Optimism mounts that Brazil's economic recovery is at last gaining steam. This, along with the low borrowing costs and the current administration's economic policies, is encouraging companies to raise money to increase investment and refinance debt. Domestic homebuilders are taking advantage of these trends, given that demand for housing in Brazil remains intense, and which the federal housing program, Minha Casa, Minha Vida (MCMV), has been addressing for the past decade. However, the current administration has implemented several changes to the program, including tightening standards for disbursing funds and shrinking the pool of available funds. Meanwhile, demand for housing among low- and mid-income families is outstripping the current supply, despite the existence of the MCMV program, the likely rise in housing inventory this year, and mortgage financing schemes through savings deposits. To foster the housing sector's recovery, a state-owned lender is planning to launch several new mortgage products this year. Finally, competition among developers could increase, given that falling borrowing costs are driving up demand for mid- to higher-end homes. S&P Global Ratings is monitoring what impact these trends may have on homebuilders it rates.

The Government's Involvement In The Housing Sector

To address the chronic housing shortage in Brazil, the federal government established a housing subsidy program, MCMV. In the decade since its launch in 2009, the program delivered more than 6 million housing units with investments totaling more than R$500 billion (see chart below). The program provides cheap funding to developers to construct homes for low- and middle-income families. In addition, the program extends subsidized mortgages and subsidies to prospective homebuyers. It does so according to the four brackets, which are based on the families' annual income, home price ceilings, and mortgage rates.

One of the top priorities of the current administration that took office in January 2019 is to reduce bloated public spending. In that sense, the government made several changes to MCMV and plans to cut its funding, which represents 10% of the annual federal budget. Since January 2019, Caixa Econômica Federal (CEF), a public bank and the program's main funding agent for homebuilders and mortgages, has tightened standards for disbursing funds and transferring units to buyers. This has caused unscrupulous developers to exit the program because of several resulting problems, including unfinished units, subpar building methods, lack of amenities near the new construction, and mortgage defaults. As part of these changes, the government eliminated Bracket 1. Nonetheless, we're optimistic about the program's future prospects, given that CEF gauges its model to balance loan amounts and default levels, lending only to creditworthy borrowers and diminishing default rates.

Transfer of funds from CEF to the homebuilders for Brackets 1, 1.5, and 2 were frozen several times during 2019 and January 2020 due to subsidy cuts the current administration imposed, directly impacting the developers' cash flows. We expect the government to help steady the funding level, as it did at the end of 2019 through a provisional measure. Although we don't expect material impact on the rated companies with more robust balance sheet, we believe this may have major implications for smaller homebuilders that fully depend on CEF transfers to fund their costs.

In addition, to compensate for future cuts in the program's funding but continue stimulating the economy, the government enacted several regulatory changes last year. These include the wider use of the workers' severance fund (known by the Portuguese initials of FGTS) for such purposes. (FGTS is a monthly compulsory contribution made by the employer, on the employee's behalf, to a specific account registered under the employee's name in a government bank at 8% of the monthly salary. It's not a withholding or deduction from the employee's wages, but a cost fully paid and remitted by the company. The purpose of the fund is to provide employees an insurance under special conditions, such as retirement or dismissal without a just cause.) We're currently uncertain about the extent that budgetary and regulatory changes will affect the MCMV program in the long term. However, the federal multiannual budget for 2019–2022 allocates R$60 billion to build more than 500,000 housing units on annual basis. Therefore, we don't expect changes to MCMV, at least in the short term. Recently, there have been discussions to change the program's name and subsidies structure in 2020, while it will maintain a goal to provide 500,000 homes annually. In the meantime, the homebuilder sector currently estimates that it has capacity to supply 1 million units annually.

