Seth Sulkin is the President and CEO of Pacifica Malls K.K., a Tokyo-based real estate asset manager specializing in commercial properties.
The creation of the J-REIT market 10 years ago spurred huge change in the Japanese real estate market, resulting in increased institutional ownership, the introduction of Western-style valuation and management practices and higher transparency. While the market rose for much of the last 10 years, systematic flaws in the J-REIT market didn’t seem to matter. Now that the Japanese real estate market is floundering, it is time for the Japanese government to take a fresh look at what it did wrong and how to correct it. Without a transformation of the J-REIT market and fresh non-recourse lending, it will be very difficult for the real estate market to recover in any meaningful way.
Unlike most countries, where REIT management is contained in the same entity that actually owns the real estate, Japan created a system where REITs are paper companies that own property and asset management is performed by separate entities on a contractual basis. The first few J-REITs were created by Japan’s corporate elite, such as Mitsubishi Estate, Mitsui Fudosan and Mitsubishi Corp., which set up subsidiaries to manage the REITs and sold properties off their balance sheets to seed the portfolios.
As a result, many investors, particularly individuals, focused more on the name of the sponsors than the actual portfolios and operating performance. Until about two years ago, J-REITs borrowed money quite differently than real estate private equity funds. Lenders to the J-REITs, which were primarily large Japanese banks, provided huge amounts of unsecured loans at extremely low rates. This contrasts with private equity funds, which borrowed then and now on a “non-recourse” basis, meaning that the properties were pledged as collateral, but the lender did not have a general claim on other corporate assets. When the real estate debt market virtually disappeared in 2008, J-REITs whose sponsors were not affiliated with the Mitsubishi, Mitsui, Nomura or other major Japanese corporate groups were practically shut out of the debt market or forced to borrow at much higher rates and with full collateral.
Illustration by Phil Couzens
It is no coincidence that many of the J-REITs struggling for survival right now have foreign sponsors. Major Japanese banks never really developed sufficient underwriting capabilities to properly value the collateral of non-recourse loans. Instead, they prefer relationship-lending with well-established domestic companies which will honor loan commitments on underperforming assets, even when it doesn’t make economic sense. This contrasts with Western investors, who sometimes walk away from assets when the value is less than the outstanding loan amount. One foreign-controlled J-REIT has already gone bankrupt (New City Residence); several face looming debt maturities with no attractive solutions, and others are in the process of being absorbed into J-REITs controlled by major Japanese companies. In a November 2009 report by Nomura Securities on the proposed “merger” (in reality, takeover) between the Japan Retail Fund (managed by an affiliate of Mitsubishi Corp.) and the LaSalle Japan REIT (managed by an affiliate of LaSalle Investment Management of the U.S.), the report came to the conclusion that LaSalle really had no choice but to get out of the J-REIT business because “LaSalle Japan REIT’s banks were uniformly hostile in their lending stance.”
Changing the structure of J-REITs to internalize management would reduce the influence of the original sponsors, leading to more professional practices, reduction in conflicts of interest and improved transparency. The Japanese government should increase pressure on banks to lend to real estate, particularly in the non-recourse category. A revival of the J-REIT market and greater availability of loans are the two most important steps that can be taken to jumpstart the real estate market, which is probably more critical to the economy than exports.
