FEATURE: Betting on Brazilian distress(2)

Private equity real estate firms are seeing ‘many, many billions’ of dollars in potential equity and debt investments arise from the distress of the Latin American nation’s cash-strapped public homebuilders. PERE Magazine, July/August 2012 issue.

For the past several years, growth has been the name of the game in Brazil. Lately, however, Latin America’s largest nation has been showing signs of growing pains, as opportunities to make distressed real estate investments on a wider scale are emerging for the first time.

“It’s like a kid learning how to ride a bike,” says Gary Garrabrant, chief executive officer of Chicago-based investment manager Equity International, of Brazil and other emerging markets. “Now, they’re falling off and getting bruised.”

While the country saw some challenges from the global financial crisis, Brazil pretty much sailed through that period of distress when compared to other nations, adds Tom Shapiro, president and founder of GTIS Partners, a New York-based real estate investment firm. “We’re currently starting to see the first elements of distress.” 

Boom and bust

During the mid-2000s, the Brazilian homebuilding industry underwent a public boom as a slew of companies, including PDG Realty, Cyrela Brazil Realty and Gafisa, launched initial public offerings. However, the largest to the smallest of the publicly traded companies have been challenged in one way or another, notes Garrabrant, who co-founded his firm with billionaire Sam Zell in 1999. 

The past five to seven years saw the birth and runaway growth of the Brazilian homebuilding industry, which resulted in “too many public companies,” Garrabrant says. “Now, it’s the other side, where a great rationalisation has begun.”

After going public, most Brazilian homebuilders pursued ambitious expansion plans as they became more focused on increasing growth and building market share. The companies expanded their homebuilding operations into new regions of the country and diversified beyond homebuilding into a variety of commercial real estate sectors, including office, warehouse and distribution and retail. “They became publicly traded development companies, as opposed to pure-play homebuilders,” says Garrabrant.

Many of those firms now are struggling from a combination of overly aggressive growth and surging construction and labour costs. “Heightened construction cost inflation, combined with flattening housing prices, is pressuring margins for the sector,” wrote Felipe Rodrigues, an analyst for HSBC, in an industry report last year. “The combination of both effects is causing a high level of uncertainty on homebuilders’ run-rate margins, which we believe will not be resolved over the next few months.”

With cost overruns and project delays affecting profitability, the stock prices of Brazil’s public homebuilders have plunged by as much as 80 percent from their peak. Shares of Gafisa, for example, were trading at $2.60 on the New York Stock Exchange when this story went to press, towards the bottom of their 52-week low of $2.05 and down 77 percent from a 52-week high of $10.52. Meanwhile, PDG, Brazil’s largest homebuilder, saw its stock trading at R$3.27 on the Bovespa, also near its 52-week low of R$2.87 and down 66 percent from a 52-week high of R$9.58. PDG, Gafisa and other homebuilders contacted for the story could not be reached for comment by press time.

Meanwhile, Brazilian banks, which historically have been conservative about lending, have pulled back on financing to homebuilders in the face of shrinking margins and project delays. “There will be a need for capital from private funding sources,” says James Worms, chairman and chief executive officer of Paladin Realty Partners, a real estate fund manager based in Los Angeles. “Whenever there’s any kind of increased inefficiency or stress in the real estate capital markets, it’s harder to get cheap capital. Those are conditions that private equity firms find advantageous.”

Plays for public builders

Indeed, in late May, local private equity firm Vinci Partners presented a plan to raise about R$800 million (€310.6 million, $387 million) for PDG, largely through the buyout firm’s investment funds. Under the plan, which has been signed off by PDG’s board but still needed shareholder approval at press time, Vinci could own as much as 21 percent of PDG’s equity in four years, according to a research note by JPMorgan analysts Adrian Huerta and Marcelo Motta. 

Vinci isn’t the only buyout firm that has tried to capitalise on the distress of Brazilian public homebuilders. Earlier this year, in February, Gafisa rejected a buyout offer by Equity International and local private equity firm GP Investimentos on the basis that the offer significantly undervalued the company’s assets. 

Incidentally, Equity International made its first Brazil investment in Gafisa in 2005 and, in partnership with GP Investimentos, helped to expand the São Paulo-based homebuilder’s business nationally and take the company public, with listings on the Bovespa in 2006 and the NYSE in 2007. Equity International began selling off its 23.4 percent ownership stake in Gafisa in 2007, and it sold its remaining 2.7 percent stake in the company last year. 

“It’s not easy to acquire public companies in Brazil,” acknowledges Garrabrant. Still, it is possible to buy or invest in a portion of a company, or acquire assets from a company, as builders are likely to scale back on their real estate holdings, particularly those that were built or acquired during the post-IPO expansion mode. 

“In a way, this is a return to core, both in property type and geography,” Garrabrant says. “We expect homebuilders to exit their non-core activities, as well as regions where they have the least expertise.” He expects that such an exit by public homebuilders from non-core activities and regions would open up new investment opportunities for private equity real estate firms targeting Brazil. 

