Japan's real estate trusts rise from the abyss

Japan's 40 real estate investment trusts (Reits) are slowly and painfully recovering from their worst experience since they were introduced in 2001. However, some analysts still see major structural problems in the industry.

But the good news first. On June 29, the Tokyo Stock Exchange Reits index reached a year-to-date high, finishing at 976.16 points. On Tuesday, it had slipped back to 973.14.

 In fact, the Reits market has been quietly but steadily recovering since its 2009 nadir of 704.46 points. "Recent developments contradict the picture of doom and gloom earlier this year. The sector has picked itself up from its lows," said Alexander Jampel, a partner at Baker and McKenzie, Tokyo office. "The key point is the availability of refinancing, and here things have improved: the government has made it clear that it is determined to support the industry."

Indeed, since April, reports have emerged that the government will establish an enormous fund to provide cash to the sector. Japan's ruling Liberal Democratic Party has announced the fund could be as large as $8 billion. The state-run Development Bank of Japan would be a key player in such a plan, as it would contribute funds to finance real estate investments by Reits.

That recovery is welcome because Reits have been a huge success in Japan in terms of rekindling interest in the property market. That pushed up prices, and triggered a welcome mini-boom on the back of Japan's export-led recovery from 2002 onwards. As such, they created a great deal of wealth for the real estate market. And because Reits are voracious buyers of assets, they have played an important role in improving the physical infrastructure of many Japanese cities (developers found a ready market for their projects).

The test, however, was always going to be how Reits would perform in a downturn. And go down they did, as reflected by the TSE Reits index: from a record high of 2594.94 in May 2007 to 704.46 in October later the same year.

The problem with Reits is that they are very pro-cyclical. They thrive when asset prices go up, and they themselves drive up asset prices due to the volume of acquisitions they generate (since the number of potential investors is massively increased when Reits get listed). A 'virtuous' (if it can be so defined) cycle sets in whereby greater demand pushes up prices, which in turn pushes up demand. As such, Reits can be seen as key contributors to real estate asset bubbles.

But when they go down, they get savaged by the opposite phenomenon. As investors stop buying (in Japan's case, foreign investors began to repatriate funds in a panic after the Lehman Shock in late 2008), asset prices go down, and banks start bumping up against the loan-to-value ceilings they impose on their borrowers. As asset prices decline further, banks may call in or not extend their loans. Such moves can end up bankrupting the Reits, even if they are competently run.

"Refinancing is a significant problem -- with the advent of limited recourse loans to finance property, the majority of real estate related loans have maturities of no more than three to five years. This leaves Reits with asset-liability mismatches and refinancing risk in a market where banks are trying to reduce exposure to real estate," pointed out Paul Kruger, a partner at Linklaters in Tokyo.

There are two possible explanations for this grave asset-liability mismatch. Firstly, speculators were too bullish. They figured they did not need to pay for more expensive longer-term loans, since they aimed to turn over their assets quickly. Alternatively, lenders were concerned about the non-recourse aspect, and consequently kept the loans flexible. The banks have turned out to be right.

The government's capital injection plan will mitigate that lack of funding, as will unofficial encouragement to banks that they should start rolling over the loans. But Kruger said that won't resolve the deeper issues. "Investor protection was at the forefront of the government's mind when Reits were established. However, by creating highly regulated entities with little flexibility, investors may well end up being the losers."

Indeed, the government has been forced to step in because it has not provided Reits with the instruments to help themselves out. Because it was considered multiple share classes would not be friendly to retail investors, only straight equity can be issued -- a difficult proposition in today's markets. But alternatives like preference shares are not permitted.

For a while, it was hoped that mergers and acquisitions would help the sector. Even here there are some major obstacles, said Kruger. "If an investor acquires more than a 50% equity interest in a Reit, the Reit loses its tax benefits. Even if the investor is prepared to forego the tax benefits, it is very difficult to squeeze out minority shareholders." In other words, an acquisition would destroy the very aspect of a Reit which makes it attractive to investors, its favourable tax treatment.

There has been some merger activity, however, which shows how investors have attempted to use the rules. Earlier this month, Daiwa Securities Group (DSG) bought a 13% stake in DA Office Investment. DSG also bought the trust's management company, DaVinci Holdings. Once it controls the management company, it controls the Reit. However, it could be hindered by the minority interests in disposing of the Reits as it would wish, for example by selling the assets at a discount to a subsidiary.

A real estate analyst who preferred to stay off the record added that the very structure of Reits is conducive to a number of problems, which usually only become apparent in a market downturn. Essentially, the tax benefits depend on the Reit not managing itself, so that all the income passes through to the investors. However, that means an external manager is necessary, and he is usually appointed by the sponsor. The manager has a clear conflict of interest when acquiring the assets injected into the Reit by the real estate sponsor, since the higher the price he can command from the Reit, the better off the sponsor will be. "The problem was especially acute at the top of the boom, when lots of small, privately held real estate funds saw the Reits basically as an exit vehicle," said the analyst.

Roko Izawa, a director at Standard and Poor's in Tokyo, adds that another inconsistency in the market is that "although J-Reits are supposed to be segregated from the credit risk of the sponsors, in Japan, investors looks at the credit worthiness of the sponsors". That is, the sponsor's connections to funding providers are as important and may take precedence over the cash flow of the assets held by the Reit.

Although the Reit sector is picking itself up from its lows, it will be interesting to see how far the recovery can go. Government intervention apart, fundamentals don't look good. In June a leading survey announced that Tokyo office vacancy rates were at a four-year high, with one real estate brokerage informing Bloomberg News that it could reach 10% over the next few years. In late May, the Ministry of Land announced that in the first quarter land prices dropped in 148 out of the 150 locations across Japan at which the government tracks land prices. Prospects for GDP growth could also cap a recovery. Standard and Poor's is predicting a 6.5% contraction this year. It looks as if investors should continue to be wary of this market.