And why most real estate developers in Brazil are doing awfully bad this year…

No wonder that the investments of billionaire Sam Zell are closely monitored. In 2006, he sold his commercial real estate company, Equity Properties, for US$39 billion. It was the biggest deal in the history of the U.S. housing market – which collapsed just a few months later.

In Brazil, Zell also was active. In May 2010, he began to sell his shares of Gafisa, the fourth largest real estate developer in the country, of which he was a partner since 2005. When the billionaire decided to sell his shares, executives who work for Zell repeatedly said that he saw nothing wrong with the developer, and that the sale was part of the natural cycle of investment. 
It is impossible to know whether this was indeed the reason – or if Zell was “smelling” problems in the operation of Gafisa. The fact is that the American investor, once again, jumped off the boat at the right time. In the last two years, the company’s stock lost nearly 70% of its value. In the last six months alone, the stock tanked 35%. The company, one of the brightest stars of the IPO wave in Brazil, is today viewed with suspicion by investors. And the numbers show why. 
According to Exame, Gafisa’s stock today is the worst performer in its sector. Its equity returns are 79% lower than the average of its competitors – Brookfield, Cyrela, MRV, PDG and Rossi. The debt is about 40% higher. In a meeting with investors in late November, Alceu Duilio Calciolari, president of Gafisa for about seven months, gave a statement that surprised the audience: he admitted not having the actual extent of the company’s problems. 
Company executives are analyzing the financial situation of thousands of low-income clients who may not have the means to pay for their properties. They are also reviewing problematic projects that can potentially be canceled. “This mapping is a long process that will only end in 2012,” said Duilio.

Emergency measures 
Until the extent of the company’s problems is fully understood, Gafisa has been taking some emergency measures to boost cash. The first is to re-negotiate payment to suppliers. The accounts payable worth more than BR$100,000 due in November and December will be delayed a few months. 
“This information have spread out and suppliers are very worried. Since 2004, the company has never made a renegotiation of this size,” says a former Gafisa director. Companies such as Gerdau and Votorantim have reduced credit lines to the developer.
Duilio says this kind of practice is part of the “urgency to meet this year’s goals.” Moreover, Gafisa have recently fired 200 people (10% of its workforce) in the last week of November.Struggling to obtain long-term credit, Gafisa has recently issued short-term promissory notes, a financing instrument more expensive than the usual corporate debt market. It works like an account overdraft: easy to use, but with a high cost. In early December, the developer issued BR$230 million, to be paid in one year, with yearly interest rates of about 14% (the industry average for funding for longer maturity dates is around 12%).“The rate is very high,” says William Richardson, an analyst at Credit Suisse. It was the first time Gafisa issued a promissory note. “We needed to raise money quickly to put in progress a strategic decision, but we still can not give details of what is yet,” said Duilio.Gafisa could instead have raised money by issuing shares in the stock market, but because the stock has fallen about 50% over the past year and the dilution of current shareholders would be very high, the company chose the debt market.Gafisa faces problems common to most developers. After the euphoria of 2005, 2006 and 2007, when 20 companies in the sector captured BR$ 12 billion in Bovespa, the hangover came in.

In the last two years, the lack of construction material and labor have made overall costs soar. Most companies were not structured to accommodate this growth. When they found the shortcuts, it was too late. Gafisa competitor Cyrela, for example, had a loss of US$ 533 million due to more than estimated construction costs.
But Gafisa has a further difficulty: Tenda, the low-income housing developer it acquired in 2008 for what at the time seemed like a bargain, considering Tenda’s shares had fallen 60% a few weeks before the acquisition, which was highly celebrated by the market. Apparently, the market was wrong.

Tenda has yielded the expected returns – in fact, it actually not only lagged financially but its operation has been showing problem after problem. According to Duilio, Tenda’s profitability per project is close to zero when it should have been in between 10% and 15%, as projected before the acquisition.

“Tenda’s focus on volume was not working. They launch projects, but are unable to deliver,” says a construction analyst at Bradesco. The new owners only realized this after the acquisition, and now try to calculate the size of the inherited problems.

There are cases of some projects costing 50% more than initially anticipated and others that were built without following on the original design. Moreover, it was found that Tenda had a rudimentary credit approval system. Of the 32,908 customers who bought their homes with Tenda, only 5380 (just over 16%) can actually afford it. About 5,000 of them do not have the credit profile required to get financing, therefore, Gafisa will refund them with what they already paid for the properties.

The company is also reviewing the situation of 81 of Tenda’s construction sites. The goal is to determine how many buildings will have to be canceled due to environmental issues or design errors. “If these projects are canceled, Gafisa will have pretty much written off its existing investment at Tenda,” says another analyst at Bradesco.

“It’s as if Tenda is a tumor within Gafisa,” says an executive who left the company in 2011. “The problems posed by Tenda contaminated Gafisa.” Internally, employees assigned to work with Tenda’s projects often see it as punishment, since they know that the chance of meeting targets and receiving bonuses is minimal.

Alphaville: Gafisa’s Jewel

A broad company restructuring was announced by Gafisa a month ago. As part of the new model, housing projects made to low-income clients will only take place if previously approved by Caixa Economica Federal, with a specific clause that these buyers will be fully financed by the bank. Most analysts approved the company’s decision to be more conservative.

Gafisa lost more than half of its market value in 2011. It is valued at just over US$ 2 billion, almost the same as smaller companies such as Eztec and JHSF. Its assets are worth about 75% more than its current market value, a sign that their stock is cheap. This might explain why the company had been recently approached by private equity groups and other developers.

“Every market participant had about three meetings in recent months to talk about Gafisa,” says the partner of an interested fund. Their eyes are in the operation of Alphaville, by far the best business within Gafisa, with a profit margin of about 30%.

Its competitor PDG and at least two funds sent official offers to acquire Alphaville. It’s our crown jewel. We will not sell it,” says Duilio.

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