Four Wasted Years: Colombia’s Experiment With The Left Fails. Now That Radical Reforms Are Off The Table, The Currency Rallied 23% and 10-Year Bonds Decreased 330 Bps. A Strong Rebound Awaits When The President’s Term Ends in 2026.
Hundreds of thousands protest President Petro April 21, 2024 - Fuera Petro!/Fire Petro!
EXECUTIVE SUMMARY
Colombia has the highest GDP growth (2013-2023) in the Americas, its commercial real estate is performing well while its residential real estate, usually strong, is suffering. 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, poor public policy, scarcity of capital and a vulnerable currency.
Interest rates: Since most real estate debt is floating rate, the surge in interest rates to 16%+ from 8-9% pre-COVID, is impacting developers, landlords and home purchasers. Interest rates are now on the way down.
Poor Public Policy: Most affordable housing sales are driven by subsidy programs. The new government narrowed the eligibility for subsidies retroactively, 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.
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.
Vulnerable Currency (COP): While considered an undervalued currency, the COP remains vulnerable to international monetary policy (Fed tightening) and the country’s high current account deficit.
The real estate market has been disciplined and has avoided overbuilding. Colombia real estate is not succumbing as much to some of the macro socio-economic trends impacting real estate in the developed world such as WFH and e-commerce.
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 10.5% yield on 10-year Colombian bonds, unlevered underwriting returns remain around 12.5% 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
LatAm's growth is expected to decelerate from 2.2% in 2023 to 1.7% in 2024. This will leave LatAm as a laggard among emerging markets (EM), behind both the overall global growth rate of 2.1% and the overall EM growth rate of 3.9%. Factors restricting growth in 2024 include 1) a broad slowdown in global growth, 2) challenging weather conditions that could depress agricultural output, and 3) the lingering impact of elevated interest rates.
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. In 2024, Colombia GDP growth (1.8%) will be on par with the average of its regional peers - Peru (-2.7%), Chile (-2.0%), Brazil (1.6%) and Mexico (3.1%). However, the relative weights of the Brazil and Mexican economies bring the headline growth of the region to 1.7%.
However, now that the commodity boom fueled by China's rapid economic expansion in the 2000’s has fizzled out, the region may now be on the verge of renewed importance to the global economy in the context of:
Nearshoring/friendshoring: With many firms in the US rethinking their dependence on Chinese factories, 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.
Energy: LatAm is an important source of the inputs needed for the new energy economy. It contains 40% of the world’s copper reserves, 35% of lithium reserves, and significant deposits of nickel, cobalt, and other critical minerals. It is also a large exporter of legacy energy sources such as oil, coal and natural gas.
Food: Export of agricultural products has grown 8% annually since the mid-90s and now represents 13% of global trade. The region is also well placed to scale up agricultural production with comparative advantage with vast expanses of fertile land (30% still unexploited) and abundant water.
From 2020-2023, there was much discussion about the new wave of leftist governments 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.
Now the political pendulum may be swinging the other way. Peru and Chile have seen popular pushback against their leftist agendas. Argentina has elected a populist right-wing government and Venezuela, which has election in July 2024, has a viable center right opposition with strong popular support.
In the past 15 to 20 years, large parts of LatAm forged trade agreements and they are now substantially more connected to the broader world than ever before. Foreign investors are noticing – 2023 was a banner year for foreign direct investment in the region, at more than $209 billion.
There is a catch to this promising landscape: the historical ambivalence of Latin American governments toward the private sector and the market-based reforms necessary to modernize their economies. In 2012, East Asia had roughly the same per capita incomes to LatAm, as measured by purchasing power parity. Today, East Asia is 40% ahead. The region continues to be viewed as one of untapped potential.
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.
Aa a result of early tightening by the region’s central banks, inflation has peaked and interest rates, still high, are on the way down. Following steep selloffs in 2020-2022, region’s currencies have stabilized, but remain below historical levels.
Colombia
After two years of spectacular growth (2021: 11:0% 2022: 7.5%), Colombia’s growth slowed to 0.6% in 2023. Colombia’s medium-term economic growth prospects remain strong. From 2024-2028, Colombia’s GDP growth (2.8%) is expected to surpass that of the US (1.9%), Canada (1.8%), Europe (1.5%) and its LatAm peers (2.4%).
Colombia has not been immune to global inflationary pressures. Inflation peaked at 13.3% in March 2023 before ending the year at 9.3%. By February 2024, inflation had fallen to 7.7%. Consensus inflation for 2024 is 6.3% and 2025 is 3.8%.
