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Real Estate Limited Partners in Latin America

Real Estate investment for Limited Partners (LPs) in Latin America can really be seen as a tale of two countries, namely Mexico and Brazil, and recent experiences there offer important contrasts between each country's different market practices leading up to the global recession, some of the ways in which local participants responded differently, and, ultimately, lessons that the global recession may offer Limited Partners for future investing strategies in Latin America.

For LPs, the contrasts between Brazil and Mexico couldn't be sharper, but identifying the appropriate strategy going forward may not be as clear. There seems to be a general consensus today that investors want to avoid Mexico but remain committed to investing in Brazil. One can't blame them. This situation, in fact, is nearly a mirror image of the situation ten years ago when investors, beleaguered by years of boom and bust in Brazil, concentrated almost exclusively on Mexico as it emerged from the 1994 peso crisis. What we now know, of course, is that investors who were early to the game in Brazil have been rewarded handsomely, while experiences in Mexico are mixed at best.

During the last fund-raising cycle, most investment strategies that came to market were structured as country Funds. The emergence of country Funds, headed by dedicated local management teams, introduced a new era of competition for LP capital, which means LPs now have more options when analyzing investment choices.

This question of how LPs invest going forward will become more prominent as the reality sets in that foreign-based managers are really not set up to deal directly with day-to-day issues on the ground, and one lesson investors may take from the current crisis is that being closer to the investment itself is generally a good thing. This reality check is pushing LPs to look at their investment vehicle choices, their ability to defend their interests, fees they are paying as well as the overall investment strategy.

Issues facing LP investors are further complicated if the Fund is co-mingled. For LPs who had the ability and foresight to demand a seat at the table, either de facto or through negotiations, having more say in the matter when investments turn south turns out to be a pretty good thing.  The lesson that LPs need to plan for a downturn when executing agreements is a prominent theme throughout the industry.

Over the last five years, Mexico and Brazil each benefited from a tremendous influx of equity capital, and excessive liquidity permitted global managers to tap into leverage that further increased demand for risk assets. As allocations for alternatives increased, Funds grew in both size and number and, as a result of this heightened demand for assets, the path diverged between Brazil and Mexico as the need to invest relatively larger pools of capital pushed managers to assume the maximum permissible risk each respective market offered.

Due to the expansion of local credit, asset appreciation in Mexico readily exceeded that of Brazil. As an example, proforma exit cap rates for commercial retail dipped well into the high single digits at the peak, even though short-term Mexican Treasuries were yielding 8.25% at the time. Stabilized, credit-tenant industrial traded as low as 7.25% on a cap-rate basis. Current estimates put cap rates in the 12–14% range for commercial retail and 9–10% for stabilized industrial. The current spread between short-term rates has widened substantially to 500–800bps as the Banco de Mexico cut rates 375bps and prices fell. For a project that funded in 2006, total estimated losses could easily exceed 50% when converted back to USD. The deterioration of the Mexican peso caught many by surprise but added fuel to the fire of over leveraged real estate.

Brazil, on the other hand, continues to be an all-equity market wherein sales values for stabilized investments tend to track government bond yields, adjusted for IGPM, but the real difference is that most projects were underwritten on an unleveraged basis. That distinction is important, because if Brazil does move toward a bubble, it will most likely be evidenced by an increased use of leverage.

By 2007, the rush to invest in Mexico reached a point where clear cases of bad underwriting had emerged. Aggressive assumptions on everything from lease rates, time to stabilization, residential unit pricing, sales velocity and aggressive exit cap rates seemed to justify higher going-in costs across the board. The urgency to put money out overtook the fundamentals, and the technical trade, premised on maximizing the IRR, was squarely the focus. LPs who had the foresight to establish the dual criteria of an xIRR-based hurdle as well as a threshold multiple-on-capital hurdle avoided some of the more painful situations because, from an absolute return perspective, most investments did not pass muster after 2006.

