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When Japan launched its first real estate investment trusts back in September, the market was supposed to work like this: Ownership of lots of prestigious office towers would be bundled together into special investment vehicles whose shares would be traded on the Tokyo Stock Exchange. All rent and other income after expenses would be paid to the REIT and passed on to shareholders. Wooed by rich and steady dividend payments and the chance that this A-1 real estate would appreciate in value, investors would flood into REITs, halting an 11-year, 80% slide in commercial land prices.
Maybe that's the way it will work someday. But Japan's REIT market is off to a wobbly start, beginning with its unfortunate launch the day before the September 11 terrorist attacks in the U.S. Since then, Japan has sunk into recession, its property values have continued to decline, and wary Japanese investors have become even more shy of anything that resembles financial speculation. "It certainly has been a slower start" than REIT managers hoped for, says Clem Salwin, a Tokyo-based executive director for UBS Warburg.
The first victims of this bad timing were real estate heavyweights Mitsui Fudosan Co. and Mitsubishi Estate Co., which launched the first two tradable REITs on Sept. 10, backed by $2 billion in properties. The REITs are now trading slightly below their initial public offering price. On Mar. 12, a third REIT came to market, backed by Mitsubishi and UBS; it is doing a bit better than the other two.
So will the Japanese REIT market die aborning? No, for despite investors' lack of enthusiasm, an additional six or seven public REITs, including a $757 million effort by Goldman, Sachs & Co., are planned for this year. The hope is that as banks finally work out their bad debts--most of which are backed by property and buildings--the market will begin to thrive. The property will come on the market as the banks or the government foreclose on the assets of deadbeat companies. Also, companies are selling headquarters and land to free up cash. "We are talking about a structural change in the real estate market," says Salwin. Still, the average trading volume in Japan's REIT market is now a paltry $3 million a day, compared with $380 million in the 40-year-old U.S. REIT market.
Whatever skeptics may say, Japan's REITs do have their selling points. The government and the private sector are promoting the REIT market because it is a proven way to recycle capital into real estate, which keeps the property market liquid and vibrant. And the returns can be good. The three REITs now trading all offer an annual dividend of about 5%--while 10-year Japanese-government bonds are returning 1.4%, and banks are offering just 0.3% on three-year time deposits. The properties being folded into Japanese REITs are certainly first rate, usually prime office towers charging top rents in fashionable parts of Tokyo. "Most of the properties have occupancies of 95%," says Standard & Poor's credit analyst Tomoyoshi Omuro. He forecasts that the market capitalization of Japan's REIT market will eventually reach $75 billion, or about half the U.S. market.
But hurdles abound. A possible office-tower glut next year could depress rents and reduce the potential pool of profitable properties needed to drive the REIT market. Shuji Tomikawa, a real estate analyst at Mitsui Fudosan, forecasts that Tokyo's 100 million square feet of class-A office space will expand by 20% over the next couple of years, pushing the average occupancy rate down from 96% to 92%. The new buildings were started back in the late 1990s, when financial institutions and professional-services companies were still expanding. Now, foreign investment banks and accounting firms, dispirited by Japan's slump, are cutting back on office space. Also, the government still needs to offer better tax incentives for transferring properties into REITs, something that lit a fire under the U.S. market in the early 1990s. Add it up, and "I just don't know where the demand [for REITs] will come from," says Jack Rodman, managing director of Ernst & Young Asia Pacific Financial Solutions LLC.
Of course, the best thing that could happen to Japan's REIT market would be a real economic recovery that would put a floor under the real estate market. A V-shaped recovery is not in the cards. But if Japan can nurture its fledgling REIT market, it could give its economy a welcome boost. By Brian Bremner in Tokyo