The Reit Stuff

Can Japan's new real estate investment market live up to expectations?

Real estate investment trusts first became popular in the United States almost 120 years ago, at a time when they allowed investors to avoid paying double taxation. Trusts were exempt from paying taxes at the corporate level if they distributed a majority of their income to shareholders. In 1930, the US government abolished these tax advantages, but it re-introduced them in 1960 when postwar demand for real estate funding was skyrocketing. To qualify as pass-through entities -- entities that do no need to pay corporate taxation -- Japanese REITs will have to pay out a minimum of 90 percent of their revenues to investors.

REITs have grown in popularity among institutional and private investors in the United States over the last two decades as other real estate tax shelters have disappeared and pension fund investment has become possible. In general, REIT share prices are less volatile than normal shares and offer a good hedge against inflation. REITs now control over 8 percent of all commercial property in the United States, and manage over $10 trillion worth of assets. Trading in some 300 publicly listed funds has quadrupled in recent years, with hundreds of millions of dollars now changing hands on a daily basis in the REIT market.

So why has it taken so long for REITs to get to Japan? "Up to the breakout of the bubble economy, real estate was a kind of gold in Japan," says Yasuhiko Amino, a director with Ken Real Estate Investment Advisors, a subsidiary of a large Tokyo-based realtor that plans to list a REIT later this year. "Holding real estate had very high status value, and it had very strong collateral power. If you had a small piece of land, a bank would give you huge money against that land. So the focus was on speculative deals, buying and selling, and generating capital. Land prices grew too high, however, which meant that cash flow and income yields were extremely low. But the crash of real estate prices has led us to new opportunities to purchase real estate from the point of cash flow," says Amino.

Foreign investors have been the catalyst behind the recent upsurge in Japan's real estate market. "Investment in the real estate market started about three and a half years ago," says Amino. "At that time there were very few Japanese companies who were able to invest in the market in Tokyo. Some of the first foreign investors were real estate groups such as DLJ (Donaldson, Lufkin, & Jenrette) and Westbrook. Then larger groups like Morgan Stanley and Goldman Sachs started to expand their investments in the real estate market, as well as in the purchase of non-performing loans." The Nikkei Shimbun reported in April that Morgan Stanley plans to invest $5 billion in office buildings and apartment blocks in the Tokyo region over the next three years, hoping to take advantage of opportunities spawned by depressed prices. Japanese banks and investment companies are now also becoming more active in the market, according to Amino. "At first, Japanese banks had a kind of allergy to investment in the real estate market because they had burnt their fingers so badly during the bubble by lending huge sums of money to real estate holders. That is now totally changing, and with relaxed monetary policies, banks are learning that the real estate market is very useful for them as well. Japanese money is now becoming very active in acquiring real estate and providing non-recourse loans to investors."

The removal of a government ban on REITs last November made possible the establishment on the Tokyo Stock Exchange of a REIT market in March of this year. But the first REITs were not ready to launch until September. The slow start was partly due to a dispute over taxing capital gains on REIT investments (REIT investors will have the choice of paying the taxes when they file their annual tax returns or when they sell their REIT shares, just as with normal stocks). Nonetheless, Japan's real estate securitization market has grown to over JPY2 trillion in the last two to three years and is expected to top the JPY4 trillion mark by next March, according to a report released in May by a committee of the Ministry of Land, Infrastructure, and Transport.

Mitsui Fudosan, Japan's largest real estate company, was set to launch the first REIT on the Tokyo Stock Exchange (TSE) on September 10. Its JPY200 billion fund, established in cooperation with Mori Trust Daiwa Real Estate Investments, was expected to pay dividends of JPY15,300 per share. Meanwhile, Japan's No. 2 real estate firm, Mitsubishi Estate, teamed up with Tokyo Marine & Fire Insurance and Dai-ichi Mutual Life Insurance to list a fund with starting assets of JPY100 billion.

