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Fighting to keep growing

21 Sep 2006

Listed J-Reits are more acquisitive than ever before, but as investors of all kinds from Japan and overseas vie to buy properties, competition has never been so intense. Can the J-Reits keep expanding at the pace they have come to expect? The answer is yes for some, but for others, probably not.

Across Japan, legions of Japanese and foreign buyers are scouring the land for acquisition opportunities in the regenerating commercial property market.

The value of property securitised through real estate investment trusts, privately placed property funds and other transactions soared 30% to a record ¥6.9tr ($59.5bn) in fiscal 2005, according to the Ministry of Land, Infrastructure and Transport. Of this, J-Reits represented ¥1.74tr ($15bn), or a quarter of the activity.

The ministry noted that office buildings made up 35.2% of the total, followed by residential housing at 20%, commercial facilities at 12.1%, hotels with 4.1% and warehouses 2.9%.

Exact numbers are more myth than fact, but the number of non-J-Reit commercial property buyers hunting for real estate in Japan might now be more than 200.

After the onset of the Japanese financial crisis in 1997, buyers such as Morgan Stanley and Goldman Sachs created specialist acquisition vehicles to buy Japanese commercial property, using their expertise in the distressed US property market of the 1980s and 1990s.

They have since shifted their emphasis to performing properties as Japan's economic fortunes have lifted commercial property out of the mire.

The buyers trawling through Japan for catches include such well-known global financial names as Aetos Capital, GE Capital, AIG and the warehouse specialist, ProLogis.

The Morgan Stanley Real Estate Fund has reportedly bought some ¥1.7tr of property in Japan and to keep up with the times, in March launched a ¥3tr international fund, planning to invest nearly half the money in Japan.

MSREF is not just an acquirer, but also an active trader of properties, supplying the market with buildings for sale as well as competing for new purchases.

Record acquisition

In early July MSREF sold a landmark building in central Tokyo, nicknamed 'the Battleship', to DaVinci Advisors KK, another property fund operator, for ¥143bn ($1.25bn). It was the highest price ever paid for a single property in Japan.

Investors from Singapore are also very active, sometimes working alongside Middle Eastern interests to help them recycle petrodollars into Japan's property market renaissance.

CapitaLand, the largest property firm in Asia and backed by the Singapore government, is an active buyer of retail and other commercial properties in Japan. The Government Investment Corp of Singapore is another keen buyer.

There are plenty of other well-known names, like the ubiquitous Macquarie Bank of Australia, which in late August, through Macquarie Global Property Advisors, announced the purchase of $52m of buildings in Sapporo and Tokyo.

But the demand for property is not evenly spread. Some sectors and regional markets are benefiting particularly.

In a research report published in July, CB Richard Ellis, the US property services firm, noted that tightened vacancy rates and strong rental uplift potential meant that office properties continued to be the main focus of investment activity in the second quarter of calendar 2006.

Average yields on acquisitions, it said, had compressed to about 3.5% and some deals were reported to have been completed for even lower returns.

In another report, CBRE said acquisitions of residential condominium assets since December 2001 had been heavily weighted towards Tokyo's 23 wards.

"Over the period," the authors write, "there has been a notable compression of capitalisation rates for condominium assets in the central five wards of Tokyo to just below 5% on an NOI [net operating income] basis. For condominium assets in the outer 18 wards of Tokyo, capitalisation rate compression has been more modest, to just above 5%. Outside Tokyo, capitalisation rates have tended around the 6% NOI level, but have compressed to close to 6% in [calendar] Q1 2006."

J-Reits start selling

Faced with such intense competition for new deals, many J-Reits have been prepared to adjust their portfolios to improve income, or to divest assets for a lucrative capital return.

CBRE highlights the fairly recent but accelerating trend towards J-Reits selling assets. One example was Da Vinci Office Trust's sale of its 20 year old office building, Da Vinci Gyoen-mae 311, in Shinjuku ward to Tomoe Corp for about ¥2.2bn. According to press reports, the Da Vinci J-Reit made a roughly ¥480m gain on the property, which it had acquired only in October 2005.

In June Japan Real Estate, one of the market-leading J-Reits, disposed of four properties that had been part of its launch portfolio for ¥7bn.

J-Reits and their sponsors are also increasingly trading or swapping assets. Mori Trust Sogo Reit sold the Hitachi headquarters building in Chiyoda ward in May for ¥42bn and bought the Akasaka-mitsuke MT Building in Minato ward for ¥27bn at an estimated 4.5% NOI yield.

CBRE notes that the disposal of the Hitachi HQ, which constituted 29% of MTR's portfolio, reduced its portfolio value by ¥15bn, but will allow MTR to book an estimated ¥811m disposal gain and eliminate the risk of a building due to become 100% vacant and needing substantial refurbishment.