Salaries for senior professionals in Mexico went through the roof, and attrition rates were uncomfortably high. Retaining talent became a major issue because professionals, it seemed, were spending a significant amount of time looking for the next big job opportunity. The tales of who was being paid how much to work for whom, doing who knows what, were rampant. Each week it seemed a new pool of capital was looking for a degreed, bilingual Mexican citizen to oversee their local operations.

The failure in Mexico to retain talent highlights the breakdown of the fundamental need to align management with the investor. Mexico's attrition rate for senior professionals within the industry was demonstrably higher than that of Brazil. Why there was high turnover may have as much to do with cultural issues as it does with compensation practices within the Funds themselves, but the fact remains that LPs entrusted their capital to platforms that couldn't guarantee their senior staff would stick around. The over reliance on local professionals who fit a specific mold more often than not yielded a sub-par professional who lacked the ability to properly vet an investment or say no to the next best career opportunity.

The principal issues facing LPs today depend largely on which countries the LP is exposed to and what the LP wants to do going forward. The strength of Brazil's currency provided not only a safe harbor for foreign investors but, ironically, raises the question of to whether risk-adjusted returns will be as attractive from this point on.

Back in March 2009, revisions to projected returns in Brazil would seem to suggest the currency risk was properly priced because, at that time, the overall projected losses were minimal (no one was projecting much of a profit on a currency-adjusted basis, but they weren't losing their shirts either). The question going forward is will investors, in their rush to capture alpha, push the boundaries too far, because complacency about the currency, coupled with competition for deals, can be a formula for pushing asset prices too far upwards. Equity International, for example, announced intentions to create a Brazil debt program earlier this summer, which in and of itself is not a bad idea, but is an indication that investment inflows to Brazil are forcing capital to seek out new areas of opportunity. Going further out on the risk-reward continuum seems to be one of the features of overpricing assets and under-pricing risk. What Brazil really teaches us is that less leverage is a good thing, and if it isn't broke, don't fix it.

Some of these performance differences can be explained by the strength of the Brazilian Real, but the severity of loss in Mexico appears to fundamentally have much to do with its correlation to the U.S. economy, compounded by the fact that leverage was widely used. When the U.S. slowed, leverage and correlation exacerbated the situation in Mexico. LPs should think about Mexico as a total reset similar to that of the U.S., and as such, risk-adjusted returns should outpace Brazil during the next cycle. This assumes of course that Mexico's correlation with the U.S. will remain true as the U.S. recovers.
In Brazil and Mexico, both residential and commercial retail development were highly favored by investors. While land prices and development costs increased in both countries, Mexico experienced a much sharper increase in cost inputs, which can only be attributed to the impact of leverage. Low-income housing net margins, for example, shrank from 18–20% to 12–14% by 2008. Retail developers began to assume long-term exit cap rates in the 9% range and lease rate increases of 5% or more per year. In their defense, much of this had everything to do with the overall robust sense that things were going really well. As a developer in Mexico, if Wal-Mart said they wanted to build a mall in Veracruz, you basically said, sure, let's get it done! The problem of course is that these deals turned out to be very good for Wal-Mart and not so good for the risk capital partners.
Brazil's experience with retail expansion has resisted the downturn for two core reasons. First, the consumer economy didn't experience a pullback anywhere close to that of Mexico. Second, Brazilian developers assume risk on an all-cash basis. Any downtick in rental rates is temporary and linear. In terms of residential in Brazil, the higher-end markets definitely got ahead of themselves, but when things started to show signs of slowing down, developers quickly slowed construction, which was all equity, and, more importantly, never veered from the basic development model based on pre-sales. Clear signs of a recovery in the upper end are evident today, and developers are simply resuming pre-sales and construction.

Brazil's experience with the middle- and low- housing segments, which are financed through the CAIXA system, remain very active and well financed. The issue for these housing segments in Brazil is that the government's CAIXA program is so efficient that developers really don't need that much capital. It's a great IRR, but the amount of equity is unbearably tiny for most institutional investors.

