J-REITs to the Rescue!

Japan's real estate investment trusts invigorate the market.
by Catherine Chang

After a devastating collapse in the 1990s, Japan's real estate market is back on investors' radars. J-REITs, the Japanese versions of the real estate investment trusts already popular in the US and elsewhere, are largely to thank for it.

Since the first two funds listed on the Tokyo Stock Exchange just six years ago, J-REITs have gradually revived the struggling market, emerging as new vehicles for property investment that have grown to an impressive total market capitalization of nearly JPY 3.5 trillion as of August 31, 2006.

The ABCs of J-REITs
J-REITs pool money for selective investments in real estate, often with a focus on office, retail or residential properties. The income garnered from rents, lease management and sales is returned to investors as dividends.

By securitizing real estate, the J-REIT structure allows private investors to easily stake an ownership claim in large properties by eliminating the need to put down hefty capital for a property investment.

"Before it was only investors who could take a bigger risk," said Shunichi Minami, senior executive officer of Mitsubishi Corp.-UBS Realty Inc., the asset management company behind Japan Retail Fund Investment, one of the oldest J-REITs and the first to specialize in retail properties. "The J-REIT market has contributed a lot to the turnaround of the real estate market in general. People are coming back."

With nearly all of their profits going into dividend payments, J-REITs naturally provide comparatively high returns without having to give up much of their profit toward future business development. J-REITs are required to distribute 90 percent of their profits to investors' pockets as dividends. In return, they reap the benefit of a tax exemption that lets them skip out on corporate income taxes, helping them to keep their yields high.

For these reasons, J-REITs have become increasingly popular in their short six-year history. Investors are warming to the relatively stable flow of dividend yields, which have fluctuated between 3 and 6 percent since the market's inception - an attractive return in a country where interest has hovered at nearly zero since 1999.

"When the real estate market became stabilized in 2002 and 2003 with about a 6 percent type of return, people started to consider: which is the better investment opportunity, 6 percent or zero?" Minami said.

As investor interest has been renewed, the number of J-REITs on the market keeps rising. As of August 31, 2006, there were 38 J-REITs, with 10 listed in the first eight months of the calendar year and 13 that listed in 2005. According to a May report on REITs in Asia from CB Richard Ellis, nearly a dozen more are expected to list later this year.

The overall pickup of the stock market and increase in property demand - starting with office space - has also driven the J-REIT market. In the past, most owners of office buildings in Tokyo were individuals or small corporations with their core business in other areas. After the real estate bubble burst, they were hit with waning demand for office space in new, large-scale buildings that suddenly had no takers.

"Now the economy is recovering and large developers have become more aggressive in introducing large-scale buildings with superior quality, and more buildings that are held by these amateurish landlords would be coming down to the property turnaround market," said Dylan Robertson, senior associate at CB Richard Ellis. "It should represent a cause for acceleration, not deceleration, of assets under management for J-REITs."

Specialization and Internal Growth
As the J-REIT market continues to expand in size, the latest additions to the pack are differentiating themselves by focusing on narrower niche markets. While first-generation funds filled their portfolios with office, retail and residential properties, some newcomers are choosing to get more specific. The Japan Logistics Fund, for example, invests specifically in distribution centers, and Japan Hotel and Resort, Inc., as the name suggests, solely acquires and leases hotels.

"Specializing in a certain region of Japan or a specific class of property is more risky, but then the potential returns are higher," Robertson said. "Specialization allows a smaller, leaner, more focused team and therefore faster decision making."

Still, not all recent funds are choosing to go this route. Others just entering the market, while still investing in a combination of office, retail and residential space, are carving out new markets for themselves within these broad categories. One strategy has been to look beyond the large-scale, A-class spaces - that is, those buildings with total floor area of at least 33,000 square meters in Tokyo's central five wards. Instead of competing with well-established REITs funds, which often drive up A-class prices in bidding wars, newer entrants are looking to B-class, or mid-size, property offerings.

"Our core target is mid-size office properties which we can expect to increase in rent itself. The market is very good for office properties, especially in Tokyo," said Masahiko Tajima, General Manager, Financial Planning Division, at Kenedix Realty Investment, which listed on the TSE in 2005.

Kenedix Inc., the fund's sponsor, is itself a relatively new company with about 10 years of history as a real estate asset manager. Taking advantage of Kenedix Inc.'s expertise in mid-size properties is a more profitable plan than reaching for larger properties," Tajima said.

"Mitsubishi Real Estate and Mitsui Real Estate do not handle mid-size office properties. They are A-class office property players-real estate giants. We at the Kenedix Group cannot compete with Mitsubishi and Mitsui. We understand that," Tajima said. "So we do focus on the B-class office properties; we do not hesitate to say our portfolio specializes in B-class office properties."

Robertson added that mid-size properties are also popular with private real estate funds, which have emerged as major market players since late 2002.

"Although private real estate funds are not able to acquire large prime office properties like the major players in the real estate industry, they have an advantage in buying good mid-sized office buildings," Robertson said. "Under the difficult conditions to acquire high-quality office buildings, J-REITs backed by private funds are becoming major players in the market. Since most private fund companies have managed funds based upon mid-sized offices, these companies often list J-REITs as an exit strategy for their assets."