One case in point is open-air retail, or community shopping centres, which Garrabrant views as a sector that has immense growth potential in Brazil and in which Equity International currently lacks a platform. Indeed, the firm is aiming to accelerate its expansion into the sector through the acquisition of an open-air retail platform – a business line that is part of the operations of several public homebuilders currently facing challenges, he noted.

Debt opportunities

As for stalled homebuilding projects, “if there’s an opportunity to take some of these assets off public builders’ hands on an at-cost basis, certainly these are opportunities that local and foreign private equity firms would consider,” says Worms. 

While equity and debt investments in individual projects are much more short term and have a more definable exit strategy, they generally produce lower yields. Therefore, the larger opportunity would come from investing in the companies themselves.

Meanwhile, private equity firms that provide mezzanine debt to a public homebuilder on an entity level typically would expect returns around 20 percent. This is somewhat lower than the 25 percent returns expected by most private equity firms with strategies similar to Paladin’s primary investment thesis, which is making pure equity investments through joint ventures with local operators to build a number of housing projects within a designated area. 

Paladin currently owns a large stake in a Brazilian publicly-traded real estate company called Viver, which it acquired in 2009 on behalf of its third Latin America real estate fund, Paladin Realty Latin America Investors III. The transaction, which occurred at a time when the global credit crunch tightened access to traditional sources of capital, provided the homebuilder – then known as INPAR – with R$180 million of new equity to expand its business. 

Riskier investments

The real estate opportunities presented by Brazilian homebuilder distress, however, runs counter to the general trend of investment capital moving towards more secure, stable assets. “Brazil has always been a risky jurisdiction, and this volatility has added to that,” says Darin Bifani, founder of Puente Pacifico Investment Advisory, a Santiago, Chile-based business advisory firm that counsels clients on cross-border investments in Latin America. Many large fund managers are likely to take a wait-and-see approach with investments in the country, he notes.

Indeed, Maximo Lima, founder of Hemisfério Sul Investimentos in São Paulo, says he’s interested in lending against public builders’ land banks at a large discount, where his firm can foreclose on the asset if the loan isn’t repaid and either develop the site for its original residential use or for a commercial use such as retail. Additionally, the firm is eyeing purchases of non-core assets or businesses, which can be picked up at attractive valuations. 

Although the firm has communicated its interest to public builders, Hemisfério Sul isn’t ready to pull the trigger just yet on such investments, for which it has return expectations in the mid-teens for debt and in the mid-20 percent range for equity. “There’s no hurry to do anything right now,” says Lima, noting that the Brazilian housing market is in the nascent stages of a down cycle, where prices and sales velocity are beginning to decline. 

“Things are bad today, but they’ll get worse tomorrow,” Lima continues. “I see a significant amount of pain for homebuilders over the next couple of years.” 

Lima anticipates that Hemisfério Sul will become more active on negotiating deals with public builders in the next six to 12 months. Investing in homebuilder distress right now is risky because “there’s a substantial risk that prices will drop,” he explains. “If we wait for the drop to occur, then the risk comes down.” 

A cautious approach isn’t surprising, especially when some limited partners aren’t sold on the strategy. Whether it is a capital infusion in a homebuilding project or in the homebuilder itself, “I don’t see the attractive opportunity,” one major institutional investor in Latin America tells PERE. “Why would it be a good investment to give them money if they’ve shown a lack of judgment? They have a broken record in a reasonably robust economy.” 

Buying off commercial real estate assets or platforms from homebuilders “is the only [opportunity] that makes sense,” the investor adds, although it isn’t an investment his organisation currently is considering. 

Investing in assets

In spite of this, some managers already are moving ahead. While most of the Brazilian public homebuilders are seeking a capital infusion on the entity-level, GTIS is steering clear of such investments because of the difficulties involved with the valuation of companies. 

“We’re sceptical about the book value of these entities,” says Shapiro. “What are the hidden liabilities and costs with a company? You don’t know unless you’re an insider.” Entity-level investments, moreover, run the risk of being dilutive to shareholders, since their stakes in the company are suddenly reduced by the entry of a large new investor.

Instead, GTIS is targeting investments in individual assets and projects that have been affected by liquidity issues. The firm currently is working on a number of distressed deals – particularly in the hotel, residential and office sectors – involving public companies, Shapiro says. “While we’re seeing opportunities now, we think we’ll see a lot more opportunities in the next 12 months.”

Shapiro adds that his firm is proceeding slowly in terms of potential investments in Brazil’s public companies, given a pipeline that he expects will “be in the many, many billions” of dollars. GTIS, which held a final close of $810 million on its second Brazil fund earlier this year, so far has invested just $200 million of the vehicle’s capital in anticipation of future deals to come from the public builders. “I think you get paid for being patient,” he says.

