Investing in Real Estate in Emerging Markets

While the economy in the US and Europe continue to melt, savvy investors are turning their eyes to "alternative" investments, such as gold, venture capital, and foreign real estate. Today, I want to talk about one of these alternative investments, which readers of this blog are now familiar with: foreign real estate.

Every emerging country is different and the one I'm following more closely is Brazil. Just watching the stock prices of Brazilian home builders -- many of whom IPOed or raised more money in the last couple of years such as Gafisa, Mills and Rossi -- and their underlying fundamentals, it becomes apparent that they're making money, and a lot of it.

But there is no need to watch the stock market for this if one is attuned to what's happening with the real estate market. Brazil has a strong economy where the lower class is getting richer, thanks to a solid economic policy in the last couple of years and a myriad of government subsidies and protectionist laws (the latter two of which, by the way, have their many downsides in the long run, but that's another story).

Good deals don't last long, but they're happening everywhere. I'm aware of new high-end beach houses in gated communities in the south, commercial buildings in the financial town of Sao Paulo all the way to low-end popular apartments in Rio de Janeiro, right where the World Cup 2014 and the summer Olympic games 2016 will take place.

Out of these, the popular apartments in Rio caught my eye. One particular set of buildings is planned for 2012. The builder is offering very low financing, according to government rules to incentivise the low middle-class to buy their first home, and financing is eligible for such government credits. It's as sweet a deal as the cash for clunkers was in the US. These are modest two-bedroom, one bath small units about 10 minutes from the beach, right where the bulk of the Olympic games are supposed to take place.

The risks:
1. Too many investors and speculators driving up the price to the point they can only resell to other investors and not to their target audience. That's the basis to form a bubble.
2. Overbuilding. This shouldn't be a problem for at least the next two years or more, since Brazil has a shortage of homes and pent-up demand. But the market is local and each area has a given capacity for building and demand that are unique. Those with first-hand knowledge of their region will have the upper hand.

The benefits:
1. The upside is tremendous. Some investments are returning anywhere from 20 to 60% a year.
2. In the worst case, investors can rent their units. Demand exists.
3. Qualifying for credit in Brazil is tough, but when buyers are approved, they really are creditworthy and chances of investors getting the short end of the stick are low.

Unfortunately, none of the opportunities I mentioned above are available anymore. Good deals don't last long. But others will come up. Readers interested in finding out about upcoming deals and similar opportunities should get in contact through the comment section below.

Disclaimers: No shares in companies mentioned. I own real estate in Brazil.

Final Update on Real Estate Investment

This is my last update on my much discussed foreign real estate investment. The final return on this investment is now about 33%.

We started with an expected return range from 40 to 98% in mind. We assumed something in the middle of the range was doable. There were unforeseen costs and a surge in supply in the area, which made the sale difficult and thus brought the price down. In the end, 33% over about a year is still a very strong return (construction started this time last year, but the land had been purchased six months prior -- the land, though, was cheaper than the construction itself).

The lesson here is to have a margin of safety, as we did, and to watch out for hidden costs, which eat into the profit margins.

All told, this was a successful investment in two fronts: a successful learning opportunity for three first-time real estate developers and a nice return to go along and set the bar high from here on.

Now I'm preparing for the next one. Or two or three.

Bracing for Inflation

I'm no economist. Neither I have a crystal ball. Nonetheless, all I hear is talk about inflation. I don't know where it is, but from all I've read and thought about, one thing is clear: the US dollar will continue to lose value (as has been the case in the last 40 years or so since coming off of the gold standard), and it is likely to lose value faster than in the last ten years.

Again, I'm no economist. I don't know that there isn't a perfectly acceptable magic way out of this. But economists too have predicted seven of the last three recessions...

Anyway, it doesn't take much understanding about money to figure out that the USD is toast. With 30% of GDP compromised as debt and with the Greenspan-Guidotti rule out-of-the-whack the picture doesn't look rosy for Uncle Sam.

So what's an investor to do?

Well, by and large, nothing much one wouldn't do in normal times: buy undervalued, dividend-paying stocks. In the long run, if anything is going to hold value, it's a well run company with valuable assets (physical or intellectual) with a strong franchise.

