The Bear, The Bull and Human Psyche.

“Everything I have experienced suggests that, at core, economic conditions and markets are grounded in the human psyche.  That is, confidence or the lack thereof, profoundly affects markets and economies, and confidence in turn, has throughout history of markets and economies tended to swing from excesses in one direction to excesses in the other.” 

Robert Rubin, former US Treasury Secretary.

“So far as there are investors in the market who exhibit sub-optimal behavior, and human beings are prone to error, value investment strategies can exploit these market inefficiencies to earn a value premium which may not be a compensation for risk.”

National University of Singapore and Institute of Real Estate Studies, Value versus Growth International Investment Strategy Working Paper

 

The Winds of Change in Brazil

How do these two quotes relate to Brazil real estate investing post August 31, 2016, the date of ex-President Dilma’s impeachment?  Where is the human psyche of Brazil currently? Why is the equity market the best performing in the world this year?

winds-of-change

Why has this not affected the real estate market? Importantly, is now the time to take a hard look at the Brazil commercial real estate investment thesis? It all depends…..

 

Investor Orientation – Growth vs. Value Investing

decision-time

For real estate investors with interest in Brazil real estate during the next economic cycle, it appears that now is the time to make a decision about their investment strategy.  Investors tend to have either a growth or value investor orientation. The author cannot comment on which orientation is better; there is, perhaps, no right answer. However, this answer will greatly affect how an investor looks at the Brazil real estate investment opportunity at this time in the real estate cycle.

If the reader believes that he or she or one’s firm possesses a growth orientation, in the interest of time there are better things to do than to continue reading this newsletter.  I suggest heading to your local Starbucks (my wife and I enjoy sharing soy lattes), going to your favorite news website, calling your kids or spouse, or perhaps reaching out to that best friend in college you have meant to contact for years! No offense taken and thanks for reading!  However, if you and your firm possess a value investor orientation, please keep reading.  Likely, now is perhaps your time to get to work. Skip Starbucks, save your money, the office coffee is fine!  Let’s get to work!

 

Newsletter’s Objective

This newsletter’s objective is to provide a context for the evaluation of Brazil real estate after the impeachment of Dilma Rousseff on August 31, 2016.  Our objective is to examine the impeachment’s impact on real estate assets and attempt to provide a perspective that may be helpful for a global real estate investor’s investment strategy towards Brazil.

 

New Best Friends

hand-shake

In particular, we will review a value investor’s approach to Sao Paulo commercial real estate  at this stage in the real estate cycle. Finally, as a reward for not running to get that soy latte, we will provide some ideas and tools to supplement your current research on the Brazil real estate market.  We have some ideas to add important data, perspective, and experience to improve your investments in Brazil during this very important stage of the real estate cycle.   Moreover, the team at InDev Capital and I personally will be in touch much more regularly and in much more detail over the next several weeks.  The investment environment has just become very interesting. Consider InDev Capital your new best friend! Deal?

On Wednesday of last week, August 31st, Dilma Rousseff was officially impeached.  This is not a political newsletter, and therefore we will not cover the impeachment process and its political and/or legal merits. We will solely focus on its impact on real estate investors. For additional information about the importance of the impeachment for real estate investors, please read our previous newsletter. 

Brazil’s change in leadership, now official, is very important for real estate investors to note.

 

The Value Investor Stopwatch Has Started…

stop-watchIn my neighborhood of Vila Madalena / Sumarezinho (an upper middle class neighborhood in Sao Paulo), construction cranes literally started to move the next day. The night and day difference in the confidence level of those fortunate few with liquid cash in Brazil is impressive.  The change is starting; will it be as rapid as the changes on my block? The jury is still out and there is a lot of inertia and work to be done. However, for those investors thinking that the window to invest in Brazil on a value basis will last indefinitely, I suggest caution.  It was obvious that many investors were waiting on the sidelines for the impeachment to happen. How much of the economy has been on standby?

Again, unsure but value investors need to be aware that the clock has started ticking…click, click, click…

Even before the impeachment was final, the equity markets in Brazil had already priced in the impeachment and reforms.  The BOVESPA is up 33.57% until the end of August.  In addition, the currency has strengthened as well. Are these moves justified?  Perhaps… or perhaps not. Admittedly, there is likely some of Robert Rubin’s excess in my humble opinion.  However, the real estate market has not enjoyed this enthusiasm. The animal spirits have not returned. Why?

 

The Weight of Time Starts to Take its Effect…

weight-of-time

I was in NYC with a very smart investor about two months ago. We see each other often and talk about transactions.  He had not done any real estate investments in Brazil but was often in town and looking at opportunities.  He said something that is very true, “Joseph, the weight of time is starting to have an effect.”  How does this weight of time create opportunities for real estate investors in this cycle?

