Illustration by Phil Couzens
listed on Sept. 10, 2001, the market has gained considerably both in size and maturity. Still, the J-reIt market is an unruly 10-year-old going through difficult growing pains, and there are no signs that its parents, the Japanese government and Tokyo Stock Exchange (TSE), are taking any actions to address obstacles to future development.
With interest rates in Japan and many other industrialized countries at historic lows, investors are desperate for higher yields and J-REITs, which were designed to be a medium-risk, medium-return financial product, should theoretically be a perfect solution. With 35 issues now listed on the TSE owning a variety of property types, such as office, residential, retail, logistics and hotels, investors can choose by asset class, location and portfolio quality. With a range of dividend yields from 3.5 to 7 percent, this offers a huge premium over ordinary savings accounts and Japanese government bonds. Still, as the popularity of exotic (and risky) foreign bond funds investing in Brazilian reals, South African rands and other currencies has shown, many Japanese individuals not qualified to be taking high risks are sending their money abroad when they could easily put their money into J-REITs and enjoy a reasonable yield with far lower risk.
The biggest problem with J-REITs is structural. The Japanese government chose an external management model, rather than the internal management model common in the U.S. What this means is that J-REITs are paper companies that own properties, but outsource asset management to affiliates of their “sponsors.” The sponsors, which are mostly Japanese and foreign real estate companies, are typically minority shareholders in the J-REIT, but exercise total control over decision-making through their role as asset managers. Given the generally passive nature of Japanese shareholders, this means that the sponsor, which technically doesn’t even have to own any J-REIT shares, effectively controls a separate listed company that it can exploit for its own benefit and to the detriment of J-REIT shareholders.
The second major problem created by external management is that J-REIT prices often correlate more with the financial health of their sponsors than the quality of their portfolios. A big reason for this is the ability to borrow. For any company that has ever tried to get a loan in Japan, it is very apparent that banks have a strong preference to lend to companies that don’t need the money; any company that actually needs to borrow has great difficulty obtaining funds.
Prior to the global financial crisis, both of these problems existed, but the real estate market was so buoyant that conflicts of interest were largely ignored and even J-reIts with weak sponsors had little trouble borrowing. For the last three years, however, a number of J-reIts found that they could not survive on their own, resulting in one bankruptcy and several mergers. As the volume of real estate transactions has plummeted, J-reIt transactions stand out even more, because of investor disclosure requirements. While the quality of investor relations for ordinary listed companies seems to be improving, the opposite appears to be true for J-reIts. For anybody interested in this topic, I strongly encourage you to compare the quality of property acquisition press releases from 2001 to the present. Some J-reIts are slightly better than others, but non-professional real estate investors trying to understand the rationale behind specific transactions would struggle if they relied only on information released by the J-reIts.
During the peak of the real estate mini- bubble in 2008, one of the largest J-reIts abruptly stopped disclosing the initial yield for new acquisitions, a critical piece of data for both shareholders and real estate market players to gauge the deal terms. When my company called that J-REIT’s investor relations department at the time to find out why, we were told that prices were getting so high (and yields so low) that the asset manager was causing problems (meiwaku in Japanese) for investors by continuing to disclose such information, so it decided to stop announcing the yield, or “cap rate” as it is widely known.
While some J-REIT acquisitions are of good quality assets at fair market prices, a surprising number are not. I haven’t seen a good analysis comparing transactions on an arms-length basis with those between J-reIts and their sponsors, but I think such a study would show that related-party deals tend to strongly favor the sponsors. J-REITs often acquire assets from their sponsors at what appear to be above-market prices, some of which are poorly-located or otherwise flawed properties that would be hard to imagine buying at any price. to maintain my relationships in the real estate community, I am reluctant to point out specific transactions here, but I do encourage readers to review press releases for transactions between J-reIts and their sponsors and try to make any sense of the acquisition rationale. An even more interesting exercise is to read the explanations made for round-trip transactions, or assets that have traded back and forth between J-REITs and sponsors. the stilted language and lack of logical explanation reminds me of the way that Japanese politicians used to answer questions without actually conveying any meaning, such as with the now unofficially-banned phrase zensho shimasu (“we will act with prudence”).
Seth Sulkin is the President and CEO of Pacifica Capital K.K., a Tokyo-based real estate asset manager specializing in commercial properties.
More than a third of existing J-REITs have a market cap of less than 50 billion yen, which is generally seen as too small to survive independently; another 10 are in the 50-100 billion yen range, which is better, but still too small to provide for good liquidity. Only 12 have a market cap of more than 100 billion yen, which is seen as the minimum size both for the asset manager to be profitable and for shareholders to be able to buy and sell quickly and easily. The Japanese government and TSE need to reconsider whether the J-REIT market is best off in its current state or whether internal management would be a better alternative. At the very least, they need to find a better way of mitigating the conflict of interest between sponsors and J-REITs.
