costs incidental to the ownership of property. They include annual
ground rent, fire insurance, rates, cost of repairs, and management and letting commissions. The
following are the major items included in the list of outgoings with respect to real estate
property:
 Repairs and maintenance-This varies with the type of construction and age of property.
To estimate the annual figure, reference is made to past records, % of rental value or
judgement is used.
 Insurance-Based on the value assigned to building in terms of % of the cost of
reinstatement or of the rental value. Where the building is under mortgage the owner is
expected to take a mortgage protection.
 Management costs-Occurs when property is let to various tenants. Includes collection of
rent, repairs, answering to tenant questions etc.
 Void/vacancies-Occurs when a tenant move away from the property and it takes long to
locate another one.
 Service charges-Occurs when property is let in multiple occupation items include
cleaning and lighting of staircases, corridors, toilets, employment of watchman etc
 Property taxes (Rates and ground rents)-To local authority for provision of communal
services e.g lighting in streets and waste collection
 Income tax Income from property is taxable.In valuation, it is necessary to make
allowances for tax.
 Sinking funds as appropriate-This is applicable to leashold property where some
amount is set aside from the income so that at the end of the lease term capital is
recouped. The amounts set aside in a ‘Sinking Fund’ is usually invested in the fastest and
safest form of investment at lower rates. Most property owners in Kenya do not seems to
take out sinking funds due to ignorance or reluctance to reduce spendable income.

Definitions Of Common Terms In Valuation Of Properties

 Price ;It is the actual observable exchange price in the open market (it is historic comparable
information)
 Value ;It is an estimation of the price that would be achieved if the property was to be sold in
the market, and
 Worth ;It is a specific individual’s perception of the capital sum that she/he would be
prepared to pay (or accept) for the stream of benefits that she/he expects to be produced by
the property.
28
 Market Value ;It is the estimated amount for which an asset should exchange on the date of
appraisal between a willing buyer and a willing seller in an arm’s length transaction after
proper marketing wherein the parties had each acted knowledgeably, prudently and without
compulsion.
 Valuation ;It is simply a model to try to determine price. Value is the end result. It is the
quantification of an understanding of the market; the legal impact; the physical constraints;
the planning regime; the availability of finance; the demand for product and the general
economy, all of which influence the value of property. Valuation is the process of
determining market value; an estimation of the price of exchange in the market place. It is the
art of estimating the value of a particular interest in property for a specific purpose at a
particular moment taking into account all features of the property and also considering the
market factors( Britton .et. al,1980).
 Capitalisation;Involves the conversion of income into a value, or the estimates of the
present worth of future benefits. When the streams of income is involved, the process used is
multiplying the income by a factor which represents the present value of future incomes and
allowance for both income and capital recovery.

Real Estate Valuer;

This is a professional who estimate the value of any property in order to determine the exchange
potential of the same in monetary terms. A valuer is expected to advice a seller on the price to
ask for a property, a prospective tenant on the rent to be paid for a premise, a financial institution
on the value of the security to which loans can be advanced against and a person dispossessed
under compulsory acquisition on the compensation to be claimed. A valuer is expected to advise
on the policy to adopt in the management of investment properties. This may include the
maintenance of the capital values, examination of rents and outgoings. A valuer may have to
advise a particular investor in real estate property on the types of investment best suited to their
needs. In such a situation, consideration to be accounted for includes investors liability to income
tax, the neighbourhood, and whether a buyer would be found if the property would be put to
market.

Functions of the Valuer

The services of a competent professional called a valuer may seek therefore anyone with an
interest in, or contemplating a transaction involving land and buildings. For instance, a valuer
may be required to advise:
29
1) A seller to know the price he/she should ask for his property,
2) A prospective tenant on the rent he/she should pay for the premises,
3) A financial institution on the value of the security which can be attached to loan or mortgage
4) A person dispossessed under compulsory acquisition on the compensation he can claim.

In Kenya, the practice is governed by the valuers Act, Chapter 532 of the Laws of
Kenya(1984).The act establishes the valuers Registration Board with the responsibility of
registering and regulating the activities and conduct of registered valuers

Purpose Of Valuations
Valuation may be required for many different purposes ranging from open market transaction to
compulsory purchase. Although the underlying preferred method of valuation should not be
dependent upon the purpose of the valuation, it is important that the purpose is determined before
undertaking any calculation.
Statutory Valuations-are governed by legislation in which the valuer is frequently required to
assume conditions laid down by law(e.g as in compulsory acquisition or residential tribunal).
Non-Statutory valuations-This stems from the natural events such as buying and selling, leasing
and insuring of property.

Type of Valuations Purpose for valuation

a) Statutory valuations Ground Rents
Stamp duty
Rating
Compulsory purchase
Rent tribunal
assessments(Business and
Residential premises)
b) Non-statutory
valuations
Mortgage Financial Security
Insurance Mortgage protection, fire &
other risks

30
 Asset Valuation Book purposes
Business transfer(sale)
Rental Assessment Property letting, owner
occupied house allowance
Auctions Reserve price
Investment Property development
appraisal

a) Sale Report
The most common purpose for requesting a valuation is for sale. Although this is often referred
to as a valuation, it is actually more akin to marketing advise, as normally the estimate of price is
given for a future date after the property has been fully marketed. Conversely, a valuation for
purchase is, by its nature, an estimate of the individual’s best bid and thus it is a calculation of
worth.

b) Accounting Purposes
A more correct use of the term valuation is the value of property as reported in company (or
public) accounts. The majority of property owners have to prepare valuation of their properties
for the purposes of their accounts. This is a statement of the company’s wealth on a particular
date. Thus the value of the property element within the business is an estimate of the Market
Value on the date of the accounts.
c) Loan Security
Banks and other lenders commission the valuation of property acting as collateral for a loan.
They want a market value on which they can judge the amount of the loan based on a “loan to
value” ration. They are attempting to manage the risk of the loan by ensuring that the property
has sufficient value to act as security for the amount lent.
d) Minimum Price or Auction Reserve
Often when a company or public body is selling its assets by tender or auction, they are obliged
to only accept offer in excess of their valuation of the asset. Thus a Market Value has to be
determined as a guide. Similarly, in cases where an owner has a property that is unusual or
where there are special circumstances pertaining to it, the valuer may be instructed to place a
reserve value on the property for auction.
e) Insurance

31
All property must be insured in the case of replacement – but this is really unconnected to the
sale price – which of course includes the land. For insurance purposes the normal basis of
valuation adopted will be the cost of replacing the building in the event of destruction or partial
destruction.
f) Taxation
Valuers frequently have to value property for tax purposes. The principal taxes fall into groups;
capital and revenue. Often these valuations are formula based and diverge from normal market
value calculations.
g) Compulsory Purchase
Often public schemes involve the purchase of land and this acquisition is subject to a compulsory
order. The principal basis of compensation for the land and buildings taken is based on open
market value. This is often a case where the valuer has to deal with specialized property such as
churches, schools and the like.

Methods of Real Estate Valuation

Property values are affected by many factors, the relative importance of which differs with each
heterogeneous property. Some of the factors may be matters of opinion involving subjective
judgment which are not quantifiable. Experience and valuation techniques are very vital when
determining the value of property. Record keeping is very important for valuers in order to
capture the observed facts or past events

Steps in valuation process

The valuer does not create value but interprets the market and express opinions. One must
therefore know all possible factors which can affect the demand for and supply of real estate and
collect the relevant information needed in order to analyze activity in the real estate market. The
valuation process involves the following steps:
(i) Carry out a survey of the subject property by collecting all information available including
legal; physical, and income aspects.
(ii) Collecting data and information necessary for the analysis of activity in the real property
market. There are essentially three types of data the valuer needs in this regard:
 Sales of comparable properties, which reflect direct estimates of values of the respective
properties under given market conditions.
 Income, which reflect the price that the market places on the annual value of the benefits
derived.
32
 Cost, which provides an estimate of the maximum amount an investor will pay to obtain a
new property that produces benefits of a given value. It provides an identification of market
value since market values of new properties will seldom be less than their cost of production.
(iii) Analyzing data to obtain value estimates.
(iv) Making estimates of value for the subject property.
(v) Writing the valuation report showing the value estimate.

Valuation Methods
There are several methods available to the valuer, each of which can be recognized by the data
on which it is based. Each method is suitable for each situation. The following are some of the
specific methods:
1) Comparative sales method/sales comparison approach
This is the most realistic method of all valuation methods. It is based on the comparison of the
property to be valued with similar properties and the prices achieved for them, taking into
account the differences between them.
The comparability of properties is based on the use of the property, location (characteristics of
the neighbourhood), site area, site conditions, physical properties of the buildings (floor area,
building materials used, amenities such as garage, etc), and the income related factors. These
factors can be deduced to a mathematical regression function expresses as:

Y = ƒ(X1, X2 Xn)………………………………………………………… (1)

Assuming that a linear relationship exists between the price and each of the independent
variables, X1……Xn, the above function may assume the following price equation:

Y = a+ b1X1, + b2X2+ …… + bnXn……………………………………… (2)

Where;
Y = Average price for all properties for which prices are available,
a = constant representing intercept obtained after analyzing several properties
b1…bn = Partial regression coefficients, being proportional contributions of each of the
independent variables
X1…Xn = Individual variables assumed to affect property price
2) Income capitalization method/Income Approach

33
In this method, a prospective owner capitalizes the income he expects to earn from property and
bases his offer to purchase on the present worth (i.e. the capitalized value of the anticipated
income). Similarly, an owner who is considering selling his property compares the price he is
offered with the capitalized value of his future property.
In this situation it is imperative that a valuer who proposes to use this method obtains
information on:
(i) Income derived from the property and the relevant outgoings. The rent must be comparable
with similar properties; and,
(ii) The rate at which the net income should be capitalized.
Illustration one:
James who owns residential properties in the Muthaiga up market on Nyahururu town is
considering it for sale. He lets his ten properties Kshs 50,000 per month and the rate of returns on
residential property is 10%. Outgoings are charged at the rate of 20% per annum. James expects
to receive his future income for the next 50 years.

Required:
Determine the value of sale of the property which is up for sale using income capitalization rate.
Solution:
Income receivable (Kshs 50,000* 12) Kshs 600,000
Less outgoing deduction @ 20% 120,000
Net income Kshs 480,000
PVIFA10%,50years 9.91
Value Kshs 4,756,800

3) Cost Approach/ re-instatement method

There are many properties owned by public authorities such as fire stations, schools and religious
institutions for which sales and income information are not available. They cannot therefore be
valued by either comparative sales method or income capitalization. An alternative approach is
the cost method, based on the assumption that an individual will not pay for property more that it
would cost him to acquire a similar one.

