How You Can Profit from a New Middle Class

Monday, October 25, 2010

Dear Reader,

Brazil has energy, food, water and manufacturing resources in abundance. It is emerging as one of the world’s economic powerhouses. Brazil is now defined as a “middle class” country with 53% of the population falling into this bracket. This new middle class wants to move into a shiny new condo or house.

The Brazilian government wants to help them do that, through a program called “Minha Casa, Minha Vida”. This translates to “My House, My Life” and is making home ownership affordable to Brazil’s lower and middle classes. The program has 60 billion reals ($35.4 billion) in the kitty. The program, through a system of subsidies and cheap loans, will help one million Brazilians become homeowners this year alone.

This is great news if you are a low or middle income earning Brazilian…but where’s the opportunity for us foreign investors?

Firstly, these subsidies will greatly increase demand from end-users. Expect supply shortages, particularly in that all-important middle bracket, to emerge. This will have a ripple impact throughout the real estate market.

Foreign buyers can’t avail of the subsidized loans. However, we may be able to buy qualifying units pre-construction and sell them on completion to an end-user who can avail of the subsidy. Alternatively, we might just want to sit on the unit, earn rent and watch it appreciate as Brazil’s middle class becomes wealthier.

Finally, we could just invest or JV (joint venture) with a developer who is doing a project targeted at this market. This is where I see the biggest opportunity.

Brazilian developers (even the big ones) prefer to JV with finance partners rather than borrow from banks. Borrowing money from banks in Brazil is expensive and developers are conservative. They are always on the lookout for investors.

One of my contacts on the ground in Brazil is doing his own small project. I have been picking his brain about the whys and hows of every decision he has made.

Developing housing for Brazil’s middle class was previously restricted to those with deep pockets. No mortgage finance was available. So, not only did the developer need to fund construction but they also needed to provide finance for their buyers. Buyers would pay for their home over 10 years, via low monthly instalments.

This has changed. Today, with the Minha Casa Minha Vida program, 30-year, fixed-rate mortgages are available to Brazilian buyers. The developer can now get paid in full as soon as the home is delivered. This has created opportunity for the smaller guys.

Today, the 14 homes my friend is building are 840 square feet on two stories with three bedrooms and two bathrooms. They are targeted at young families or couples. Importantly, they will have scope for expansion from the get-go. You are selling to a generation who aspire to something more. They are already thinking about taking their next step up the ladder.

These homes have a private garden and space to extend the home. This is already built into the plans. There is enough space for a swimming pool in the backyard, or the owners could build a garage, or an extra room. This upward mobility is an important part of the offering.

My developer friend bought this land for 130,000 reals. It took nearly eight months and 35,000 reals to clear the title and have it divided into 14 individual plots. This land was cheap because there were issues with the title he needed to clean up. He knew he would be able to do this, so he was happy to take it on.

You, most likely, would prefer to go for a clean, ready-to-go plot. Figure on paying 15,000 reals ($9,000) per individual plot for land with nothing tricky in the title. Buy land like this and you could be breaking ground on construction in two months.

Making this business work is all about the speed at which you can deliver units and move on. His numbers show an annualized ROI of around 30%. He has done better (almost 40%) in larger plots for 40 or 50 homes. The larger the plot, the cheaper the land on a per-plot basis. Each time I speak with him he focuses in on the relationship between delivery timelines and ROI. It makes sense…

“Speed is essential. We can make 30% each time we turn around and we can go from buying the land to selling the houses in eight months. Our money turns around 1.5 times a year at this rate. That’s three times every two years. 90% in two years sounds like an amazing deal. And it is. That’s why everyone is doing it.”

The model does seem to stack up once you don’t bite off more than you can chew and your processes are streamlined. To maximize your ROI you need to move quickly to:
1) Close on land
2) Get your permits
3) Build and sell
4) Close on home and mortgage
5) Get paid and start again

My friend takes four months to build, with an additional four months for each project, to cover:
- 45 days to get the mortgage for the buyer
- Two months to get building permits and licenses
- A two-week contingency

Allowing for only a two-week contingency is tight. That’s why you need to have your processes nailed and work with the best partners to get this type of ROI.

He is working on a model to reduce the timeliness and increase ROI. He thinks he can do this by overlapping the tail end of one project with the start of the next project. This can be done without a requirement for much additional capital.

He is excited about this…

“It’s possible to do it even faster. When we buy a larger plot of land, let’s say an entire city block (110 yards by 110 yards – that’s my self-imposed limit not to compete with the big guys). So, in a city block I can fit about 55 single homes (or 76 duplexes.) I start by getting licenses and permits for all 55 of them but just invest the money to build 10. After the first 10 are delivered and the money comes in, we reinvest the money to make 10 or 15 more and we already have all permits so it’s just 5.5 months and we can go around again.”

As you see above, he isn’t trying to compete with the big boys for large pieces of land. I’m glad to hear this. He’s right to focus on his own niche. He goes on…

“In this type of project, the leverage can make us reach very high ROI because the initial investment isn’t big and you can go around several times in a very short time. In the example I gave, we only invested the price of the land and the cost for 10 houses. Then, after 4 or 5 rounds we finished the entire block. We made 100% of the profit in about 2 years but only invested about a quarter of the cost at the start.”

This model and these numbers are manageable.

Ronan McMahon

P.S.: Members of my Real Estate Trend Alert group got access to my friend’s pro formas a few weeks back. If you’d like access to these, and more details on this opportunity, click here to find out more about RETA.