The Effect of a US Recession on Mexico Real Estate Market

By Bruce D. Greenberg, MAI, SRA, ASA, President, Valuaciones Montaña Verde, SA de CV

Technically, the United States economy is not yet in an economic recession, which is defined by two consecutive quarters of economic contraction, or negative economic growth. However, many economic indicators such as jobless claims, manufacturing activity, housing starts and core inflation, which have traditionally signaled the onset of a recession, are already indicating that, at the very least, a significant slowdown is inevitable. Despite technical definitions of the current health of the United States economy, one of the obvious causes and weaknesses of the current situation is the sector of residential real estate.

The severity of this readjustment cycle lies in the long period of historically low interest rates, which created prolonged artificial appreciation, due to the cheap cost of debt financing, speculation and sub-prime lending. Now that the housing bubble has burst, there is a large segment of American homeowners who have less financial leverage than they had anticipated in recent years. With values of homes decreasing steadily, and US consumers facing a liquidity crisis, their financial reaches have been reined in significantly.

Although the US consumer is resilient, as are the financial markets in the United States, the culmination of numerous economic trends has created a sore spot in the economy that is unlikely to be concealed with a temporary bandage.

The evidence of a recession in the US economy appears imminent, and it is well-known that the effects of any US downturn affect the stability of markets in México. These negative effects are experienced in the amount of cross border trade conducted, employment levels in manufacturing, tourism and foreign investment directed at México. These impacts vary across different sectors of the Mexican economy, and are felt more acutely in certain industries depending on the origins of the economic problems. In the current US economic cycle, the slowdown is a direct result of financial imprudence on the part of lending institutions, lack of liquidity among consumers and depreciating real estate values. These weaknesses translate directly to vulnerability in the Mexican tourist real estate markets.

Despite the overall negative impact of the current US downturn, when properly analyzed, there are many unaffected demographics and other distinct opportunities that are emerging, which will dominate growth in the current cycle. Understanding the niches where potential remains will be crucial to ensuring profitable ventures in this market.

THE MEXICAN ECONOMY Over the past two decades the Mexican economy has experienced sweeping changes due to a number of factors, the largest catalyst being NAFTA. Since the signing of NAFTA in 1992, many sectors of manufacturing have experienced a boom and benefited greatly. However, in recent years, the US demand for Mexican products has gradually weakened due to the influx of Chinese products. In December 2007, INEGI published a statistic from the Labor Ministry, reporting that factory employment had decreased by 2.7% from the previous year.

With the current decrease in consumer spending in the US, demand for products made in México, such as automobiles, textiles and garments, GDP from manufacturing is expected to decrease again in 2008. This impacts the average Mexican by increasing unemployment in the important manufacturing Another transformation to the Mexican economy has been the increased internationalization of the financial sector. Due to its consistent economic growth and progress in financial securitization, as compared to many Latin American countries, México has been an attractive place for foreign direct investment. This has allowed foreign capital to assist the expansion of many sectors including real estate development. In 2006, Moody’s, Standard and Poor’s, and Fitch Ratings all designated México’s sovereign debt as investment-grade, lowering the risk associated with lending capital.

With a scarcity of capital in the US financial markets, México could be entering a period where investment from Spain and other European countries increases its share of total foreign investment. However, despite the financial woes in the US, interest rates are once again approaching historic lows, allowing financial institutions to expand their portfolios. With the lack of lucrative investment opportunities in US real estate, some financial institutions will look abroad to increase their exposure to mortgage backed assets in foreign markets. Private equity firms have acknowledged that, investment in México is increasingly becoming more attractive for the reasons stated, and that they are actively seeking more investment opportunities in emerging markets than previously.

Foreign injections of capital aside, the Mexican financial sector has rebounded strongly from the times of the “Tequila Crisis,” and Mexican financial institutions have become a significant source of available capital. A parallel effect of the US recession could be seen in the activity of stakeholders as opposed to opportunists. Referring specifically to real estate development, the new builders who are undertaking projects strictly during strong growth cycles have begun to disappear. The stakeholders, however, such as the experienced Mexican developers who want to advance México’s prosperity and have a long-term vision, will remain in the market, and emerge more dominant when the market regains its full strength.

