Emerging Trends in Latin America 2011
15 February 2011
Offshore investors see plenty of potential in two primary emerging markets, but various hurdles limit opportunities.
Where the United States has gone boom-bust and Canada offers only modest growth, Latin America's story centers on the enormous potential of two emerging markets, Brazil and Mexico. Together they account for two-thirds of the region's population "and most of its growth dynamics." But amid the swirl of young populations, an energized middle class, and the immense promise of expanding industries, investors deal with inevitable corruption and lack of transparency, the need to sort out the reliability of local partners, and, in the case of Mexico, the scourge of drug violence. Enticements and obstacles leave most North Americans intrigued by the possibilities, but not straying off home turf. In the United States, particularly, contending with difficult domestic issues distracts from considering emerging market investments. But for those who do, the action is all about two countries: "They take the oxygen away from all other Latin American markets."
Brazil: Opportunities and Limits
Emerging Trends interviewees express few doubts: "The boom period has legs, the cat is out of the bag, people want to be where the action is, and that's Brazil." The country is self-sufficient in agriculture and energy, and expands its high-tech manufacturing. More offshore institutions "get their feet wet," but find limited opportunities in existing real estate because only a handful of buildings meet investment grade. Then they confront hurdles from Brazil's transaction culture of "group ownership," which makes deal making difficult. "It's hard to get all parties to sell."
Development may be where the real action lies. "There's a ton of demand for a ton of new space. You can build housing forever, and people will want it." Plus, shopping centers are few and far between, and distribution warehouse facilities are in short supply to serve growing consumer appetites. "The middle class is huge and dramatically increasing; populations concentrate in urban areas, creating intense demand for highrise residential and retail." Again, local companies with big development platforms and insider connections have "a tremendous advantage and try to maintain a stranglehold; outsiders can't compete" and must make alliances. "Brave investors" enter secondary markets to develop malls, and strip centers will follow next.
For office markets, investors find an extremely limited menu in only two cities, Rio de Janeiro and Sao Paulo.
"Everyone wants to be in Rio. The relatively small business district has virtually "zero percent vacancy," and rents skyrocketed "30 percent in the last year." The mountains rising from ocean landscape leaves "no place to build," while the coming Olympics and World Cup fuel interest. Similarly, Sao Paulo's office sector remains tight, escalating rents and values. "It's a bubble driven by user demand, not speculators." Poor infrastructure limits new development opportunities. The city's roads and mass transit cannot handle population growth; 800 new cars each day add to already congested streets.
Interviewees expect yields to squeeze down, and markets to cool off but remain enticing. "Five years ago, investors expected IRRs (internal rates of return) of 40 percent. Now that's dropped into the high teens, and core funds are next."
Mexico: Potential and Concerns
Mexico offers obvious positives, a hard-working population, an expanding middle class, and the resulting increased demand for homes and consumer goods. But everybody reads about mind-blowing drug wars, police corruption, and political assassinations. In addition, real estate markets hit the skids when the U.S. economy tanked. Prices declined 30 to 35 percent and now recover, more than "halfway back", but it's been "tough sledding."
Finally, banks relax lending curbs after "a huge liquidity crunch" brought on by the worldwide credit crisis. Mexican investors did not over borrow: patient equity players "take a patrimonial view" and count on long-term returns, relying on healthy demographics and controlled development. In fact, most cities and property sectors have avoided overbuilding. Boosters suggest that "markets now align" for significant growth from pent-up demand, and highlight opportunities to fill the remaining capital gap. "There's a large hole to fill," especially for construction loans. New laws allow domestic pension funds to invest in real estate and infrastructure, which could increase property market liquidity and demand for product. "We're seeing the checkbook at the end of the tunnel." But many jobs depend on the U.S. economy, manufacturing of time-sensitive products or heavy machinery that cannot be shipped by boat from Asia, hotel and tourism related businesses, and call centres. Locals necessarily raise concerns about when and whether the United States will emerge from its doldrums.
Industrial real estate "should improve during 2011" after a no-demand, no-development period. The U.S. downturn cuts two ways: overall declines in manufacturing and distribution activity, especially from "hardest-hit" northern border states, have been offset somewhat by more U.S. manufacturer relocations due to the weakened peso. Interior warehouse markets, serving Mexico City, suffered less. Retail "makes a good long-term play," betting on the growing middle class. Office markets show decent recovery and low vacancies in Mexico City, but offer "negligible investment opportunities" because mostly domestic owners do not sell. Lenders require tenants in place for financing new construction, so "speculative development won't happen."
Most multifamily housing is owner occupied and heavily government subsidized. Developers receive a guaranteed return over ten-year periods without much upside. For-sale housing remains supply constrained by lack of construction financing, while the second-home market "went off the cliff" when U.S. retiree demand evaporated. Canadians fill some of the void, gaining buying power from their stronger dollar and the weaker peso. In favoured coastal Baja and resort markets, cheap land could be a bargain. "The second-home market will come back."
Locals lament "too much distraction from drug issues," which torpedo revenues for some resort hotels already feeling the effects of U.S recession. "We need to deal with perceptions; it's our biggest hurdle to overcome." Other interviewees admit to "grim" security concerns, particularly in northern cities like Tijuana, Juárez, and Monterrey. "Business goes on, but not many relocations."
Government planners encourage future development to focus on more urban concepts and city centres, getting away from expanding suburban envelopes. The road-dependent sprawl model, copied from the United States, reaches the point of diminishing returns, creating hardships for many Mexicans who cannot afford cars or cannot support multicar households. Serious congestion and pollution, especially around Mexico City, must be addressed, too.