With Rents Linked To Inflation (11.5%) And 20% Currency Appreciation, Office/Retail Properties are Having A Good Year. Residential Construction Is Also Linked To Inflation But High Mortgage Rates And Changes To Subsidies Have Depressed Pre-Sales To 10-Year Lows.
EXECUTIVE SUMMARY
Colombia has the highest GDP growth 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, 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.
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.
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 11.5% 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 3.5% in 2022 to 3.0% in both 2023 and 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 high inflation. 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 China.
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 (1.8%) will be on par with its regional peers - Peru (1.4%), Chile (-0.8%), Brazil (2.1%) and Mexico (2.4%). However, the relative weights of the Brazil and Mexican economies bring the headline growth of the region to 1.9%.
Since the commodity boom fueled by China's rapid economic expansion in the 2000’s 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.
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.
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 – 2022 was a banner year for foreign direct investment in the region, at more than $220 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.
As 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
Colombia is now one year into the four-year term of Gustavo Petro, the country’s first-ever leftist president. Having campaigned on an agenda to redistribute wealth, execute rural land reform, end the war on drugs and reduce oil dependence, Petro is looking to break from the country’s conservative politics. However, Petro has shown worrying authoritarian and anti-capitalist traits.
But Petro had to cobble together a broad coalition to obtain a governing majority in Congress. His party, Pacto Histórico, has fewer than 20% of seats in both the Senate and the House of Representatives, and his narrow runoff victory gave him a relatively weak mandate.
In his first months in office, Petro succeeded in passing a landmark tax reform, and getting Congress to approve his framework for negotiations with illegal armed groups. He reached an agreement to buy 3 million hectares, a strategy that will be very important in his agrarian reform plan and re-established relations with Venezuela by reopening the border.
In the first half of 2023, Petro sought 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 could greatly reduce the role of private equity funds (by as much as 70%), a major source of real estate financing. It is expected that the new state-controlled pension fund would be professionally run and would initially buy local bonds. In anticipation of the proposal, Q4 2022 saw a quick sell-off of the country's currency, bonds and stocks.
Colombia is a country in need of reforms and some of the Petro’s reforms are in the right direction. But by not consulting outside of his inner circle, much of the reforms, as proposed, are unworkable in practice. In May, evidently frustrated by congressional opposition to his sweeping reforms, Petro fired most of his cabinet, including his respected Minister of Finance, and effectively dissolved his congressional coalition. The reshuffle prompted a further fall in currency, bonds and stocks.
Petro said attempts to restrict his social reforms could lead to “revolution,” and asked for the nation to support him during a May speech. Petro blamed Colombia’s elites for holding up his agenda. Notwithstanding, the social support for his ”revolution” is virtually nil.
Since Petro took office, Colombia currency, bonds and stocks have traded with a significant political risk premium. Analysts estimated the risk premium negatively impacted the COP by 15%. It was assumed that this political risk would slowly taper away as Petro’s term ran out.
Support for the president had decreased from 56% at the time of his inauguration to 35% recently. Then things went from bad to worse. In June, leaked audio was released in which Petro’s campaign chief threatened to reveal dirt about how last year’s presidential campaign was funded. The implications are significant – was Petro’s campaign financed by cartels? militias? Venezuela? This is a big scandal in Colombia and further undermines Petro’s credibility as an anti-corruption politician. Petro’s approval fell further to 26%. Since then, Petro’s son has admitted to collecting campaign funds from criminals while his brother said that a million+ votes had been bought from prison populations in exchange for leniency for certain convicted politicians. There is recent talk that Petro is suffering from health issues.
Markets reacted favourably and the COP rallied 10% and the 10-yer bond spread decreased 100 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.” Consequently, nearly 2/3 of the previously mentioned political risk premium has gone away.
However, it may be too early to fully right-off political risk. Petro remains ideologically anti-capitalist and anti-development while maintaining (rumoured) ties to former guerilla associates. Petro still maintains executive powers that, while weaker than congressionally approved reforms, could still prove disruptive. The risk of radicalization or of concentrating political power does not seem significant at this stage.
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. It is not expected that Petro will expand his power base following the elections.
Colombia has been an exception in LatAm - it has never been led by revolutionaries, as has Mexico and Bolivia, or by popular movements, such as Peronism in Argentina, or by a socialist president like Salvador Allende in Chile.
At stake is the future of what was one of South America’s most reliably conservative states, popular with investors for its prudent economic polices and prized by Washington as its closest military ally in the region.
In summary, Petro may be down, but he is not out.
