Monthly

Spotlight November 2014

BRAZILIAN ESTATE MARKET

And so castles made of sand, fall in the sea, eventually Jimi Hendrix
This month we take a brief look at the real estate market in Brazil, and give some thoughts towards the
current market environment and outlook for both the residential and commercial markets. Starting with
the residential sector, for many years bulls on the Brazilian real estate boom have cited the justifications
of a large housing deficit of over 5 million homes; an incipient mortgage loan market, which has been
growing from low levels and providing access to funding for a wider range of purchasers with increasing
wages and more disposable income; and increasing access to market financing for secondary market
homes.

Pragmatically however, with the price of real estate in Rio de Janeiro and Sao Paulo doubling over the
last five years, we see limited justification for such moves, especially when compared with real incomes
which have not increased nearly as quickly, and also when looking at the macroeconomic environment,
which has deteriorated over the same period. However despite our more conservative view towards the
market and observations of the macroeconomic climate, unemployment remains low across the country,
providing support to the market, and one of the reasons why we have not seen a sharp correction in
house prices.

Sao Paulo Property Price Evolution (2009-Present)

Source: LPS Lopes Investor Presentation

More specifically, with respect to the economy, what we have been seeing in recent years is a rising
interest rate environment in Brazil, which has been adopted in order to help curb inflation generally
across the country. We acknowledge that there is clearly a long-term structural need in Brazil for further
housing supply, but the exuberance in real estate price rises seen in recent years, which have additionally
been fuelled by speculative investors looking to make short term gains, and who very often flipped these
investments rather than taking final occupancy, may now be over. Speculative investors were viewing
the real estate market purely from an undervalued asset perspective, and with higher interest rates
alternative fixed income investments also become an alternative. These both the developers and market
participants were not addressing the structural deficit problem, but rather capitalising on the
combination of factors which provided an unemotional investment case for real estate in Brazil.

TALL TREES DO NOT GROW INTO THE SKY

Analysing the current market of new launches of apartments, the real estate market in Brazil, particularly
for the large metropolitan cities, is dominated by a handful of major developers, many of whom raised
large amounts of money during around 2008-2010 in order to expand their development pipeline while
the economy looked more robust and GDP was growing at close to 8% per year. With a typical
development taking around three years from start to completion, these developers have had a difficult
time recently facing both a wave of higher supply combined with a softer economy and a more indebted
consumer. Since these firms rely on cash generation from end sales to assist in financing their ongoing
pipeline of developments, as sales have slowed these listed companies have struggled with ever
increasing indebtedness and stretched balance sheets causing many to mothball projects until the supply
demand scenario improves.

With the market clearly adjusting to an excess of launches and softer end demand, including
cancellations from purchasers, what we are seeing now is that these developers are now having to offer
discounts in order to shift excess inventory. Such discounts are reaching levels of 35% in recent months,
as the business model of developers is not to hold such finished inventory. Reading the weekend edition
of the Estado newspaper in Sao Paulo you are bombarded with adverts trying to sell the latest new
launch of apartments, with developers so keen to get potential buyers into the market they are even
tempting viewers with offers such as free bottles of whisky when visiting some show apartments. This
excess will take time to shift, and in aggregate, the most recent September figures by the Brazilian
Association of Mortgage Housing indicated that the four main Brazilian construction companies had over
25,000 unsold units across the country, representing an inventory of around R$15bn. We see this current
excess supply as providing a cap on any significant residential real estate gains across the country.

Looking at the commercial real estate market in Brazil, this can illustrate a potential leading indicator for
the residential market. For commercial real estate, and office space in particular, the excess supply and
slowdown effects are quite visible. Sao Paulo office vacancy rates for example increased from 13% to
18% during 2013, and many buildings have significant empty space across the city. One such example is
the iconic table shaped Patio Malzoni building on Avenida Faria Lima. When it first opened in 2012, its
vast office space was the most expensive in the country with flagship tenants such as Google and Bank of
China.

VILA NOVA ADVISORY

2|Page

Patio Malzoni One tower with no tenants

Source: Google Images

However, now there are only tenants in one of the two 19 floor towers. The billionaire owners of the
building, rather than reducing the rental costs to attract demand (office rents fell 15% in 2013 in Sao
Paulo), are sitting tight and will only rent the building when prices rise once more. Given the continued
completion of new high-end office launches across the city and the pure number of cranes in operation
across the horizon, this adjustment may take some time.

LOCATION, LOCATION, LOCATION

Although the current environment when looking at residential real estate may look toppy, unless there is
a significant increase in unemployment across the country, we do not see a significant risk of a sharp
correction in property prices, largely due to the low level of overall gearing of real estate in Brazil versus
more developed markets. Additionally, Brazil has some unique characteristics with its real estate market,
and at least for Sao Paulo, there are certain areas, which we see as longer-term safe havens. We note
that the majority of large international metropolitan cities have the highest value real estate in the heart
of the city, or near the central business districts. Sao Paulo however has experienced a donut effect over
the last century, with the desirable areas expanding away from the centre of the city, which although in
recent years is experiencing a rejuvenation, and recovery in real estate value, is still far from being a
desirable area to live for affluent Brazilians.

The phrase location, location, location still however holds firm in Sao Paulo, with areas that offer
amenities and space commanding a significant premium. Much like what has been seen in London in
recent years, with square footage prices in desirable districts in zone one skyrocketing, Sao Paulo has
seen a similar effect for its equivalents. The chart above illustrates the average launch prices for the city
of R$9,290 per square meter, but anecdotally a recent apartment in Vila Nova Conceicao overlooking the
park exchanged hands for R$32,000 per sqm. The justification is that, in a city troubled by high levels of
traffic congestion, and many other day-to-day social hurdles, affluent Brazilians and ex-pats are able to
pay a premium for convenience and safety.

Real estate is a global investment class, but investing in real estate very much requires local knowledge
and understanding of the market. Given its global appeal as an investment class as well as for

VILA NOVA ADVISORY

3|Page

homeowners, we see both domestic and international investors monitoring the sector with interest. For
international investors, additional considerations, such as the strength volatility of the Brazilian real have
to be considered. Nevertheless large real estate investors such as Sam Zell in the US, who is an expert
real estate investor across many emerging markets, has stated that commercial real estate in Brazil has
become a more interesting asset class, and with interest rates continuing to rise, and an oversupply of
product, there is an expectation for a re-pricing of some commercial assets.

VILA NOVA ADVISORY

4|Page