• While the official data on property values show that real estate prices and rents are continuing to decline, there is currently a lot of money--both foreign and domestic--looking for high yielding property, often to convert into a REIT (real estate investment trust).
  • Indeed Japan’s REITs have come of age, and are now a viable investment class by themselves, with more REITs being listed daily, and offering +/-4% yields.
  • Japanese real estate companies are now learning to user "other people's" capital in their property development activities, often through REITs. This will help to deleverage one of the most highly leveraged (indebted) sectors in Japan, and will give these companies added profit growth leverage as profit margins improve in line with the decrease in debt leverage.

Oil Price Inflation and Property Prices

We are (brashly?) suggesting that oil prices could go to $80/barrel in the foreseeable future. Oil at $80/barrel would be inflationary while at the same time hamper economic growth. However, inflationary expectations, irregardless of a stagflationary economy, would be good for property prices, and foreign institutional investors haven’t been waiting around for an "all clear" sign from the Japanese government that deflation had been defeated before piling into Japanese property.

  • Lone Star Funds recently made a successful bid to buy three Tokyo buildings for about 117 billion yen ($1.06 billion) from a Japanese taxi company (Kokusai Motors), making it the largest property purchase in Japan by a foreign investor in six years. Lone Star beat American International Group, Morgan Stanley and other bidders for the office towers located in the city's Akasaka financial district. Lone Star has raised as much as $5 billion for a sixth fund, 80% percent of which will be used to buy assets in Japan and South Korea. The Akasaka purchase brings to more than JPY191 billion of direct real estate investments Lone Star has made in Japan in the past 12 months.
  • The Government of Singapore Investment Corp (GIC) is creating a stir with its aggressive investment in central Tokyo real estate. GIC owns the major share of the Shiodome City Center, a Tokyo office building that cost JPY100 billion and opened in April 2003. This June, GIC paid JPY42.5 billion for a new twin-tower high-rise built by Kajima Corp in Tokyo's Shinagawa ward.
  • Billionaire George Soros, Starwood Capital Group and other global investors are also boosting investments in Japanese real estate because of signs that two years of economic expansion will help property prices recover from more than 13 years of declines.

Signs of a Bottom

The decline in Japanese land price continued in 2003, with signs of renewed demand in central Tokyo not enough to stop nationwide prices declining for the 12th year. Nationwide land prices decreased 5 percent to JPY115,000 yen ($1,037) per square meter, according to the National Tax Agency. Prices in the Tokyo region, which includes the capital and Chiba, Kanagawa and Saitama prefectures, dropped 2.7% to JPY257,000.

But Mitsui Fudosan and major developers point out that rises in land prices in the most expensive areas of regional cities like Nagoya and Fukuoka showed demand was beginning to bottom out. Tokyo property prices have stabilized following a 13-year slide that reduced values by 80 percent since 1990. Property values in Japan's most expensive spot on Chuo Avenue in Tokyo's Ginza district rose 8.2% to JPY13.76 million per square meter, while average prices in Tokyo's main 23 wards continued to fall by 1% to JPY586,000 yen. Commercial property prices were also lower, with prices falling 2.63% in the half year to March 31. But this was the slowest pace since the six months ended Sept 30, 1991. Moreover, the pace of declines in the national average continues abate, with the 5% decline in national land prices last year being smaller than the previous year's 6.2% drop.

Tokyo's condominium prices, down one-third since 1990, rose 1.6% percent last year to an average of about 41 million yen for a typical 80 square-meter unit, from a lows in 2000, according to the Japan Real Estate Institute.

Moreover, the availability of property is on the increase. Many Japanese companies plan to speed up property sales ahead of asset impairment accounting rule changes that take effect in April 2005, which will require companies to report assets based on market value.

"2003 Problem" Solved by Economic Recovery, REIT Scramble

In 2002, both developers and investors were concerned about what looked to be a "2003 problem", with a rush of large commercial building completions expected to push up vacancy rates and push rents further lower, particularly on space for older buildings. But vacancy ratios in Tokyo’s five central wards peaked at 8% in 2003 (after rising from below 4% in 2000) and had declined to 7.22% by June, according to Miki Shoji. The average vacancy rate for the 2,597 buildings surveyed by Miki Shoji declined largely because of a sharp decline in vacancy rates for the 33 new buildings surveyed, from over 16% a year ago to 6.85% as of June. The supply of vacant large scale building space decreased by some 125,620 square meters during the first half of this year.

Competitive rents being offered by landlords seems to have aided the take-up of new space. Average asking rent was JPY17,589/tsubo (3.3 square meters) in June, down 5.86% YoY, and compared to JPY28,000 in 1998. The average asking net rent for large-scale newly completed buildings was JPY24,391/tsubo, also down over 5% YoY. Because of the rent competition even among large landlords like Mori Trust and Mitsubishi Estate, the 500,000 tsubo of vacant floor space as of December 2003 had declined to 456,349 tsubo.

Learning How to Use Other People’s Capital

Once among Japan’s most heavily indebted (leveraged) companies, real estate firms are learning to use investor funds in their development projects. Mitsui Fudosan Co. (code: 8801) is the project manager for developing a 26-storey office building in the Shirogane district of Tokyo's Minato Ward. The company, however, is not investing in the building and does not own any part of it. Footing the development cost is a Mitsui Fudosan subsidiary funded with capital provided by institutional investors. After completing the structure, it will be sold to Nippon Building Fund (code: 8951), a listed REIT, for about 28 billion. Mitsui will earn fee revenue in the project by overseeing the development, including the formulation of development plans, negotiating with subcontractors/government authorities and attracting tenants. After the building is completed, Mitsui seeks to earn fees by managing the building's tenants. Mitsui calls this sort of property -- one into which it does not invest any money -- an asset in custody. As of the end March 2004, the company held JPY1.44 trillion yen worth of "assets in custody" on consolidated basis. It aims to expand this to JPY3.0 trillion in fiscal 2008.

