Why is Japanese Real Estate a Good Place to Invest?

By Jeff Wynkoop

Interest rates

Markets around the world are going through tumultuous times. In March, the US Federal Reserve Bank pushed the base federal funds target rate up to 4.75- 5.0%, when a year ago it was at 0.25-0.5%. At its December 2022 meeting, the Bank of Japan tweaked its yield curve control (YCC) policy for the first time since its 2016 implementation, allowing yields on the 10-year JGB to range up to 0.5%. The European Central Bank also raised its main bank rate in March by half a percentage point to 3.0%, when a year ago rates were still negative.

Why do interest rates matter so much to real estate? One reason is a rise in interest rates causes the value of future income streams to fall. When buyers price an asset, future income is discounted in order to estimate present value. The higher the cost of capital, or the higher your required rate of return, the higher the discount rate you need to use, which also accounts for risk and the lost opportunity of investing in something else with those dollars. This means that when interest rates go up, present values (and generally the price buyers are willing to bid for real estate) go down.

Even more fundamentally, when interest rates go up, it costs more to borrow money. If you have a variable rate loan from a bank, your payments go up. Deals that pencil in at lower interest rates suddenly cost too much. For lenders, higher interest rates mean outstanding loans have a greater chance of default. Lower asset values also affect capital requirements, meaning banks have to hold more and lend less to shore up capital. More cost for borrowers, more risk for banks.

The market fears that the BOJ’s adjustment to the YCC could begin a new uptrend in Japanese interest rates. If the BOJ gets rid of its YCC policy completely, interest rates on the 10-year JGB could quickly go up to 0.8-1.1%, as estimated by the Japan Center for Market Research in its Dec. 27 report. The Japan NLI Research Institute (NLI) projects that without the YCC, the 10-year could rise by at least 0.4%, and if the BOJ discontinues both the YCC and its bond buying program, by as much as 0.8-1.0%. On the ground, NLI estimates that for every 0.1% increase, there is pressure on J-REIT dividends to fall at least 1.6%, and J-REIT share prices to fall in the 2-4% range. On March 31, 2023, the JGB rate was 0.36%. This means a jump of 0.5% to 0.86% could cause J-REIT market prices to fall swiftly 10-20%. Heady stuff.

So, this is easy, right? Some people think the BOJ will eventually have to catch up with other central banks, and the new tightening regime will cause a precipitous fall in Japanese real estate prices. Look out below.

The problem is that it isn’t easy to forecast where Japanese real estate prices are going for at least three reasons. One, although the BOJ has indicated the goal of normalizing rates in the future, economic indicators have not yet satisfied the argument that raising rates is necessary. Two, Japanese companies are, on the whole, in good financial shape, and Japanese growth prospects are positive. It seems there should be enough money in the system to overcome a few modest rate increases, helping real estate prices stay high. And three, the Tokyo Stock Exchange (TSE) may be poised to trend upwards since price-to-book ratios (and net asset value ratios for J-REITs) are less than one for a majority of all listed companies (including 1 or less for over 60% of all J-REITs).

Currently the BOJ’s hands are tied. According to the April 6 Nikkei newspaper, the BOJ watches four main economic measures in its fight against inflation: CPI, the GDP deflator, unit labor costs, and the ‘demand gap.’ Regarding CPI, the BOJ is on record as saying that until there is a stable, constant CPI above 2%, it should continue monetary easing. In the BOJ’s January 18 Outlook Report, CPI was estimated as 3.0% in 2022, but it was forecasted to drop to 1.6% in 2023, and stay under 2% for all of 2024. Currently monthly CPI is expected to be less than 1% by the end of the year. On the other hand, the GDP deflator and unit labor costs are moving in the right direction to raise rates: the GDP deflator moved from negative in 2021 to +0.2% in 2022, and the OECD reported unit labor costs were 2.0% in 2022. However, the demand gap, a measure of capital investment and investment in labor, has been negative in Japan for the last eleven quarters, and for Oct.-Dec. 2022, it stood at -0.43%. According to the IMF, pressure from demand in the US moved to positive territory in 2022 to 0.03%, but it was -0.53% in Germany, and -2.04% in Japan.

The Japanese Economy and Financial Markets

With lower rates for longer, Japan compares well to other major markets. The IMF expects the Japanese economy to grow 1.8% in 2023, and 0.9% in 2024 (with the US growing 1.4% and 1.0%, and the Eurozone 0.7% and 1.6%, respectively). This is despite the fact that Japanese inflation is expected to be the lowest of the three economies. In addition, in the March 31, 2022-23 period, the TSE was up approximately 1%, while the S&P500 was down 9%. In the same period, the TSE J-REIT index was down from 2031.5 to 1805.5 according to Yahoo Finance, an 11.1% decrease. Maybe an approximate 10-20% fall in listed J-REIT market prices is already baked in?

