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By Greg Rockwell
Principal
Excend Capital


Latin American Real Estate: Emerging Markets as a Shelter in the Storm

The European debt crisis has provided fresh insight to investors worldwide that the systemic problems uncovered in the highly developed capital markets of the United States and Europe are far from completely resolved, but rather, will continue to be a source of uncertainty for the foreseeable future. The ECB solution, much like the U.S. stimulus package, appears to be a bandage to cover up the problem and attempt to bring stability back to the financial markets, rather than a long-term solution. Indeed, the real dilemma at this point in the U.S. and Europe seems to be the inevitability of the ongoing effects of these systemic problems, even if those effects can be delayed for a period through government intervention.

In contrast to the ambiguity of the ideological debate that continues among pundits, professors, and politicians, managers must make clear choices on how to deploy assets in the most effective way for protection and profit. The comparatively stable markets in Latin America, and in particular real estate investments, present one of the surprisingly logical choices. In the wake of the economic crises, the conservative fiscal and monetary policies of Latin American countries over the last ten years appear prescient. Public debt in the region is very low compared to the developed world. Consumer access to credit varies from country to country, but is generally low, increasing moderately, and shows none of the exotic flair that characterized the subprime crisis in the U.S. Recent elections in Brazil, Chile, and Colombia show continued and increasing political support for stable, pro-business government leadership, and it appears increasingly likely that the coming elections in Argentina will also move that nation’s political leadership back in a more business-friendly direction. 

While Brazil, as the emerging superpower of the Americas, clearly dominates the headlines, attention should be given as well to the other significant economies, especially Chile and Colombia. Each of these three countries has unique features that can provide strong reasons for managers to consider investments in their respective real estate opportunities.

With a geographic size roughly equivalent to the contiguous United States, an enormous population with increasing discretionary income, and vast natural resources, Brazil offers obvious benefits to investors in every sector. Brazil’s IT sector is experiencing rapid growth as businesses mature and have need of sophisticated information systems, and consumers with discretionary cash move into the information age. 

Growth in alternative fuels and fossil fuels is also bringing major development into the country. Brazil is the world leader in profitable ethanol production, and oil exploration in recent years has uncovered enormous oil and gas reserves. The machine of growth in Brazil barely slowed during the economic downturn and companies are reporting huge revenue growth in the first quarter of 2010. The southern states in Brazil have captured most of the attention, but the oil and ethanol industries in the Northeast are creating a strong demand for development as well, as skilled workers and engineers are moving to the area at unprecedented rates.

Chile occupies a unique place in Latin America with a growing, stable economy for over 30 years. Economic policy established under the rule of General Pinochet laid the groundwork for a well-regulated, free market system that has led Chile to be the most prosperous country in Latin America per capita. Chile enjoys better access to capital and among the highest credit ratings on the continent. Sophisticated institutional banking, a mature pension system valued at over $100BB, and consistent stock market growth averaging more than 12% for the last 10 years have all contributed to the amazing stability of the country. 

One of the greatest contributors to steady growth in Chile is the use of an inflation index for virtually all financing in the country. The Unidad de Fomento (UF) was established in 1967 for international payments, but over time the usage of the UF expanded until its universal use today. The index tracks inflation in Chile using a monthly survey of the cost of goods and services, similar to the U.S. CPI. All contracts are then denominated in UF, hedging inflation risk, and providing a transparent real return for investors. All real estate value in Chile is denominated in UF (currently about $40.4 to 1UF). Interest rates on loans are denominated against the UF as well. Hence a mortgage rate may be UF + 4%, meaning the interest rate is 4% plus inflation. Consumers have the option of paying a higher interest rate to transfer the risk of inflation back to the lender, but almost no one does.

Chile is the only country in the world to adopt this type of inflation indexed system, but the results appear to be clear. Chileans accept the system as absolutely beneficial, attributing the stability of the markets in general and of the real estate market in particular to the effect of the UF. Chile enjoys an extremely low historical inflation rate, with steady growth, and no real estate bubble in sight.