In order to carry out this valuation it is necessary to:

(i) Estimate the cost of the building; and ,

34
 (ii) Estimate for market value of the site.

In the case of an existing building, the cost can be estimated in three ways:
(i) Replacement cost by depreciating the cost of the building using current building
materials and construction techniques.
(ii) Reproduction cost by depreciating a building constructed in similar fashion.
(iii) Factored historical cost by indexing historical cost to reflect current prices.
Illustration two:
A school building with total area of 1,000m2 is 10 years and needs to be valued for book purpose.
The estimated full life is 60 years. It stands on an area of land measuring 1.2ha. Vacant land in
the vicinity has been selling @ shs 100,000. Current construction costs for similar buildings
average shs 3,000 per square meter. The school management uses straight line method of
depreciation on the buildings at the rate of 1.667%.
Required:
Determine the capital value of sale of the building using cost/re-instatement method.
Solution:
Building (1,000m2*Kshs Kshs
3,000) 3,000,000
Depreciation 500, Kshs 2,499,900
@1.667%*10year 100
Land 1.2ha @ 100,000 120,000
Capital value Kshs 2,619,900
Illustration Three:
Calculate the value of a building with gross area 100m 2 for insurance purposes. Similar buildings
cost an average Kshs 4,000 per square meter. The building is 10 years old. Site works is 20% of
the cost of building. Depreciation is 1.667% p.a. Professional fee was charged at 15% of the total
cost of the building.

Solution:
Building (100m2 @Kshs 4,000) Kshs
400,000
Add site works @20% 80,0 Kshs 480,000
00

35
 Deduct depreciation @ 1.667% 80,016
for 10yrs
Ksh 399,984
Add professional fees @15yrs Ksh
59997.6
Total reinstatement cost Kshs
459981.60

4) Profits method
With certain types of property such as theatres, restaurants, and hotels, the valuation may have to
be made purely by reference to profits. The principle is that the value will be proportional to the
volume of trade or business carried out; presumably, the higher the profit an entrepreneur can
make the higher the rent he will be willing to pay. Thus if we know the gross profit of the
proprietor, the remaining balance is available for the rent of the premises.
Illustration Four:
Value the following property for sale, given the following information:
Shs
Income from sale of rooms 450,000
Income from restaurant 650,000
Miscellaneous income 40,000
Income from drinks 660,000
Purchases 800,000
Staff salaries and wages 500,000
Director’s fees 25,000
Rates + ground rent 35,000
Power, water, etc 100,000
Incidental expenses 200,000

The owner has invested shs 440,000 in stock, furniture and other effects, and in addition needs
three months gross receipts as capital. The operator’s expected return is 14% for 50 years.(Note:
The investment is not considered but the profits)

Solution:

36
 Kshs 000 Kshs
000
Gross income from
Miscellaneous Income 40
Rooms 450
Restaurant 650
Drinks 660 1,800
p.a.
Less
Purchases 800
Other expenses
 Staff salaries and wages 500
 Director’s fees 25
 Rates and grounds rent 35
 Power, water, etc. 100
 Incidental expenses 200 860 1,660
p.a.
Net profit attributable to rental 140
income
PVIFA14%,50 years 7.13
Value of property on profits method 998.2

5) Residual method
This method is normally applied to property with development potential; either undeveloped or
partly developed.

The principle is to examine the value of the property when developed to the best advantage.
From the gross development one need s to deduct the costs of realization. The balance of the
“residual” amount is the value of the property in its present state reflecting the development
potential. This type of property may include a parcel of land with development approval, or land
where no sale evidence exists except rental evidence or sales of developed properties. It may be
applied in old buildings in need of rehabilitation:

37
It would be necessary to consider the value after rehabilitation and the costs of rehabilitation so
as to reach a decision criterion. The costs of development deducted from new value include:
(i) Building costs (Labour and materials, etc)
(ii) Professional fees (Architecture, engineer, etc)
(iii) Cost of capital (Interest on loan)
(iv)Developer’s profit
(v) Disposal costs (legal fees, selling commission)
Illustration Five:
An old building along Kenyatta Avenue in Nairobi occupies a site measuring 40x20m 2.The
planning for the area allows a plot average of 80% and a plot ratio of 6.0. The parking is to be
done in the basement. Modern offices in the area let for shs 150 per m 2 per month with a service
charge of 10%. The car spaces rent for shs 500 per month, the provision being one car space for
every 20 m2 of office floor space. Current construction costs average shs 4,500 per m 2 and the
construction period would be 24 months.

Required:
Advice a prospective developer how much he should pay for the site if he expects a return of
15%.

Solution:
a) Gross development value
Office space(40*20*6) 4,800m2
Plot coverage 0.8
Lettable space @80% 3,840m2
Monthly rent@ shs 150/m 150 576,000
Rent for parking (3,840*500)/20 96,000
Total monthly rent 672,000
Deduct outgoing say@10% 67,200
Net monthly income 604,800
Annual income (604,800*12) 7,257,600
PVIFA15%,50 years 6.67
Total value when developed 48,408,192

38
b) Realization costs
Construction costs (4800+640m2) @ 4,500 24,480,000
Professional fees @ 10 % ( 24,480,000*10%) 2,448,000
26,928,000
Cost of capital (@18% for 12 months 4,847,040
Disposal costs (legal fees, commissions, etc) @10% of developed value
4,840,481
36,615,521
Developer’s profit at risk@15% 5,492,328
Total realization cost 42,107,849
Plot when developed ( 48,408192-42,107,849) 6,296,343
Defer by 2 years @15% to obtain present value 0.756
Present value of the plot 4,760,035
Note
The outgoings are calculated each at 10% only because part of the costs would be met from the
service charges of 10%.Without service charges outgoings would be higher. Interest on capital
used is taken for half the period of construction because cash is not released at once, but only in
stages as construction proceeds. Cost of disposal such as legal fees and letting or selling
commissions are based on the disposal value. The residual value of land will only be realized
after development and so the amount so obtained has to be converted to present values using the
PV tables

Depreciation
Depreciation has been defined as the difference between the market value of a property in its
actual condition and the market value of the hypothetical similar property developed with newly
constructed improvement( Mackay, 1968:77). When property losses value it is said to be subject
to depreciation and when it gains value it is subject to appreciation.
Causes of depreciation in a property
1) Physical deterioration resulting from gradual decay over the years of existence as well as
wear and tear imposed by use. The rate of depreciation depends on quality of construction,
materials, exposure to weather elements, manner of use and degree of maintenance,
2) Due to functional obsolescence because the building has not been designed or constructed in
accordance with current tastes and preferences of investors, and;

39
3) Due to economic obsolescence which may affect entire neighborhoods as well as individual
properties. Such factors include obnoxious development, legislative restrictions or
deterioration of community facilities.
4) Exhaustion of mine-Is a process of depreciation since the buildings, structures and plant must
be depreciated with reference to the life of the mine.
5) Government policies in form of legislation, fiscal or monetary policies affect values.

Calculating depreciation:
The following are some of the approaches in calculating depreciation:
(i) Straight line depreciation method
(ii) Constant percentage method
(iii) Sinking fund method
(iv)Annuity method
(v) Sum-of-the-year’s method
(vi)Quantity survey method/cost to cure/ observed condition method.

A real estate developer

A real estate developer is an individual or a firm that converts raw land into an operating
property by adding improvements such as buildings, roads, utilities, landscaping, etc to the land.
A developer may also be involved in rehabilitation or re-development project by which a
destroyed property is improved; an abandoned property is repaired and converted for better use.

The role of a real estate Developer

A developer is required to do the following
i) Carry out a market analysis to determine the desires and needs of potential consumers in
the area.
ii) Get approval from the local government planning body in order to ensure that the plans
conform to the applicable regulations: local laws, governing the conversion of raw land
into building sites e.g.
 Rights of way for streets with specific location
 Alignment
 Width etc
 Easements for utilities and disposal of wastes
 Reserved areas of public uses
40
  Minimum dimensions and building setback lines for lots and blocks
In Kenya land use is subdivided into urban and rural land. The land plan act Cap 303 of the laws
of Kenya is the main regulatory instrument on urban land use that puts urban land under
jurisdiction of the municipal towns and urban councils, while the land control act Cap 302 of the
laws of Kenya regulate the use of rural land. This act controls and regulates decisions pertaining
to land ownership and settlement policies in Kenya.

