Latin American Market Outlook First Quarter 2004

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1 Prudential Real Estate Investors (US) Latin American Market Outlook First Quarter 2004 Market Perspective The improvement in the Latin American business climate that began in late 2003 is gaining momentum, particularly in the more mature regional economies. In fact, in the first three months of the year, some market observers revised their full-year forecasts upward. Major economic indicators for the first quarter show that economic activity is generally picking up in the region, especially compared with The region s major economies weathered negative external factors well during the first quarter, but an energized electorate is proving more difficult to please. In the coming months, it may be increasingly tempting to some governments to sponsor programs that would win votes, at the expense of sound macro- and microeconomic management. Market observers are closely watching for any abrupt policy changes that may stem from a derailing of current economic and political policies. But the business sector is focusing on the big picture, which points to institutional improvements on all fronts, particularly in countries such as Mexico, where the central bank has gained independence from the executive branch. The first quarter, while historically slow in terms of business activity, was unusually prolific in terms of real estate activity, including groundbreaking deals that had been in the works since late last year. Two landmark events took place in Mexico: the acquisition of a US$300 million industrial portfolio by a US institution and the launch of housing agency Infonavit s residential mortgage-backed security program. Prudential Real Estate Investors (US) 8 Campus Drive Parsippany, NJ USA Ph Fax Web prei.reports@prudential.com The role of the region s debt and equity capital markets is becoming more influential and is growing in significance as a source of capital for real estate companies and projects. In Brazil, the syndication of real estate funds is once again picking up speed, while in Mexico, the introduction of the Mexican real estate investment trust (REIT) is prompting institutions and individuals to rethink how real estate assets are owned, managed, transferred or sold.

2 Regional Economy Official figures released in the first quarter generally confirmed market expectations for 2003 economic growth. The United Nation s Economic Commission for Latin America and the Caribbean (ECLAC) estimates that the region grew by 1.5% in 2003, up from 0.4% in ECLAC projects that regional growth will increase to 3.5% in In Mexico, the economy grew 1.2% in 2003, continuing a recovery that began in 2002, when the economy grew by 0.7%, after contracting 0.2% in Current expectations put Mexico s 2004 growth substantially higher, between 3.0% and 4.0%. Brazil s 2003 GDP came in at a 0.2%, taking most analysts (who had been expecting a positive, albeit small figure) by surprise. This is considerably less than the 1.3% and 1.9% growth in 2001 and 2002, respectively, bringing President Lula da Silva s first year in office to a disappointing close. For 2004, however, forecasts point to GDP growth of at least 3.0%. Elsewhere in the region, 2003 GDP was mostly within expectations. In Chile, 2003 GDP growth registered 3.3%, up from 2.1% in 2002, paving the way for a strong 4.5% expansion currently forecasted for Argentina grew as much as 8.7% in 2003, which was above expectations but still far from fully recouping the contractions of 4.4% and 10.9% in 2001 and 2002, respectively. In 2004, Argentina is projected to maintain high growth current estimates are 5.5% for the year. Colombia s economy likely grew 3.5%, up from 1.76% in 2002, while Peru s political problems caused a decrease in its 2003 GDP growth to 4.0% from 4.9% in As expected, Venezuela s ongoing internal unrest was responsible for its second year of recession the economy contracted by 9.2% after receding 8.9% in During the past two years, the close link between Mexican and US manufacturers has had a negative impact on Mexican manufacturers that have extensive production-sharing operations with their US counterparts. However, an upturn in Mexico s economy became apparent in 3Q03, on the heels of a strong recovery in the US manufacturing sector. As US inventories reached low levels, Mexican manufacturers benefited from a disproportionate share of the upturn, compared with other global manufacturers. Industrial production in Mexico is pointing up in 1Q04, thanks to a recovery in the export-oriented maquiladoras. After having posted the lowest annual price increase in 35 years during 2003 (3.98%), Mexican inflation forecasts for 2004 are above 4.0%, at the upper end of the central bank s target range. As a result, monetary policy has been consistently tightened, causing short-term interest rates to increase by more than 70 bps during the quarter. Similarly, early-year inflation concerns made Brazil s central bank interrupt the downward trend in basic interest rates in a cautionary move that brought significant criticism, even from political allies. Mexico continues to build up its US dollar reserves, which reached a record $59 billion during the first quarter. This has occurred despite a slowdown in foreign direct investment during 2003 (which is expected to recover in 2004), as the strong inflow of foreign currency has been maintained by record-high oil prices and remittances of Mexicans living abroad ($13.3 billion in 2003 also a record). This all supports a strong peso, which poses some risk to Mexico s export competitiveness in the medium term. To avoid a depreciation of the peso and a rise in inflation, 2