Ok, but there might be something else investors can do to tweak their portfolios a bit: they should move their cash away from the USD and bonds and into:

1. Diversified baskets of foreign currencies
2. Physical assets (commodities, oil, gold)
3. More stocks, favoring global companies with business presence in large foreign markets.

TIPS is not an unreasonable option, but being a taxable security and being tied to the official inflation rate (which is computed by those devaluing the currency), I tend to leave them as a distant fourth option.

Foreign currencies

I've discussed the role of foreign currencies before. So I'll just add that there's no reason to completely avoid emerging markets. The Brazilian Real is old news. But the Mexican Peso (FXM) pays a reasonable interest and I don't see it defaulting or going into hyper inflation anytime soon.

Physical assets

My beef with commodities and physical assets in general is their lack of dividends, lack of internal growth rate. Nonetheless, it doesn't hurt to have some as a backup plan.

My favorite commodity would be oil, given its importance as an industrial raw product and its finite production. Also, gold tends to do well in uncertain times like now.

But my favorite physical asset is really real estate. With real estate, one can obtain dividends (rent) and increase its value over time, through proper maintenance, and upgrades.

More stocks

As you may have guessed, investing in businesses is still my favorite option, be them your own business (assuming you're competent and are in a good industry) or someone else's, under the same assumptions, plus the condition that these companies trade for a discount and/or pay juicy, growing dividends.

However, there's no telling what will happen with the US or the USD. If the country defaults, we lose. If we go to war, we lose (as Phillip Fisher said in his book, "War is always bearish on money. To sell stock at the threatened or actual outbreak of hostilities so as to get into cash is extreme financial lunacy. Actually just the opposite should be done") and if do nothing, well, nothing will be resolved.

Disclosures: Long brazilian Real and global real estate.

Infrastructure Opportunities in Brazil

To spur economic activity in Brazil, the government decided to do something unique: it opened up basic infrastructure projects (railroads, energy, roads, ports, etc) to private investors to use their retirement funds.

Explaining the deal

Let's go in parts: in Brazil, employers must contribute a fraction of their workers' salary to a tax-free account, which such workers can only use in very specific circumstances (buying a house, involuntary unemployment, etc). The money in such retirement funds are typically restricted and can only be invested in a few investment vehicles tightly regulated by the government, such as savings accounts and CDs. Therefore, it's no surprise they don't earn a huge return compared to all the options that would be available were such restrictions inexistent.

Now, in order to heat up the much needed area of infrastructure development, the government is allowing workers to invest part of their retirement funds into selected infrastructure projects.

What does this have to do with non-brazilian workers, you ask? Everything. Why? Because the companies poised to gain from these government-lead efforts are many and if brazilian investors join the bandwagon these companies should ring nice profits in the next few years.

The bad news

The bad news is that many of these builders and engineering companies are private and as such are very hard to invest in directly. They are the likes of Grupo Votorantim, Queiroz Galvão, Camargo Correa, and Odebretch.

The good news

The good news though is that some are public and even the private ones sometimes hold smaller subsidiaries that are publicly traded. For example, the financial arm of Grupo Votorantim, Votorantim Finanças, emits bonds from time to time, while Queiroz Galvão's subsidiary Braskem is publicly traded under the symbol BRKM3 -- though, Braskem is in the plastics and recycling business.

Camargo Correa also holds several companies, some which are public, such as ticker CCRO3, which is in the business of maintaining roads and commercially exploiting their toll booths. With more roads, toll booths are sure to boom too.

Finally, there are is one company left that is publicly traded and directly into the construction business: Andrade Guitierrez, which trades under the ticker CANT3B.

Sadly though, none of these are available as ADRs in the US. However, a strict ADR investor can still get some fringe benefits by investing in basic materials and exploration companies, such as chemicals company Braskem (ADR symbol BAK), Steel companies Gerdau (GGB) and Siderúrgica Nacional (SID), mining company Vale do Rio Doce (VALE) and homebuilder giant Gafisa (GSA). A far away alternative would be ETF EWZ.

