Investing in Brazilian real estate: Coming to terms with a new reality October 05, 2010 Home Property News During early May, Natal hosted Nordeste Invest, a landmark forum for international investment in Northeast Brazil. Leading real estate investors and developers exchanged views and provided many vital insights into the evolution of this dynamic market. The conference highlighted several far reaching changes in the business environment following the recession, particularly in the tourist sector. While the outlook remains attractive, the focus is moving to residential and commercial real estate investments. Complexity is increasing, with a growing level of investor sophistication and a marketplace that is now demanding more differentiated offerings directed at Brazilian consumers and the rapidly expanding domestic demand. In conclusion many players have yet to adapt their approach and will need to be more innovative to be successful in future. The Brazilian economy has been one of the most resilient during the continuing global economic turmoil over the last couple of years. Brasil is attracting the serious attention of international investors because of its new found economic prosperity, growth and stability. With the right strategy overseas investors can make excellent returns, which are largely unavailable in their home markets. A prime example of this trend is Sam Zell, the bell-weather investor in international real estate, who is currently increasing his exposure to the Brazilian market. He is raising $500 million for new investments largely in residential and commercial property. Significantly, Brazilians have increased their purchasing power over forty percent in the last five years. This is underpinning a sustainable consumer boom and anticipated buoyant property demand for several years to come. The Northeast region of Brazil is as big as Germany, Britain, Italy and France combined and is broken up into nine states. It is famous for its year round hot tropical climate, spectacular beaches, and rich diverse culture. Traditionally one of the poorest regions in Brazil it represents about twenty percent of the whole economy and is currently playing catch-up with the rest of the country. According to a recent central bank survey it continues to exhibit even stronger GDP growth than other regions, at some two percent higher than the expected 6.3 percent national average in 2010. Even though the real estate investment market in the Northeast has been a hot spot for investors for some years now, it has being subjected to some major structural shifts during this time. Post the recession inward investment flows by smaller international investors are now drying-up. These were previously the foundation of the market and were aimed principally at the tourist segment. They are declining because the Brazilian real has strengthened dramatically against major currencies. The continuing financial crisis, notably in Europe, is exacerbating this trend―a situation that is believed will remain for the foreseeable future. At the same time the overall economic fundamentals still make the Brazilian market highly attractive to local and foreign capital alike. However, the nature of investors and their focus is changing. Offsetting the downturn in smaller investment, there is increasing growth in private equity, pension funds and other more sophisticated players. They are all seeking to take advantage of the comparative strength of one of the most favorable BRIC nations and invest in an emerging economic powerhouse. International real estate investment funds (REITs) are increasingly including Brazilian real estate as part of their emerging markets portfolio. Locally, REITS are referred to as "Fundos de Investimento Imobiliário," and were established in Brasil in 1993, but only since a change in regulation at the end of 2008, has there been much activity. According to the government regulatory body, the Comissão de Valores Mobiliários (CVM), Brazilian REITs had about 3 billion dollars under management at the beginning of 2010. Despite significant advantages and tax breaks for private investors, they are yet to realize their full potential as investment vehicles. The key trend that is currently shaping the real estate market is the growth in domestic consumer demand and the expanding middle class, which has now become the most important engine of Brazilian economic growth. Wealthy Brazilians are replacing international buyers. They come largely from the economic hubs in the South of the country and are buying second homes in the Northeast―the principal tourist destination nationally. Many of the resort developments being promoted along the spectacular Northeast coastline were initially conceived during the heady growth years up to 2007 and targeted mainly at Europeans and North Americans. They have now lost their original customer base. The Brazilian real estate sector is only just beginning to wake up to the true challenge that this represents. Some of the more astute developers are starting to adapt their projects and market to domestic consumers. However, the majority appears content to continue with the same old approach to resort development―a combination of beachfront villas, apartments, hotels and golf. At Nordeste Invest, investors expressed concern about the growing danger of over-supply in the resort segment. Already there is evidence of a number of projects in difficulty. Another important conclusion reached by the panelists at Nordeste Invest was that the key to future success will be to provide differentiated propositions and maintain flexibility to adapt to the further changes in the market. As you might expect, for the time being this implies (at minimum) a modified offering and a price point that meets the needs of Brazilian buyers. Further thought must also be given to providing new experiences. An example suggested was the development of a combined family entertainment