The enactment of the so-called Special Purpose Company (SPC) bill in mid-1998 was a milestone for real estate securitization in Japan. The scheme introduced under that legislation allowed market participants to gather expertise in a primitive REIT-style environment. Essentially, there are two frameworks for securitizing an asset under this system. In the corporate variety, the party purchasing the asset sets up a special purpose company to acquire the asset. In the second, the owner of the asset enlists the services of a trust bank to set up a special purpose company. The asset is then transferred to the SPC, which uses the asset as collateral to issue bonds and subordinated securities to investors. Proceeds from the sale of securities are paid to the seller of the property, while investors receive returns on their investment through future cash inflows from the property revenues, such as rents.

For many firms, particularly those with a low credit rating, asset securitization is an attractive option. As investor returns are generated through asset-related income, a company's own credit worthiness is of less importance. It allows companies to procure funds and improve their cash flow position while keeping additional interest-bearing debt off the balance sheet. Real estate companies themselves are also hoping to prosper from the success of the market. Leading real estate developer Tokyo Tatemono, which plans to launch a REIT before the end of the current fiscal year, hopes to boost operating profits by 23 percent by the end of 2003. Its REIT, to be set up jointly with three other companies -- Taisei Corp, a major construction company, and two insurance firms, Asahi Mutual Life Insurance and Yasuda Mutual Life Insurance -- will invest mainly in real estate in the Tokyo region.

Hiroshi Gomo, managing director of Mori Trust Daiwa Real Estate Investments, highlights one of the fundraising advantages associated with REITs. "Until now the real estate sector had been dependent on loans from the banks. Land was very much a fixed asset, and it took 10 to 15 years before funds in real estate could be recouped. But with the introduction of Japanese REITs, real estate will become much more of a liquid asset. It will therefore be possible to recover funds invested in real estate much more quickly, and also to make new investments with much greater speed. I think REITs will have a very big impact on the real estate market of the future."

Many of the same merits, of course, apply to non-real estate companies who need to invest in real estate. By far the most popular kind of real estate securitization deal in Japan has involved the sale and leaseback of a company's headquarters from an SPC. In one of Japan's largest securitization deals thus far, Seibu Department Stores announced in January that it had raised JPY108.1 billion in a deal with Yasuda Trust & Banking to securitize its flagship store in Tokyo's Ikebukuro district. Seibu will lease back the premises at an estimated fee of JPY10 billion a year. Trust banks also look set to establish a number of REIT funds themselves in the near future, which they will sell to customers through affiliated retail banks. Mitsubishi Trust & Banking recently obtained ISO 9001 certification for real estate management, which it hopes will win it approval from companies assigning credit ratings to real-estate backed securities.

Until recently, it has been trust banks that have handled most of the big name securitization deals in Japan. Unlike in the United States, in Japan when a firm transfers property directly to an SPC, it must pay a capital gains tax. A company can only avoid the capital gains tax by first entrusting the property with a trust bank and then carrying out the transfer to the SPC. However, trust bank fees are very high.

But Gomo of Mori Trust believes REITs offer many advantages over the current system. "The SPC market was very limited. For each securitized asset, you needed to issue a security, and as there was no secondary market, there was also very little liquidity. Most securities also have a time limit, which means that refinancing may be a problem in the future. If the economy is good there is no problem, but right now the economy is still bad, so there is no guarantee that future refinancing will be possible." He says the real estate sector has now reached a point where the re-emergence of inflation in the market is a live possibility. "REITs have thus become a hot issue."

While institutional investors have been the largest buyers of securities in the real estate securitization market thus far, government and private sector officials are hoping to attract small-time investors to the new secondary market. If REITs gain acceptance as investment products for individuals, private sector institutes predict that as much as JPY10 to JPY20 trillion could flow into the trusts over the next five to 10 years.

William Schoenfeld, president of Asia Pacific Land, a private asset management company, points out that "REITs only need to attract a small percentage of the JPY1,300 trillion in personal savings which the Japanese public has amassed, in order to become a success story." While he thinks the buyers of Japanese REITs will be mainly domestic Japanese investors, he says some big-name foreign institutional investors may also purchase them to fill out the percentage of their portfolio invested in the Japanese market. "REITs may provide among some of the best dividend yields in the Japanese market," says Schoenfeld.

