Up until the end of the game, it was all a dream[]
As we see at the beginning of the game, Tooty is urging Banjo to wake up so that they can go on an "adventure". Then she gets kidnapped by Gruntilda who just happens to live right around the corner from Banjo. How would he and Tooty never notice this and more importantly, question who lives there?
The answer is simple. Gruntilda doesn`t exist. Banjo, Kazooie and Tooty all live in Spiral Mountain by themselves. There is no witch living next to them. But there is when Banjo begins to dream. Dreaming about him going on a worst case scenario adventure to save his sister from a machine that "steals her looks". That is obviously the material of an early morning dream. After Banjo defeats Grunty and knocks her off the tower, we see him, Kazooie, Bottles, Tooty and Mumbo at a beach island. Now let`s get one thing straight:
BOTTLES AND MUMBO ARE REAL.
But, it is common to dream about real people you know in your dreams, as we saw him do this throughout the game with Tooty and Kazooie. So:
We saw bottles talking to Tooty before we got insight into Banjo's dream, which means he is real. In a way, the first person we see in the game is Gruntilda. Then we see Tooty talking to Bottles, which diverts from Banjo`s dream to reality, then back to his dream when she is kidnapped by Tooty. As for Mumbo, he is real because he isn`t really a skull face, but a man with a mask on who lives as a savage in Spiral Mountain (seeing as everyone else is an animal). Banjo probably knew him and also added him to his dream, imagining him as having magical powers due to his interest in black magic in the real world.
So to sum it up:
- Entire game was Banjo`s dream
- Kazooie, Tootie. Banjo, Bottles and Mumbo are real
- Gruntilda is not.
- Up until the very end when they are viewed at the beach is Banjo`s dream.
- The fact that they are talking about Banjo`s dream at the beach is because they were humouring Banjo as the dream felt so real to him that he would become gravely confused if he heard it was a dream.