By Mike Fickes

The Pacific Rim turns to REITs to revitalize its property markets

For the past three years, Larry Sperling has directed the Asian real estate business of Credit Suisse First Boston (CSFB) from his office in New York. However, this August he relocated to Japan, testifying to the significant future CSFB sees in real estate investment trusts in Japan.

This year and next, REITs will emerge to alter the property markets across the Pacific Rim, in Japan, Singapore, Korea, and other countries. CSFB and many other U.S. companies will have a keen interest to see how Pacific Rim REITs develop and perform in cultures and markets very different to their own and how public real estate industries emerge in other countries.

Market For REITs in Japan

Sperling's assignment is to build an investment banking business around Japanese REITs (J-REITs). His analysis of the Japanese property market suggests that J-REITs offer substantial investment banking opportunities.

To support this position, Sperling points to statistics assembled by the National Association of Real Estate Investment Trusts (NAREIT). NAREIT's figures show that stock markets in Pacific Rim countries contain substantial percentages of real estate companies. In Hong Kong, for example, 27 percent of stock market capitalization resides in real estate companies. The percentage in China is 23 percent. In the Philippines, real estate occupies 22 percent. Singapore's public real estate companies total 16 percent of that market. Indonesia comes in at 9 percent.

In Japan, however, the figure is 0.7 percent. So while it is clear that Asian investors place great value on real estate, it only seems natural that, as J-REITs come to market, investors will buy.

J-REIT IPOs Launch

Sperling expects the J-REIT IPO market over the next five years to reach $30 billion [all dollar values in this story are in U.S. $], a level approximately equivalent to the $28 billion REIT IPO market that emerged in the U.S. from 1992 through 1998.

The first two J-REITs went public on Sept. 10, 2001. Japan Real Estate Investment Corp., a REIT set up by a consortium led by Japanese real estate developer Mitsubishi Estate Co. Ltd., and Office Building Fund of Japan Inc., established by a group led by developer Mitsui Fudosan Co. Ltd., both posted stable public offerings despite difficult market conditions. Japan Real Estate Investment had an IPO price of 525,000 yen, while Office Building Fund had an offering price of 625,000.

Industry observers say that U.S. REIT issuances in the early 1990s garnered capital totaling hundreds of millions of dollars. Today, however, investment bankers want to see the potential for $1 billion before taking on an IPO.

However, estimating the size of the Japanese commercial property market has proven difficult.

According to a March 2000 Nikko Salomon Smith Barney report, the Japanese commercial real estate market was estimated at just under $4.9 trillion. The report cites the Economic Planning Agency of Japan as its source. A spokesperson from the Lend Lease Corporation offices in New York expresses skepticism in comparing that figure to the $4 trillion to $5 trillion U.S. commercial property market, because of different criteria for classifying commercial real estate.

Lesia Bates, vice president and senior credit officer with Moody's Investors Service in New York, agrees that such comparisons require care. "According to our analyst that follows Japanese banking, the total commercial loan exposure in Japan is about $5 trillion," says Bates.

That figure includes everything that businesses borrow. Based on that figure, Japan's commercial property market is likely closer to $100 billion, Bates says.

"It's difficult to place a value on commercial real estate in Japan because so much is based on land value," Bates adds. "And how do you value land? The value of land is only meaningful when you are generating cash flows."

Cross Border REIT Transactions Nearly two years ago, Lend Lease Corporation launched the Lend Lease U.S. Office Trust, which owns $1 billion (Australian) in U.S. office properties. According to David Ross, CEO in the Asia-Pacific region for Lend Lease of Sydney, the trust has used Australian capital to purchase 50 percent of a number of assets from Equity Office Properties of Chicago. "This idea works when there is a yield arbitrage between countries," Ross says. "For example, in the U.S., you can buy quality office assets at yields of 9 percent plus. In Australia, our office trusts are trading at yields in the 7 percent range. As a result, you can buy assets in the U.S. with capital from Australia and list those assets at some premium to issue price because the yields are attractive." The reverse, of course, doesn't work. In Singapore, for example, yields on retail assets are 5 percent. Australian LPTs with retail properties provide returns of around 7 percent, Ross says, making it impossible to raise capital in Australia to invest in 5 percent Singapore retail properties. In any event, the emergence of REITs in the Pacific Rim may give rise to opportunities for cross border businesses by REITs. The number of U.S. REITs expanding into the Pacific Rim is rapidly growing. Starwood Hotels & Resorts opened a St. Regis-brand hotel in Shanghai, China at the end of July and ProLogis Trust announced its first development in Japan earlier that month.

