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.
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 which 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 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.