Cities of god

Private equity real estate investors are rushing into Brazil in search of heavenly returns. But amid the aura of political and economic stability, the emerging market risks continue to loom large. By Paul Fruchbom

Presidential politics in Brazil, as in much of the rest of the world, have a long and sordid history. In 1954, president Getulio Vargas, who came to power during one of the country's several military coups, committed suicide after his security forces botched the attempted assassination of a rival. Thirty years later, the military handed power to a civilian government led by Tancredo Neves, who promptly died one month after his inauguration date. And in 1992, Fernando Collor de Mello, the first directly elected president in Brazil's history, resigned amid corruption charges levied by his own brother.

Judged against such a colorful past, the recent victory of Brazilian president Luiz Inácio Lula da Silva—widely known as Lula—was a rather bland affair. With the exception of a bribery scandal—which, to be fair, is not exclusively the province of Brazilian politics—perhaps the defining characteristic of Lula's re-election was its negligible impact on the economy.

The same could not be said four years earlier, when Lula became the country's first left-wing president in almost half a century. Amid fears that the new administration would abandon the conservative economic policies of its predecessor, Brazil suffered a crisis of confidence: foreign direct investment stalled; the value of Brazil's currency, the real, declined; and interest rates, always a concern in the inflation-plagued region, began to climb.

Yet by adhering to the basic tenets of the Plano Real—the set of economic measures which have clamped down on inflation since the mid-1990s—Lula was able to silence his critics and foster a sense of comfort and stability, both at home and abroad. All of which helps to explain the rather muted response to a populist, left-wing president cruising to a landslide in the world's fifth most populous country.

“Historically, politics have really influenced the economy,” says Gil Mendes, a Sao Paolo-based partner with Ernst & Young. “But with the introduction of the real plan, everything has become more stable”

That stability can be seen in the country's trade growth, its increasing levels of foreign investment and the prediction among many observers that Brazil will soon become investment grade. Over the past five years, exports have set record levels due to the boom in commodity prices and Brazil's expanding agri-business industry. Foreign direct investment is predicted to reach $18 billion (€15 billion) this year, up from $15 billion in 2005, according to Prudential Real Estate Investors. Inflation is expected to fall below 4 percent by next year and interest rates, which have fallen by six percentage points over the last 14 months, are expected to continue to decline even further in the near future.

“Little by little, inch by inch, [Brazil is] moving to investment grade,” Sam Zell told PERE earlier this year. “So whatever other crazy shit is going on, the bottom line is that there's an awareness and an attractiveness to what I'll call economic stability.”

That sense of both political and economic stability is luring an increasing number of foreign real estate investors. In addition to Zell and his private equity real estate vehicle, Equity International, other firms active in Brazil include US developers Hines and Tishman Speyer, Canadian pension plans such as Caisse de depot and Ontario Teachers, as well as investment firms like Brookfield Asset Management (formerly known as Brascan) and Paladin Realty. And more are on the way. Sources note that The Carlyle Group is looking to establish a private equity real estate presence in the country and may have a team up and running by the end of the year. And there are rumors that both Morgan Stanley and Blackstone are looking at real estate opportunities in Sao Paolo and beyond.

“We are getting a lot of new private equity capital in Brazil,” says Steve Dolman, a Sao-Paolo-based vice president with Hines, which has been investing in the country since the late '90s. “It's a signal that investors are comfortable with the Brazilian real estate market.”

Settled by Portugese explorers in the 16th century and later populated by waves of immigrants from Europe and Asia—the country has the largest Japanese population outside of Japan—Brazil has a long history with new arrivals to its shores.

Multi-national corporations began coming to Brazil in large numbers during the 1990s, drawn by the country's new democracy, vast natural resources and large domestic population. According to Dolman, it was this influx of foreign firms—and their need for office and industrial space—that initially led Hines to Brazil in 1998. In 2005, the Houston-based firm teamed up with CalPERS to form HCB Interests, a $200-million vehicle focused on Brazil, much of which has been invested in the industrial sector.

