In recent years the Brazilian real estate market has undergone a phase of significant growth, the results of which could be clearly seen at the end of 2007. During that year, 19 development and construction companies were listed on the São Paulo stock exchange, having raised R$11.2 billion (about $6.4 billion). New real estate properties worth R$26.5 billion have been delivered to the market and the house-loans balance has shifted from R$24.1 billion in 2002 to R$35.7 billion in 2006, reaching R$48.4 billion (about $27.6 billion) in March 2008.

Historically, real estate developers and construction companies in Brazil have been financed by commercial banks. In the past two years, this scenario changed and equity transactions (IPOs) have become an important source of funding.

Recently, however, equity capital for real estate companies has become scarce, creating significant investment opportunities, which in turn created a need for alternative capital structures. As a result, existing structures are being reviewed and new alternatives are being developed in the Brazilian market with a view to financing the real estate market, and market participants are increasingly venturing into alternative financing structures.

Ideally suited

Real estate funds (fundo de investimento imobiliário or FII) are used in Brazil for the financing of real estate projects and for the acquisition of commercial real estate property for leasing. Real estate investment funds are also an option for small and medium investors to invest in real estate securities.

The FII is a collective investment vehicle that raises funds from investors through the issuance of shares, and directs such funds for investment in real estate assets (that is, land, real estate development projects and after-completion real estate properties) or rights in real estate assets. The fund is organised as a closed-end fund, thus not allowing for redemption of shares before its liquidation or amortisation.

Due to the nature of the securities that represent their equity, FIIs are subject to the jurisdiction and supervision of the Comissão de Valores Mobiliários, the Brazilian Securities Commission (CVM).

The FII is similar to US real estate investment trusts (REITs). Unlike the REIT, however, the FII is not organised as a company or trust. As an investment fund, it is a collection of assets jointly owned by one or more investors under the structure of co-property. There is no corporate structure behind pools of assets held by Brazilian investment funds, including the FII. Therefore, investors are holders of shares that represent their co-investment in the assets of the fund.

The funds of an FII may be invested in the development of real estate projects, real estate construction, acquisition of completed real estate properties, as well as projects that facilitate access to housing and services, including in rural areas, for the purpose of future disposal, renting or leasing. Rights of use, development and acquisition of properties may similarly form part of the FII's portfolio. As a result, FIIs are ideally suited to financing a wide variety of real estate ventures.

Specialist opinion

An FII must have an administrator that is a financial institution supervised by the Brazilian Central Bank. It is worth noting that the assets of the FII, although acquired on a fiduciary basis by its administrator, must be segregated from the administrator's equity. This distinction is important because the FII assets are not available to the administrator's creditors.

An FII's equity must be distributed among shares with identical characteristics, granting holders equal voting rights in general shareholders' meetings, and an equal share of the fund's profits. Investment in the fund's shares is not subject to any requirements with respect to minimum investment size or minimum investor net worth.

Given the specific investment purpose of the FII, shares may be paid for in land or other real estate property. In such circumstances, the value of those assets must always be supported by an appraisal report prepared by three experts or by an independent specialised third party duly authorised to perform such work. In either case, the report must specify the criteria used in the analysis.

Little liquidity

The income generated by the FII's investments in the real estate assets should be distributed on a continuing basis to its shareholders. Applicable regulations require that the FII distribute at least 95% of the income earned to its shareholders. Such distribution must be calculated using the cash-basis method, based on the balance sheet or financial statement for the six-month period ending on June 30 or December 31 of each year. Retentions may be approved by the FII's shareholders, provided that (i) the fund has entered into a purchase commitment or binding letter of intent for the acquisition of a real estate property, the payment for which shall become due in future months, or (ii) a retro-fit, showing construction or refurbishment of its real estate properties is in progress and the available cash has been committed for that purpose.

An FII cannot incur or assume any indebtedness or provide any guarantees secured by the fund's assets. Therefore, acquisition of property by the FII would be funded either by the fund shareholders or by the fund's own revenues.

All types of investors may acquire FII shares, including retail and foreign entities. The fund shares are usually admitted for trading on the secondary market. Liquidity of the shares, however, is still limited.