3 market observers have called for structural reforms, which would create investment opportunities and attract fresh capital. In Brazil, exports (particularly agricultural products and steel) continue to be the bright spot in the balance of payments. After exports rose by 21% in 2003, the country posted its first current account surplus in more than a decade. Here, the challenge has been to bolster companies that cater to the internal market, as domestic consumption is being stifled by unemployment and depressed wages. However, economic indicators all point up in Brazil for In fact, a survey by the Ministry of Development published in late January indicates investment intentions in Brazil are up 71.2% from one year earlier. In both Mexico and Brazil, unrelated corruption scandals involving government officials dominated local headlines during most of the first quarter. More than anything, these scandals tended to distract the public and sidetrack politicians from focusing on more pressing matters. On the other hand, these scandals are also evidence of a more transparent business environment, which is exposing and discouraging corrupt practices. Capital Markets Investors in Mexico have closely followed inflation readings during the first quarter, in an attempt to anticipate the monetary authority s stance on interest rates as prices started to rise. As previously indicated, monetary policy has become stricter since January and has therefore pushed up the yield curve. Nevertheless, base interest rates remain low by Mexican standards (5.5% in early January, 6.2% in late March for 28-day Cetes Treasuries). Also, financial institutions have felt increased pressure to grow their consumer and corporate loan portfolios, which are some of the smallest in the region. The private sector workers fund, Infonavit, the main source of home financing in Mexico, finally made its debut in the capital market with a much-anticipated MXN750 million ($68 million) residential mortgage-backed security issue. The so-called Certificados de Vivienda, or Cedevis, securities were peso-denominated at a fixed interest rate and were priced to yield 9.15%. The issue is expected to increase Infonavit s financing capacity this year by 20,000 mortgages, bringing the number of mortgages to be issued by the agency to 325,000 in Also in the quarter, GICSA, a diversified real estate company, undertook a successful securitization of tenant leases for three of its shopping centers. The MXN620 million ($56 million) issue was fully placed via the Internet. While in recent months Mexican issuers have been more actively tapping into the country s debt capital market, activity is also brewing on the equity side. Market participants are now discussing new legislation that regulates the Mexican equivalent of REITs. Entities such as the Mexican Stock Exchange are supportive of the new investment vehicle, so it would not be a surprise if the first Mexican REITs begin to come to market as early as the second quarter of Also in the pipeline, it appears that two more Mexican homebuilders (Urbi and Homex) may go public this year, joining four others on the Mexican stock exchange. In Brazil, despite high interest rates (16.25% for benchmark Treasuries as of the end of March), the government placed $1.5 billion in 30-year bonds at a spread of 376 bps over US Treasuries in 3

4 January. Since then, the spread on the country s sovereign bonds has increased to more than 550 bps over US Treasuries thanks mainly to political problems. Brazil s indebtedness still impedes the upgrading of its sovereign credit ratings, as confirmed by an S&P announcement that no rating changes were foreseen for the rest of This was definitely not the case with Chile, which, in addition to inflation of 1.1% in 2003 and interest rates at a low of 1.75%, had its already investment-grade sovereign rating raised by S&P one notch, to A from A. Office Office space is generally facing oversupply in all of Latin America s major markets, due to the joint effects of strong construction activity beginning in the late 1990s followed by a general slowdown in the various economies. Currently, construction activity has slowed considerably, and developers expect a new wave of economic progress in Latin America will help bring the markets back into balance. Mexico City is a good example of the state of office markets in the region. Despite a slow rise in occupancy in 2003, vacancy is still more than 20%. Although vacancy persists across the board, some submarkets with newly completed space, such as Santa Fe, have even higher vacancies. Completions slowed markedly in 2003, but new office buildings due in early 2004 should bring vacancy up. Rents in top-quality office space in Mexico City range from $20 to $25 per square meter. In 2003, rents were hurt by the slower economy and increased availability of new, high-quality space. Rents in 2003 fell by 20% to 25% in dollar terms. Vacancy in the Sao Paulo office market has been stable at slightly above 15%. However, the almost 250,000 square meters delivered in 2003, concentrated in class A space, has pushed vacancy in class A buildings to more than 25%. With the postponement of some major office developments, completions for 2004 are expected to total just half of the historical average. Gross absorption was also strong in 2003, particularly toward the end of the year, but net absorption remained just at historical levels, hence the increased vacancy. Average rents in Sao Paulo range from $12 to $20 per square meter per month. Rents for top-quality space have just been keeping up with inflation, while on average, rents in the market fell in real terms throughout last year. In Rio de Janeiro, average market lease rates are in line with inflation and are just above those of Sao Paulo: between $15 and $22 per square meter per month. The Rio de Janeiro office market saw some of the strongest completion activity over the past few years in 2003, particularly in the distant neighborhood of Barra da Tijuca. Only a handful of new office projects have been announced or are under construction in Rio, but given the relatively small size of the market, some larger projects due as early as the end of 2004 are poised to have an impact. Residential Mexico s residential sector had another strong year in 2003 and remains on track to deliver 700,000 new homes per year by 2006, as called for in a government-backed national plan. The sector s expansive mood is evident in the fourth IPO of a Mexican homebuilder on the country s stock exchange in October and the probable listing of two more developers in Small and 4

