Is Japan real estate poised for a gold rush?

As the real estate market struggles, opportunities are arising for distressed asset specialists.
The Real Estate Investment World forum held in Tokyo last week was full of gloom and doom. Delegates who had bought the $3,500 tickets, obviously long before the credit crunch really hit, chatted together like survivors of a particularly nasty storm û albeit very well dressed survivors. And they certainly had plenty of bad news to discuss with the value of real estate acquisitions in Japan still below Ñ10 billion ($103 million) for 2008, compared with between Ñ50 billion and Ñ60 billion last year, according to figures provided by RREEF Alternative Investments, a unit of Deutsche Bank.

Yet if you dug a little deeper you could see that some delegates were surprisingly relaxed. Most bankers did not want to be quoted given new uncertainties in the market, but the consensus seemed to be that if all goes according to plan, halcyon days could be here for the investors who have ôkept their powder dryö.

Michael Bowles of Jones Lang LaSalle, Japan, pointed out that the last real estate boom, between 2001 and 2006, was the result of foreign banks coming to Japan in the 1990s and snapping up non-performing real estate loans from Japanese banks. The banks were being forced to write off their real estate debt as asset prices collapsed. Foreign banks which were in Japan at the right time not only benefited from the rock bottom asset prices, pointed out Bowles, but also became experts in the real estate issues of the Japanese market. In addition, as the Japanese market picked up thanks to a strong export performance, real estate investors benefited from an unusually large yield gap with Japanese government bonds (JGBs). All these factors allowed major players like Morgan Stanley, Lehman Brothers and numerous private equity companies to make considerable sums of easy money in the early years of the new millennium.

But even then, while individual players made out very well, the average annual return of 4.8% between 2000 and 2007 was below that of the UK and the US, which returned 11.2% and 12.8% respectively for the same period.

Unfortunately for Japan, there does not seem to be many ways other than distressed situations in which to make money in the Japanese real estate market. For the past 19 years, land prices have risen in only two, namely in 2005 and 2006, before flattening out in 2007/2008. Rents are now beginning to fall, with the first rent reductions for new office buildings announced on Monday.

Also, as several delegates to the world forum obliquely remarked upon in their panel discussions, they are dealing with a regulatory environment that has a far more robust attitude than former Federal Reserve governor Allan Greenspan when it comes to tolerating asset bubbles. Thus, in 2007, as the real estate exposure of Japanese banks rose from the low teens to the mid-teens in percentage terms, the government essentially instructed the banks to rein in their lending. The result was a downturn in real estate prices which hurt the market even before the credit crunch from the rest of the world swept through the Japanese economy.

The result of the credit crunch has been much harder for Japanese banks than originally assumed based on Mizuho Financial GroupÆs $1.2 billion investment in Merrill Lynch, the acquisition of Lehman Brothers by Nomura Securities, and the 21% investment in Morgan Stanley by Mitsubishi UFJ. Bank analysts are warning of a serious financing crunch as the profitability of Japanese banks gets savaged by their high exposure to the Tokyo stockmarket, of which they own 15%. With the Nikkei index dropping to a 25-year low in early November, lending among Japanese banks is becoming much more cautious.

The stockmarket weakness is also creating havoc among J-Reits (Japanese real estate investment trusts), with yields hitting 30%-40%. Some delegates suggest that the private market is actually more robust than the public market and that the sensible course of action is to de-list. Some delegates noted, however, that the real estate fundamentals in Tokyo are sound despite the financing problems, with commercial land prices still low relative to GDP on a historical basis and vacancy rates just over 3%. Anything over 3% is considered high by international standards, but rents in Japan tend to fall and rise much more slowly.

The Reit sector is considered essential for the health of the broader real estate market. One banker said that "the danger of Reits failing is potentially to turn a cyclical correction into a deeper and longer downturn". And the decline has already begun. The Reit sector suffered a serious blow in the run-up to the conference when New City Residence Investment Corporation started bankruptcy proceedings with liabilities of Ñ112 billion ($1.14 billion) û the first Reit to ever do so. On October 9, the trust put out a press release stating that ôthe corporation has reached a stage where it cannot easily raise funds to acquire the properties scheduled to be acquired or funds for the repayment of borrowingö.