Approaches relating to Property Management

There are various approaches that relate to property management.
1. A firm that deals exclusively in property management is referred to as property management
firm. It specializes in providing management services to institutional and individual real
estate owners. Do we have any in Kenya?
2. The real estate brokerage firms with a department set up to manage property referred to as
full service real estate companies. These companies offer a full range of real estate services
e.g. buying and selling of real estate, performing appraisals, sub-dividing and development
etc
3. Use of a property manager – a property manager who has the responsibility of a specific
building is known as a site manager. A manager who lives at the property being mortgaged.
4. Resident manager-This manager performs the caretaker roles and oversees daily operation of
the property provides, a critical link between the tenant and the property (manager). The
property manager is a real estate professional who is hired to maintain the property and
ensure profitability of the owner’s investment.
Functions of the Property Manager
Property managers act for the owners because the owners do not want to be bothered with the
effort or they live at a distance or they are willing to pay because the property managers can do a
better job. The functions include
1. Generating income by sourcing and keeping tenants for the property owner
This involves
a) Promotion and advertising of rental units
b) Negotiating leases
c) Modifying facilities to meet the tenants needs
d) Acting as liaisons with tenants and handling complaints
e) Public relations
2. Providing financial controls, records and accounts
41
This involves:
a) Preparing management plans, financial analysis, budget and reports for owners
b) Controlling expenses
c) Rent collection
d) Payment of operating expenses and mortgage payments
e) Keeping records of receipts and disbursements
3. Preserving value of the property by providing upkeep and maintenance.
This involves
a) Hiring employees or securing outside services
b) Security and parking facilities
Interest in Lands
Property rights
The land which is not demarcated and registered in Kenya is governed by Trust Land Act
(Chapter 288 of Laws of Kenya) which vests such land in the county council as the trustee for
communities living in those areas.
The land which is registered is governed by several Acts of Parliament which determine the full
extent of ownership. Some of the most important Acts of parliament governing the ownership of
land in Kenya are:
1) The Indian Transfer of Property Act (ITPA)-Defines the various interests that exist and can
be held over land and the manner in which the interests may be created and transferred. Land
held under ITPA merely indicates what interest a person holds in land but when such a
person wishes to register such an interest in the land then he/she must register under RTA.
2) The Registration of Title Acts 1920 (RTA)-Involves the registration of title.
3) The Registered Land Act 1963 (RLA)- Covers land that has been adjudicated, demarcated
and registered from the trust land areas. Covers all land registration in Kenya. The people
who are registered as holders or owners of interest in land are issued with title deed or land
certificates.
Categories of interests in land
There are three main categories of interests in Kenya:
1) Estates
 Freehold interests-Highest form of landownership; the owner holds the land in
perpetuity without payment of any rent except the property tax.
 Leasehold interests-Lease for a given term subject to payment of annual rent and
observation on the restrictions given in the lease.
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 2) Encumbrances which are burdens on the title of a holder in land but in favour of some
people who initially did not hold interests in the given piece of land,
3) Servitudes-Are the rights that a person acquires over another person’s land .This interests
are difficult to value but often have a reducing effect on the value of land when compared
to similar land not affected.
 Easements,
 Profits,
 Restrictive covenants
Types Real Estate Property in Kenya
Registered land in Kenya may be used for various purposes under the following categories
i). Rural use-Farmland, Forestry, Mineral land
ii). Urban Use-Commercial, Industrial and Residential
iii). Special Purpose-Petrol station, hotel and restaurants, recreational facilities, halls and
places for assembly, institutional properties
Valuation of Commercial Property
This includes offices and shops, Industrial property and Residential property.
-Offices are considered the premier type of property investment due to the rental growth and
flexibility of use of the premise. Factor affecting investment in this area includes location, design
and lettable area. The factors that influence the quality of retail investment include the direction
and flow of pedestrian, availability and regularity of public transport, potential for expansion,
availability of parking ,Flexibility of the lease arrangement, design etc
-Residential Properties-As discussed earlier includes flats, Maisonnettes and bungalows. There is
a large deficit of demand for accommodation and this requires government intervention.
Valuation issues in relation to this include the location and accommodation facilities.
-Special Properties-
The Concept of Market Value
Value may be defined using two main classifications:
1) Utility value
It is the value to the owner-user, which includes the value of amenities attached to the property,
as in the case of the owner occupier.
2) Market value
It is the value in exchange, the value in which property can be sold or exchanged at a given price.
Market value of real property refers to the amount of money which can be obtained from an
interest at a particular time from persons able and willing to purchase having considered the
43
utlity and benefits they will derive from the interest. Market price results from the estimates of
value made by vendors and purchaser on the basis of previously paid for similar interests.

Non Specialized Property

The type of property that would be referred to as non-specialized are the dominant property types
of residential, offices, shops, industrial units and warehousing. These will be valued by wither
the investment or comparative methods or, in some markets by the Replacement Cost Approach.

Similarly whilst some valuation are carried out against the backdrop of a statutory or legal
framework. For example, properties being acquired by compulsory purchase will be valued in
accordance with acquisition laws in the acquiring country, yet the valuation methods
underpinning them will not differ simply because the acquisition is compulsory. Likewise, with
valuations for taxation. The general principal is that a property is either specialized or non-
specialized regardless of the reason for the valuation. It is the property type that determines
method, not the purpose of the valuation.

Specialized Property
The type of property that would be referred to as specialized are those properties where there is
insufficient market date to value them by some form of comparison. The assumption with all
valuations of specialized buildings is that they are to be valued on the assumption that the
existing use of the building will continue. On this basis, there are a number of assets that could
be described as specialized. These may be:

Agricultural Land Although, in its purest form, agricultural land can be valued by
comparison often the market is distorted by governmental policy and the
value of the land may relate to the payments that are made in the form of
grants and set-asides or quota allocations. As such, the value is
determined on an Accounts or Profits method.

Telecommunications This may incorporate a whole host of facilities. Aerial masts are
now so common that comparative valuations are now the norm. Whilst,
cabling, overhead wiring and relay or booster sites may, in the absence of
comparison, be valued by reference to their contribution to the business.
As such, their value is determined on an Accounts or Profits method.
44
Mineral Extraction This is a classic case of land as a factor of production. The land is the core
element of the business and as such the value of the land is based on the
likely profits arising from the extraction of the mineral(s) in the ground
relative to the costs of extraction. As such, the land value is determined
on an Accounts or Profits method. Alternatively, it is possible that a
Residual approach could be adopted, which is a simple variation on the
Accounts basis.

Land Fill As this is the reverse of the above, Mineral Extraction, then it follows that
the same thought process will apply. Except in this case, profits are
generated by what you can put into the ground not take out. Once again,
the land is core to the business and the appropriate method will be the
Accounts or Profits methods.

Bars and Restaurants In many countries, the sale of bars and restaurants has become
commonplace and as such there can be sufficient comparable information
available for it to be values by either the comparable or Investment
methods. However, in areas where there is a paucity of comparables, then
the valuer needs to resort to an analysis the likely profits arising from the
use of the building as a leisure business from the sale of food and drink.
As such, the property value is determined on an Accounts or Profits
method.

Casinos and Clubs Although both these concerns rely heavily on the sales of food and drink
as above, they also have other ways in which to generate income. In the
case of clubs, there will be an entry fee in addition to the services provided
in the club. In the case of casino, the income is generated through
gambling receipts. This is just a variation on a theme and the correct
valuation method will be the Accounts or Profits method.

Cinemas and Theatres A variation on the above. The facility charges an entry fee but in
addition derives a substantial amount of its revenue from the concessions

45
 stands through the sale of snack, sweets and drinks. Again, the correct
valuation method will be the Accounts or Profits method.
Hotels Another leisure property where the building is integral to the business.
The room charge is only one component to the revenue producing
potential of a hotel. Generally, the larger the hotel, the more variation in
the ways in which they generate income. They can offer food, drink and
entertainment. But many of them also offer conference facilities, health
clubs and swimming pools. All of which generate additional and often
substantial income. Once again the appropriate valuation method will be
the Accounts or Profits method.
Leisure Properties
(Private) An all encompassing heading to cover health clubs, Tennis courts,
swimming pools, football pitches, golf clubs, athletic clubs and the like.
Some of these are now sold sufficiently often to generate comparables
allowing them to be valued by either the Comparable or Investment
methods. But, as with hotels, it is more normal to view the property
associated with the business as an asset to generate income by changing a
market price (which may be high to reflect exclusivity) for its use and as
such the most common valuation method will be the Accounts or Profits
method.
Leisure Properties Most local or municipal authorities have a brief to provide leisure facilities
to the general facilities to the general public and generally at a subsidized
price. As such, they are non-profit making organizations and thus the use
of an Accounts or Profits method would be inappropriate. In these cases,
the only way in which value can be assessed is by reference to the
replacement cost of the building. And thus the Contractor’s or Cost
method should be used.

Care/Nursing Homes As with leisure properties there is a distinct split in the market
between private and public nursing homes. The former are values as
income generating properties by the Accounts or Profits method. The
latter, the public nursing/care homes, are non-profit organization and will
be valued by the Contractor’s or Cost method.

46
Hospitals Again we have a split between private and public hospitals. The former
are valued as income generating properties by the Accounts or Profits
method. The latter, the public hospitals, are non-profit organizations and
will be valued by the Contractor’s or Cost method.

Development Property Development property is on the cusp between specialized and non-
specialized property. Obviously, the end use of the competed
development may be either a specialized or non-specialized use and as
such the calculation of the completed development value might, in the
case of specialized property, rely upon a Profits or Contractor’s method.
However, the overall method adopted to determine the land/property value
in its existing state will be the Residual method.

Petrol Stations Petrol Stations are income-generating business and as such they are valued
by the Accounts or Profits method.

Woodlands As with Agricultural property, it is possible for woodland to be valued by

comparison. However, most woodland is an income-generating business
which benefits from grants and tax incentives and as such they tend to be
valued by the Accounts or Profits method.

Churches The majority of the churches are non-profit organizations and in most
countries is recognized as charitable institutions. As such, they will be
valued by the Contractor‘s or Cost method.

FINANCING RESIDENTIAL PROPERTIES

Financing can be a very important component of investing in real estate. In general, when
investors desire to obtain financing, they usually pledge, or hypothecate, their ownership of real
estate as a condition for obtaining loans. In many cases, investors also pledge personal property
to obtain loans. What follows is an introduction to notes and mortgages, two legal instruments
that are used frequently in real estate financing

