The Wild, Wild South

After almost a decade of hyperinflation, Brazil’s economy has stabilized: interest rates are decreasing and the country is on the verge of receiving its first-ever investment grade status. This paper is a synopsis of research conducted as part of Kellogg’s Global Initiatives in Management program into the attractiveness of Brazil’s real estate market, including which market segments offer the best current opportunities, based on interviews with current investors and developers focused on this sector, along with secondary research. Recommendations for capitalizing on Brazil’s residential and retail real estate markets are also presented.

Overview of Brazil’s Real Estate Market

In 1994 Brazil’s government adopted Plano Real to stabilize the country’s economy and introduce a new, dollar-linked currency, the Real. Plano Real facilitated mortgage lending, which had been dormant since the late 1970s due to economic instability, leading to a shortage of about eight million homes in Brazil. Brazil’s real interest rate was about 7% in 2008, leading to a much more favorable lending environment. The passage of two lending laws in 1997 and 2005 also helped increase the number of loan originations.

Real estate financing in Brazil has a checkered history, with a highly government-controlled housing financing system (SFH; Sistema Financeiro de Habitacao) that flourished from the mid-1960s to the late 1970s, resulting in over 3 million loans. But SFH had succeeded amidst rampant inflation largely due to a system of inflation indexation that ultimately became unsustainable. In the 1990s borrowers filed lawsuits against financing institutions and began defaulting on their loans, a problem aggravated by anti-inflation economic measures and alleviated only in the later years of that decade by laws mandating modernization of the housing financing system.

Currently both private and state banks supply credit for residential and commercial real estate, and new instruments have been created to allow the securitization of property loans. Brazil’s real estate market is also becoming better integrated into global markets, with multinational real estate firms including Jones Lang LaSalle and CB Richard Ellis establishing offices there.

The Companhia Brasileira de Securitazaao (CIBRASEC) was created in 1997 to be the catalyst for Brazil’s mortgage market, modeled after US securitization companies such as Fannie Mae. CIBRASEC’s controlling partners are Brazil’s largest public and private banks, international firms such as ABN/Amro, and agencies such as subsidiaries of the World Bank. CIBRASEC will likely hasten the maturation of Brazil’s real estate industry by spreading risk among multiple parties.

The prospects for the real estate market and for real estate finance will improve as rapidly as economic growth is resumed. Brazilian incomes have experienced modest improvements since the most recent economic downturn in 2001. With respect to affordability, the large concentration of Brazilians that earn less than 3 times the minimum wage – approximately 45% of all households – indicates that the majority of Brazilians continue to fall outside unsubsidized mortgage financing standards, despite the recent reduction in interest rates. Developing mortgage products that can address the funding needs for low-income borrowers will be an important future challenge for Brazil’s mortgage market if it is to sustain the observed growth rates of previous years.

Real Estate Opportunities and Challenges

In part because Brazil’s office real estate sector may be considered a mature market in some cities, with vacancy levels below 10% and rents among the world’s highest, investor interest has focused largely on the evolving residential and retail sectors.

Residential Real Estate

Since 2006, 16 Brazilian residential development companies have used IPOs or follow-on capital increases to raise a total of R$11.8 billion, or about $7.4 billion, a strong sign of the interest in this sector. Several factors point to growing demand for residential property. Among these is Brazil’s young population with a declining number of occupants per household. Almost 45% of the country is between 15 and 39 years old (compared to 36% in the US), the prime home-buying age segment.

Recently improved mortgage financing terms have made homeownership more accessible to Brazilians, most significantly the extension of mortgage durations from 10 to 25 years and the increase in loan-to-value ratios from 40% to 80%. These have reduced dramatically the average monthly mortgage payment for would-be home-buyers. UBS estimated that the number of families capable of buying homes in Brazil increased from 5 million in 2005 to almost 12 million in 2007, an increase from 10% to 25% of all households.

That leaves three quarters of the population unable to buy a house. For this situation to improve, new home prices would have to drop significantly below R$100,000. Such housing is in the works, according to Merrill Lynch’s real estate private equity group, and the trend is expected to make real estate affordable for about half of Brazil’s households.

For the other half, those who still wouldn’t be able to afford a home, several factors must converge to improve their odds of ownership. First is the availability of even cheaper financing, which seems feasible given interest rate trends. Next is the introduction of greater efficiency for gaining necessary building-related approvals, which can take over a year given request volumes and bureaucracy. These delays inevitably affect profitability. Homebuilders must also gain access to land in the outskirts of the large cities that, while conveniently located enough to attract demand, remains affordable to low income buyers.

Retail Real Estate

After years of low investments, Brazil’s retail real estate sector is expanding at an unprecedented rate, with the three largest mall operators’ shares listed on Sao Paulo’s stock exchange for the first time in 2007. Today Brazil ranks 10^th in the world for number of shopping centers, with about 350 total, representing about 80 million square feet of gross leasable area (GLA). The sector is marked by high geographic concentration and a very fragmented ownership structure that includes international players, domestic pension funds, and regional entrepreneurs. Shopping center revenues represent only 18% of Brazil’s total retail sales (excluding cars and oil products), compared to 70% in the US.

According to one retail industry interviewee, Brazil’s mall owners can expand their businesses in several ways:

· Greenfield shopping centers. Risks and returns are high for this option, which involves building malls in areas that have few or none presently.

· Acquiring ownership stakes in third-party malls. This may generate quick market share gains, but pose more challenges in gaining control of the asset, as it involves investing alongside other players.

· Acquisition of incremental stakes from other shareholders in malls already in the portfolio. This allows companies to reach a majority stake and presents the lowest investment risk.

· Brownfield expansion of existing malls’ GLA. This is a viable option when a company owns a controlling stake in a well-performing mall. The additional investment required by this alternative is comparatively low.

In late 2006, Chicago-based Equity International, Sam Zell’s real estate investment vehicle, acquired a majority stake in BR Malls, a major shopping center operator in Brazil, from the family that owned the company, replacing top management and implementing strategies that helped propel BR to the industry’s top. Given the options above, it’s not surprising that BR’s expansion plans involve mainly expansion of its existing portfolio. BR expects to add 600,000 square meters by 2010, with more than half of this increase generated by brownfield projects. Of course companies not already in this market could not implement such a strategy directly.

Brazil’s real estate market is clearly primed for growth. A strong real, decreasing interest rates, and improvements in mortgage lending regulations should continue to spur real estate expansion, particularly in the residential and retail sectors. The development of more affordable housing is particularly important for the residential sector, while ambitious retail players can take advantage of consolidation opportunities in that fragmented market. This is only the beginning of a long cycle of real estate development and expansion in Brazil.