Unlike currency or public equities, real estate is illiquid, fixed in a location, and has inelastic supply.  In addition, it attracts significantly less informed market participants than other types of investments at certain times in the cycle. At some point in the cycle, everyone believes that they understand real estate investing. Real estate, and particularly commercial real estate, is prone to very strong supply demand cycles.

The valuation of public real estate companies in Brazil is perhaps at an all-time low. In fact, they are a subject of an upcoming newsletter.  Moreover, many private developer bankruptcies are now starting.  According to Exame, over 25,000 families have prepaid for residential units whose developers cannot finish the project. The why to both of these events: the weight of time.

The result of the weight of time is that many smaller developers and some larger developers do not have the profits (more importantly the cash that would have come from profits) or internal capital from the last cycle to start a new cycle.  The discounts given during the downturn lowered profits and cash to move forward.  This lack of cash and lack of credit  creates opportunities for value investors.

This weight of time reminds me of a retail store on my street here in Sumarezinho.  One retail store that I pass every day is about to shut down next month. The owner held on as long as he could but the “weight of time” over the past two years of negative GDP and the resultant consumer pullback have forced him to close down.  On the same street, actually around 400 feet away, a new owner is excited about the future of his retail business and his cheap lease he negotiated. This is a simple example of why fresh capital has a unique advantage in a market where there is some daylight in the political situation and the weight of time starts to really, really hurt some players in the market.

 

What Does Kelly, North Carolina (population 540 in 2010 census) have to do with Value Investing in Brazil

grandmas-house

As I get older, I realize that my late grandmother, born in a small town called Kelly, NC was a very wise person. Over time, I have realized that anything that I could not explain to my grandmother in two sentences either I did not fully understand or did not make sense.

As I was writing this newsletter, I heard her say, “Little Joe, value investing is like going to Piggly Wiggly (southern grocery store) and buying two pounds of chicken but because it is on sale you only pay the price of one pound.” 

So let’s return to this concept of price and value in Sao Paulo.  Commercial office space rents are down up to 40% from their peak in certain areas. In addition, there are significant constraints on new supply in certain regions due to lack of land, zoning, and transportation.  Importantly, a key source of value investing in commercial real estate is to choose assets that have the most scarcity in their micro region and when the economy returns even slightly, their value increases disproportionately to other assets.

Based on the weight of time discussed earlier, the number of sellers is greater than the number of buyers and many in the market are net sellers due to balance sheet situations caused by the downturn. So yes, there are opportunities, though often not obvious, for value investors in Sao Paulo commercial real estate currently.

Why not obvious? There is almost no project-level debt on commercial real estate.  InDev Capital covered this a while back in a newsletter called “Where’s the Beef”, no connection to Piggly Wiggly by the way.  We will discuss how to source these non obvious value investor commercial transactions shortly. But first let’s talk about timing… how long is a value investor’s window of opportunity?

 

Value Investor Window – Opportunity

window

The equity markets may have responded perhaps too positively to the change in government. However, the real estate market has not yet improved and the “non obvious” buying opportunities are still in place. Why and for how long?  The reality is that there is a number that will drive how fast and when an investor can sell at maximum price. In fact, that number is the “Elephant in the Room” literally.

 

Interest Rates – The Elephant in the Room…

The picture above represents the environment in numerous corporate offices in Brazil, in almost any capital-intensive industry and certainly every real estate company’s office.  Discussions are happening, people are wearing ironed shirts, conducting business and there is literally a giant elephant in every room.

Although there are various factors that keep a lid on significant price appreciation and a real estate recovery, the “elephant in the room” is high interest rates. Why?

REITS

These high interest rates keep the REIT market effectively shut. Many individual investors lost a tremendous amount of money in the REIT market at the end of Brazil’s last real estate cycle.  Things will have to be substantially better for the retail investor market in Brazil to recover. That market is effectively shut until interest rates are significantly lower.

Ultra High Net Worth and Family Offices

High interest rates also create a low incentive for the ultra high net worth investors to invest in real estate.  Why should an investor move his or her money from government treasuries earning 12% interest rate at only sovereign debt risk to an asset class where many UHNW investors have invested in commercial AAA office with 50% to 100% vacancy?

Corporate Buyers – Real Estate Operating Companies

Corporate acquirers and developers have market capitalizations significantly below their net asset value.  These companies are effectively shut out of the capital markets and are not significant buyers.  In fact, they are net sellers as they try to reposition assets to buy for the next cycle.

Pension Funds

Pension Funds have also retrenched. They have lost a significant amount of money off bad investments (and sadly some corruption) and are currently net sellers.

