Foreign investment and the Brazilian real estate market.

ABSTRACT. This article discusses the main aspects of the Brazilian real estate market in order to illustrate if it would be attractive for a typical American real estate investor to buy office-building portfolios in Brazil. The article emphasizes: [i]--the regulatory frontiers, comparing investment securitization, using a typical American REIT structure, with the Brazilian solution, using the Fundo de Investimento Imobilidrio--FII; [ii]--the investment quality attributes in the Brazilian market, using an office building prototype, and [iii]--the comparison of [risk vs. yield] generated by an investment in the Brazilian market, using a FII, benchmarked against an existing REIT (OFFICE SUB-SECTOR) in the USA market.

We conclude that investing dollars exchanged for Reais [the Brazilian currency] in a FII with a triple A office-building portfolio in the Sao Paulo marketplace will yield an annual income and a premium return above an American REIT investment. The highly aggressive scenario, along with the strong persistent exchange rate detachment to the IGP-M variations, plus instabilities affecting the generation of income, and even if we adopt a 300-point margin for the Brazil-Risk level, demonstrates that an investment opportunity in the Brazilian market, in the segment we have analyzed, outperforms an equivalent investment in the American market.

KEYWORDS: Foreign investments; Brazil; Office market; Currency risk; Monte Carlo simulation

1. INTRODUCTION

Funds allocated to investments in real estate businesses tend to be conservative and in general invested based on two determining premises: regular homogeneous income and the expectation of low fluctuations with respect to the value of the real estate. In other words, real estate investments tend to be on average less volatile than other typical assets in capital markets such as stocks, hence the frequent use of these investments to increase stability in the portfolios strategy of diversification.

In less developed economies, these premises may not prevail because, sometimes, even the assets of the real estate market suffer from the impact of market volatility and erratic macroeconomic movements. Such economies tend to jeopardize security concerns that determine investment decisions in real estate. Since the 1St and 2nd quarters of 2006, there has been increased speculation about the migration of foreign investments to the real estate segment of Brazil, mainly to construct office buildings. Nevertheless, even if you consider the current liquidity in the world economy and the natural trend that part of these funds should seek for real estate markets, foreign investors are reluctant to risk investing in this segment of the Brazilian market.

The opportunity for foreign investors to invest in the Brazilian real estate market should be considered keeping in mind the structural aspects we discuss in this article. We also show medium-term projections for Sao Paulo office market indicators with the purpose of comparing them to those of the United States. Taking into consideration Newell and Webb (1996), Geurts and Jaffe (1996) and Stevenson (2000), we can infer that the aspects to be covered in assessing a foreign investment opportunity to enter a specific economy in the segment of real estate, should include analyses of. [i]--the impact on the economy resulting from the exchange rate for strong currencies and the investment hedging cost, as pointed out by Liu and Mei (1998) and Ziobrowski et al. (1996, 1997); [ii]--regulatory boundaries to understand investor protection; [iii]--the level of liquidity of investments in real estate as permitted by the investment-sharing systems present in the Brazilian economy; [iv]--the strength of the secondary market to measure the possibility of making use of this liquidity; [v] the pattern of available information to interpret the market's behavior and [vi]--the potential return on investments.

Macroeconomic aspects, which involve exchange rates and secondary market hedging, are discussed in general terms. Special attention is given to: [i]--the discussion of regulatory frontiers, comparing a typical REIT structure with the Brazilian FII [Fundo de Investimento Imobildrio/Real Estate Investment Fund], which in Brazil is the structure most similar to an American REIT; [ii]--the intrinsic quality of investing in office buildings to let using a portfolio of hypothetical buildings from the Brazilian market and [iii]--the comparison of risk vs. return on foreign investments in Brazilian office buildings to rent via an FII, against the same type of investment in the American market, in an office building-REIT.

