Searching for the bottom: what you need to know before you buy land in Japan - Real Estate part1 - Industry Overview

Japan, Inc., March, 2003 by Stefan Whitwell

TOKYO REAL ESTATE PRICES have fallen for 11 straight years. Commercial land in the capital has dropped in value by almost 80 percent. That must mean that now is the time to buy, right? Not so fast.

Tokyo is the largest commercial office market in the world, with 840 million square feet of office space in its 23 wards, according to a Morgan Stanley strategy report from 2001. Just take a look at the Tokyo skyline and you will see the enormous construction projects underway--the biggest just keeps getting bigger. Some people might find the timing of this expansive construction curious at a time when the economy is ailing, companies are reducing staff, unemployment keeps climbing to record highs, foreign companies are leaving Japan and, last but not least, land prices and rents are falling. What gives?

The Land and Transport Ministry's latest land price survey, released last July, revealed that land prices fell by an average of 5 percent from a year earlier, the 11th consecutive year-on-year decline. Since 1990, residential land prices in Tokyo have declined 60 percent and commercial land prices in Tokyo have declined 79 percent, according to media reports. Yet, despite this downward trend, foreign investment funds with multi-billion dollar war chests have flocked to Japan in the last three years in the hopes of making fortunes by buying financially distressed properties at a huge discount. This is how many companies initially built their wealth during the late 1980s and early 1990s in the US, buying from the Resolution Trust Corp., which was set up by the US government to help clean up the banking sector. But will this same strategy work in Japan? While everyone agrees that Japanese real estate is cheap by historical standards, is it really cheap vis-a-vis the fundamentals? Or are prices going to continue to drop?

First, ask yourself why Japanese real estate prices went up in the first place: because of loose bank lending and widespread speculative buying. Why did real estate prices go down? Business slowed and people could no longer service the debt. This led to liquidity problems because there were no buyers for these properties at prices high enough to pay back the loans. This set of circumstances created a vicious cycle with enormous shock effects on the Japanese system, since most lending was collateralized by real estate, not by the underlying cash flows of the business.

So why do the optimists think Japanese real estate prices are going to appreciate? Some domestic institutional investors think the economy is going to turn around, and they are happy to buy land at current prices because the yields exceed what they could earn by buying Japanese government bonds or by putting their funds in the bank. Foreign funds tend to believe that prices are low by historical standards and Japan is near the bottom of the cycle, or that Japan is going to he forced to inflate its economy by printing massive amounts of yen, which will help real estate appreciate. The people working at these funds will also tell you they like the "positive carry" the fact that the cost of borrowing here is less than the yield on the investment, which means that by borrowing you can increase your returns while still keeping your cash flow positive].

But most foreign investment funds have short investment horizons and need to sell in three to five years. They also need high rates of return to appease their largely foreign sources of capital, which means that "carry" alone is not enough--they have to sell at a higher price. Foreigners are hoping that Japanese mortgage-backed securities markets develop quickly enough to create the liquidity that will facilitate their exit. It is worth pointing out that while these derivative credit markets do create liquidity, which in turn stimulates investment demand for real-estate-backed investments, they do not affect the real, underlying user-driven demand for real estate.

In the hears' camp

The pessimists say real estate could fall further. Their core reasons include excess supply, a weak economy with no clear signs of structural recovery and historic levels of unemployment. Consider for a moment what drives user demand, and compare that with the reality in Japan today: jobs (fewer in Japan with each passing days; demographics Japan's population is expected to decrease from 127 million people in 2000 to 90 million people by 2050--that's a decline of nearly 30 percent due to plummeting birthrates and a society which discourages permanent immigration; quality of life spoor air, mediocre water, concrete jungles, long commutes, long work hours fraught with face time, promotion based on age more than merit); supply; and pricing.

Even after the massive decline in land prices, the average price for a used 70-square-meter apartment in Tokyo during the first 10 months of 2002 was [yen] 35.607 million or approximately $297,000, according to the Real Estate Economic Institute and the Haseko Research Institute. By comparison, American Property Consultants, a company I work for, buys entire apartment complexes in large US cities for investment purposes at an average purchase price per apartment of [yen] 4.8 million--and these apartments are also about 70 square meters. Obviously some US cities are more expensive than others, but in general Tokyo prices are still far from cheap, especially taking into consideration the fact that the US has a stronger economy and significantly better demographics due to immigration and strong birthrates.