47
A promissory note is a document which serves as evidence that debt exists between a borrower
and a lender and usually contains the terms under which the loan must be repaid and the rights
and responsibilities of both parties. Unless stated otherwise, the borrower is personally liable for
payment of all amounts due under the terms of the note. (These loans are said to be made “with
recourse” to the borrower.) While many loan provisions may be included, notes usually contain
at least the following:
1. The amount borrowed—this is generally the face amount of the note, which is usually
advanced in total when the loan agreement is executed. However, in cases involving construction
loans, amounts could be advanced as a construction progresses, not to exceed a maximum
amount.
2. The rate of interest—this could be a fixed rate of interest or an adjustable rate. If it is the
latter, exactly how the rate may be adjusted (changed) will be specified.
3. The dollar amount, due dates, and number of payments to be made by the borrower—(e.g.:
$500 per month due on the 1st of each month following the closing date for 300 consecutive
months).
4.The maturity date, at which time all remaining amounts due under the terms of the loan are to
be repaid.
5 Reference to the real estate serving as security for the loan as evidenced by a mortgage
document (to be discussed).
6. Application of payments, which are usually made first to cover any late charges/
fees/penalties, then to interest, and then to principal reduction.
7. Default—occurs when a borrower fails to perform one or more duties under the terms of the
note. Default usually occurs because of nonpayment of amounts due.
8. Penalties for late payment and forbearance provisions—the latter specifies any grace periods
during which late payments can be made up (usually with penalties) without the lender declaring
that the borrower is in default. The lender does not give up the right to declare that the borrower
is in default at some future date by allowing a grace, or forbearance, period. Forbearance is used
by lenders when they believe that borrowers will make up late payments. They allow time for
borrowers to make up such payments when they believe that benefits from this course of action
will exceed the time and the expense of declaring the loan in default and embarking on
foreclosure proceedings and, perhaps, forcing the sale of the property.
9. Provisions, if any, for unscheduled (early) payments or the full or partial prepayment of
outstanding balances when included, this is usually referred to as a “prepayment privilege.” It
allows borrowers to make early payments, or to repay the loan, in part or fully before maturity. If
48
allowable, the note will indicate whether future payments will be reduced or whether the loan
maturity date will be shortened. This provision is a privilege and not a right because the dollar
amount and number of payments to be made by the borrower are specified in (3). Aprepayment
provision is generally included in residential mortgage loans. However, when financing income-
producing properties, it may be highly restricted and require payment of a fee or penalty.
10. Notification of default and the acceleration clause in the event of past due payments, the
lender must notify the borrower that he or she is in default. The lender may then accelerate on the
note by demanding that all remaining amounts owed under the loan agreement be paid
immediately by the borrower.
11. Nonrecourse clause as quoted above, when a borrower executes a note, he is personally
liable, or the loan is made “with recourse.” This means that if he defaults on the loan, the lender
may bring legal action that may result in the sale of the borrower’s other assets (stocks, bonds,
other real estate) in order to satisfy all amounts past due under the terms of the note. In contrast,
the “nonrecourse clause” is a provision in the note whereby the lender agrees not to, or specifies
conditions under which it will not, hold the borrower personally liable in the event of a default.
In this case, the lender may only bring an action to force the sale of the property serving as
security for the loan. The borrower is released of personal liability. This clause is very important
to real estate investors and developers.
12. Loan assumability this clause indicates under what conditions, if any, a borrower will be
allowed to substitute another party in his place, who will then assume responsibility for
remaining loan payments. This could occur if the borrower wishes to sell a property to another
while allowing the new buyer to retain favorable financing terms that may have been previously
negotiated. Lenders who deny borrowers this right can do so by expressly prohibiting it and/or
by including a
“due on sale” clause which requires that all remaining amounts due be paid upon sale of, or
transfer of title to, the property. However, if the note provides that a new owner may assume the
loan, the lender usually requires that the credit of the new owner be equivalent to that of the
previous owner, or be acceptable to the lender. The note will also specify whether or not the
original borrower remains personally liable or is released from liability when the loan is assumed
by the new borrower.
13. The assignment clause giving the lender the right to sell the note to another party without
approval of the borrower.
14. Future advances provision under which the borrower may request additional funds up to
some maximum amount or maximum percentage of the current property value under the same
49
terms contained in the original loan agreement. These advances may be subject to an adjustment
in the rate of interest.
15. Release of lien by lender—lender agrees to release or extinguish its lien on the property when
the loan is fully repaid
Real Estate Markets
Real estate is a cyclical industry that is affected by both local and national economic conditions,
including: growth in population and employment, consumer spending, interest rates, and
inflation. While macroeconomic conditions are important factors affecting the overall state of
the real estate industry, local supply and demand conditions are by far the more important factors
affecting real estate markets.

A bank's commercial real estate and construction lending may be targeted to one or more of the
five primary real estate sectors namely;
a) Office
b) Retail
c) Industrial
d) Hospitality
e) Residential (multifamily and 1- to 4-family).
Each of these market sectors has its own characteristics.
Office Property
In the office sector, the demand for office space is highly dependent on white collar employment.
Office space expansion generally lags economic recoveries. Offices are the "flagship" investment
for many real estate owners. They tend to be, on average, the largest and highest profile property
type because of their typical location in downtown cores and sprawling suburban office parks. At
its most fundamental level, the demand for office space is tied to companies' requirement for
office workers, and the average space per office worker. The typical office worker is involved in
things like finance, accounting, insurance, real estate, services, management and administration.
As these "white-collar" jobs grow, there is greater demand for office space.
Returns from office properties can be highly variable because the market tends to be sensitive to
economic performance. One downside is that office buildings have high operating costs, so if
you lose a tenant it can have a substantial impact on the returns for the property. However, in
times of prosperity, offices tend to perform extremely well, because demand for space causes
rental rates to increase and an extended time period is required to build an office tower to relieve
the pressure on the market and rents.
50
Retail Sector
In the retail sector, the demand for retail space and the level of retail rents are affected by the
levels of employment and consumer confidence and spending. There is a wide variety of Retail
properties, ranging from large enclosed shopping malls to single tenant buildings in pedestrian
zones. At the present time, the Power Center format is in favor, with retailers occupying larger
premises than in the enclosed mall format, and having greater visibility and access from adjacent
roadways.

Many retail properties have an anchor, which is a large, well-known retailer that acts as a draw
to the center. An example of a well-known anchor is Wal-Mart. If a retail property has a food
store as an anchor, it is said to be food-anchored or grocery-anchored; such anchors would
typically enhance the fundamentals of a property and make it more desirable for investment.
Often, a retail center has one or more ancillary multi-bay buildings containing smaller tenants.
One of these small units is termed a commercial Retail unit (CRU).The demand for retail space
has many drivers. Among them are: location, visibility, population density, population growth
and relative income levels. From an economic perspective, retails tend to perform best in
growing economies and when retail sales growth is high. Returns from Retails tend to be more
stable than Offices, in part because retail leases are generally longer and retailers are less
inclined to relocate as compared to office tenants.
Industrial Sector
The industrial sector is most susceptible to the level of consumer spending, inventory levels,
defense spending, and the volume of exports. Industrials are often considered the "staple" of the
average real estate investor. Generally, they require smaller average investments, are less
management intensive and have lower operating costs than their office and retail counterparts.
There are varying types of industrials depending on the use of the building. For example,
buildings could be used for warehousing, manufacturing, research and development, or
distribution. Some industrials can even have partial or full office build-outs. Some important
factors to consider in an industrial property would be functionality (for example, ceiling height),
location relative to major transport routes (including rail or sea), building configuration, loading
and the degree of specialization in the space (such as whether it has cranes or freezers). For some
uses, the presence of outdoor or covered yard space is important.
Hospitality Sector

51
The hospitality sector is affected by the strength of the Kenyan shilling, consumer spending, the
price of air travel, and business conditions. A weak shilling induces foreign visitors to travel to
Kenya, while prompting Kenyan vacationers to remain in Kenya.
Multifamily Residential Sector
Finally, in the multifamily residential sector, the demand for apartments is heavily influenced by
the affordability of ownership housing, local employment conditions, and the vacancy of existing
inventory. Multi-family residential property generally delivers the most stable returns, because
no matter what the economic cycle, people always need a place to live. The result is that in
normal markets, residential occupancy tends to stay reasonably high. Another factor contributing
to the stability of residential property is that the loss of a single tenant has a minimal impact on
the bottom line, whereas if you lose a tenant in any other type of property the negative effects
can be much more significant. For most commercial property types, tenant leases are either net or
partially net, meaning that most operating expenses can be passed along to tenants. However,
residential properties typically do not have this attribute, meaning that the risk of increases in
building operating costs is borne by the property owner for the duration of the lease.

A positive aspect of residential properties is that in some countries, government-insured

financing is available. At the expense of a small premium, insured financing lowers the interest
rate on mortgages, thereby enhancing potential returns from the investment.
Population growth is a key factor for all sectors of the real estate industry because it influences
consumer spending and the demand for goods and services. It also influences central bank’s
appropriations and state funding for local infrastructure projects and other services directly
affecting real estate markets. Changing demographics, such as increases in the level of
immigrants or retirees, are also important factors affecting real estate markets.

Real estate is usually held as part of a larger portfolio, and is generally considered an alternative
investment class. Real estate fits well as part of a portfolio because it has several qualities that
can enhance the return of a larger portfolio, or reduce portfolio risk at the same level of return.
Benefits-some of the benefits of having real estate in your portfolio are as follows:
1. Diversification Value - The positive aspects of diversifying your portfolio in terms of asset
allocation are well documented. Real estate returns have relatively low correlations with
other asset classes (traditional investment vehicles such as stocks and bonds), which adds to
the diversification of your portfolio.

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2. Yield Enhancement - As part of a portfolio, real estate allows you to achieve higher returns
for a given level of portfolio risk. Similarly, by adding real estate to a portfolio you could
maintain your portfolio returns while decreasing risk.
3. Inflation Hedge - Real estate returns are directly linked to the rents that are received from
tenants. Some leases contain provisions for rent increases to be indexed to inflation. In other
cases, rental rates are increased whenever a lease term expires and the tenant is renewed.
Either way, real estate income tends to increase faster in inflationary environments, allowing
an investment to maintain its real returns.
4. Ability to Influence Performance - Real estate is a tangible asset. As a result, an investor can
do things to a property to increase its value or improve its performance. Examples of such
activities include: replacing a leaky roof, improving the exterior and re-tenanting the building
with higher quality tenants. An investor has a greater degree of control over the performance
of a real estate investment than other types of investments.
Other Considerations
Real estate also has some characteristics that require special consideration when making an
investment decision:
 Costly to Buy, Sell and Operate - For transactions in the private real estate market,
transaction costs are significant when compared to other investment classes. It is usually
more efficient to purchase larger real estate assets because you can spread the transaction
costs over a larger asset base. Real estate is also costly to operate because it is tangible and
requires ongoing maintenance.
 Requires Management - With some exceptions, real estate requires ongoing management at
two levels. First, you require property management to deal with the day-to-day operation of
the property. Second, you need strategic management of the property to consider the longer
term market position of the investment. Sometimes the management functions are combined
and handled by one group. Management comes at a cost; even if it is handled by the owner, it
will require time and resources.
 Difficult to Acquire - It can be a challenge to build a meaningful, diversified real estate
portfolio. Purchases need to be made in a variety of geographical locations and across asset
classes, which can be out of reach for many investors. You can, however, purchase units in a
private pool or a public security, and these units are typically backed by a diverse portfolio.
 Cyclical (Leasing Market) - Not unlike other asset classes, real estate is cyclical. Real estate
has two cycles: the leasing market cycle and the investment market cycle. The leasing market
consists of the market for space in real estate properties. As with most markets, conditions of
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 the leasing market are dictated by the supply side, which is the amount of space available (or,
vacancies), and the demand side, which is the amount of space required by tenants. If
demand for space increases, then vacancies will decrease, and the resulting scarcity of space
will cause an increase in market rents. Once rents reach economic levels, it becomes
profitable for developers to construct additional space so that supply can meet demand.
 Cyclical (Investment Market) - The real estate investment market moves in a different cycle
than the leasing market. On the demand side of the investment market are investors who have
capital to invest in real estate. The supply side consists of properties that are brought to
market by their owners. If the supply of capital seeking real estate investments is plentiful,
then property prices increase. As prices increase, additional properties are brought to market
to meet demand.
Although the leasing and investment market have independent cycles, one does tend to
influence the other. For instance, if the leasing market is in decline, then growth in rents
should decrease. Faced with decreasing rental growth, real estate investors might view real
estate prices as being too high and might therefore stop making additional purchases. If
capital seeking real estate decreases, then prices decrease to force equilibrium. Although
timing the market is not advisable, you should be aware of the stage of the market when you
are making your purchase and consider how the property will perform as it moves through
the cycles.
 Performance Measurement - In the private market there is no high quality benchmark to
which you can compare your portfolio results. Similarly, it is difficult to measure risk relative
to the market. Risk and return are easy to determine in the stock market but measuring real
estate performance is much more challenging.