Another question surrounding J-REITs is where will the investment capital come from? According to Sperling, retail investors and pension funds will provide the lion's share. CSFB research shows that personal savings in Japan totals $12 trillion, while pension funds hold approximately $2.4 trillion. Neither group has substantial property interests right now.

Income investments in Japan appear to come up short, when compared to generally accepted REIT return projections. Certificates of deposit in Japan currently return 22 basis points, according to Sperling. At 35 basis points, five-year Japanese government bonds don't perform much better. Analysts say that J-REITs will pay dividends between 2 percent and 4 percent.

"We believe J-REITs will have a fundamental appeal for retail investors and pension funds," Sperling says. "It is a structure in which property assets won't be tied up in a diversified conglomerate or in real estate companies involved in various activities. The primary focus of J-REIT management will be managing assets in the J-REIT. This will eliminate many of the conflicts investors are concerned about."

Foreign Interest Remains Lukewarm

Foreign investors, however, have major questions about J-REITs. "I don't see enough positive momentum building in the underlying Japanese economy," says William Hauser, director and portfolio manager for HVB Capital Management in New York. "Japan's economy recently fell back into recession for the fourth time in 10 years. Consumption is flat. New investment is particularly weak. Deflationary pressures remain a concern.

"Japan remains highly exposed to a global slowdown, particularly in the areas of information technology and the automobile industry. The Bank of Japan is hamstrung in terms of further policy action. Overall, it's not pretty."

Hauser does see comparisons between the current Japanese property market and the U.S. property market of 1991, which eventually produced numerous successful REITs, in which Hauser now invests. "But there is one major difference," he says. "The U.S. stepped up and tackled its problems head on with very aggressive legislation. FIRREA (Financial Institutions Reform Recovery and Enforcement Act of 1989) and the Resolution Trust Corporation (RTC) overhauled the banking system. The government took proactive measures to clean up the S&L crisis and the real estate crisis."

But Hauser sees nothing like this in Japan right now. Many real estate owners can't sell and they can't borrow, he says. Because large-scale write-offs and wide-scale bankruptcies do not offer politically or culturally acceptable solutions, the Japanese government may lack the tools necessary to address these issues.

Sperling, however, believes Japanese property markets have stabilized. "Land prices are down 70 percent to 80 percent from the peak," he says. "Rental rates are down 40 percent to 50 percent and stabilizing. Office vacancy rates are 2 percent across 23 central wards in Tokyo, and the Class-A vacancy rate in Tokyo was less than 1 percent as of May 1, 2001."

What about the falling GDP in Japan? Even if GDP does fall, Sperling says, knowledgeable forecasters project an exceedingly tight office market and an increase in vacancy of less than 1 percent.

Then again, Sperling concedes that J-REITs primarily will attract domestic Japanese investors rather than international investors seeking yields above the 2 percent to 4 percent projections for J-REITs.

Pacific Rim REIT Structures

Investors from the U.S. may experience a case of déjà vu when looking at J-REITs. "The structure closely mirrors the U.S. REIT structure prior to 1986," says Moody's Bates, "For example, J-REIT properties must be managed externally."

In the U.S., banks as well as investors worried about the potential for conflicts of interest stemming from the use of external management companies. As a result, the requirement was lifted in 1986.

Some analysts speculate that the J-REIT structure eventually will eliminate this requirement as time passes and conflict of interest questions arise.

"Singapore REITs have not received all the tax transparency clearances needed to make them successful," Ross says. "At the moment, tax is paid at the industry level, which defeats the purpose."

