The Nikkei Weekly recently reported that foreign investors since last year have been buying up Japan’s real estate. Driving demand are stable property yields of 5.3% that far exceed the risk free return on government bonds. Does this suggest that our readers should jump into the property market? Not unless you are a professional investor, suggests Seth Sulkin. Seth is President and CEO of Pacifica Capital K.K., a Tokyo based real estate asset management and property development company. We interviewed Seth to better understand from the professional’s perspective the current state of Japan’s real estate market.
Stable Income But No Capital Gains
According to Seth, before 2008 Japan’s property market was buoyant. Occupancy rates were rising. Cap rates (a measure of the initial property yield used by the real estate industry) were in decline causing the value of property to rise. “Since the financial crisis, Japan’s fundamentals are terrible,” said Seth adding, “Japan will lose one-third of its population over the next 40 years. Already in central Tokyo there are many empty buildings. That number will multiply. It’s hard to imagine why prices will rise again.” Indeed, it is difficult to envisage that real estate will rise in value given the country’s deflation and demography. As the graphs depict, Japan’s land prices have been trending downward since 1991, while its population is both aging and in decline.
Although capital gains are unlikely, investment in Japan’s real estate offers stable income. Japan enjoys the largest spread in the world between property yields and interest rates. Ten-year Japanese government bonds are yielding just over 1%. Blue chip companies can borrow for as little as 50 basis points. “If you buy a Grade A office building offering a 4.5 -5.0 % yield and you’re paying 50 to 100 basis points to borrow,” said Seth, “that’s a huge positive spread that cannot be achieved anywhere else in the world.” In cities like London, where property is in high demand but interest rates are also high, the cost of borrowing can exceed yields. Therefore investors, particularly those in Asia and Europe, see Japanese property as a way to earn safe and steady returns. “They’re not looking for capital gains,” said Seth. “They are looking for stable income.”
Attracted by the stable income, pension funds are increasing their exposure into Japanese real estate. Historically pension funds have avoided owning property because of its illiquid nature. Real estate had been considered an alternative asset class along with hedge funds and the like. Conservative by nature, pension funds bought mostly bonds and some stocks. That has changed. According to Seth, “Pension funds have learned lessons from recent stock market crashes not to put all their eggs in one basket. The correlation between equities and real estate is low. Putting 3 to 5% of your assets into real estate is now usually considered to be a healthy way to diversify risk.”
Much of the focus of that investment has been on the Tokyo market. Japanese workers, tired of long commutes, are taking advantage of deflated property prices by moving back into Tokyo’s 23 wards. Property investors are attracted by the Capital’s steady increase in population that is rising by 1/2 % each year (see below graph).
Many Japanese buy one room mansions costing about ¥10 million as investments. Seth, however, does not recommend that individuals directly buy property for investment purposes. He believes the risks and the difficulties outweigh the rewards. “If you are an individual, you don’t want to be in the business of being a landlord for one unit,” said Seth. “It’s too much hassle. You need to collect rents, find new tenants and pay brokerage fees each time a tenant moves. Sometimes tenants run away causing damage. It’s not worth it.”
On the other hand, if you have a few million dollars and you want to buy a multi-unit building, you can expect a net operating return before depreciation of about 5% to 5 .5%. For a fairly new building, the capital expenditure required for maintenance is quite small. As the building gets older, the figure increases. If it’s an old building, your return depends upon whether you maintain it. All being said, if you buy a well located building that is about five years old and 95% occupied, you should get a reasonably stable income. Just don’t expect rents to increase or make a capital gain.
One contrarian play involves converting luxury apartments in Tokyo into rental accommodation. It combines the move by Japanese back into central Tokyo with the exodus of expats following the Lehman shock. The bursting of the financial bubble “has hurt the luxury expat apartment market,” notes Seth. “This opens the door for the opportunity to buy an ex-pat luxury apartment building and then to rent it out at reduced rates to the Japanese.”
The other interesting play is to convert a rental building to a condominium. “I don’t expect individuals to be making these kinds of investments as they require a lot of money, but it’s an interesting play if you want to make a capital gain on residential property,” said Seth. “That’s about the only way to do it.”
The individual investor who wants exposure to real estate and steady dividends can invest in Real Estate Investment Trusts (REITs). REITs are pooled real estate investments that can be bought by the retail investor. Seth, however, is unimpressed with corporate governance of Japanese REITs. Unlike U.S. REITs, which he considers having the best run property funds, the management of Japanese REITs is outsourced. The REIT itself is just a paper company which owns the property. The sponsor sells properties off its balance sheet into the REIT. The REIT is then managed by the outsourced company. “This creates all sorts of conflicts of interest,” said Seth adding, “The value of Japanese REITs is correlated not so much with the quality of the portfolio, but with the credit quality of the sponsor.” If you must own Japanese REITs, Seth suggests that you limit your investment to the big Japanese sponsors like Mitsui Fudosan, Mitsubishi Estate and Mitsubishi Corporation. “They have the safest REITs, but offer lower dividend yields.”
Commercial Real Estate
The most interesting story in commercial real estate over the last couple of years, according to Seth, has been increased investment by ethnic Chinese companies (from Singapore, Hong Kong, Taiwan, and Malaysia) into Japan. Although he is not yet seeing an inflow of mainland Chinese money, Seth believes this is just a matter of time. Ethnic Chinese companies are buying up logistics operations, senior citizen homes, and especially business hotels. “These buyers are not just looking for yield,” said Seth. “They are looking at the price per pound (obtained by dividing the price of the property by its leasable area).” Western professional investors, on the other hand, buy property based primarily on the criteria of yield and underlying market fundamentals. Seth provided his insights into what might be behind the ethnic Chinese investment criteria. First, property prices are already high in places like Hong Kong and Singapore, where there is a shortage of land and growing populations. To the value investor, land prices in Japan may be considered comparatively good value for money. The second and perhaps more persuasive argument is that ethnic Chinese are seeking to invest in countries with strong property rights. “In China the government owns all the land,” said Seth. “You may have a 30-year lease. But because the law in China is not that old, nobody knows what you need to pay to renew it. Given that laws in China and contracts are ‘flexible’, that’s a risk.” In Japan, on the other hand, ethnic Chinese can own the freehold property. The price per pound is relatively cheap and the Chinese get to own the “dirt” in a safe country. From the ethnic Chinese perspective, buying Japanese real estate might well diversify risk.
Professional investors like Pacifica Capital focus on investing in distressed properties where there is the possibility to make a capital gain. Last year Pacifica Capital began to buy up listed companies that own real estate with the idea that they would take them over, make better use of the property, and eventually Exit. The company is focused on acquiring prime central Tokyo real estate in Ginza, Omotesando, Shibuya and Shinjuku where tenant demand and liquidity is the greatest. “The reason we started looking at listed companies was to get property cheaper than buying it directly,” said Seth. “Many Japanese companies, especially manufacturers, own real estate that is not effectively utilized. If you buy the company, it’s a cheaper way to acquire real estate than buying the real estate directly.”
Seth Sulkin, President and CEO of Pacifica Capital K.K. Pacifica Capital manages money for professional investors such as U.S. and European pension funds, family offices and real estate private equity funds. www.pacifica-cap.com