Sources and Acquisition of Investment Property

Real estate markets in most countries are not as organized or efficient as markets for other, more
liquid investment instruments. Individual properties are unique to themselves and not directly
interchangeable, which presents a major challenge to an investor seeking to evaluate prices and
investment opportunities. For this reason, locating properties in which to invest can involve
substantial work and competition among investors’ .To purchase individual properties may be
highly variable depending on knowledge of availability. Information asymmetries are
commonplace in real estate markets. This increases transactional risk, but also provides many
opportunities for investors to obtain properties at bargain prices. Real estate investors typically

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 use a variety of appraisal techniques to determine the value of properties prior to purchase.
Typical sources of investment properties include:
 Market listings (through a Multiple Listing Service or Commercial Information Exchange)
 Real estate agents
 Wholesalers (such as bank real estate owned departments and public agencies)
 Public auction (foreclosure sales, estate sales, etc.)
 Private sales
Risks Associated With Real Estate Lending
The applicable risks associated with real estate and construction lending are: credit risk, interest
rate risk, liquidity risk, transaction risk, and compliance risk.
a) Credit Risk
Credit risk is the risk to earnings or capital arising from an obligor's failure to meet the terms of
any contract with the bank or otherwise fail to perform as agreed. Credit risk is found in all
activities where success depends on counterparty, issuer, or borrower performance. It arises any
time bank funds are extended, committed, invested, or otherwise exposed through actual or
implied contractual agreements, whether reflected on or off the balance sheet. Given the nature
of most commercial real estate markets, the financing of commercial real estate projects is
subject to an exceptionally high degree of credit risk. The limited supply of land at a given
commercially attractive location, the exceptionally long economic life of the assets, the very long
delivery time frames required for the development and construction of major projects, and high
interest rate sensitivity have given commercial real estate markets a long history of extreme
cyclical fluctuations and volatility. In the context of commercial real estate lending, the bank's
credit risk can be affected by one or more of the following risks that imperil the borrower:
i. A real estate project can expose the borrower to risk from competitive market factors,
such as when a property does not achieve lease-up according to plan. These competitive
market factors may have their origins in overly optimistic initial projections of demand,
or they may be increased by a slowing of demand during or shortly after the completion
of a project. Competitive market factors can be compounded by a high volume of
distressed property sales that can depress the value of other properties in that market.
Investors who buy distressed property can charge lower rents, luring tenants away from
competing properties and bidding rents down.
ii. Interest rate sensitivity of real estate investments is an important consideration when
lending to the real estate industry. From the borrower's perspective, interest rates affect
the cost and availability of financing, the cost of construction, and the financial viability
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 of a real estate project. Given the floating rate of most debt and the fixed rates on many
leases, increasing interest rates are detrimental to the future repayment capacity of most
real estate projects. Higher interest rates also reduce the market liquidity of real estate by
making alternative investments more attractive to investors. Some banks are requiring
their larger commercial real estate borrowers to hedge the interest rate risk in their
projects by entering into interest rate swaps or collars.
iii. Rollover of leases is another risk to the borrower that is present in most commercial real
estate projects. Real estate markets that feature five- and ten-year leases are particularly
vulnerable to declining values. In extremely depressed real estate markets, leases have
commonly been broken mid-contract, as tenants went out of business or simply
threatened to move out unless their leases were renegotiated. Similarly, competing
owners with large inventories of empty space have been known to buy-out existing leases
in order to attract tenants to their properties. The value of even fully leased buildings can
decline when leases must be rolled over or extended at lower, current market rates. As
expiring leases cause project cash flows to decline, the developer may become unable to
meet scheduled mortgage payments.
iv. Commercial real estate developers must consider and plan for the risks associated with
changes in their regulatory environment. Changes in zoning regulations, tax laws, and
environmental regulations are examples of local and federal regulations that have had a
significant effect on property values and the economic feasibility of existing and
proposed real estate projects. A developer faces construction risk that a project will not be
completed on time (or at all), or that building costs will exceed the budget and result in a
project that is not economically feasible.

b) Interest Rate Risk

Interest rate risk is the risk to earnings or capital arising from movements in interest rates. The
economic perspective focuses on the value of the bank in today's interest rate environment and
the sensitivity of that value to changes in interest rates. Interest rate risk arises from differences
between the timing of rate changes and the timing of cash flows (repricing risk); from changing
rate relationships among different yield curves affecting bank activities (basis risk); from
changing rate relationships across the spectrum of maturities (yield curve risk); and from
interest-related options embedded in bank products (options risk). The evaluation of interest rate
risk must consider the impact of complex, illiquid hedging strategies or products, and also the

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potential impact on fee income which is sensitive to changes in interest rates. In those situations
where trading is separately managed this refers to structural positions and not trading portfolios.
Most commercial real estate project financing done by banks is on a floating rate basis, so the
interest rate sensitivity for the lending bank is relatively low.
c) Liquidity Risk
Liquidity risk is the risk to earnings or capital arising from a bank's inability to meet its
obligations when they come due without incurring unacceptable losses. Liquidity risk includes
the inability to manage unplanned decreases or changes in funding sources. Liquidity risk also
arises from the bank's failure to recognize or address changes in market conditions that affect the
ability to liquidate assets quickly and with minimal loss in value. In the context of commercial
real estate project financing, liquidity risk is a function of the bank's ability to convert the book
value of its loan asset to cash. This conversion can be achieved by discounting the loan,
refinancing it with another lender, or selling the project to an investor. The market liquidity risk
associated with most commercial real estate project loans is high because the appraised value
that the bank is lending against is usually not achieved until the project is completed and reaches
a stabilized level of occupancy.
d) Transaction Risk
The risk to earnings or capital arising from problems with service or product delivery. This risk
is a function of internal controls, information systems, employee integrity, and operating
processes. Transaction risk exists in all products and services. Banks engaged in construction
lending need effective systems for monitoring the progress of construction and controlling the
disbursement of loan proceeds. Ineffective systems can introduce significant operational risks.
e) Compliance Risk –(Legislative and Environmental risk)
Compliance risk is the risk to earnings or capital arising from violations of, or non-conformance
with, laws, rules, regulations, prescribed practices, or ethical standards. Compliance risk also
arises in situations where the laws or rules governing certain bank products or activities of the
banks clients may be ambiguous or untested. This risk exposes the institution to fines, civil
money penalties, payment of damages, and the voiding of contracts. Compliance risk can lead to
a diminished reputation, reduced franchise value, limited business opportunities, lessened
expansion potential, and lack of contract enforceability. Banks engaged in commercial real estate
lending also expose themselves to what is commonly referred to as environmental risk.

Policies or procedures should be in place to protect the bank from liability for any environmental
hazards associated with real estate that it holds as collateral. Asbestos in commercial buildings,
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contaminated soil and underground water supplies, or use of the property to produce or store
toxic materials are only a few examples of environmental risk that may subject a bank to
potential liability.

Ideally, a bank should attempt to identify environmental risks before funding a loan or offering
any type of commitment to lend. If the bank discovers that it has already accepted contaminated
property as collateral, however, it should monitor the situation for any adverse effects on credit
risk. It should also take steps to minimize any potential liability to the bank. A bank should seek
the advice of environmental risk experts if it believes the environmental problems are serious.

Underwriting Standards (Due Diligence in Real Estate investment Risk Analysis)

A bank's lending policy should reflect the level of risk that is acceptable to its board of directors.
Clear and measurable underwriting standards should be included in the policy to guide the
lending staff when evaluating all of the credit factors associated with a loan, including:
(i) The capacity of the borrower, or income from the underlying property, to adequately
service principal and interest on the debt. Typically, banks will establish minimum
"debt service coverage" ratios the number of times net operating income will cover
annual debt service. While minimum ratio requirements will vary between banks and
by type of project, they usually fall within the range of 1.05 to 1.5.
(ii) The value of the mortgaged property,
(iii) The overall creditworthiness of the borrower, including the demands of supporting
other projects.
(iv) The "hard equity," in the form of cash or unencumbered equity in the property that is
required to be invested by the borrower.
(v) Whether, and to what extent, the bank will give any credit for appreciation in the value
of previously purchased land for purposes of its minimum equity requirements.
(vi) Any secondary sources of repayment.
(vii) Any additional collateral or credit enhancements (such as guarantees, mortgage
insurance or take-out commitments).
Finance Instruments
I. Promissory Notes
A promissory note is basic evidence of a borrower’s legal obligation to pay a debt. The debtor
(usually a buyer) is the maker of the note; the creditor (the lender) is the payee. The note will
specify the names of the parties, the amount of debt, the interest rate, and how and when the
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money will be repaid. The promissory notes used in real estate loans are negotiable, to facilitate
resale of the loans on the secondary market. A negotiable instrument is freely transferable by
the payee to a third party. If a promissory note is endorsed “without recourse,” the original payee
will not be liable if the maker fails to make payments to the third party. A third party purchaser
who buys a promissory note from a payee in good faith is known as a holder in due course

