Market Perspective. Prudential Real Estate Investors. Latin American Quarterly July 2007

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1 Prudential Real Estate Investors Latin American Quarterly July 2007 Market Perspective Executive Summary A long cycle of relative tranquility and high liquidity in international markets continues to benefit Latin America. Consumers are driving the economic activity in the region, and motivating real estate developers to build new shopping malls and housing projects. Capital is entering the Latin American property market in various ways, and real estate is attracting attention in the public equity and debt markets. Latin America s main office markets are all experiencing a recovery. Fears of oversupply, caused by a soft cycle that lasted over four years in some locations, are fading. As a result, market indicators have improved, and investor interest is back. Office development is occurring across the region and is focusing on trophy properties. The economic buoyancy of some Latin American countries, where falling interest rates drive stability and strong internal consumption, resembles Mexico in In Mexico, the availability of long-term debt with attractive terms was the main driver of growth in the housing market. Economic stability, a stronger financial sector and more professional management of government-run mortgage lending institutions have all proven beneficial to the country s homebuilders and homebuyers. Prudential Real Estate Investors 8 Campus Drive Parsippany, NJ USA Ph Fax Web prei.reports@prudential.com Despite new investments in manufacturing segments increasing in countries like Argentina and Brazil, industrial real estate in these countries has not yet seen the activity that Mexico has for many years already. User-ownership still prevails, and the preferred way for investors to participate in the market is through less risky build-to-suit schemes. Regional Economies Latin American economies continue to enjoy the benefits of a mild external environment and positive internal indicators. Countries in South America (Argentina, Brazil, Colombia and Peru in particular) are receiving strong capital flows that fuel investment. On the other hand, these inflows

2 have also created concerns about rising prices in countries like Chile and Colombia. In Argentina and Venezuela, high inflation is already a reality. In Brazil, President Luis Inacio Lula da Silva, now in his second term, has maintained his popularity thanks to successful developments in the economy and despite recurring opposition criticism. Although infrastructure and income distribution are improving, Brazil s long-term growth depends on solving bottlenecks via tax and welfare system reforms. The government s Growth Acceleration Program (PAC in Portuguese) and a sharp increase in credit availability are driving Brazil s economy. GDP is forecast to rise by at least 4.0% in The Central Bank has managed to keep inflation under control with relative ease. Year-end inflation should hover around 4.0%. During the quarter, rating agencies S&P and Fitch raised Brazil s sovereign debt to BB+, one notch below investment grade. Reforms are also high on the agenda of Mexico s President Felipe Calderon. In late June, a fiscal reform was proposed that aims to increase revenue by 1.5% of GDP in 2008 and up to 2.8% in It also attempts to reduce tax evasion while increasing efficiency. In expectation of the legislative reform, S&P changed the outlook on Mexican sovereign debt from stable to positive. The credit agency cited growing prospects for the fiscal reform, steadily improving external liquidity and higher external debt burden as the basis for the change. Mexico s sovereign debt is currently rated BBB. The Chilean economy continues to benefit from strong exports of raw materials, which created the basis for GPD growth in 1Q of 5.8%. According to the IMF, per capita GDP in Chile should reach a record US$9,000 during Meanwhile, unemployment a running concern there has receded, and consumption is surging at almost 10% on the year. Internal consumption is also leading growth in the Peruvian economy, which saw growth of 7.5% in 1Q. A similarly robust economy in Colombia is fueled by heavy capital inflows that strengthen the local currency, and which prompted the government to implement a control on foreign capital inflows toward the end of the quarter. GDP grew by 8% in 1Q, during which Fitch raised Colombia s foreign debt rating to BB+. 2

