Building in Brazil

As the vast Brazilian real estate market becomes saturated with GPs both large and small, prime properties are being gobbled up at a frenzied pace. As with other BRIC markets, development is now the name of the game. By Eva Poon

Look on the agenda of any GP with an eye on the world's emerging markets and undoubtedly Brazil is somewhere on the top of the list, right next to fellow BRICs India and China.

With recent developments, including the country's upgrading on the S&P and Fitch, and some not-so-recent developments, such as the emergence of the country's residential sector, Brazil is likely to see continued waves of capital directed to its expanding real estate market. “Large capital flows are influenced by the credit markets,” says Bill Cisneros, managing director at New York-based GoldenTree InSite Partners. “The fact that Brazil is now investment grade is very exciting to global institutions that can direct capital to Brazil, and I think that they will respond to that opportunity.”

It's hard to come to Brazil and buy stabilized assets at good returns because there are very few of them and the guys that control those kinds of assets require pretty high prices to let go of them. It's much more of a development market than it was five years ago.”

But GPs around the world descending on Brazil are facing a different landscape. As prime real estate assets around the country are snatched up at a feverish pace (as already evidenced in the office market, which is facing exceptionally low vacancy rates) private equity real estate firms may have to adopt a more development-oriented investment strategy, focusing on ground-up plays rather than elbowing for an increasingly limited supply of desirable assets.

Build, don't buy
Compared to the market five years ago, investors in Brazil are now facing a different kind of market – one in which many of the good assets have already been bought up by capital flooding into the country. Today, Brazil is largely a development market, says Maximo Lima, co-founder of Sao Paulo-based private equity real estate firm Prosperitas.

“It's hard to come to Brazil and buy stabilized assets at good returns because there are very few of them and the guys that control those kinds of assets require pretty high prices to let go of them. It's much more of a development market than it was five years ago,” he says. The office sector, for example, has a substantial lack of big buildings available to purchase, adds Cisneros. Investors, like the California Public Employees' Retirement System (CalPERS), may end up paying very high prices for one of the very few institutional-quality office buildings in the country.

Vacancy rates in the office sector are very low, adds Roberto Perroni, head of Brazil for McLean, Virginia-based firm, JER Partners. The country's largest market, Sao Paulo, had a vacancy rate of more than 20 percent in 2005. Today, it has less than seven percent. In Rio de Janeiro, the vacancy rate for triple-A office buildings is less than one percent.

The problem is compounded with new office developments being snapped up like hotcakes. Many US and European investors have been coming to the market trying to buy office projects in Brazil, says Perroni. “In the past, it would be just possible to sell an office building after you get the tenants, but today it is very easy to sell an office building even before the building is ready – even before you have any tenants.”

The limited supply of property is due in part to the cyclical nature of real estate, argues Lima. Five years ago, the market was in a down cycle and development had basically ground to a halt. There was a decent amount of vacancy in the major markets. But because there was such a low level of development, as the economy took off again, existing properties were filled up and vacancy, as it stands today, is extremely low. There is a new wave of development coming into the market, he says.

And that is already happening. Houston, Texas-based real estate firm Hines – which has a long history in Brazil – is planning to quadruple its industrial and logistics investments in the country over the next three years as part of its joint venture with CalPERS, boosting the number of parks being developed from five to almost 20 within three years.

In December last year, New York-based Tishman Speyer also closed on a $600 million (€408.6 million) vehicle to invest in the growing Brazilian market, with a focus on acquiring, developing and redeveloping office, residential and mixed-use properties. Tishman is targeting investments in São Paulo and Rio de Janeiro as well as other urban areas lacking supply of high-quality office and residential assets.

Pricing in the country has also made property developments appealing to real estate GPs. According to Cisneros, pricing in Brazil is very attractive. “We are developing world class office properties at an expected yield on cost in the 15 to 18 percent range, and believe that these will continue to be saleable at a cap rate of around nine. These are huge spreads, and enable us to underwrite unlevered returns in the mid-20s.”

A similar phenomenon is happening in the retail and commercial space, says Ricardo Mader, executive vice president for Jones Lang LaSalle Hotels in Sao Paulo. “Today it's very, very difficult to find any good commercial or retail assets available because everything was bought in the last 18 to 24 months. So we're going to see a trend more toward new development across property sectors.”

Sector boom
The residential market in Brazil has seen a definitive turnaround in the past few years with available financing for residential property becoming much more abundant. Mortgages are increasingly accessible and the lower interest rates in the country have made properties more affordable. “The availability of mortgage capital is clearly transforming affordability in the country,” says Cisneros.

The value of mortgages has increased threefold from 2005 to 2007, says Perroni, with around R$5 billion ($3 billion; €2 billion) of mortgages in 2005, financing around 60 thousand units, to more than R$18,000 billion of mortgages in 2007, financing almost 200,000 units.

A tremendous amount of money was also raised for residential property through a large number of homebuilders going public. According to Rossana Duarte, a partner at Sao Paulo-based law firm Tozzini Freire, between 2005 and 2007, 21 real estate companies went public. Homebuilders have tapped into around $7 billion in the public markets and are deploying that capital around the country.

All this has led to a residential boom in Brazil, and much of the focus has been on the lower- to middle-income segment of the market. As the middle class in Brazil continues to grow -now already representing more than half of the population in the country – so too is demand for affordable housing. In fact, says Perroni, the country has a housing deficit of around eight million units.

“Usually [firms] look for a local developer to secure knowledge of the market. But also because they control some good opportunities, good land and good projects. They are only waiting for equity partners.”

It would be hard for any GP to ignore Brazil's favorable demographic trends. The average age in the country is 27.5 years, and over the next 10 to 15 years, the workforce population – people aged between 25 and 50 – is expected to grow to around 45 percent of the population.

