Reais estate

Brazil has a booming real estate finance market but the government is encouraging developers to focus more attention on residential property by raising the cost of funding for commercial real estate. But nobody is sure what unintended consequences the changes could have. Jason Mitchell reports.

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Last year, the total issuance of Certificates of Real Estate Receivables (CRI, by its initials in Portuguese), the country’s main asset backed security for real estate finance, reached R8bn (US$4.8bn) against R4bn in 2009, according to research by Jones Lang LaSalle, the global commercial real estate group.

In 2009 and 2010 around R1bn of this issuance was backed by credits originated from individuals, arising generally from the sale of residential property. The remainder was backed by credits that originated from corporations, which normally arise from the capital requirements to finance real estate projects (usually commercial, industrial or retail developments).

Under Brazilian rules, 65% of all deposits in national savings and loans accounts must be invested in real estate finance. In practice financial institutions have used these deposits to invest in CRI instruments backed by credits originated from individuals and from corporations. From February 28, only CRI instruments backed by credits originated from individuals will be eligible for the 65% allocation.

Experts are unsure what effect the change will have on the country’s real estate market, but it is likely to lead to greater sums of financing being available for residential projects, at the expense of commercial, retail and industrial development. Before the change, the cost of financing commercial projects through the CRI varied from 10.5% plus an inflation measure, known as TR, to 11.5 % plus TR. It is now expected to rise to 13.5% plus TR. Investors in the national savings and loans account receive 6% plus TR.

At the end of 2010 the government also created an incentive for foreign investors to invest in the CRI instrument. Any income they earn from investing in it is now exempt from taxation, which could open up a major source of financing for all types of real estate development.

“The CRI instrument has become an important source of finance for commercial property developers,” said Andre Rosa, regional director of capital markets at Jones Lang LaSalle in Brazil. “However, the government wants to encourage residential real estate development and the cost of finance is now set to increase for commercial property developers,” he added.

“We are still not sure about the implications of all these changes. Although commercial projects will lose a source of financing from national savings and loans accounts, the new tax incentive could lead to foreign investors starting to back commercial development in a big way.”

Local experts believe that Brazil’s real estate finance and mortgage markets have the potentially to grow markedly during the next few years because they start from a low base: total bank credit against GDP is 45.9%, according to Inter-American Development Bank. And total mortgage credit is around 5% of GDP, according to Jones Lang LaSalle.

Coalition of the willing

One of the most traditional forms of real estate finance in Latin American countries, including Brazil and Mexico, has been for a group of wealthy families to come together to back a project. In Brazil, in particular, developers have preferred to sell equity in a project to a group of wealthy investors rather than take out a bank loan, because of historically very high interest rates.

“To some extent this still happens in Brazil,” said Rosa. “But during the past five years property developers have become more professional and it has become much more common for a property company to raise capital through a public offering or a follow on. Equity is still the main way real estate development is financed in Brazil, although debt is becoming more important.”

In 2007, 17 home builders realised IPOs in Brazil and an additional four follow ons took place, raising a total of R12bn. The share price of several of the companies dropped markedly during the international financial crisis and the number of groups has been reduced to 13 through consolidation.

Property developers in the country have started to collect considerable cash proceeds from housing projects launched in the 2007 to 2008 period. They were were fully funded and the net amount collected is expected to represent, on average, 150% of the companies’ book value and more than 200% of all equity capital raised so far, according to Barclays Capital.

Since the end of last year, the home builders sector in Brazil has seen a sell-off, which has led some premium stocks to trade below, or very close to, their impairment value. For example, four companies - Gafisa, Brookfield, Even and Tecnisa - are valued at less than their net receivables (net of construction obligations and debt and disregarding the land bank). Two other companies – PDG and Cyrela – are trading below their estimated impairment value this year.

“Ironically, prices seems to be reflecting a near shutdown valuation,” said Guilherme Vilazante, a Latin America cement and construction analyst at Barclays Capital. This is despite an environment of margin improvement, especially in the mid-high segment; strong cash flow generation in the next quarters, as 2007 and 2008 units are delivered; and strong earnings momentum, even if volume growth turns out to be below expectations this year. This doesn’t take into account the strong track record the housing sector boasts in the face of economic downturns.

Underestimated

One reason healthy companies in the sector are trading below their impairment value is the undue use of price-earnings as a reference for valuation, said Vilazante. This does not take into account the strong cash inflows during the next couple years and underestimates considerably the companies’ ability to generate cash during a growth period. Barclays Capital prefers the most discounted names (Gafisa, Brookfield, Even and Tecnisa), which are trading well below liquidation value and offer the most risk-reward potential on the upside.

During the past four years, it has become common in Brazil for private investors to consider alternative investments, including real estate funds managed by banks and other financial institutions. Investors receive a monthly income from them and they have a fiscal advantage because they are not taxed as individuals. More than one hundred of these funds have been set up since 2007, according to Jones Lang LaSalle.

“Historically, Brazilians have been used to very high interest rates in the region of 20%,” said Rosa. Now, with interest rates in the 10% to 12% range, investors are looking at other ways to boost yield. “The real estate funds have become extremely popular and have really helped the real estate sector to develop in the country,” he said.

Since 1993, Brazil has had a structure called Fundos de Investimento Imobiliario (FII). It is sometimes referred to as a REIT, but it is mostly used for private investments in specific projects. Although the volume of FII trades has increased markedly, the number of transactions remains low. The country’s high interest rates have made it difficult for FIIs to compete with funds but they may become one of the best exit strategies for portfolio holders in the future.

“The real estate finance market is developing in so many ways in Brazil,” said Rosa. “As well as REITs, there are all kinds of individuals, companies and funds that are very actively building up their real estate portfolios: private equity funds; pension funds; public companies; ultra high net worth individuals; and property companies.”

Build to suit transactions - where normally a multinational company hires a developer to construct a building for it to occupy - are also becoming more common in Brazil. They usually have a contract for more than 15 years and banks are more willing to lend to this type of project at a better rate. Such projects involve less risk for banks, as under normal leases in Brazil a tenant can walk away from a contract and only receive a three month penalty.

Sao Paulo only has 2.4m sq m of class A office space and Rio de Janeiro has 1.1m sq m, according to Jones Lang LaSalle. The vacancy rate for class A space in Rio de Janeiro is 3% against 6% in Sao Paulo. Normally, landlords in Brazil only want to develop class A offices in Sao Paulo or Rio de Janiero, where the demand is highest, because it is so easy for tenants to renege on a contract. However, build to suit transactions are leading them to develop prime office space in other parts of the country.

In 2001 and 2004, Brazil introduced new regulations that made it easier for lenders to foreclose on a property when the home loan falls into default. Banks have started to offer more mortgage credit since the change. Self-financing – where a developer would build a project and provide the buyer with a loan – is fading out.