| tate investment for Limited Partners (LPs) in Latin | | | | developers are simply resuming pre-sales and |
| America can really be seen as a tale of two countries, | | | | construction. |
| namely Mexico and Brazil, and recent experiences | | | | Brazil’s experience with the middle- and low- |
| there offer important contrasts between each | | | | housing segments, which are financed through the |
| country’s different market practices leading up | | | | CAIXA system, remain very active and well financed. |
| to the global recession, some of the ways in which | | | | The issue for these housing segments in Brazil is that |
| local participants responded differently, and, ultimately, | | | | the government’s CAIXA program is so |
| lessons that the global recession may offer Limited | | | | efficient that developers really don’t need that |
| Partners for future investing strategies in Latin | | | | much capital. It’s a great IRR, but the amount of |
| America. | | | | equity is unbearably tiny for most institutional investors. |
| For LPs, the contrasts between Brazil and Mexico | | | | Mexico’s middle- and low-income housing |
| couldn’t be sharper, but identifying the | | | | sectors, while still active, were leveraged through the |
| appropriate strategy going forward may not be as | | | | private sector mortgage banks, which in turn had credit |
| clear. There seems to be a general consensus today | | | | lines from international banks. When foreign lenders |
| that investors want to avoid Mexico but remain | | | | pulled their lines in 2008, developers were essentially |
| committed to investing in Brazil. One can’t blame | | | | hung out to dry. The principal difference between Brazil |
| them. This situation, in fact, is nearly a mirror image of | | | | and Mexico is how the governments’ |
| the situation ten years ago when investors, | | | | respective subsidized housing agencies pay |
| beleaguered by years of boom and bust in Brazil, | | | | developers. In Brazil, a developer is paid according to |
| concentrated almost exclusively on Mexico as it | | | | pre-sales and construction advance, supplanting the |
| emerged from the 1994 peso crisis. What we now | | | | need for outside construction financing. Conversely, |
| know, of course, is that investors who were early to | | | | Mexico’s INFONAVIT only pays developers |
| the game in Brazil have been rewarded handsomely, | | | | once the certificate of occupancy is delivered and the |
| while experiences in Mexico are mixed at best. | | | | sale is closed. In an up market, the Mexican model |
| During the last fund-raising cycle, most investment | | | | allows free market forces to incentivize the production |
| strategies that came to market were structured as | | | | of more homes, faster, but in a downturn the industry |
| country Funds. The emergence of country Funds, | | | | becomes a victim of the scarcity of capital. |
| headed by dedicated local management teams, | | | | In the particular case of Mexico’s resort |
| introduced a new era of competition for LP capital, | | | | hospitality sector, values reached levels never seen |
| which means LPs now have more options when | | | | before. The allure of building into what felt like an |
| analyzing investment choices. | | | | unlimited demand cycle of foreign buyers drove price |
| This question of how LPs invest going forward will | | | | appreciation in destinations like Cabo San Lucas and |
| become more prominent as the reality sets in that | | | | Puerto Vallarta into the stratosphere. A two-bed |
| foreign-based managers are really not set up to deal | | | | condominium in Cabo could have fetched $800,000 at |
| directly with day-to-day issues on the ground, and one | | | | the peak. If you wanted a view and access to the |
| lesson investors may take from the current crisis is | | | | ocean, you were probably looking at double that. |
| that being closer to the investment itself is generally a | | | | Foreign investors dove head first into risky beachfront |
| good thing. This reality check is pushing LPs to look at | | | | land bets in Mexico that will take years to be made |
| their investment vehicle choices, their ability to defend | | | | whole. Conversely, Brazil’s resort tourism |
| their interests, fees they are paying as well as the | | | | market has remained focused on domestic end users |
| overall investment strategy. | | | | and, perhaps due more to geography, Brazil never |
| Issues facing LP investors are further complicated if | | | | came close to exploiting the foreign-buyer market for |
| the Fund is co-mingled. For LPs who had the ability and | | | | second homes the way that Mexico did. |
| foresight to demand a seat at the table, either de | | | | Mexico’s GDP is expected to contract 8.7% for |
| facto or through negotiations, having more say in the | | | | 2009, whereas Brazil is expected to pull back 1.5%. |
| matter when investments turn south turns out to be a | | | | The fact that Brazil’s GDP is roughly 1.6 times |
| pretty good thing. The lesson that LPs need to plan for | | | | the size of Mexico’s only emphasizes the |
| a downturn when executing agreements is a | | | | impact this global recession will have on the allure of |
| prominent theme throughout the industry. | | | | Brazil as an investment over the next cycle. The |
