BRAZIL By Débora Morilha

With South America's largest economy and population, Brazil has the region's greatest potential for a developing publicly traded real estate industry. At the end of 2004, Brazil had more than 186 million residents and GDP growth of 5.1 percent reaching $1.4 trillion. Those numbers were enough to attract the attention of REIT pioneer Sam Zell's Equity International Properties Ltd., which invested $50 million in Brazilian property company Gafisa, SA in June 2005. Equity International is not alone in exploring opportunities in this South American hotspot.

While Brazil's economy is well diversified, most of the economic activity, especially in the service and industrial sectors, is concentrated in the southeastern region within the São Paulo and Rio de Janeiro metropolitan areas. The two cities boast the country's highest office building stock, with more than 9 million square meters of leaseable area in São Paulo and 4 million square meters in Rio de Janeiro.

The quality of commercial real estate assets has improved considerably over the last few years. However, the market as a whole still presents signs of immaturity mainly in financing vehicles and lease enforcement laws. Prudential Real Estate Investors estimates the size of the high-grade commercial real estate market in Brazil at $497 billion, which makes it the largest in South America.

In Brazil there exists a structure, Fundos de Investimento Imobiliário (FIIs), that is referred to as a REIT, but it is mostly used as a special-purpose entity to own and operate independent property investments, and it is mostly funded with private capital. However, a more genuine REIT format for owning real estate, and funding it through the public capital markets, is expected to come to Brazil sooner rather than later.

FII were instituted in 1993 and regulated by the CVM (Brazilian Securities Commission). Despite their short history, they have evolved and are becoming increasingly consolidated.

The first Brazilian FIIs were privately owned and their shares were not publicly traded. The FIIs were used to fund new developments and as an exit strategy by developers. In this first phase, the main investors were pension funds that, in addition to placing long-term investment, were also required by government regulation to reduce their investment percentage in direct real estate. This scenario was beneficial for the booming of the fund industry. However, new government regulations inverted this trend stating that no single investor could own more than 20 percent of a single FII.

It wasn't until 1995 that the first FII began to trade publicly. As FIIs entered the retail market they attracted individual investors and the industry became more widespread through the actions of professional advisors and brokers.

In January 2003, the FII industry surpassed another barrier, launching the first IPO listed on the Bovespa (São Paulo Stock Exchange). Previously, FIIs had been traded somewhat inefficiently in the over-the-counter market, providing minimal credibility, liquidity and security to investors.

Presently, 64 FIIs operate in Brazil, and 14 of these trade their shares in the SOMA (Asset Market Operating Organization) and in the Bovespa. In 2004, the volume of FII trades increased by 700 percent at Bovespa, a clear indicator that the market is maturing, although the actual number of transactions remains low. Among other advantages, trading on the stock market assures fair prices, transparency of activities, and guaranteed settlement.

Despite these positive trends, some problems still hold back this segment from full take-off in Brazil, the dominant factor being high interest rates. As part of government policy to control inflation, the prime rate currently stands at 19.75 percent, a situation likely to continue in the short term and making it very difficult for FIIs to compete with funds that add on the prime rate.

S N A P S H O T

CAPITAL: Brasilia LAND AREA: 8,456,510 sq km POPULATION: 186.1 million (July 2005) POPULATION GROWTH RATE: 1.1% GROSS DOMESTIC PRODUCT (GDP): $492.3 billion (2003) GDP GROWTH RATE: -0.2% GDP PER CAPITA: $2,720 UNEMPLOYMENT RATE: 11.5% (2004) MAIN INDUSTRIES: Textiles, shoes, chemicals, cement, lumber, iron ore, tin, steel, aircraft, motor vehicles and parts, other machinery and equipment. CURRENCY: Real LANGUAGES: Portuguese Source: CIA's "The World Factbook" and the World Bank Group's "World Development Indicators Database."

What's Next For Brazilian FIIs?

The current challenge is to attract investors in this very competitive market where monetary policy and sustained high interest rates favor investments in other types of financial products. Nevertheless, long-term prospects are positive. The FII market is showing increased signs of consolidation and attracting the attention of Brazilian and international investors (as evidenced by Equity International's presence).

As a general rule, Brazilian FIIs are linked to very few real estate properties. According to Jones Lang LaSalle, approximately 65 percent of FIIs are associated with a single property or portion thereof, although funds are increasingly being launched in connection with multiple properties. This means that someone investing in a FII is actually investing in just one or a few actual buildings, whereas with a U.S. REIT an individual invests in a company holding dozens or hundreds of properties. As the Brazilian FII industry continues to become more consolidated, there is the possibility that funds would expand to broader portfolios of properties.