Many investment managers and real estate developers also appear to be counting on what one investment manager describes as the "stampede factor" to make REITs successful. "Japanese people have a great tendency to move with one great force in one direction, much like a flying arrow," says Anan Itsuro, assistant general manager at the Japan Real Estate Institute. He says this could happen with REITs. But Itsuro is cautious: "Government officials and private sector leaders are portraying REITs as if they were some kind of savior or Messiah for all the country's woes. But nobody talks about the risks. REITs in my opinion are too darn risky, and investors could be left holding worthless pieces of paper in the future." Itsuro notes that the approximately 3 percent in returns REITs are expected to bring may not justify the risks involved. "Given that it is possible to get about 3 percent interest or more from a savings account in a lot of Western countries, I don't think that individual foreign investors will be interested in the slightest in buying Japanese REITs."

Nobutaka Kojima, who runs a small real estate company called Kyoei Estate, is convinced that small-time Japanese investors would be better off staying out of the real estate market. "For somebody who has only JPY5 or JPY6 million and is thinking of investing in the real estate market, I would say forget about it. Three percent of JPY5 million is JPY150,000, so it is just not worth the risk." He would advise those with JPY30 million or more who are thinking of investing in the real estate market to buy some small property themselves, rather than buying into a REIT.

But Amino at Ken Real Estate Investment Advisors counters, "There is very little chance of investors losing their capital if they buy a fund with assets of a good standard and if they do not buy the REIT share at too high a price."

Experts point to a number of problems that need to be resolved in order for the REIT market to flourish. Insufficient information disclosure is probably the most often cited barrier to market growth. Itsuro says, "There is absolutely no disclosure in the Japanese real estate market. Realtors have always tightly guarded the value of their properties from competitors. If you think they're going to disclose the true value of the properties now that they intend to transfer them to affiliated REITs, you are kidding yourself."

TSE guidelines require the funds to release detailed investment information, including rent -- normally not publicized, in order to protect privacy. Gomo at Mori Trust believes that too much disclosure may ultimately not be in the best interests of investors. "Within one building, each company may have a different contract, and for that there are good reasons. We also have to think of confidentiality matters from the point of view of the tenant. It is basically impossible to make the details of each and every contract public. From the investor's point of view, it may seem that disclosing this level of information will provide greater clarity, but taking disclosure too far will create problems when it comes to finding good reliable tenants -- the sort of tenants that provide stable incomes and help investors get good dividends." Gomo urges investors to look carefully at a fund's assets, management strategy, and backers in total when making their investment choice.

Two major concerns make the disclosure of information crucial. First, investors need to be sure that the price at which property is transferred to the REIT is accurate. Gomo stresses that under the current system the property is appraised by a professional real estate appraiser at the time of the transfer and after the contract is signed. "There is a double check in place, which I think is very good. It is therefore impossible for property to be transferred at mischievously high or low prices," he says. Gomo also points out that the appraisal is based on the property's income earning potential, and not on past precedents for sales prices in a certain area, as was a common measure before. Still, not everybody totally agrees. "While theoretically the asset transfer price is going to be done by appraisals and by the company doing the IPO, the company selling the asset will have a major influence on that pricing. Theoretically, it is going to decided by market price -- big theory!" says one analyst who wishes to remain anonymous.

Disclosure is also important to investors to ensure that third party contracts that detract from a REIT's income, and therefore from investors' dividends, be allotted to vendors based on market principles. The same anonymous analyst says, "In Japan, the REIT is managed under contract by an asset management company, not the holding company. The assets are thus held by a company which has essentially no management." He says many people are not aware that the performance of the REIT is determined not only by the market, but also by management. While the REIT's holding company is the one listed, he says, "You have a second non-listed asset management company, which decides who gets the third-party contracts for cleaning the toilets, fixing the elevator, repairing the roof, or just leasing the building out. Those third-party contracts tend to go to 100 percent subsidiaries that charge great fees. That is the concern that everyone has." A similar system was abolished in the United States in 1986, and today the holding company is also directly responsible for the management of the assets.

Schoenfeld says, "One of my greatest fears for the success of the REIT market is that some bozo will start playing games, causing a scandal that could tape the whole market. Disclo-sure and professional management are going to be one of the keys to the long-term success of the REIT market."

