Operating Cash Generation And Margins Should Gradually Improve By The End Of 2024

After rising costs and persistently high interest rates between 2021 and 2023, mid- and high-tier rated homebuilders' margins dropped almost 4 percentage points in 2022, with margins in 2023 still below pre-pandemic levels. Work stoppages during the pandemic and supply-chain disruptions lifted construction costs and delayed project completions. In addition, projects launched between 2021 and 2023 were recognized on balance sheets in the first half of 2024.

We now expect margins to continue to rebound among mid- and high-tier homebuilders in the next few years. However, we currently expect improvements at a slower pace than previously forecasted, given macroeconomic risks stemming from higher inflation and still high interest rates in Brazil. Additionally, the National Index of Construction Cost (INCC-M) points to a slight acceleration going forward, given the accumulated rate of 4.84% in the 12 months ended August 2024 (versus 3.06% and 11.40% in the same periods of 2023 and 2022, respectively). Although we believe most of the rated companies in the sector have some cushion on their balance sheets to accommodate potential inflationary hikes, we believe that a significant surge of this index could erode profit margins of low-tier developers.

Mid- and high-tier builders still reported negative operating cash flow (OCF) in the first half of 2024 because of cash mismatches, which are compensated only once the projects are delivered. Therefore, OCF should turn positive mainly in the second half of the year, increasing gradually over the years given the consistent housing start and sales pace. Compared with previous forecasts, however, OCF is taking longer to recover. This is because of project delivery delays due to supply-chain disruptions in the past three years. In 2025, we expect an average OCF among the rated developers to rise to R$169 million, compared with R$24 million in 2024.

Operating Improvements Likely To Help Reduce Leverage Amid Expected Debt Refinancing In 2025

Approximately 40% of the reported debt among the rated mid- and high-tier homebuilders consist of debentures and other corporate debt instruments. The remaining portion is related to construction credit lines, which are also linked to unit transfers to banks through real estate credits.

Out of the total debt outstanding among these entities, around 24% (about R$1 billion) will mature in 2025. Considering the expected cash generation starting in 2025 stemming from the higher number of project deliveries, and cash-flow benefits from new starts under the MCMV program and associative credit, we believe that these companies will use cash to reduce leverage.

However, a significant portion of their debt will likely need refinancing, prompting homebuilders to tap capital markets and financing from banks. We don't view this as a major credit risk as we believe the depth of the Brazilian capital and banking markets would be sufficient to cover those needs for entities with solid credit fundamentals. In addition, due to likely growth in housing starts, despite the slower pace than in 2023, we believe homebuilders will seek financing from capital markets to execute projects and acquire land. Therefore, given better operating metrics for the abovementioned reasons, we expect companies to gradually reduce their leverage, resulting in average FFO to adjusted debt of 19% in 2024 and 26% in 2025, and adjusted debt to capital of 43% in 2024 and 39% in 2025. These ratios are in comparison with the 11% and 43% averages, respectively, in 2023.

High Interest Rates Chip Away At Primary Source Of Mortgage Funding

In Brazil, banks are required to use 65% of special savings deposits, known as SBPE (Sistema Brasileiro de Poupança e Empréstimo, the Brazilian savings and loan system) for mortgage lending due to the lack of long-term funding alternatives. However, since 2021, savings deposits balances have stagnated due to persistently high interest rates, which make savings account returns less competitive than other bank and fixed-income products. As of May 2024, total savings deposits balance was roughly R$1 trillion, a 2% decrease from its peak at the end of 2021. Residential mortgages, on the other hand, grew on average 12% per year since 2021.

In response, in order to diversify mortgage funding sources, banks have been relying on issuance of LCIs or securitizations. LCIs have grown 2.5x since 2021, reaching R$360 billion as of May 2024. We expect this trend to continue in the following years, as interest rates should continue to depress savings deposit growth. Moreover, banks have been focusing on secured lending, including mortgages, due to the rise in delinquency of unsecured loans since 2022. We expect the share of mortgages, as a percentage of total loans, to remain relatively stable at about 18%, and Caixa Economica Federal (BB/Stable/B) to maintain its dominance in this lending segment with about 68% of total mortgages. We believe a tighter access to SBPE-funded mortgages and higher interest rates could pose risks to the homebuilder sector's financial health and stability.

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MCMV Program Changes To Increase Housing Starts In 2024

Housing starts among the mid- to high-tier developers jumped approximately 11% in 2023, while net sales by 24%. Despite the slowdown in SBPE-based home financing, which potentially weakens builders' pricing power, the drop in inflation accelerated the sales pace. This has expanded the pool of potential homebuyers.

In addition, we expect mid- to high-tier developers to engage in construction of low-tier houses. This shift is largely due to modifications to the MCMV program. For instance, in July 2023, the federal government raised the price ceiling for homes sold under the program's Bracket 3 from R$264,000 to R$350,000, and expanded housing subsidies. We believe these changes will increase access to the MCMV program for potential homebuyers. Simultaneously, these changes are likely to raise the profitability of low-tier homes sold through the program.

