The J–REIT market has taken off. Here is what's next.

By Michele Lerner

Japanese REITs have come a long way since the enactment of the first J-REIT legislation in November 2000, and the growth of this industry has helped to revitalize the Japanese commercial real estate sector and the broader Japanese economy.

"J-REITs were started as a national policy to help end deflationary economic conditions and assist financial institutions in disposing of bad loans," says Koichi Nishiyama, president and CEO of the J-REIT Nippon Building Fund Management Ltd. "As a result, REITs were a factor in the recovery of the Japanese economy, because the transparency within the real estate market increased together with fluidity, and overseas financial institutions poured capital into the marketplace."

Japanese REIT Legislation Japanese REITs may be structured as an independent corporation or as a contractual relationship through a trust bank. J-REITs are understood to be special purpose vehicles with no employees, limited business scope and pronounced leverage ceilings. They are externally managed via a management company with fee-based compensation. Additionally, they are allowed only to invest in properties and cannot conduct development businesses. J-REITs are treated as tax-exempt entities if they pay out dividends equal to at least 90 percent of their profit to investors.

Kazuhiko Arahata, CEO and president of Japan Real Estate Asset Management Co.,Ltd Japan Real Estate Investment Corporation, agrees that J-REITs helped the Japanese economy recover. "It is highly advantageous that Japanese real estate has become more liquidized. This enables investment funds to flow into real estate, which stopped asset deflation."

Ichiro Makijima, executive managing director of the Association for Real Estate Securitization (ARES), says that during the initial year and a half after J-REITs' inception, their market prices continued at the same level as their original listed prices. "However, with continued high dividends, the stock price increased and the market grew steadily."

Both retail and institutional investors alike now are finding value in Japanese REITs. "The primary focus of Japanese retail investors has been the spread of the yield offered by REITs versus Japanese Government Bonds," says Steve Carroll, managing director at CB Richard Ellis Global Real Estate Securities. "While this spread has narrowed meaningfully since September 2001, it remains in excess of 100 basis points and demand for REITs continues to grow."

Factors in J-REIT Success

Tatsuo Inoue, president and CEO of Nomura Real Estate, says there are three main factors that have contributed to J-REIT success, including "The overall improvement in the real estate market, the marginal difference between interest rates and yield, and the overall tax system, which includes tax reduction measures for stock purchases."

Peter Mitchell, CEO of the Asian Public Real Estate Association (APREA) believes that the government's structural reform program, aimed at lifting Japan out of its recession, along with corporate and banking sector changes, helped J-REITs. "Corporations have been able to dispose of non-core real estate and use the assets to develop their core businesses."

Recent J-REIT success is due to the overall improvement in the real estate market,the marginal difference between interest rates and yield, and the overall tax system, which includes tax reduction measuresfor stock purchases. — TATSUO INOUE, NOMURA REAL ESTATE

Carroll says that a lack of high-yield fixed-income alternatives has contributed to J-REIT success, along with a general improvement in investor sentiment toward the commercial real estate market. Merrill Lynch analyst Yoshihiro Hashimoto agrees with Carroll and adds that interest by foreign investors in enhancing the diversification of their real estate allocations was also a major driver toward J-REIT success.

However, Yoshizumi Kimura, an analyst with Nikko Citigroup Limited, says that one of the most apparent reasons that J-REITs have been so successful is that they have a conservative balance sheet. "Investors find J-REITs attractive because they have a strong balance sheet and they are strongly managed. This is key for producing high yield dividends." He also points to a relatively benign interest rate environment, strong asset growth of the J-REITs via accretive acquisitions completed in recent years and global media attention to the J-REIT sector as factors influencing REITs' accomplishments.

Regulatory Changes on the Horizon?

However, regulatory changes ultimately may have an even greater impact on J-REITs' future. The Japanese government is currently evaluating allowing J-REITs to invest overseas, according to ARES. "These possible changes in legislation will increase opportunities to acquire assets, and external growth will be easier," Makijima says.

