Latin American Real Estate Markets: Are they immune to the US Credit Crunch Crisis? Particular Focus: Case of Mexico By: Luis F.

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1 Latin American Real Estate Markets: Are they immune to the US Credit Crunch Crisis? Particular Focus: Case of Mexico By: Luis F. Moreno Treviño 1 All sectors of the Latin American real estate market are growing. Consumers are driving the economic activity in the region and motivating real estate developers to build new shopping malls, housing projects, hotels and offices. Strong capital flows and increasing population growth are fueling investment. Economic stability and positive internal indicators have motivated investors to take advantage of new opportunities in all real estate sectors, including industrial, commercial, residential, retail and hospitality. The growth of demand in Mexican real estate, as well as that for Argentina and Brazil -as largest economies in Latin America- is correlated with high Gross Domestic Product ( GDP ) growth rates. According to the International Monetary Fund, from 2004 to 2006, the GDP of each of such countries has generally increased at a higher rate than in other developed countries, such as the United States of America, Britain and France from 2004 to , and this trend has been forecast to continue over the next few years. According to the Economist.com, the annual real GDP growth rate of Argentina, Brazil and Mexico is expected to outpace that of the US, Britain and France for the next five years. What differences should investors be aware of when deciding to invest in real estate in Latin America? (1) Efficient Governmental Social Institutions for housing assistance. Argentina Brazil Mexico (2) Pro tenant legislation. (3) Pro landlord legislation. (4) Efficient foreclosure on Mortgages. (5) Strong financing and banking domestic institutions. With its large and growing population, strengthening economies and increasing affluence, Latin America is emerging as an alternative investment market to the US and Europe. Surprisingly, economic size does not correspond to the size of the real estate market. Although Argentina, Brazil and Mexico are growing and flourishing economies, real estate investment depends on whether such markets offer the required legal safeguards for their investments, available 1 Luis F. Moreno is a Partner at Haynes & Boone, LLP, and is managing partner for the Firm s Mexico City Office, in addition to heading its real estate practice. Mr. Moreno is immediate past Chair of the Section of Real Estate Law of the International Bar Association, and currently serves as Chair of the Committee on Foreign Investment in Real Estate of the RPPT Section of the American Bar Association. More information on Mr. Moreno can be found at his firm s webpage ( 2 International Monetary Fund, World Economic Outlook Database, October 2007.

2 financing schemes and readily accessible means of foreclosing over collateral, laws governing leases, and governmental assistance. (1) Efficient Governmental Social Institutions for housing assistance. The decentralization of the Argentina FONAVI (Spanish acronym for the National Housing Fund) provides a good illustration of the shallow success that decentralization can have when responding primarily to political considerations rather than to the desire to improve service provision and the structure of governance in general. In Brazil, there are several governmental initiatives to develop housing assistance in order to support the implementation, monitoring, and evaluation of the Government reform program. Mexico has the best scenario with the INFONAVIT, which pushed a decade-long modernization drive into high gear to speed up lending and reach more working-class families. Specialized mortgage lenders had stepped into the breach, working with government funds. Now, as the banks look for a way to expand the market, they are buying these lenders - along with their expertise in administering loans to middle- and working-class customers - and signing on to co-financing programs with INFONAVIT. (2) (3) Different Legal Scenarios. Even when Argentina, Brazil and Mexico are all civil law rooted countries, legislation governing real estate may differ quite a bit amongst them. Now, let s take the example of Brazil. In Brazil, tenants must make sure that their contract is registered in the real estate registry office, due to the possibility of the property being sold while it is still being leased. If not registered, the new buyer will not be obligated to honor the lease agreement, and may give the tenant only 90 days notice to relinquish the property. This is not the case in Mexico, because leases run with land. That is, if the owner of land sells the real estate, such property will be encumbered by that particular lease, and the new owner of the land needs to abide by its terms until the lease expires. Notwithstanding, Mexican law favors the tenant, and it is difficult for the landlords to evict tenants, although procedural law has changed and such process now takes half of the time that is used to. In Argentina, a lessee can leave the lease after six months of rent, with little penalties to pay (one month and a half of monthly rent in case of leaving after the six months period but prior to one year, and only a month if after a year). This, of course, scares away from Argentina investors which collateralize their investment with cash flows deriving from leases. In Mexico, leases may be agreed up to 10, 15 or 20 years in some cases, depending of the type of property being leased. These leases are binding for that period of time and usually carry on with large penalties should the lessee decide to walk away from the lease. (4) Mortgages. In Argentina, mortgages are not a real alternative. This has been true since their latest economic crisis during years 2000 and Legislation is currently in effect, which prohibits banks or financial institutions to foreclose on mortgages obtained on houses from 2001 to This, of course, has staled development of an MBS market. The Brazilian mortgage market is still very immature. Currently, foreigners cannot obtain mortgages. This has made buyers to usually arrange alternative financing in both Argentina and Brazil. This is not the case for Mexico. In Mexico, a lender, whether domestic or foreign, may obtain a mortgage as part of