Residential
The surge of pre-sales that started in September 2020 began to reverse mid-2022. YTD sales are down 59% versus 2022 (Base Effect: 2022 H1 sales were still surging). Compared to pre-Covid levels, YTD sales are down 40%.
The fall-off in pre-sales is largely attributed to a) rising mortgage rates which have increased 500-900 bps since bottoming out in mid-2021 and b) changes to the subsidy programs that now prioritize rural areas at the expense of urban areas.
Cancels, which were below 20% prior to COVID, have recently increased to 67%. Note that cancels (=monthly cancels/gross monthly sales) may be distorted by the denominator effect as gross sales are substantially down.
Most affordable home (VIS) pre-sales are 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:
Pre-sales should stabilize at current levels for 2023 and H1 2024, before recovering to pre-COVID levels in 2025.
Cancels should peak at 70% in 2023, many of which will occur near 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 2024/2025.
Either by developers’ choice or by lack of available financing, many projects will be delayed and/or aborted. This will result in a 40% decrease in construction starts in 2024. This should keep inventories under control.
Pre-sales and deliveries should return to pre-COVID levels in 2025 (or higher due to pent-up demand).
Prior to COVID, annual pre-sales were around 180,00 units but surged to 227,000 units in 2021. El Dorado Capital Advisors believes annual pre-sales will decrease to 90,000 units in 2023, 140,000 in 2024 and recover to 180,000+ in 2025.
Since the COVID surge in 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 34%.
Higher inflation (11%) is increasing development costs while higher minimum wage (16%) is increasing revenues, particularly in VIS units that are indexed directly to minimum wage. Units at fixed prices (Non-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.
With high interest rates and weakened sales, many smaller developers are slipping into default on their debt. El Dorado Capital Advisors expects a consolidation of housing developers with the very best developers gaining market share.
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.
Office
Overall, office vacancies have not spiked significantly post-COVID. In fact, net absorption has been positive and rents are up 6.3% YTD in Bogota and 13.1% YTD in Medellin. The office market has been helped by a growing presence of BPO tenants. With new suppply down 70%, expect vacancies to continue to decrease. Compared to the rest of North America, physical occupancy is very high with nearly all employees working 3+ days in the office.
Vacancies (Bogota 10.6%, Medellin 8.0%) compare favourably to regional peers (Mexico City 23.3%, São Paulo 25.6%, Rio De Janeiro 36.4%) and international markets (New York 16.7%, Toronto 15.8%).
Vacancies in leased-up buildings remains low (<5%) with most of the vacancy concentrated in buildings delivered in 2020-2023. El Dorado Capital Advisors expects that, unusual for Colombia, significant tenant improvements and rent concessions will be required to lease up this space.
As most rents are CPI linked (ususally CPI+1%), in-place rents and NOI will increase 10-15% in 2023. Such high NOI growth and low vacancy is a rarety in office markets. All this during a period of low business confidence, high interest rates and high political uncertainty.
Due to the pullback in financing sources for real estate funds, El Dorado Capital Advisors expects a slew of assets coming to market in 2023/2024 with the effect of putting upward pressure on cap rates and discount rates. If so, it will be difficult for appraisers to ignore these sales comparables and may lead to devaluations of existing fund assets.
Office cap rates widened slightly to 7.5%-9.0% from 7.5%-8.5%. El Dorado Capital Advisors expects cap rates to increase to 8.0%-9.5%.
Most office tenants have long-term leases with contractual annual rent escalations (>CPI). Tenants generally pay their own improvements.
Industrial
While benefitting from historially low vacancy rates and positive absorption, new demand has waned in 2023 due to uncertainty, as companies postpone decision-making.
Colombia’s industrial market did not experience the spike in rental rates typical of many developed markets. Since 2018, average market rental rates increased only 12%, not even keeping up with inflation, 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.
Most industrial tenants have long-term leases with contractual annual rent escalations (>CPI). Tenants generally pay their own improvements.
Retail
Overall, vacancy remains healthy across all markets, although rental rates have decreased slightly in Barranquilla and Cali. Colombia’s retail sales recovered strongly after COVID but have weakened in recent months as interest rates increased.
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. It appears that condominium shopping centers are experiencing higher vacancies than single-owner shopping centers as the disparate owners are less able to act in the best interests of the shopping center.
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%. El Dorado Advisors expects cap rates to increase to 8.0%-9.5%.
Most retail 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 16% (33% 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 foresees pent up demand fueling a strong real estate recovery in 2025-2027 once interest rates recede and investor confidence returns.
Conclusion
Despite headwinds, commercial properties are performing well but may be at risk of devaluation. Residential development will continue to suffer through 2024 but we expect a strong rebound after 2025. 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.
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