Types of notes
a) Straight note: required payments are interest only, with a balloon payment at the end of
the term
b) Installment note: payments include part of the principal as well as interest Promissory
notes.
II. Security Instruments
A security instrument makes the borrower’s property collateral for the loan and gives the lender
the right to foreclose in the event of default. Originally, under the theory of hypothecation, a
borrower would transfer title to the property as security for the duration of the loan term. Now, in
most jurisdictions, a mortgage simply creates a lien against the borrower’s property in favor of
the lender
Types of security instruments
Mortgage: a two-party security instrument where a borrower (the mortgagor) Mortgages his
property to the lender (the mortgagee). Deed of trust: a three-party security instrument between
the borrower (grantor) and the lender (beneficiary) where a third party (the trustee) holds the
power of sale
III. Foreclosure
A. Types of foreclosure
a) Judicial foreclosure:
A mortgagee files suit against a defaulting borrower, obtain judgment, and execute the judgment
against the property of the Mortgagor. The judgment may be levied against any of the mortgagor
property. The Mortgagee may ask the court to order the property sold at an auctioneer’s sale to
satisfy the unpaid debt.
b) Nonjudicial foreclosure:
With a deed of trust, the lender does not need to file a lawsuit in the event of default; the trustee
will arrange for the sale of the property through a trustee’s sale. The trustee will provide notice
of default to the borrower and then give notice of a trustee’s sale. In the period before the sale,
the borrower may reinstate the loan by paying the delinquent amount plus costs. A deed of trust
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borrower does not have the right of redemption; the lender is typically not able to receive a
deficiency judgment. When the property is sold at the trustee’s sale, title immediately passes to
the winning bidder
Alternatives to foreclosure
a) Loan workouts:
The borrower may convince the lender to arrange a repayment plan to pay off past due amounts;
alternatively, the borrower may try to convince the lender to modify the terms of the loan.
b) Deed in lieu of foreclosure:
The borrower can deed the property to the lender to satisfy the debt; if the property is worth less
than the amount owed, the borrower may be required to sign a promissory note for the
difference.
c) Short sale:
The borrower may obtain the lender’s consent to sell the home for what it will bring on the open
market (usually something “short” of the full amount owed); the lender receives the sale
proceeds and releases the borrower from the debt.
d) Obtaining lender consent:
The borrower may have to be at least 90 days behind on payments and prove financial hardship
by filling out an application and providing copies of bank statements, pay stubs, and bills
e) Income tax implications:
Unless they qualify for an exception, borrowers receiving a reduction of debt are liable for
income taxes on the debt relief

Finance Instrument Provisions

 Subordination clause: allows an instrument recorded later to take priority over an earlier
recorded instrument.
 Late charge provision: adds a late fee to overdue payments.
 Prepayment provision: may impose a penalty if the borrower repays some or all of the
principal before it is due, in order to compensate the lender for lost interest.
 Partial release clause: in a security instrument covering multiple parcels, provides for the
release of part of the security property when part of the debt has been paid.
 Acceleration clause: allows lender to declare the entire loan balance immediately due if the
borrower defaults.
 Alienation clause and assumption: “due on sale” clause limits the borrower’s right to
transfer the property without the lender’s permission unless the loan is paid off first.
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  If loan isn’t paid off, the new owner may take title subject to existing liens; the lender
will retain the power to foreclose on the property,
 Alternately, the new owner may assume the loan; the new owner will take on
responsibility for paying the loan while the former owner retains secondary liability,
 If the lender approves an assumption, it may charge an assumption fee or reset the
interest rate

V. Types of Real Estate Loans

a) Junior or senior mortgage: a senior mortgage has first lien position, while a junior
mortgage has lower lien priority
b) Purchase money mortgage: in its narrower sense, a mortgage that a buyer gives to a
seller in a seller-financed transaction.
c) Home equity loan: a loan using property that the borrower already owns as collateral
d) Refinance mortgage: a new mortgage used to replace an existing mortgage on the same
property, often used by borrowers when interest rates drop.
e) Bridge loan: a temporary loan used by buyers to purchase a new home before the sale of
their old home closes.
f) Budget mortgage: a mortgage where payments include not only principal and interest,
but also property taxes and hazard insurance.
g) Package mortgage: a mortgage that covers the purchase of both real property and
personal property (such as fixtures or equipment)
h) Blanket mortgage: a mortgage containing a partial release clause that uses multiple
properties as collateral,
i) Construction loan: a short-term loan used to finance construction of improvements on
land already owned by the borrower.
j) Nonrecourse mortgage: a mortgage that does not allow for a deficiency judgment
against the borrower; the lender’s only remedy is foreclosure.
k) Participation mortgage: a mortgage where the lender receives a percentage of earnings
generated by the property as well as interest payments.
l) Shared appreciation mortgage: a mortgage where a lender is entitled to a portion of
any increase in the property’s value,
m) Reverse equity mortgage: a mortgage where a lender makes monthly payments to a
homeowner (usually an older person); the home will typically be sold when the owner
dies in order to satisfy the debt
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Exercise one: Secured and unsecured creditors
Discussion Prompt: Harold borrowed sh 20,000 from Teresa and sh 20,000 from Ivan. For each
loan, he signed a promissory note, agreeing to repay the money on specified terms. Teresa also
required Harold to sign a mortgage, creating a lien in her favor against his house. Ivan didn’t do
that.

Required:
a) If Harold failed to pay Teresa, what legal recourse would she have? If Harold failed to
pay Ivan, what legal recourse would Ivan have?
b) Which creditor is in a better position, and why?

Exercise two: Foreclosure methods

Parched Gulch Bank holds a deed of trust on the Nguyens’ land. The Nguyens still owe sh
250,000 on the loan and have been in default on their payments for six months. Parched Gulch is
preparing to foreclose, but it estimates that the property will bring no more than sh 200,000 in a
foreclosure sale.

Required:
Should Parched Gulch pursue a judicial foreclosure or a nonjudicial foreclosure?

Exercise three: Buying land for development

Some developers are buying a 10-acre parcel of land. They’re planning to eventually subdivide it
into 20 lots, build a home on each one, and then sell the lots individually. When they borrow
money to buy the land, what two special provisions should the developers make sure are
included in the security instrument? Explain why each provision is needed.

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LONG TERM MORTGAGE LENDING
Interest Rates in Mortgage Lending
Pricing a loan refers to the rate of interest, fees and other terms that lenders offer and borrowers
are willing to accept when mortgage loans are made. Consideration is also made on the supply
and the demand for loan-able funds, the role of inflation and how they both affect the rate of
interest. Charges included apart from interest include loan discounts, origination fee, prepayment
penalties or prepaid interest.

A fixed-rate mortgage (FRM), often referred to as a "vanilla wafer" mortgage loan, is a fully
amortizing mortgage loan where the interest rate on the note remains the same through the term
of the loan, as opposed to loans where the interest rate may adjust or "float". As a result, payment
amounts and the duration of the loan are fixed and the person who is responsible for paying back
the loan benefits from a consistent, single payment and the ability to plan a budget based on this
fixed cost.

Determinants of the Mortgage Interest-Fixed Interest Mortgage

Most mortgage lenders are financial intermediaries and financial institutions that serve as
conduits of linking the flow of funds from savers to borrowers. Borrowers use the savings in the
form of mortgage credit. The market rate of interest on mortgage loans is established by what
borrowers are willing to pay for use of funds over a period of time and what lenders are willing
to accept in compensation for use of such funds.

On the demand side, the demand for mortgage is derived demand or determined by the demand
for housing which is also determined by the number of household requiring housing, household
income, size, age, tastes, preferences for other goods and interest rates that must be paid to
acquire mortgage credit. Therefore the demand for housing establishes the demand for mortgage
credit at various rates of interest.

On the supply side the interest is dependent on what lenders are willing to accept when providing
funds to borrowers. Supply is a function of the cost of attracting the funds from savers, the cost
of managing and originating loans, losses from loan default and fore-disclosure, in case of fixed

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interest rates loans, the potential losses due to unexpected changes in interest rates after loans are
made.
Other Factors Considered By Lenders
These factors include the returns and associated risk of loss on alternative investment in relation
to returns available on Mortgage. Hence Mortgage market is part of the larger capital market
where lenders and investors evaluate returns available on mortgages and all competing
investments e.g bonds, stocks and other alternatives and the relative risks associated with each.
Real Rate of Interest
This is the minimum rate of interest that must be earned by savers to induce them to divert the
use of resources (funds) from present consumption to future consumption.
Interest Rates and Inflation Expectation
Apart from the real rate of interests, investors are concerned on how inflation will affect
investment returns. This is of concern especially to investors and lender making or purchasing
loans made at fixed rates of interest over long periods of time. The interest rates must be
sufficiently high to compensate the purchasing power during the period the investment or loan is
outstanding.(Inflation expectation must be incorporated).

Illustration
Assume a Ksh.1,000,000 loan is made at a nominal interest or contractual interest rate of 10%,
with all principal and interest due at the end of one year. Assume the inflation rate is
6%.Compute the real interest on the Mortgage.
Future Value=1,000,000(1+.10)=1,100,000
Adjusted future values=1,100,000/(1+.06)=1037735.85
Real interest =1,037,735.85-1,000,000=(37,735.85/1,000,000)x100 =3.773585=3.8%
Therefore if the lender wants 3.8% real interest rate, the lender must charge a nominal rate of
10% to compensate for the changes in price levels due to inflation. The possibility that inflation
will be more or less is one of the many risks that lenders and investors must consider.

Default Risk
This is the risk that the borrower will default on payment of obligation (interest and principal)
which varies with the nature of loan and the credit worthiness of individual borrowers. Premium
is normally charged to cover for this possibility.
Interest Rate Risk

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 This is dependent on the uncertainty or the future supply of savings, demand for housing, and the
future levels of inflation. The uncertainty about what interest rate to charge when a loan is made
is referred to as interest rate risk. Inflation contributes a lot to this risk.
Prepayment Risk
If loans are prepaid when interest rates fall, lenders forgo the opportunity to earn interest income
that would have been earned at the original contract rate. As funds from prepaid loans are re-
invested by lenders, a lower rate of return (interest) will be earned. When interest rates increase,
the loan is not likely to be prepaid.
Other Risk
 Liquidity Risk-Ability to quickly turn an asset into cash
 Legislative risk-tax status, rent controls
Fixed interest mortgage is a loan that charges interest rates that do not change throughout the life
of the loan. It is the traditional loan used to finance the purchase of a home and what most people
have in mind when they think of a mortgage. Most home mortgages are 15-30 years fixed rate
mortgages with payments on monthly basis. The standard time value of money calculation for an
annuity is used to calculate the constant monthly payments.

Advantages of Fixed Rate Mortgage

i). Buyers can spread out the cost of paying for expensive purchase by making smaller, predictive
payments over the longer period of time. Because the interest rate does not change, homebuyers
are protected from sudden and potentially significant increases in monthly mortgage payments if
interest rates rise
ii). They are easy to understand since completed payment schedules and shifting interest rates are
avoided. The basic components of the loan are principal and interest are repaid on a monthly
basis
iii). Most fixed rate loans permit borrowers to make extra payments in order to shorten the term of
the loan or make lump-sum payments to retire the loan with no prepayment penalties.
iv). The fact that a fixed rate mortgage has a higher starting interest rate does not indicate that this is
a worse form of borrowing compared to the adjustable rate mortgages. If interest rates rise, the
ARM cost will be higher while the FRM will remain the same. In effect, the lender has agreed to
take the interest rate risk on a fixed-rate loan.