3 its collateral package. In addition, guaranty trusts have been evolving quite well and are now the preferred vehicles to issue either RMBS or CMBS. (5) Strong financial system. It is very common for foreign investors to seek local joint venture partners who can share the risks of developing or acquiring properties and deal with specific needs such as finding qualified labor, contractors, and legal advisors. While foreign investors continue to face challenges in entering Latin America, those who conduct thorough due diligence, find the right local partners, and develop a solid understanding of the risks and opportunities which are inherent to any such particular market, are likely to collect much higher returns than those that they would otherwise obtain in their domestic markets. The financing environment can present challenges as well. Because of the high costs of bank financing in Latin America, the spreads between investors capital costs and their returns on investment are usually narrower than in the US or Europe. As such, obtaining local financing is less attractive, leading investors to seek capital through international institutions which, in turn, require due diligence and underwriting procedures commensurate with those observed in more developed markets. With more robust economic fundamentals and higher levels of foreign reserves, larger countries such as Mexico, Brazil and Argentina are no longer as vulnerable to an American downturn as they used to be in the past. Despite the geographical proximity of the two countries Mexico and the US-, there are significant differences in the characteristics and stage of development of the housing markets in Latin America and the US, that make the Latin American market likely to be resilient to the problems in the US housing industry. This, considering, for example, that in Mexico there is no such thing as a sub prime market, as such market is understood in the US or Great Britain. Is Latin America immune to US Subprime viruses? While the U.S. subprime crisis is still facing severe complications, Latin America's real estate sector is experiencing continued strong demand, helped by record investments, growing economies and years of pent-up demand for new property. This, I believe, has to do with the fact that Latin American corporations and banks, managed funds, insurance companies, and other types of financial institutions, hold almost no assets of these type. In addition, U.S. sub prime exposure has been limited because of the dynamics of the Latin American market, local regulatory requirements, and cautious risk management practices. More specifically, the region was never overexposed in the mortgage sector or subprime market, and therefore should not feel the impact of the US credit crunch. As we mentioned, Latin American nations are experiencing their biggest growth rates in years and have strengthened their economic fundamentals: Debt levels are low, existing housing international reserves are high, there is no bubble in housing, and many countries currently run trade surpluses. However, no country can be guaranteed immunity from a global cyclical downturn. Thus, if the U.S. market does not correct itself and stabilize soon, the Latin American market could face a downward trend.

4 But what is going on in Mexico? (1) FIBRAS: a failed attempt of importing REITS into Mexico. Various changes have been made to FIBRAS since their introduction. Despite those changes, there still are no FIBRAS in the Mexican market. One might argue they were born prematurely four years ago, and are now ready to be taken out of the incubator. But this is not precisely the case. As we know, an increasing number of US real estate funds, developers and trusts have turned to include Mexican real estate in their portfolios, as well as domestic and cross-border transactions of varying degrees of complexity, involving Mexican real estate backed up securitizations (including resort properties and prime office buildings). Over the last few years, Mexican real estate financing and development projects have become increasingly common and attractive to a much wider investor base. With such growth, real estate assets have become the base for the building up of the securitizations market in Mexico, and have thus prompted the introduction in Mexico of the so called real estate investment trusts, known as FIBRAS (Fideicomisos de Infraestructura y Bienes Raíces). The main purpose of FIBRAS is to obtain funds from the market, by means of the issuance of Certificados de Participación, or any other type of security. The concept is very similar to that of Real Estate Investment Trusts (REITs), in the United States and Canada. Its sole activities are related to construction or acquisition of real estate destined for sale and/or rent, and cash flow management deriving from those rents. For the typical investor, it is a structure that provides the opportunity to participate in the ownership or rent of real estate by offering periodic payments (dividends-rents) and, at the same time, it affords them the possibility of appreciating their value (added value-capital gains). FIBRAS main business purpose needs to be (i) the construction or acquisition of properties which are destined for their lease or sale, in the latter case after them having been leased for at least one year; or (ii) the acquisition of intangible rights that entitle their holders to collect rents in connection with the underlying properties. Relevant to FIBRAS is the fact that their potential to become a new real estate instrument will complement financing for the construction of housing, which constitutes a significant challenge, in addition to the fact that it could play an important role in financing under the concession scheme with government based housing entities such as SHF (Spanish acronym for Federal Mortgage Bureau), FOVISSSTE (Spanish acronym for the Housing Fund for the Institute of Social Security Serving the Workers of the State) and INFONAVIT (Spanish acronym for National Workers Housing Fund Institute). It must be emphasized that these institutions could use financial resources deriving from FIBRAS in the future, in order to complement their credit activities.