Carroll agrees that if the legislation regarding foreign investment is changed, J-REITs could grow their portfolios more rapidly through the acquisition of properties in potentially higher yielding markets. This would be similar to Australian and U.S. REITs seeking value through acquisitions outside their home markets in recent years.

Changes in legislation will increase opportunities to acquire assets, and external growth will be easier. — ICHIRO MAKIJIMA, ARES

"Regulatory changes will be a necessary step to meet global standards," says Masahire Horie, director, president and CEO of Tokyu Real Estate Investment Management.

However, some Japanese analysts are unsure that the legislation is necessary "Global funds are already flowing into Japan," says Hashimoto. "For example, Australian REITs have purchased second-tier Japanese properties. There is no need for new regulation changes within J-REITs." However, he says that other changes may take place, such as introducing an UPREIT structure.

Kimura says he believes that the legislation may pass in the next few years, but he doubts that it will be this year.

J-REITs Broader Impact

Photo by DAJ/Getty Images

While the debate on the Japanese regulatory structure for J-REITs continues, the success of Japanese REITs in the global investment marketplace has fueled interest in REITs throughout Asia. "The introduction of the REIT system in Japan has affected Singapore, Hong Kong and other Asian REIT markets," Makijima says. "Since Japan's share of the Asian market is high, it may become a supporting influence in the region."

In fact, the depth and size of the listed real estate market in Asia has increased dramatically since the birth of J-REITs. "Japanese REITs are the driving force toward creation and growth of REITs markets in other Asian countries," Arahata says.

Carroll sees J-REIT success as having a domino effect in Asia. "Although it took some time for Japanese investors to gain confidence in investing in REITs, the market's demand began growing dramatically and more REITs were successfully floated," he says.

Moving Forward

Further J-REIT growth will depend importantly on whether the industry can continue to find good acquisitions in the improving Japanese real estate market. "Due to the concurrent influx of foreign and domestic capital targeting Japanese real estate, most REITs have essentially been priced out of the market," Carroll says. "Yields on properties that meet the investment criteria of J-REITs have declined to levels such that the REITs are typically not able to compete against buyers with lower initial income expectations."

Listed Japanese REITs and Property Companies
	REIT	Equity Market Cap in millions of U.S. dollars
	Mitsubishi Estate	$33,716.2
	Mitsui Fudosan Co.	25,828.7
	Sumitomo Realty & Development	18,023.3
	Nippon Building Fund Inc.*	8,389.6
	Japan Real Estate Investment Corporation*	5,416.9
	Tokyu Land	4,533.0
	Japan Retail Fund Investment*	3,797.1
	Tokyo Tatemono	3,592.1
	Nomura Real Estate Office Fund*	3,401.7
	NTT Urban Development	3,076.1
	Japan Prime Realty Investment*	2,720.0
	Orix JREIT Inc.*	2,099.6
	Nippon Commercial Investment*	1,410.4
	TOKYU REIT*	1,374.0
	United Urban Investment*	1,340.2
	Kenedix Realty Investment*	1,216.6
	Mori Trust Sogo REIT*	1,043.4
	Heiwa Real Estate	955.5
	Premier Investment Co	857.1
	Daibiru Corp	832.8
	Shoei	805.7
	Goldcrest	785.5
	Aeon Mall Co ltd	703.4
	Diamond City	692.8
	Toc	680.8
	Daikyo	538.7
	Total	$127,831.4
Source: FTSE EPRA/NAREIT Global REIT Index as of Mar. 31, 2007* Denotes Japanese REITs

However, T. Ritson Ferguson, CEO and managing director at ING Clarion Real Estate Securities, who manages several global real estate funds that invest in Japanese REITs, says there will be more growth in the Japanese real estate community. "Existing companies are growing bigger and we anticipate several Japanese IPOs in the next year or so. As long as the Japanese economy keeps expanding, it's going to bode well for the Japanese REIT and real estate community."