Disadvantage of FRM’s

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 i. Qualifying for loan is more difficult because the payments are less affordable than those
offered by other loans. This is especially so when interest rates are high, although the fixed
mortgage charge interest rates that are slightly higher than the rates available on other types
of loans, even when interest rates are low. Higher interest rates enable borrowers to get
predicted payments, but reduce the amount of money that a would be homeowner can quality
to borrow, thus limiting the prices of homes that can be considered.
ii. The fixed interest mortgage present a problem to lenders since interest remains fixed on the
date of origination until the loan is repaid. Therefore lenders must consider the real rate of
interest; the risk premium and premium from inflation from the onset since under estimation
will lead to a financial loss and vice versa.
iii. Fixed rate mortgages are usually more expensive than adjustable rate mortgages. Due to the
inherent interest rate risk, long-term fixed rate loans will tend to be at a higher interest rate
than short-term loans. The relationship between interest rates for short and long-term loans is
represented by the yield curve, which generally slopes upward (longer terms are more
expensive). The opposite circumstance is known as an inverted yield curve and occurs less
often.
When to Choose a Fixed Rate Loan
FRM is recommended for people who have a steady source of income and intends to own their
home for an extended period of time. The simplicity and predictability of fixed rate mortgage
make them popular choice for a first time home buyer.

Adjustable Rate of Mortgage (ARM’s) or Variable Rate Mortgage

A variable-rate mortgage, adjustable-rate mortgage (ARM), or tracker mortgage is a
mortgage loan with the interest rate on the note periodically adjusted based on an index which
reflects the cost to the lender of borrowing on the credit markets. The loan may be offered at the
lender's standard variable rate/base rate. There may be a direct and legally-defined link to the
underlying index, but where the lender offers no specific link to the underlying market or index
the rate can be changed at the lender's discretion. The term "variable-rate mortgage" is most
common outside the United States, whilst in the United States, "adjustable-rate mortgage" is
most common, and implies a mortgage regulated by the Federal government with caps on
charges. In many countries, adjustable rate mortgages are the norm, and in such places, may
simply be referred to as mortgages.

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It is a loan in which the rate of interest is subject to change from time to time. When such a
change occurs monthly payments are adjusted to reflect on the new interest rates. Over a long
period interest rates generally increases. An increase of interest rates will cause the monthly
payment on a variable rate to move higher. It provides for variable payment which change with
the economic conditions. Lenders and borrower share the risk of interest rate or interest rate risk.
This enables lenders and borrowers to match changes in interest costs and changes in the revenue
more effectively. Adjustable rates transfer part of the interest rate risk from the lender to the
borrower. They can be used where unpredictable interest rates make fixed rate loans difficult to
obtain. The borrower benefits if the interest rate falls but loses if the interest rate increases. The
borrower benefits from reduced margins to the underlying cost of borrowing compared to fixed
or capped rate mortgages.

Features of ARM’s
The most important basic features of ARMs are
1. Initial interest rate. This is the beginning interest rate on an ARM.
2. The adjustment period. This is the length of time that the interest rate or loan period on an
ARM is scheduled to remain unchanged. The rate is reset at the end of this period, and the
monthly loan payment is recalculated.
3. The index rate. Most lenders tie ARM interest rates changes to changes in an index rate.
Lenders base ARM rates on a variety of indices, the most common being rates on one-,
three-, or five-year Treasury securities. Another common index is the national or regional
average cost of funds to savings and loan associations.
4. The margin. This is the percentage points that lenders add to the index rate to determine the
ARM's interest rate.
5. Interest rate caps. These are the limits on how much the interest rate or the monthly
payment can be changed at the end of each adjustment period or over the life of the loan.
6. Initial discounts. These are interest rate concessions, often used as promotional aids, offered
the first year or more of a loan. They reduce the interest rate below the prevailing rate (the
index plus the margin).
7. Negative amortization. This means the mortgage balance is increasing. This occurs
whenever the monthly mortgage payments are not large enough to pay all the interest due on
the mortgage. This may be caused when the payment cap contained in the ARM is low
enough such that the principal plus interest payment is greater than the payment cap.

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 8. Conversion. The agreement with the lender may have a clause that allows the buyer to
convert the ARM to a fixed-rate mortgage at designated times.
9. Prepayment. Some agreements may require the buyer to pay special fees or penalties if the
ARM is paid off early. Prepayment terms are sometimes negotiable
Reasons for ARM
ARMs generally permit borrowers to lower their initial payments if they are willing to assume
the risk of interest rate changes. In many countries, banks or similar financial institutions are the
primary originators of mortgages. For banks that are funded from customer deposits, the
customer deposits will typically have much shorter terms than residential mortgages. If a bank
were to offer large volumes of mortgages at fixed rates but to derive most of its funding from
deposits (or other short-term sources of funds), the bank would have an asset-liability mismatch:
in this case, it would be running the risk that the interest income from its mortgage portfolio
would be less than it needed to pay its depositors. Banking regulators pay close attention to asset-
liability mismatches to avoid such problems, and place tight restrictions on the amount of long-
term fixed-rate mortgages that banks may hold (in relation to their other assets). To reduce this
risk, many mortgage originators will sell many of their mortgages, particularly the mortgages
with fixed rates.
Advantages ARM’s
i). ARM have a lower initial interest rates than the fixed interest mortgage resulting in lower interest
at the initial stage but cumulatively this rate is high depending on the available interest risks
exposure.
ii). Qualifying for a variable rate loan tends to be easier than for a fixed rate mortgage because the
initial payments are affordable. This is particularly so when interest rates are high because lower
payments enable buyers afford more expensive homes.
iii). ARM’s have a set period of time during which interest rates are lower than the FMR. This is
commonly referred to as a teaser or introductory rate. After this period the interest will be based
on the prevailing market interest rate. Such flexibility enables buyers to account such as bonus
payments, expected inheritances and economic environment where interest rates are falling, in
which case the interest rates and monthly mortgage payments can actually decline over
time.AMR also provide lower monthly payments for people who do not expect to live in a home
for more than a certain number of years and those who expect to be able to pay off their
mortgages rapidly.
iv). ARM are more flexible than the FRM enabling buyers to choose terms that provide a lower
initial payment for periods ranging anywhere from one month to 10 years
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 v). Some studies have shown that the majority of borrowers with adjustable rate mortgages save
money in the long term, but that some borrowers pay more. The price of potentially saving
money, in other words, is balanced by the risk of potentially higher costs. In each case, a choice
would need to be made based upon the loan term, the current interest rate, and the likelihood that
the rate will increase or decrease during the life of the loan.
Disadvantages
i). The risk to a homebuyer under ARM is payment shock which happen with interest rate increases.
ii). The ARM is significantly difficult to calculate. The rates are available in a variety of terms and
choosing the appropriate loan can be a challenge. Costs are not easily comparable, interest varies
significantly by lender. After a grace period interest rate change significantly.
iii). The loans have complex terms including penalties for loan prepayment and excessive fees for
refinancing.
iv). The loan come with complex terminology which the borrower need to understand. Sampled
examples include:-
-Index is the interest rate series agreed on by the borrower and the lender over which the lender
ha control(e.g Interest rate on 1 year Treasury security index, The average cost of funds index
and The London interbank offered rate(LIBOR)
-Adjustment Frequency which refers to the frequency of time between interest rate adjustments.
-Adjustment Indexes which helps borrower gauge the amount expected interest rate change
-Margin which helps borrower understand the relationship between their loan rates and the
underlying benchmarks used to set the rates
-Ceiling is the maximum interest rate after all the increases.
-Teaser rate. When the actual rate is very low compared to the expected rate an indication that
lenders are competing and are willing to offer lower rates initially.
-Reset date. Period in time when mortgage payments will be adjusted. E.tc
When to choose a AMR
Variable rate loans are generally recommended for people who anticipate declining interest rates,
only plans to live in a particular home for a limited number of years, or anticipate being able to
pay off their mortgage before interest rate adjustment period.
Fixed Rate Vs Adjustable
Which type do lenders prefer?
ARM’s which passes interest rate risk on to the borrower.
Which type do Borrowers prefer?

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Fixed rate which has lower interest risk. If rates rise, borrower is locked in at a lower rate. If
rates fall there is an option of refinancing.

GOVERNMENT RULES AND TAX RULES

Definitions:
Tax is a compulsory financial contribution imposed legally by a government to raise revenue.
Property tax is a tax levied on real property. Real Property includes real estate, buildings,
and anything permanently attached, such as elevators and air conditioners.
Generally, tax regimes operate on the basis of two principles:
A. Ability-to-Pay principle- This presents a case against person withholding taxes due. It
is held that people should be taxed according to their ability to pay, regardless of the
benefits they receive. Firstly, societies are not always able to measure benefits derived from
government spending. Secondly, it is assumed that persons with higher incomes suffer less
discomfort paying taxes.

B. Benefit Principle- is based on two ideas. First, those who benefit from government
services should be the ones to pay for them. Second, people should pay taxes in proportion
to the amount of services or benefits they receive.
Tax systems operate under the principles of Equity, Simplicity and efficiency.

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Taxes affecting Real Estate developers in Kenya

1.0 Land Transaction Costs

Land tenure is the name given, particularly in common law systems, to the legal
regime in which land is owned by an individual, who is said to “hold” the land.

Over history, many different forms of land ownership, i.e., ways of owning land have been
established. This part concentrates on the costs incurred from Land Acquisition up to the
time the Land Title is registered in the name of the Project/The Developer.

In a Joint Venture Agreement, a Company formed between the Land Owner and the
Financier can carry the title of “The Developer”. It is possible for the name of an
apartment to be the same as that of The Developer especially in a Joint Venture
Agreement.

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 a) Land acquisition
Stamp Duty – A tax levied on the value of the land transaction.
 4%- Within municipality
 2%- Outside municipality
b) Surveyors Fees
To clearly establish the boundaries before land is registered
 Option 1: Government Surveyor- Kshs.2,450.00 per plot
 Option 2: Private Registered Surveyor- Kshs. 15,000+ per plot
c) Conveyancing- Transferring land ownership from the seller to the buyer.
Conveyancing Fees are levied at rate of Kshs. 1,250 per lease.
d) Title Registration Costs
e) Registrative Cost is levied as a charge for the services offered by government in
registering the land under new ownership/ processing fees. This is levied at Kshs.
250 per lease. Once The Developer has acquired the Land, it can proceed to the next
phase of engaging Consultants to do the design, Documentation and Tendering.

