FEATURE: Southern exposure

The Latin American real estate market does not move in lock step. As the wave of investment in Mexico begins to ebb, capital is moving into Brazil, Argentina and other markets. PERE Magazine March 2009 issue

Here's a sign of the times – the new case against Mexico's real estate market isn't that it is part of Latin America, but rather that it is part of North America.

But while economic tumult has left investors wary of the US' southern neighbour, it has not dampened enthusiasm for other markets within vast and variegated Latin America. For example, several years of over-enthusiasm for Brazilian IPOs has now flooded the market there with distressed investment opportunities. And Argentina's enormous market is attractive for those who can get comfortable with the macroeconomic risk. Other markets within Latin America elicit a mixed bag of enthusiasms from international investors.

Having been a hot destination for foreign investment for roughly a decade, the Mexican market is now more developed, expensive and very competitive.

Mexican mix

The country has attracted the capital of US REITs, pension funds, insurance companies and private equity funds, says Thomas McDonald, chief strategic officer of Chicago-based Equity International. By 2002, Mexico was widely recognised as investment grade, allowing in a flood of institutional investment from groups prohibited from investing in non-investment grade countries.

In addition to this relative saturation, the Mexican market's leverage levels and correlation with the US are now of concern to private equity real estate investors and the institutions who back them. Mexico and Chile remain the most heavily leveraged countries in the region that is otherwise known for relatively low levels of debt on real estate.

“Although the country remains interesting, it is more correlated with the US than Brazil, which we think can actually be countercyclical to global real estate markets,” says New York-based GoldenTree InSite Partners managing director William Cisneros.

New York-based private equity real estate firm Falcon Real Estate Investment Company considered investing in Mexico but decided against it in favour of the US. For the Falcon Family of Funds, comprised of the Americas Real Estate Opportunity Fund and the KP Agribusiness Fund,

Falcon president Jack Miller decided Mexico has already been “discovered” and the economy was too closely tied to that of the US, where he thought the investment opportunities were stronger, to provide diversification within the product. The fund allows investors to allocate capital to direct investment in Colombia, Argentina, Brazil, Uruguay and opportunistic commercial real estate markets in the US.

Latin American appeal

Despite the pullback of interest in Mexico, Latin America as a region retains its appeal to major investors.

“The global real estate waters may choppy, but for ING Clarion there is still a rising tide to be found in the emerging markets of Latin America,” chairman and chief executive officer Steve Furnary tells PERE. ING is now working to fully develop its Brazilian operations before considering expansion into Peru, Argentina and Chile among other Latin American countries.

“The demographic and socio-economic drivers of these markets will be overwhelming and real estate will be priced very favourably for investors following the deleveraging that is taking place,” Furnary says.

For example, demographics in Brazil currently resemble the US baby boom of years past, according to Cisneros. The workforce, defined as individuals between the ages of 25 and 50, currently makes up 35 percent of the population, a statistic expected to reach 45 percent within a decade.

“We like Latin America because the demographics are so compelling and that's not going to change,” says Philip Fitzgerald, managing director for emerging markets at Los Angeles-based Paladin Realty Partners, which has developed projects throughout Latin America with a projected capitalisation of more than $3 billion. “What will change is the opportunity set.”

Brazilian “candy”

Investing in Brazilian real estate today is like being a “kid in a candy store with just a few other kids that also have money to compete for the candy”, adds Cisneros. Brazil has emerged as a hot market for real estate over the last several years and received a boost when US rating agencies S&P and Fitch upgraded the country to investment grade last year. But the impact of the global credit crisis has brought the opportunity to an entirely new level.

“There's a distressed aspect to the Brazilian market that creates opportunities that didn't exist before and the distress is really on the supply side,” says Paladin's Fitzgerald, noting that the distress is stemming largely from overextended and undercapitalised public companies as opposed to private companies.

Beginning in 2006, more than 20 real estate companies went public on the Brazilian stock market, “only a handful of which had any business doing so”, says Fitzgerald. These newly public companies were suddenly provided with massive quantities of capital at high valuations. They then expected to indefinitely rely on the public markets for capital.

It quickly became clear circa late-2007 that these public companies were not going to obtain additional equity capital in the short term from the capital markets. They then turned to the credit markets which were generous for a time and then shut down as well. Today, real estate stocks are down between 75 percent and 95 percent while being simultaneously cut off from both the equity and debt markets.

The listed companies are heavily overcommitted to projects they are unable to finance. “Let's call the market cap of the public real estate companies today about R$8 billion (€2.7 billion; $3.5 billion), says Cisneros. “They have about R$18.5 billion in construction financing commitments going forward. They are now shrinking their pipelines to fit these new capital constraints, and helping the market self-regulate by reducing expected future supply.”

Ready-to-go

Private equity real estate firms have the opportunity to buy into these companies at massively depressed prices, form joint ventures to complete projects or buy up assets being shed to finance other projects at bargain prices.

