By Jim Costello on July 2nd, 2018
Sorry, while it may be topical, I have no observations here on Brazil and the World Cup. My friends in Brazil could certainly use a win, though, to lift their spirits. The country has gone through a number of years of recession and political turmoil. Conditions seem to be changing, but there are still risks for real estate investment.
Deal volume in Brazil returned to healthy levels in Q1’18, up to $3b on a 12-month trailing basis. If deal volume continues growing at the recent pace, it will quickly return to the highs seen before the start of the recession in 2014. Looking solely at the income potential of assets in Brazil, there is reason to be optimistic that investors will continue to seek out new investment opportunities.
Our data partners at SiiLA Brasil note that market fundamentals are looking up in the country. In a conference call in mid-May, the SiiLA team reported that the forces driving office property income are doing well in São Paulo given a combination of limited construction and stabilizing tenant demand.
According to SiiLA Brasil, office rents had been falling in the Chucri Zaidan submarket of Sao Paulo from 2015 to May of this year. The sharpest declines were seen in 2016, however, with the trend relatively flat in late 2017 and early 2018. Combine this recent stability in rents with vacancy rates on the way down as supply begins to taper off and property income is poised to grow.
Does this growth in property income justify continued growth in investment activity? There is a compelling yield play for commercial property investment in Brazil with cap rates for commercial properties averaging 8.8% in Q1’18. There are, however, still financial risks involved.
The perceived risks of investing in Brazil have fallen sharply from the worst parts of 2015. One way to measure this risk is to look at the bps spread between the 10 yr benchmark bond yield in Brazil vs. the equivalent in the US. At the worst points in the Brazilian recession in 2015, that spread moved up to 1,500 bps with Brazilian 10yr benchmark bond yields hitting 16.5% in Q4’15.
As economic conditions stabilized in Brazil following the recession and political turmoil around Petrobas, this risk premium narrowed to 800 bps by the end of 2017. At that point, deal volume for commercial property in Brazil began to grow again as investors became more comfortable with the risks.
This risk premium is displayed here on a quarterly average basis. This spread increased from 690 bps in Q1’18 to 820 bps for Q2’18 so far. More recent higher frequency moves pushing this spread above 900 basis points into June raise some flags of caution.
The story in Brazil is tied up in broader emerging market risks. The increase in US interest rates and recent strengthening of the US dollar poses a bit of a capital flow risk to emerging markets in general. For Brazil in particular, the benchmark bond rate has jumped from 9.5% in March of this year to 12.1% so far in June. There is an election coming up in October, and challenges remain around the fiscal situation in the country.
The improvement noted on the income side of the equation on asset values is, so far, independent of these financial sector risks. Those fundamentals may be enough to keep investors excited about the opportunities in Brazil and continue to push deal volume on an improving path. Another World Cup win would not hurt either.