Latin American real estate markets traditionally have reflected the region’s economic instability. Interest rate volatility and periods of high inflation impeded the development and long-term financing of commercial properties. The lack of long-term capital and the extremely low savings rates of Latin American countries, when compared with similar growing economies, also have hampered the development of the real estate market.

The region’s relatively unsophisticated real estate business is characterized by a historically informal structure. To stimulate a more active market, the region needs appropriate vehicles that would efficiently route institutional money into real estate for long-term investment. It needs more income-producing properties that offer opportunities to investors, as well as a willingness by investors to seek out unexplored opportunities.

To further enhance the development of the real estate market, investors need qualified professional management that offers local expertise and knowledge of each market. They also need institutionalized systems and procedures, and more transparent and developed capital markets. Capital is abundant. What is scarce are well-structured investment opportunities that fit the requirements of institutional money.

Several factors appear to be spurring change, however. One is the emergence of new players.

For example, local institutional investors such as pension funds and retirement funds likely will help redirect institutional money into the production sector and assist in the development of new strategies for accessing the capital markets. These investors are expected to funnel a significant amount of money into high-quality investment opportunities that offer an appropriate trade-off between risk and return.

For the past three years, another group of investors also has focused on the region. US institutional investors, led by professional real estate advisors, have shown an interest in and have learned about specific Latin American markets. They now are looking for high-yield equity investment opportunities, following the steps of successful private real estate investors who had a vision for the region eight or 10 years ago. These few audacious investors have been building portfolios of income-producing property-some existing and some newly developed- fueled by private capital and partially financed by local banks.

New Objectives for Developers
Until now, the Latin American commercial real estate market has catered to developers with very short-term horizons and a lack of long-term financing, which favored the development of real estate for sale versus real estate for rent. The result has been the subdivision of property ownership, inefficient use of corporate capital, poorly managed property, and low-quality and inefficient assets, since they were not conceived as long-term investments.

When creating new properties, developers now must consider the needs of the more demanding end-user who is not necessarily the buyer.

They also must bear in mind a property’s ability to attract credit-worthy tenants and its operational performance. Developers must also weigh the long-term objectives of professional real estate investors, whether local or foreign, as they expand the region’s real estate base. Income-producing property in Latin America is scarce, but a vibrant investment market requires such assets.

The risk of investing in a foreign country with little access to transparent and accurate information requires fair compensation for capital. Expected equity returns, which are required to be in the mid-twenties, are not easy to achieve, especially when dealing with Class A property, or stabilized assets.

Building a successful track record in the region in terms of required returns for professional managers and advisors calls for structuring investment opportunities that will involve either development, commercial or legal risks. Equity investors will be hard-pressed to find existing opportunities producing the required return. Substantial time is needed to structure sound investment options. That process involves understanding the market, performing thorough due diligence and feasibility analysis, forming strategic joint ventures and alliances, developing a good relationship between the parties and assuring management capabilities once the transaction is closed to meet budgets and goals. The complexity of the process and characteristics of the region make foreign capital flows very slow.

At the same time, the fiduciary responsibility of investment advisors has made them shun opportunities in “out-of-the-list” countries, no matter how seducing they are. All efforts focus on Argentina, Brazil, Chile and Mexico (ABCM), increasing competition for deals, and consequently making it even more difficult to obtain required returns. Equity investors should be aware that opportunities in other markets do exist. It is possible to find sound, market-tested investments in areas where local private and institutional investors are willing to share risks, where investors will face lower competition, and where local successful companies and multinational tenants are already profiting and have real estate needs. The more efficient use of corporate capital and the need for governments to privatize state-owned companies to cover fiscal deficits have and will continue to attract multinationals to the region, creating the need for rental space in countries outside of the ABCM countries as well.

On the debt side, new financial instruments such as residential mortgage-backed securities have emerged. No country in the region has a government agency that sponsors an active secondary mortgage market or provides default insurance or guarantees to mortgage loans.

Without government backing, issuers of mortgage-backed securities programs must provide internal or external credit enhancements to furnish investors with coverage against credit risk and to guarantee timely payments of interest and principal.

Mechanisms such as subordination, over-collateralization, private insurance, money deposits, guarantees from financial institutions, cash flow surplus accounts and loan replacement are examples of possible enhancement mechanisms.

With mortgage securitization, financial institutions can access the capital markets as a funding source by means of financial products that not only are new for them, but also are new for local investors. Local investors have eagerly accepted mortgage-backed securities for two reasons: the confidence in the credit institutions involved and the low risk of the securities, due to a very high-quality credit enhancement provided by the originator. It is expected that future issuers will shift more risk to investors in the securities, or to third parties.

Tighter Regulations
Despite these developments, the trend toward tightening of capital requirements for Latin American financial institutions will impose a burden on the lending industry that will affect the growth of an active real estate market. Financial institutions soon will face three alternatives to complying with the higher capital requirements.

First, they may have to raise equity, which in turn dilutes ownership. Second, they may have to generate higher profits to accumulate enough capital and comply with the greater standard, an alternative that under the ever-increasing competition for funds may be hard enough without increasing risk exposure.

Third, they may have to reduce the size of their balance sheets, for example by means of securitization, provided that the sale of assets will not compel additional capital.

This last alternative is feasible only if the securitization process effectively reduces their risk exposure, spreading the risks among investors and other third parties. This, in turn, coincides with governments’ desire to guarantee the soundness of local financial systems. The possibility of creating government institutions that offer partial credit guarantees for mortgage-backed securities should not be discarded. It may contribute to the sounder, safer and faster development of a secondary mortgage market in the region.

The mortgage business will lead Latin American credit institutions towards servicing instead of risk-taking activities. Risk will be assumed by more specialized and knowledgeable institutions, whose risk preferences are higher. The “unbundling” of the mortgage industry will create new business opportunities for servicers, originators, conduits, and mortgage insurers. Origination and servicing fees will become more important than spreads, encouraging higher volume of loan origination. In the absence of a government initiative on credit insurance, the emergence of private mortgage insurance could offer a solution. Insurance companies are professional risk-takers that can diversify their portfolios with mortgage-pool insurance. In any event, strict underwriting standards, risk concentration controls and thorough understanding of the real estate market will be required by the guarantor of mortgage-backed securities programs.

Gonzalo Garcia is director of the Investment Advisory Group PIX Partners Inc., a real estate development firm and managing director of PIX Partners Colombia SA.