Mitsubishi Estate (code: 8802) is following suit. One example is the Kawasaki LeFront, a shopping center in front of the JR Kawasaki Station. Mitsubishi developed the site with funds provided by investors and, after completing it, sold it to a privately-issued realty investment fund set up by Mitsubishi. Even Mori Building Co., which had long had a policy of owning the assets it develops, has set up a privately-placed investment fund to collect money from investors. Sumitomo Realty & Development (code: 8830) is preparing to list a REIT on a stock exchange this autumn.

Trust and Commercial Banks Join the Fray

Fueling these moves is the availability of loans extended by fee-hungry financial institutions. Such loans account for about 70% of the total amount of money which privately-placed realty funds invest in real estate, and 40% of the REITs' investment funds. Because those funds have invested in blue-chip properties in central Tokyo, prices have begun rising recently, and this is working to solve the "2003 problem" much sooner than most feared in 2002.

Major trust banks are also strengthening their real estate investment trust (REIT) sales by marketing these instruments to individuals in addition to such traditional investors as corporate pension funds and financial institutions. With the slide in land prices in such areas as central Tokyo subsiding, individual investors are showing a stronger appetite for real estate investments. Seeking commission income, the trust banks believe that REITs are a promising market with further growth potential, and easier to sell than equity funds.

Chuo Mitsui Trust and Banking has already sold JPY8.1 billion yen of a REIT that went on sale in November 2003 and invests in U.S. properties. The bank's Japan REIT fund investing in domestic real estate assets has already sold JPY1 billion yen since August Allowing domestic investors to invest in Japan REIT funds starting at JPY10,000 yen has meant that property investment is now available to everyman (and woman) instead of just high net worth investors. Meanwhile, a Japan REIT fund that went on sale June 14 by Mitsubishi Trust & Banking sold JPY1 billion in just one week and topped JPY10 billion two months later.

REITs Become a Viable Investment Class

Nowadays, Japanese investors have a wide range of REIT offerings to choose from. Mizuho Trust & Banking (8404) began selling a U.S. REIT fund in 2003, while UFJ Trust Bank and Sumitomo Trust & Banking (code: 8403) have begun offering U.S. REITs as well. With their long-standing expertise as intermediaries in real estate transactions, trust banks are well-versed in the establishment, management and assessment of REITs, and thus this is an attractive fee business for them.

The total assets held by Japan's listed REITs reached about JPY1.59 trillion yen as of March 31. These REITs plan to boost their assets by 70% to roughly JPY2.7 trillion, while the companies that intend to set up and list REITs expect to purchase about JPY620 billion in properties by the end of March 2007, bringing the combined asset amount to about JPY3.32 trillion yen.

The REITs are bolstering their asset purchases in a bid to diversify their revenue sources. By establishing an earnings structure that is not greatly affected by changes in utilization rates of certain properties, the funds aim to attract a wide range of investors. Because the decline in land prices for central Tokyo, which is home to a number of prominent properties, is showing signs of abating, the REITs are snapping up assets while they are still at attractive price levels.

Another reason why companies are stepping up their asset purchases is that REITs are becoming accepted by investors. REIT dividend yields are currently about 4%, much higher than returns offered by long-term Japanese government bonds. With individuals and regional banks also becoming REIT investors, the market capitalization for REITs jumped 120% from a year earlier to surpass JPY1.2 trillion yen as of April 30. In turn, the REITs are helping to drive urban renewal projects. The interesting thing about all of these shiny new urban renewal complexes is that they are soon filled with throngs of people and become tourist attractions in their own right. In other words, if you build it (at least in the center of Tokyo), they will come. Strong demand for properties could spur more real estate developers to pursue such projects, especially if the buildings they deal with are snapped up by REITs and enable them to recover their investments quickly.

Beyond Intrinsic Value?

Intense bidding for popular properties in central Tokyo among domestic and overseas real estate funds is one of the major reasons prices are recovering. AMB Black Pine, the Japanese operation of a U.S. real estate investment firm, acquired property in Ota Ward from the Tokyo Metropolitan government in April for 10.6 billion, or 90% more than the reference price.The Japanese unit of ProLogis, which lost the bid for the property, plans to continue investing JPY60 billion a year. The company announced plans Thursday to build a distribution facility that it will lease to Seiyu Ltd. (code: 8268).

But active participation in the Japanese property market has changed the price formation mechanism for property transactions. It is now based on discounted cash flow (rental income), and not on the myth that property prices rise forever, as was the case during the "bubble".

Real Estate Stocks are Correcting , But it Will be Back

The so-called "reflation plays" have been hit the hardest during the recent consolidation, on investor doubts about the sustainability of the economic recovery, and the prospects for an early end to deflation and ZIRP (zero interest rate policy).

However, the rally seen over the past year was but a prelude to the movement that could be seen with full-fledged reflation. Indeed, the major real estate developers will be better positioned this time to leverage a secular recovery in real estate, because they have learned to use other people’s capital, which in turn means there is much room to de-leverage their balance sheets and bring more of the improving real estate margins to the bottom line.

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