Road to Recovery Faces Electoral Cycle
ECONOMY
Latin America
After a dramatic economic downturn 2020, growth in LatAm outperformed expectations growing 6.8%, driven by robust trading partners growth, higher commodity prices, and favorable external financing conditions. On the domestic front, progress on vaccinations, continued fiscal support and accumulated savings from 2020 also supported growth.
However, LatAm countries are not a homogeneous bunch – each has their unique economic drivers and challenges, and overall, the interdependence of the economies is less significant than, say, in the EU. Consequently, individual country performance was unequal, with some countries - Colombia (10.6%), Peru (13.3%) and Chile (12.0%) - generating excellent 2021 growth while other countries – Brazil (4.7%) and Mexico (5.3%) – lagged. For 2022, Colombia (4.5%) is expected to outpace all its regional peers - Peru (2.8%), Chile (1.9%), Brazil (0.3%) and Mexico (2.8%) while the regional growth will be 2.4%.
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. Global price pressures were initially expected to be short-lived, however inflation expectations continue to be revised upwards. Monetary policy across the region, like in the rest of the global economy, will tighten as central banks hike rates to counteract inflation. However, LatAm remains particularly vulnerable to international monetary policy fluctuations.
As major commodities exporters, LatAm countries disproportionately benefit from commodity gains. The commodity index was up 46% in 2021 and was up another 26% YTD in 2022. Notwithstanding, commodity prices are still 65% below the peak seen in 2008. Consequently, talk of a commodity super cycle is already heating up.
LatAm countries missed out on the supply-trade boom from the late 1990s to the mid-2010s following a surge in world trade. However, increased political uncertainty in China and Russia has many firms in the United States rethinking their dependence on Chinese factories. Hence, LatAm has another opportunity if it can improve its shipping infrastructure and liberalize its trade policies.
Political discontent, which had been simmering for several years before COVID, has become more widespread. Citizens have demanded greater fiscal supports as household incomes fell during the pandemic, and strong anti-incumbent sentiment will favor left-leaning parties. Brazil and Colombia have elections in 2022 which could bring leftists Lula de Silva and Gustavo Petro to power. Similarly, leftist victories in late 2021 in Chile took market-friendly reforms off the table. Investors have taken note and widened the political risk premium on LatAm bonds and currencies.
Currency Risk: In 2021, every major currency in LatAm has weakened against the US dollar. A combination of delayed vaccine rollouts, global “risk off” sentiments and regional political risks have at various points throughout the year led to sharp sell-offs of the LatAm currencies. Over the medium-term, some of the most acute political risks will fade across the region while central banks continue hiking interest rates, allowing for an appreciation in most currencies.
Colombia
Colombia grew 10.6% in 2021, handily beating market expectations, and on average, operated 2.8% above pre-pandemic levels. Consensus growth expectations have increased to 4.5% in 2022 and 3.7% in 2023. The strong growth results reflect the positive response of the economy to the mid-year relaxation of mobility restrictions and were powered by a strong contribution from private consumption.
2021 CPI was 5.6%, above the ceiling of BanRep’s target range (2%–4%) for the sixth month in a row. Core inflation increased 4.5%, while ex-food and regulated goods inflation came in at 3.5%. Consensus inflation expectations have increased to 5.5% in 2022, 4.2% in 2023 and 3.5% in 2024.
The central bank raised its benchmark interest rate by 100bps to 4.0% in January 2022, its 5th consecutive rate hike. The consensus expectation is for the Central Bank to raise rates a further 100bps to 5.0% in March and a further 150bps to 6.5% by the end of 2022.
While COVID cases around the world surged in January 2022, in Colombia, new daily cases are up only slightly. Colombia did not suffer as much from the Omicron variant. Colombia has now fully vaccinated 63% of its population (versus 80% in Canada and 64% in US) and has begun administering booster shots.
Colombia’s prospects have greatly improved from the dark days of Spring 2021 when there were widespread demonstrations against an ill-conceived tax reform leading both S&P and Fitch to downgrade Colombia’s credit rating to BB+. In fact, Moody’s later affirmed Colombia’s rating at Baa2 (two notches above investment grade threshold) and improved the outlook from “negative” to “stable”. Fitch subsequently reaffirmed Colombia’s outlook as stable.
In 2021, the COP devalued 15.8% vs USD and 16.5% vs CAD (CAD appreciated 0.8% vs USD). YTD 2022, most LatAm currencies appreciated with the COP appreciating 7.8% vs USD and 6.2% vs CAD. While considered an undervalued currency, the COP is forecasted to remain depressed until after the presidential elections.
