Aug 2005

LONG ONLY JAPANESE EQUITIES

Last month we outlined why we avoid investment in cyclical and commodity businesses. This month we review the prospects for real estate in Japan especially as the quoted companies in the stock market have performed particularly strongly of late.

The annual survey of prefectural land prices was released last week and confirmed that land prices in Japan as a whole continue to decline, in the year to July 2005 by 4.2% per annum for the 14th year in succession. It also revealed that prices in central city locations notably Tokyo and Nagoya rose from last year for the first time since 1991. Commercial land prices in Tokyo's most central 8 wards rose 1.4% and residential prices by 2.5%. Commercial land prices have stabilised or risen as vacancy of new and old buildings has fallen. What is less easy to determine is the trend of rents. Many commentators talk of firming rents in new buildings but data on this is unreliable as many initial tenants strike special deals that may undercut the published rent. What seems clear is that the declining trend of rents, ongoing since 1990, has certainly diminished and may have halted. What is less clear is whether there is any basis for claiming that rents in general are rising, even though many commentators and investors, often with a vested interest, make such claims. What is also unclear is to what degree the price and rental trends in central Tokyo are a leading indicator for Japan as a whole. Certainly in the past central Tokyo prices have tended to lead the country. Clearly the draw of location and a greater supply of modern buildings should provide more support to the central Tokyo market than others in Japan but at the same time a migration of tenants to central Tokyo may have the opposite impact of creating vacancies and leading to lower rents and in peripheral markets.

In order to investigate this further we have looked at the net rental history (rental income minus rental expenses) of the top 7 individual properties in the largest of Japan's Real Estate Investment Trust's ('JREIT'), the Nippon Building Fund, incorporated and listed on the market in 2001. 5 of the properties are located in central Tokyo and 2 in greater Tokyo. These 7 buildings have accounted for 40-60% of the floor space and total rents of the company since it began. Nippon Building Fund publishes semi-annual accounts with details of rent, rental expenses (disclosure stopped in June 2003, estimated since then), percentage occupancy and ownership of each building. From this we discover that net rents (rental income minus rental expenses including depreciation) fell 20% in the year to December 2002, 11% in the year to December 2003 and 15% in the year to December 2004. This supports our suspicion that although prices may have increased, rents have not yet risen. As a result property yields are falling. The yield on book value of the portfolio of 7 properties has fallen from 5.7% in 2001 to 3.5% today. In reflection of this trend the yields on JREITS index (all listed JREIT's) is now 3.5% have fallen from a equivalent level when it was first established.

It is the JREIT's and property investment funds that are primarily responsible for better capital values of property over the last three years as they have drawn substantial marginal investment capital into the property market primarily in search of yield. Since 2001 the JREIT market has expanded to a ¥2.5T industry and unlisted investment funds established by property asset management companies and financial institutions account for at least as much again. It seems counter-intuitive to expect property yields of 3.5% to contract further as 30-year bond yields are just 1% lower at 2.5%. This already represents an unusually low premium over bonds for what is a notoriously illiquid assets class. Therefore, from here increasing capital values have to be function of increasing rents rather than contracting yields.

In early 2004 we became concerned about an oversupply of condominiums following the aggressive discounting ongoing at the beginning of the year. Indeed our long/short fund took a short position in one of the highflying developers. The anticipated oversupply never materialised forcing us to buyback our short following an announcement of better than expected results. It transpired that investment funds, flush with cash and keen to invest quickly in order to earn fees, had bought entire blocks of condominiums more than offsetting the oversupply and the slackening demand from individuals. However the oversupply was then transmitted to the rental market leading to a fall in rents with discounts of 10-15% commonplace, rent-free periods and deposit waivers. Vacancy in central Tokyo has reportedly increased from 3% to 9% over the last year. Another less tangible concern about JREIT's in particular, is that most of them have been constituted from the property portfolios of larger property companies or large companies with substantial property interests. The initial transfer of property from parent to the JREIT (which then usually becomes a subsidiary or affiliate), although ostensibly an arm's length transaction, is not a market based one as professional valuers rather than the market determined the transfer prices. A cynic might observe this transfer of ownership as a neat way of improving the quality of the parent company property portfolio without have to actually sell properties in the open market. We worry, if property suffers a renewed downturn at some juncture in the future, whether the quality of the JREIT portfolio might be a high as originally supposed.

In conclusion we have three concerns about property. We think property yields are too low relative to bonds and provide an inadequate cushion against the risk of rising interest rates or continued declining rents. We are concerned about oversupply in the condominium market that we fear will have a deleterious effect on rents and capital values. We think that the recent stability and gains in property prices are attributable to the establishment of JREIT's and property investment funds, a source of demand for property that could dry up, or worse reverse if investment funds are redeemed, if returns do not match expectations. As a result we have no current investments in property companies or funds.

Michael Lindsell
Sep 2005