After peaking at 13.25% in October 2023, the policy rate decreased to 12.25% in March 2024. The consensus expectation is for the interest rate to continue to decrease to 7.0% at the end of 2024 and 5.5% at the end of 2025.
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.
As in developed countries, El Dorado Capital Advisors expect cap rates and valuation discount rates to continue increasing. So far discount rates have increased 150bps and cap rates 50 bps. We expect a further 25 bps increase in cap rates.
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 two years into the four-year term of Gustavo Petro, the country’s first-ever leftist president. In 2023, evidently frustrated by congressional opposition to his sweeping reforms, Petro fired most of his cabinet, and effectively dissolved his congressional coalition.
When Petro took office, Colombia currency, bonds and stocks traded with a significant political risk premium. Analysts estimated the risk premium negatively impacted the COP by 15%.
Petro seems to be embattled on all sides, navigating an ever more difficult labyrinth of his own creation. His approval rating is now 32%, a loss of 24% points since his inauguration. In October 2023, opposition candidates swept regional elections, dealing a further defeat to Petro.
In 2023, markets have reacted favorably to his failings and the COP rallied 23% and the 10-yer bond spread decreased 330 bps. Per Wells Fargo “Markets are comfortable with the Petro administration starting to crack. If Petro’s reform agenda is unable to be implemented and Petro is essentially in a lame duck scenario, that combination takes a lot of political risk off the table.
However, it may be too early to fully write-off political risk. Petro remains ideologically anti-capitalist and anti-development. Petro still maintains executive powers that, while weaker than congressionally approved reforms, could still prove disruptive.
2024 will be an important year for Venezuela with the potential for regime change in July. A democratic Venezuela would be a big plus for Colombia and for the region.
When Petro first came to power, many Colombians moved their money out of the country. The atmosphere of uncertainty has frozen decision making and stifled new investment. Overall, with its ineffective government, Colombia will underperform relative to its potential for the balance of Petro’s term (ending 2026). We expect a strong rebound thereafter which may be further enhanced by possible regime change in neighbouring Venezuela.
Residential
After a surge of pre-sales that began in September 2020, pre-sales bottomed out in 2023. From here a slow recovery begins.
The fall off in pre-sales was largely attributed to a) rising mortgage rates which increased 500-700 bps since bottoming out in mid-2021 and b) changes to the subsidy programs that now prioritize rural areas over urban areas.
Cancels, which were well below 20% prior to COVID, then peaked at 80% (now 60%). Indeed, cancels surged as many 2020-2022 pre-sales no longer qualified for subsidies and/or mortgages.
However, mortgage rates are already on the way down and should end the year around 100bps above pre-Covid levels. This should fuel a resurgence in pre-sales.
El Dorado Capital Advisors believe that the residential market will play out as follows:
Cancels have peaked and will continue to subside.
Annual pre-sales should slowly recover from 88,000 in 2023 to 120,000 in 2024, 160,000 in 2025 and 170,000 in 2026. In 2027-2028, pent-up demand could drive pre-sales up to 200,000.
Either by developers’ choice or by lack of financing, many projects will be delayed and/or aborted. This should keep inventories under control.
VIS (affordable) units are priced at 135-150x minimum wage in the year of delivery (not year of pre-sale). Minimum wage increased 16% in 2023 and 12% in 2024 and should continue to increase at CPI+2% going-forward. Meanwhile, construction cost inflation is trailing inflation (7.3% in 2023 versus CPI of 9.3%). Thus VIS profitability has increased.
Unlike VIS pricing, non-VIS prices are generally fixed at the time of the offer and developers cannot pass-through unexpected higher inflation to purchasers.
Since the COVID surge in pre-sales, banks have tightened their lending standards to both developers and purchasers. In effect, these financing limitations have acted to self-regulate the market and prevent overbuilding. Since April 2020, completed inventory has declined 20%.
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.
With 50% of Colombians renting and no purpose-built rental housing or large-scale professional managers, there may be an opportunity to establish a residential rental platform.
Office
Overall, office vacancies have not spiked significantly post-COVID. In fact, 2023 net absorption has been positive and rents are up 8.5% in Bogota and 12.6% in Medellin. The office market has been helped by a growing presence of BPO tenants. With new supply down 70%, expect vacancies to continue to decrease.
Vacancies (Bogota 9.5%, Medellin 7.0%) compare favourably to regional peers (Mexico City 23.4%, São Paulo 25.6%, Rio De Janeiro 36.4%) and international markets (New York 22.8%, Toronto 17.4%).