GTIS previously had undertaken a distressed deal involving a Brazilian public homebuilder in 2009, when the firm acquired a 50 percent stake in 106 Seridó, a R$1 billion development project consisting of two luxury condominium towers in one of the wealthiest areas of São Paulo. It acquired the stake from Klabin Segall, a publicly-listed real estate firm that owned the development site. 

Having defaulted on some of its debentures, Klabin Segall was in need of fresh capital. GTIS’ $100 million investment, which was used to acquire the company’s stake in 106 Seridó and complete the project, provided Klabin Segall with enough liquidity to get the company in order and sell itself subsequent to its deal with GTIS.

Window of opportunity

Considered the crown jewel of Klabin Segall’s portfolio, 106 Seridó is seen as an extreme example of a distressed deal. Still, “the approach is we’ve got to figure out what assets we want to go after and then approach the companies,” says Shapiro. “The better opportunities are always the ones that aren’t on the market.” He adds that the art of negotiating such a deal is being patient and coming to an agreement on an asset that works for both parties.

“There’s a lot of horse trading that goes in these deals,” Shapiro continues. “It takes a while for companies to realise the level of distress that they’re in. Other times, companies think the situation is temporary, so they don’t want to do that much.” 

Shapiro expects to see more mergers and more dilutive deals in the Brazilian homebuilding industry, as well as some builders going out of business. While it’s difficult to predict how long the opportunities coming from distressed public homebuilders in Brazil will last, he likens it to the ongoing distress that continues to unfold for public homebuilders in the US.

“If you asked me five years ago, when the US homebuilding industry was a wreck, how long the window of opportunity would be, I would have guessed maybe 24 months,” Shapiro says. “It’s proven to be a lot longer than that.” 


Beyond Brazil
Private equity real estate firms point to Colombia, Peru and Mexico as the next big opportunities in Latin America

While Brazil remains the powerhouse market in Latin America for private equity real estate firms, industry players say other countries in the region are posing some stiff competition.

“No doubt, our institutional investors want to expand beyond Brazil,” says Gary Garrabrant of Equity International. “When we organized our last group of investors, people asked about Colombia for the first time.”

Indeed, Colombia “is opening up and offering opportunity in terms of scale,” Garrabrant adds, noting the relative lack of competition and strong growth in the market. In addition, multinational corporations are just starting to lease space in the country after years of building and owning their properties. 

Last August, Equity International made its first investment in Colombia, injecting $75 million of capital into Terranum Development, a Bogotá-based commercial real estate investor, developer and manager. Through Terranum Corporate Properties, the private equity firm currently is in active discussions with a wide range of multinational corporations that are interested in establishing a presence in cities such as Bogotá, Medellín and Cartagena.

Terranum, however, is focused not just on Colombia but the overall Andes region, which also includes Peru and Chile, notes Garrabrant. The region is appealing because “it’s brand-new,” he says. “It’s probably five to seven years behind Brazil.”

Paladin Realty Partners also plans to ramp up investment activities in the Andes region, particularly in Peru and Colombia. “We like Peru and Colombia for the same reason we like Brazil,” says James Worms, whose firm closed on its first real estate deal in Colombia earlier this year. Paladin teamed up with local developer La Trocha to form Pali-Trocha, a homebuilding platform that will focus on residential infill development and boutique hotels in urban Bogotá, as well as opportunistic land and commercial deals in suburban areas outside of the city.

According to Worms, both Peru and Colombia have similar demographics to their giant neighbour to the east, with large numbers of young people joining the workforce and driving future growth, and are led by governments that largely have stabilized. Additionally, both countries have a significant housing deficit that is not being met right now and are just beginning to tap into the mortgage market.  

The hotel sector in Colombia has exploded because of government tax incentives that have attracted a tremendous amount of foreign investment, adds Darin Bifani of Puente Pacifico Investment Advisory. The country “has a goal of positioning itself as an international conference and business centre.”

Meanwhile, Roberto Ordorica, head of Prudential Real Estate Investors’ Latin America operations, says Brazil has lost some of its competitive edge, as long-standing structural constraints involving a complicated tax system and high interest rates have hindered competitiveness and limited economic growth. Instead, he is bullish on Mexico, which currently has one of the lowest rates of inflation in Latin America, record-low interest rates and consumer confidence at the highest level since 2008.

“Mexico has really responded well over the last 12 months,” says Ordorica. “We’re seeing healthy growth, which is good for real estate.” He expects Prudential to shift more of its attention away from Brazil – where it currently is active in residential and industrial real estate – toward Mexico, where the firm is involved in the housing, industrial, retail and office sectors. “Over the next 12 to 18 months, I would expect more activity in Mexico,” he adds.

The main issue with Mexico, however, is security. “That’s what scares people away,” Ordorica says. “If you get beyond that, we would expect the next three years in Mexico to be terrific years.”