Infrastructure projects and private financing drive the construction sector in Kenya

Kenya’s stand-out economic performance in a global environment of low growth is due, in part at least, to a vibrant construction industry. The sector has been accelerating at a rapid pace and making a substantial contribution to the country’s strong GDP growth figures, on the back of major public works projects and rising demand for mixed-use and residential developments. For domestic and international contracting firms the local market offers a wide range of opportunities across diverse areas of expertise from commercial real estate to power plants, roads and rails.

However, the market is not without its challenges. The funding and financing environment at all stages of project execution is tough, creating negative cost implications and a potential obstacle to the long-term, sustainable growth of the sector.

Basic Indicators

In spite of the challenges, the construction industry is going through something of a golden period, expanding rapidly and playing a major part in the country’s recent success story. The industry contributed 5.2% to GDP in 201,5 making it a stand-out performer, and it grew at 13.6%, the second fastest sectoral expansion after financial intermediation services. While growth slowed slightly to 9.3% in the third quarter of 2016, compared to 15.6% in the same quarter of 2015, the industry remains a key component of the country’s growth and development strategy.

This trend is the result of a concerted effort to improve the long-term growth potential of the country. The IMF has noted that, “Inadequate infrastructure — including unreliable energy, an ineffective urban-rural road network and inefficient ports — is one of the largest impediments to economic growth in Africa.”

A 2010 report by the World Bank found that infrastructure contributes half a percentage point to the country’s per capita GDP growth. However, the group found that raising infrastructural standards to those of the region’s middle-income countries could increase this contribution to three percentage points per capita. Indeed, while the country has made some strides, it has some way to go to create a highly competitive environment. For example, Kenya ranked 42nd out of a 160 countries on the World Bank’s 2016 Logistics Performance Index. Demographics also play a significant role in driving the sector forward, with a population of 44.2m people is young and growing rapidly. More than 60% of Kenyans are under the age of 25, and the population is expanding at 1.9% per year. This requires a significant increase in housing and urban development, from transport networks to schools and utilities.

High Priority

As such, the government has committed to heavy spending on infrastructure in a bid to make the country more competitive. Between 2010, when the World Bank published its findings, and 2015 the federal government allocated almost 27% of the national budget to spending on energy, transport, water and sanitation, and environment-related infrastructure. This shows no sign of abating.

The government has a spending target of approximately $4bn per annum on infrastructure, and has increased the fiscal allocation for such purposes in the FY 2016/17. Under the current budget, spending on energy, infrastructure and ICT increased from 26.9% of total spending to 30.4%, the largest share of any sector. This is part of a continent-wide story. In the next decade, infrastructure investment across Africa is forecast to grow at 10% per year, according to PwC.

The impact of this for Kenya’s construction industry is largely positive, but does increase risk. The commitment to infrastructure expansion and economic growth illustrates the strong political will and robust rationale for continued capital spending on construction.

Risk Exposure

However, the industry has become highly dependent on public expenditure for growth, which can prove risky in the event that the government fiscus weakens . “The main contributor [to construction growth] is public funding. This represents more than 80% of funding,” Maurice Otieno, general manager for research, business development and capacity building at the National Construction Authority (NCA), told OBG. In the medium term there is little risk that the flow of capital into the sector will be cut off. “For the next three years we will see sustained growth,” Otieno told OBG. However, given that much of this investment is being financed from the national budget and government borrowing, the longer-term outlook is less certain. Indeed, the country’s budget deficit has been increasing steadily. In FY 2016/17 it is forecast to reach 9.3% of GDP. However, given the actual spending patterns of government departments, the Ministry of Finance predicted that the actual figure will be 6.9% of GDP.

Private Sector Push

Kenya’s public debt levels are manageable and low risk, even after a $2.8bn eurobond in 2014, but there is also a recognition that the government will need to look to private sources of funding to meet its $4bn per year commitment to infrastructure spending. In January 2015 Henry Rotich, cabinet secretary of the National Treasury, told the local press that the country has an annual infrastructure budgetary deficit of $2bn, and is looking to make up this shortfall through a number of methods including public-private partnerships (PPPs). In recent years the government has largely sought private sector interest for the development of utilities in the country – Kenya has one of the highest numbers on the continent of independent power producers in the pipeline, for example (see Utilities chapter). The government has also sought development and donor funds to help finance projects. For example, in July 2016 local media reported that the government was seeking a $1.5bn line of credit from the International Finance Corporation (IFC) to complete its 10,000-km road building programme. The money would be put to use for the completion of 4000 km of urban roads, with state funding used to complete 6000 km of rural roads. In total the government requires almost KSh550bn ($5.4bn) ) to complete the total project.

Financing Models

Nairobi is looking to the IFC after its previous financing model fell apart. Under that structure, contractors were to design, finance, construct and maintain roads with the government scheduling repayment once the project had been completed. Contractors were to negotiate loans with the banking sector that would be guaranteed by the government. Using an annuity road fund holding all road revenues, the government would then repay the consortium or banks at a specified rate over an agreed period. However, the effort to bring in private capital and financing to the project has proved challenging. “The annuity financing model was a new concept and banks were unwilling to lend because they felt there were more risks involved. We had very high financing costs, so we paused to look at other alternatives including external borrowing,” John Mosonik, the principal secretary in charge of infrastructure, told media.