| Over the last five years, Mexico and Brazil each | | | | question for LPs, however, is which country will offer a |
| benefited from a tremendous influx of equity capital, | | | | more compelling entry point a year or two from now, |
| and excessive liquidity permitted global managers to | | | | when new capital would be invested? |
| tap into leverage that further increased demand for | | | | At a recent conference on Latin America real estate, |
| risk assets. As allocations for alternatives increased, | | | | few institutional investors planned to allocate either time |
| Funds grew in both size and number and, as a result | | | | or money to Mexico, but invariably all were interested |
| of this heightened demand for assets, the path | | | | in Brazil. Whether or not this situation persists only time |
| diverged between Brazil and Mexico as the need to | | | | will tell, but the dearth of investment capital has |
| invest relatively larger pools of capital pushed | | | | negative implications for existing investments in Mexico |
| managers to assume the maximum permissible risk | | | | as well as opportunities for new capital to enter at a |
| each respective market offered. | | | | much better cost basis than in Brazil. History illustrates |
| Due to the expansion of local credit, asset appreciation | | | | that persistent illiquidity mainly serves to push values |
| in Mexico readily exceeded that of Brazil. As an | | | | down further, which, in turn, hastens a new cycle for |
| example, proforma exit cap rates for commercial retail | | | | opportunistic investing. For an LP invested in Mexico |
| dipped well into the high single digits at the peak, even | | | | today, the question of what to do rests on the |
| though short-term Mexican Treasuries were yielding | | | | willingness to suspend the experience from what just |
| 8.25% at the time. Stabilized, credit-tenant industrial | | | | happened and refocus on what will most likely occur |
| traded as low as 7.25% on a cap-rate basis. Current | | | | over the next several years. |
| estimates put cap rates in the 12—14% range | | | | When an investment goes bad, the instinct is turn the |
| for commercial retail and 9—10% for stabilized | | | | page, but to do so with an eye on maximizing |
| industrial. The current spread between short-term | | | | proceeds within market-based time constraints is an |
| rates has widened substantially to 500—800bps | | | | art. Furthermore, if a manager has no more incentive |
| as the Banco de Mexico cut rates 375bps and prices | | | | to maximize proceeds, what mechanisms are left to |
| fell. For a project that funded in 2006, total estimated | | | | ensure that the LP’s capital is being managed |
| losses could easily exceed 50% when converted back | | | | with the maximum level of fiduciary? The short |
| to USD. The deterioration of the Mexican peso caught | | | | answer is not much. The question for an LP invested in |
| many by surprise but added fuel to the fire of over | | | | Mexico today is how to re-align interests, because, |
| leveraged real estate. | | | | whatever the ultimate strategy, selling will take time. |
| Brazil, on the other hand, continues to be an all-equity | | | | The extent to which an LP is able and willing to step |
| market wherein sales values for stabilized investments | | | | up their allocation to Mexico will largely define its |
| tend to track government bond yields, adjusted for | | | | options. By increasing the allocation, an LP immediately |
| IGPM, but the real difference is that most projects | | | | secures the ability to completely restructure its |
| were underwritten on an unleveraged basis. That | | | | relationship with the manager, including the fee |
| distinction is important, because if Brazil does move | | | | structure, management retention practices, the |
| toward a bubble, it will most likely be evidenced by an | | | | investment strategy and the LP’s rights. If |
| increased use of leverage. | | | | increasing the allocation is unrealistic, an LP could |
| By 2007, the rush to invest in Mexico reached a point | | | | theoretically incentivize a manager by resetting the |
| where clear cases of bad underwriting had emerged. | | | | cost basis, but that begs the question: why reward |
| Aggressive assumptions on everything from lease | | | | failure? The LP, then, is left with either swapping out |
| rates, time to stabilization, residential unit pricing, sales | | | | the manager, which is complicated, or bringing in an |
| velocity and aggressive exit cap rates seemed to | | | | outside advisor to monitor the manager, charging the |
| justify higher going-in costs across the board. The | | | | cost back to Fund. The latter seems to be the |
| urgency to put money out overtook the fundamentals, | | | | preferred strategy at this point in time but may prove |
| and the technical trade, premised on maximizing the | | | | to be only a Band-Aid over time. |
| IRR, was squarely the focus. LPs who had the | | | | The fact that capital is actively looking to invest in |
| foresight to establish the dual criteria of an xIRR-based | | | | Brazil and that Brazilian managers can point to relative |
| hurdle as well as a threshold multiple-on-capital hurdle | | | | success during the downturn will limit their willingness to |
| avoided some of the more painful situations because, | | | | negotiate with LPs. All things being equal, an LP should |
