Despite Exceptional Growth, Country Risk and Currency Suffering From A Perfect Storm
EXECUTIVE SUMMARY
Colombia has the highest GDP growth in the Americas, its commercial real estate is performing well, and its residential real estate, after a surge in pre-sales in 2020-2022, is returning to pre-COVID pre-sale levels. The main drivers of real estate growth - population growth, working age population growth, household formation – all are strong. However, Colombia is vulnerable to international monetary policy fluctuations and has a new government with a still uncertain (seemingly investor-unfriendly) agenda. Investors have taken note and widened the political risk premium on Colombia bonds and currencies.
Compared to the current 13.5% yield on 10-year Colombian bonds, unlevered underwriting returns remain around 11%-12% for core properties and 15%-20% for speculative development. El Dorado Capital Advisors believes these returns are satisfactory for local investors at this time. We conclude that a pricing correction, some distressed situations, or a decrease in country risk premium will probably trigger the next wave of international investment.
ECONOMY
Latin America
Global growth is projected to slow from 6.1% in 2021 to 3.2% in 2022 and 2.9% in 2023. Due to war-induced reshuffling of commodity suppliers, emerging markets that are net energy/food exporters have seen their 2023-2027 prospects improve. Colombia is expected to outperform many of its emerging market peers and developed markets in general. However, the stronger US dollar has dampened foreign investment in the region, and internal political events have increased uncertainty.
As major commodities exporters, LatAm countries disproportionately benefit from commodity gains. The commodity index was up 38% in 2021 and is up another 23% in 2022. However, commodity prices have been on the decline in recent months.
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 2022, Colombia (7.9%) will outpace all its regional peers - Peru (2.8%), Chile (2.1%), Brazil (2.0%) and Mexico (2.0%). However, the relative weights of the Brazil and Mexican economies bring down the headline growth of the region to 2.8%.
The LatAm region, like the rest of the global economy, has experienced a sharp rise in inflation as economies rebounded. Now, many LatAm countries have inflation higher than the upper range of their respective inflation targets. However, most of the region's largest economies are well along in their monetary policy cycles, so relative to developed markets, monetary policy positioning is actually at multiyear highs in terms of both nominal and real interest rates.
LatAm’s biggest risk at present is not another “lost decade” fueled by financial crises, but rather a decade of missed opportunities. 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 another opportunity in nearshoring/ friendshoring if it can improve its shipping infrastructure and liberalize its trade policies.
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.
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 Latin American central banks will likely push real interest rates back into positive territory for much of the region, boosting the relative attractiveness of Latin American assets. Moreover, following steep selloffs in 2020 and 2021, 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 7.0% y/y in Q3-2022. Colombia outperformed nearly all global economies during Q3 2022. Looking ahead, a significant slowdown is expected into 2023.
Colombia has not been immune to global inflationary pressures with 2022 inflation at 13.1%, well above BanRep’s target range (2%–4%). Consensus inflation expectations have increased to 7.6% in 2023 and 4.7% in 2024.
The central bank raised its benchmark interest rate 12.0% in December 2022. The consensus expectation is for the Central Bank to raise rates a further 50bps in January, to reach a peak of 12.5%. The consensus forecast for the end of 2023 is 9.0% and 2024 is 5.5%.
Covid-19 resulted in most economies increasing their Debt-to-GDP levels by 10-20%. Colombia’s Debt-to-GDP, which reached 66% in 2020, will have recovered strongly by 2027 (56%).
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 a hostile global environment; in other words, a “perfect storm” says JP Morgan. That perfect storm 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 -11.8% vs CAD (-18.1% 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 100bps.
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 three 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.
But Petro had to cobble together a broad coalition to obtain a governing majority in Congress. The risk of radicalization or of concentrating political power does not seem significant at this stage. Petro’s presidency will likely be marked by a movement in the direction towards a more equal society rather than a full-scale revolution. He has signalled that he wants to shift the Colombian economy more towards a western European form of capitalism rather than a Cuba/Venezuela form of socialism. In the long run, this may improve Colombia economic potential, but for the next four years, expect more investor-unfriendly policies.
