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Brazil: New Real Estate Financing Options

Aug 1, 2008


By Fábio Nogueira, COO & Partner, BFRE – Brazilian Finance Real Estate Participações S.A.

After years in the doldrums, Brazil’s civil construction sector is surging from a combination of low inflation, strong economic growth and the consequent rise in incomes. At the same time, residential, commercial and industrial developments are all benefitting from a major expansion in financing, including a growing variety of options outside the traditional financing products and banking system. Falling interest rates have driven local investor diversification, creating space for new options linked to the capital markets, including securitization of receivables and real estate funds.

The Real Estate Market in Brazil
With a national housing deficit of almost eight million, Brazil’s real estate market offers huge potential. Fortunately, residential construction is expanding fast and many companies are trying to capitalize on the need for housing. Analysts predict new housing sales will grow 20% through 2008, driven in part by much greater availability of financing with $11.92 billion flowing into real estate through 2007, up 70% on the $7 billion of 2006; at least $18 billion is already locked in for new construction through 2008. Some 22 new shopping centers opened their doors in 2007, totaling 3,497 stores.

Despite the impressive growth, Brazilian banks are not yet very active in mortgage financing. Banks’ combined real estate portfolios closed out 2007 at $25 billion, 23.5% up on the previous year but still just 4.5% of the $548 billion total bank lending, against a share as high as 45% in some more developed markets. Most Brazilian bank lending is short term and consists of, for example, corporate working capital, personal loans and credit for purchase of consumer durables, in particular automobiles.

The Brazilian real estate sector suffered for years from a lack of credit. It survived by using its own funds and short-term bank loans normally secured against purchasers’ financing contracts at extremely high interest rates. Direct financing of purchasers by financial institutions was virtually nonexistent because of high interest rates and legal risks which made it difficult for banks to reclaim residential real estate in cases of default.

Today, lower interest rates and revamped legislation (i.e. the lender’s right to foreclosure and separating a construction company’s assets from those involved in real estate projects) have paved the way for expanded credit. Remaining problems, such as the lengths of mortgages and delays of up to 90 days for approving loans, will tend to disappear as the sector acquires a credit history that provides local long-term parameters for analyzing loans.

Mortgage Backed Securities
Brazil has had legislation in place governing securitization companies for just 11 years, with regulations recently revised by the CVM, the Securities and Exchange Commission of Brazil which oversees the sector. The market is showing signs of fast growth despite trailing first-world countries by years in terms of experience and the size and scope of transactions. According to CVM data, 40 mortgage backed securities (MBS) totaling $510 million were offered last year. This was almost four times the $131 million notched up with 13 offerings in 2001.

Securitization companies play a fundamental role in Brazil, buying receivables from the developers, constructors and mortgage originators and packaging them into standardized MBS certificates, which are then sold to the market through a public offering. Securitization companies help provide greater strength and credibility when the investor analyzes a security’s credit risk, evaluating the credits that will guarantee the MBS and supplying the primary market with these securities.

MBS are long-term bonds, normally carrying a four-year redemption backed by real estate receivables and aimed at investors with at least 300,000 reais available. They offer annual inflation per an agreed price index, plus a fixed interest. An additional attraction for private investors is the exemption from income tax on annual earnings, although a 15% tax is due on capital gains when the bond is sold. This is Brazil’s lowest tax rate on fixed income bonds.

The price of the bond has three components: the interest rate for purchase of the MBS by the investor; the spread of the securitization company; and the emission costs of the MBS. This last component is based on the risk evaluation of the portfolio and the cost of placing the bonds with investors. In general these securities pay interest of around 10% a year, an attractive rate to compensate for the risk of loss should the real estate purchaser whose mortgage serves as collateral for the fund fail to pay his debts. The basic rule for anyone thinking of investing is to take professional advice. Specific legislation for foreign investors is available on the CVM site at www.portaldoinvestidor.gov.br.

One securitization model that works well in Brazil includes call and extension commitments, where the securitization company brings forward the total flow of receivables but the issuer retains responsibility for payment of debts should the borrowers default. Another option is the so-called pure securitization, where the securitization company acquires purchase and term sale receivables with a deed of trust and there is no shared obligation on the part of the seller. Just as with a bank loan, in the case of non-payment, the securitization company has legal mechanisms to repossess the property without undue delay.

There are two types of MBS in the market: The regular MBS is for existing buildings, where the investor avoids any construction risk; while the pre-completion MBS comprises projects that are not yet completed or sometimes not even started. There are also MBS for single large projects, for example a factory, office or an apartment block, or for various smaller projects grouped together.
Real Estate Financing Alternatives
(a) Real Estate Investment Funds
Another alternative for investment and real estate financing are Real Estate Investment Funds (REIFs). These are closed funds that buy or develop assets like shopping centers then sell shares to the public. Remuneration is monthly, derived from rent payments, and capital repayment comes via the sale of shares on the stock market or the liquidation of the fund, so allowing a distribution of proceeds among stockholders. This option has no minimum investment level and is open to any individual who is less concerned with immediate liquidity. The income is tax free, but capital gains pay 20%. Earnings vary according to rent levels and the change in value of the development. Risks for the investor include possible default by occupants whose rents service the fund, and the building losing value over time.