Although some sectors of the economy are bound to feel the acute effects of the US economic problems, overall México is in a better position than in past recessions, to avoid the turbulence to the north. After the Dot-Com Bubble in 2000 and the ensuing US recession, the real estate industry in México felt the effect somewhat. However, neither demand for Mexican real estate nor its subsequent appreciation had been fully realized. This latent demand and potential for upward price movement was experienced in the years from 2002-2006, in which Mexican real estate made its mark among international buyers.

President Calderon, with his savvy team of economists, has been proactive in counteracting the potential impacts of a US recession. The infrastructure plan that was successfully passed through Congress, will serve as an economic engine for growth and employment, at a time when some sectors are contracting.

For years, conservative and liberal voices have debated over allowing Pemex to receive private investment to improve much needed infrastructure and increase exploration. With dwindling output, Pemex posted record losses in 2007 operating at a $1.5 billion deficit. Although economists have forecast a bleak scenario for 2008, Pemex posted a profit in the 1st quarter of 2008, shocking many who expected steep losses. This reversal is due to the increases in worldwide fuel prices, breathing much needed life into this backbone of the Mexican economy. If tax receipts from Pemex oil revenues increase during 2008, the government will be able to maintain a budget surplus. However, it is likely that the contentious debate will continue and that many voices, including Calderon’s administration, Another pillar of the Mexican economy which will remain important is the tourism industry. September 11, 2001 was a turning point for Mexican tourism, causing a greater number of Americans to travel to closer, more familiar places such as México. México’s attractiveness to US tourists only continues to increase as the Peso remains affordable, and European currencies overwhelm the dollar. In addition, Fonatur is reportedly increasing its budget three-fold, which will assist in maintaining high levels of tourism while fuel costs are on the rise. Overall, tourism appears as though it will maintain its momentum and remain strong for all of its related sectors


HOW THE US RECESSION WILL AFFECT MEXICAN REAL ESTATE

México’s ability to attract tourists to its cultural and natural appeal has been one of its strengths in promoting investment in tourist properties. These are attractions that endure recessions and real estate downturns, and factor into the overall cycle of real estate buyers. Therefore, tourism, especially in a slow market, is a valuable asset in reaching and capturing real estate buyers.

As mentioned, second-home buyers in México transition through various phases within a real estate life cycle. As many as 22 million Americans visit Mexico annually. For many buyers, purchasing a timeshare or fractional interest is their initial way of transitioning from being tourists into purchasing a property outright. In times of financial uncertainty, such as the current economic slowdown, some low-end buyers are less willing to take the risks involved in a traditional purchase of a condo or villa, and will turn to timeshare or fractional ownership. In addition, Americans have been funding some of their Mexican investments with the equity in their US properties. With home values depreciating across the US, homeowners are less likely to borrow from their equity to finance cross-border transactions.

With the downtrend in home values in the US, it will be increasingly difficult to attract this low-end demographic to purchase until the market improves. Through the duration of the US economic downturn, timeshares and fractional ownership will be strategic products that allow for continued capture of US buyers. When the US buyer regains its liquidity and the dollar regains its strength, this demographic of US buyers will be in a perfect position to purchase condominiums, homes or homesites.

In contrast to the tightening of the low-end market, the high-end buyer remains financially liquid and maintains the ability to purchase luxury condominiums, villas and exclusive oceanfront properties. Additionally, if mid-range products experience a decrease in prices, this wealthier demographic might take advantage of the opportunity to buy an additional properties for investment purposes.

It is important to distinguish among buyers in “drive-to” markets, such as Puerto Penasco, Rosarito, and San Felipe, and the buyers from the rest of the Mexican tourist markets, or the “fly-to” markets. These drive-to markets cater to a demographic of buyers from Southern California & Arizona, with different characteristics from the majority of buyers in the other markets.