Another life ago when I was an owner and an executive in a mid sized construction company, a joke was to not get hit by a beer truck.  Well, two fine gentlemen, Ilan Goldfajn and Henrique Meirelles, should definitely avoid all beer trucks in Brazil.

Due to the work and decisions of these two men and their teams, along with President Temer’s political experience, it is likely that interest rates will start their downward movement later this year.  The Boletim Focus, a weekly release by Brazil’s Central Bank summarizing expectations from the majority of financial institutions, released today (September 5th) a consensus about the expected interest level by the end of 2017 of 11.00%, i.e. a cut of 325 bps. This likely movement in interest rates is how the value investor window for commercial real estate starts to shut.

However, remember Mr. Rubin’s quote that started the newsletter. Prices start moving when confidence returns. After two or three movements of downward revisions of the SELIC interest rate, many of the well capitalized local insiders will have access to capital (public valuations improve) and wealthy families will become more aggressive in the market. The best value investment opportunities will start to leave the market and either not sell or trade to insiders.

 

Value Investor Execution and Putting it All Together

execution

Even if we believe interest rates are headed downward, as value investors we must not base our entire return assumptions on the forward yield curve and cap rate compression.  So what are the key strategic elements of a value investor’s commercial real estate plan now in Brazil?

Value > Price 

It all starts here. As my late grandmother would say, two pounds of chicken while paying for one pound. The commercial assets purchased must be below their intrinsic value. This requires extensive analysis and data on the market.  Importantly, it is important to have a strategic advantage in the acquisition process.

These types of transactions usually go to fast movers and investors that are partnered with a well known and capitalized local sponsor. Speed is key in these transactions.  We will discuss later how an investor can invest prudently while closing on a relatively rapid basis.

Underwriting

To truly understand this Value > Price analysis, an investor must make certain assumptions about what the yield to costs / capitalization rate upon stabilization is and when this stabilization occurs.  If there is vacancy, what is a reasonable assumption to lease up?  The key is to understand whether an investor could purchase the asset at the given price and sell either immediately or soon after some value added enhancements at a 150bps to 300bps plus capitalization rate compression.  This will be covered in more detail in our commercial white paper in 10 days!

Market Equilibrium

Full understanding and conviction about the supply demand ratio in Sao Paulo and in the micro region of the asset greatly assists in understanding the potential downside and upside of the asset. In particular, as most assets will have rents that have recently readjusted, modeling in real rent growth above inflation requires not only an understanding of market equilibrium but also tenant behavior.  This micro equilibrium is crucial to determine the possibility of real rent growth.

Tenant Behavior

Not all regions of Sao Paulo are created equal.  For example, currently the Vila Olimpia area has had significant net absorption. Why? Because the area is the choice of many information technology start ups and asset management firms.  It is important to understand how tenants behave in a given region.  For example, there is a significant high quality AAA space in Chacara Santo Antonio. If an investor buys an asset in Berrini, will that specific building’s tenants move upon lease renewal from a class A to a class AAA in a different location? Why or why not?

Adding Value

What specific actions can the new owner take to increase the revenue or decrease the cost of the building? What improvements can be made to increase the rent?  Are those improvements net accretive? How can the owner lower energy consumption? Should security and management be managed internally? Should the new owner renegotiate all the contracts? What is the correct electrical load? How does one lower the condo fees to increase net rent with no increase to the tenant?  These questions need to be answered.

Capitalization Rate is a Bonus not a Strategy

As an investor reviews his or her acquisition strategy, it is important as they look at assets that the “value investor” checklist is covered.  Then and only then is capitalization rate part of the equation.  Again, we will spend more time on this next week in our white paper for interested readers.

 

Next Steps – If You Have Read This Far… Do Not Stop Now!

next-stepsGet Smart – Fast

The clock has started for value investors. InDev Capital is publishing a detailed white paper on commercial real estate in the next ten days for interested investors and readers of this newsletter. If interested in receiving a copy, please sign up by clicking here.

Talk to Experts – Not Just Brokers

It is important to talk to seasoned investors and market players as fast as you can, particularly if you have specific questions.  If you desire to speak to an impartial expert on a given topic, please click here to receive more information about this service.

Follow Up and Next Steps on Commercial Real Estate

InDev Capital is committed to helping investors navigate this next phase of the Brazil real estate cycle.  If you have specific questions for me or ways that you think InDev can be helpful, please feel free to email me personally at joseph.williams@indevcapital.com and I will respond within 24 hours or the next Beer or Soy Latte is on me!

Warm Regards,

Joseph W. Williams

CEO & Founder InDev Capital

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