At least 65 REIFs are registered with the CVM and a third of them are traded on Bovespa, the São Paulo stock exchange. Shares can be purchased directly by investors who are registered with an authorized broker or via the companies that structure the funds. The CVM site (www.cvm.gov.br) has information about funds that are under analysis or have already been approved, while information about funds that are traded on the stock market and the brokers who are authorized to deal in them can be found on the Bovespa site, www.bovespa.com.br .

(b) Mortgage & Real Estate Notes
Mortgage Notes are bonds issued by financial institutions and guaranteed by payments from real estate financing – in other words, the debt of borrowers. They are free of income tax, with a minimum term of 180 days, and can offer returns of 10% a year. This is below the 11.25% available on Interbank Deposit Certificates (CDI in Portuguese) but nevertheless represents a higher net yield after tax. Mortgage notes generally pay interest plus inflation adjustment in line with Brazil’s federally determined Reference Rate (Taxa Referencial – TR), or a percentage of the CDI rate, and start at 5,000 reais. Yet another option is the Real Estate Note. In this case, the guarantee is offered by the assets of the financial institution, as in a bank deposit certificate. Institutions use the money to finance real estate loans. Risks for the investor lie in an eventual financial problem involving the institution issuing the note or increased default on the loans that back the security.

These securities can be acquired mainly from mortgage companies and savings banks, as well as banks linked to the housing sector. Information on legislation and authorized institutions is available on the sites of the CVM (www.cvm.gov.br) and the Brazilian Central Bank (www.bcb.gov.br).
(c) Private Equity
One of the structures most commonly used for large developments is private equity. In Brazil, private equity funds are regulated by the CVM and are known literally as “funds that invest in shareholdings” (Fundos de Investimento em Participações) or FIPs. Essentially similar to private equity funds in more developed markets, Brazilian FIPs offer major investors, in particular foreigners, a foothold in the local real estate market. They are closed joint-ownership funds whose assets are destined to the acquisition of shares, debentures, subscription bonus or other securities that are convertible or negotiable for stock offers in open or closed companies. FIPs are for qualified investors only, starting at 100,000 reais. The potential investor should contact the institution which structured the operation or one of its distributors. These may be stockbrokers or banks, in particular private banks catering to high-income clients. The CVM site offers information about operations being prepared or already concluded.

Because FIPs are closed funds, with no right to redeem shares before the wind-up, the regulations must set time limits for subscription and duration, together with procedures for disinvestment. In general this will be seven to 10 years after fund creation.

A FIP raises money for projects to be developed as Special Purpose Companies (SPC) under its control, each project being an individual SPC. For example, one SPC might build a rental office block, a factory for a specific company and develop a residential condominium; but all three SPCs would belong to the same FIP, which releases money for each project as required. Once a project is completed and its constituent units sold off, the fund could then return cash to investors or reinvest in similar projects via new SPCs. In the case of a built-to-suit office block or factory, the rents to be received by the SPC could be securitized and transformed into a MBS, then offered to the market. In this way the FIP would anticipate future revenues and be able to plan new projects.

As FIPs are long-term investments, Brazilian law offers foreign investors the benefit of income tax exemption. Brazilian investors, however, are liable for 15% income tax on the difference between purchase and sale price of the shares.

Risks for the investor lie in the effective implementation of the project, which might never get off the ground, or when completed might fail to attract purchasers. There is also the question of liquidity, given that FIPs in general return the amounts invested only after seven years or more and Brazil has no real secondary market for trading shares in private equity funds.
Learning From Others
Starting late means Brazil can learn from more developed markets and avoid problems caused by high-risk mortgages like the US subprime loans. Currently the Brazilian market is not even satisfying the demand of all prime borrowers, so there is great potential for further low-risk growth. What Brazil needs next is to develop a secondary market for real estate securities so that investors can exit their position before maturity. Today, most MBSs are held to maturity by their original purchasers, who for the most part are banks, major pension funds and high net worth investors who are clients of private banks.

Following the disastrous experience of the 1970s, the Brazilian market adopted additional lending safeguards. Legal defense mechanisms were created to avoid financial institutions, investors and even mortgage borrowers losing money through arrears, default and constructors’ cash-flow problems. The main mechanism is the Deed of Trust, whereby real estate ownership is effectively transferred only when the borrower has paid all his debt. The advantage is that the debtor can use the property without owning it outright. Property remains in the name of the constructor or bank (called the fiduciary) who has the right to auction it in case of default. Occupiers have a legal maximum of 60 days to vacate.

Another mechanism that provides security both for investors and anyone else who builds or buys real estate is segregated ownership. This separates the accounting of a company’s assets and its projects. Should the builder experience financial difficulties, the interested parties can substitute the developer in the administration of the project and allow work to continue without recourse to the courts. In the case of the builder going bankrupt, the credits relating to a completed or ongoing project do not form part of the bankrupt estate, which would hamper project completion and imply losses for all involved.

Brazilian builders and developers understand that sustained growth of civil construction depends on the sector increasingly seeking finance through capital market instruments. The process is likely to accelerate this year with standardization of MBS contracts, already under way at the CVM. New rules should further boost operational transparency, reducing risks and expanding opportunities for safe and professional investment in the real estate market by both local and international investors. n

BFRE – Brazilian Finance Real Estate
Participações S.A.

Fábio Nogueira, COO and Partner
Telephone: +55.11.4081.4499
Email: fabio.nogueira@bfre.com.br
Website:  www.bfre.com.br


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