Japan was toppled this year by China as the world’s largest holder of foreign exchange reserves, but it still ranks near the head of most of the world’s league tables of accumulated wealth. Notable among its claims to distinction are the ¥1,400,000bn ($11,800bn)-worth of financial savings, excluding land, held by Japanese individuals (second after the US) and the estimated value of the nation’s land stock, still valued at ¥2,300,000bn despite steep declines following the bursting of the late 1980s property bubble.
The Tokyo Stock Exchange (TSE), after a catastrophic fall followed by 16 years of sideways movement, is still the world’s second largest, after the New York Stock Exchange.
Set beside these benchmarks it is surprising that Japan ranks only eighth or ninth among the world’s real estate investment trust (Reit) markets, with 41 funds holding ¥6500bn-worth of real estate assets. This is not because the market is younger than most of its peers. The first J-Reits went public in September 2001, about five decades behind the US, but several years ahead of the UK, Germany and France, all of which now outrank Tokyo.
Hopeful beginnings
The Japanese market appeared to be taking off in 2005 and 2006 when the TSE saw 25 Reit initial public offerings (IPOs), more than doubling the total number of listings. This year, however, has seen a reaction. Only one new Reit had listed by the end of July and analysts say the total for the year may not reach five. Within the Asia-Pacific region, the value of publicly securitised land in Japan is overshadowed by Australia, where more than 30% of property is traded on the stock market.
The catch, says a senior official in the Financial Services Agency (Japan’s main financial regulator) is that listed Reits are the tip of the iceberg. Japan ranks among the top three markets for securitised property, says the official, if you include mainly unregulated private funds holding an estimated ¥10,000bn-worth of assets. While some public funds are small, the non-public sector includes giants such as the Japanese portion of Morgan Stanley’s MSRES fund, which recently launched its sixth fund, raising $8bn, with 40% of the total earmarked for Japan.
Private funds are by definition less visible than Reits but the situation will change at the end of September with the implementation of a Financial Instruments and Exchange Law (FIEL), which will drastically widen the FSA’s authority over capital markets, other than the already tightly regulated equity sector.
The FIEL will allow the FSA to inspect all real estate investment funds and will mean that asset managers need to meet stricter compliance and governance standards, says Taisuke Miyajima, president of Kenedix Reit Management, manager of a leading Reit specialising in medium-sized office buildings. That could raise costs dramatically, especially for small firms staffed by only four or five professionals.
Regular inspections
Sosuke Takechi, executive director of the planning department of the Association for Real Estate Securitisation, says it is not clear how rigorously or thoroughly the FSA will exercise its inspection rights under the new law but he believes the consequences could be sweeping.
Most Reit analysts believe the FSA’s ultimate aim in extending its remit is to create a healthy integrated market that could reflect Japan’s financial status as one of the world’s top real estate markets. But it is doubtful whether that will happen soon. The FIEL may tend to level the playing field between listed
J-Reits and the largely unregulated unlisted sector, says Toru Esaki, a Reits analyst at Mitsubishi UFJ Securities. However, real equality will only come with a parallel set of measures to remove some of the crimping restraints on the listed Reits market that have hampered growth in the name of shielding investors from risk.
Progress in this area is hard to assess. Alexander Kinmont, an adviser to Prospect Asset Management, a Hawaii-based firm that manages a J-Reit fund of funds listed on the London Stock Exchange’s AIM market, believes the government is in a “delicate position” because the J-Reit market was conceived as a vehicle for individual investment but is “actually dominated by institutions”.
In July, Japanese financial institutions owned 53% of the J-Reits market with overseas investors holding another 24.5%. Individuals held a mere 12.5%, with corporations making up the remainder.
J-Reits, unlike their peers in most other markets, cannot invest in property outside Japan, partly because land appraisal systems in Japan differ from those in other markets. A second important constraint is segregation between asset managers and developers.
Under the current Japanese system, Reits are special purpose companies (SPCs) that are managed by dedicated asset management companies requiring licences from two government agencies, the FSA and the Ministry of Land Transport and Infrastructure. Asset managers are not permitted to initiate property developments, but can buy land and buildings from related developers who are known as ‘sponsors’.
This system works well enough when the sponsors are willing to sell property to asset managers for securitisation but less well when developers prefer to hang on to their most valuable assets, as has been the case with some household names in the domestic Japanese market. Another problem noted by Yuichi Hiromoto, founder-president of Mitsubishi Corporation-UBS Realty, which manages Japan Retail Investment Corporation, is that Reit asset managers cannot take the initiative in launching property development projects.
