The Rent-To-Own Model Could Completely Transform Latin America's Real Estate Markets

12 Apr 2014

A key current issue for many Latin America governments, real estate companies and people seeking housing is that the cost of owning quality homes is simply rising faster than the ability of people to pay for them. 

In Chile, housing price increases are easily outstripping general headline inflation rates and the percentage of people that own homes in Santiago has surprisingly fallen, according to the IDB, over 15% during the last decade.  Growth rates in home ownership have also fallen over the last ten years in Mexico City, Bogota and Buenos Aires. In Brazil, while home ownership rates have risen, housing prices in inflation-adjusted terms have increased over 50% over the last decade. 

This problem is shortly, at least in the case of Chile, about to get much worse because real estate companies have already said that the coming tax reforms will cause them to hike real estate prices approximately 10%.  This will hit hard the great majority of people who work at jobs whose salaries have benefited less than might be expected despite years of economic growth. 

Even for persons who are employed in sectors or in positions where salaries have risen quickly, the slowdown in the economy will certainly cause salary growth to sharply brake.  In the mining sector, for example, salary growth year-on-year has significantly fallen and given copper price trends mining companies are not surprisingly in no mood to lock themselves into high future salary cost obligations.

Viewed from the perspectives of US and European real estate market experience and the comparatively low levels of mortgage penetration in Latin America, it might be expected that this increasing housing affordability gap could be solved by mortgage market growth, but there are several reasons why this is unlikely to occur. 

To begin with, pumping additional liquidity into the real estate market obviously increases real estate demand.  This in turn pushes up real estate prices, increasing housing costs and creating demand for more credit to pay for those costs.   This is the classic recipe for the last thing that a market where affordability is declining needs – price inflation.

Second, the increased demand for credit and expanding banking sector credit risk as repayment ability falls will undoubtedly cause credit costs to rise.  Credit markets in Latin America are neither as efficient nor horizontally or as vertically developed as in more advanced markets and as a consequence borrowing is not cheap.  

The SELIC rate in Brazil is now a worrying 11% and it is hard to see how mortgage interest rates could reasonably be held below 14% or 15% once bank lending costs and default risk is priced in without public sector intervention.   In a market just coming out of a downgrade and looking at slowing economic growth, few people other than distressed debt speculators are going to have significant appetite for holding that kind of credit risk on their books.

Third, most Latin America banking authorities have learned all too well the negative consequences  of excessive leverage and wide scale debt defaults and so will likely clamp down on lending long before private sector and consumer debt levels come anywhere near those in the United States.     

Due to increased barriers to home ownership, one potential path forward that immediately comes to mind is to significantly increase the size of rental housing markets.  Historically, however, the vast majority of the rental market in Latin America has been comprised of the secondary market rental of previously purchased properties – there are comparatively few housing projects that are built with the specific objective to generate returns through unit rentals.  This is because many developers need to sell units before or during the development phase to pay for construction, many developers are reluctant to or financially incapable of taking rental default risk, the professional rental property management sector is relatively undeveloped and there can be significant legal and practical challenges to evicting non-paying tenants.

A potential solution to this problem is a rent-to-own housing development model where some portion of the rental payments are credited against the future purchase price.   The absence of high up-front housing purchase costs in the form of a down payment would significantly address affordability issues and equally as importantly give people increased options to live in good quality housing in areas that are closer to their place of work.  

Because rental payments allow tenants to live in properties that they could not immediately afford to purchase, it gives them the opportunity to live in places that are better located, more connected, safer and have far better amenities.   One negative trend that has occurred in sale- driven real estate development models is that to control costs housing projects have increasingly been built farther away from city centers that have limited infrastructure and limited access to essential services such as hospitals.

Second, it gives people, many of whom are facing a high degree of future financial uncertainty, the opportunity to slowly transition from being long term debtors to long term equity holders.   Beyond the financial and psychological benefits of home ownership, this will allow consumer spending – which has become an increasingly important factor in Latin American GDP growth – to remain high. 

The rent-to-own model should also reduce default risk because the costs to the tenant in the event of default will significantly increase.  In a rental property with no purchase option, from a financial perspective there is limited risk from the renter’s perspective in the event of a default.  In a property with a purchase option, a defaulting renter risks the loss of a future equity interest that may have been built up over years of rental payments.    This risk increases once the purchase option is exercised and the property is mortgaged.

From the perspective of real estate companies, the rent-to-own model allows them to diversify revenue streams over time to avoid the typical pattern of revenue peaks when units are sold and revenue valleys while projects are being developed.  Flattening revenue cycles would protect real estate companies from the risk of sudden downturns in housing prices and presumably lower their own credit costs.  Developers could also control revenues by designing in what year tenants will be required to exercise their right to purchase the unit.   The purchase price could be set in advance to ensure that the developers’ project IRR target was met and that they were appropriately compensated for deferring the date of receipt of purchase price proceeds.

Large scale primary rental market housing also creates interesting opportunities for capital providers.  While banks may be reluctant to provide mortgage loans to a single family with limited credit history, in a large project with many rental units default risk statistically falls significantly.    Banks could in turn could convert the lower portfolio risk into special financial products that offer lower interest rates.    

The potential large number of units that could be developed in Latin America in a rent-to-own model and the structured nature of the cash flows over the rental period up to the targeted purchase exercise date creates many interesting financing and investment opportunities.  It would be relatively easy to offer to funds or even to retail investors a structured financial product whose returns were driven by the rent payments and the potential additional upside if the purchase option were exercised.  This type of product would also solve what has historically been a major land acquisition and construction finance problem for Latin America real estate developers, as the proceeds from the up front sale of bonds to investors could be used to finance construction costs.      

The growing issue of housing affordability in Latin America is and will increasingly become a major policy, financial sector and consumer issue.  As it is hard to imagine that credit markets will be able to solve this issue alone, other solutions have to be created.  The rent-to-own model is one way to potentially create a path to home ownership for tens if  not hundreds of millions of people that balances affordability,  real estate developer return and risk management requirements, credit sector risk and investor interest in finding new types of investment products with potentially highly attractive investment returns.