Paladin: Brazil suffering from office supply glut

The oversupply could create buying opportunities for some investors over the next two to three years.

With falling rental rates and rising vacancies, the Brazilian office market is being plagued with a glut of new office construction. For some real estate managers, however, this oversupply could present some new buying opportunities.

The Class A office markets in São Paulo and Rio de Janeiro have risen to 28 million square feet and 15 million square feet, respectively, according to a new report from Paladin Realty Partners. Between 2012 and 2014, 9 million square feet to 10 million square feet was added to the market, while an additional 4 million is projected to come online this year, the firm said.

The excess Class A office inventory is a result of Brazil’s economic slowdown, which has led to slower absorption, as well as a significant amount of new supply that has been built by Brazil-focused real estate funds and large developers in recent years. From 2007 to 2012, prior to significant amounts of private equity real estate capital being raised, new supply ranged from 1 million square feet to 1.5 million square feet of new space a year, which was very easily absorbed by Brazil’s growing economy. But with office supply doubling or tripling in the ensuing years, “that was a train wreck waiting to happen,” said Fred Gortner, co-founder and chief operating officer at Paladin Realty.

In São Paulo, the office development pipeline is expected to drop off considerably after this year. Rio, however, will continue to see high levels of new supply through 2017, with 5 million square feet of additional space – or one-third of the current inventory – expected to come online over the next three years. “Given that its major industries, such as oil and gas and mining, are being especially impacted by the economic downturn, Rio will probably suffer much more than São Paulo,” said Daniel Takase, investment director in Paladin’s Brazil office.

Already, the markets have borne the negative impact of oversupply, with Class A rents falling by 22 percent in São Paulo and 10 percent in Rio, vacancy rates climbing to 24 percent and 18 percent, respectively, and cap rates rising by 100 basis points to 200 basis points. “These factors, combined with attractive currency levels, have created a compelling value proposition to acquire high-quality existing commercial properties at attractive prices,” Paladin said in its report.

“I see the next two to three years as a good time for US dollar-based investors to be acquiring high-quality commercial income-producing assets in Brazil,” said Gortner.

The sellers of such assets, however, aren’t likely to be other Brazil-focused real estate fund managers, which are expected to hold onto the assets throughout the downturn. After all, because of difficulty of obtaining commercial real estate financing in the country, the firms typically have had little or no leverage on those properties. “They can afford to be patient and ride the market,” he said. “They don’t have a gun to their head like they would with a highly leveraged building in the US.”

Instead, Gortner expected other Brazil-focused real estate investors, including local pension funds, private companies, listed vehicles and international owners to be offloading assets over the next few years, due to motivations or pressures not directly related to the particular asset being sold. This would particularly be the case with developers that act more as merchant builders and which don’t have an incentive to hold the assets over the long term, he said.