5 Even when still non existing in the market, this would be an ideal time to list FIBRAS 3 with the stock market because (1) multiples at which shares on the market are quoted are nowadays highly attractive, due to excess liquidity and to a lack of assets with a suitable dividend structure; (2) this type of security is ready to be acquired by institutional, local and foreign investors (pension funds, insurers, investment companies and SIEFORES (Spanish acronym for Investment Companies that Specialize in Retirement Funds); (3) discounts on this type of security are significant on shares listed and maintained by regulatory agencies; (4) being afforded several tax benefits, and (5) a new investment instrument in the market. (2) What lies ahead for Mexico? An increasing number of entities are becoming apt in assessing the risk of Mexican real estate transactions. As traditional niches tend to commoditize and hence offer lower yields, some financial entities work at developing competencies in fields offering better perspectives. Some of those fields include 4 : Commercial mortgage backed securitizations ( CMBS ). Financial entities have learned that funding the development of projects, originating portfolios, and then structuring a commercial mortgage backed securitization on a rolling basis is the preferred strategy for real estate financing in order to maximize the return on investment. As CMBS begins to materialize and a stable and hungry capital markets sector continues to evolve, CMBS in Mexico appear to be an inevitable next step in the industry. Secondary home securitization. Although the secondary home for foreign borrower market is not as mature as the commercial real estate segment, the binational nature of secondary mortgages facilities, their ability of being securitized in cross border transactions (i.e. secondary homes could be securitized in Mexico, the United States and/or in both countries), and the success of domestic mortgage based securitizations suggest that many investors will be looking at this market as a viable alternative, at least for origination funding. Bridge loans. As competition and the number of players increase, some lenders not traditionally willing to take non stabilized project risks may have to resort to construction or other type of bridge development funding (i.e. funding of project commercialization costs, receivable financing or leveraged buyouts) as vehicles for creating or preserving client loyalty. Hospitality industry. Hospitality industry continues to expand as foreign and domestic tourism flow keeps growing. Funding of stable and developing destination projects (i.e. ecotourism or city tourism projects not that vulnerable to weather conditions or economic turmoil in a specific country) and/or projects in unconventional properties (i.e. golf courses, theme parks) will become an increasingly attractive opportunity for higher yields. 3 Jorge Ávalos Carpinteyro. FIBRAS a la Vanguardia. Inmobiliarie Magazine, October 1st, Renato Martínez Quezada. Fuentes extranjeras de financiamientos para proyectos inmobiliarios en México. Inmobiliarie Magazine, January, 29, 2008.

6 FIBRAS. As mentioned above, the liquidity of the market will force real estate investment trusts to evolve from tax and market perspectives so that they can become a real and efficient tool for funneling the liquidity of capital markets into the Mexican real estate market. It is not a matter of if, but of when will it happen. Structured debt. Mezzanine loans (for development), revolvers, second mortgages and acquisition lines are rarely available and the market will probably push towards financing entities willing to provide funding for such type of needs. The future still poses many challenges for the availability of funding conditions matching those of developed economies in Mexico. However, as long as the economic returns for those daring to invest and develop the necessary skills to overcome any hurdles are there, more and more investors will divest their liquid funds from low yield generating markets to a market that has proven profitable for many in a continued and stable manner. Conclusion. Real Estate Finance in Latin America is booming. Growth, economic stability, and financial innovation are spurring investment in Real Estate throughout Latin America. An interesting new trend is that worldwide financiers are looking at seizing the positive inertia of the Mexican real estate sector and are actively participating in loans and testing for new opportunities, therefore assuring a brilliant and profitable future for the industry in Mexico.