Credit Access

Indeed, across the construction sector, the cost of financing remains a major challenge that has ramifications for all contracting firms. “The biggest challenge, especially for small and medium-sized contractors is access to affordable funding,” Otieno told OBG. “Funding is there, but the biggest challenge is interest rates. It increases the cost of construction.”

Certainly the availability of funds for contractors is clear, with credit expanding rapidly in recent years. Lending to the construction sector increased by 30.1% between June 2011 and September 2015; however, the cost of financing remains high, with the weighted average rate for all loans from commercial lenders standing at a total of 18.25% in May 2016. Such rates have had significant ramifications for certain segments of the economy, with non-performing loans (NPLs) jumping up in the first quarter of 2016, particularly in the real estate sector.

This follows a significant jump in NPLs in the construction sector in the first quarter of 2015. Then, bad loans held by construction firms increased by 28%, which has significant ramifications for the industry. Not only does this increase risk exposures for firms active in the property segment of the market, but the cost of financing also has a knock-on effect on the overall cost of construction in the market. “Contractors prices have been very high because the cost of financing is very high,” Otieno told OBG. “There is a lack of capacity in managing projects. Firms are not able to contract the risks, so the bidding prices are very high.”

Cash Flows

This is exacerbated by the problem of delayed payments for projects, which has plagued the sector for sometime. Indeed, following a spike in NPLs in 2013, the Central Bank of Kenya noted, “Delayed receipts from the government of Kenya for completed projects or contracts affected repayment patterns of customers in the building and construction sector.” For contractors, this presents an additional risk and the spectre of late repayment penalties charged by the banks. While contracts are clear on the payment schedule and client obligations, payments for public sector projects, are ultimately determined by the cash flow in the exchequer. The country also has clear regulations regarding settlement and arbitration, although recourse to the courts remains a last resort.

Given these challenges, and the implications they have for the cost of construction, the government is currently studying ways to provide cheaper financing options for contracting firms. The NCA is looking at a number of measures, including the possibility of creating a financing entity specifically for the construction industry. This potential contractors’ assistance fund would take seed money from donor agencies and offer subsidised interest rates for contractors. Another option would be the introduction of invoice financing through the establishment of a special purpose vehicle to pay contractor invoices.

Filled Pipeline

However, despite these constraints there is no shortage of work or bidders in the sector. According to a 2015 report by the consultancy firm Deloitte, Kenya had the highest number of infrastructure deals in the East Africa region in 2014/15. The country accounted for almost a third of the region’s 61 deals. The total value of projects in East Africa reached KSh5.9trn ($57.6bn), according to Deloitte. In Kenya the emphasis is on basic infrastructure, with transport accounting for 51% of projects and energy deals accounting for a further 30% of projects. This infrastructure development offers a broad array of contracts for construction firms, including a massive road building programme, the continued development of the Standard-Gauge Railway, and the Lamu Port and Lamu-Southern Sudan-Ethiopia Transport Corridor.

Chinese Participation

In certain areas, this ambitious building programme has been possible because of the involvement of Chinese financing and contracting. The nascent rail network, for example, has involved the state-owned China Road and Bridge Corporation (CRBC) as the main contractor and the Export-Import Bank of China as the main financier of the infrastructure thus far. The first phase of the $13.8bn project is approaching completion. The network will ultimately link Mombasa and Nairobi with Kampala in Uganda and Juba in South Sudan. By June 2017 the stretch between Nairobi and Mombasa should be completed, according to the CRBC. This will reduce travel times between the two cities from 12 hours to four hours. It will also provide the capacity for 25m tonnes of freight per year.

Local Content

The success of these contractors poses a competitive challenge to domestic construction firms. However, the NCA has tried to address these concerns with new regulations, mandating that 30% of the value of any construction contract awarded to a foreign company must go to local contractors. As such, this should ensure a competitive sub-contracting landscape for local firms, while leaving the market open to foreign competitors. Given the challenges of financing its ambitious building programme, Chinese – and more broadly, foreign – involvement is crucial, but so too is expanding capacity for local firms. “The slowdown of the Chinese economy will have an effect on Kenya’s construction, however, we are seeing new investors coming in the last one or two years, and interest [from] the US is growing,” Gabriel Ouko, partner for infrastructure and capital projects at Deloitte, told the local press

Outlook

Given the strong growth in the sector, and the number of projects in the pipeline, it is unsurprising that there is significant interest in penetrating the local market. While there are challenges in terms of funding for the government, and financing and cash flow for contracting firms, there are substantial opportunities. These sources are unlikely to dry up in the short to medium term as the government reiterates its commitment to major local infrastructure transformation. However, in the longer term, the sustained growth of the sector will be dependent upon the ability to bring more private funding into projects on the ground.

 

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The Report: Kenya 2017

Construction & Real Estate chapter from The Report: Kenya 2017

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