Others see the management question in terms of culture. Limited property trusts (LPTs) have operated in Australia for nearly 30 years, relying strictly on external management. "All REITs in the Pacific Rim, including Singapore REITs and J-REITs are based on the same model as Australia, with the external management structure," says David Ross, chief executive officer in the Asia-Pacific region for the Sydney, Australia-based Lend Lease Corporation. "This debate rages on. But if you look at the track record of LPTs in Australia, investment performance has been strong. Lend Lease launched General Property Trust in 1971, and its compound return over 30 years is around 15 percent per annum. It's difficult to argue that, being able to survive that long with a broad range of investors and that sort of performance, the structure has major conflicts."

Ross also points out that internal management doesn't necessarily eliminate the potential for conflicts related to remuneration.

Bruce Kiley, a partner with PricewaterhouseCoopers, notes that external managers can work across several types of REITs and provide a level of business efficiency. "It's just a different concept than the U.S. approach," he says. "Part of this comes from the fact that U.S. REITs in the early 1990s were often family owned property companies with large bank debts. The idea of a family patriarch getting external fees bothered the banks. Eventually, the market said this is a conflict of interest and forced the change.

"But in Australia and Japan, property companies are not family oriented. They are corporations that select competent and professional corporate management to run properties. Of course, you can argue whether or not these management firms are competent.

"But in the end, it is a difference in culture, with the U.S. firms being unique (among world property companies) in this change from family ownership to corporate ownership."

The tax treatment of Australian LPTs is slightly different as well. Ross of Lend Lease cites the two fundamental tax rules: First, LPTs must buy property for long-term investment. Second, LPTs must distribute all taxable income, which is then taxed in the hands of the investors at the marginal tax rate. "Some of the income in the trust is tax deferred, depending on where the income is generated," says Ross. "We get deductions for depreciation and that causes some of the income to be tax free."

Singapore, Korea REITs Under Construction

In Singapore, legislation created a REIT structure in 1999, but tax issues have not been finalized. "S-REITs (Singapore REITs) have not received all the tax transparency clearances needed to make them successful," Ross says. "At the moment, tax is paid at the industry level, which defeats the purpose."

CSFB's Sperling says that the eventual resolution of this issue should produce tax treatment similar to U.S. REITs but notes that other issues are at play in Singapore. "Real estate historically has traded below government bond yields in Singapore," he says. "Currently, government bond yields are 3.5 percent and some real estate owners are still holding out for the 4 percent cap rates they could have received before the Asian economic crisis. When real estate assets start trading at 5.5 percent to 6 percent, then the Singapore REIT market will emerge." The first S-REIT is expected to be launched by developer CapitaLand in early 2002.

Korea, too, is developing a REIT structure, which Ross calls the next phase of development in Asia. Legislation authorizing K-REITs became effective July 1, 2001.

For REITs to succeed in Korea, a number of unique issues will have to be addressed. According to a Moody's report entitled "REITs in Korea: Future Real Estate Saviour?," these issues include opening a closed real estate market, the creation of industry expertise, the establishment of infrastructure necessary to ensuring market liquidity and transparency, and the establishment of a simplified REIT tax treatment that overcomes the country's generally complex approach to taxes.

Public Real Estate Worldwide

What does the emergence of public real estate companies in the Pacific Rim mean to U.S. REITs? Most analysts speculate that little or nothing will change for U.S. REITs in the immediate future. At the same time, they hope for the long-term success of REITs in the East, likening their emergence to the rollout of a successful brand franchise.

HVB Capital's Hauser explains, "When McDonald's or any other well-recognized brand name opens a new franchise or introduces a new product, there is always a question about how this new entity will represent the brand.

"What happens to the 'REIT' brand name because of a blow-up in one country or another? The last thing we would want to see is the word 'REIT' being tarnished with a negative connotation. The reverse is also true. To the extent that international REITs thrive, that can add credibility to the 'REIT' name and to the real estate asset class overall."

Michael Fickes, a frequent contributor to Real Estate Portfolio, is a freelance writer based in Cockeysville, MD.