Japan's Real Estate Trusts Rise from the Abyss

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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 favorable 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.

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