ECM 2005 - REITs dominate in Japan
Now in their fourth full year of existence, Japanese real estate investment trusts (J-REITs) have risen from relative obscurity to become the darlings of the country's equity capital markets. But with inflation rearing its head, and a near-term interest rate rise appearing certain, the red-hot REIT sector may be primed for a fall. Brad Frischkorn reports.
With almost all of the Japanese multi-billion dollar privatisation offers wrapped up, and the public CB market showing few signs of an imminent thaw, the explosion of J-REITs is grabbing almost all of the limelight these days.
Not since the arguably overpriced Nippon Building Fund – one of the first to come in 2001 – has a J-REIT IPO been truly disappointing. Originally pitched as a domain for intrepid foreign investors and regional banks without solid loan portfolios on which to rely for revenue, J-REITs are now courted by most types of institutional buyers.
From an investment banking perspective, supply can barely keep pace with demand. A total of 23 J-REITs now populate the exchanges – double the number in 2003 – with more than ¥3trn (US$27.3bn) in market capitalisation. Several funds are now looking forward to their third capital increase.
“In terms of issuance, there's no end in sight,” according to Gareth Lake of Nikko Citigroup, the largest Japanese underwriter of J-REITs. “We’re still in a time of exponential growth. There is still a technical shortage of J-REIT paper.”
Market prices seem to support that bullish outlook. The Tokyo Stock Exchange’s REIT index has doubled since its founding 18 months ago. Buy-and-hold investors of Nippon Building Fund, now one of the largest J-REITs, would have gladly overpaid for shares three years ago.
Property acquisitions continue at a torrid pace. In late August, Japan Real Estate Investment Corp (JRE), another of the market’s pioneering issues, announced that it would acquire a building under construction on the lot formerly occupied by the now defunct Nippon Credit Bank’s headquarters for ¥81.5bn – the largest single J-REIT acquisition ever. Slated for both office rental space and commercial retail tenants, JRE will finance the purchase by selling 20-year paper – also a first for the sector.
The numbers for the private real estate investment fund (REIF) market are just as impressive. After doubling from 2004 levels to over ¥2.5trn now, that market is poised to double again by the end of 2006. Da Vinci Advisors, one of the largest private real estate managers, recently announced plans to establish a fund worth ¥1trn by 2006. Foreign-owned property funds are projected to hit ¥4trn in value around the same time – a 100% increase from 2003.
Another bubble feared
All this frenetic activity has naturally given rise to criticism, and Japan is certainly no stranger to stock market and property market bubbles. The debate over valuations for both real estate and the funds that securitise them is understandably dynamic. But while they are higher now than in recent years, there is no clear consensus that land values are excessive on an absolute basis.
After reaching stratospheric heights during the valuation bubble of the mid-1980s and early 1990s, as of January 1 2005 the national average price for residential property had fallen for the thirteenth straight year. Land prices in Tokyo, however, rose last year for the first time over that period, by 0.4%.
Other data provided by the National Tax Agency show that whereas real estate values had previously been edging up only in prime areas of central Tokyo, land prices had also now risen in areas outside the city centre. Redevelopment projects such as new monorail and subway lines have helped to push up demand in Tokyo suburbs such as Tachikawa, and further away in Yokohama, Osaka, and even in select parts of Kyoto.
But while some areas of Tokyo saw their values jump almost 20% last year, other areas continued to weaken. This is in sharp contrast to the days of the bubble economy, when land prices rose almost equally all over the country. In regional cities, maximum land prices are down as much as 25% in recent years, and still languish as low as one-eighth of their peak 1992 levels.
The uneven rebound in land prices, both from region-to-region and by class, is seen as largely due to securitisation fund buying. A June survey by the Ministry of Land, Infrastructure and Transport found that real estate securitisation in the fiscal year 2004 surged 90% to ¥7.5trn, bringing the cumulative total since 1997 to more than ¥20trn.
REIT, REIF and re-securitisation plans comprised 80%–90% of the force behind this trend. Business offices comprised about a third of the total (down from 80% in 1997), against 15% for commercial facilities, and 14% for housing facilities.