2. REAL ESTATE INVESTMENT FUNDS IN BRAZIL

An FII is the typical structure available in the Brazilian market for investment sharing in real estate, which offers fiscal advantages not found in other forms of securitization in Brazil and whose structure differs from the REITs in the American market, as described in Young (2000) and Ambrose and Linneman (2001). These investment pools focus on the real estate market allocating resources to an investment manager. All the financial operations are regulated by the Rules for Fund Operation, where they are registered and submitted for approval by the CMV [Comissdo de Valores Mobilidrios/Brazilian Securities Commission], a government agency for regulating capital market operations, which in some ways is similar to the American SEC.

The legal concept of FIIs created some restrictions with respect to real estate maintenance, registration and transactions, as well as to certain business-development activities, which the FIIs are free to carry out. These restrictions were relaxed by Federal Law 8.668 (1993), which governs the creation and operation of the FIIs, and by CVM Instruction 205 (1994), which outlined the FII constitution, operations and management, providing management and operation norms in detail.

Law 8.668 (1993) defined that the operations (buying/selling of assets) and profit sharing of FIIs is tax-free, which was not the case earlier. Under current legislation, private investors are exempt as long as they comply with certain rules of distribution such as not owning more than 10% of the total shares in an FII.

In Brazil, where high taxation can discourage investing, the tax exemptions offered to the FIIs and their investors are so many, and so significant that other real estate-based portfolio securitization solutions end up being ignored, even if they present a more advanced structural design than that of the FIIs. In general, FII shareholders are only taxed after shares have appreciated and been sold at a profit.

Still, under Brazilian legislation, one can set up structures of investment sharing in real estate under concepts equivalent to those of the REIT, using an SPE [Sociedade de Prop6sito Exclusivo/Sole Purpose Company] as the environment to shelter the portfolio and attracting investors by means of shares of mandatory dividend or perennial result-sharing debentures. However, an SPE must pay a tax on income and earnings, which leaves the investment less attractive than a real estate portfolio sheltered in an FII.

One other important difference between FIIs and the American REIT lies in the legislation covering management: [i]--FIIs must necessarily be under the administration of financial institutions rather than commanded by an entrepreneurial type executive; [ii]-the management of SPEs and REITs is in the hands of such individuals, see Young (2000).

This imposition refers to the entrepreneurial skills that such an administrator of SPEs and REITs should have in dealing with real estate transactions whereas, financial institutions, in the view of asset managers, deal with investment products of high liquidity and volatility while also working with investment protection and instruments of hedging. The manager of an FII administers a portfolio having little manager's specialization, which, in real estate deals, should stand out with respect to specialized skills, not to financial management. FII administrators typically manage portfolios having little or no flexibility in that the FII is comprised of a single building. The administration of such a portfolio does not involve the dynamism of a continual change in portfolio positions, but merely requires topical actions and the administration of rental contracts and leases. For example, at BOVESPA [The Sao Paulo Stock Exchange] one can negotiate shares of an FII, the portfolio of which comprises a single office building leased to Caixa Economica Federal (a state-owned bank) for 10 years and with the tenant having the option to renew for another 10. In cases like this, the managerial skills required of the administrator comprehend collecting and distributing the monthly rental among the shareholders and renegotiating the price, perhaps every 5 years. The other FIIs listed at BOVESPA do not differ from such rigid patterns: they comprise office buildings (one per FII), shopping centers (one per FII), and one of them has a hotel in its portfolio.

Brazil's real estate investment market will only begin to encourage the funding of foreign resources once the securitized formats for in vesting have more diversified portfolios for leasing and the administrator has the authority to buy, sell, renew and, in general, take advantage of opportunities that strengthen the portfolio.

We must note here that an FII, classified as an investment condominium, is subject to Brazilian legislation forbidding the use of leverage. All investments require positions of 100% equity.

According to the register of CVM [Brazilian Securities Commission], in September 2007 there were 67 FIIs in existence with each having an average total net asset value of R$ 3.03 million reais (US$ 1.55 million dollars (1)). Most of them comprising a single building and registered as funds with a restricted purpose.

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