Mexico's middle- and low-income housing sectors, while still active, were leveraged through the private sector mortgage banks, which in turn had credit lines from international banks. When foreign lenders pulled their lines in 2008, developers were essentially hung out to dry. The principal difference between Brazil and Mexico is how the governments' respective subsidized housing agencies pay developers. In Brazil, a developer is paid according to pre-sales and construction advance, supplanting the need for outside construction financing. Conversely, Mexico's INFONAVIT only pays developers once the certificate of occupancy is delivered and the sale is closed. In an up market, the Mexican model allows free market forces to incentivize the production of more homes, faster, but in a downturn the industry becomes a victim of the scarcity of capital.

In the particular case of Mexico's resort hospitality sector, values reached levels never seen before. The allure of building into what felt like an unlimited demand cycle of foreign buyers drove price appreciation in destinations like Cabo San Lucas and Puerto Vallarta into the stratosphere. A two-bed condominium in Cabo could have fetched $800,000 at the peak. If you wanted a view and access to the ocean, you were probably looking at double that. Foreign investors dove head first into risky beachfront land bets in Mexico that will take years to be made whole. Conversely, Brazil's resort tourism market has remained focused on domestic end users and, perhaps due more to geography, Brazil never came close to exploiting the foreign-buyer market for second homes the way that Mexico did.

Mexico's GDP is expected to contract 8.7% for 2009, whereas Brazil is expected to pull back 1.5%. The fact that Brazil's GDP is roughly 1.6 times the size of Mexico's only emphasizes the impact this global recession will have on the allure of Brazil as an investment over the next cycle. The question for LPs, however, is which country will offer a more compelling entry point a year or two from now, when new capital would be invested?

At a recent conference on Latin America real estate, few institutional investors planned to allocate either time or money to Mexico, but invariably all were interested in Brazil. Whether or not this situation persists only time will tell, but the dearth of investment capital has negative implications for existing investments in Mexico as well as opportunities for new capital to enter at a much better cost basis than in Brazil. History illustrates that persistent illiquidity mainly serves to push values down further, which, in turn, hastens a new cycle for opportunistic investing. For an LP invested in Mexico today, the question of what to do rests on the willingness to suspend the experience from what just happened and refocus on what will most likely occur over the next several years.

When an investment goes bad, the instinct is turn the page, but to do so with an eye on maximizing proceeds within market-based time constraints is an art. Furthermore, if a manager has no more incentive to maximize proceeds, what mechanisms are left to ensure that the LP's capital is being managed with the maximum level of fiduciary? The short answer is not much. The question for an LP invested in Mexico today is how to re-align interests, because, whatever the ultimate strategy, selling will take time.
The extent to which an LP is able and willing to step up their allocation to Mexico will largely define its options. By increasing the allocation, an LP immediately secures the ability to completely restructure its relationship with the manager, including the fee structure, management retention practices, the investment strategy and the LP's rights. If increasing the allocation is unrealistic, an LP could theoretically incentivize a manager by resetting the cost basis, but that begs the question: why reward failure? The LP, then, is left with either swapping out the manager, which is complicated, or bringing in an outside advisor to monitor the manager, charging the cost back to Fund. The latter seems to be the preferred strategy at this point in time but may prove to be only a Band-Aid over time.

The fact that capital is actively looking to invest in Brazil and that Brazilian managers can point to relative success during the downturn will limit their willingness to negotiate with LPs. All things being equal, an LP should be able to negotiate substantially better terms with a Mexican manager in the current environment. LPs who invested in Brazil earlier this decade already made their money and have their deals cut with the manager, but new investors are up against a wave of interest that will only grow stronger as the global recession recedes.