Vacancies in leased-up buildings remains low (<5%) with most of the vacancy concentrated in buildings delivered in 2023-2025. El Dorado Capital Advisors expect that, unusual for Colombia, significant tenant improvements and rent concessions will be required to lease up this space.
As most rents are CPI linked (usually CPI+1%), in-place rents and NOI should increase 6-7% in 2024. Such high NOI growth and low vacancy is a rarity in office markets. All this during a period of low business confidence, high interest rates and high political uncertainty.
In Bogota, office market rents have increased ~15% since 2020 while construction costs have increased ~30%. This suggests that: 1) many in-place rents are above market, and 2) market rents are going to have to catch up ~15% before any new construction is initiated. With low vacancies and tenants reluctant to move because they pay their own improvements, leases are generally being renewed at these above-market rents.
Compared to the rest of North America, physical occupancy is very high with nearly all employees working 3+ days in the office.
Office cap rates widened slightly to 8.3%-8.7% and discounts rates have increased to 12.5%-13.0%.
Most industrial 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. Colombia’s retail sales recovered strongly after COVID but have weakened in recent months as interest rates increased.
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 increased slightly to 8.0-8.5%.
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 - 4%, Medellin - 3%) with positive net absorption. Colombia’s industrial market did not experience the spike in rental rates typical of many developed markets. Since 2018, average market rental rates increased 28%, while North American rates increased 100%-200%. Colombia has a small industrial base and its logistics market has been limited by road and transportation infrastructure. Furthermore, the rapid growth of e-commerce, characteristic of most developed markets, has not yet occurred in Colombia.
Historically, Colombia has had only a limited number of large-scale credit tenants which has increased the risk of owning large single-user buildings.
Colombia’s industrial market is relatively small at ~10M M2 versus Canada’s 190M M2 and USA’s 1,500M M2.
Industrial cap rates increased slightly to 7.5%-8.5%.
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 16-17% 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 10% (30% 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, lack of liquidity in secondary markets, 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 foresee pent up demand fueling a strong real estate recovery in 2027-2028 once interest rates recede and investor confidence returns.
Conclusion
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 be attractive when this sentiment inevitably reverses.
Appendix – Colombia Residential
Land Sale Structures
The typical land sale structure in Colombia is a “land swap” where the landowner rolls-in land in exchange for a percent of sales (13-20%). The structure of selling land for an upfront payment is less common. Upfront land purchases would provide investors with a more meaningful equity investment and longer investment period particularly when applied to large multiphase projects,
Strata
In Colombia, neighborhoods are classified by Strata that vary from 1 (poorest) to 6 (richest) that are used by the state to determine cross-subsidization indexes for public services. For example, the electricity rate may be 25x more expensive in a Strata 6 home than in a Strata 1.
Housing Unit Classification
In Colombia, housing below a price ceiling - 135x monthly minimum wage in small cities and 150x monthly minimum wage in large cities – are eligible for subsidies. Any unit below the price ceiling is referred to as a VIS unit (Vivienda de Interés Social) while those units at the price ceiling are referred to as Tope VIS (TVIS) units. Approximately 65% of housing development is VIS/TVIS units and are generally Strata 2-3.
An even lower classification exists for VIP (Vivienda de Interés Social Prioritaria) with a price ceiling of 90x monthly minimum wage. These represent approximately 5% of housing development and are generally Strata 1.
The most important subsidy program is “Mi Casa Ya” that provides up to a 20% pricing subsidy and 5% discount on mortgage rates. These subsidies total ~60,000 per year. Since 2023, The “Mi Casa Ya” program now sets new requisites based on the Sisben score (Identification system for potential recipients of social programs) and creates a points-based system to prioritize access to subsidies. Under the new points-based system, households located in small towns and rural areas are prioritized.
Note that the VIS price in a pre-sales contract is a multiple of minimum wage, not a fixed price. The final price will be determined by the minimum wage in the year of delivery. Thus, VIS developments are inflation hedged and, in fact, slightly benefit from surges in inflation.
Deposits
Deposits are typically 30%, paid in equal installments until closing. Purchasers prefer longer installment periods which can be as long as 36 months at a project’s launch.
Each individual phase of a project is set up as a separate development trust with a third-party fiduciary controlling cash flow. Funds cannot be commingled between phases, projects or with the developer. This serves to protect consumers and prevent the types of Ponzi-like structures seen in China where deposits on current phases may be used to fund development of previously sold phases.
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