3 GDP Growth 12% 10% Forecast % 6% 4% 2% 0% Argentina Brazil Chile Colombia Mexico Peru Venezuela Source: IMF, World Economic Outlook Database, April 2007 In Argentina, the environment is more politically charged in the run-up to the October presidential elections. GDP grew fast at 8% in 1Q, and unemployment receded, but inflation is steady at a high 9%. Argentina needs investments in key areas, particularly in energy generation, to allay fears of upcoming shortages during the Southern Hemisphere s winter. In Venezuela, while growth was 8.8% in 1Q, inflation doubled in one year and is near 20%. President Hugo Chavez continued to implement populist policies, including the controversial nationalization of the country s most popular TV broadcasting company. Capital Markets Stock markets in Latin America rallied throughout 2Q, as most major indexes posted high gains based on favorable external conditions. The Brazilian Ibovespa Index excelled among its neighbors with a 19.3% gain over the past three months, while the Mexican IPC and Argentinean Merval posted 6.8% and 3.6% increases, respectively. The S&P 500 was up 5.5% during the same period. The stock market rally started in mid-2006 and has not stopped. Minor setbacks, such as the hiccup in the Shangai stock exchange in late February and problems with U.S. subprime mortgages, were not enough to eliminate the underlying bullish sentiment in local markets. External conditions fueled growth, as the high-liquidity environment continues to draw investors to Latin America in search of higher returns. Brazil has been on the radar screen of international investors for quite some time, but the past three months have been remarkable. Brazil has one of the highest interest rates in the world, despite 16 straight rate cuts by the Central Bank and macroeconomic stability. Thus, international investors borrow money in low-interest-bearing countries, such as Japan, and invest in countries offering higher returns, such as Brazil. These investors have flooded the local market with foreign money, boosting stocks and reducing the yield on Brazilian bonds. Inflows of foreign capital in April, for example, were the highest in history. Brazil s currency has 3

4 appreciated greatly over the past months despite the efforts of the Central Bank: the real appreciated 6.25% in 2Q, even though foreign reserves rose to a record US$147 billion. One source of foreign capital inflows is the participation of investors in the IPOs of Brazilian companies, continuing a trend that started over a year ago. Real estate companies continue to attract capital. During 2Q, six real estate developers (CR2, Agra, JSHF, Even, Inpar and EzTec) and one shopping mall operator (BR Malls) raised over $1.8 billion. Many real estate companies continue to work on IPOs, including shopping mall operators Multiplan and Aliansce, as well as low-income housing developers MRV and Tenda. In Chile, a leading real estate developer, Socovesa, is working with local regulators on an IPO. During the quarter, Brazilian companies also chose to tap capital markets through the issuance of fixed income securities. For example, housing developer Company SA suspended a secondary share offer and chose to issue debentures instead. Housing developers Rossi and Cyrela issued debentures worth about $400 million in the quarter, while BR Malls, which became publicly traded in May, made a follow-on debenture issuance worth $153 million. Real estate developer PDG Realty and shopping mall operator Iguatemi are also working on debenture programs worth over $100 million each. Two of Brazil s leading retailers, CBD and Lojas Americanas, together raised $500 million in the fixed income market during the quarter. In Mexico, bond issues are the current preferred means of raising capital. Mexico s number-three grocery retailer, Comercial Mexicana, placed bonds worth $272 million in international markets, while shopping mall operator GAV raised $105 million in a similar placement. Infonavit, Mexico s leading provider of mortgage financing, prepared its largest-ever issue of mortgage-backed securities, worth $260 million. Mexican stock markets also rallied through most of 2Q but ceased to advance in the beginning of June. The Mexican IPC tends to closely follow the S&P 500, as both economies are highly interconnected. When U.S. 10-year bond yields went above 5% in early June, the market feared yields would go as high as 6%, thus drawing investors attention away from stocks. In addition, higher oil prices hovering around US$70 helped to cut some of the market s recent gains. Despite external influences, Mexico s internal economic outlook improved during 2Q, with inflation moderating after the first quarter spike. May s CPI was up 3.95% over the past 12 months, back in the Mexican Central Bank s 2% to 4% comfort zone. The Central Bank raised short-term interest rates by 25 bps to 7.25% in April in a measure to control inflation. The monetary authority stated it could raise rates even further if inflation fails to move toward the 3% target. Office The main office markets in Latin America are all experiencing a recovery. Fears of oversupply, caused by a soft cycle that lasted over four years in some locations, are fading. As a result, market indicators have improved, and investor interest is back. From Mexico City to Sao Paulo, any good-quality office building put up for sale today will attract several potential 4