complex and resort. The ability to innovate was perceived to be the competitive battleground of the future, when it is believed only the best projects will succeed. Investors spelled out the criteria that they use to assess the viability of markets and stressed that the market in Northeast Brazil is in competition for capital in a global market place. Nonetheless, it was observed that Brazil scores well at most levels. · The first thing investors are seeking is the overall political and economic stability of the market. Over the last eight years of the Lula government, sound fiscal discipline has certainly paid off creating the right conditions for international investment including an inflation rate below five percent. Brazil has avoided a credit crisis, because there has been a relatively low level of debt. · The second factor is the economic fundamentals, which drive real estate value―a growing market, an emerging middle class and expanding population are all keys to sustainable activity. These combine with a resource rich export oriented economy, with growing oil production, massive water resources, and the best green energy matrix of any of the large economies. No further evidence is needed of the strength of the economy than the level of foreign direct investments that have been pouring into the country and the fact that the BOVESPA (the Brazilian stock exchange) was the highest performing stock market globally in 2009 with eighty five percent returns in dollar terms. There is even the added bonus of the hosting the World Cup in 2014 and the Olympics in 2016, which is currently spurring much necessary infrastructure investment and will eventually help establish Brazil as a key player on the world stage. · The final point investors analyze is the legal framework and the ease of doing business― although Brazil has a lot to improve in this area, the country is in tune with free enterprise and probably the easiest of the BRICs for international investors to understand. Although in the past some investors were badly supported and wrongly directed. As in all emerging markets, this only emphasizes the importance of finding serious local partners and professionals, and the need to do careful due diligence. The time for licensing and environmental permitting is also a key element, notably for new development and at best is long and drawn out. Moreover, the rules are opaque and are can be interpreted at municipality, state and federal level, which is leading to retroactive decisions on licensing― undermining investor confidence. The Minister, who was present at Nordeste Invest, has promised to review legislation and provide greater transparency. Adapting to the new market conditions most of the more sophisticated investors appear to be turning their attention to the residential and commercial sectors of the market, which benefit substantially from changing demographics and growing consumer trends. For the moment, they are shying away from tourist areas, which seems will only recover in the longer-term. The most important of the new segments is affordable housing. The growing population has created a significant housing deficit, to which the government has responded by launching in 2009 the Minha Casa Minha Vida or My Home My Life program, which has the objective to build a million new housing units nationally within three years. Under the program the federal government is investing twenty five billion reals to provide subsidized loans to middle and lower income homebuyers through the state owned bank Caixa Federal. Developers can expect returns in excess of thirty percent for well managed projects. Following the recession, international investors are now weighing the risk of new greenfield projects. Preference is now heavily in favor of those projects generating some short-term cash flow. Unless the returns are spectacular, it is becoming almost impossible to sell a resort development with a typical 15 to 20% yield five years out. The sort of profits that were available four or five years ago are becoming harder and harder to achieve. Gone are the days when cash flow of a major resort development could be financed out of pre-sales and today the relatively high interest rates for local financing are one of the main factors limiting further market expansion. Other investor focus is in city center residential development, which is directed at the expanding middle class and incentivized by the increasing availability of mortgage finance. Strong consumer demand also creates a need for more shopping centers and malls—only 400 exist, one per 500,000 people countrywide. Moreover, savvy investors are also looking at picking up distressed projects, often badly capitalized or under-funded, which can offer superior returns in shorter time scales. Finally, a key issue affecting the recovery of the tourist sector is accessibility, above all for international visitors. For example, charter flights from the UK to Natal were cancelled in the wake of the recession. Direct flights to the region from Europe are now almost wholly dependent on the Portuguese carrier TAP and from the US are very limited. Although new airport infrastructure is being built in the region to accommodate additional passengers, there was a general sense that insufficient effort was being put in to lobbying airlines to initiate new routes. One delegate was even calling for a new Northeast airline to be established to address this issue. Inevitably the complexity of the market will continue to increase and the level of sophistication of investors will grow. Against this background the right strategic investment advice for investors and the ability of developers to correctly “package” their projects to attract new capital are becoming critical success factors. A good locally based understanding of the market and its most important trends is an essential tool to get the job done right and compete in the new market reality.