Investment decision to generate income: leasing of real estate versus Real Estate Investment Funds REIT, in the Brazilian Market

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1 Investment decision to generate income: leasing of real estate versus Real Estate Investment Funds REIT, in the Brazilian Market Abstract The market of properties funds negotiated in stock market and real estate market of properties have an uncertain scenario in the Brazil, with opportunities and risks of investments, despite the appearance of being based on the same type of asset, are markets with very different characteristics. The aim of the research was to compare the foundations of three real estate investment trusts (REITs) traded on the stock exchange BM&FBovespa, which have higher liquidity by investing in real estate, both in order to obtain monthly income arising from the lease. The methodology used was the case study compared making use of secondary data published to research the type ex-post-facto. The results were that, based on May 2015 data, the real estate funds have higher return on investment that aims to generate income by real estate rent compared to the popular residential location, middle and high standard. The commercial shed rental property cited in the example presented above profitability of residential real estate, but profitability was lower than the 3 most liquid REITs traded on the BM&Fbovespa, that showed benefit in terms of profitability in the period surveyed. Key-words: Investment decision. Property rental. Real estate investment fund.

2 1 - Introduction The researched theme it is a comparison between investment in real estate in order to generate income from leasing and investment in REITs, which also provides income with its lease. The objective of the research was to compare the foundations of three real estate investment trusts (REITs) traded on the stock exchange BM&FBovespa, that had the higher liquidities of all the REITs asset offered in May 2015, and the direct lease of residential and commercial properties with rents calculated on a monthly average from the costs involved. 2 - Theoretical framework: Investment in leasing properties and REITs Investing in real estate can be a way to convey emotional security for the small investor because it is "the safe haven to those who do not believe much in government, or like financial assets" (Martins, 2004, p.74). Mota (2013, p.13) states that the Brazilian real estate market is one of the world's largest, for "the last 25 years has grown rapidly with the construction of numerous commercial, residential and industrial enterprises." The market for real estate funds and real estate for lease have an uncertain scenario, with opportunities and risks of investments, despite the perceptions of similarity, because they are based on the same type of asset, they are markets with different characteristics in terms of liquidity. Martins (2004, p.75) says, "Without going into judgments of moral and humanitarian order, the practical matter is that residential rent is an extremely problematic type of income." As for the terms of security, Damodaran (2003) states that real estate investments are real assets, valued by the cash flows, risk and growth rates. According to Halfeld (2008, pp.12-13) the lack of liquidity, which is presented as a disadvantage for the investor who needs to make a quick sale, which usually has to do with the concession at a discounted rate, also takes the form of a long-term protection, which the author calls a "virtue" of the investment. Investment in construction of rental housing had an inversion in the roles of materials component and labor to carry out the constructions, this fact resulted in increased cost and expansion of the labor risk involving the business, which did not deter thousands of new entrepreneurs building to harness the sector's growth (CBID, 2015). However, after the wide

