Rio de Janeiro is having its moment. Already world-famous for Copacabana and Ipanema, Brazil’s second largest city soon will become home to the 2014 World Cup and 2016 Summer Olympics. Now, it has another international distinction: one of the world’s most expensive office locations.
According to a recent Cushman & Wakefield report, Rio’s Zona Sul submarket was ranked the third-most expensive office location in the world, jumping five spots from last year’s ranking. What’s more, Rio was one of just two cities in the Americas to place among the top 10 most expensive office markets, along with New York’s Madison/Fifth Avenue submarket, which ranked eighth. In the Americas, Rio’s prime rental growth in 2012 was second only to Bogota, Colombia’s Andino district. In fact, four of the top five cities with the largest prime rental growth in the Americas were located in Latin America.
The question that arises is what impact rising rents will have on office investment in Latin America. In countries such as Peru, Ecuador and Colombia, the impact will be minimal, since the rate increases began at a low base, which means that rents still will be lower than traditionally more expensive locations.
In the case of Brazil’s Rio and São Paulo office markets, however, significant appreciation in rents has made it more challenging to source opportunistic investments. The office sector was the largest source of profits for Brazil-focused private equity real estate funds for the 2007 to 2009 vintages as a result of escalating lease rates and declining cap rates in those two cities.
These days, GPs that still have funds targeting office properties in Brazil “might be disappointed with the results,” said Ken Wainer, managing principal at VBI Real Estate, a private equity real estate firm based in São Paulo. Opportunistic returns in the property type have become more difficult to achieve, not only because much of the leasing acceleration and cap rate compression already have occurred but also because land prices and construction costs have soared.
Additionally, in the case of São Paulo, “we’re seeing potentially too much space coming online,” said Wainer. With a projected 15 percent increase in new space in the city over the next four to five years, supply is likely to exceed demand, which could put downward pressure on rental rates as developers compete for tenants.
Indeed, Maria Sicola, executive managing director of the Americas at Cushman & Wakefield, said she already has seen a decline in returns among Latin America-focused funds in 2011 and 2012 as compared to previous vintage years. “It’s a safe bet that it will continue to occur,” she added. Meanwhile, investment into Brazil increasingly may move into sectors like industrial, as well as secondary markets.
For VBI, office investments in Brazil tend to be “idiosyncratic,” where the uniqueness of a location can help attract tenants from other parts of the city or the project has a cost basis that’s well below market. Neither, however, is likely. “You can’t search for something unique – a diamond in the rough – because you’re just going to end up looking at a lot of dirt,” said Wainer.
New York’s GTIS Partners, which has developments in both Rio and São Paulo, is being relatively conservative in terms of future rental growth when underwriting projects. However, Josh Pristaw, who co-heads the firm’s Latin America business, sees a flipside. As high rents make prime locations prohibitively expensive for some tenants, “it can create investment opportunities in other parts of those cities and positively impacts our other projects” in locations where it can develop or redevelop Class A product at less than 50 percent of the cost for a similar development in one of the prime locations.
Pristaw maintained that GTIS’ current Brazil investments are expected to achieve similar returns to its earlier deals. The difference is that those returns likely will be based less on rental growth and more on value creation. “We like to focus at the nexus where both large amounts of capital and significant expertise to deal with complexity are required,” he said.
Still, not every Latin America-focused manager has the capital and expertise to pull off complicated deals like GTIS. For this reason, it seems that opportunistic office investments in both Rio and São Paulo have become as hard to find as a diamond in the rough.
That is, at least for now. As rental growth is expected to level off in South America because of increasing supply, Cushman & Wakefield’s Sicola expects some reshuffling with the firm’s global office markets ranking, although that isn’t expected to happen for more than a year. In the meantime, sit back and watch Rio put on a good futebol game.