Homebuilders And MCMV

The share of homes that six homebuilders, which S&P Global Ratings rates, sell under the MCMV program varies. Construtora Tenda S/A (Tenda; brAA+/Stable/--) primarily builds home units that fall under the program's Bracket 2 (mid-tier homes), and it intends to expand its share of that segment. On the other hand, MRV Engenharia e Participacoes S.A. (MRV; brAAA/Stable/--) plans to raise the share of its home sales volume through the SBPE-funded mortgages to up to 30% in the next four years from only 5% in 2019, while shrinking the one through the MCMV program. Cyrela Brazil Realty S.A. Empreendimentos e Participacoes (Cyrela; global scale: BB-/Positive/--; national scale: brAAA/Stable/--), a major player in the mid- to high-end housing segment, generates about 20% of its revenues from the low- to mid-tier segments through its subsidiaries (Plano&Plano and Cury Empreendimentos Imobiliários Ltda.) and special-purpose entities. HM Engenharia e Construções S.A. (HM; brA-/Stable/--) sells 80% of its housing stock through MCMV, and Even Construtora e Incorporadora S.A. (Even; brAA/Stable/--) with some minor partnerships also develops units for the program. Tecnisa S.A. (brAA-/Stable/--) is the only developer we rate that doesn't have exposure to MCMV, building exclusively mid- and high-end houses.

In our view, MCMV will set ground for bigger and stronger developers to expand their share of the housing market. This is because these companies offer good quality housing stock, are usually more efficient in transferring units to CEF, and are more agile in adapting their products to homebuyers' shifting tastes. Additionally, they're able to issue domestic bonds at more attractive rates. Yet, most of these developers are limited by narrow geographic or product diversification, because their operations are mostly in the state of Sao Paulo and the country's southeastern region, the country's wealthiest area. Only MRV operates in most of Brazil's 26 states, while Tenda aims to expand its operations to 13 states from 9 currently.

We expect the six homebuilders' potential sales value (PSV) to reach over R$20 billion in 2020, a 30% increase compared to 2018, supporting our view that the major players will continue to invest in the lower-end housing segment despite the changes in MCMV. We forecast combined sales of R$18 billion in 2020, a 13% rise year over year, a slight improvement in average gross margins to 34% in 2019 and 2020, and strong cash conversion. We forecast the companies' funds from operations (FFO) to reach R$2 billion in 2020, up 35% from our 2019 forecast. The increase in launches matched by the increase in cash flow from operations (CFO) should result in relatively stable leverage metrics during the next two years with average CFO to debt of 15%-20% and debt to capital close to 40% in 2020. We also expect developers to benefit from low interest rates, enabling them to extending their average weighted debt maturities and decreasing the average borrowing costs. Cash flow generation remains the main barometer to watch because it would indicate any potential sign of a sector downturn. Ultimately, our stable outlook on all the national scale ratings on these developers incorporates these expectations.

The Industry Is Likely To Expand, While Competition Could Intensify

The uptick in Brazil's economic activity is spilling over into the housing industry. The latter expanded 4.4% in the third quarter of 2019 over the same period in 2018, the IMOB Index (real estate stock index tracked by the Brazilian exchange) reached an all-time high, and the volume of follow-on offers and new debt issuances, especially structured finance products, has risen in 2019. The Brazilian interbank deposit rates plunged to an all-time low of 4.5% on Dec. 11, 2019, from almost 14% at the end of 2016, providing an additional stimulus to the industry. As credit gets cheaper, upfront house payments become smaller and entice more families to buy homes.

The Brazilian Homebuilders Association (ABRAINC) estimates that a 1% drop in interest rates can make mid- and higher-tier homes affordable for up to 800,000 families, and entry-level starter homes for up to 2 million families. Furthermore, we have observed an inverse correlation between interest rates and unit sales in the past 10 years, leading to our expectations that the annual home sales will grow in 2020, reaching a pre-recession level.

The upswing in economic indicators is presenting more alternatives for homebuilders in meeting the substantial demand for housing. Mortgage rates for the mid- to high-end homes are now lower than those that MCMV offers. As a result, more homebuyers are turning to mortgages funded by the special consumer bank savings in the Brazilian System for Savings and Loans (known by its Portuguese initials as SBPE). Rates for mortgages through SBPE are based on a reference rate (Taxa de Referência [TR]) and inflation rate, enabling MCMV to disburse more mortgages to new homebuyers in the lower brackets. In addition, the falling mortgage rates are likely to raise demand for homes at MCMV's upper bracket and those that are more expensive. This would enable developers, such as MRV, Cyrela, Even, and HM--which deliver units under Bracket 3 -- to increase their market share at the expense of peers, such as Tenda, which focus on home in Bracket 2. However, some homebuilders, such as Tenda, will continue focusing on Bracket 2 units and are testing new technologies to improve construction methods.

