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Weekly UpdatesThe secondary market in Brazil is incipient, the number of FIIs negotiated on the Stock Exchange being 24; these others are restricted to non-regulated markets and are, in reality, private investment funds belonging to private groups. The net asset value of the FIIs at Bovespa represented US$ 887 million in September 2007, or 57.1% of the FII market value.
In September 2007, NAREIT (2007) had 183 publicly traded REITs registered on the American market, with an approximate market value of US$ 438 billion (Equity Market Capitalization--EMC). Using the EMC as reference, a medium-sized American REIT2 represents about 1.6 times the entire FII market.
The value of the real estate investment market represented by the 183 REITs to which investors have access on the American stock exchange is 494 times greater than that of the 24 Brazilian FIIs negotiated at BOVESPA.
Another important aspect of the REIT portfolio concept in comparison with the single building securitization currently used by the FIIs is that the EMC value of a medium-sized REIT on the American market is about 100 times that of the net asset value of a medium-sized FII in Brazil. The small size of FIIs may be a drawback in that their ability to absorb market fluctuations is quite limited whereas, with larger more diversified real estate portfolios, improving one's position by acquisitions or sales in order to increase profits is always a real possibility.
The lack of attention developers have dedicated to the system of attracting funds by way of FIIs may be, in part, responsible for the slow evolution of the Brazilian market. If we consider the dimension and value of the REIT EMC which is equivalent to 2.8% of the American GDP, this relation in Brazil would represent a market potential of R$60 billion, which is nearly 20 times greater than the market's current appraisal. Illustrating the magnitude of this potential is the region of Luiz Berrini Avenue, where the total value of new triple A office buildings does not exceed R$6 billion.
3. INVESTING IN A PORTFOLIO OF OFFICE BUILDINGS
To indicate the investment quality of office buildings on the Brazilian market, we will use the following: [i]--let us consider a triple A hypothetical building in the city of Sao Paulo. In general we can say that the variables (rental values, prices, operational costs and vacancy rates) attributed to the prototype come from public databases and surveys conducted by the Real Estate Research Group of the Polytechnic School of the University of Sao Paulo; [ii]--we will set up a building portfolio with an expressive investment value (foreign capital), sheltered in an FII, to offer investors the opportunity to sell their shares at Bovespa; [iii]--we will deal with quality indicators which FII shares should have. Later on, we will deal with foreign-investment risks related to exchange-rate fluctuations without hedging.
Considering that the investment is made to build a portfolio to be placed on the secondary market by means of FII shares and that this securitization structure is the one that presents the least taxing impact for individual (not corporate) investors, our speculation on investment quality follows the phases shown in Figure 1.
First, we produced analyses on investment quality and then risk analyses for foreign investors in office buildings to lease in the Sao Paulo marketplace. The two strategies employed:
[FIGURE 1 OMITTED]
[I]--the more aggressive analysis (Figure 1) corresponds to the strategy of looking for the quickest possible exit in which investors develop the portfolio and sell the FII shares to small and medium investors, while leaving management in the hands of a specialized financial institution.
[II]--the more conservative analysis (Figure1) corresponds to keeping the investment for the entire 20--year operational cycle.
The first quality analysis is in reais, followed by an evaluation of the risk exchanging the American dollar carries, used as reference for foreign investment. This analysis does not consider any eventual costs in transactions US investors might have if they chose to invest in Brazil.
The portfolio used as reference corresponds to a set of 10 typical triple A buildings containing 10.000 square meters of ABR [Area Bruta Rentavel/Gross Leaseable Area--GLA] each, the investment demand for acquisition being R$ 609 million, including the FII structuring costs.
The referential scenario for the 20-year rental operational cycle comprises the parameters shown in Tables 1, 2 and 3. We can see that all scenario variables are set within boundaries, in which each variable fluctuates randomly. Considering these limits, the indicators will be presented at intervals, considering laboratory samples, just like in Hughes (1995), constructed from the exploration of multiple scenarios with inflation and exchange rate fluctuations. Actually, we are applying here a Monte Carlo simulation in order to generate confidence intervals for the average of the prototype portfolio's rate of return aiming to compare it with the returns of an American Equity-REIT investment.
