Since Morgan Stanley Real Estate began rummaging around the Japanese property market eight years ago, its real estate funds have amassed office towers, apartment buildings, hotels and nonperforming property loans worth a combined $10 billion. The vast majority were opportunistic acquisitions: The New Yorkbased investment firm paid far less than book value for comparatively old and often troubled assets.
Recently, though, Morgan Stanley, while sticking with its established approach, has begun to pay up for prime real estate. Six months ago, for example, it acquired Tokyo's 33-story Shinagawa Mitsubishi Building for $1.34 billion, well above the $900 million estimated book value. The 1.7 million-square-foot skyscraper in the Minato business ward was less than two years old. One of the owners, Mitsubishi Motors Corp., was having financial difficulty and felt pressure to sell the building; in addition, the building's occupants, Mitsubishi Motors and parent Mitsubishi Corp., did not plan to stay long.
"We feel we got a good price," says Sonny Kalsi, the Tokyo-based head of Morgan Stanley's Asia real estate group. "It's our view that the Tokyo office market probably hit bottom 12 months ago."
Japan's real estate market is recovering along with its economy. And Morgan Stanley is part of a growing and increasingly diverse contingent of foreign investors that are buying Japanese properties at prices that are a long way from distressed. The group includes such U.S. firms as AMB Property Corp., Colony Capital and Goldman, Sachs & Co.; the government of Singapore's real estate investment arm, GIC Real Estate Pte; and German fund manager Deka Immobilien Investment.
The foreign investors, along with Japanese real estate investment trusts and other domestic buyers, are fueling steady growth in real estate transactions. CB Richard Ellis Japan estimates that commercial property sales in Japan totaled $23 billion in the fiscal year ended March 2004, up from $20 billion in the previous 12 months. The recent deals are no longer confined to Tokyo, and they encompass warehouses as well as office towers, hotels and residential buildings. "In the past year capital flows have not only accelerated but also become more diverse in terms of investors, geography and asset class," says Morgan Stanley's Kalsi.
Supported by a growing economy -- Japan's GDP is expected to increase by 1.6 percent this year, following a 2.6 percent gain in 2004 -- commercial property values have almost certainly bottomed out and are probably on the upswing. According to the Japan Real Estate Institute's urban land price index, at the end of March, land in metropolitan Tokyo averaged a 1.2 percent increase over the previous year. It's the first time since 1990 that land values had gained year-over-year. Although commercial land prices continued to decline during 2004, they fell at a slower pace: down 5.6 percent, versus 7.4 percent in 2003.
Another sign of the nascent real estate recovery: Buyers are accepting lower capitalization rates (operating income divided by purchase price). Reid Mackay, director of institutional investment properties for CB Richard Ellis's Tokyo office, estimates that from 1997 through 2004, investors bought properties at capitalization rates averaging between 6.5 and 7 percent; recently, that figure fell to less than 5 percent.
Frankfurt-based Deka, which has purchased four buildings in Japan since 2001, bought an 88,800-square-foot property occupied by Japanese retailer Don Quijote Co. in Tokyo's Chiyoda ward last August. Says Johannes Haug, the Deka board member in charge of international business, "Good properties now sell for between 4 and 5 percent cap rates, which shows there's a wall of capital in the market." He adds pointedly, "If this continues to go on much further, it may become difficult for us to justify investing."
Does this mean Japanese commercial property has passed from distressed to overpriced? "There is the prospect that if you buy assets now, you'll be earning out into an inflating environment," says Grant Kelley, the Hong Kongbased CEO of Colony Capital's Asian operations. Colony, headquartered in Los Angeles, has $12.4 billion of real estate assets under management, of which $1.2 billion is in Japan. Roughly 80 percent of that sum was invested in the past year. Kelley still sees plenty of opportunity. "We think the moment is right," he says. "In Japan it's a macroeconomic bet based on a restructuring economy, which is now, we believe, on the verge of solid asset growth." He estimates that Colony might invest as much as $2.5 billion a year in Japan over the next several years.
Such optimism is a far cry from the gloomy outlook that prevailed in the late 1990s. That's when the first wave of foreign capital, ignoring the grim consensus, moved into Japan's depressed real estate markets. The players were mostly opportunistic U.S. investors such as Goldman, private equity firm Lone Star Funds and Morgan Stanley. They concentrated on nonperforming property loans and distressed real estate. In October 1999, for instance, Los Angelesbased Kennedy Wilson, a real estate services and investment management firm, paid less than $20 million for a portfolio of nonperforming loans with a face value of $250 million.
In 2001, however, the commercial real estate market began to show signs of life with the debut of Japanese REITs, which have provided welcome liquidity. Japan's 17 REITs, all but one of which trade on the Tokyo Stock Exchange, have a combined market capitalization of about $20 billion.