One of the curious effects of the UF is the non-appreciating nature of residential real estate in Chile. Once the effects of inflation are removed, real estate values are effectively flat, increasing, perhaps, 1% per year, and consequently, Chileans don’t regard the purchase of a home as an investment. Home prices don’t appreciate, and the concept of a home equity line of credit would be utterly foreign. While this is certainly a strange concept to outside investors, upon consideration it is easy to see that such a system has many significant benefits. If the enemy of the free market is uncertainty, natural price stability is certainly its friend. Individuals are incented to save and make real investments because they are relieved of the illusion that the value of their home will always go up. It is also easy to see that the fallacies that sowed the seeds of the subprime crisis are impossible under such a system.

Of course, despite (and arguably because of) the effect of the UF, there is plenty of opportunity for real profits in Chilean real estate.  New construction demand is strong, reasonable leverage is readily available for good businesses, and a project level capital investment in residential development can expect to achieve consistent real returns in the range of 10-20%. Entity level equity participation can also be found with experienced developers that need growth capital to further develop their businesses. 

Investment opportunities in commercial real estate and hospitality are also available with highly experienced, successful businesses looking for additional liquidity, or to recapitalize existing liabilities into equity. With an existing shortage of hotel rooms in Santiago, and a government projection of 6% growth for the next four years, conservative IRR projections in hospitality can range up to 30%.

Colombia offers its own set of attractive qualities for investors. Behind Brazil, Colombia is poised to be the next explosive growth story in Latin America. Colombia has the third largest population in Latin America (after Brazil and Mexico) with over 45 million people and is the most urbanized country in Latin America.  Colombia has had a reputation for political instability and drug violence, but the last ten years have seen a precipitous drop in drug-related violence in Colombia. During that time the economy has grown rapidly, and the government has encouraged economic development and business growth. The country’s financial services infrastructure is not as well developed as that of Chile, but changes in the law in the last five years allowed for the formation of private equity funds in Colombia, and there are now several well-run funds in the country with investments in a wide range of sectors. Rapidly growing industries in Colombia include oil, transportation, and shipping.

The rapid expansion of the economy is creating a strong demand for real estate development, especially retail and commercial buildings. Access to capital is lower in Colombia than in Chile or Brazil, and consequently, rates of return tend to run higher than the other major Latin American markets. Colombia has better free trade laws than Brazil, and elections in the first week of June reinforced the pro-business direction of the country’s government. 

As with the rest of Latin America, Colombian businesses have been historically closely held by wealthy families. However, the influx of capital from the developed world is creating incentives for closely held companies to open up to foreign capital in order to move toward more profitable business practices. For example, because of less access to credit, developers have traditionally pre-sold commercial spaces in shopping centers in order to finance project construction. With the emergence of private equity possibilities, developers are beginning to consider bringing in outside investors as equity partners and in order to finance project pipelines. Another strong opportunity in both Colombia and Chile are long-term leaseback projects with real rates of return above 10%.

Real estate investment in Latin America, as with anywhere else, requires careful due diligence, and good local partners. For managers seeking alternative investments away from the current turmoil of the European and U.S. markets, Latin America looks increasingly attractive. 

About the Author

Greg Rockwell

GREG ROCKWELL
Principal, Excend Capital Group

Greg Rockwell is a principal at Excend Capital Group and leads the capital markets activities at Excend—facilitating M&A and private equity investments for organizations throughout the Americas. The firm focuses on the IT, business services, energy, and real estate sectors.

Previous to working with Excend Capital, Mr. Rockwell worked as an advisor to hedge fund and investment advisory groups. He also worked in the retail arm of KeyBank, leveraging up the retail mortgage program. He has also participated in the startup and expansion of various entrepreneurial companies in the financial, business services, and manufacturing sectors.