Table 1 contains the variables for calculating the expected rental revenue. The scenario contemplates a conservative cycle of market reorganization as well as the market insertion of a likewise conservative portfolio, keeping in mind that there is still a significant amount of vacancy in the market (approximately 15%) and that the absorption can only take place if the Brazilian economy expands. Following, in the Table 1, are the forecasts for the office market overall performance in relation to Brazilian economic growth.
The boundaries of fluctuation were set up, not only in Table 1 but also in Tables 2 and 3 to allow us to generate lab samples with which to simulate the rate of return volatility as the market's performance changes.
Table 2 presents the occupation rate parameters of a portfolio prototype building and the FII accounts. All cost parameters listed in the table come from the Real Estate Research Group (2006).
The macroeconomic scenario in Table 3 is based on the Brazilian IAER (Institute of Applied Economic Research (www.ipea.gov.br) scenarios for the general Brazilian economy. Two factors affect investment quality: [i]-Brazilian reais are affected by inflation and under Brazilian law rental contracts may only suffer re-adjustments annually based on the rate of inflation measured by the general price index, (IGP-M); [ii]--investments in U.S. dollars are submitted to a second loss vector, in that at present, the Real (R$) is overvalued against the dollar.
We admit that a certain exchange discrepancy will be compensated for in the next two years and that, from then on, there will be a recurring detachment from the exchange rate to the IGP-M variation. The effects of inflation and persistently increasing exchange rates represent risks for foreign capital investment in Brazilian real estate. For this, there are no hedging mechanisms at accessible costs. The dollar's detachment from the Real places it in the condition of an open risk vector, which we will investigate later.
The hurdle rate for small and medium savings perceived in the Brazilian market, seeking income in safe homogeneous real estate flows, is roughly 10% a year, effective above the IGP-M. See Rocha-Lima and Alencar (2006).
In Table 4, we indicate the value of the FII shares with the aim of identifying foreign investment quality when it chooses an earlier exit (strategy I). The establishment of the share market value is based on the basic case scenario (see Tables 1 and 2) and the imposition of a risk-protection level, reached by constructing a worse scenario than the referential one (by using the fluctuation limits set up Table 1 and 2).
An analysis of the portfolio behavior during the 20 year operational cycle linked to the referential scenario and the 10% yearly hurdle rate of return, as in Rocha-Lima and Alencar (2006), revealed that the total present value of the FII shares would be R$ 795,419 reais, which is equal to R$ 1.3061 reais for each R$1.00 share at the time of investment. The total investment value at that time was R$ 609,000 reais.
If we add disturbances within the limits of the scenario described in this analysis, at the mark of R$ 755,763 reais, the share at R$ 1.2410 reais, and in relation to the original value of R$ 609,000 reais, investors would have complete protection against the greatest fluctuation visualized in the scenario . In other words, under the most critical market conditions3, one would still be able to obtain in the 20-year cycle, an annual rate of return equivalent to 10%. At this investment value, if the portfolio behaved within the assumptions presented in the basic case scenario with no deviations, the annual rate of return would be 10.58%.
However, the Brazilian market does not necessarily demand such high protection for investments even though the shares may be positioned at higher risks. The placement price can be set for an average rate of return between 10 and 10.58% per year and included in the prospectus for selling shares. We then use the total worth of the shares, $ 775,787 thousand that is equivalent to R$ 1.2739 for each R$ 1.00 investment. This produces the result indicated in Table 4 and the investors exit the portfolio leaving the FII to the market.
[FIGURE 2 OMITTED]
4. INVESTMENT QUALITY, IN REAIS
If the investment in the portfolio is kept for the 20-year operational cycle, the R$ 609,000 thousand reais investment made in setting up the portfolio (the purchase of real estate and structuring of the FII) would be able to produce an annual FII rate of return of 13.20%. And even with the disturbances brought on from penetrating the market, generating revenue and inflation and with 90% reliability, the referential scenario still indicates the rate of return for the FII account would not drop below 12,55%. Figure 2 illustrates a laboratory sample for this rate of return, obtained with a Monte Carlo approach, showing the boundaries of the confidence interval on the average, when isolated behavior disturbances are made to occur in each of the portfolio buildings (4).
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