Some flaws with Japanese REITs

I haven't touched on Japanese real estate and thought I would excerpt a good story BusinessWeek picks up from FinanceAsia.com covering the Japanese REIT market. As long-time readers may recall, I looked at Japanese real estate an year or so ago. Japanese real estate is totally contrarian and one would be hard-pressed to find an asset market that has been in a bear market for 20 to 35 years, depending on how you measure (if you looked at land prices, prices are close to the 1970's prices!!!) Having said that, Japanese real estate is extremely risky mainly due to the declining population (less demand for real estate is inevitable if population shrinks). Indeed, there were numerous fake rallies and I was wondering in early last year if 2008 would be the bottom. Well, given the calamity in the global financial markets, I don't think we need to look at the prices to see how 2008 turned out.

I do not much about Japanese REITs and would not recommend them without studying them further, but they are one of the straight-forward ways to gain exposure to real estate in Japan. The BusinessWeek article points out some flaws with those structures:

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.

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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.

There is also an anonymous source in the article who talks about serious conflict of interest in the J-REIT structures:

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 contrarian in me says that Japanese real estate is worth considering at some point. But I would be careful for the time being and wait a bit to see if the real estate market in China and Hong Kong explode. You might miss out on the bottom by waiting to see how China recovers so it's a decision one has to make. If one is interested in Japanese real estate, they may want to check out some of Martin Whitman's picks. He has favoured class-A office buildings in major Japanese cities and thinks they will be valuable (Whitman also likes real estate companies listed in Hong Kong that operate in Hong Kong and China but I think his holdings are highly vulnerable to a real estate bust in China. In contrast, Japanese buildings are at 20 to 35-year lows.)