The biggest example of this trading and swapping trend was the asset swap by Nippon Building Fund, another leading J-Reit, with its sponsor Mitsui Fudosan.

The sponsor exchanged five Tokyo office buildings worth ¥110.1bn for NBF's ¥91bn JFE Building plus a capital adjustment.

CBRE reported that the portfolio of five properties should give NBF an estimated NOI capitalisation rate of 4.8%, compared to the 3.9% generated by the ageing 1974 JFE Building.

Of course, the J-Reits also make plenty of ordinary acquisitions. CBRE notes that in the second quarter of fiscal 2006, J-Reits were busy buying small and medium sized office properties priced at less than ¥6bn.

In April, for example, Kenedix Realty Investment purchased 10 office buildings from its sponsor for ¥30bn. The average NOI yield was 6.0%, with a maximum of 6.8% and a minimum of 4.8%.

Creed Office Reit acquired seven office buildings for ¥13.1bn, spread across Tokyo, Kanagawa, Nagoya, Sapporo and Sendai.

And the Reits are operating in more and more sectors. In February, Japan Hotel & Resort, a real estate investment trust formed by Goldman Sachs and property firm Mori Kanko Trust Co, made a strong debut on the Tokyo Stock Exchange, jumping 15% from its IPO price of ¥520,000. At the time, JHR owned six Japanese hotels.

It was soon joined in the sector by a second specialist, Nippon Hotel Fund, expanding the number of hotel properties securitised in the J-Reit market to 19, with an aggregate acquisition value of about ¥110bn.

Fast growth is over

Yuichi Hiromoto is president and CEO of Mitsubishi Corp UBS Realty, the asset manager for Japan Retail Fund Investment Corp, the leading listed Reit specialising in retail property.

A thoughtful observer of Japan's property market, Hiromoto argues that the period of rapid growth and well-priced deals for the J-Reits is already mostly in the past.

When JRF listed in March 2002 it owned just four properties, worth a total of ¥44bn. Through a series of follow-on offerings and asset acquisitions it has grown rapidly to 37 properties across the country, worth about ¥401bn as of July 31 this year.

In doing so, it has surpassed the ¥400bn target set at listing. "The focus is now not solely on size," says Hiromoto, "but more than ever on the sustainability of returns amid an increasingly intensive market for acquisitions. As I said a couple of years ago, we are building for the future, but brick by brick and making sure the foundations are solid."

Keep it in the family

The founding shareholders of many of the J-Reits are obviously a core source of properties for them, although the trust managers should also try to locate deals outside their family groups, especially if the trust founder is a smaller player or is running out of stock.

Nomura Real Estate Office Fund, which in late August was the fourth largest listed J-Reit, has been keen to diversify its acquisition sources.

The management company is 100% owned by Nomura Real Estate Holdings, which is itself planning to list by the end of September this year, when it will become the fifth largest quoted property group in Japan.

The connection to Nomura supplied half the 12 properties the Reit owned at IPO. Since then seven of the 17 further assets it has bought have been located through open market sources. Of the rest, only one has come directly from within Nomura, but nine have emanated from Nomura connections and leads.

This prompts Atsushi Ogata, head of the fund management group at NOF's asset manager, Nomura Real Estate Asset Management, to call the relationship with Nomura a "practical and effective liaison in which there is very often a similarity of interest".

Ogata explains that many vendors do not want to disclose their names as sellers, so are keen to go through the private Nomura network.

"In other instances," he reports, "the vendors prefer to negotiate sale-and-leaseback agreements privately, without altering the market. And then of course there are Nomura assets that the group wants to monetise but over which it still wants to exert some management influence."

Dedicated to logistics

Japan Logistics Fund enjoys a strong deal flow from its founder shareholder, Mitsui & Co, the household name behind Mitsui & Co Logistics Partners, the fund's asset manager.

Mitsui is also a shareholder in Japan Real Estate Fund, the second largest J-Reit and along with Nippon Building Fund the first to list, on September 10, 2001.

"Mitsui not only has a household name to help spur investor interest, but the firm is a regular source of new acquisitions for our trust, given its huge presence in logistics and distribution across Japan and indeed in the Asia Pacific region," explains Ryo Yamakawa, president of Mitsui & Co Logistics Partners. "Mitsui wanted to establish their own dedicated J-Reit and decided on logistics as the sector in which they could offer the best deal flow and also the highest level of management expertise and experience."

Yamakawa explains that the logistics sector has not tended to attract investment by third parties, as facilities were normally built by owner-operators. "But in recent years," he says, "the presence of ProLogis and then AMB from the US helped begin to change the views on the sector. Then we listed in May last year and the beginnings of this market were set in stone."

ProLogis and AMB are US property companies that specialise in logistics facilities.

Yamakawa sees only a modest flow of acquisition opportunities from outside the Mitsui group, as the own-and-operate mentality persists. "However," he says, "we expect the divestment of logistics facilities to accelerate in the years ahead and ultimately this sector will become very liquid, emulating the office market."

