Mexico and Brazil have Latin America's biggest economies and the region's most mature real estate markets. Richard Gwilliam reports
Latin America is a region that, until recently, has been largely absent from the radar screens of most international investors. But, with the increased interest in emerging markets, it has come into view. With strong economic growth and maturing property investment markets, the region has some notable opportunities to offer. Mexico and Brazil are the two dominant powerhouses in Latin America. As well as being home to more than half of the region's population, they account for over half of its GDP. Brazil recently overtook Mexico as the largest economy and, with a GDP of nearly $2trn (€1.3trn) on a purchasing power parity basis in 2007, it is the ninth-largest economy in the world, surpassing Italy (Mexico is twelfth, now larger than Canada). Latin America's third-largest economy, Argentina, has a GDP less than one-third the size of Mexico's.
Both Mexico and Brazil have had their economic problems. Mexico's currency crisis of 1994 prompted mass unemployment and started a recession that saw the economy contract by more than 6% during 1995. Brazil suffered from hyperinflation for a prolonged period in the 1980s and early 1990s - the price level increased by a factor of several hundred billion between 1980 and 1995. In 1998 both countries were affected by the Latin America financial crisis.
Recently, both economies have matured and become more stable (aided by reforms and improved political stability), while still delivering healthy growth. It seems much of the risk that characterised the two economies in the past has been reduced. Mexico has (along with Chile) the highest-rated long-term sovereign credit in Latin America, while Brazil is close behind at just one notch below investment grade, with many expecting it to be upgraded in the near future.
Mexico's economy is closely linked to that of the US - over 85% of Mexican exports are to its northern neighbour. The links have been bolstered substantially through the North American Free Trade Agreement (NAFTA) which came into effect in 1994. Though Mexico has benefited from increased trade and virtuous effects on its currency, it has increased its economic dependency on the US. Indeed, the US slowdown was the main driver of Mexican stagnation at the beginning of the millennium, with zero GDP growth in 2001 and 0.8% in 2002, after running at an average of 5.5% in the previous five years.
Mexico's economic fundamentals are solid at present, with consumer demand, manufacturing and the oil sector (through high prices) all healthy. Growth was strong in 2006, at 4.8%, but exposure to the US remains Mexico's biggest vulnerability in the near future. Growth in 2007 was 3.3%, and it is projected to slow further over 2008, to less than 2%, being hit by the US downturn.
Brazil's chronic inflation appears to have been tamed - it is now running at below 4%. The use of inflation-targeting by the central bank has been successful in reducing inflation. This said, interest rates remain among the highest in the world - currently at 11.75% - despite having fallen substantially over the last three years, having been almost 20% in the summer of 2005. The falls in rates have certainly helped to boost the economy, with the robust 3.8% GDP growth seen in 2006 improving to a strong 5.4% over 2007.
As one of the BRIC countries, Brazil is regarded as a key driver of the planet's economic future; economic growth for the BRIC nations is expected to outstrip that of other major economies over the next few decades. Indeed, many economists estimate that Brazil's GDP will more than double by 2025.
Not only are Mexico and Brazil Latin America's largest economies, but they also have the region's most mature real estate markets. The most recent Real Estate Transparency Index, produced in 2006 by Jones Lang LaSalle, classifies both markets as Tier 3, meaning ‘semi-transparent'. The only other Latin American countries to attain Tier 3 transparency are Chile and Argentina. Out of the 56 countries in the index, both are in the top five most improved, with Brazil at number one, having achieved a movement up from Tier 4. Mexico just missed out on Tier 2 and actually achieved Tier 1 status for ‘professional standards and transaction process'.
Though not yet ‘highly transparent', Mexico and Brazil's property markets have now achieved a reasonable level of transparency. Their continued improvement has made for a more hospitable environment for international investors. These circumstances have resulted in the two markets attracting increasing amounts of foreign capital. Data from Jones Lang LaSalle shows that US investment capital purchased about seven times more real estate in Mexico than in Canada in 2005, while Canadian investors themselves have poured billions of dollars into Brazilian property in recent years. The combined transaction volume of Mexico and Brazil soared by 80% over 2007.
As has happened around the world, Mexico and Brazil have seen property yields fall in recent years. Office cap rates in Mexico City are now below 9%, having been at 12% less than five years ago. The slashing of Brazil's interest rates over the last three years has certainly helped lower property yields there - São Paulo office cap rates, though still among the highest in the world at around 12%, have fallen from 16% just a few years ago. It is generally expected that cap rates in both countries will continue to fall, particularly in Brazil.
Favourable economic conditions bode well for rental growth prospects in both countries, with young and growing populations supporting long-term real estate demand. Mexican industrials have seen tremendous rental growth in recent years, benefiting from increased need for distribution space, manufacturing activity, global integration in supply chains and the border with the US. Brazil has started to see similar growth in industrial rents. Rental growth in both countries' retail sectors has been driven by a growing middle class and the expansion of consumer credit. Office rental growth is perhaps not quite as assured - while demand has been healthy, the sector is prone to overbuilding. It is the residential sector that may see the strongest rental growth in both countries, as the demographic profiles lead to rapid growth in the number of households. Development has tended to focus on the high end, meaning a shortage of affordable housing, putting heavy upwards pressure on rents.
Though offering promising opportunities, risk remains in these still emerging markets. Investment is perhaps most suited to those willing to accept more risk, rather than those invested only in core markets. For those who do choose to invest, it is advisable to work with local partners. Property deals are often done with known contacts only and, if going down the development route, local partners can be essential in procuring development permits.
Both countries have a large pool of investible property that is still outside the existing market and owner-occupied property offers sale and leaseback opportunities. Indirect investment is also an option. To take advantage of the favourable capital market climate, more than 20 Brazilian real estate companies have gone public in the last two years, and REIT structures, though in early stages, are expected to grow.
Mexico and Brazil both have some attractive opportunities for investors. With strong economic growth providing sound fundamentals underpinning occupier demand for real estate space, and an increasingly globalised property investment market, those who are prepared to take on the risks of investing there may be rewarded well. Of the two countries, Brazil, with its superior fundamentals but lower liquidity and transparency, necessitates the more opportunistic investor.
Richard Gwilliam is a research analyst at PRUPIM
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