| from an absolute return perspective, most investments | | | | be able to negotiate substantially better terms with a |
| did not pass muster after 2006. | | | | Mexican manager in the current environment. LPs who |
| Salaries for senior professionals in Mexico went | | | | invested in Brazil earlier this decade already made their |
| through the roof, and attrition rates were | | | | money and have their deals cut with the manager, but |
| uncomfortably high. Retaining talent became a major | | | | new investors are up against a wave of interest that |
| issue because professionals, it seemed, were spending | | | | will only grow stronger as the global recession |
| a significant amount of time looking for the next big job | | | | recedes. |
| opportunity. The tales of who was being paid how | | | | The absence of leverage in Brazil turned out to be a |
| much to work for whom, doing who knows what, | | | | good thing for many reasons. First and foremost, |
| were rampant. Each week it seemed a new pool of | | | | unleveraged returns are by definition more |
| capital was looking for a degreed, bilingual Mexican | | | | conservatively underwritten. A manager who has to |
| citizen to oversee their local operations. | | | | fund with 100% equity capital will look more closely at |
| The failure in Mexico to retain talent highlights the | | | | an investment because of the simple law of limited |
| breakdown of the fundamental need to align | | | | resources. The same manager with an ability to |
| management with the investor. Mexico’s attrition | | | | leverage that same equity will put less in so that he |
| rate for senior professionals within the industry was | | | | can fund more investments, because maximizing the |
| demonstrably higher than that of Brazil. Why there | | | | number of projects will yield more fees. Because of |
| was high turnover may have as much to do with | | | | this, there is an inherent tension between maximizing |
| cultural issues as it does with compensation practices | | | | the number of deals and protecting investor capital, |
| within the Funds themselves, but the fact remains that | | | | driven mainly by the front-end fee incentive. This is one |
| LPs entrusted their capital to platforms that | | | | of the greatest obstacles to maintaining proper |
| couldn’t guarantee their senior staff would stick | | | | alignment of interest. The fact that Mexico is currently |
| around. The over reliance on local professionals who fit | | | | undergoing a reset in asset prices means the next |
| a specific mold more often than not yielded a sub-par | | | | wave of capital to enter Mexico will invest on an all |
| professional who lacked the ability to properly vet an | | | | equity basiswhich is a good thing from an |
| investment or say no to the next best career | | | | underwriting standpoint, because the LPs will benefit |
| opportunity. | | | | from better underwriting standards and a wider |
| The principal issues facing LPs today depend largely | | | | selection of opportunities. |
| on which countries the LP is exposed to and what the | | | | The question of properly aligned fee structures is |
| LP wants to do going forward. The strength of | | | | central. Even though there is strong LP interest in Brazil, |
| Brazil’s currency provided not only a safe | | | | fees are being negotiated down with some success. |
| harbor for foreign investors but, ironically, raises the | | | | Namely transaction-related fees such as internal |
| question of to whether risk-adjusted returns will be as | | | | acquisition and disposition commissions are being |
| attractive from this point on. | | | | reduced, if not eliminated. Asset management fees are |
| Back in March 2009, revisions to projected returns in | | | | focusing on invested versus committed equity, and LPs |
| Brazil would seem to suggest the currency risk was | | | | are paying close attention to the definition of inside |
| properly priced because, at that time, the overall | | | | the box, with an eye on capping exposure to any |
| projected losses were minimal (no one was projecting | | | | individual investment. |
| much of a profit on a currency-adjusted basis, but | | | | The most likely areas for opportunity in Brazil will |
| they weren’t losing their shirts either). The | | | | continue to be build-to-suit industrial, mid-rise value-add |
| question going forward is will investors, in their rush to | | | | office and middle-income residential (although it’s |
| capture alpha, push the boundaries too far, because | | | | hard to put a lot of equity out without buying into a |
| complacency about the currency, coupled with | | | | developer). Commercial retail is a very competitive |
| competition for deals, can be a formula for pushing | | | | market, and the most successful strategies have been |
| asset prices too far upwards. Equity International, for | | | | joint ventures with solid local developers. It will be |
| example, announced intentions to create a Brazil debt | | | | interesting to see what the impact of the Olympics will |
| program earlier this summer, which in and of itself is | | | | be for the country and Rio de Janeiro specifically, and |
| not a bad idea, but is an indication that investment | | | | there will be a real estate angle to be sure. |