In the short term, Toshihiko Okino at UBS Warburg says he does not expect the REIT market to grow very substantially, forecasting that the total asset size of the REIT market will reach only about JPY700 billion. Market capitalization will be even lower, at between JPY350 and JPY500 billion, says Okino, as many REITs have funded asset purchases with up to 50 percent of debt. While Okino expects the market to see a "substantial increase" in the future, he highlights that many REITs are having difficulties in finding new properties. Low interest rates, he points out, make the cost of holding on to property very cheap for firms.

But will falling land prices stymie the REIT market anyway? Land prices in Japan have fallen continuously for the last 9 years, with nationwide prices falling by 6.2 percent on average in 2000, compared with 7 percent in the previous year, according to a National Tax Administration survey issued in early August. Prices for commercial plots in Tokyo are down almost 75 percent from their peak in 1991, falling by 8 percent last year alone, while prices for residential properties have fallen by almost half over the last decade. Price declines in other parts of the country have been even steeper (though prices in some areas of central Tokyo bucked the overall trend by rising last year). REIT investors may be encouraged, however, by the report's finding that the decline in prices has slowed for two years in a row.

Fears also exist that anticipated changes in accounting practices requiring firms to record all assets on their books at market price, along with increased government pressure on banks to dispose of their bad debts, will lead to a large sell-off of real estate in the next two years. Akio Makabe, chief economist at Dai-ichi Kangyo Institute says, "Pressure on banks to disclose the full nature of their bad debts could cause them to sell off greater amounts of real estate, which would obviously have a downward effect on land prices." Yuta Seki, a senior researcher at Nomura Research, estimates that Japanese companies would have to dispose of almost a third of their assets, at a value of some JPY100 trillion, to regain capital efficiency levels last seen before the start of the bubble economy in 1985. Makabe adds, though, "In certain cases, prices have already fallen to almost half their fair value valuations, so you will also see some price increases there. In the long term, REITs may also offer support to land prices."

William Bourne, managing director of Scudder Investments Institutional Business Group in Tokyo, is generally bullish about Japanese real estate investment for the mid-term. "After 10 years of asset prices falling in Japan, we think that the conditions are such that over the next five to 10 years, we will see an increase in asset prices."

Amino at Ken Corporation is generally upbeat about the recovery in real estate prices in Tokyo, but he warns there is still a considerable time lag in the recovery prospects for real estate outside of the capital. "Tokyo is already a very hot market with very tough competition among domestic and foreign investors to buy really good properties, often to shift into REITs or other financial products," says Amino. But as Japan's economy becomes ever more centralized around Tokyo, he says, even really good class-A properties in such areas as central Osaka have great difficulties in finding tenants, making it difficult for investors to make quick returns there. The high prices in the capitol may, however, cause investors to search for opportunities outside of Tokyo.

Even if REITs do take off in Japan, Schoenfeld cautions investors, "REITs are simply another investment tool. They should bring greater transparency and liquidity to Japan's real estate market, but they will not change the underlying value (as opposed to price) of the asset itself." As REITs help reflect changes in market prices more quickly, they may help to avoid another real estate bubble in the long run. Schoenfeld points out, "One of the results of that, for example, is that it recently helped avoid another overbuilding cycle in the United States. In 1998, as the market was heating up a little bit, the REITs got just whacked, and when the REITs got whacked, a lot of funds for speculative development went out of the market. Without the funds, these speculative developments just didn't happen. It put a cap on the new supply coming into the market. In a normal real estate cycle, we would be in radical oversupply in the States, but that didn't happen. A lot of that was attributable to the fast response of the REIT share prices to the perceived pending oversupply. In that sense, REITs have become a major factor in the market. REITs helped in the United States in this last cycle to smooth out the cycle somewhat and to avoid the speculative excesses of past cycle peaks. This is not a short-term benefit but a long-term benefit."

One person who may not be glad to hear that is Kyoei Estate's Kojima, who lost big when the bubble collapsed. Kojima firmly believes that sooner or later the Japanese government will have to orchestrate a mini-bubble if the economy is ever to recover. While Kojima blasts REITs as too risky for small-time investors, he himself has not lost his taste for a little risk. "If the bubble comes along again," he says, "I'll certainly be getting aboard for the ride. But next time I won't be taking the bullet train ... I'll be getting on a semi-express." @