The limitations on the assets that may comprise the FII's portfolio, and the distribution requirements, have delayed the development of the real estate funds market. In that sense, the CVM has submitted a new regulation for a public hearing. The public hearing is now finished and the new regulation is to be enacted before the end of the year. Among several important changes, the new regulation would allow real estate funds to invest in asset-backed securities – real estate receivables certificates (certificados de recebíveis imobiliários, CRIs), real estate credit certificates (cédula de crédito imobiliário or CCIs), receivables funds (fundos de investimento em direitos creditórios or FIDCs), shares of private equity funds and shares and debentures of real estate companies.

Finally, it is worth noting that like any investment fund incorporated in Brazil, the FII is not subject to taxation on revenue and capital gains arising from its own transactions (at portfolio level), although some specific exceptions may apply. Investors will be subject to taxation that should be analysed on a case-by-case basis.

Securitisation

Securitisation of real estate receivables is usually made through CRIs. CRI are securities backed by receivables originating in real estate financing granted by real estate developers and financial institutions. CRIs may only be issued by real estate credit securitisation companies (companhias securitizadoras), which are publicly-owned companies with the sole purpose of acquiring receivables and issuing CRIs.

CRIs are subject to public offerings registered with the CVM, and are usually registered for trading in the secondary market with a settlement and clearing agency for private credit instruments. A CRI may be guaranteed by (i) mortgage, (ii) fiduciary assignment (cessão fiduciária) of real estate receivables, (iii) pledge of real estate receivables, and (iv) fiduciary transfer of real estate property (alienação fiduciária).

An alternative for the securitisation of real estate receivables is the CCI, a negotiable credit instrument. The CCI is issued by the creditor of the underlying real estate credit and represents a real estate credit owned by the issuer. Unless otherwise expressly agreed, no prior approval or consent of the underlying credit debtor is required for the issuance of a CCI.

A CCI may represent the total amount of underlying credit, or part of such credit, in which case the sum of the value of all partial CCI issued must not be higher than the amount of the underlying credit itself. The CCI may be guaranteed by the same guarantees available to the CRI, plus the personal or corporate guarantee of the issuer. The CCI usually has the same guarantee as the underlying credit.

The CCI is usually issued and sold privately. No CVM registration is required for that purpose. Although theoretically a public offering of a CCI would be possible, at this time there are no precedents for that.

The main difference between securitisation by means of a CRI and securitisation by means of a CCI is that the CRI must be subject to public offering – and, therefore, to disclosure and registration requirements and to intermediation by an authorised financial institution – while the CCI is commonly negotiated privately. It is worth noting that several restrictions apply to private sale of securities in Brazil, especially with respect to sales efforts and to the use of marketing materials. Therefore, so far CCIs have only been used in cases where the parties already know the investor.

Flexibility

FIDCs are investment funds that acquire receivables and securities representing credit rights. Together with the companhias securitizadoras, FIDCs are currently the most adequate vehicle for carrying out securitisation operations. An FIDC may be structured either as an open-ended or a closed-ended investment fund.

Like the FII, the FIDC's portfolio is generally not subject to taxation on revenues and capital gains. Investors will, however, be subject to taxation that should be analysed on a case-by-case basis.

Recently, FIDCs started to be used as vehicles for warehousing real estate receivables. In these transactions, the FIDC acquires real estate receivables from developers and securitisation companies, and undertakes to sell the receivables back when the developer or securitisation company (as the case may be) is ready either to sell or securitise the relevant portfolio.

In addition to receivables (which must represent not less than 50% of the fund's net worth), the FIDC may invest in financial assets, namely: securities issued by the Brazilian Treasury; securities issued by the Central Bank of Brazil; credits securitised by the Brazilian Treasury; securities issued by states and municipalities; bank certificates of deposit and receipts; and other fixed income notes, securities and financial assets.

An FIDC's equity may be represented by senior and subordinated shares. While senior shares may only have one class of shares, more than one class is permitted for subordinated shares. This allows the division of subordinated shares into mezzanine and junior shares, making the market more flexible. It should be noted, though, that the FIDC shares, whatever their class or series, represent only ideal portions of the fund's net asset value and thus cannot be linked to a specific portion of the equity of an FIDC.

Cash payments

As a general rule, each share entitles its holder to one vote in the general shareholders' meetings of the FIDC. However, such voting rights may be limited, provided that it is expressly set forth by the fund's regulations. In general, subordinated shares are not entitled to vote, or have limited voting rights relating to specific matters.

