The macro signs are strong for Brazil, but challenges are daunting for institutional investors seeking access to the maturing market. Stephanie Schwartz-Driver reports

Brazil's story for institutional real estate investors is certainly compelling. The overall theme is one of rising prosperity and steady economic growth, the result of almost two decades of prudent governmental policies that have succeeded in raising millions of people into the middle class. In fact, it is estimated that around 30% of the population has made this transition in the past decade.

The demographics of Brazil give no indication that this rise is going to stop. In a total population of 200m people (three times the population of the UK and five times that of Spain), around two-thirds are under the age of 35.

This represents a "population bonus", says Axel Chaves, managing director and head of the Brazil office of Paladin Realty Partners. "Based on the demographics, for the next 20 years more people will be working and producing than not, and over that time period there will be the formation of around 1.7m new households per year. This creates lots of opportunities."

"It boils down to more demand than supply for quality real estate," says Jeb Belford, managing director at Clarion Partners. "There is tremendous demand for all types, but it is not very easy to deliver new supply."

This demographic and social shift is creating a huge opportunity for real estate developers because there is a deficit of around 6m housing units in Brazil, representing people either living with their extended families or in below-standard accommodation.
Part of the pent-up demand has been created because long-term residential financing is a recent phenomenon, enabling middle-class buyers to step onto the property ladder. Underwriting is very conservative, with the government's support, and regulations enforcing a redirection of retail savings into mortgage lending. "Mortgage capital in Brazil is where the US was 30-40 years ago, and behind its current peer group," says Bill Cisneros, senior managing director at GTIS Partners, one of the largest real estate private equity companies in Brazil.

And as middle-class demand grows, the government is encouraging lower-income first-time buyers with its Minha Casa Minha Vida (my home, my life) scheme, which provides low-interest rate financing and cash subsidies to buyers.

Government policies to encourage the flow of mortgage capital and subsidies to first-time buyers at both lower and middle-income levels are one part of the government's aim to ensure stability. There is also a mandatory savings system, into which 8% of salaries is invested, and the savings in this programme can be used by first-time buyers.

While the government is providing the financial grounding for home buying, it tacitly relies on private developers to create affordable housing, so the residential sector is an obvious target for institutional real estate investors. Some are building middle-class developments, while others are creating workforce housing, catering to a huge demand for residential real estate.

Paladin, for example, focuses around half of its investment capital in Brazil on affordable and middle-class housing - and about two-thirds of that goes towards middle-income properties. "This is a growth story, very different from the distress story of most opportunity funds," says Fred Gortner, managing director, Paladin.

"The typical middle-income project in Brazil is light years [away] from that in the US or western Europe. The demands are completely different and much more visible. Further, because of the relative dearth of capital and housing stock in Brazil, profit margins are significantly higher, so investment strategies can be executed with much lower leverage than the typical opportunity fund," he adds. "Looking at the real estate fundamentals, and putting aside currency, home building is a much less risky strategy in Brazil."

In addition to persistent unmet demand, developers benefit from the fact that most new developments are pre-sold, and this practice continues. "Even though the economy is slowing, it is usual to have 100% of units sold before construction," Chaves says, adding that in the firm's last offer for sale in December, 420 residential units were sold in a weekend. In addition, most Brazilian buyers are purchasing units to live in, not to speculate on, adding to the stability of the housing market.

There are, nonetheless, some pressures. In Sao Paulo, house prices have risen sharply, in excess of inflation. Average new house prices rose 85% from early 2009 to late 2011, against a rise in inflation of only 15%. In Rio, house prices were up around 30% in 2011. Although they are not expected to fall in 2012, capital value growth is expected to moderate during the year to approximately 5-10% nationally. Land prices have also risen, but these rises will be constrained as conservative developers, with the past history of hyperinflation still on their minds, are anxious about overpaying.

Looking beyond housing
In Brazil, home ownership is proving to be an engine of financial growth. "This is a huge transformation, driving demand for everything," says Chaves. "Other business emanates from growing home ownership: speciality finance, retail, warehousing and logistics," says Gary Garrabrant, CEO and co-founder of Equity International, whose portfolio of holdings in Brazil includes stakes in BR Malls, a leading retail property company that is now the largest in Brazil and Latin America, AGV Logística, a private logistics company, GuardeAqui, a private self-storage company, and Brazilian Finance & Real Estate, a private specialty finance company, and Bracor, a private corporate property company that is winding down.

Garrabrant sees many opportunities outside housing as the middle class continues to grow. One example is self-storage, he says: there are fewer than 50 self-storage units in Brazil, versus some 50,000 in the US. Retail is also developing, and Equity International is interested in second-generation retail properties - Garrabrant points out that there is only one outlet centre in the country, although enclosed malls are well established.
Clarion Partners "is a strong believer in residential and industrial", according to vice-president Marcela Drigo. "In these sectors, there are clear mismatches between demand and supply, and strong fundamentals," she says.

In terms of industrial product, the country is handicapped by obsolete stock. "Only one-quarter is considered institutional quality, which means there is a lot of room to grow," Drigo says. Clarion Partners focuses on new developments around Sao Paulo and Rio de Janeiro, the main distribution hubs.

The main driver for industrial development is internal consumption for all kinds of products, Drigo adds. Manufacturing is growing, and companies need more warehouses and distribution centres.

"It is a common misapprehension that Brazil is export-driven and commodity-dependent," says Gortner. "But two-thirds of Brazil's GDP is generated by internal consumption, reflecting the rapid increase in Brazil's middle class."