With more funds scrambling to win investors' attention, some are boosting their income by focusing more on internal growth. To increase the profit of existing assets, funds are intent on raising rents to match the current rise in property prices.

"We put our capital expenditure into each property based on [tenants'] needs and thereby we increase their level of satisfaction. Now is the time to negotiate with those tenants to raise rents to the level of the current market," said Tajima, explaining Kenedix's strategy for internal growth. Tenants at mid-sized properties are generally small to mid-sized entities (10 or 20 employees) that tend to expand or shrink their business rapidly, he added.

"Since the rate of tenant turnover is high compared with A-class tenants, when we find a vacant space, we can find new tenants at the current market level. This is very important," Tajima said. "For the last six months, we have seen about a 10 to 20 percent rent increase on vacant units for new tenants."

Tajima pointed to the Les Belles Modes building in Kojimachi, where Kenedix invested money in the renewal of office spaces and was able to attract new tenants at a rent 20 percent higher than the previous tenants had paid. This is a good example of the company's strategy for internal growth through increasing asset value.

But focusing on the internal growth structure is not just a strategy for newcomers. Veteran J-REITs are also making changes to capitalize on the upward shift of the real estate market. When the J-REIT market first launched, fixed rentals and long-term leases proved the most stable source of profit. But now that the real estate market is stabilizing and on an upward trend, well-established funds are also looking to shift to growth-type assets, which have variable rents that match market levels.

"With the growth-type of fund, we have multiple tenants and we can replace tenants and effectively increase properties' rent revenue," Minami said. Currently, the fund operates a portfolio that includes roughly 80 percent income-type assets, but Minami said the goal is to expand to more growth-type assets. "The changes will be gradual. It's not going to change overnight, but we are aiming to gradually move toward a growth type," he said.

Working Out the Kinks
While J-REITs have been credited with reviving Japan's real estate, recently the market has not been as rosy. According to a May 2006 report from CB Richard Ellis, the last term saw increased market divergence, with the range of performance differing markedly among funds.

"If the success of J-REITs is determined by whether their opening prices stand above their IPO prices, then only half of the J-REITs that listed in the first eight months of the current fiscal year would be considered a success," Robertson said. "This is mainly because investors have become discerning."

With more choices for potential investors, each J-REIT must now step up their operations to distinguish themselves from competitors. However, there is a clear investor penchant for J-REITs with well-known sponsors, according to Robertson.

"To date, most J-REITs which did not achieve the IPO price at the end of the first day of trading had sponsors who were not widely regarded," Robertson said. "A wider diversity of
J-REITs is entering the market and this movement is expected to continue with more sector-specific J-REITs coming to the market in the second half of 2006."

"When the real estate market became stabilized in 2002 and 2003 with about a 6 percent type of return, people started to consider: which is the better investment opportunity, 6 percent or zero?"

Residential J-REITs have taken a financial hit lately, lagging behind funds that specialize in office or retail properties. At the end of April, only one all-residential J-REIT, FC Residential Investment, finished with a profit.

J-REITs have also been scrutinized for what critics say is a lack of transparency and regulations that are too lax. In June, ORIX JREIT was cited by the Securities and Exchange Surveillance Commission (SESC) for what the Nikkei Shimbun, a major financial daily, reported as "shady practices." After a month-long investigation, it was revealed that the fund had included overvalued property in their portfolio by failing to double-check prices claimed by sellers. Since insider trading rules do not apply to J-REITs yet, some also say investors are exposed to too much risk. TOKYU REIT came under fire in March after their stock price spiked unusually high days before a sell-off of a Yokohama building, housing the high-end U.S. department store Barneys New York, was announced.

While the Ministry of Land, Infrastructure and Transport (MLIT) and the Financial Services Agency (FSA) have pledged to form a joint panel to discuss educating investors on risks involved in J-REIT investment, regulations are still lagging.
"It's still a very new market. We just started, and some regulations have to be amended," said Minami, whose fund also ran into trouble with the SESC when it was accused of falsifying board meeting minutes. The SESC eventually penalized it.

Investing Abroad?
With the increasing number of players and property prices rising, it's no wonder J-REITs are digging for new methods to secure their foothold in the market. The days of simply riding the upward trend may be coming to an end. The slight bump up in interest rates will also put more pressure on J-REITs to operate more efficiently, as finance costs will rise with the rates. But despite the obstacles, J-REITs have more than enough room to grow.

"The share of J-REIT-owned buildings in the Tokyo office market in floor space terms was only 3.8 percent in March 2006," Robertson said. "[This] implies colossal room for growth of assets under management by J-REITs."

By next year, J-REITs could also be reaching overseas for potential assets. In June, the Nikkei reported that MLIT may allow J-REITs to acquire foreign properties for their portfolios as early as fiscal year 2007.

But companies are in no particular rush to extend beyond the Japanese market, at least for now.

"In Japan, we have not captured all the real estate market still available to us," Minami said. "The Japanese market is still very attractive, so we will just focus on our market for now. We have only just started." JI