5 buyers. In contrast, sellers were unlikely to find a buyer in the slow marketplace of just a few years ago. Vacancy in Sao Paulo is now low, and rents have recovered to levels last seen four years ago. The same situation is prompting firms to make aggressive moves to acquire office properties in the city through sale-leasebacks or straight acquisitions. At the same time, important projects are getting off the ground, including large office buildings in Sao Paulo and Rio de Janeiro. This contrasts sharply with the dormant market of falling rents and rising vacancies seen previously. Class-A Office Vacancy Rate 20% 1Q05 1Q06 1Q07 16% 12% 8% 4% 0% Mexico City Sao Paulo Rio de Janeiro Santiago Buenos Aires Source: CBRE Office development activity is occurring elsewhere in the region, but, in general, it is focused on trophy properties in major cities and not on widespread, smaller-scale development, as in the last cycle. A development group is moving ahead with what will be Chile s tallest building and is venturing into development in Peru. In Mexico City, development of the landmark Arcos Bosques 2 property is moving ahead, 10 years after phase one was completed. Construction of new office space in Mexico City is occurring after faltering for a few years. With vacancies never above 8%, and rents pointing toward their level before the current cycle, local firms are moving ahead with new projects and redevelopments. Residential The economic buoyancy of some Latin American countries, with decreasing interest rates driving stability and strong internal consumption, resembles the Mexico of There, the availability of long-term debt with attractive terms was the main driver of growth in the housing market. From a lackluster market creating fewer than 200,000 units a year, Mexican firms produced about 750,000 homes last year, well on the way to meeting the goal of one million per year, as stated in President Calderon s housing plan. This figure is aggressive, but it is barely enough to keep up with the demand stemming from an aging population. Economic stability, a stronger financial sector and more professional management of government-run mortgage lending institutions have all helped the country s homebuilders 5

6 and homebuyers. According to IMEF, a policy institute, the sector could grow by 12% per year during the next five years. One indicator of the strength of the residential sector is that during 1Q, the amount of mortgages provided to Mexican households grew by 30% versus the same period in 2006, helping bank loans to the private sector in general grow by 26%. Infonavit, Mexico s largest provider of residential mortgages, is broadening its participation in the market, particularly in the lower-income segments. In 2006, Infonavit issued 421,000 new mortgages, more than half of the total provided by all Mexican financial institutions. This year, Infonavit plans to issue at least 500,000 mortgages. The entity is moving ahead with its mortgage-backed security program, which is setting the tone for the rest of the market. Infonavit has sold more than US$1 billion worth of MBS since the program began in late 2005, and in mid-2007, the entity was readying its largest issue ever, worth US$260 million. Commercial banks, which returned to the residential mortgage market after being virtually absent for nearly a decade, are all expanding their mortgage portfolios by creating innovative financing schemes and terms. Mexico s specialized mortgage lenders, sofols, flourished when banks were absent from the market but now face competition from banks. In fact, some banks are absorbing sofols. Both offer mortgages to foreigners acquiring second or retirement homes in Mexico and to Mexican nationals living abroad who want to reinvest in their homeland. The housing sector has been growing quickly for several years now, along with investments by housing companies. Mexico s Construction Board, CMIC, estimates that the housing sector will invest almost $22 billion in For many years, and with few exceptions, housing development has been the territory of local firms. More recently, however, foreign developers are furthering their participation in this booming segment. They invest in three main ways. First, they form investment funds, which act as capital sources for existing local companies to grow their operations. Second, private equity firms do straight investments in existing developers. And finally, foreign companies establish Mexican subsidiaries to do development. This is happening especially among Spanish firms, which are competing with local developers to develop second homes in resort areas on the coast, but which are also venturing aggressively into large metropolitan areas with projects that cater to the middle class. In Brazil, the availability of mortgages continues to improve, with issuances of new mortgages growing 86% in 1Q. The Brazilian banking association, Febraban, states that lending to homebuyers rose by 50% per year between 2004 and 2007, versus the negative rates seen from 2001 to Private-sector banks are starting to play a more important role in the country s mortgage market, which was previously dominated by state-run Caixa Economica Federal. Bradesco, the nation s largest private bank, recently extended its maximum financing term to 25 years a remarkably long time by Brazilian standards. Economic stabilization, which unlocked latent demand, contributed to the successful IPOs of Brazil s housing companies during the past few years. Investors, particularly foreign ones, still seem to have an appetite for these IPOs. In fact, four more housing developers (CR2, Agra, Inpar and EzTec) all sold shares during 2Q and raised a combined US$1.1 billion. 6