| inflows to Brazil are forcing capital to seek out new | | | | Opportunities in Mexico are clearly going to be of the |
| areas of opportunity. Going further out on the | | | | distressed variety, which will require a specific |
| risk-reward continuum seems to be one of the | | | | personality and skill set. Developers and acquisition |
| features of overpricing assets and under-pricing risk. | | | | folks in general don’t make good distressed |
| What Brazil really teaches us is that less leverage is a | | | | guys because their strength is execution in an up |
| good thing, and if it isn’t broke, don’t fix it. | | | | market, so finding the right manager is the first |
| Some of these performance differences can be | | | | challenge. The likely areas of opportunity in Mexico will |
| explained by the strength of the Brazilian Real, but the | | | | be in the middle-income residential sector, mainly with |
| severity of loss in Mexico appears to fundamentally | | | | undercapitalized builders, discounted land and unsold |
| have much to do with its correlation to the U.S. | | | | vertical condo. Additionally, there are going to be |
| economy, compounded by the fact that leverage was | | | | opportunities to acquire stabilized commercial retail and |
| widely used. When the U.S. slowed, leverage and | | | | second-generation industrial. While the office market |
| correlation exacerbated the situation in Mexico. LPs | | | | remains relatively overbuilt in Mexico City, those |
| should think about Mexico as a total reset similar to | | | | opportunities are most likely going to be on the debt |
| that of the U.S., and as such, risk-adjusted returns | | | | side. Most would agree that there will not be a |
| should outpace Brazil during the next cycle. This | | | | distressed debt market like the mid 1990s, simply |
| assumes of course that Mexico’s correlation | | | | because the banks are well capitalized and, frankly, |
| with the U.S. will remain true as the U.S. recovers. | | | | operated with prudent lending policies throughout the |
| In Brazil and Mexico, both residential and commercial | | | | cycle. |
| retail development were highly favored by investors. | | | | There have been some notable transactions with local |
| While land prices and development costs increased in | | | | developers. One involving a low-income developer, |
| both countries, Mexico experienced a much sharper | | | | Corporativo Javer, had previously announced a sale of |
| increase in cost inputs, which can only be attributed to | | | | the entire company to Advent International in July 2007 |
| the impact of leverage. Low-income housing net | | | | for a rumored $500 million and never closed, but |
| margins, for example, shrank from 18—20% to | | | | recently announced a 60% sale of the Company for |
| 12—14% by 2008. Retail developers began to | | | | $180 million to a consortium lead by Southern Cross |
| assume long-term exit cap rates in the 9% range and | | | | and Evercore Partners, of which Pedro Aspe is a |
| lease rate increases of 5% or more per year. In their | | | | founder. The estimated valuation not only represents a |
| defense, much of this had everything to do with the | | | | 40% discount to the Advent terms, but the equity |
| overall robust sense that things were going really well. | | | | injection also carries a 13% preferred return. In many |
| As a developer in Mexico, if Wal-Mart said they | | | | ways, this transaction is a good example of the kind of |
| wanted to build a mall in Veracruz, you basically said, | | | | reset Mexico will likely continue to experience. |
| sure, let’s get it done! The problem of course is | | | | While those who invested in Brazil have reaped |
| that these deals turned out to be very good for | | | | tremendous benefits, it is unclear if future investments |
| Wal-Mart and not so good for the risk capital partners. | | | | will be as compelling for a new LP. Historically when |
| Brazil’s experience with retail expansion has | | | | capital inflows increase, asset prices tend to follow, |
| resisted the downturn for two core reasons. First, the | | | | and the window of opportunity may have a much |
| consumer economy didn’t experience a | | | | shorter duration than many are considering. What |
| pullback anywhere close to that of Mexico. Second, | | | | could happen in Brazil, however, is a simple case of |
| Brazilian developers assume risk on an all-cash basis. | | | | gentle crowding rather than an outright bust. If that is |
| Any downtick in rental rates is temporary and linear. In | | | | the case, returns in Brazil over the next five years, on |
| terms of residential in Brazil, the higher-end markets | | | | a risk-adjusted basis, may actually underperform, |
| definitely got ahead of themselves, but when things | | | | because the competition for deals will simply mean |
| started to show signs of slowing down, developers | | | | less capital gets put to use even though more of it |
| quickly slowed construction, which was all equity, and, | | | | becomes available. Mexico, on the other hand, is going |
| more importantly, never veered from the basic | | | | through a full reset, and the terms by which an LP can |
| development model based on pre-sales. Clear signs of | | | | invest are definitively more favorable than in Brazil. |
| a recovery in the upper end are evident today, and | | | | |