With regard to equity rights, senior shares have priority over subordinated shares in the receipt of payment, amortisation and redemption amounts. However, the establishment of priority among holders of senior shares is prohibited. Different priority levels may be created for subordinated shares. FIDC regulations may establish different payment conditions (for example, different remuneration and payment dates) for different classes of shares and different series of senior shares.

FIDC shares shall be paid-in in cash, although subordinated shares may be paid-in in receivables, provided that that is established in the fund's by-laws. Additionally, payment of amortisation and redemption of subordinated shares may be made in receivables. The redemption of senior shares may likewise be made in receivables upon liquidation of the fund.

Mezzanine financing

Real estate developers in Brazil normally finance their projects with direct loans granted by commercial banks. These loans are usually secured by a portfolio of guarantees encompassing personal and in rem guarantees (such as the mortgage of the real estate property and pledge of receivables) granted by the real estate developer. However, commercial banks' financings are usually limited to between 70% and 80% of the total development and construction cost. Regulatory requirements and the high exposure of commercial banks to the real estate sector have created a gap between what regular lenders will provide and what developers and construction companies need from credit providers. In that sense, mezzanine finance has become an important source of capital for Brazilian developers and construction companies.

In Brazil, mezzanine investments are usually structured as profit sharing debentures. Debentures are a debt security issued by Brazilian corporations. As debentures are expressly provided for by Brazilian corporate law, they give investors a high level of legal certainty.

Debentures are generally issued by the special purpose company (SPV) that will develop the relevant real estate project, and are subscribed and paid in by the investor. Payment of debentures may be made once or in instalments. Each disbursement may be subject to conditions precedent, such as compliance with the construction schedule.

The debentures indenture may impose restrictions on the SPV, such as a negative and financial covenant, the breach of which would allow the investor to accelerate the debt. In addition to that, debentures may or may not be convertible into SPV shares.

Mezzanine investments are usually unsecured, given that the real estate property, the shares/quotas of the SPV and the future receivables guarantee the senior lender. That lender usually forbids the creation of second priority liens on those assets. Experience shows, however, that carefully drafted agreements may offer the mezzanine investor satisfactory protection.

Control

In addition to this, investors may participate in real estate projects through an SPV. In Brazil, an SPV may be incorporated either as a limited liability partnership (sociedade limitada) or as a corporation (sociedade anônima).

In both cases, the SPV generally acquires the land on which the real estate property will be developed directly. Accordingly, the building contracts are executed in the name of the SPV. Usually, the SPV engages the developer to develop and manage the property, upon the payment of an administration fee.

The relationship between the partners of limited companies or corporations may be governed by several contractual arrangements, namely: (i) a shareholders' agreement setting forth the relationship of the partners as shareholders of the company; (ii) an investment and/or divestment agreement, governing the terms and conditions of the investments and divestments to be performed by the company and/or the partners; and (iii) a construction agreement.

The SPV by-laws and an adequate shareholders' agreement may offer the investor a significant level of control over the SPV's activities, enabling the monitoring of physical and financial schedules, compliance with specific legal requirements and indebtedness control.

Author biographies

José Eduardo Carneiro Queiroz Mattos Filho, Veiga Filho, Marrey Jr e Quiroga Advogados José Eduardo Carneiro Queiroz was admitted to the Brazilian Bar, São Paulo Chapter, in 1997. He graduated from the School of Law of the University of São Paulo in 1997 and from the School of Business Administration of Getúlio Vargas Foundation in 1993. He also studied economics and political science at Georgetown University in 1994. Queiroz is a full professor of banking law and capital markets law at the School of Business Administration of the Getúlio Vargas Foundation. His practice areas are banking, capital markets, structured finance, foreign investment and corporate law. He speaks English and Portuguese. Marina Anselmo Schneider Mattos Filho, Veiga Filho, Marrey Jr e Quiroga Advogados Marina Anselmo Schneider was admitted to the Brazilian Bar, São Paulo Chapter, in 1999. She graduated from the School of Law at the Catholic University of São Paulo in 1997. In 2000 she completed a specialist qualification in corporation law at the Catholic University of São Paulo, and she did a Master's Degree in law at London University (LLM) in 2004. Her area of practice is capital markets. As well as her native language she speaks fluent English.