7 These highly capitalized, newly public Brazilian housing developers seek to maintain their market shares through regional expansion in a highly competitive market. Thus, these firms are quickly closing joint ventures or straight acquisitions of smaller developers with a regional focus. Many firms, such as Cyrela, Rossi and PDG Realty, announced deals during the quarter. Cyrela currently has the largest market capitalization of any real estate developer in Latin America and is also considering a partnership with Argentina s leading real estate firm, Irsa, to enter Argentina s residential market. Many of Brazil s large homebuilders, which historically focused on the middle class, are now entering the lower-income segment of the market. As interest rates fall and credit becomes more available, the lower-income segment will clearly benefit, a phenomenon that has occurred in Mexico over the past five years. The initiatives so far are relatively timid, although several companies have announced plans for subsidiaries that will aggressively focus on the segment. Meanwhile, the two leaders in this market, Tenda and MRV, are working with local authorities to become publicly traded and hence capitalized to counter the competition of new entrants. Industrial The development of industrial real estate markets in Latin America follows manufacturing activity and the need for distribution space. Nowhere is that clearer than in Mexico, where global integration in supply chains requires manufacturers to keep up with the rapid pace of innovation. The country benefits enormously from its long, shared border with the U.S. A real distinction exists between the export-led activity in the north and the distribution-led activity in central locations. The proximity to the U.S. market was, for example, the motivation of an Argentine conglomerate to commit to pay $3.2 billion for a Mexican steelmaker during 2Q. Mexico is seeing a reduction in oil exports amid a sharp rise in imports, which is helping expand the trade deficit. Mexico s manufacturing sector is growing only moderately, in response to the slow U.S. market. Meanwhile, exports to Europe are on the rise, although they still represent only a fraction of the volume that goes to Mexico s NAFTA partners, which account for about 85% of Mexico s exports. Nevertheless, the Mexican government has initiated talks with India to try to add yet another country to Mexico s long list of free trade partners. In Mexico s central locations, demand is driven by expanding consumption and the resulting need for more distribution space for manufacturers that cater to the internal market and retailers. New, modern distribution space is required, and congested locations soon become outdated with the establishment of other locations bordering the main metropolitan areas and following the distribution network. In North Mexico City, the country s most active distribution market and home to some of the highest-quality distribution space, developers are looking for alternative locations. Pressured by high land prices as the area competes with other uses, industrial real estate developers are considering locations farther out, at land prices that still justify the resulting lower rents. The key is current and future accessibility. The project of Arco Norte, a new beltway now under construction that will connect the various highways around Mexico City may play such a role. 7

8 The area may represent an alternative to congested locations and a direct link to Mexico s railway network and ultimately to ports on the Gulf of Mexico and the Pacific. Mexico s industrial real estate is also highly correlated with the manufacturing sector, of which automotive production is the main component. Auto production in Mexico slipped during 1Q, in response to soft demand from the U.S., the main destination of its exports. However, production picked up in 2Q, helping to keep Mexico s trade deficit relatively under control. Foreign carmakers are choosing Mexico as a production platform for vehicles later exported to North America, versus Argentina and Brazil, where auto production focuses on low-cost vehicles for regional use. Chrysler, with a long presence in the auto manufacturing cluster of the northern Mexican state of Coahuila, confirmed in 2Q plans to invest US$570 million in a new facility in the city of Saltillo, which is expected to start producing engines in A new entrant, China America Cooperative Automotive, Inc. (CHAMCO Auto) also plans to start producing 150,000 vehicles per year in 2009 at a future facility in Baja California. Automakers are investing across the region. In Argentina, Volkswagen, following in the steps of GM, Fiat and Renault, announced plans to expand production. The Argentinean carmakers association, Adefa, expects the sector to invest $3.5 billion in the next three years, enough to raise production to 750,000 units per year from the current 500,000. South Korea s Hyundai/Kia is set to invest $1 billion in a new facility in Brazil, Latin America s largest producer of vehicles, according to government officials. The company is currently building its first Latin American facility in that country. Despite new investments in automotive and other manufacturing segments, industrial real estate in Brazil has not yet seen the activity that Mexico has for many years already. User-ownership still prevails, and the preferred way for investors to participate in the market is through less risky build-to-suit schemes. Industrial parks are uncommon, versus the stand-alone format, and speculative activity is very rare. Current stock is fairly outdated, although end-users require newer facilities. Retail Retail sales are rising in every large nation in the region. Despite differences in internal economies, countries like Argentina, Chile and Colombia saw retail sales grow by at least 10% in the first half of The pace of growth is even stronger in the robust economy of Peru, where in April credit to consumers grew by 42% compared with the previous year. 8