3 availability of secured credit, stagnation experienced in 2015 added to the high costs of labor, has led many investors to reflect on diversifying into new investments The Brazilian market Real Estate Investment Trusts - REITs, consists of 90 REITs offered via the stock exchange. REITs are equity funds, as it has no pre-fixed compensation, which means, "profitability is associated with the revenue from the property or properties that form the trust" (MOTA, 2013, p.17). With an associative business character, the real estate investment trust is a type of condominium, which may be permanent or not, that is, "the fund can survive indefinitely or may be organized for a single undertaking, and when it ends, it may be extinct. Extinguished the trust, the constituted voluntary condominium is also extinguished" (MOTA, 2013, p.17), and the conceptual terminology in force in the real estate funds market is regulated by CVM - Brazilian Securities Commission (Illustration 01). Illustration 01 - Concepts on the real estate market. Cost of real estate Cost of real estate held for sale Cost of real estate under construction Property acquired or constructed for income or for capital appreciation over the long term Real estate acquired or constructed for sale Real estate transfer classified in investment property for inventory Real estate transfer classified in inventories to investment property Gains / losses on the valuation of assets / liabilities Provision for losses Loss on impairment Reversal of provision for loss Concept CVM nº 516 legislation It is understood as cost of real estate acquired the purchase price plus any transaction costs directly attributable to the purchase transaction For properties held for sale in the ordinary course of a business, the cost also includes the costs incurred in bringing the property under normal conditions of sale. It is understood as cost of properties under construction all expenses directly related to the unit under construction. It should be classified as investment property, within the non-current assets investments subgroup. The property classified as investment property shall be recognized initially at their cost value. After initial recognition, the properties for investment must be continuously measured at fair value. The property acquired or constructed for sale in the ordinary course of business should be classified as properties held for sale within the current assets inventories subgroup. Such property shall be assessed at the lower value of cost or net realizable values. The transfer of real estate classified in investment property for inventory should only be done when there is a change in its use, evidenced by the start of development for the purpose of sale. The value cost of the property attributable to the initial recognition as inventory is the fair value of the property in use in the date of the change of its use. The transfer of properties classified in inventories to investment property should only be done when there is a change in its use, evidenced by the start of use for the purpose of obtaining income. The value attributable to the initial recognition of the property as investment property is the carrying value of the asset at the time of change of use. Any difference between the fair value of the property and the initial recognition value should be recognized immediately in the income statement Gains or losses resulting from the valuation of assets or liabilities of the fund, although not financially realized, should be recognized in the income statement. Provision for losses should be recognized whenever there is evidence of impairment loss of the financial assets of the fund valued at amortized cost The loss on impairment must be measured as the difference between the asset's carrying amount and the present value of the new expected cash flow calculated after the change of the estimate. The return loss record should be made in the income statement. The reversal of the provision for losses previously recorded must be done provided there is an improvement on the previous estimate of expected credit losses. Source: Caetano (2014, p.31) - prepared based on CVM Instruction 516.

4 3 - Research methodology The methodology used was a compared case study making use of published secondary data for the ex-post-facto type of research, or from the past event because the researcher cannot change the historical facts and are portrayed on data (GIL, 2008, p.45), and the research aimed to study the problem of investment decision for leasing income purposes. For that, it was adhered to the purpose of answering the following question: What assets can generate more advantageous for leasing income: rental property or REITs? The data collected have their amounts referring to one month, and inflation, the appreciation of real estate and shares of REITs were considered null and equivalent for demonstration purposes by not considering price volatility but with fixed data set in May 2015 with values of the property and the lease provided by real estate agency X. 4 - Presentation of search results 4.1 REITs For the study, it was taken as base the most traded REITs in 2015, therefore, the most liquid ones, i.e., the ones that did not have difficulties in being bought or sold by the investor. The monthly income provided by REITs BBPO11: 0.78%, BRCR11: 0.96% and KNRI11: 0.77%, which together represent 66.32% of the buying and selling movement among the 10 most traded and 35.5% of the daily drive among 99 REITs traded on BM & FBOVESPA, and this shows that these three REITs are the ones with the highest liquidities. In illustration 02 the monthly net income (Income / month free of income tax) provided by the REITs and their percentual relation to the value of the quota. Illustration 02 - Monthly Net income of REITs BBPO11, BRCR11 and KNRI11. Code Name Share MV/NW Income/month % / Share BBPO11 BB Progressivo II R$ 102,94 107,50% R$ 0,80 0,78% BRCR11 BTG Pactual C. O. Fund R$ 105,00 64,06% R$ 1,01 0,96% KNRI11 Kinea Renda Imobiliária R$ 119,49 76,41% R$ 0,92 0,77% Source: XP investments (data from June 15, 2015). 4.2 Property Leasing

