A disproportionate share of global investment continues to go to Brazil; RE investors could benefit most, says Victor Lopez Beltran

Brazil is the largest economy in Latin America and the seventh largest (or fifth depending on your source) in the world. It has also evolved as the world's largest manufacturer of aircraft, as well as the biggest producer and exporter of sugar cane-based ethanol. Extremely rapid growth in investment, and especially in domestic consumption, has recently risked overheating the economy and accelerating inflation.

The Brazilian government worked hard to deliver a smooth 2011, as economic growth slowed noticeably during the second half of 2011 when the economy grew 2% after a minor contraction in the third quarter.

Overall in 2011, Brazil's economy expanded at a modest 2.7% following a healthy 7.5% gain in 2010, which is lower than the worldwide rate
of 3.2%.

Brazil has emerged as an important destination for both corporate occupiers that want to expand their global footprint, and investors looking to diversify their real estate portfolios geographically. The growth in investment opportunities continues to evolve at a rapid pace, given the land reform and privatisation measures undertaken in the past three decades. In the 1980s debt-ridden Brazil moved from a military-state government structure toward a democracy built around market-based reforms. More recently, the country is making significant progress in structural reforms, including the push for free markets and flexible exchange rates, and the broad elimination of many forms of capital controls.

We expect the Brazilian economy to keep on growing this year, thanks to strong domestic and foreign direct investment (FDI). Real GDP should advance at least 3.2% this year and growth should average 4.5% to 5% pa in the longer term. In the medium term, planned infrastructure spending for global sporting events such as the FIFA 2014 World Cup and the 2016 Summer Olympics will maintain Brazil's economic momentum.

Brazil's dynamic economy continues to attract interest from both institutional real estate investors and global occupiers alike. This interest has been a boon to local office markets across key cities. Unlike some other advanced economies, office vacancy rates for quality space remain at historic lows for the region, where average vacancy levels stand at 7-10%, and rents have continued on an upward trajectory. Underlining this trend, a large amount of new office supply is coming onto the market and much of it is pre-let.

Buoyed by Brazil's improving economic landscape in the past six months, the São Paulo office market has continued to strengthen. Given this performance, the scarcity of land in the city and strong pre-let interest for new supply, we expect rental levels for the office market to go to new highs in 2012. There was a remarkable increase in new supply during the first quarter, which caused the prime vacancy rate to increase to 3.2% from the previous 2.1% in the fourth quarter of 2011 (the lowest vacancy ever recorded in this market). This increased vacancy in trophy buildings pushed the overall vacancy rate to 4.0% from 3.6% in the previous quarter. However, deliveries in the first quarter of 2012, particularly of premium product, came online with a high percentage of pre-let space; most new developments are also pre-let. In addition to new developments, landlords are also renovating properties to meet tenant demand, as a solution to land scarcity.

In line with global trends, Rio de Janeiro has recently experienced an increase in vacancy levels resulting from reduced absorption, the first sign of weaker demand in this key office market. However, the expected delivery of new class-A space over 2012, mostly with a high percentage of pre-let commitments, is likely to cause the demand-supply imbalance to continue in the short term.

The slowdown in take-up, coupled with low available new supply, resulted in almost no change to the vacancy rate, which was 4.4% in Q1, only 0.1bps higher than the vacancy registered in the previous quarter. Class-A vacancy also recorded a minimal change (8.4% from previous 8.2% in the fourth quarter of 2011). Large new developments, such as the Laranjeiras Corporate office building in the Flamengo sub-market, are due to come online in the second half of 2012, and might affect the vacancy rate. This, as well as retrofits and other works being undertaken to existing offices, should also ease the pressure on rents, which escalated to unprecedented levels in 2011. Rents are particularly high downtown and in the South Zone sub-market due to improved infrastructure and lower net new supply compared with other areas.

Despite mounting fears of another global crisis in the wake of the US sovereign rating downgrade, 2011 was one of the best years for industrial absorption levels across Brazil. We expect the country's industrial markets to continue expanding in 2012 as well. Strong domestic demand is particularly supporting leasing activity. National net industrial absorption has improved, totalling 587,800sqm during 2011, outpacing the year-end 2010 levels by 23%. Despite strong demand, overall industrial vacancy rates increased 1.7bps to 7.9% during Q4 2011, because of the large amount of new space coming online. However, in contrast to Brazil's office market, industrial supply exceeds demand by a gap of 24%. Higher-quality industrial product continues to attract the majority of industrial tenants. As a result, class-A industrial vacancy rates bucked the wider trend and fell 1.1bps to 4.2% during Q4 2011, marking the lowest industrial vacancy rate recorded in Brazil.

With sales activity rising almost 42% to $9.5bn in 2011 from $6.7bn for 2010 (source: Real Capital Analytics), Brazil continues to dominate investment activity in the region, accounting for 75% of all transactions. Traditionally, investors have targeted the office and industrial sectors. However, fuelled by the favourable economics described earlier, retail is actually the most popular asset class, accounting for 31% of transactions, while industrial comes in a close second with 25%, leaving office with roughly 13%. Of the largest 10 transactions identified in Latin America in 2011, which represented almost 28% of the region's total, eight were in Brazil. The largest deal was a $1.1bn portfolio sale of industrial assets, totalling roughly 827,000sqm.

Cap rates have compressed in Brazil from 12-15% two years ago to 10.7% today, as the perceived risk premium on real estate investments in the country has subsided considerably. In this new era, confidence in the Brazilian economy and regulatory environment has attracted both domestic and cross-border investors to the key markets. One of the largest local Brazilian investors is BR Malls Participacoes, a Brazilian retail management company that owns and operates more than 50 shopping malls.

Longer-term, flexible exchange rates, a diversified industrial base and sound economic policy should continue to attract foreign direct capital into the region. According to UNCTAD, FDI flows to Latin America and the Caribbean increased by 13% in 2010, led by interest in Brazil. Many of the investments going to Brazil originated from Asia and were directed at extractive industries (oil, gas and mining).

In terms of absolute volume, Brazil was the fifth top destination worldwide for FDI fund flows in 2010, following the US, China, Hong Kong and Belgium. These flows have increased the value of Brazil's currency, raising concerns about the competiveness of imports in the longer term. Local Brazilian manufacturing firms have been affected by the elevated value of the local currency, the real.

The government has recently stepped in by providing some tax relief and lowering interest rates despite elevated inflation rates, and yet Brazil will continue to attract a disproportionate share of FDI flows over the next decade, bringing with it continued opportunities for real estate investors.

Victor Lopez Beltran is director, Latin American research at CBRE