9 Private Consumption per Head e US$ Thousands Argentina Brazil Chile Colombia Mexico Peru Venezuela Source: EIU Consumer demand is driving retailers to vie for market share. In a sign of the times, French grocery retailer Casino with a significant position in several of Latin America s main markets said it will open its first stores in Argentina since the country s financial meltdown in late Its rival, Carrefour, is investing US$145 million to open new stores there this year. Argentina is also attracting investors from the region, such as Chile s Cencosud, which is entering the country with its brand, Almacenes Paris. Cencosud is also entering Colombia, through a homeimprovement brand in joint venture with Casino. Colombia is clearly important to Casino, which recently announced plans to invest US$1 billion there in the next three years. Casino already controls Colombia s largest retailer, Almacenes Exito. Regional expansion is necessary for Chilean retailers, who are faced with a limit to growth in their home market. Parque Arauco, a department store and shopping center operator, announced plans to further its investments in Argentina and Peru and to enter Colombia and Mexico within the next three years. Two Chilean firms, Falabella and D&S, announced a merger agreement, thus creating the largest retailer in Chile and one of the largest in the region. Sales in Mexico are rising faster than the economy. The national retailers association, ANTAD, which tracks the performance of over 12,000 outlets, saw sales grow in May at 7.1% on the year a decrease from 1Q. ANTAD is a proxy for the formal retailers in the country and, indirectly, for shopping center sales. As is typical, the figure was much higher than the official retail sales indicator calculated by Mexico s statistics institute, INEGI, which accounts for sales in all formats. Mexican retailers are continuing to expand into financing, with the opening of banking operations to provide credit to their customers. The list of companies providing this service grew longer in the quarter, with the opening of the bank of Coppel, a discount department store. Consumers in Brazil are also driving retailer expansions. Growth in overall retail sales is close to 10% on the year, more than double the economy s growth pace. The Brazilian association of 9

10 shopping center retailers, ALSHOP, estimates shopping center sales will rise by 7% in The Brazilian shopping center market has remained relatively dormant for four years, with the majority of new investments made in expansions of existing centers. Last year, the situation started to change, with new mostly foreign capital flowing to local shopping center operators to allow for consolidation in the sector. Traditional operators like Iguatemi and Multiplan are tapping the stock market and are putting this capital to work. Iguatemi announced a US$100 million investment in the shopping mall component of what will be a landmark mixed-use project in Sao Paulo, in addition to two other malls in Brasilia and Florianopolis. Multiplan started a new project in Porto Alegre and is moving ahead with a new mall in Sao Paulo near Iguatemi s new mall in the same city. Despite ongoing consolidation, Brazil s shopping mall market is still fragmented: the three leading companies in Brazil hold only about 15% of the market. Conclusion A prolonged cycle of relative tranquility and high liquidity in international markets continues to benefit Latin America. Economies in the region are enjoying the foreign currency flows brought by demand for local products as well as direct investments into the region. Stock markets posted record gains so far this year, and local currencies continued to appreciate. The result is that internal economies strengthened: despite bouts of inflationary pressure, most countries are managing to keep prices under control. Price increases are caused by strong internal demand from companies and individuals. Consumers, in fact, are driving the strong economic activity across the region and causing real estate markets to react. Consumers newly found access to mortgage financing is behind the expansion of the Mexican housing market, a situation that is now occurring in Brazil. Consumers are also driving a transformation in the retail sector: as retailers adapt to cater to the tastes and needs of the middle class, real estate firms rush to build properties with the specifications required by these powerful users. Even the office market, briefly ignored during the past few years, is making a comeback. Demand for space brought market indicators back on track and prompted developers to once again consider and in many cases to move ahead with investments in new and existing properties. Capital is finding different ways into Latin American properties; and real estate is currently one of the stars of the region s public equity and debt markets. 10

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12 The Investment Research Department of Prudential Real Estate Investors publishes reports on a range of topics of interest to institutional real estate investors. Individual reports are available free of charge in hard copy, by or via the Web at Reports may also be purchased in quantity for use in conferences and classes. To receive our reports, change your contact information or to be removed from our distribution list, please us at prei.reports@prudential.com, or telephone our New Jersey office at Prudential Real Estate Investors 8 Campus Drive Parsippany, NJ USA Tel Fax Web prei.reports@prudential.com Copyright 2007, Prudential Real Estate Investors PREI Prudential Real Estate Investors is a business unit of Prudential Investment Management, Inc., a registered Investment Adviser and indirect wholly owned subsidiary of Prudential Financial, Inc., Newark, New Jersey.