Mr Hiromoto’s firm is in a joint venture with Mitsubishi Corporation, a general trading company, and UBS, a diversified financial group with no other property investments in Japan. Mitsubishi Corporation-UBS underwrites and securitises large-scale, urban redevelopment projects, including shopping centres but cannot make a direct approach to the local governments that are at the centre of many such projects. “We have lobbied the government about this,” says Mr Hiromoto, but he thinks the FSA is unlikely to change its policy any time soon.
The lopsided development of real estate securitisation in Japan reflects its origins in the late 1990s, when the Japanese economy faced two major challenges. Private real estate funds, often organised by major foreign asset management companies, began to appear in the late 1970s when the stability of Japan’s financial system was threatened by a huge overhang of non-performing loans (NPLs), much of it collateralised by property that had been devalued since the collapse of an asset bubble at the start of the 1990s.
Foreign investment banks helped resolve the crisis by buying NPLs and redeveloping the property collateral, using a valuation method that stressed potential earnings from buildings, rather than the ‘absolute valuation’ of land based on location, which had been standard practice during the asset bubble. Properties were then packaged into securitised funds that could be sold to institutions on the basis of rental income. “The process was similar to the growth of the US Reits market in 1991 at the end of the savings and loan crisis,” says Mr Hiromoto.
Unproductive savings
The second challenge that faced Japan in the 1990s (and is still an issue today) was to create a dynamic capital market to absorb some of the personal financial assets that were languishing in low-paying, unproductive bank deposits. Launching a Reits market looked like a promising way to do this but the government had to woo investors who had been shell-shocked by collapsing land and equity values in the early 1990s. Segregation of Reit asset management from the real estate development industry was intended to minimise risk. Other incentives included exemption of Reits from corporation tax and a requirement for 90% of rental earnings to be paid out to the market.
From its launch in 2001 until 2006, the TSE’s Reits market displayed steady but unexciting growth, yielding investors a premium of about 2% over long-term interest rates and helping finance the redevelopment of office space in central Tokyo. From the last quarter of 2006 the market underwent a dramatic change. The Tokyo Stock Exchange Reit index swept past its Topix index (based on the value of all listed stocks) as investors, particularly foreign hedge funds, became aware that a mini-bubble was developing in Tokyo’s three central wards, with office vacancy rates falling sharply and land values in some strategic locations showing year-on-year valuation increases of more than 30%.
The TSE’s Reit index peaked on May 31 at 2612.98, up more than 1000 points from its level in August 2006, but then went into reverse, reaching 2000 by late July as a rise in long-term Japanese interest rates narrowed the gap between Reit earnings and long-term interest rates to less than 80 basis points, and hedge funds exited the market
Analysts called the decline a correction rather a collapse. “Reits will probably find solid ground at around 1800, and I would expect that to happen late this year or early next,” says Takashi Ishizawa, chief real estate analyst at Mizuho Securities.
“What we have seen in the past six months is that smaller, less famous Reits can be dangerously squeezed while famous names soak up investors’ money,” says Mitsubishi UFJ’s Mr Esaki. He believes that the Reits market will undergo major consolidation in 2008 with smaller Reits merging to increase liquidity, or forming alliances with powerful non-listed real estate investors in the hope of gaining access to new properties.
Property developers can buy directly into Reits, or become partners in their dedicated management companies, says Mr Esaki. In fact, three such alliances had already been struck by the time the Reit index fell to 2000 at the end of July. In May, Morgan Stanley acquired a 27% stake in Crescendo Investment Corporation, a diversified office and residential Reit with a relatively weak domestic sponsor.
Foreign rescuers
Two other cases of powerful foreign developers riding to the rescue of stressed smaller J-Reits were CapitaLand of Singapore’s acquisition of a 33.4% stake in Morimoto Asset Management (the manager for BLife Investment Corporation) in February, and a tie-up in March between LCP Investment Corporation and the Japanese arm of GE Real Estate. Both BLife and LCP are medium-sized Reits that had faced difficulty in funding expensive purchases of residential and office space in central Tokyo before they acquired foreign patrons.
A snag about foreign (or indeed major Japanese) developers acquiring stakes in small Japanese-listed Reits is that Japanese law provides for Reits to lose their tax immunity when more than 50% of their stock is owned by three (or fewer) investors. A further worry is that foreign patrons of endangered smaller Reits may be more interested in using their acquisitions as a stepping stone for launching their own Reits in the Japanese market than in strengthening the portfolio of the funds in which they invest.
Therefore it remains highly uncertain how consolidation of the J-Reits industry will proceed, says Mr Esaki. Despite such doubts there is a consensus that the sector has reached a turning point. To realise their potential, J-Reits need both consolidation and to be granted a freer hand by regulators. Once the market has crossed these hurdles, Japan should come into its own as one of the world’s leading centres for real estate securitisation.