The Japanese economy looks good from other angles as well. The Nikkei reported on April 1 that net profit for Japanese companies in the fiscal 2022 year was at an all-time high, and from April 1, 2022 to Dec. 31, net profit for the period was the 2nd highest on record. Listed companies hold over 100 trillion JPY net current assets, up 23 trillion since 2015. According to NLI, J-REITs finished December 2022 with the highest total asset values on record (measured by acquisition price), and own properties with over 5.1 trillion JPY in unrealized profit. In 2008, they held only about one trillion JPY in unrealized profit. This time if financial markets were to drop, J-REITs have a much larger buffer with which to adjust portfolios and protect future dividend payments.?

Because so many Japanese companies own marketable real estate, it is important to look at both J-REITs and the TSE when considering the CRE market in Japan. The Nikkei reported as of March 31, 2023, there were approximately 1800 of 3300 TSE-listed companies with price-to-book ratios (PBRs) of less than one. On April 3, over 60% of J-REITs had net asset value ratios (NAVs) of one or less. Why is this important? PBRs, and NAVs for J-REITs, are measures of market capitalization versus net assets. If the ratio is less than one, this means the net assets the entity owns are estimated to be worth more than its total outstanding shares, indicating shares may be undervalued.

NLI measured NAVs for Logistic J-REITs at 1.2 at the end of 2019, rising to 1.4 in 2021, and now at 0.99 as of Jan. 31, 2023. In the same timeframes, NAVs of the five biggest Office J-REITs together were 1.2, 1.01, and 0.86, and NAVs for Residential J-REITs 1.2, 1.12, and 0.92. NAVs for the entire J-REIT market have moved from roughly 1.2 in 2019, 1.1 in 2021, to 0.92 as of Jan. 31, 2023. (According to NLI, the historical average for NAVs for all listed J-REITs is 1.11%.)

Usually shares trade at a premium to PBRs and NAVs to account for value created by good management, etc. If shares trade at a discount to net assets, to try to increase share price a company can, for instance, increase dividends, buy and retire shares, or merge with another company. Private equity investors can also purchase all of the company’s shares and sell the assets off for a profit. In the alternative, asset prices can come down to match market capitalization.

The Nikkei reports that in 2022, TSE-listed companies bought more of their own stock than at any other time in history, and 16% more than in 2021. Traditionally, Japanese management tends to focus on total sales and profit margins, rather than ROE, but buybacks have been increasing. The issue is that many CEOs don’t believe buybacks can cause lasting change in price trends, i.e., that they are only transitory in effect. Interestingly, there were seven J-REITs which implemented buybacks in 2022, and five were still above the buyback price 60 days later.

So, are asset prices going to go down to meet market caps, or are market caps going up to NAVs, or both? According to the Nikkei, if PBRs for all TSE companies were to rise to 1.0 or more, it would represent an almost 150 trillion JPY market increase. There have been three times in history when NAVs slipped below one, after the GFC, during the corona crisis, and last December. According to the Association of Real Estate Securitization (ARES), in 2008 it took five years for the J-REIT market to recover over one, in 2020 it took ten months. Now that NAVs have been below one for over three months, how much longer will it take this time to recover?

USD/JPY

The USD/JPY rate was historically low in 2022, and there was a ten yen drop in the rate two years in a row for the first time since 1995-96 according to the Nikkei. The JPY was also weak against other currencies last year, but not historically so, meaning this was a USD story as much as anything else. The US CRE market is showing indications of being at a tipping point, with sudden high interest rates slowly trickling into the economy. US office utilization is still very low (the 10-city Kastle Systems Barometer was at 48.4% on March 27), and according to a recent report by the Pension Real Estate Association, office space in US central business districts may need to be revalued 30-70% downward in the next few years (with logistics up to -30%, multifamily -20%). For US capital, a pullback from Japan can be expected, regardless of the exchange rate. This would obviously be deflationary, and not conducive to the BOJ raising rates very much any time soon.