Investors are paying renewed attention to industrial property. Traditionally, this was not seen as an investment sector: Factories were owned by the corporations that used them. But as manufacturers and logistics providers look for newer and better-situated distribution facilities, investors are beginning to develop and own such properties.
In mid-December, LaSalle Investment Management, with headquarters in Chicago and London, raised $400 million in equity from institutional investors in the U.S., Europe and Asia for its Japan Logistics Fund. The fund plans to acquire $1.5 billion worth of modern logistics facilities in key Japanese distribution markets. In one of its first deals, LaSalle bought land in Ichikawa City, in the Chiba prefecture not far from Tokyo, and is building a 600,000-square-foot facility for freight company Nippon Express Co. Nippon will use it to serve Amazon.com customers in the greater Tokyo area.
"As warehouses become what we believe will be an accepted, if not preferred, asset class for yield- and stability-focused investors, that will open up more and more opportunities for us," says Jack Chandler, the Singaporebased CEO of LaSalle's Asia-Pacific operations. "As Japanese institutional and individual investors start thinking about modern, well-leased, well-located warehouses as an investment category, there will be all sorts of vehicles that will be of interest to them above and beyond listed REITs."
According to CB Richard Ellis, industrial properties represented the third-largest real estate sector by sales in Japan for the 12 months ended March 2004. Properties totaling $4.3 billion traded hands, up from $3.6 billion the previous fiscal year. The biggest sector was offices, with $7.7 billion of properties changing ownership. The second largest was the catch-all "other," including everything but office, industrial, retail and multifamily real estate; in this sector owners sold properties totaling $5.5 billion.
In Japan, as in most markets around the world, the office sector is considered the key indicator of the overall health of commercial real estate. And in Tokyo, whose five main wards encompass roughly 250 million square feet of office space, the office segment is improving in line with increased demand. According to research by DTZ, a London-based global real estate services provider, the office vacancy rate across Tokyo's five wards declined in 2004's fourth quarter for the sixth consecutive quarter, to 6.1 percent. In Chiyoda ward, which boasts some of the country's most expensive and prestigious office space, the figure dipped to 4.7 percent.
In a few high-grade buildings, rents are beginning to rise. DTZ reports that average office occupancy costs for the five wards rose 0.8 percent in 2004. The biggest increase was in upscale Minato, where occupancy costs averaged $74.10 per square foot at the end of 2004, a 2.1 percent increase from the start of the year. The Shibuya ward, on the other hand, experienced a 0.4 percent decline, to $74.50.
New construction has been restrained. The five wards saw 11.3 million square feet of new supply in 2004, only about half the amount added in 2003. New supply is expected to decline further this year, when an additional 9.4 million square feet will come on line.
But the pace of construction could pick up in 2006 and 2007 if real estate values continue to strengthen. Mitsubishi Estate Co.'s Shin-Marunouchi Building, which broke ground in mid-March, should open for business sometime in 2007. The 2 million-square-foot tower, designed to include stores and restaurants as well as offices, is part of a redevelopment project that Mitsubishi Estate has undertaken for its properties in Marunouchi, the major business and financial district in the Chiyoda ward.
"This is a good time to begin construction on the 38-story Shin-Marunouchi tower," says Masahiro Kobayashi, Mitsubishi Estate's deputy general manager for corporate communications and investor relations. "It's a changed market -- it's improved."
Faced with increased demand for Tokyo properties, some investors are looking for deals in other Japanese cities. Osaka, Japan's third-largest city, has become fertile territory. Last year's transactions included Nippon Building Fund's August purchase of the Aqua Dojima Daiwa Dojima Building in central Osaka for $175 million; and United Urban Investment Corp.'s November acquisition of Shin-Osaka Central Tower, a 633,000-square-foot office and hotel complex near the Shin-Osaka bullet-train station, for $236 million.
For the moment, at least, Japan's real estate market is benefiting from historically low interest rates. "If you look globally, it's one of the only markets where you've got a positive spread between borrowing rates at 2 percent, on average, and a cap rate of maybe 4 percent," notes CB Richard Ellis's Mackay. "The biggest fear is of interest rates rising and capitalization rates continuing to compress." Still, interest rates would be rising from a very low base and would themselves be evidence of an improving economy.
"The main value driver in the Japanese market for the past seven years has been the very large spread between the yields on properties and the cost of funds," says Eric Lucas, who heads the Babcock & Brown Japan Property Trust, the only Australian Stock Exchangelisted property trust focused on Japanese real estate. "As long as that spread remains sufficiently wide and the yield on the properties can be maintained, property investment will continue to make a lot of sense in this market."
Concludes Lucas: "There's little doubt that the market has passed its bottom. The question is, where does it go from here?"