“Our first fund with Calpers is more heavily weighted in the logistics markets, which is a big difference from other countries,” says Dolman.“Brazil is a developing country that is trying to become a developed country. One of the key components is, as interest rates come down, more people can buy goods on credit cards, which puts pressure on [delivering] products to the consumer.”

Dolman adds that Hines is currently putting together its second Brazilian fund with CalPERS and will focus more of its efforts on the office sector, which is exhibiting strong fundamentals in both Sao Paolo, the country's largest city with 11 million people, and Rio de Janeiro, population 5.5 million. According to Richard Ellis, office vacancy rates in the two cities were at 15 percent and 9 percent, respectively, in the second quarter of 2006.

“A couple of years ago, there was a massive oversupply of office space because nobody wanted to move into new space,” says Daniel Citron, chief executive officer of Brazil for Tishman Speyer, which has been investing in the country since the mid-1990s. “Today, we have had 13 consecutive quarters of positive net absorption. Rents are starting to move up.”

Another factor favoring rental growth is the limited supply of high-quality office product in both markets. In Sao Paolo, for example, Class-A space currently represents less than 10 percent of the total stock, according to Citron, while in Rio the figure is closer to 5 percent. Earlier this year, Tishman announced the development of its first project in Rio, a $200-million, 36-story office tower that is expected to be the city's largest high-quality commercial building.

“The story in both markets,” says Citron, “is really the upgrading of companies that are currently [there].”

Yet while the overall strength of the Brazilian tenant base improves, some other facets of the commercial real estate market have not kept pace. According to Equity International, a lack of debt and equity financing has led to a situation where a vast number of multi-national and Brazilian companies own significant amounts of their corporate real estate. To capitalize on this opportunity, the private equity firm has established a new company, Bracor, to acquire a platform of high-quality properties, leased to high-credit tenants, across Brazil.

“It's a melding of real estate and finance,” says Gary Garrabrant, chief executive officer of the firm, which has been looking at the Brazilian market for almost a decade. “There is not a developed investment property market. If one were to sell a building, one would be hard pressed to find a handful of qualified people to look at it.”

Garrabrant and his team have also been active in the residential sector, a market characterized by strong demographics, a young population and a housing deficit of seven million units. Last year, the firm made a $50 million investment in Gafisa, a Sao-Paolo based homebuilder, partnering with Brazilian private equity firm GP Investments. Soon thereafter, the company went public; Equity International's stake is now valued at more than five times its initial investment.

Other investors active in the residential sector include Paladin Realty Partners, which recently closed a $200-million Latin American real estate vehicle. According to the firm, a majority of the fund will be invested in residential projects, half of which will target the affordable housing sector, with Brazil, along with Mexico and Chile, one of the primary areas of interest. And in October, Brookfield Asset Management raised approximately $500 million in an IPO of Brascan Residential Properties, a Brazilian developer of luxury residential properties, on the Sao Paolo stock exchange.

Beyond the residential sector, demographics are also behind investor interest in the retail sector, where an emerging middle class and declining interest rates are helping to boost consumer confidence and disposable income. Over the past several months, three major shopping center companies have received substantial investments owner and operator of 13 shopping malls. Two months earlier, Ivanhoe Cambridge, the real estate investment arm of Caisse de depot in Quebec, announced a joint venture with Ancar, a mall management firm that owns centers in Brasilia and Rio. And in June, Cadillac Fairview, the real estate investment arm of the Ontario Teachers' Pension Plan, acquired a 46 percent interest in Multiplan, which owns nine retail centers across the country. In addition, Brookfield recently closed a $700-million retail fund focused on Brazil.

“There is a cultural component to the shopping center in Brazil,” Thomas McDonald, executive vice president of Equity International, recently told sister site “It is in some ways a town center because it is safe, air conditioned, enclosed, has a combination of retail, food, bowling alleys, movie theaters, and in some cases medical centers. The average visit I'm sure is [longer] than in the US.”