In September, Colombia passed a new tax reform. For investors, the main measures are the increase of the corporate income tax rate from 30% to 35%. Overall, this is a watered-down tax reform, but one which was politically palatable.
The first round of the presidential elections in Colombia will be on May 29, 2022. According to the result, the country could go to a second-round ballot. Congressional elections in March 2022 may provide early indicators on the May 2022 presidential contest. Presidential front-runner Gustavo Petro has been campaigning on a message of ending new oil and gas exploration, expropriating unproductive land, raising import duties, raising taxes on the wealthy, implementing the 2017 peace deal and increasing public sector participation in the economy. While Petro’s lead is impressive at 32%, he remains short of the 50% necessary for a first-round victory. Centre-Right candidate Federico Gutiérrez has 27%. Petro’s leftist stance and rhetoric are regarded as radical among moderate voters who may unite to vote in “anybody but Petro'' in the second round.
Overall, the Colombian real estate market continues to demonstrate resiliency in 2021 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.
However, due to higher-than-normal political risk and structural vulnerabilities to international monetary policy movements, 10-year bond spreads remain around 360 bps wider than before COVID. 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). 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.
Residential
For 2021, pre-sales were 227,000, construction starts were 157,000 and deliveries 127,000. Direct costs increased around 10% yet the 2022 minimum wage increased 10.1%, an increase that flows directly to VIS pricing.
El Dorado Capital Advisors (El Dorado) doubts that much of the higher-than-average pre-sales in 2020/2021 will ever be converted to actual sales (pre-COVID pre-sales were around 160,000 pa). El Dorado believes that many projects will be delayed and/or aborted. The projects most at risk are unstarted projects of smaller developers whose equity is trapped in existing projects and for whom lenders will not advance development financing until they are fully repaid from existing projects.
Cancellations, while seemingly stable at 22%, signal that affordability (ie. mortgage eligibility) is constrained. Affordability may worsen in coming months as mortgage rates are expected to rise.
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 39%. El Dorado expects late-stage projects to benefit as purchasers are motivated to acquire finished product before subsidy programs run out.
Prices of VIS (low income) housing increase annually with minimum wage (approximately CPI +1.5%). Non-VIS prices have been increasing at a slightly higher rate. Profitability is expected to stay constant as higher development costs, due to higher steel and materials costs, are offset by higher unit prices and shorter construction loan durations.
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 160,000 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 (unlike commercial real estate) has not yet benefitted from the cycle of declining mortgage rates that has fueled so much price appreciation in developed markets. Mortgage rates are currently 9.0% for VIS and 8.0% for Non-VIS, but are expected to rise with the benchmark interest rate.
Currently there may be opportunities to:
Invest in viable projects from smaller developers that are being held back due to 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.
Retail
Colombia's retail sales advanced 15.9% in 2021. This advance represents an advance over pre-pandemic retail sales and follows a year of strong retail sales growth. Similarly, consumer confidence has nearly recovered to pre-pandemic levels. Nearly all stores, restaurants, theatres, gyms and amenities have reopened.
There is evidence of a strong pipeline of brands waiting to re-enter the market once mall traffic returns to normal. Consequently, rental rates and vacancies should recover quickly in the best malls while some older malls may become obsolete.
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.
Most retail tenants have long-term leases with contractual annual rent escalations (>CPI).
Office
Bogota is the fourth largest market in Latin America, behind Mexico City, Sao Paulo and Santiago. Its office market is composed of nine sub-markets that encompass nearly 2,800,000 m2 investment-grade space. Investors and users’ preference for high quality spaces is deepening. In the last few years, demand has shifted to bigger floorplates, innovative/cleaner technologies, and strong security and risk prevention systems.
For 2021, most office tenants continue paying their contractual rent whether or not they are using the space with the exception of some street front retail and coworking space. While tenants are contemplating shedding space to accommodate work-from-home, in practice most tenants are simply delaying major leasing decisions
In 2020, the Bogota Class A vacancy rate increased to 14% and has further increased to 17.5% by mid-2021. Market rental rates have decreased 8.5% but renewal rental rates are staying at previous levels. Renewals, usually 90-100% are now 80%-90% and for shorter terms. All tenants are asking for shorter leases (2-3 years) or additional concessions for signing longer leases (5 years). Fortunately, the planned production of new space for delivery in 2021-2023 was already at historic lows before COVID. The office market is expected to recover by 2024.
In terms of property valuations, discount rates (10.5% to 11.5%) and cap rates (7.5% to 8.5%) have remained relatively constant. However, appraisers’ market and renewal assumptions have been reduced. Consequently, 2021 appraisals have increased an average of only 3%, slightly below inflation.
Most office tenants have long-term leases with contractual annual rent escalations (>CPI).
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