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The Brazilian economy (NYSE:EWZ) is hot right now no matter how you look at it and the real estate market there is no exception. With an explosively growing middle class and unemployment numbers hitting all time lows, one would think that nothing could go wrong in an emerging market like this. People might even say that one can’t go wrong with some Brazilian real estate “given how spectacular everything is.” Still, it wasn’t so long ago that we heard a similar mindset in the U.S. and we all know how that ended.

Gafisa SA (NYSE:GFA) is a real estate developer of Brazil. We think Gafisa is starting to feel the housing tide turn against it. Now the firm isn’t in dire financial straights today and it isn’t being run by a bunch of jokers. But regardless of any strengths, when any real estate market goes down, it makes everyone guilty by association. We rate Gafisa SA a pass currently because the Brazilian real estate market looks to be getting speculative. It is becoming tougher to forecast accurately, and the firm’s most recent earnings report made it clear that even a small drop in revenue can take a big cut out of earnings.

“It’s Different This Time”

The first issue we see with the Brazilian real estate market is that it reminds us a lot of the former U.S. real estate market. It’s getting hot very fast, everything in the “local” world is perfect, and the egos of people are starting to reach dangerous levels. We aren’t tying to rain on the Brazilian success parade but we’ve heard this all before and to simply forget the past, or argue that it’s different this time seems foolish. So when all variables come together, it generally doesn’t spell out a happy ending for real estate in Brazil.

When homebuilders enter the “danger zone” we stick clear of where ever they want to go. The deeper one goes into a bull real estate market and the more time passes by, the higher the probability that something will be overpaid for. At some point the Brazilian market will become overpriced. And since real estate works in multi-year projections, the chance of realizing it before additional assets are committed to another project seem low. Gafisa could easily make this mistake as it looks to dominate the low and middle-income market. Further, no one truly knows when the real estate party will end in Brazil, including Gafisa. After all, if it’s so 'easy' to forecast real estate markets, then the U.S. wouldn’t still be in the middle of a real estate slump, years after the initial crash.

Branding Power in Low Class Housing

Gafisa has increased our concerns now that it’s touting its branding power. Last time we checked, standard residential units don’t come with designer emblems on the house. What really matters is property location. As well, we doubt that branding power holds much value relative to low and middle-income housing. After all, this isn’t Trump Tower in New York.

The firm isn’t even close to being the largest player in real estate either, but the firm’s ego would fool you. This reminds us of the guy who rents a Ferrari for the weekend to look cool and in the process spends over a month’s worth of income. With this type of new mindset starting to publicly seep out of headquarters we wonder what type of mindset is being used to make decisions and to evaluate projects. If Gafisa starts saying that the Brazilian real estate market is truly different than any other real estate market in the world or some comparable remark, that’s the biggest cue to hit the exits.

Be it New York, San Francisco, London, Paris, Dubai, Tokyo, and or anywhere else in the world, real estate prices ultimately are determined by the laws of demand and supply combined with a significant time lag. Brazilian real estate may be hot for a few more years, but that doesn’t mean Brazilian homebuilders will be. And when the cycle comes to an end, we doubt it’s going to be a soft landing.

The Road of Profitability is Getting Rough

The firm’s most recent earnings report has given us greater reason for concern. For example, operating profits fell 36.8% relative to only a 12% decline in net operating revenue year over year. The interim CEO stated that the results were in line with internal expectations and that the cause was due to the consolidation with Tenda Developments. First off, it doesn’t sound like a great move or that this is an accretive acquisition if it materially impacts operating profits that much. In addition, this again brings about concerns on how level-headed management is acting in a bullish Brazilian real estate market. If small changes and acquisition hiccups are having a large impact on the firm in a good real estate market, we don’t want to know what it will look when like when things slow down or go south.

Conclusion

The Brazilian economy as a whole is likely to remain robust for some time but that in no way guarantees that this potential real estate bubble is a safe place to be. Without question, Gafisa will be materially impacted by any type of slow down in the real estate market. Further, it doesn’t seem like the firm is keeping a cool head as it keeps on trying to ramp up new projects. This current strategy sounds no different than that of real estate developers in formerly hot markets such as Florida. These developers just kept ramping up production more and more until things finally went to far. We rate Gafisa a pass because we don’t see a suitable risk reward scenario given the current environment.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: 3 Reasons Why Gafisa S.A. Is Vulnerable