Cracks Begin To Form - While Real Estate Fundamentals Remain Strong, High Interest Rates (17%+) And Scarcity Of Capital Have Given Rise To The First Distressed Opportunities
EXECUTIVE SUMMARY
Colombia has the highest GDP growth in the Americas, its commercial real estate is performing well, and demand for residential real estate remains high. The main drivers of real estate growth - population growth, working age population growth, household formation – all are strong. However, Colombian real estate is entering a period of stress caused by high interest rates and a scarcity of capital.
Interest Rates: Since most real estate debt is floating rate, the surge in interest rates to 17%+, from 8-9% pre-COVID, is choking developers, landlords and home purchasers.
Scarcity Of Capital: Proposed pension reform would redirect a large part of pension savings away from private funds, including private real estate funds, into a new government run fund.
Yet valuation parameters remain sticky. Local players seem to be counting on a swift recovery in interest rates, not the “higher for longer” anticipated by international economists.
Compared to the current 12.5% yield on 10-year Colombian bonds, unlevered underwriting returns remain around 12% for core properties and 15%-20% for speculative development. El Dorado Capital Advisors believes these returns are low, even for local investors. We conclude that a pricing correction, some distressed situations, or a decrease in country risk premium will be needed to trigger the next wave of international investment.
ECONOMY
Latin America
Global growth is projected to slow from 3.4% in 2022 to 2.9% in 2023 and 3.1% in 2024. LatAm’s economies held up well last year despite the shocks from Russia’s invasion of Ukraine and global interest rate hikes.
Inflationary pressures are receding in many countries due to the early and determined efforts of central banks as well as lower global prices of food and energy.
Despite this encouraging news on growth and inflation, 2023 is likely to be a challenging year for the region. Growth this year is poised to slow, amid higher interest rates and falling commodity prices. Job creation and consumer spending on goods and services are both slowing, and consumer and business confidence are weakening. Growth will also be held back by a slowdown in trading partners, particularly the United States and the euro area.
LatAm countries are not a homogeneous bunch – each has their economic drivers and challenges, and overall, the interdependence of the economies is less significant than, say, in the EU. Consequently, individual country forecasts are unequal. For 2023, Colombia (1.1%) will lag some of its regional peers - Peru (2.5%), Chile (-1.5%), Brazil (1.2%) and Mexico (1.7%).
Since the commodity boom fueled by China's rapid economic expansion in the 2000’s fizzled out, countries in LatAm have not found a comparable engine of growth. One potential growth area is nearshoring/friendshoring. Increased political uncertainty in China has many firms in the US rethinking their dependence on Chinese factories. Hence, LatAm has an opportunity in nearshoring/ friendshoring if it can improve its shipping infrastructure and liberalize its trade policies. To date, Mexico has been an early winner. At the recent North American Summit, the partners agreed to relocate 25% of Asian imports to North America, adding up to 2% GDP growth to Mexico. Over the next decade, between $60 billion and $150 billion could flow into Mexico as part of these efforts. Other LatAm countries may also benefit.
As major commodities exporters, LatAm countries disproportionately benefit from commodity gains. The commodity index was up 17% in 2022 but is down 6% YTD in 2023.
LatAm is experiencing a new wave of governments to the left of the political spectrum in Peru, Brazil, Chile and Colombia. They arrived, all of them, against a backdrop of growing social unrest, spilling over into street demonstrations. But they also came with the economic ghosts of the pandemic in tow, which partly explains their rise to power, as well as the constraints on their ability to implement their ambitious social proposals. However, many of the new generation of leaders have weak mandates that will hinder their agendas. Already, Peru and Chile have seen popular pushback against their leftist agendas. Investors have taken note and widened the political risk premium on LatAm bonds and currencies.
However, global capital markets must acknowledge an uncomfortable fact: Many of the leftist governments of recent vintage across the region have been decent stewards of their economies, certainly no worse than the right. In fact, historically the LatAm left has done a better job than the right delivering on stock market returns. Often, the causes of the left — battling poverty and inequality, investing in public education and social services like housing for the poor — ultimately improve societies in a way that can enhance their stability, productive capacity and purchasing power, the kind of things that power economies and drive stock prices up.
Countries with high current account deficits, such as Chile and Colombia, are more exposed to high global interest rates, creating tighter liquidity conditions, but the foreign-exchange reserve levels in these countries are ample. What's more, these nations enjoy access to financing from foreign private and multilateral organizations, which reduces the risk that a sudden halt in external financing will evolve into a deeper economic crisis.
