What you need to know:
- In recent years, the business has gone on a huge real estate investment spree.
- Economic growth does not necessarily translate into household incomes and consumption growth.
About two years ago, I was having a locker room conversation with a friend who had asked me what I thought of Nairobi’s shopping mall construction boom.
I was explaining to him the economic problem of investment when someone across the room interjected with a stream of invectives.
He dismissed my negative sentiments and asserted that investors were smarter than my theoretical economics.
There is an interesting backstory to this conversation.
The angry gentleman is a senior executive with one of my clients.
Twenty years ago, in the run-up to the 1997 General Election, the company had come up with an aggressive business plan, predicated on the economic trajectory.
My prognosis, on the other hand, was that the next few years would be challenging. My advice had been to brace for hard times.
The leaders of the business listened, shelved their ambitious plans and survived the post-1997 election recession.
This episode has been recounted in virtually every strategy workshop that I have participated in.
In recent years, the business has gone on a huge real estate investment spree.
My suspicion as to why the gentleman came out guns blazing was that he did not want to contemplate the possibility that they may be caught out in a property glut.
The economic problem of investment I was explaining before the rude interruption is perhaps best appreciated by contrasting investment with consumption. Consumers are creatures of habit.
They tend to do the same shopping every week.
They buy clothes occasionally, travel a few times a year, buy a consumer durable (fridge, TV, car) every other year, and so on.
The spending of a single consumer, no matter how wealthy and extravagant, can only be an infinitely small fraction of the total consumer spending.
For these reasons, total consumer spending tends to be a “well-behaved” component of the economy.
That is, it is a stable, predictable variable.
Investment is a different animal altogether.
An enterprising visitor to a remote sleepy village notices that her hosts travel a long distance to mill their grains.
After a couple of conversations, she is convinced that there is an opportunity.
The reason why there is no mill is that the market is small, but she happens to know of plans to tarmac the road passing by the village.
She calculates that while business will be slow at first, once the road works started, the business will thrive.
She does not tell anyone. She takes out a sacco loan and buys a mill.
Unbeknown to her, two other members of her visiting group were privy to the same information, and have the same idea.
All of a sudden, a market that could not support one posho mill gets three at a go.
It gets worse. The government runs into financial trouble and plans to tarmac the road are shelved.
During the construction of the mills, the village will experience a small economic boom.
Young people will get jobs. The villagers cannot believe their luck.
When the mills open, the cost of milling their grain comes down dramatically, and of course, they no longer have to pay transport to take their grain for milling 10 kilometres away.
But six months down the road, the investors have ran out of working capital and they now know that the road will not be build.
They all close shop. Life in the village returns to normal.
This is the “bad behaviour” of investment that I was explaining to my friend in the locker room.
Investment is the source of most of the boom and bust cycles that we experience in the economy.
And so it is that I now have three shopping malls within walking distance, two spanking new ones and an old one that is about to double in size.
Fired up by the “Africa Rising” narrative and the attendant stories of Africa’s rapidly expanding middle class, property investors saw a market for acres and acres of upmarket retail space.
As a person who spends a lot of time with economic data, I have been rather intrigued by this theory for four reasons.
First, economic growth does not necessarily translate into household incomes and consumption growth.
In neighbouring Ethiopia, for instance, investment is approaching 40 per cent of GDP (ours is 21 per cent).
This means that the rapid growth is largely investment-driven and the consumer purchasing power may in fact not be growing by much.
In our own case, we have been told ad infinitum that the Standard Gauge Railway will boost growth by 1.5 per cent during its construction.
One-and-a-half percentage points works out to a quarter of the growth during the period.
How many households has this growth added to the middle class?
It is as if our posho mill investors in the village, presented with statistics showing the “booming” village economy, decide to set up a grocery shop as well, without realising that they are the cause of the boom in the statistics.
It is, so to speak, a case of investors chasing their own tails.
Second, even if the middle class is expanding rapidly, the base is extremely small.
Kenya’s middle class is one of the biggest, in both absolute and relative terms.
The number of high and upper middle income households the high-end malls are targeting is in the order of 100,000.
Over 90 per cent of them are in Nairobi. In a high-income country, this would be the consumer base of a city of half a million people.
It is difficult to see a city of that size that can support the scale of retail infrastructure that has popped up in Nairobi almost overnight.
Third, consumption behaviour is slow to change.
The presumption that rising incomes will activate western consumer lifestyles overnight is a tenuous one.
From buying clothes from their friends to their nyama choma rituals at Njuguna’s and other masandukuni, well-to-do Kenyans are a notoriously difficult bunch to pigeonhole, and I suspect the same goes in other African countries.
Fourth, smart investors ought to know that boom times is not the best time to make long-term investments.
The prices of everything, from land to transport to construction material, are usually inflated (which, for commodity-dependent economies, is why there is a boom in the first place).
Many of the investment hotspots — Nigeria, Angola, Zambia — are primary commodity exporters.
The commodity-fuelled investment booms have since come to an abrupt end, and not for the first time.
Did our well-heeled investors, with all their highly paid analysts, fall into the same trap as our posho mill entrepreneurs?
The answer is probably yes. Conventional investment tools, such as estimating the net present value, payback periods and internal rates of return, are not very helpful when it comes to this type of investment decision.
They are useful for choosing among competing investment projects. But investment decisions entail two other headaches, namely uncertainty and irreversibility.
Uncertainty elements relate to not knowing what the competition is up to and how the market will evolve.
When an investor identifies a potential opportunity, he has to consider whether to be the first mover, or wait and see how the market evolves.
First movers can lock potential competitors out of the market but on the other hand, they can be stranded with bad investments, like our posho mill entrepreneurs.
Irreversibility has to do with sunk costs and asset specificity.
Think cement factory. It can only be huge and expensive, takes forever to build and cannot be converted to any other purpose if the anticipated demand for cement fails to materialise.
A few years ago, Kenya Airways thought it would corner the African market and expanded its fleet willy-nilly.
Fortunately for Kenya Airways, aircraft, unlike a cement plant, are a reversible investment — they can be sold or leased out to other airlines.
The key decision that investors face is whether to take the plunge now or wait and see how things evolve.
Consider our ill-fated posho mill entrepreneurs. The key uncertainty was whether the road was going to be built or not.
The question is whether to invest now or to wait and know for sure whether the road will be built.
Suppose a posho mill investment costs Sh1 million.
Suppose further that if the road is built, it will generate Sh5 million over its life.
If the road is not built, it will only generate Sh2 million.
Assuming a 10 per cent discount rate (the discount rate, which is the interest rate in reverse, helps us to give future income a current value), the value of the project if the road is built, less the initial investment, works out to Sh2.5 million today.
If the road is not built, the project is worth Sh0.6 million today.
The difference between the two is the value of certainty as to whether the road will be built or not. It works out to Sh1.9 million.
In the economic theory of investment, we call this value the “option value of waiting”.
It is higher the more uncertain the prospects of an investment and the higher the potential sunk costs.
Although the real options theory of investment as it is called has been around for close to four decades, it has yet to filter into investment analysis practice.
I read in the newspaper the other day the confession of one shopping mall investor that they estimated the size of Nairobi’s middle class by hiring a plane to fly over the city and count the number of satellite TV dishes.
I should hope they did not make a billion shilling investment on the basis of that data, but I would not be at all surprised if they did.