Ernesto – Father
Ernesto starts a business in 1999 with a group of partners. The partners have all worked for other developers for about ten years. The team is in business for 7 years and then the market really starts to pick up. Launches increase 50% in 2007. The group is highly skilled, buys land correctly, sells at the appropriate sales speed to maximize profits, and manages the construction and marketing cost much better than most of its peers.
The company becomes one of the largest residential developers in Brazil. As a result, the company is sold to a larger firm in 2008, receives payment in cash and stock, and the partners set up a private investment company/family office.
Caio – Son
Ernesto has a son, Caio, who likes the real estate development business. He watched Ernesto and his father’s partners while growing up in the late 1990s and early 2000s and worked at the company during this time. Upon his father’s sale of the business, Caio convinces Ernesto to back Caio, against Ernesto’s desire, to start a new development company.
This company has excellent resources, both capital and human, and quickly builds a great land bank and begins the same execution path of the original founder’s company. It follows a similar pattern of rolling profits back in and building an extremely high-quality land bank. In 2012, all is on track for a record year in 2015. The land bank has excellent sites and in 2015 the company should make enough profits to create another round of “life-changing money.”
The Downturn
However, in 2014/2015 the momentum of the market slows significantly. The company has a tremendous land bank but the cash flow is now severely constrained due to low sales. As some lands were purchased on sales assumptions based on the market in 2011 and 2012, there is significant mispricing and the margins are just not there. This was not the son’s expectation upon starting the business. In fact, there had never been a downturn of similar scale and scope since Ernesto started the first business in 1999. Caio’s dream of a large exit or a huge pile of cash via execution of exits of his significant land bank is deferred.
This story is the evolution of an excellent investment opportunity in São Paulo. High quality developers did not stop their operations, which is extremely difficult to do, and as a result often reached scale at the absolute wrong time. This does not mean that they are not top-tier developers; in fact, in many cases they are excellent. However, as the market started to change, their engine was already moving and they simply did not have the time to correct.
Now What? Developer Re-start Finance
While Ernesto and Caio may not have stopped their engine in time, the team clearly understands the current market opportunity. The developer sees areas of micro demand and specific projects that are selling well even in this environment. These projects have the following characteristics: one, usually in a neighborhood that has secular demand (either an aspirational neighborhood or a neighborhood that is inter-generationally attractive); two, core demand of a particular product type – for example, some areas have a large number of studios and one bedroom while the demand for sale is in two bedroom product; and three, pricing must be attractive relative to other projects. Even in today’s market, if the product is right, and the price is right, the demand is there. It is a matter of having the adjusted market-matching product, which means the price that makes sense and project/architecture/size of unit that has strong demand at the moment in that neighborhood. Our target developer, Caio and Ernesto, has a land bank in these areas.
Normally, this type of high-quality developer with generational experience would either negotiate very hard to limit investor profits or would fund all of their work with close family and friends or their own capital. However, now this developer has to choose different options. Due to the downturn, he must raise capital on terms he would have never accepted before and, therefore, one can negotiate to enter the highest return projects (the crown jewels) at a price that would have been unthinkable before. This developer has to start over with a new capital partner to restart the business or he will wind down his operation and sell his land bank at an unsuitable time.
The investment opportunity is to selectively work with these top-tier developers at the peak of investor negotiation leverage. While not an easy pill to swallow, the smart developers will take this opportunity to work with fresh capital to live to see another day.
While we will discuss specific economics in our case study later in the document, an investor can price its appetite to invest with reduced risk at a 25%+ nominal IRR based on conservative sale assumptions and actual current market comparables.
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