The absence of leverage in Brazil turned out to be a good thing for many reasons. First and foremost, unleveraged returns are by definition more conservatively underwritten. A manager who has to fund with 100% equity capital will look more closely at an investment because of the simple law of limited resources. The same manager with an ability to leverage that same equity will put less in so that he can fund more investments, because maximizing the number of projects will yield more fees. Because of this, there is an inherent tension between maximizing the number of deals and protecting investor capital, driven mainly by the front-end fee incentive. This is one of the greatest obstacles to maintaining proper alignment of interest. The fact that Mexico is currently undergoing a reset in asset prices means the next wave of capital to enter Mexico will invest on an all equity basis—which is a good thing from an underwriting standpoint, because the LPs will benefit from better underwriting standards and a wider selection of opportunities.
The question of properly aligned fee structures is central. Even though there is strong LP interest in Brazil, fees are being negotiated down with some success. Namely transaction-related fees such as internal acquisition and disposition commissions are being reduced, if not eliminated. Asset management fees are focusing on invested versus committed equity, and LPs are paying close attention to the definition of "inside the box," with an eye on capping exposure to any individual investment.

The most likely areas for opportunity in Brazil will continue to be build-to-suit industrial, mid-rise value-add office and middle-income residential (although it's hard to put a lot of equity out without buying into a developer). Commercial retail is a very competitive market, and the most successful strategies have been joint ventures with solid local developers. It will be interesting to see what the impact of the Olympics will be for the country and Rio de Janeiro specifically, and there will be a real estate angle to be sure.
Opportunities in Mexico are clearly going to be of the distressed variety, which will require a specific personality and skill set. Developers and acquisition folks in general don't make good distressed guys because their strength is execution in an up market, so finding the right manager is the first challenge. The likely areas of opportunity in Mexico will be in the middle-income residential sector, mainly with undercapitalized builders, discounted land and unsold vertical condo. Additionally, there are going to be opportunities to acquire stabilized commercial retail and second-generation industrial. While the office market remains relatively overbuilt in Mexico City, those opportunities are most likely going to be on the debt side. Most would agree that there will not be a distressed debt market like the mid 1990s, simply because the banks are well capitalized and, frankly, operated with prudent lending policies throughout the cycle.

There have been some notable transactions with local developers. One involving a low-income developer, Corporativo Javer, had previously announced a sale of the entire company to Advent International in July 2007 for a rumored $500 million and never closed, but recently announced a 60% sale of the Company for $180 million to a consortium lead by Southern Cross and Evercore Partners, of which Pedro Aspe is a founder. The estimated valuation not only represents a 40% discount to the Advent terms, but the equity injection also carries a 13% preferred return. In many ways, this transaction is a good example of the kind of reset Mexico will likely continue to experience.

While those who invested in Brazil have reaped tremendous benefits, it is unclear if future investments will be as compelling for a new LP. Historically when capital inflows increase, asset prices tend to follow, and the window of opportunity may have a much shorter duration than many are considering. What could happen in Brazil, however, is a simple case of gentle crowding rather than an outright bust. If that is the case, returns in Brazil over the next five years, on a risk-adjusted basis, may actually underperform, because the competition for deals will simply mean less capital gets put to use even though more of it becomes available. Mexico, on the other hand, is going through a full reset, and the terms by which an LP can invest are definitively more favorable than in Brazil.

About the Author

Mr. Anderson is Managing Member of Tierra Partners and oversees advisory services for institutional investors with an emphasis on pension clients in the Latin America region. Tierra Partners has advised on $1.5 billion in aggregate real estate investment exposure on behalf of pension investors in Latin America since 2009. Tierra Partners' principal focus is manager & strategy consulting in addition to asset level analysis.

why does BUY cars at invoice get all the attention ?but nothing else?

On all the site's I see the "buy at invoice" for cars. How about a couch? or a freezer? or tile flooring? lighting? or real estate? I sold furniture, the mark up was 400% IF we all want to beat up the dealerships and salespeople how about the other professions? like a Dr? or a Vet? why do we as a people thrive trying to get a new car at cost and NOTHING ELSE?

Lee, thank you.

As a decade-plus veteran of the car business, this has always been a sticking point. People want to really stick it to that car guy, and make sure he makes as little as possible. But they will buy a living room set at 10% off and think they got a deal. In real $$$ that living room set will have more profit than most new cars.

The truth is, cars and houses are just about the only places where buyers can still negotiate the deal. With furniture, jewelry, clothes, etc they take the sticker price, or "sale" price and move along. Usually without realizing just how much profit they have handed to the retailer.

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