The aggressive tightening by LatAm central banks will likely push real interest rates back into positive territory for much of the region, boosting the relative attractiveness of LatAm assets. Moreover, following steep selloffs, most of the region’s currencies are undervalued according to measures of real effective exchange rates, which should further entice international investors.
Colombia
Colombia’s real GDP grew by 7.5% in 2022, outperforming nearly all global economies. Looking ahead, a significant slowdown is expected into 2023.
Colombia has not been immune to global inflationary pressures with February 2023 inflation at 13.25%, well above the central bank’s target range (2%–4%). Consensus inflation expectations have increased to 11.5% in 2023 and 6.0% in 2024.
The central bank raised its benchmark interest rate to 13.0% in March 2023. The consensus expectation is for the rate to remain at 13.0% until Q3 at which point it will begin to decrease to end 2023 at 12.0% and 2024 at 5.5%.
Among LatAm nations, Colombia has a particularly compelling opportunity in nearshoring/ friendshoring of supply-chains. To date, this has manifested itself in strong services growth, primarily in IT and business process outsourcing (BPOs) which has lent strength to the office market.
Colombian local assets have deteriorated materially in recent months in response to declining confidence domestically, a weak fiscal and external accounts position, and an unfavoutrable global environment. This is being exacerbated by a massive pile-on of hedge funds betting against the COP, and the new president’s often investor-unfriendly rhetoric. In 2022, the COP devalued -10.3% vs CAD (-16.9% vs USD), the worst performance of any LatAm currency.
Local market participants may see these external fluctuations as noise (they have happened before; they will happen again) and not impactful on the long-term value of real estate. From an international investor's perspective, the floor on pricing should be reassuring, however, by not incorporating these risks into pricing, the relative value proposition for Colombian real estate is less attractive (for now). However, like in developed countries, El Dorado Capital Advisors expects cap rates and valuation discount rates to eventually increase. So far discount rates have increased 100bps while cap rates have remained flat.
Once repricing has occurred, there may be opportunities for international investors who see these risks as overstated and anticipate political risks abating, currency returning to its fundamental value and credit rating restored to investment grade.
Colombia is now nine months into the four-year term of Gustavo Petro, the country’s first-ever leftist president and a former guerilla. Having campaigned on a radical agenda to redistribute wealth, execute rural land reform, end the war on drugs and reduce oil dependence, Petro is looking to break with the country’s conservative politics.
In the first half of 2023, Petro seeks to boost state control with key reforms in healthcare, pensions and labour. Pension reform is the most troubling for capital markets and real estate. The proposal will redirect a large part of pension savings away from private funds (big investors in local public debt, corporate bonds, stocks and real estate) into a new government run fund. The result has been a quick sell-off of the country's currency, bonds and stocks.
In the second half of 2023, attention will focus on October’s local elections when Colombians vote for all 32 governors and local legislatures, as well as 1,102 mayors across the country. Investors should watch carefully. Should Petro be successful in expanding his movement, it could establish itself as a new political force with the ability to dominate Colombian politics for years to come and seek even deeper reforms.
Support for the president has decreased from 56% at the time of his inauguration to 40% today. Already, Peru and Chile have seen popular pushback against their leftist agendas. Investors may wait until 2025 when Petro, with only a year left in his mandate, will have little room to maneuver.
REAL ESTATE
Residential
2022 national residential pre-sales were down -12% versus 2021. The surge of pre-sales that began in September 2020 began to reverse mid-2022 so that monthly sales ended the year down ~50% versus the beginning of the year. YTD 2023 sales are down 53% from 2022.
The fall off in pre-sales is largely attributed to rising mortgage rates which have increased 600 bps to 16% since bottoming out in mid-2021.
Pre-sales are largely driven by subsidy programs, the most important of which is “Mi Casa Ya” that provides up to a 20% pricing subsidy and 5% discount on mortgage rates. In 2023, the new housing minister announced a reformed “Mi Casa Ya” program that sets new requisites based on a social vulnerability score. Under the new points-based system, households located in small towns and rural areas will be prioritized at the expense of urban areas. As proposed, the reform is retroactive meaning that a purchaser that met the conditions for a subsidy 2-3 years ago may no longer be eligible when the unit is delivered.
El Dorado Capital Advisors believes the consequences will be as follows:
Sales should stabilize at current levels for 2023, down 40% from 2022, before recovering to pre-COVID levels in 2025.
Cancels should peak at 30% in 2023, many of which will occur near the delivery date.
Developers were anticipating a spike in deliveries in 2023 resulting from record 2020/2021 pre-sales. El Dorado Capital Advisors expects that the spike will be more subdued with many deliveries pushed into 2024.