As the acquisition market is tight and the number of third party buyers is growing, cap rates are falling, albeit nowhere near as low as in the office sector.

Switching partners

When founders run out of properties for the J-Reits to buy, mergers between asset managers might give them a new lease of life.

Japan Reit Advisors Co is the asset manager for United Urban Investment Corp (UUR), which listed on December 22, 2003 and houses a diversified portfolio of offices, retail facilities, hotels, residential and other properties.

Trinity Investment Trust founded JRA, but sold out in May this year to new controlling shareholders. Marubeni Corp, the Japanese conglomerate, holds the largest stake at 51%, followed by Credit Suisse with 44% and Kyokuto Securities 5%.

"About 80% of the initial portfolio of UUR came through Trinity, but they have now exited both those properties and Japan Reit Advisors," explains Hitoshi Murakami, chief financial officer at JRA. "This represents a new lease of life for UUR and one that unitholders will be excited by, as we demonstrate the additional potential these new shareholders bring."

Hisamitsu Abe is chairman and chief executive officer of JRA. "The new principal shareholders will give us additional weight and potential," he says. "To be a diversified Reit does not only mean heightened security for unitholders, it also means growth through access to a solid flow of transactions from our core shareholders, as well as from the market at large."

Life at the tough end

But while some J-Reits are managing to source new properties, others are finding it difficult.

Often this is because their stock price is languishing below its IPO price and simultaneously below net asset value, making it tough to find dividend-accretive acquisitions, particularly as cap rates on deals are falling.

Moreover, even if they can find appropriate targets, the equity market might not support the sale of fresh units.

Koji Kaneko, chief executive officer of Fund Creation Reit Advisers, asset manager for FC Residential Reit, points out a curious anomaly in the residential property market.

"There are ever more buyers seeking out residential property acquisitions and at ever lower cap rates, yet stockmarket investors seem to be avoiding investment in the residential J-Reit sector," he says. "If the institutional and corporate money seeking the acquisitions are right, then surely the public market is inefficiently valuing the J-Reits. Both cannot be right."

Whatever the outlook, FC Residential Reit is in a difficult position, as cap rates on residential acquisitions have dropped to around 4.5% for high quality locations.

As FCR is paying out close to 5% in dividends, the prospects of rapid expansion through acquisition are limited. Moreover, with borrowings at about 44% of assets, the trust can only raise its leverage to about 60% and remain conservatively geared.

Another such troubled J-Reit is Creed Office Investment Corp, a smaller trust that listed only in March this year and has one of the worst unit price performance records since listing.

By September 13, its unit price was quoted at ¥470,000, down 6% from the ¥500,000 IPO price set by lead managers Daiwa Securities SMBC and Morgan Stanley. In July it was trading as low as 18% below the offer price.

By August, the yield on Creed Reit had risen to about 5.6% as the unit price had slipped, making it difficult for the trust to buy new properties and finance them through new equity.

This is especially frustrating, as Creed Reit focuses on class B office buildings in which the management team believes there are plenty of alluring acquisition opportunities.

Hideya Yamanaka is CEO at Creed Reit Advisors, which manages the Creed Reit. "In this market segment," he explains, "there are more buildings compared to class A and this tends to [make for] easier acquisitions. Regarding the rental term of our portfolio, regular two year contracts are [predominant], which will allow us to benefit from the rental uplift currently underpinning the market."

In the Tokyo metropolitan area, Japan's leading office market, there were in 2003 a total of 61,350 major buildings, including 29,520 office buildings, according to the 2003 Building Survey by the Ministry of Land, Infrastructure and Transport.

There are only 1,120 large office buildings with a floor area of 10,000 square metres or more. The other 28,400 office buildings are small or medium sized.

This diversity of opportunity has helped Creed Reit buy seven buildings at yield-accretive prices since the IPO, but the management team know that unless their unit price rises they will become more and more financially hampered in competing for new deals.

Winners and losers

Creed is far from alone in struggling to find acquisitions and in being troubled by a weak stock price. In an August 7 report UBS calculated that more than 40% of the J-Reits were trading below net asset value. That also means they will be paying out a generous yield, making it tough to find accretive purchases.

Across the range of J-Reits — from large, low-yielding trusts supported by household name shareholders to smaller, high-yielding Reits backed by lesser known founders — most of the managers remain as hungry as ever to grow through acquisitions.

The reality, however, is that apart from the recent Japan Retail Fund follow-on issue, new equity issues by the listed trusts have dropped in size during 2006, due mostly to the competitive acquisition market, but also to a more discerning equity market and investor concerns about cap rates and dilution.

Time will tell if the combined might of the 38 J-Reits can keep their numerous private and other competitors for acquisitions at bay. But one thing is certain — the J-Reits will keep fighting.

21 Sep 2006