5 large homebuilders alike encountered financial sources increasingly eager to provide both construction as well as mortgage financing. Infonavit, the private-sector employees fund and Mexico s main provider of mortgages, officially projects 305,000 new contracts to be closed in 2004 up from 300,000 in This figure could expand, assuming the agency s residential mortgage-backed security program, which began in March with a MXN750 million placement, reaches the MXN5 billion mark targeted by the institution. Infonavit s main focus will continue to be low-income housing and the slightly pricier affordable segment (roughly 18.5% and 80% of its loan portfolio in 2003, respectively). Infonavit is, nonetheless, expanding its participation in the middle and high-end segments through a joint program with commercial banks. Activity in these segments likely will increase significantly in 2004 because housing firms are seeking greater exposure to increased margins. On the other hand, this is where the biggest expansion in mortgage credits will likely occur, as mortgage companies, or sofols, and commercial banks both try to dominate these segments. Sofols, using resources from either the government-managed mortgage bank or funds raised directly on the capital markets (such as mortgage securitizations), financed about 50,000 homebuyers in Commercial banks, which specialize in the upper range of the market, financed just under 16,000 homebuyers during the same period. In Brazil, after a dismal year for the construction sector, which contracted by 8.6% in the period, the government is being pressed to present a consistent plan to boost housing. In fact, just a few days after the GDP figures were released, the country s finance minister announced a plan to increase the availability of funds for housing, as well as to strengthen the legal framework of real estate transactions, with particular attention to protecting the buyers of pre-sold housing units. The plan could increase the amount of housing financing in Brazil by about $1 billion. Caixa Economica Federal should continue to coordinate most initiatives in the sector, particularly after posting a record $556 million net profit in 2003, which prompted criticism that it needed to significantly expand its lending portfolio to real estate developers and buyers. Industrial In the past few months, Mexican industrial markets have received a boost from the rising demand of US manufacturers. Mexican manufacturing exports have risen, as have imports of capital goods, which are a leading indicator of industrial activity. Activity is thriving in border cities that just a few months ago had soft markets. The impending establishment of large manufacturers in the region, and the suppliers they often bring with them, has renewed enthusiasm in the area. Adding to the country s already extensive list of preferred trade partners, in February, Mexico closed a free-trade pact with Japan. The Asian nation was already the third most important source of foreign capital for Mexico s maquiladoras, and the new pact should further increase Japan s Mexican investments. Mexico is now the only country to have free-trade agreements with the US, the European Union and Japan. As of January, Mexico is also a member of the newly established Central American Free-Trade Agreement (CAFTA). In early 2004, a breakthrough transaction made waves in the Mexican real estate market. Several US institutional investors vied for a portfolio of more than 50 properties throughout the country. 5

6 The purchase represented the largest investment (about $300 million in gross assets) by a US institutional investor in the Mexican real estate market to date. The portfolio is estimated to have sold for a premium at a going-in cap rate of 10.5%, which is below current cap rates for singleproperty transactions. In Brazil, industrial real estate investments are historically a rare alternative for anyone other than individual investors. Therefore, it is worth mentioning that some investment clubs, managed by real estate firms, are increasingly seeking build-to-suit deals for strong manufacturing tenants. Although current interest rates make these all-equity deals rather uncompetitive, an expected fall in real rates lies at the core of this investment strategy. Retail The Mexican retail market is attracting an increasing number of institutional investors, who seek to tap this rapidly developing market. Consumption patterns remain stable despite the economic slowdown of the past few years, and opportunities exist for certain property types (such as neighborhood shopping centers and stand-alone, big box retailing). The market is also testing alternative sources of financing for retail real estate. As mentioned earlier, in March, a Mexican company successfully undertook the securitization of lease payments from tenants in three highend shopping centers. These are all peso-denominated contracts, which appealed to local investors. As the market further consolidates, opportunities for attractive peso returns in Mexico s retail market will likely expand. In South America, corporate mergers and acquisitions set the tone for the retail sector during the first quarter. One important event was Wal-Mart s acquisition of a portion of Royal Ahold s assets in Brazil for a reported $300 million. The deal, Wal-Mart s first acquisition in the country, will likely open a new round of consolidation in Brazil s retail sector. Along these same lines, the grocery store unit of Portuguese company Sonae reportedly put its Sao Paulo retail assets up for sale, choosing to concentrate on its more competitive operations in southern Brazil. On the other hand, Sonae s real estate unit is expanding, with both new construction and acquisitions of shopping malls under way. Investment Outlook The first quarter ushered in the economic rebound that Latin America expected this year. Despite some mixed unemployment readings and inflationary pressures, the major economies seem to have set up the institutional framework to allow certain issues to be resolved without disrupting economic activity. In fact, economic indicators support the notion that Latin America is in recovery mode. Businesses across the region are finding new ways to benefit from this expansion phase, and real estate is no exception: different property types are being tested, and capital markets are being tapped in increasingly sophisticated ways. 6

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8 The Investment Research Department of Prudential Real Estate Investors (US) publishes reports on a range of topics of interest to institutional real estate investors. Individual reports are available free of charge in hard copy 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 US office at Prudential Real Estate Investors (US) 8 Campus Drive Parsippany, NJ USA Tel Fax Web prei.reports@prudential.com Copyright 2004, Prudential Real Estate Investors (US) Prudential Real Estate Investors (US) 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. Prudential Real Estate Investors (US) is not affiliated with Prudential plc (Pru UK).