Behind all of this, it is difficult to exaggerate the government’s role in helping to unlock one of the world’s most illiquid real estate markets. In fact, say some critics, with the economy mired in an asset-sapping deflationary spiral for over 10 years running, engineering a solution from above was probably seen as more expedient than continuing to wait for the market’s invisible hand to resolve issues on its own.
Angus Muirhead, a Tokyo-based real estate analyst with Lehman Brothers, points out that changes made in the late 1990s to archaic land regulations that, for example, did away with some capital gains taxes, represented a huge boon. The subsequent shift to mark-to-market accounting also enabled companies to redress debt problems much more easily than before.
“With the regulatory reforms, land sellers now have someone to sell to, and new owners can build 30%–40% more on their land than they could before,” said Muirhead.
The worry is that while some regulatory changes were overdue and probably necessary to prod the market forward, the extent of the intervention smacks of a regulatory “fix” for deflation based more on simple book-keeping changes than anything else.
However, few of those making money again in the reinvigorated real estate market are complaining, and certainly not the savvy foreigners who were able to snap up distressed land assets at firesale prices over the last several years. Even construction prices are edging up for the first time since 1990.
No panic yet
Most of this activity has had its greatest impact on prices for prime land in Tokyo, where the majority of J-REIT assets are based and where the best gains may have already been realised. According to a May survey by the Association for Real Estate Securitisation, fewer financial institutions are investing in land-based products.
The respondent group, comprised of 107 life and casualty insurers, trust and regional banks, and pension funds, reported a 10% year-on-year fall in REITs, REIFs, and funds of funds, to 78%. The news quickly sent REIT indices down. But many observers see little reason to panic. One real estate analyst at a Japanese securities house noted that the recent dip in fund prices has been followed by an even stronger increase in buying. “A lot of people are still waiting to get into the market – those who missed out the first time around when prices rose so quickly and kept rising,” he said.
Another analyst at a foreign brokerage pointed out that while the 50% average premium for office J-REITs is significantly higher than the average premium on US REITs, which is 30%: “residential J-REITs are just starting to catch up with commercial property J-REITs. Trading volume is increasing, and they are starting to trade at their NAV levels.”
The one certainty regarding J-REIT investing is the need for the spread to JGB 10-year yields, which is currently 210bp–220bp, to remain healthy – especially while yields and liquidity in the corporate bond market remain low. The near universal consensus, however, is that with inflation picking up, spreads are likely to drop, possibly to as low as the mid-150bp level in the next 12 to 18 months, causing marginal buyers to dry up.
After missing its fiscal year 2005 target for projecting the end of deflation, the government is now insisting on fiscal 2006 as the target, citing year-on-year CPI numbers that show deflation dancing precariously close to the zero line.
Lehman’s Muirhead believes that regardless of inflation, the spread narrowing may occur more quickly. He sees the government reallocating some ¥150trn in national pension funds in the near-term future, an amount far too great for the JGB market to absorb. Short on liquidity and longevity, J-REITs still wear the "alternative investment" label, but a portion of these assets will almost certainly wind up there, according to Muirhead.
Akio Uchida, a fund manager who oversees retirement assets at MS Citi Life, says that J-REITs are already overbought, and need to add another 100bp in yield to become attractive again. “It would not be a shock to see JGB (10-year) yields immediately jump to the 2% level,” he said. “There’s more value in privately placed REITs which can still offer double-digit yields, as long as they are at least ¥30bn.”
For now, the land securitisation trend is looking like an unstoppable train. Non-financial companies such as Nippon Steel and Oji Paper are leading the pack in the new issuer market. In terms of asset diversification, a wave that has already spread to parking lots and employee training centres seems likely to reach hotels as well.
For buyers, the competition will continue to bring more options. For REIT issuers, however, the inability to attract large institutional interest has already shifted the weight of IPOs onto the shoulders of retail investors, who typically comprise 60%–80% of new issue book orders. “Fund managers have their work cut out,” said one ECM manager at a Japanese brokerage. “They have to work harder to create value.”