“One year ago we would go after the natural development,” says GoldenTree's João Teixeira, a Brazil-based managing director, referencing ground-up development beginning with the purchase of land. “At this moment we have good opportunities to jump into ongoing projects with part of the pre-sales already done or ready-to-go projects with the land already titled and the project approved.”

The secondary appeal of buying into stalled projects already in progress, in addition to heavily discounted pricing, is a reduced timeframe. It would previously have taken four to five years to go from purchase of land to receivable, says Teixeira. Now that time can be cut down to roughly one to two years.

With the vast number of unfinanced projects distressed public companies are committed to, they are offering private investment firms their pick of projects in the pipeline. Many are gravitating towards projects offered up in affordable housing due to the economic crisis and resulting government intervention.

Brazil has a housing deficit of about five million units that has been driving interest in residential development for some time. However, the shift to the affordable segment is a significant change from the pre-crisis focus of most investors on the growing middle class, expected to experience the most impact from the economic environment.

In support of the sector, the Brazilian government is expected to announce incentives for both developers and buyers of low income housing in the near future. At press time, no official announcement had been made. However, initiatives may include mortgage insurance, making funds available linked to the construction of affordable housing and concrete housing construction goals raising the profile of development.

“To the extent that they come out it's a positive sign,” says McDonald. “The missing piece has been what the government needs to do. It's the financing piece and the government's efficient administration, that has been missing.”

Dollars to Argentina

While investors nearly universally acknowledge the appeal of Brazil as well as some non-BRIC markets in the region, Argentina is a far more debated investment destination due to the lack of political and economic transparency. The current regime, headed by President Cristina Fernández de Kirchner, is perceived to be unstable, inconsistent and prone to pursuing policies that undermine the integrity of the domestic economy such as the controversial nationalisation of roughly $25 billion in private pension funds approved this past November.

The sheer size of the Argentine market is a draw. Although GDP growth has not been strong over the last year, growth has been rapid over the last six years and the economy remains the region's third largest, says Daniel Melhem, managing director at Falcon's Argentine partner Knightsbridge Partners. Even if the country continues to underperform in terms of growth it will remain far larger than other nearby markets. Argentina has a population of 40 million and a GDP of roughly $260 billion. By contrast, Colombia's population is 10 percent larger with a GDP only half that of Argentina's.

Argentina's already cheap currency continues to devalue, which contributes to the country's strong tourism industry. Knightsbridge is currently looking at purchasing existing fourand five-star hotels. These properties take advantage of the currency devaluation because rates are charged in dollars whereas costs are paid in pesos.

Currency appeal

“The good thing about Argentina is that when you're buying and renting commercial properties it's all done in US dollars so we're not all that concerned about the exact currency situation,” says Miller. “When you buy a building you pay in dollars, you get rents in dollars and when you sell it you get dollars back.”

This currency appeal is lost on others. Fitzgerald laughs at the suggestion that it is possible to be comfortable investing in Argentina until there's more transparency in the economy and particularly from the government.

“Here's just one problem in Argentina right now: you have under-reported inflation so you have no ability to budget a project so when you go to build something you have no idea what it might cost,” says Fitzgerald. “Even if you put an inflation index in your contracts the inflation is under-reported by the government. Therefore, your costs could easily far exceed what you are actually going to be able to recover.”

On the subject of Argentina's fraught political system, it is sometimes an acceptable risk to trade rule of law for growth, says Equity International's McDonald. However, investment in Argentina cannot be justified where there is substantial growth in more stable countries just outside its borders. “[Argentina] systemically has a track record of behaviour of turning their back on global institutions of the highest credibility,” he says.

Although Argentina's domestic policies are a turn-off for many considering entering the market, the experience of investors with projects in progress does not necessarily support the view that real estate investment there is untenable. The country has significant problems since defaulting on its public debt and devaluing its currency in 2002, acknowledges Taurus Investment Holdings' president and chief executive Peter Merrigan. Since that time, there has been no debt available in the market meaning deals have to be done on an all equity basis.

Nonetheless, Taurus moved into Argentina roughly five years ago to develop and operate a 67-acre research park on the Universidad de Austral campus near Buenos Aires. “In Argentina, the perception from the outside world recently has been quite negative but if you get into a situation like the one that we're in, we're actually quite pleased with what's going on down there,” says Merrigan. “The project is sound and the people that we're involved with are of high quality.”

Merrigan does admit that were the opportunity to arise today, it is unclear whether they would move into the country although they would carefully consider it. “We certainly would prefer to see a more consistent and transparent form of government. That would make everyone's life easier.”

While many investors are completely writing off Argentina, Melhem argues that the tumultuous market and investor aversion make this the ideal time to invest for those who can see past the current regime, especially with the government turning over in October and more pragmatic candidates in the pipeline.

“I'm glad we didn't invest two years ago but coming in now going forward will be great for investors,” says Falcon's Miller.