Why Lower for Longer

There are other reasons why it seems likely that the BOJ will raise rates much less than other central banks in the future. The Japanese government has the highest outstanding debt level of any major economy, and higher interest rates mean higher interest payments. Unlike the US, variable rate mortgages constitute the majority of residential mortgages in Japan, and raising rates too much, too fast would directly hurt the average consumer in the pocket book. In the last few years, the USD/JPY exchange rate has tracked interest rate differentials to a large degree, meaning a significant interest rate increase would cause the JPY to go up, disproportionately hurting Japan’s export-led economy. There are built-in deflationary pressures too. Japan’s demographic issues are well-known. Foreign buyers of Japanese real estate are likely to leave the country if their domestic economies suffer a significant downturn. In addition to the nagging worry about government debt levels, there is geopolitical stress from North Korea as well.

More Reasons Why Japan Real Estate is Attractive

Japan has a big, liquid domestic market, social and political stability, and a European-style legal system. Low-cost debt capital is plentiful. Its cities are projected to suffer negative effects from global warming less than almost anywhere else in Asia. Furthermore, the Nikkei reports that traditionally Japanese companies have distributed roughly 50% of their profit, but in the US, the average is over 80%, leading to much better PBRs in the US, but less cash on hand to get over financial difficulties. According to the April 5 Nikkei, for the biggest listed companies, PBRs of one or less on the S&P 500 were around 12% (and less than 10% for all S&P companies), for Europe’s Stoxx 600 roughly 23%, and for the Topix 500, 43%. On average, companies in Japan simply do not have the same bankruptcy risk as US companies.

Another important factor making Japanese real estate relatively attractive is the yield spread between borrowing costs and cap rates. NLI estimates the US REIT spread is now approaching 0, while for typical J-REIT shares, it is still 3.5% (measured against 10-year JGBs). And this despite Tokyo prime office cap rates being 3.7% when Kuroda started in 2013, and 2.3% in Sept. 2022, according to Reuters. The Tokyo yield spread for all offices is currently over 2.0%, higher than Shanghai, New York, London, Sydney, Singapore, Seoul, and Hong Kong. Other markets even have negative spreads (for instance, Sydney’s is -0.3% according to the March 24 Nikkei Asia newspaper). What’s more, the yield spread for J-REITs in the aggregate has remained around 3.0% or more consistently since 2013. This means even if the 10-year JGB goes up .05%, the yield spread could remain around 3% for most J-REITs.

Now let’s discuss the Japanese multifamily, logistics, and office investment markets.

Multifamily

A major factor in housing demand is population change, including change in the number of households. According to the Ministry of Internal Affairs and Communications, there were over 75,000 new residents in Tokyo’s 23 wards over the last four years (2019-22). Although there was an outflow of roughly 13,000 people in 2021, the first outflow since 1996, the city rebounded with an inflow of over 20,000 in 2022. 2023 is also forecasted to see a net influx of new people living here. Over the same 4-year period, Osaka (47,000), Sapporo (39,000), Fukuoka (27,000), and Nagoya (7,000) had an influx of new residents as well, and they all had positive population growth during each of the years (except Nagoya which had less than 1000 people leave the city in 2022 only). Coupled with the general trend of Japanese families living with less grandparents and being less nuclear, this bodes well for future prospects of this asset class.

In Tokyo, NLI estimates that the average household moves residences a little over once every four years. This churn facilitates market prices being able to adjust rapidly to market conditions. It is no wonder then, given the general uptrend in Tokyo population, that asking rents are currently historically high. According to a report by Leasing Management Consulting KK, by the end of 2022, asking rents were equal or higher than the historical peak for four of the five main wards of Tokyo, with only Minato-ku lagging (RC or SRC Buildings, less than 10-years old). Condo prices are also at all-time highs, and many people either have to rent or get out of the city. Considering asking rents and population trends, it makes sense that Tokyo multifamily is currently so popular in the real estate investment market.

Logistics

The uptrend in this market is taking a pause, and Logistics J-REIT shares were significantly down in 2022. The big story for logistics in the Tokyo area is the new supply coming online. According to the Japan Logistics Field Institute (JLF), in the 2021-24 four-year period, in each year there will be more new space being completed than ever before previously. In 2021 (in sq.ms), 3MM, in 2022 4.22 MM, in 2023 4.35 MM, and in 2024, 3.31MM (the prior high was 2.8MM in 2019).

CBRE says vacancies in the Tokyo area were 2% in 2021, rising to 5.2% in 2022, and are forecasted to be 8.0% in 2023 and 8.4% in 2024 (ARES Magazine, Vol. 71). This would be the first 4-year year-on-year growth in vacancies since 2004 when CBRE began tracking logistics vacancies. Nevertheless, logistics demand is still growing every year, meaning that rents will be largely flat. Rents are also helped by the fact that logistics leases are oftentimes long term (usually 5-10 years). In addition, once a firm has its logistics net set up, it is hard to change one location without affecting other locations in the net.