While few of his policies have been articulated, his first step has been a tax reform aimed at collecting more taxes from the rich. The potential impact on investors includes higher capital gains tax (from 10% to 15%), higher dividend taxes (from 10% to 20%) and a new 1% equity tax.
Support for the president has decreased from 56% at the time of his inauguration to 46% today. Already, Peru and Chile have seen popular pushback against their leftist agendas.
REAL ESTATE
Residential
YTD November 2022, national residential pre-sales were down -11%, -10% for VIS and -11% for Non-VIS. The surge of pre-sales that began in September 2020 began to reverse mid-year with November monthly pre-sales down 43% vs 2021. By the end of the year, pre-sales should be 205,000 for 2022 versus 227,000 in 2021.
As in many developed countries, pre-sales surged until mid-2022 when mortgage rates were low and declined rapidly as mortgage rates escalated. Mortgage rates have now increased 500 Bps to 15.5%, their highest level in at least 10 years. Mortgages rates are expected to remain high in 2023 before recovering in 2024
El Dorado Capital Advisors believes the consequences will be as follows:
Sales should stabilize at Q3 2022 levels for 2023, down 35% from 2021, before recovering to pre-COVID levels in 2024.
Cancels should peak at 30% in 2023, many of which will occur near the delivery date.
Developers are 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. This should keep inventories under control.
Pre-sales and deliveries should return to pre-COVID levels in 2024.
Pre-sales are largely driven by subsidy programs. The new government has confirmed the continuation of the VIS subsidies but the lower Non-VIS subsidies ended in 2022.
Since the COVID surge in sales, banks have tightened their lending standards to both developers and purchasers. In fact, outstanding development debt has decreased slightly.
However, these financing limitations have acted to self-regulate the market and prevent overbuilding. Since April 2020, completed inventory has declined 43%.
The demand for housing remains very strong. Colombia currently has a 3.5M unit housing deficit. With household formation averaging 340,000 per year while housing development can produce 180,000 units per year, the deficit continues to widen. While 45% of Colombian’s rent, nearly all new supply and subsidies are geared towards condo development.
Colombia residential real estate has not yet benefitted from the cycle of declining mortgage rates that have fueled so much price appreciation in developed markets.
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
Overall, office vacancies have not spiked significantly post-COVID. In fact, net absorption has been positive and rental rates are stable. Current vacancy rates in Bogota and Medellin are 11.7% and 6.2%, respectively. The office market has been helped by a growing presence of BPO tenants.
The leasing of newly developed buildings has been more difficult. Fortunately, the production of new space for delivery in 2020-2024 was already low before COVID.
There has been speculation that the new President will raise property taxes. Since leases are semi-gross (landlord responsible for property taxes), this could flow through to the landlord’s bottom line.
Office cap rates remain unchanged at 7.5-8.5%.
Most office tenants have long-term leases with contractual annual rent escalations (>CPI). Tenants generally pay their own improvements.
Retail
Overall, vacancy remains low and absorption is positive. However, there has been some softening of rental rates. Current vacancy rates in Bogota and Medellin are 6.9% and 4.5%, respectively. The retail market has been helped by a strong retail growth, up 7.2% y/y in September 2022.
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.
Office 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 performing very well with low vacancy, positive absorption and increasing rental rates. Current vacancy rates in Bogota and Medellin are 3.7% and 8.2% respectively.
Most industrial tenants have long-term leases with contractual annual rent escalations (>CPI). Tenants generally pay their own improvements.
SUMMARY
Overall, the Colombian real estate market continues to demonstrate resiliency in 2022 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 work-from-home and e-commerce.
A window of opportunity existed to make large-scale investments in Colombian real estate from around 2005 to 2015, although some small-scale opportunities remain even today. That window closed around 2016 for new large-scale investments (existing investments performed as expected) and we are closely monitoring when that window will reopen again. El Dorado Capital Advisors is looking for 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 be attractive when this sentiment inevitably reverses.
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