Therefore, we expect housing starts to rise to high-single digits in 2024 and 2025. However, high basic interest rates, squeezing available credit for home buying, could pose risks for the mid- to high-tier builders. This is particularly the case during the transfer phase, where the increase in initial mortgage payments may be financing installments may not align with buyers' gross monthly incomes, potentially leading to increased sales cancellations and delays in cash-flow recovery.

However, the mid- to high-tier developers' participation in the program requires a certain level of expertise to ensure project profitability, such as navigating the bureaucracy involved in applying for the program. Moreover, given the lack of inflation adjustment after the transfer of newly-built units to banks, the high speed of construction, and the high cost of land and labor pose difficulties in maximizing the profitability of each project and reducing exposure to potential inflationary spikes.

For a greater detail on the MCMV program, see "Recent Developments Signal Favorable Trends For Brazilian Homebuilders", published July 25, 2023, and on builders of affordable housing, see "Brazilian Low- To Mid-Tier Homebuilders Continue To Thrive Amid Government Housing Program Changes And Rising Demand", published July 15, 2024.

Real Estate Boom In São Paulo

Roughly 64% of the rated high- and mid-tier homebuilders' projects are in the city of São Paulo, given high demand for housing there and residents' higher incomes than in other parts of the country. In June 2024, the city hall approved modifications in the calculation of grants required from homebuilders, which seek to develop projects exceeding the construction area limits set by the city's Master Plan, as per the revised zoning law. The revision has also changed the total residential construction capacity in areas near public transportation, enabling developers to build residential high-rises as long as they dedicate part of new projects to low-tier projects.

In addition, homebuilders can now increase their construction potential area by 20% if they offer 20% of their land values to FUNDURB (an urban development fund of São Paulo), and receive a 20% discount in required grants if new units incorporate sustainability-linked items such as alternate energy use.

All of these changes reduce incentives for builders to develop non-residential projects, and we expect that the rated high- and mid-tier homebuilders will be able to increase their average potential sales value (PSV) with existing land possessions. Of the companies we analyze, five primarily operate in São Paulo. We project that their combined PSV will total R$7.4 billion in 2024 and R$8.3 billion in 2025, compared with R$7.2 billion in 2023.

Limited Land Availability In Large Cities May Restrict Expansion Of Homebuilders

The majority of the rated homebuilders operate primarily in large urban centers such as São Paulo, given resilient housing demand, a wider pool of high-income potential homebuyers, and a larger labor force, which will contribute to solid growth pace in the next few years. However, many high- and mid-tier homebuilders compete with each other to acquire land for future growth, as affordable housing developers have pursued land acquisitions in suburban areas.

Moreover, homebuilders can burn cash to acquire attractive pieces of land. As an alternative, we believe homebuilders will prioritize physical and financial swaps with current landowners. Companies with stronger negotiation positions are likely to weather better periods of limited land availability.

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Regulatory Changes Facilitate Capital Raising At More Attractive Rates

The introduction of Resolution CMN 5,118 on Feb. 1, 2024, restricted the eligible collateral for the issuance of Real Estate Receivables Certificates (CRIs). The primary objective of this change is to prioritize the allocation of funds raised through CRIs to companies in the real state sector. As a result, the pool of potential issuers has significantly narrowed. In our view, this should reduce competition for financing, enabling developers to raise capital at more attractive rates.

The Luxury Residential Real Estate Market Offers Challenges And Unique Opportunities

Despite high-end projects offering greater profitability due to the transfer of inflation-fueled costs from inputs into prices, and larger cash inflow during the construction period, the luxury housing segment caters to more demanding clients in terms of project location, unique features, construction quality, and floor plan offerings, resulting in high competition. In an effort to differentiate themselves from their competitors, the high-end builders have launched projects in partnership with luxury brands to enhance their portfolios.

The Tax Reform May Take A Toll On Homebuilders In The Long Term

In July 2024, Brazil's Congress approved the first reading of the tax reform. Currently, the total tax burden on the housing industry varies between 6.4% and 8.0%, consisting of PIS and COFINS (calculated as a percentage of gross revenues of homebuilders). The proposed overhaul will create two new tax categories, replacing the existing ones--the Goods and Services Tax (IBS) and a Goods and Services Contribution (CBS)--which will fall on the homebuilder sector as well as others. The total tax burden on the sector is expected to reach around 27%. Although the approved text includes discounts for developers (up to 40% of the total tax amount), the overall tax burden will likely be onerous on the rated mid- and high-tier homebuilders, potentially increasing the price of homes and reducing demand. The tax reform is expected to be fully implemented in 2033, and it can be revised in the next few years.