None of these investments though are sure things, of course. These are just starting points. It's possible that these companies are overvalued and that the boon due to the new government-sponsored infrastructure projects have already been factored into their prices. Do your own homework before investing.

Disclaimer: I own GGB at the time of writing.

Status Update on Real Estate Development

A while back I told you about my investment in foreign real estate. Now it's time to see one more step: the conclusion of the construction.

Voila. It's a beautiful construction, thanks to the clever design, effort and sweat of my investment partners at Squadra Arquitetura.

Now the numbers.

The house as it is now cost us more than originally planned, for various reasons that don't matter much here. All told, it was about 32% more than planned. This will certainly eat into our margins.

The good news though is that we raised our asking price a bit. If it goes for our current asking price, we'll be profiting 59%, which is less than the 98% I originally mentioned, but still above our minimum of 40%. So, the margin of safety is there.

Anyway, I'll be posting a final update here when the deal if finally settled. If you want more details, take a look at Squadra Arquitetura's blog (in portuguese only).

Opportunities in Foreign Real Estate Market -- Part II

We've already seen an alternative basic recipe for investing in real estate: choose a stable to growing-market, build it, look for profits in renting, not selling it. Then, last time I discussed how my market of choice is currently Brazil. Now, I present the other two pieces of the recipe: building it and getting the return.

With a suitable location in mind, two investors and I bought the land and started building a small, single-family house in a new development area. Here are some pictures, courtesy of F.S.P. and C.R.S.


The first thing you'll notice is how different the materials are from typical north-american construction. When in Rome...

But what really matters is that we now have two possible sources of return: sell it for a profit or collect rent on our cost basis, which is much lower than if we had bought it.

We did our math and the returns work out to the following: selling it might generate a pre-tax profit anywhere between 40 and 90%. Realistically we think 40% is a low-ball estimate and it's very doable. 90% maybe not so much. But that's the ballpark of what other investors are getting.

If things don't work out as planned, our survey of the area indicates that rent should yield annually between 15 and 20%. Not a bad return at all for a rental.

We'll know soon how it turns out. Stay tuned for updates on this investment.

Opportunities in Foreign Real Estate Market -- Part I

Last time, we talked about a safer way to invest in real estate. We discussed how one should build instead of buying to lower the entry price, look for a stable to growing market and think of returns in terms of renting rather then selling.

Now, let's look at a practical example. I'll start with the market.

Foreign Real Estate Market.

I happen to know a bit about the real estate market in Brazil, since I've been following it for a few years now, from a distance. I also know some savvy real estate investors there. So Brazil was a potential candidate market for me.

Because the Brazilian economy has been doing remarkably well over the past 10 years or more and inflation has been tame all along, two things happened that spurred investments in real estate.

First, people got effectively richer. The lower middle class who previously couldn't afford houses now can.

Second, with inflation under control, long-term mortgages start to make sense again. You see, until recently in Brazil banks didn't lose. They didn't hold the risk of fixed-rate mortgages in the same sense as here in the US. Fixed-rate in Brazil until recently meant after inflation. That's right, your payment would fluctuate with inflation, so that banks were protected from the robbing power of inflation, while consumers had to take that risk themselves.

But with inflation under control, banks started to accept the risk of inflation. So truly fixed-rate mortgages are now a practical reality in Brazil.

With these two things -- more people with money and fixed-rate mortgages -- buying real estate starts to make more sense now for more people. And thus, real estate prices have followed suit.

One region I track prices is the shore area of Rio de Janeiro. There, in the last 2.5 years, some low-end single-bedroom apartments have appreciated 49%. That's a 17% annualized return in an environment of no more than 5% annual inflation.

Another area is the southern city of Porto Alegre, where investors are seeing about 8% annualized price appreciation, depending on the neighborhood, of course. This is a more reasonable price appreciation and appears less speculatory than the Rio de Janeiro scenario.

With the Brazilian stable to growing market in mind, I set out to find raw land to develop, build and sell, with the assurance that a worst-case return based on rent would still make financial sense. I will get into the specifics next time.