According to JLF, there was a record of 1.42MM sq.ms. new logistics space in the Osaka area in 2021, and per CBRE, vacancies are set to rise from 1.4% in 2022 to 4% in 2023 and 4.7% in 2024. Nevertheless, the need for logistics space is likely going to continue growing in the future, and CBRE believes rent levels will slowly keep going up in Osaka. The Ministry of Economy, Trade, and Industry estimates that 8.8% of all consumer transactions occurred online in 2021. Based on the growth in online consumer transactions over the last 10 years, by 2030 it is likely the percentage will grow to the 13-15% level. Logistics may be taking a short pause, but the future seems bright.

Office

The supply story for office is similar to logistics due to the glut of new space hitting the market. According to Mori Building’s 2022 Office Report, the average new office space added to Tokyo’s 23 wards each year since 1986 was 1.04MM (all in sq.ms). In 2023, 128MM is slated to be added, and in 2025, 119MM. However, in 2022 new office space totaled only 48MM, and it is projected to be 74MM in 2024, and 71MM in 2026. Over the five-year period, this projects to 88MMsq.ms per year in Tokyo, well below the past yearly average. Other major Japanese cities are, however, building more new office space in 2023-25 than the 10-year average. According to data from Sanko Estate, Osaka will add roughly 50% more than average, Sendai over 200%, Sapporo over 300%, and Fukuoka over 400% more, with only Nagoya adding less than the 10-year supply average.

There are key differences to logistics on the demand side however. Although Tokyo office utilization is much higher than in the US, it is still only at about 70% (CBRE, ARES Vol. 71). In a sense, office is becoming the new retail, with the hit retail has taken from the Internet similar to the hit office is taking from remote work. According to Xymax Research, as of April 2022, 73.4% of companies use office as part of a hybrid work strategy (some in-office, some remote). (ARES, Vol. 69) 25.1% of companies have satellite offices (located in the suburbs to supplement main offices), which is up from 10.7% in 2017. The trend in hybrid work/use of satellite offices seems here to stay. This changes the use characteristics of main offices, so they become more important for company-wide meetings, BCP, and attracting talent. Also, there may be more cross-competition in office grade and location as rents come down due to new supply. Companies will simply look for nicer offices. There is a new main office market strategy emerging, since not all workers need a desk every day. Accordingly, 66% of companies are planning to adjust their office strategy in the next few years (Xymax, ARES Vol. 71).

Office in Japan is typically categorized as either large scale office (at least 10,000sq.ms floor plate) or small/midsized. Differences in rent levels and floor plate size mean in the past, these categories have not directly competed. There are more potential tenant companies for smaller buildings, which has led to less rent volatility previously. As rents converge due to higher supply in Tokyo however, things are changing. Large scale buildings tend to be closer to subways, have better security, and be built with more earthquake-resistant features. Since 2000, 75% of the new office stock in Tokyo has been large scale. (Xymax, ARES Vol. 71) Still, according to Xymax, over 90% of all office buildings are small/midsized (ARES, Vol. 64), and in 2000 the total floor area in Tokyo was 60/40 in favor of small/midsized, but now over 50% of all office space is in large scale buildings.

The average age of small/midsized office buildings will be 43 years in 2030, and 50 years in 2038 according to Xymax. 79% were built in 1990 or earlier, and the useful life of reinforced concrete office buildings is typically 47 years (Xymax, Vol. ARES 64). Buildings this old also tend to have underutilized parking spaces. The big issue for owners in the future is that to remodel or retrofit, they usually need to get financing, as well as convince tenants to agree to leave the space, at least temporarily. This causes major headaches, since most tenants have a long-term leasehold, and can negotiate a concession to comply if they so choose.

According to brokerage Miki Shoji, as of the end of Dec. 2022, there have been 19 months of over 6% vacancy in office, and 29 months of office rents dropping (-13% from peak) in Tokyo’s five main wards. CBRE says for all Tokyo offices, rents are generally down 10-12% from the peak, and in the other two biggest office markets, Osaka and Nagoya, the picture is similar (Osaka grade A, down 9%, grade B -11.1%, and Nagoya grade A -11.4%, grade B -3.8%). (ARES Vol.71)

In sum, well-located Japanese real estate will likely continue to provide positive yield spreads for the foreseeable future. Although Japan does have demographic issues, etc. there is much to like about investing in real estate here. As Warren Buffet once said regarding investing, “be fearful when others are greedy and greedy when others are fearful.”