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FRIDAY LETTER: Pain and gain

Still reeling from its stunning World Cup defeat this week, Brazil might want to brace itself for more grief, this time on the real estate front. Private equity real estate investors will want to pay attention

For a country where futebol is the lifeblood, it’s hard to think of anything more devastating than Brazil’s crushing 7-1 loss against Germany in the World Cup this week. It was impossible to miss the images of weeping Brazilians splashed across news sites everywhere. Then there were the comments from local media, such as the newspaper Lance, which called the defeat one of Brazil’s “biggest humiliations” and “most shameful.”

And as gut-wrenching as it sounds, there may be more pain in store for the World Cup’s host country, albeit in an entirely different arena – hospitality. For the private equity real estate industry, however, that pain could yield compelling investment opportunities – although careful handling will be imperative.

The World Cup, along with the 2016 Olympics, has helped spur a hotel construction boom in anticipation of increased domestic and international tourism from the two events. Indeed, Brazil currently has the third-largest hotel pipeline in the world, behind only the US and China, with 408 projects totaling 69,023 rooms, according to a spring 2014 report from Lodging Econometrics. Meanwhile, the country’s inventory of operating hotel rooms currently stands at 218,658 rooms, up 12 percent from five years ago.

Whereas the Olympic Games will be concentrated mainly in Rio de Janeiro, the World Cup was held in 12 host cities across the country. Some of those cities, such as Curitiba and Belo Horizonte (the site of the already-infamous Brazil-Germany match), are considered secondary and tertiary markets that don’t typically attract the visitor numbers to justify the newly expanded capacity. Post World Cup, many of these markets are likely to suffer from an oversupply of hotels, with the resulting decline in occupancy and room rates expected to drive up hotel distress.

The post-tournament drop-off, however, is just part of the problem. Arguably, the bigger hit to Brazil’s lodging industry will come from the country’s widely-predicted economic decline. According to the International Monetary Fund, GDP growth is expected to slow to 1.8 percent this year, down from 2.3 percent in 2013. Such a decline would be detrimental to Brazil’s lodging sector because of the anticipated slowdown in domestic leisure and business travel, which actually accounts for most of the country’s hotel demand, according to advisory services firm Alvarez & Marsal. In fact, there’s a nearly 1:1 correlation between hotel room demand and GDP growth, the firm noted.

Compounding the difficulty is the fact that construction and land prices have been driven sky-high by increased competition in Brazilian real estate in recent years. And to make matters worse still, many new hotel developments have been financed largely by high-net-worth investors through a condominium format, which has allowed deals to move forward even when market fundamentals haven’t always been sound.

For the private equity real estate industry, the obvious conclusion is that Brazil’s hotel sector is likely to become a new source of distressed deal flow in the region. Investing in it will not be straightforward. It won’t be as timely and orderly as in the more mature markets of Europe and the US.

Just as Brazil will be slow to recover from its World Cup loss, so should industry players be deliberate in capitalizing on hotel or other real estate distress in the country. In fact, successful execution will require plenty of time and patience. Time may heal all wounds, but it’s always better to avoid getting hurt in the first place.