Nevertheless, we will continue monitoring the rated developers' operating and financial performance. We expect their leverage to decrease slightly in the upcoming years, given that companies are extending their debt maturities and lowering borrowing costs through refinancing. The rising housing inventory is likely to consume cash. Therefore, we will track cash flow generation to see if the companies' finances remain healthy. Brazil's recession took a heavy toll on homebuilders amid falling demand for homes and tight financing conditions.

Housing Inventory Will Continue To Lag Demand, But Range Of Funding Sources Is Likely To Expand

Despite the recent uptick in the job creation, tax revenue, and increased business confidence, the housing shortage remains a substantial challenge for the government. According to its forecast, 1 million additional families with at least R$3,000 in monthly income will be formed by 2030, one-third of which will be eligible to apply for the MCMV program. In that regard, the country will continue to confront a massive housing shortage because the MCMV program and mortgage funding through FGTS are currently insufficient to meet the demand, while developers need a much wider access to financing.

In our view, capital markets could play a much larger role. We expect homebuilders to continue tapping the capital markets through follow-ons and other debt instruments. In the past 10 years, Brazilian homebuilders have issued more than R$15 billion in equity follow-on offers (R$3.5 billion alone in 2019) and more than R$52 billion in debt issuances (R$3.6 billion in 2019), which are often repackaged into Certificados de Recebíveis Imobiliários (CRIs) because they're tax-exempt for individual investors.

Given that issuances of CRIs soared 94% to R$15.8 billion 2019 over 2018, according to the Brazilian Financial and Capital Markets Association, we believe a similar trend will occur in 2020. As homebuilders look for new funding alternatives, the repackaging of their debt instruments into CRIs will remain attractive, as long as these instruments are tax-exempt for retail investors. In addition, as domestic interest rates have fallen, investors are more willing to take on more credit risk in search of higher yields. Therefore, appetite for CRIs, mainly backed by the homebuilders' repackaged securities, is rising among investors.

On the other hand, with a lower availability of MCMV funds for mortgage financing, we believe more homebuyers--eligible for MCMV's Bracket 3--may qualify for mortgages under the housing finance mechanism, Sistema Financeiro Habitacional (SFH). Savings deposits mainly fund these types of mortgages. Nevertheless, savings deposits' growth has been slower than that of mortgages because people are shifting their investments due to falling interest rates, and this trend will likely continue in the following years, in our view. Yet we believe the residential mortgage-backed securities (RMBS), which currently represent only a minor share of CRI issuances, could become a viable funding alternative for Brazil's mortgage lenders starting in 2020. CEF is planning to take the lead in the development of Brazil's RMBS market. The bank recently launched a mortgage product linked to inflation, which will likely attract more interest than the standard TR-linked mortgage from investors. CEF announced its intention to securitize at least 50% of its inflation-linked mortgage portfolio by March 2020, which has been growing rapidly since the August 2019 launch and totaled about R$4.4 billion at the end of 2019. In March 2020, CEF also intends to launch fixed-rate mortgages, which may also be targeted for securitization in the future.

Nevertheless, we believe that indexing mortgages to inflation comes with risks. Such mortgages amortize later than those linked to TR, and rising installments over time increase the risk of default. The installments of mortgages linked to IPCA are initially 35%-40% smaller than those of TR-linked mortgages, but they increase on a monthly basis in nominal terms, given that the loan amount is adjusted for inflation (see charts below). In addition, the high volatility of Brazil's economy increases the risk of a sudden rise in inflation, which could push up homeowners' debt burden and delinquencies, and weaken credit quality of securitized mortgages.

On the other hand, we believe the development of inflation-linked and fixed-rate mortgages will bolster the growth of Brazilian real estate market and mortgage lending in the short to medium term. While fixed-rate mortgages increase predictability of borrowers' debt service, the installments of mortgages linked to inflation are initially more affordable and are comparable to the cost of rent in some cities, which could make tenants more interested in acquiring their own property. Therefore, the recent innovations in the mortgage industry may boost homebuilders' sales growth and the real estate market in the following years.