5 The example 01 (Illustration 03) is 4 popular apartments valued at R $ 150, each, with leasing of R$ monthly, and managed by real estate agency, resulted in a net monthly income of 0.23% compared to the value of the real estate. Illustration 03 - Leasing of popular apartments. Example 01-4 popular apartments R$ ,00 Monthly revenue from lease Apartment 01 (value at R$ ,00) R$ 600,00 Apartment 02 (value at R$ ,00) R$ 600,00 Apartment 02 (value at R$ ,00) R$ 600,00 Apartment 02 (value at R$ ,00) R$ 600,00 Monthly revenue (apartments 1, 2, 3 e 4) R$ 2.400,00 Annual revenue R$ ,00 monthly gross profitability % 0,4 Annual spending on real estate agency Contract fee (first month's rent) R$ 2.400,00 Management fee (10% over 11 months) R$ 2.640,00 Total rates R$ 5.040,00 Annual maintenance spending Apartment 01 R$ 200,00 Apartment 02 R$ 200,00 Apartment 03 R$ 200,00 Apartment 04 R$ 200,00 Total maintenance R$ 800,00 Total expenses R$ 5.840,00 Earnings before Income Tax R$ ,00 Individual income tax (27.5%) R$ 6.314,00 Annual net income R$ ,00 % Annual net return 2, % Monthly net profitability 0, Example 02 (Illustration 04) is 01 average standard apartment valued at R$ 300,000.00, with leasing of R$ 1, per month, and managed by real estate agency, resulted in a net monthly income of 0.19% compared to the value of the real estate. Illustration 04 - Leasing of average standard apartment. Example average standard apartment R$ ,00 Monthly revenue from lease Monthly revenue R$ 1.000,00 Annual revenue R$ ,00 % Monthly gross profitability 0, Expenses real estate agency Contract fee (first month's rent) R$ 1.000,00 Management fee (10% over 11 months) R$ 1.100,00

6 Total rates R$ 2.100,00 Annual maintenance spending R$ 350,00 Total expenses R$ 2.450,00 Earnings before Income Tax R$ 9.550,00 Individual income tax (27.5%) R$ 2.626,25 Annual net income R$ 6.923,75 % Annual net return 2, % Monthly net profitability 0, Example 03 (Illustration 05) is 01 high standard apartment valued at R$ 600,000.00, with leasing of R$ 1, monthly, and managed by real estate agency, resulted in a net monthly income of 0,175% from the property value. Illustration 05 - Leasing of high standard apartment Example 03-1 high standard apartment R$ ,00 Monthly revenue from lease Monthly revenue R$ 1.800,00 Annual revenue R$ ,00 % Monthly gross profitability 0,3 Expenses real estate agency Contract fee (first month's rent) R$ 1.800,00 Management fee (10% over 11 months) R$ 1.980,00 Total rates R$ 3.780,00 Annual maintenance spending R$ 400,00 Total expenses R$ 4.180,00 Earnings before Income Tax R$ ,00 Individual income tax (27.5%) R$ 4.790,50 Annual net income R$ ,50 % Annual net return 2, % Monthly net profitability 0, Example 04 (Illustration 06) is 01 commercial shed valued at R $ 1,100,000.00, with leasing of R$ 6, monthly, and managed by real estate agency, resulted in a net monthly income of 0.35% compared to the value the property. Illustration 06 - Leasing of a commercial shed Example 04-1 Commercial shed R$ ,00 Monthly revenue from lease Monthly revenue R$ 6.500,00 Annual revenue R$ ,00 % Monthly gross profitability 0, Expenses real estate agency Contract fee (first month's rent) R$ 6.500,00