Andrea Stephen, executive vice president of investments at Cadillac Fairview, notes that the retail segment is extremely fragmented, providing a strong opportunity for consolidation. However, she adds, property acquisitions are complicated given the fractional ownership in many retail centers. Given that shopping center developers, like builders in many other property sectors, have historically had difficulty obtaining project financing, they would often sell off ownership interests in order to complete the development—Stephen notes that she has seen some Brazilian malls with ten different owners.

While the debt markets remain a challenge for real estate developers, the equity markets have proven fruitful—at least for now, as demonstrated by the recent flotation of Gafisa and Brascan Residential. According to Edith Bertoletti, a Rio de Janeiro-based partner with international law firm Thompson & Knight, six real estate companies have launched initial public offerings since September 2005, all of which have been successful.

“For the first time in history, real estate companies are coming to the capital markets,” says Bertoletti. “And the capital markets are understanding them.”

Despite the growing amount of activity across all of the country's property sectors, numerous challenges still exist in Brazil, which very much remains an emerging economy, with all the inherent sovereign risks that entails. As Bertoletti points outs, “People believe nothing will happen, but this is Brazil—you do have a country risk.”

Real estate investors on the ground point to a slow and torturous legal system, poor financing markets, a lack of experienced operating partners, currency issues and, perhaps most important, the risk that the flood of capital entering the market ignores all of the above.

As one of the four BRIC countries, Brazil has received a significant amount of attention from emerging market investors in search of higher returns. However, unlike India or China, Brazil has not generated the same headlines as the Asian economies. Part of the reason has to do with Brazil's relative size, but an even more pressing issue is Brazil's economy, which has been sluggish in recent years, particularly for a developing economy. Over the past four years, for example, Brazil's GDP has grown at the relatively modest rate of just under 3 percent per annum. That has put significant pressure on Lula to pursue certain initiatives to finance growth and infrastructure development through increases in government expenditures. Some observers worry, however, that a shift in economic policies has the potential to disrupt the stability that Brazil has enjoyed since the introduction of the real plan. It was, after all, a significant currency devaluation in the late 1990s that frightened off many emerging market investors.

Quoting one of her clients, Bertoletti says, “If you want to avoid currency risk, don't come to Brazil.”

Interest rates are another area of concern. Though they have fallen significantly in recent years, most practitioners expect they will fall even further, a necessary ingredient to growth in both the retail and residential sector, particularly in the latter where the country's nascent residential mortgage market will only develop if rates decline.

“This market depends on interest rates,” says Citron.“We are all betting that real interest rates will move down to something like 7 percent. If they don't, you might see a massive oversupply because everybody is moving in the same direction.”

In the financing markets, the concern is not so much interest rates, but more specifically the inefficiency of the debt markets. According to Garrabrant, Brazil only has a handful of lending institutions and, partially as a result, there are only very narrowly defined sources of debt capital. For example, one of the few forms of domestic real estate lending available is lease factoring—using the lease as the entire means of supporting the debt—which implies that there is no value given to the residual value of the property.

“The whole idea of positive leverage has been a challenge,” says Garrabrant. “There's this graduation that's going to occur, but not quite sure when.”

Whenever that graduation does occur, it is almost certain that private equity real estate firms will be there to take advantage. Yet as more and more real estate players enter Brazil, the challenges they face are not just those of an emerging economy. Like their counterparts around the world, property investors in Brazil are confronting what has become the common denominator in the global real estate industry: a significant amount of capital competing for deals. And that is making some investors very nervous.

“We're drowning in liquidity,” says Garrabrant. “It concerns me when Brazil suddenly becomes de riguer. In all these emerging markets, the risks get simplified because [investors] don't have terrific alternatives. When they lock on to something, they're willing to overlook the incumbent risks. In these places the partner quality is spotty, the respect for contracts is not the same and there is much more requirement for skilled navigation. Where it shows up? People overpay. And that is a bad thing for all of us.”