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

The government's role

The sixth major variable that affects real estate and property valuation is government regulations. These can have a serious impact on the way a city develops. For example, consider two regulations that affect the valuation of land in Tokyo as well as the city's very character: Japan's zoning laws, which closely monitor the amount of sunlight a building gets and how it affects the sunlight of nearby buildings; and Japan's floor-area ratios (FAR), which are calculated by dividing the gross floor area of a building by the area of the lot. By controlling these ratios, the government in effect controls how tall buildings can be. Both of these regulations serve to artificially prop up the price of real estate by limiting land usage.

These two regulations, as Alex Kerr points out in his book Dogs and Demons, result in a very cramped and horizontally dense city where people live and work in woefully small quarters. Tokyo has a FAR of less than 2 to 1, which, according to Kerr, is the lowest of any world capital.

If you think real estate prices are going to go up, you believe that people are going to he willing to buy the same properties for higher and higher prices. In simple terms, there are two types of buyers--those who use the real estate and those who buy it as an investment. Now let's look at the variables that drive investment demand. These are: economic fundamentals, inflation expectations (good; Japan is likely to inflate the economy by printing yen, and traditionally real estate does well during inflationary periods, interest rates (good; super low interest rates, ability to borrow (mixed; some progressive Japanese institutions will lend, but most are playing defense on account of their existing problems, positive carry good; the cost of borrowing in Japan is typically less than the yield, and lastly, relative value negative).

Who is going to buy land in Japan given this climate? Individual investors are largely irrelevant except in the individual home market in Japan, which suffers from horrible resale values and a declining population base. Domestic institutions are unlikely to pour enough into real estate to make a difference. They might like to because of the positive yield, but most are constrained by perverse notions of risk and a paucity of financial know-how. For example, many institutions in Japan are slow to reduce their equity holdings because that requires officially recognizing huge losses. In addition, most institutions hold huge amounts of Japanese government bonds (JGBs) because they are considered "risk free," despite the petite 1 Percent current yield on the 10-year note. Japanese regulators also place strict limits on the type of "risky" (non-JGB) investments that insurance companies, banks, pension funds, et cetera are permitted to hold. Foreigners will continue to buy Japanese real estate but will likely find it difficult to buy in bulk and still meet their return hurdles, since domestic institutions can pay higher prices and still meet their (lower) required rates of return. Barring a spike in inflation, some foreign funds that have recently entered Japan may struggle to meet their business targets. There are, however, a few foreign groups that will continue to thrive because their focus is on creating value through asset repositioning, or re-tenanting, for example, instead of merely hoping to pick the bottom of the market.