7 Management fee (10% over 11 months) R$ 7.150,00 Total rates R$ ,00 Annual maintenance spending R$ 400,00 Total expenses R$ ,00 Earnings before Income Tax R$ ,00 Individual income tax (27.5%) R$ ,25 Annual net income R$ ,75 % Annual net return 4, % Monthly net profitability 0, Conclusions An advantage in the administration of a single high standard apartment that has the hypothetical leasing value of R$ 1, is that there will only be one contract to inspect, one consulting in the register of the lessee, possibly in a single trip to the notary to sign and acknowledge firm, a monthly receipt and one unit to liable to maintenance. When comparing with the leasing of 4 small apartments valued at R $ 150,000.00, with leasing of R$ for each of the apartments, there is R$ 2, to be gained as monthly income but with 4 times more work from the inspection to maintenance with 4 times more probability to need repairs, consuming 4 times of the landlords time. Nevertheless, the prize for the effort and time taken is remarkable in higher gross income generated by leases, which will be 0.4%, which represents an income of about 20% above the high standard apartment. The higher income to be compensatory or not at greater effort and work because of the increasing number of units is an assessment that the investor must make based on their willingness to manage more units. In these examples, if the investor hires a real estate agency for the administration of the properties, he should consider that, in the contract case for a year lease, costs are formed by the first month's rent and 10% of the rent for each of the 11 coming months, charged monthly by the estate agency as a compensation for its administration. Such fees do not cover the extra costs, such as maintenance of buildings, fires, storms and other forms of physical deterioration of the asset. Therefore, the insurance contract is something that can be seriously considered by the investor owner. By comparing the monthly income provided by the lease of real estate examples in this simulation, it was possible to identify the difference between the ways of investing in the same type of asset which gives different types of investment, the real estate. It was concluded

8 that on the data presented, the REITs represent a form of investment that provides higher income and high liquidity, demonstrating its advantage over the property purchased for lease by real estate agencies to generate monthly income. Aware that it is possible that the distortions presented here may appear in a long-term temporal curve, it is suggested that new studies do monitor the scenario to better understand the relationship between the two types of surveyed investment. The research work it is not an investment recommendation. It did not consider the updating of the book value of real estate or shares of REITs in the study, but it is suggested to continue the study in a long-term historical curve in the Brazilian Market. 6 References BIANCOLINO, C. A., Knies, C. T., Maccari, E. M., & Rabechini Junior, R. 2012, maio/ago. Protocolo para elaboração de relatos de produção técnica. Revista de Gestão e Projetos, 3(2): BM&FBOVESPA. Fundos de investimento imobiliário. < accessed on June 12, 2015>. CAETANO, Daiane de Freitas. Os Fundos de Investimentos Imobiliários sob a Ótica Contábil: Estudo de Caso dos Fundos BTG Pactual Corporate Office Fund(BC Fund), CSHG Real Estate e RB Capital Renda I. Rio de Janeiro: Pensar Contábil, Câmara Brasileira da Indústria da Construção Civil CBIC. acessado em 16/06/2015. DAMODARAN, Aswath. Avaliação de Investimentos: Ferramentas e Técnicas para a Determinação do Valor de Qualquer Ativo. 5ª reimpressão. Rio de Janeiro: Editora Qualitymark, EID, Gabriel Sarmento. Entendendo o que é um fundo de investimento imobiliário. Julho de Disponível em: < acessado em 01 de junho de 2015>. HOYLER, Telma. Incorporação imobiliária e intermediação de interesses em São Paulo. Dissertação do Mestrado em Ciência Política da Faculdade de Filosofia, Letras e Ciências Humanas da Universidade de São Paulo. São Paulo: USP, MEU FUNDO IMOBILIÁRIO. <Acessado em 01/06/2015> MOTA, Ronaldo Rodrigues. A evolução do mercado de fundos de investimento imobiliário no Brasil no período de 1994 a março de 2013 e a utilização dessa alternativa de investimento para o investidor pessoa física no Brasil. Dissertação do Mestrado em Economia (114 p.). Brasília: UnB, NOGUEIRA JR, E. Fundos de Investimento: uma constribuição ao estudo das práticas contábeis no Brasil f. Dissertação (Mestrado em Ciências Contábeis) - Programa de Estudos de Pós-Graduados da Faculdade de Economia, Administração e Contabilidade - Pontifícia Universidade Católica de São Paulo, São Paulo, XP Investimentos. Xpi.com.br < acessado em 15 de junho de 2015 >.