Either by developers’ choice or by lack of financing, many projects will be delayed and/or aborted. This will result in a decrease in construction starts in 2023 and 2024. This should keep inventories under control.
Pre-sales and deliveries should return to pre-COVID levels in 2025 (plus some pent-up demand).
Since the COVID surge in sales, banks have tightened their lending standards to both developers and purchasers. However, these financing limitations have acted to self-regulate the market and prevent overbuilding. More than 350 projects (100,000+ units) that have achieved break-even point have not started construction. Since April 2020, completed inventory has declined 43%.
Higher inflation (13%) is increasing development costs while higher minimum wage (16%) is increasing revenues, particularly in TVIS units that are indexed directly to minimum wage. Units at fixed prices (Non-VIS and some VIS), have not appreciated as fast as direct costs and profitability of such units has decreased.
Colombia currently has a 3.5M unit housing deficit. With household formation averaging 340,000 per year while housing development can produce only 180,000 units per year, demand will simply accrue during this slowdown.
Currently, there may be opportunities to:
Invest in viable projects from smaller developers that are being held back due to a lack of financing.
Provide liquidation mechanisms for unsold inventory at the completion of projects.
Recapitalize developers or provide alternative development financing options as the current amount of capital is insufficient to meet demand.
Establish a residential rental platform.
Office
Office vacancies are stable (Bogota- 11%, Medellin 9%), net absorption is positive and rental rates are stable. The office market has been helped by a growing presence of BPO tenants. Renewals, usually 90-100% are now 80%-90% and for shorter terms. Most tenants are asking for shorter leases (2-3 years) or additional concessions for signing longer leases (5 years). Fortunately, the production of new space for delivery in 2021-2024 was already at historic lows before COVID.
Valuation parameters remain sticky. Office cap rates are 7.5-9.5% while discount rates are ~12.0% (up from 11.0% in 2021), even through the 10-year government bond rate is now 12.5%.
Since COVID, rental rates have increased 5% while construction costs have increased 25%. El Dorado Capital Advisors believes that rental rates will have to catch up with construction inflation before the next wave of office projects is launched.
Most office tenants have long-term leases with contractual annual rent escalations (>CPI). Tenants generally pay their own improvements.
Retail
Retail vacancies are stable (Bogota - 5%, Medellin 3%) and rental rates are increasing. The retail market has been helped by strong retail sales growth.
Contrary to North America where shopping centers serve an essentially utilitarian function, modern Colombian retail malls have in fact become part of the social fabric that serves a community function much like the old town squares used to decades ago. Expect resiliency from this asset class.
Retail cap rates remain unchanged at 7.5-8.5%.
Most retail tenants have long-term leases with contractual annual rent escalations (>CPI). Tenants generally pay their own improvements.
Industrial
The industrial market is very strong with low vacancies (Bogota - 6%, Medellin - 2%), positive net absorption and increased rental rates.
Most industrial tenants have long-term leases with contractual annual rent escalations (>CPI). Tenants generally pay their own improvements.
Real Estate Capital Markets
Interest rates on corporate and development debt have increased to 17-18% from 8-9% pre-COVID. This has diminished development profits and rendered many projects unviable.
In the US, the average office REIT trades at a discount to NAV of 19% (46% for US office REITS). Similarly in Colombia, publicly traded real estate funds are trading at steep discounts to NAV. This is a consequence of investors being skeptical of valuations, high interest rates diluting dividends, political concerns, and proposed pension fund legislation that would shrink the investor pool. Therefore, real estate funds, which have been major sources of real estate capital, have been shut out of the market.
While the demand for commercial and residential real estate remains strong, a scarcity of capital will suppress new supply for the next few years. El Dorado Capital Advisors foresees pent up demand fueling a strong real estate recovery in 2025-2027 once interest rates recede and investor confidence returns.
SUMMARY
Overall, the Colombian real estate market continues to demonstrate resiliency and we expect that to continue going forward. The market has been disciplined and has avoided overbuilding. We do not see Colombia real estate succumbing as much to some of the macro trends impacting real estate in the developed world such as WFH and e-commerce. However, very high interest rates and a scarcity of capital has given rise to the first distressed situations while suppressing supply for the years to come.
A window of opportunity existed to make large-scale investments in Colombian real estate from around 2005 to 2015, although select opportunities remain even today. El Dorado Capital Advisors is monitoring price dislocations or capital deficiencies that will trigger the next wave of attractive investment opportunities. While global investor sentiment is currently “risk off” across nearly all sectors, emerging markets like Colombia will once again be attractive when this sentiment inevitably reverses.
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