Consultancy Fees/Costs
A consultant (from the Latin consultare means “to discuss” from which we also derive
words such as consul and counsel) is a professional who provides advice in a particular
area of expertise such as project management, Architecture, the environment,tax law,
economics, engineering etc A consultant is usually an expert or a professional in a specific
field and has a wide knowledge of the subject matter. A consultant usually works for a
consultancy firm or is self-employed, and engages with multiple and changing clients.
Thus, clients have access to deeper levels of expertise than would be feasible for them to
retain in-house, and may purchase only as much service from the outside consultant as
desired.

Developers have to meet the cost of Consultants whom he consults in packaging his project.
Various professions are governed by various Acts of Parliament or Prescribed Professional
Fees. However, it is worthwhile to note that those provisions are only for the chargeable

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minimum and may be revised upwards from time to time by the Consultant.

Real estate appraisal

Real estate appraisal, property valuation or land valuation is the process of valuing real
property. The value usually sought is the property's Market Value. Appraisals are needed
because compared to, say, corporate stock, real estate transactions occur very infrequently.
Not only that, but every property is different from the next, a factor that doesn't affect assets
like corporate stock.
Furthermore, all properties differ from each other in their location - which is an important
factor in their value. So a centralized Walrasian auction setting can't exist for the trading of
property assets, such as exists to trade corporate stock (i.e. a stock market/exchange). This

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 product differentiation and lack of frequent trading, unlike stocks, means that specialist
qualified appraisers are needed to advise on the value of a property. The appraiser usually
provides a written report on this value to his or her client. These reports are used as the basis
for mortgage loans, for settling estates and divorces, for tax matters, and so on. Sometimes
the appraisal report is used by both parties to set the sale price of the property appraised.

In most countries or regions appraisals are done by a licensed or certified appraiser (in many
countries known as a Property Valuer or Land Valuer and in British English as a "valuation
surveyor"). If the appraiser's opinion is based on Market Value, then it must also be based on
the Highest and Best Use of the real property. For mortgage valuations of improved
residential property in the US, the appraisal is most often reported on a standardized form,
such as the Uniform Residential Appraisal Report.[1] Appraisals of more complex property
(e.g. -- income producing, raw land) are usually reported in a narrative appraisal report.

Types of value
There are several types and definitions of value sought by a real estate appraisal. Some of
the most common are:
a) Market value – The price at which an asset would trade in a competitive Walrasian
auction setting. Market value is usually interchangeable with open market value or fair
value.
International Valuation Standards (IVS) defines it as the estimated amount for which an
asset or liability should exchange on the valuation date between a willing buyer and a
willing seller in an arm's length transaction, after proper marketing and where the parties
had each acted knowledgeably, prudently and without compulsion.
b) Value-in-use, or use value– The net present value (NPV) of a cash flow that an asset
generates for a specific owner under a specific use. Value-in-use is the value to one
particular user, and may be above or below the market value of a property.
c) Investment value - is the value to one particular investor, and may or may not be higher
than the market value of a property. Differences between the investment value of an asset
and its market value provide the motivation for buyers or sellers to enter the marketplace.
d) Insurable value - is the value of real property covered by an insurance policy. Generally it

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 does not include the site value.
e) Liquidation value - may be analyzed as either a forced liquidation or an orderly liquidation
and is a commonly sought standard of value in bankruptcy proceedings. It assumes a seller
who is compelled to sell after an exposure period which is less than the market-normal time-
frame.

Price Versus Value

There can be differences between what the property is really worth (Market Value) and what it
cost to buy it (Price). A price paid might not represent that property's market value.
Sometimes, special considerations may have been present, such as a special relationship
between the buyer and the seller where one party had control or significant influence over the
other party. In other cases, the transaction may have been just one of several properties sold or
traded between two parties. In such cases, the price paid for any particular piece isn't its
market ‘value’ but rather its market 'price'.

At other times, a buyer may willingly pay a premium price, above the generally-accepted
market value, if his subjective valuation of the property (its investment value for him) was
higher than the Market Value. One specific example of this is an owner of a neighboring
property who, by combining his own property with the subject property, could obtain
economies-of-scale. Similar situations sometimes happen in corporate finance. For example,
this can occur when a merger or acquisition happens at a price which is higher than the value
represented by the price of the underlying stock. The usual explanation for these types of
mergers and acquisitions is that 'the sum is greater than its parts', since full ownership of a
company provides full control of it. This is something that purchasers will sometimes pay a
high price for. This situation can happen in real estate purchases too.

But the most common reason why the value can be different than the price paid, is that one
of the two parties (buyer or the seller) is uninformed as to what a property's market value is,
but nevertheless agrees to buy or sell it at a certain price which is too expensive, or too
cheap. This is unfortunate for one of the two parties. It is the obligation of a Real Property
Appraiser to estimate the true 'market value' of specific real property and not its 'market

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 price'.

Risk Analysis
Business Risk
Real estate investors are in the business of renting space. They incur the business risk of
loss due to fluctuations in economic activity that affect the variability of income produced by
the property. Changes in economic conditions often affect some properties more than others
depending on the type of property, its location, and any existing leases. Many regions of the
country and locations within cities experience differences in the rate of growth due to
changes in demand, population changes, and so on. Those properties that are affected to a
greater degree than others are therefore riskier. A property with a well-diversified tenant
mix likely to be less subject to business risk. Similarly, properties with leases that provide
the owner with protection against unexpected changes in expenses (e.g., with expense
stops in the lease) have less business risk.
Financial Risk
The use of debt financing (referred to as financial leverage) magnifies the business risk.
Financial risk increases as the amount of debt on a real estate investment is increased.
The degree of financial risk also depends on the cost and structure of the debt. For example,
a loan that gives the lender a participation in any appreciation in the value of the property in
exchange for lower monthly payments may have less financial risk.
Liquidity Risk
This risk occurs when a continuous market with many buyers and sellers and frequent
transactions is not available. The more difficult an investment is to liquidate, the greater the
risk that a price concession may have to be given to a buyer should the seller have to
dispose of the investment quickly. Real estate has a relatively high degree of liquidity risk. It
can take from six months to a year or more to sell real estate income properties, especially
during periods of weak demand for investment real estate such as occurred during the early
1990s. Special-purpose properties tend to have much more liquidity risk than properties that
can easily be adapted to alternative uses.
Inflation Risk
Unexpected inflation can reduce an investor’s rate of return if the income from the
investment does not increase sufficiently to offset the impact of inflation, thereby reducing
the real value of the investment. Some investments are more favorably or adversely
affected by inflation than others. Despite inflation risk, real estate has historically done well
during periods of inflation. This might be attributed to the use of leases that allow the NOI to
adjust with unexpected changes in inflation. Furthermore, the replacement cost of real
estate tends to increase with inflation. During periods of high vacancy rates, however, when
the demand for space is weak and new construction is not feasible, the income from real
estate does not tend to increase with unexpected inflation.
Management Risk
Most real estate investments require management to keep the space leased and maintained
to preserve the value of the investment. The rate of return that the investor earns can
depend on the competency of the management, known as management risk. This risk is
based on the capability of management and its ability to innovate, respond to competitive
conditions, and operate the business activity efficiently. Some properties require a higher
level of management expertise than others. For example, regional malls require continuous
marketing of the mall and leasing of space to keep a viable mix of tenants that draws
customers to the mall.
Interest Rate Risk
Changes in interest rates will affect the price of all securities and investments. Depending on
the relative maturity (short-term versus long-term investments), however, some investment
prices will respond more than others, thereby increasing the potential for loss or gain, that
is, the interest rate risk. Real estate tends to be highly leveraged, and thus the rate of return

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earned by equity investors can be affected by changes in interest rates. Even if an existing
investor has a fixed-rate mortgage or no mortgage, an increase in the level of interest rates
may lower the price that a subsequent buyer is willing to pay. Furthermore,yield rates that
investors require for real estate tend to move with the overall level of interest rates in the
economy.
Legislative Risk
Real estate is subject to numerous regulations such as tax laws, rent control, zoning, and
other restrictions imposed by government. Legislative risk results from the fact that changes
in regulations can adversely affect the profitability of the investment. Some state and local
governments have more restrictive legislation than others especially for new development.
Environmental Risk
The value of real estate is often affected by changes in its environment or sudden
awareness that the existing environment is potentially hazardous. For example, while it used
to be common to use asbestos to insulate buildings, asbestos in buildings is now perceived
as a potential health hazard. A property may also become contaminated by toxic waste that
has been spilled or previously buried on the site or an adjacent site. Environmental risk can
cause more of a loss than the other risks mentioned because the investor can be subject to
cleanup costs that far exceed the value of the property. In the final analysis, a prospective
investor in a specific real estate project must estimate and compute an expected return on
the project and compare that return with expected returns on other specific real estate
investments as well as all other investments. Any risk differentials must be carefully
considered relative to any risk premium, or difference in expected returns, in all such
comparisons. Investors must then make the final judgment as to whether an investment is
justified.
Due Diligence in Real Estate Investment Risk Analysis
The term due diligence is used in the real estate investment community to describe the
investigation that an investor should undertake when considering the acquisition of a
property. Although this process should be followed by any investor, it is particularly
important when a firm is making investments on behalf of other investors. Essentially, due
diligence is the process of discovering information needed to assess whether or not
investment risk is suitable given a set of investment objectives. In most cases, a prospective
investor will insist that any risks discovered in the due diligence process must be remedied
by the current property owner as a condition of sale.
Sensitivity Analysis
We have discussed various types of risk that must be considered when evaluating different
investment alternatives. Unfortunately, it is not easy to measure the riskiness of an
investment. There are different ways of measuring risk, depending on the degree and
manner in which the analyst attempts to quantify the risk. The performance of some
properties will be more sensitive to unexpected changes in market conditions than that of
other properties. For example, the effect of unexpected inflation on the net operating
income for a property is affected by lease provisions such as expense stops and CPI
adjustments. A property that is located in an area that has limited land available for new
development is likely to be less sensitive to the risk that vacancy rates will increase as a
result of overbuilding.
One of the most straightforward ways of analyzing risk is to perform a sensitivity analysis, or
a what-if analysis, of the property. This involves changing one or more of the key
assumptions for which there is uncertainty to see how sensitive the investment performance
of the property is to changes in that assumption. Assumptions that are typically examined in
a sensitivity analysis include the expected market rental rate, vacancy rates, operating
expenses, and the expected resale price.

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