Last year, the São Paulo residential market sold almost 37,000 units – 54 percent more than in 2005. For the whole of 2005, the market sold 24,000 units. In the five months to May 2008, the market sold 40 percent more than the same period of 2007. “The market for residential is really very, very hot today in Brazil,” adds Perroni.

What is exciting about the market in Brazil, according to Cisneros, is the fact that development is geared primarily toward domestic demand. This is in contrast to other regions like Mexico and Costa Rica where a lot of development is driven by the anticipation of US buyers. “In Brazil everything that we do residentially is sold to local buyers,” he says.

As Brazil's economy continues to grow, global GPs are also starting to expand their focus from the residential and office space to the country's industrial and retail sectors. The industrial space has historically been lacking in institutional quality industrial assets, with existing warehouses leased very quickly.

In the past, Brazilian companies used to own their own plants and distribution centers, says Duarte. But during the last few years, they started to sell these properties to real estate investors and lease them back. Real estate investors today are acquiring these properties or buying land and constructing industrial centers with developments including build-to-suit, sale-leaseback and new developments. The country has also started embracing US and European industrial market concepts, such as developing comprehensive business parks, says Lima, rather than developing in a haphazard way as in the past.

Brazil's rising income levels are also effecting changes in the country's retail sector. A primary driving factor has been the increasing purchasing power and the growth of consumer credit as a result of falling interest rates in the country. Global alternative asset manager Och-Ziff Capital Management is jumping on the Brazil story, partnering with Votorantim Financas, the finance arm of Brazil's largest industrial group, to invest at least R$500 million in office, industrial and retail projects in the country.

In addition to LPs, Brazilian pension funds have also established a foothold in the country's commercial real estate sector. “The Brazilian pension funds are back to the real estate market acquiring more property, especially commercial buildings and malls,” says Duarte. “The third largest Brazilian pension fund, FUNCEF has just announced that it wants to invest up to R$500 million in properties this year.” Brazil's FUNCEF has assets of approximately R$31.9 billion and currently has R$550 million invested in malls, representing 23 percent of its real estate portfolio.

Making the grade
As Brazil takes its place next to other investment grade countries, increasing numbers of investors – both LPs and GPs – will want to enter the market.

“A lot more people are going to have to be here, period,” says Lima. “We're already seeing that. Especially with the big US and European pension funds that could not invest in countries that are not investment grade. Now that Brazil is investment grade they have to at least allocate a little bit of money to the country.”

Some are predicting double digit growth in coming years. “I think there is tremendous growth,” adds Mader. “Certainly we're going to see double digits in the next three years. I definitely think there is tremendous opportunity for growth.”

Smaller investors will also have a niche in capitalizing on the growth. One of the big challenges in the Brazilian market is that it doesn't really favor large players, says Cisneros. In the residential markets of India and China, for example, investments center around the creation of townships. In Brazil, however, the better risk-adjusted return is finding infill locations to do smaller transactions, he says. “Once you've secured the infill location you've already created a huge amount of value. Secondly, from a risk perspective, you've got a series of independent, discrete projects. If the market turns, you'll be in a much better position to reduce your risks than if you have committed to a single huge project that has a very long time horizon and takes a lot of capital.”

Smaller funds are already being formed to take advantage of such opportunities, says Mader. And they are partnering with local developers who can offer exposure to a pipeline of projects, bypassing the competition for highly valued completed assets. “Usually [firms] look for a local developer to secure knowledge of the market,” says Mader. “But also because they control some good opportunities, good land and good projects. They are only waiting for equity partners.”

The number of joint ventures between global GPs and Brazilian developers over the past year is itself quite telling. In October last year, New Jersey-based Prudential Real Estate Investors partnered with Brazilian developer Racional Engenharia to target the country's industrial property market, focusing on the development of distribution centers, light manufacturing facilities and industrial parks in Brazil. At the same time, The Carlyle Group made its foray into the Brazilian real estate market, investing in Brazilian real estate developer Scopel to target middle and low-income housing.

New York-based GoldenTree also has multiple JVs with local partners, in addition to an 11-person team on the ground in São Paulo. Similarly, JER has employed a similar strategy in the country – forming partnerships and JVs ventures with local development companies.

The number of GPs employing a JV strategy in the country underscores another key aspect of Brazil's real estate market – the number of adequate developers in the market – a point which has remained relatively unchanged despite all the new developments in the country. “The market has become a lot more competitive and there is a lot more capital chasing deals,” says Lima. “What has not changed is that it is still a market with very few competent developers in it. The same guys that were fairly good five years ago, are the guys that are good today. No real new players in that sense have come out. But there are a lot of new capital players in the market.”

Yet despite all the challenges of investing in the country – competition in sourcing deals, finding good local partners, and, according to many GPs, dealing with the extraordinarily complex tax system – there has been an increasing flow of capital directed to Brazil. And despite the international slowdown, Brazil continues to grow at a very healthy pace, adds Lima. Others in the industry are even more upbeat on the market. According to Duarte, the Brazilian property market could triple in the next five years: “Considering that Brazil has reached the status of investment grade, the market remains hot, and the rates of return are still higher than those found in developed countries, I think that within the next five years the real estate market can be at least three times bigger than it is today. But it's optimistic.”

And a large part of that expansion will be achieved through development of properties – across property sectors. As any GP on the ground can attest, development is a must going forward. “Today if you look for more interesting returns, meaning IRRs, you have to develop projects,” says Perroni. So as LPs start to open more allocations to Brazil and investors vie for limited real estate, private equity real estate GPs looking to capitalize on the Brazil story will have to have “build, build, build” on their minds rather than “buy, buy, buy.”