Real estate prices across the rest of Japan are stagnant or sluggish, as economic activity migrates ever more to Tokyo. Indeed, Tokyo is seeing net migration of 100,000 people per year from the rest of Japan, according to brokerage CLSA. These newcomers are driving the relatively new condominium market in particular.
The Japanese market has several unusual aspects by US or UK standards. Andreas Schuster, head of real estate research at CLSA in Tokyo, sees the property market in Japan as being very different to those models. ôThe Japanese property model is more similar to the continental property model,ö he notes.
This difference is very profound. In the US and the UK, the real estate market is often consciously used by the governments as a vehicle for wealth creation. This means a tacit encouragement of housing bubbles by the authorities, such as the FedÆs three-year period of 1% interest rates after the terrorist attacks of 9/11.
In these markets, real estate becomes highly commoditised and sophisticated financing mechanisms are introduced, enabling maximum leverage. Leverage creates big equity returns and, in turn, encourages re-investments in buy-to-let properties. The key is cheap and generous financing, since this sucks in young buyers who could not otherwise afford housing. These young buyers then try to get onto the æproperty ladderÆ, whereby on retirement a large house financed by previous sales into a constantly rising market can be cashed in for a smaller property, with the balance going towards the cost of living.
Naturally, this model has one serious flaw: property markets donÆt always rise.
In Japan, there is no such property market. Although financing is very cheap, at around 3% for a 30-year mortgage (usually fixed for the first few years, but increasingly floating because of the expectation of interest rate rises), mortgages are granted after a careful evaluation of length of time in employment, type of company, salary and many qualitative factors (for example, the prestige of the employer, which is hard to quantify). Down-payments therefore often vary but can be 20%-30%, as opposed to zero or 10%, few questions asked, in Anglo-Saxon markets. Worst of all, the buyer has to pay Value Added Tax on the transaction, which amounts to 5%, as with all goods.
ôThere was only one period when real estate was traded like in Hong Kong. That was in the 1980s during the bubble. But that was exceptional,ö says Katsunori Serizawa of Mitsubishi Estate. ôItÆs not likely to happen these days because people donÆt have any faith that markets will ever rise over the long term.ö In both the commercial and the residential real estate markets, tenants get more protection than in Anglo-Saxon markets.
ôTokyo is the most liquid market in Japan, but even in Tokyo liquidity can be hampered by a strong system of tenantsÆ rights. There are two layers: the owner of the land is relatively powerless towards the owner of the building on the land. And the owner of the building is relatively powerless to the tenants of the building,ö says Serizawa.
As a result, even in extremely pricey areas like Ginza, you will find very small buildings, either shops or homes. These tenants have simply decided not to move, costing the landowners a fortune in lost development benefits. A second striking aspect of the Tokyo property market is the high price of land. Note, thatÆs land, not buildings. Physical land fetches a high premium in Tokyo. Buyers tend to focus on the land, rather than on the building on top of the land.
By some standards, this is strange. Land is not especially valuable in itself. What provides the land with value is the yield on the land, which is derived from creating desirable residential or commercial buildings. ôLand carries a premium in Japan, because itÆs been considered a valuable asset historically,ö says Schuster.
This focus on land appears in many forms. Land in Tokyo is left undeveloped far more often than in markets such as Hong Kong or London. Owners will knock down the house of a tenant, since they know nobody will want to buy it, and leave the land idle, or as a rough car park, until they can sell it. Because of the emotional attachment to land, liquidity is hard to obtain û which further pushes up the price of land. In addition, development is curtailed by earthquake protection. This does not mean the buildings are strongly built (on the contrary); it often just means that there are limits on their height. This tends to cap the rental yields on all buildings, making the high value of land all the more illogical.
One Tokyo resident, who preferred not to be named, explains the situation thus: ôLand benefits from beneficial tax treatment, while building doesnÆt. ItÆs more tax efficient to knock down the building and sell land. This was probably a strategy for supporting the construction industry in the post-war years, since buildings were constantly being torn down and rebuilt.ö
Because they know that the next buyer of the land will likely tear down the building, the building is not considered worth investing a lot of money in. As a result, owners rarely invest in fancy add-ons which could raise the price of the home, such as fire places, pools, or even in maintaining the building. ôIn addition, Japanese people like to live in new houses. They donÆt like second-hand homes. So any money spent on the house is lost money,ö says Martin Koelling, a Tokyo expat who decided to build a new house rather than buy secondhand.
Land prices were extremely high during the bubble years, but following the collapse of the bubble in 1990, they declined for the next 14 years. It was only in 2004 that land price growth started turning positive again. By that time land prices had declined 50% from their bubble peaks. Prospects for the markets are somewhat mixed. Commercial real estate in central Tokyo looks pretty promising, while the residential condominium market looks much less exciting, for example.
Central Tokyo is not just one area, but consists of several downtown districts. Marunouchi is the financial district, and arguably the most prestigious area given its proximity to the Imperial Palace. It also been through an extraordinary re-development process over the past decades, much of it engineered by Mitsubishi Real Estate. Marunouchi achieves the aim of an integrated development over a large area more spectacularly than any other Asian city. Shibuya and Akasaka are also leading downtown centres.
Nevertheless, they all have one thing in common: extremely tight supply. This tightness is aggravated by difficulty in obtaining large plots of land. A lot of further development will therefore mean re-development. Since this means taking out existing supply in order to release it in better form three or four years later, supply will be even further pinched. As a result, Schuster calls the office rental market ôthe best in 25 years, with vacancy rate rock bottom at just 1.8% in 23 of the most central Tokyo wardsö.
