Rafael became an entrepreneur when he moved to Brazil about a year ago to work in the country’s nascent housing market. Before that, he was a successful portfolio manager at a hedge fund in London where he had been saving his bonuses and waiting for the right moment to strike out on his own.

Rafael indentified an opportunity in the Brazilian real estate market, since all market drivers had forecasted a boom in this industry. The economy was growing at a 5.4% rate — thanks to its soaring agriculture, energy and agricultural industries — and was further aided by an escalation in the prices of commodities. Inflation finally seemed to be under control: It had decreased from 19.75% in 2003 to 13% in 2006, the government had been able to absolve most of its foreign debt, and the Brazilian real had appreciated more than 20%.

Brazil was also seeing very positive changes in demographics and income trends, especially in the middle class sector. Under Lula’s populist government, redistributive initiatives such as Bolsa Familia helped fuel the growth of Brazil’s middle class as the average income of Brazil’s poor went up 9% between 2001 and 2006. For the first time in history, the middle class now makes up more than half of the population. Indeed, it has grown from 44% to 52% over the last six years.

Some of the more exciting enticements for Rafael, however, were the new regulatory changes that were revolutionizing the industry. Since the late 1990s, proactive government policies, such as Alienação Fiduciária, have provided an exit strategy for banks in case a borrower defaulted on his/her loan; historically, banks are not permitted to confiscate a person’s last asset. Basically, a legal trust could be established in which the bank owns the title of the asset through which the lender holds a lien. Once the loan is repaid, the lien is removed and the trust transfers the property to the homeowner.

The past few years have seen the success of this structure, so confidence in home mortgages has escalated. Historically, Brazilians have been required to personally finance at least 70% of their homes’ value, but in May 2007, banks finally began offering 30-year loans for up to 70% of the homes’ value. From a macroeconomic standpoint, real estate lending represented only around 4% of the country’s GDP, compared to 15% in Mexico and 18% in Chile. Finally, the government also has tremendous interest in new urban residential development and has backed this claim by promising more than R$500 billion (US$230 billion) in new infrastructure to support urban growth. Needless to say, Rafael saw the perfect conditions for a booming middle-class housing sector.

By this time, Rafael was absolutely convinced about making the move into Brazil’s housing sector as an entrepreneur. However, the question he asked himself was: “What angle do I want to take when I enter this market?” It was clear that the demand existed and was expected to grow to 22.6 million units by 2020, given the current conditions. It seemed very attractive to enter on the construction side as a developer since banks were offering attractive construction loans. In 2006 alone, Brazil’s nine largest construction companies raised a total of R$5.8 billion (US$3.8 billion) in the capital market. In addition, the conditions were excellent for low-cost prefabricated housing to reach some of the lower middle-class people with steady incomes.

However, considerable barriers made this option unattractive. First, Brazil’s developers are very powerful since they are vertically integrated, have deeper pockets and political support, and already own considerable “land banks” for future construction. It would be extremely difficult for Rafael to compete with these players since he had neither the necessary capital nor the right contacts. Second, pre-fabricated housing is a relatively new technology that few Brazilian contractors know how to work with (only a few thousand units are produced per year), and Rafael had no experience in construction.

Rafael then decided to look at the financial side of the value chain because, after all, his background is in finance. Brazilian banks recently began offering long-term loan packages. However, banks lacked experience in this market. Rafael did not have the capital necessary to begin a boutique credit institution like the ones sprawling throughout Brazil, but he knew that he could partner with several banks as an independent broker. With his knowledge of finance, Rafael could make it as an entrepreneur by finding customers who qualified for loans, preparing their loan packages and selling them to banks.

Positive Signs, at First

Initially, everything was on the up side for Rafael. Almost immediately, he was originating mortgages at a rapid pace, which banks were very keen to acquire. Rafael was also feeling good as interest rates continued to decline and demand for mortgages continued to increase. At the same time, Brazil’s economy was growing rapidly: It experienced a net trade surplus in fiscal 2008, the first in its history. During the summer, S&P and Moody’s elevated Brazil to investment grade, which Rafael hoped would bring longer-term debt at lower rates while expanding his client base for borrowers.

The only long-term problem Rafael saw was that property prices were escalating rapidly in Brazil’s major cities due to the massive land and property buy-ups by the major developers. This would eventually be problematic because it could cause his middle-class client base to shrink as properties rose in value. Rafael’s only solution for maintaining a growing client base was to diversify into Brazil’s interior cities. Many of these cities — for example, Curitiba and Vitoria — have been experiencing major growth in the past few years due to the rapid expansion of Brazil’s service sectors. Property prices have remained much lower than in Brazil’s major coastal cities.

Rafael had accumulated great momentum by September 2008 and was already cash-flow positive within his first year in Brazil. But then things began to change dramatically. Until then, no spillover effect had been observed between the Brazilian economy and the U.S. Indeed, President Lula had declared that Brazil was immune to the U.S.’s economic woes since the U.S. no longer held Brazilian foreign debt and most of Brazil’s trade was with China.

But due to the global financial crisis, Brazilian exports have stagnated, and Brazil’s banks have watched their liquidity disappear. International investors, suffering from lack of liquidity in other markets, abruptly divested from this market. To make matters worse, prices for petroleum and other commodities plummeted as China reduced its imports in order to resolve its own liquidity and developmental problems. The real also saw a rapid depreciation from R$1.52 to R$2.4 (per US$), and interest rates climbed up to 20% annually. In only a few months, the expected GDP growth had been reduced from 5.5% to 2.5%.

The impact on the housing market was dramatic. Fear of stagnation and lack of access to credit reduced consumer spending. For example, a large homebuilder saw its sales plummet by 25% over only a few weeks. In addition, banks halted long-term loans for real estate construction, freezing many projects throughout the country. Over a brief period of time, foreign investors linked to real estate fled Brazil, increasing volatility.

Rafael, who had been thinking of buying a motorcycle, now is not even able to secure its financing. He sees his investments in Brazil devalue at a time when his client banks have halted their lending. Although he correctly identified a billion-dollar opportunity in a developing country, his business is currently at stake because of external shocks caused in foreign markets. The need for housing and market potential has not disappeared; it has simply been put on hold for several years. One question remains: Is Rafael able to survive?

This article was written by Marta Auleda, Gerardo Benítez, José Gómez, Juan Martínez, and Aleix Pares, members of the Lauder Class of 2010.