"Dump REITs" is not the best strategy: the gap between REIT stocks and real estate stocks

Japan, Inc., Sept, 2004 by Darrel Whitten

INVESTORS talk about being more selective (defensive) and looking for lower beta stocks to protect gains made for the year-to-date, but have apparently not yet acted on this conjecture. We continue to believe that economists, and to a lesser extent, investors, have "jumped the gun"-at least theoretically-about this recovery.

IN ADDITION, THERE APPEAR to be some misperceptions at work in the growing gap between Japanese Real Estate Investment Trust (REIT) stock prices and real estate stocks. Research in the US would indicate that REITs are a valid asset class, useful in diversifying large portfolios of Japanese financial assets--not just another interest sensitive that should be dumped when interest rates begin to rise.

A more bullish BOJ makes Japanese investors nervous

The Japanese market could remain choppy for the foreseeable future as global investors see how the US recovery deals with rising rates and tighter fiscal policy--and how the presidential race unfolds. Foreign investors are again net buyers of Japanese equities, apparently having already discounted the risk that slower China growth could harm Japan's economic recovery. The LDP's losses in the House of Councillors' elections were also not as deep as feared, while Heizo Takenaka, Prime Minister Koizumi's reform program point man, has gained credibility now that he is an elected politician.

Investors, however, profess that they have become more selective and are looking for lower beta stocks to protect gains. This implies at least a temporary move to larger and mid-caps away from small caps. However, as we have pointed out in the past, the small cap indices (particularly the TSE 2) have continued to hold up better during the recent correction, while showing much stronger performance than the Topix and certainly the big caps (such as the Topix Core 30) on the upside.

As the recent Bank of Japan (BOJ) tankan business survey showed, Japanese businesses are feeling more bullish about domestic economic conditions than at any other time since the end of the speculative boom more than a decade ago. The BOJ is now also more confident that this economic recovery is different, and more importantly, sustainable. However, this makes investors nervous because the more confident the BOJ becomes, the closer the day when the central bank abandons its zero interest rate policy (ZIRP) approaches. Investors are not yet sure that Japan's economy, financial markets and corporations can withstand higher rates.

However, Japanese firms are finally beginning to reap the benefits of many years of hard work to clean up their debt-laden balance sheets and retool their operations for greater efficiency and profitability. In addition, a wave of innovation in the digital electronics area in recent years has also helped recharge Japan's growth engine. Moreover, the banking sector's progress in reducing bad loans has provided additional thrust for the economy. Troubled companies are being scrapped or recycled into new, profitable businesses at increasing speed. These improvements will have a lasting, positive effect on the economy, and have positive implications for the secular recovery that we have been suggesting could happen--one that could possibility support an extended economic recovery like the Izanagi Keiki of the 60s.

More subdued market trading energy

Trading turnover has subsided to the lowest level in four months in a sign that the Japanese stock market is losing energy. Waning trading volumes amidst underlying bullishness is another reason why the large caps could very well continue to underperform for the foreseeable future.

Having made good gains on domestic-oriented and financial stocks, foreign investors have recently been taking profits, as evidenced by the profit-taking in UFJ Holdings by the Sovereign Group, a particularly high profile early purchase of the financial sector that set other foreign investors as well as individuals chasing after financial stocks. But the best-performing foreign funds as listed above have few of the traditional Japan blue-chip favorites. Instead, they own regional domestic-demand oriented companies like Aica Kogyo, Touei Housing, Nishimatsuya Chain and Nitori Co. and consumer finance companies such as Life Corp. and Nissin.

Growing investment in Japan's distribution through REITs

The Nikkei is reporting that two major US real estate funds will each invest more than [yen]100 billion in building large distribution/warehouse facilities in the Kansai region, while Japanese trading houses are also moving quickly to expand investment in distribution properties in major cities.

Each company reportedly intends to procure funds by listing REITs specializing in distribution facilities. AMB, a major US REIT operator, plans to inject a total of [yen]100 to [yen]120 billion into Japanese distribution facilities by spring 2006. It has already invested about [yen]30 billion in such facilities in Saitama and Chiba prefectures through AMB BlackPine, a Japanese subsidiary set up last spring. It is also expected to start building a facility in Hyogo Prefecture in August.