This demographic desires beach front real estate because they live in locations where there are no beaches, or where the oceanfront properties are beyond their purchasing ability. During the last growth cycle, condominiums were the dominant product being sold to this segment. Due to the limited influence of only a few nearby US cities, these drive-to markets tend to function and feel like more of an extension of the US than the fly-to markets.

The proximity of these markets and the strong dependence on buyers from only a few US cities, makes word-of-mouth a powerful promotional tool. In the past growth cycle, Puerto Penasco and Rosarito all experienced rapid increases in the number of new developments. Since the market peaked in 2006, absorption in these locations has declined significantly, and it appears as though they are somewhat oversupplied with condominiums. Although many proposed condominium projects have been canceled or put on hold, one additional large condominium project in any of these markets could cause a greater situation of disequilibrium.

This rapid increase in the number of developments was due to speculation on the part of investors and unsafe real estate practices of builders. These speculative investors or flippers mimicked the condominium trend in Miami, Phoenix and Las Vegas, and allowed developers to continue with projects based on short term demand. As is common, a number of developers accepted reservations of pre-construction units in exchange for minimal cash deposits. However, in many instances the deposits were not secured in third party accounts and in some cases are not being refunded to the buyers were projects have been canceled. This will create a publicity nightmare in the US for Mexican real estate. If this situation is not handled properly and efforts are not made to ensure safe real estate practices are utilized, it could have a lasting impact on these drive-to markets and to a lesser extent, on Mexican real estate as a whole. Negative publicity from Rosarito and Rocky Point has already started to generate some attention in the national news.

The fly-to markets, in contrast, are not comprised of buyers from any specific demographic that can be generalized. These markets are comprised of buyers from all over North America, as well as Europe and other foreign countries. Although there is a large influence from buyers in the Western United States and Canada, buyers from the East Coast are beginning to enter the market in significant numbers. Additionally, the price range and type of product available are much wider in the fly-to markets allowing them to meet the demands of various demographics that have different motivations for purchasing real estate.

The most important distinction to be made among the fly-to markets is that the three largest tourist markets, Los Cabos, Puerto Vallarta and Cancun, have the most diversity with regard to international buyers, and most exposure to high-end buyers. This is extremely relevant in the current cycle. Due to the strength of the Euro, Pound and Canadian Dollar, these markets can offset the weakness of the US consumer by shifting the marketing focus to other segments. More importantly, these three markets have the most expensive coastal real estate in México, which serves as an additional buffer to the concerns of the US consumer’s liquidity. Furthermore, affluent national are taking advantage of the distressed sales in these marketplaces.

Markets with significant numbers of international flights have an additional buffer to slowdowns. The East Coast of the US is still heavily focused on the Riviera Maya and direct most of their tourist dollars to those locations where there are direct flights. As airlift from the East Coast to other locations in México increases, tourism will generate new buyers for growing markets.

In many markets, developers will be competing on price more than any other factor. The effect of this, especially in markets with considerable inventory of product, will be a downward trend, or at the very least, stabilization of prices. However, in order for this to occur, developers will have to accept smaller profit margins on completed projects that are on the market, and proposed projects that are already in the pipeline. For this reason, as mentioned previously, many “opportunist” builders will engage in fewer projects during the downturn due to less lucrative returns. Also, in a slower market risk premiums will make the cost of capital increase, thereby lowering projected margins for shortsighted In addition to competitive pricing, projects that offer a wide range of amenities will be a key driver of competition. Once prices have been adjusted to meet the current market, buyers will look to amenities in making their purchase decisions. Highly amenitized projects create value for the buyer, and allow some of the developer’s costs to be hidden in HOA fees. Therefore, competitive pricing and attention to detail in development planning will allow projects to be successful while still achieving acceptable margins.

Overall, the negative impacts experienced by the coastal real estate markets in México, due to the US recession, will depend on the characteristics of the specific market; of greatest importance are the geographic and financial demographics of the buyers as well as the price points and amenities offered by developers. Developers that adapt to the current market dynamics and accept the nature of the downturn will be able to succeed with projects throughout the duration of the US downturn.

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