Japan's Real Estate Correction

I have been following the Japanese real estate market closely and Bloomberg had a good recap of the present situation. To sum up, Japanese real estate is going through a big correction as can be seen from the chart below. Unlike the US, I feel that the Japan market has the potential to rise (but potential does not necessarily translate into reality.)



The chart plots the TOPIX (a broad stock market index) against a real estate index and the TSE REIT index. You can see that the real estate indexes ran up quite a bit in the last two years.

Although I find Japanese real estate worth investigating, one of the looming risks is their shrinking population. Given that Japan has literally no immigration (it's run like a "fascist" state in a minor sense), the declining population will exert a downward pressure on real estate. This means that the attractive real estate is in the cities. I would stay away from the countryside at all costs.

(source: Akira Mori's Real Estate Riches Retreat in Japan Credit Squeeze By Kathleen Chu, April 9, 2008. Bloomberg.com)

Akira Mori, Japan's richest man, spent a record 231 billion yen ($2.3 billion) buying Tokyo's Toranomon Pastoral Hotel last September. He now says it's worth closer to 200 billion yen.

``The boom we've enjoyed for the past few years is over,'' said the 71-year-old chief executive officer of Mori Trust Co., who teamed with K.K. DaVinci Advisors, a 1.2 trillion yen Tokyo- based property fund, for the acquisition. ``Investors were convinced that prices would keep rising, so in about six months, they'll probably rush to get out regardless of price.''

The interesting thing to note is that Akira Mori implies that investors still haven't bailed and will attempt to do so. If that thinking is correct, it is prudent to stay on the sidelines for the time being.

Cracks are emerging in a market that generated annual returns averaging 14 percent since 2003. The Tokyo Stock Exchange REIT Index dropped 16 percent this year and 40 percent from its peak in May. Twenty-six of 42 property trusts are trading below their initial public offering price, according to data complied by Bloomberg.

That might sound scary to most investors but it's good hunting grounds for contrarians and value investors. I have been looking at a much of Japanese REITs but am having problems figuring out which ones are "good". One of the advantages of stock market corrections or economic slowdowns is that it gives one the opportunity to pick up brand-name companies or market leaders at decent valuations. Early on (an year ago), when I was looking at Japanese companies, I was looking at small and mid-sized real estate companies (that's how I came across the scandal-plagued Suruga Construction). But now there is no need to go with the riskier, smaller, ones. You can find some seemingly decent REITs run by big-name investment banks that have fallen in price (but note that a decline in price doesn't necessarily mean they are cheap given that many of their IPOs were during the boom at likely inflated prices.)

(What I said about brand-name, well run, companies being cheap is true for other beaten-down sectors in America as well. Instead of looking at small-caps and mid-caps, I'm looking more and more at market leaders these days. In particular, instead of concentrating on small-cap retailers, you actually have a shot at picking up solid large-cap retailers at seemingly attractive valuations. Unless your stockpicking skills are good, the small-caps will also get whacked during any economic slowdown so large-caps are more attractive right now.)

Japan's previous property boom lasted 16 years, making Mori's father Taikichiro Mori the world's richest individual in 1991, according to Forbes...

The crash was equally spectacular as Tokyo commercial land prices plunged more than 50 percent in five years and the Nikkei 225 Stock Average lost three quarters of its value.

Rents in Marunouchi, Tokyo's most expensive business district, peaked at 100,000 yen per tsubo in 1991 before dropping to as low as 35,000 yen in 2003, according to Colliers Halifax. The rate averaged 65,000 yen last year. A tsubo, the standard measure of property in Japan, is 3.3 square meters, or 35.5 square feet...

``Japanese investors suffered a severe shock when the last bubble burst, and because they lived through the crash, they're bound to be cautious now,'' said Junko Miyakawa, a senior analyst at Tokyo-based Shinsei Securities Co.

Regulators at the Tokyo-based Financial Services Agency may have sought to curb lending to prevent a new bubble from forming, said Katsuya Takanashi, CEO of Secured Capital Japan Co., which manages about 550 billion yen of real estate assets...

Soured property loans devastated Japanese lenders in the 1990s, forcing the government to spend more than 9 trillion yen on an industry bailout. Tumbling real estate prices helped trigger a decade of deflation that the world's second-biggest economy has yet to fully shake off.

Sums up what I believe is the largest real estate bubble in history.

Even though the situation doesn't seem good, some foreign investors are snapping up real estate in Japan:

Global investors led by General Electric Co. and Morgan Stanley sense a buying opportunity in a nation where Real Capital Analytics estimates the value of transactions was just 7 percent that of the U.S. last year.

GE's real estate unit may buy as much as $10 billion of Japanese property this year, anticipating tighter credit and rising borrowing costs will prompt local trusts to accelerate asset sales and drive down prices. GE uses its own cash to invest in property, unlike REITs and private funds that borrow money.

The advantage small investors have is precisely what gives G.E. an advantage. We don't have to finance ourselves (assuming we have savings) and we won't be getting margin calls if the asset price falls in the short term.