MitsubishiÆs Katsunori is more pessimistic, however. ôReal estate prices have peaked. On Sotobori Dori (a major avenue in central Tokyo) a unit of land cost Ñ100 million last year. Now itÆs Ñ70 million,ö he says.
The condominium market is faring worse, with condo starts down 62% in 2007, on the back of oversupply in the suburbs. ôReal estate developers abandoned the very expensive parts of central Tokyo and put up condo developments in the suburbs. However, they have found that not many people want to move there,ö says Schuster. In addition, the condo sector was severely hurt by the introduction of tougher building legislation last year. The introduction of this new legislation was inefficient, numerous critics have noted, since the old legislation was outlawed before the new legislation was finalised. As a result, construction firms could not move forward with new projects.
The rental market for condos reflects this weakness, with smaller and older condos especially under threat. ôThere was an explosion of condo building which is now hard to shift. As a result, you have several residential Reits trading below book value,ö notes CLSAÆs Schuster. Rents have stayed sluggish in the Greater Tokyo market as a result.
continued on next page . . .There is some silver lining to the residential mortgage market, despite the high inventory levels. ThatÆs because land prices and construction prices are rising, which will ultimately underpin the condo market. ôBuyers are not apparently fully aware of the sharp rises in land price recently. Land and condo prices are historically closely aligned,ö writes CLSA. Still, with the Japanese consumer facing a macro-economic squeeze and weaker pricing power on the back of sluggish wage growth, itÆs difficult to foresee a major increase in condo buying or rental budget.
Mitsubishi EstateÆs Katsunori adds one final, crucial factor, namely the attitude of the Bank of Japan. ôThe BOJ has been advising the banks to be careful and to reduce their exposure to real estate, since itÆs worried the banks will expose themselves excessively to real estate, just as they did in the last bubble,ö he points out.
Real estate investment trusts (Reits) have taken off in Japan over the past three years, as the real estate market has revived. Given the cultural strangeness of viewing the real estate market as an investment, much of the momentum has come from foreign investors. Foreign investor sentiment is an unusual but crucial element of the Tokyo market. ItÆs unusual because although Japan is the second biggest economy in the world, just under 30% of the market capitalisation is owned by foreigners.
J-Reits (as they are known) are no exception. Foreign fund flows were net buyers of Reits until May 2007. Since then there has been some volatility, but overall CLSA estimates net foreign inflows are increasing year-on-year. In contrast, Japanese retail investors have been net sellers of the Reit sector. Japanese retail investors have focused on buying Reits at the initial public offering and selling them immediately.
After several years of growth, Reits became a disaster for investors from the summer of 2007, partly on the back of the US subprime crisis, but also because Reits need growth to add value. Just like a company needs to grow its earnings, Reit managers need to grow their rental income through the acquisition of new properties. ThatÆs been difficult in Japan given the scarcity of land, and the Reit sector is seeing some pressure to consolidate û but not by hostile M&A, which is frowned up on.
The preferred model for consolidation appears to be via the acquisition of the asset management arm of an existing, underperforming Reit by a new sponsor. A æsponsorÆ in Reit terminology is the entity which finds and sells property assets into the listed vehicle (often a real estate company), where they are managed by the asset management company. The role of the sponsor is essentially to find new properties and sell them to the Reit.
In mid-February this year, a landmark transaction occurred when Mitsui Fudosan announced it would buy the asset management company of Frontier Real Estate Investment. The latter is owned by Japan Tobacco, which was selling a diminishing number of its factory sites to the investors in the Reit. The asset management company will now manage assets sold to the investors in the Reit by Mitsui Fudosan û which as a pure real estate company should be more successful at sourcing property.
"For us to grow further it was imperative to get a sponsor able to steadily supply (properties)," Izumi Maeda, chief financial officer at Frontier Reit Management told the press at the time of the announcement. The move cannot come too soon for Frontier, which has seen its shares gone down by 50% from their May 2007 peak. The wider Reit index is down 40% over the same period.
Given the recent low, there is some reason is to hope that JapanÆs retail investors could get back into the game. With residential and property Reit prices declining since December û mainly as a result of the new building legislation and oversupply concerns in the condo market û yields have been soaring. The yield spread over ten-year Japanese government bonds is now over 4%. At those levels, it will be difficult for value investor to stay away, estimate observers. CLSA notes that residential Reits can offer yield stability while capital gains are more likely to come from office Reits.
One foreign investor doesnÆt need further convincing. SingaporeÆs Government Investment Corporation has invested directly in real estate and also in Reits. In mid-February GIC spent $717 million on the Westin Hotel in Tokyo. A couple of weeks earlier, GIC bought 5% of Japan Prime Realty Investment, according to stock market filings. GIC also owns just under 4% of Japan Retail Fund investment, another Reit.
GIC may be making a shrewd move. ItÆs difficult to see any real correlation between the US and the Japanese stock markets. Japan may have more than its fair share of problems (demographic shrinkage, a lack of property investment culture) but its banks tend to be far more cautious than their US counterparts.
Where the US subprime has directly impacted the Japanese real estate market is in terms of leverage. "For the financing of Japanese real estate, we have seen the loan market to be less available, and the terms have been less favourable compared to a year ago," says Chang Sean Pey, CEO of Saizen Real Estate, recently listed in Singapore. CLSAÆs Schuster agrees estimating that leverage has gone down from 90% to roughly 75%. That shouldnÆt stop cash- rich funds like GIC picking up assets at rock bottom prices, however. For the value investors, Tokyo currently offers plenty of picks. For the growth investors, the outlook is somewhat bleaker.