Indeed, funding in the Tokyo real estate market has taken a sharp hit from the collapse of Lehman Brothers and Bear Stearns, and the takeover of Merrill Lynch by Bank of America, as well as the slowdown in collateralised mortgage-backed securities. Morgan Stanley was a major player in the CMBS (commercial mortgage-backed securities) market, but the securitisation markets are closed, apart for the occasional deal. (Deutsche Bank was recently able to securitise the headquarters of Shinsei Bank.)

Aggravating the financing situation is the short maturity of the loans in the Reit sector, which often have a tenor of three to five years.

ôThe removal of the foreign banks from the market has created a funding gap in the market which the Japanese banks canÆt fill,ö said one delegate. ôBecause the Japanese banks were less dependent on securitisation, they are already æat capacityÆ in terms of their balance sheet exposure to the real estate sector and cannot extend further loans.ö

Yuichi Hiromoto of Mitsubishi Corp-UBS Realty added that even the Japanese commercial paper and interbank lending markets are coming under stress, which can only aggravate the situation for real estate lending. The upshot is that there has not been a single J-Reit IPO year-to-date. Debt financing, according to RREEF, is running at one-quarter of the levels of 2006, which admittedly was a record year.

One banker said the reluctance to lend was verging on the absurd. "Reits are among the most transparent instruments in Japan, far more transparent than a conglomerate like Mitsubishi for example which is exposed to volatile oil prices. Yet the banks refuse to lend to Reits while falling over themselves to lend to Mitsubishi."

Many delegates pointed out that the over-regulated nature of the J-Reit market is making the situation worse. There are much stricter limits on the ability of J-Reits to roll over commercial paper than for any other industry, and the uses for which the funds can be employed are more strictly supervised. What were meant originally to be shareholder friendly measures can turn into a potentially dangerous lack of flexibility in a downturn. Mergers are hampered by the fact that the backer of the bank initiating the merger may refuse to add to its risk profile by backing the new entity. There is also no law in place for Reit acquisitions, so players have to resort to æproxy mergersÆ whereby the asset management companies are changed.

One banker summed up the drastic failings of the Reit sector with the words: ôReits were marketed to investors as medium return and medium risk. In fact, they have shown very low returns and extremely high risk.ö According to Lasalle Investment Management, the average market discount to net asset value in Japan is currently 31.4%, compared to 20.8% globally, 32% in the UK, and 37% in Singapore.

According to another banker, aside from a rule change to make it easier for J-Reits to survive, the players themselves must also clean up their act. Without naming names, the banker said that certain Reits must stop being used as æwaste basketsÆ by their sponsors conflicts of interest û for example when sponsors charge excessive fees to manage the assets. The trust banks, which are supposed to oversee operations in the interest of shareholders, tend not to intervene unless a law has been clearly broken.

Sean Pey Chang of Saizen Reit probably went to the heart of the matter when he discussed the difficulties he as an operator is facing with the closing of the CMBS market. ôAll of a sudden, I need to speak to financiers, and I donÆt know who they are. I never had to meet them before because my borrowings were being securitised. We are entering an era where a direct relationship with oneÆs bank is going to be essential. That will slow down capital raising, since it takes at least twice as long when a bank is using its own balance sheet as it does to securitise a loan.ö

In other words, multi-tiered, complex instruments which depend on high levels of leverage are not suitable for the time being.

Tokyo does have some strengths, however. ItÆs the largest single market in Asia, rents are very stable, and the market is not as dependent on the volatile financial sector as its counsterparts in New York and London. But while waiting for the market to recover, investors will most likely be making money out of the misery of others.
¬ Haymarket Media Limited. All rights reserved.
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