Many foreign investors active in Brazil focus their activities on the two largest cities, Sao Paulo and Rio de Janeiro. GTIS is a case in point. Cisneros explains: "Our investors want a best-in-class team in the largest, most liquid markets." There is a great demand for office space in Sao Paulo, for example, and "rents for institutional offices in Sao Paulo are approaching Manhattan-levels, simply because there is not enough supply", he says.

But other firms have broadened their geographic spread. "For us, Sao Paulo is an airport," says Garrabrant. "Some people have done well in Sao Paulo and Rio, and for them it is not worth looking outside. But we travel the country and have established national companies."

Brazil's geography is both an opportunity and a challenge. The country is vast and its different regions are all unique, with varying peoples, cultures, and business cultures, and there are two dozen cities with populations of more than one million. "We are a dominant home builder in six of them and are actively looking at other markets in Brazil," Gortner says.

Chaves adds: "Paladin has been active in Brazil for more than a decade, and I've spent my entire 30-year real-estate career here, so we know the country very well and can recognise opportunities in smaller cities. New entrants tend to look just at Sao Paulo and Rio. But it's not true that you can do anything anywhere and it will sell. Real estate is still a local business and it is possible to develop the wrong project in the wrong part of the city or with the wrong amenities. You have to be very careful in some neighbourhoods."

Garrabrant points to how a combination of Brazil's geographic size and social change presents an interesting opportunity in the hospitality sector. There are around 100 cities of a size and economic importance that make them destinations for business travel. As commerce continues to develop, business people are travelling around the country for the first time. "Traditionally, when people travel in Brazil they think about staying with friends or family, and there is not an existing hotel culture." International hoteliers are now focused on establishing their brands in the Brazilian market, and this sector represents a development opportunity, he says.

Brazil's large size means that many firms wanting to invest outside Sao Paulo and Rio find that it is easier to do so in conjunction with local partners. This is the approach taken by both Paladin and Equity International. Paladin has partners in many states, and Equity International owns stakes in many national real estate companies. "We made a decision when we formed Equity International not to create regional offices but to base a brain-trust in Chicago. We travel extensively," Garrabrant says. "We co-invest with local operating partners who become our presence on the ground."

Geography: a hindrance or an opportunity?
The country may be large, but real estate ownership is fragmented, so many deals are small. This limits the types of development deals and real estate investors who are comfortable operating there, according to Cisneros. "If you are a big real estate firm, you look at China or India where there are large-scale projects and you can deploy a significant amount of capital. In Brazil, the potential doesn't exist in that same dimension, so it is a lot trickier for the bigger guys and their business model," he says.

Smaller deal size controls the competition in Brazil. "Brazil is a very challenging market to work in. There are good opportunities but in a place where it is not easy to compete. There is a lot of noise, but in our space not that much capital is being deployed," said Cisneros. "When we started in 2007, it was the same situation as today, everyone was really excited, but since then only a handful of managers have succeeded because it is a fairly complex market."

Smaller deal size is in part of a result of the traditional real estate ownership structure in the country. Mortgage financing for substantial income properties does not exist as it does in western Europe or the US. What financing does exist is fully amortising over the short to medium term. As a result, with large office buildings or shopping malls, title is stratified, with different owners holding various floors of an office tower or wings of a mall.

This is a significant challenge to doing business in Brazil. "We don't own 100% of much because you can't," Garrabrant says. "For example, BR Malls has 45 malls in its portfolio but owns only 10 in total - the rest reflect smaller ownership interests. We are constantly trying to increase and aggregate those ownership stakes, but it takes a long time and it is incredibly difficult and complex."

This fragmentation of ownership is one challenge in the market that keeps deal size down, but it is also a factor that may keep the market from overheating. "We are not concerned about a bubble or overheating, because it is not easy to invest," Garrabrant says. "More is advertised than is actually happening."

Because real estate traditionally has been a small-scale business, with a high level of family ownership, there is a shortage of experienced real-estate professionals. "There is a smaller pool of real-estate professionals than in other parts of the world, but a class of real-estate professional is being formed as we speak," Drigo says.

"The field is attracting younger professionals from other sectors, including civil engineers and bankers. Still, as more international players come to Brazil, they are facing a certain level of difficulty in finding experienced people."

Drigo stresses that by working with an international company investors will be able to achieve the transparency, governance and level of reporting they are used to, in addition to a significant deal pipeline.

The same strength of interest in real estate that is encouraging the development of the profession is also making good opportunities harder to find. "The strong interest and the amount of capital allocation has resulted in rising land prices," Drigo says. "We have to negotiate harder, do more due diligence and look much harder than five years ago."

Many firms are still targeting high returns - yields of up to 25% - but they acknowledge these are harder to find. "Parts of the equation are sustainable, and we are confident that we will be able to find projects that meet our return expectations," says Cisneros. "But parts are not. Rents are high and the idea that they will continue to grow will end. But in the meantime, it is possible to make a lot of money."

These high return targets are in an environment in which economic growth is moderating. The Brazilian economy is expected to grow by around 3% in 2012, down from 7.5% in 2010 - but still better than most developed countries. "This is a good thing," says Gortner. "The economy cannot grow at 7.5% indefinitely; 3.5-4.5% growth is more aligned with long-term growth prospects and will keep inflation at bay."

But as the market changes, investor expectations have to change as well, notes Belford. "In the US investors distinguish between the level of return and the risk. This willingness and expectation is now developing in Brazilian investment. There is a forming sense that if you buy a fully occupied building it commands one level of return, while a higher return for a new development is appropriate," he says.

"Brazil is a maturing market. We are seeing an adjustment to cap rates and returns, but also more transparency, more international investors and more stability."