Can Japan's Newest Real Estate Boom Be Sustained?

Includes: EWJ, FXY
by: Kishore Jethanandani

A good thumb rule for bargain hunting is to look for assets recovering from a meltdown after a bubble. The traumatic experience tests the management and brings into relief the flaws in the company tactics and strategy. For the leaders, such situations are opportunities to rise to the occasion, shake-up the company and prepare it for a new growth phase. When assets of such companies rise, it is usually smart money that enters first and price movements in the assets far less volatile than in “hot” stocks.

Very few will remember the real estate bubble in Japan back in 1989 which was followed by a price decline of 70%. The recovery has just taken so long. It is only in the last few years, after the introduction of Real Estate Investment Trusts in 2000, that the real estate sector in Japan has started to recover from the after effects of the crash. The real estate sector is no longer the refuge of the Japanese mafia. Last year was a high watermark in the development of the real estate sector in Japan with a whooping 45% gain in the REIT index over last year beginning 1st March 2006 and ending in 28th February 2007. This was well above the average increase of 22.3% since the formation of REITs.

For investors who missed the rally last year, the question is whether the boom in Japanese real estate is going to be sustained. A superficial look at the declining dividend yields in Japanese real estate in comparison to 10 year bond yields would tend to suggest that the prospects are not encouraging. The differential has declined from 4% in 2002 to 2% at the end of 2006. This is likely to decline further as Japan’s Central Bank raises interest rates in response to an expanding economy.

Japan is still at an early stage of the redevelopment of its real estate sector with real estate securities accounting for only 1% of the total market capitalization. It’s only in the central districts of Tokyo that office property rents have risen substantially and vacancy rates suggest tight market conditions. According to figures collected by Miki Shoji Co (, rents at the end of March 2007 in the central district increased by an average of 10.88 percent in the Central Business District of Tokyo. At their current levels, these rents have only recovered to the peak levels in 2001. The vacancy rates have declined from the peak of 8% in 2003 to 2.72% by end of March 2007. Japan is expected to sustain its growth rate of 2% which would ensure that rents for commercial property are going to continue to increase. In surrounding business districts of Tokyo, rents either rose moderately or declined in more distant areas throughout 2006. Almost two-thirds of office property is also concentrated in Tokyo.

In other important cities in Japan, vacancy rates are still high and rents will increase at more moderate rates. In Osaka, the vacancy rates are a more moderate 5% and in Nagoya at 6%. Here the rents stopped declining by the end of 2006. There is also greater scope for developing new commercial property in these cities.

An important driver of valuations of Japanese properties is the appetite for diversification among especially pension funds. Returns from real estate are weakly correlated with equity. In addition, returns from US Real Estate are weakly correlated with Asian Real Estate. According to estimates of Ibbotson Associates, the correlation of equity and property returns were about 0.3 with small stocks and about minus 0.2 for large stocks in the USA for the year 2004. The correlation between Japanese REITs and US REITs is a low of 0.28.

The changing allocations in favor of REITs have also meant that the rates of returns from real estate have been higher in recent years. In the USA, the average rate of return on equity between 2001 and 2007 was 6.6% compared to 23% for real estate. In Japan, equity earned an average of 10.9% compared to 22.3% for real estate.

Japanese real estate promises to earn handsome gains while the risk for now will be low in the absence of mass involvement of individual investors. While direct trading of J-REITs in American stock markets is not possible yet, some brokers such as Interactive Brokers are reported to have the ability to trade in these securities.