Japanese banks may have been better prepared for the global downturn than their western counterparts, but outside capital Tokyo the mood is distinctly gloomy. Mark Faithfull reports

Experience of a previous banking crisis and lower exposure to sub-prime debt than European and US financial institutions had given the Japanese real estate sector a rosy glow in the early days of the downturn, but there is little such optimism now. In March, the Bank of Japan stepped in to buy up €7.8bn of subordinated loans in a bid to spur lending after one of the quietest ever quarters for the property sector.

It is the latest move in a series of interventions by the Japanese government and central banks targeting the greater economy and real estate specifically. But their case has hardly been aided by the collapse - mid-crisis management - of Pacific Holdings, which filed for bankruptcy in March after reporting huge losses triggered by its exposure to US sub-prime mortgages. The Tokyo-based company admitted it had liabilities of $1.7bn (€1.29bn) as of the end of February and became Japan's third largest bankruptcy this year, following moneylender SFCG and apartment developer Japan General Estate.

The plight of Pacific Holdings highlights the severe credit squeeze threatening to undermine Japan's €19.5bn real estate investment trust (J-REIT) market.

"In the first quarter of 2009 the market has been very quiet, which is very unusual for this period of the calendar year. The problem is that the two principal lending groups are both largely out of the market," says Ryukichi Nakata, director and head of Japan, Invesco.

"Securitised lenders such as the big American institutions have all but left the Japanese market and this money source has largely shut down. Capital investors, predominantly the Japanese banks, have been limited, because they need to retain 10% capital-to-value balances while their share prices fall. We are hoping that once the financial year has closed the banks will be more able to lend again as they will have another year to address their capital-to-value balances."

The general gloom is borne out by International Property Databank's (IPD) latest Japan monthly indicator, which shows that real estate has now seen three successive months of negative year-on-year capital returns [to November] after recording a capital return of -0.8% in September, with early results for October and November showing a sharpening decline.

Total returns have fallen by about 1% every month from 8.4% in May to just 1.8% for November. Retail property has replaced residential as the worst-performing sector since the middle of 2008. Toshiro Nishioka, managing director at IPD Japan, says: "The retail sector shows continuously weak performance. Capital returns on the All Retail level have turned negative to a record low in the sector's history."

Nakata adds: "In terms of specific markets, the residential sector has been hit very hard. With the population in the regions in decline and more young people moving to Tokyo, the residential market in the regions will remain very difficult."

Office vacancy rates in capital Tokyo - previously a stalwart - rose in five key wards by 0.67% to 5.6% in February. Office broker Miki Shoji Co warned that the rate in the wards of Chiyoda, Chuo, Minato, Shinjuku and Shibuya has soared for 13 consecutive months as companies accelerate consolidation.

"In the office market, vacancy rates in Tokyo have remained low at about 4-5%, and owners have been unwilling to sell, although lenders are putting pressure on them to go to market. At some point that will inevitably happen," reflects Nakata.

The situation has not been helped by the retreat from Japan by a number of western financial institutions, most recently troubled reinsurer AIG, which has put its Tokyo headquarters on the market for around $1bn through Merrill Lynch and Bank of America.

John Stinson, regional director, capital markets Asia Pacific for DTZ, says that although vacancy rate increases are a concern, his main worries are outside the capital. "Tokyo central is where the interest is, tier one cities in the regions are not of interest," he warns. "Across Asia I think there has been a definite flight to quality and to gateway cities - Tokyo, Sydney, Singapore and Hong Kong."

However, not everyone is downcast. "Is the Japanese market falling into recession? No. Since the 1990s there have been structural changes, with a better legal infrastructure and a more transparent property mechanism," claims Ryutaro Nishimura, project manager at investment manager Tokyo Tatemono.

"Tokyo is the best prospect in 2009. Occupancy rates are higher than in London or New York. There is a population concentration in Tokyo."

Indeed, money is beginning to circle. ING Real Estate has been building a $675m Asia Pacific property fund of funds, understood to be primarily focused on Japan. The fund will invest in opportunistic and value-added opportunities on behalf of pension funds and will aim to produce a 15% internal rate of return. The fund will invest in funds of seven to 10 years with 50% to 75% gearing.

Nicholas Wong, head of ING Real Estate Select's Asia Pacific operation, stresses: "We still want to invest in the retail, office, logistics and residential sectors. Fundraising is much more difficult than before but our clients still want to be here."

Similarly, Singapore-based Ascendas decided to enter the Japanese market in November 2008 and is planning a €750m investment within two or three years, targeting logistics and offices in Tokyo and Osaka.

"German open-ended funds, Morgan Stanley and Blackstone have been looking - the office market is off 75 basis points, with probably another 25 to go. The main opportunity is to buy better assets than those available in the past," adds Stinson.

There are also opportunistic buyers on the lookout. Lone Star, the Development Bank of Japan and Goldman Sachs are among the final bidders for failed REIT New City Residence Investment Corporation, which owns apartment buildings in upscale areas of Tokyo such as Ginza and Harajuku, but filed for court protection from creditors in October with almost €1bn in debts. It was the first J-REIT to fold.

Since then the Bank of Japan has moved to allow bonds issued by some J-REITs to be included as eligible collateral for its loans, in an effort to encourage financial institutions to hold such bonds and to broaden the funding options available to J-REITs.

"The government has intervened, but the political situation we have here, with the opposition party controlling the upper house, means that it is difficult for much to get done and it seems likely we will have an election this year," says Nakata. "Most people would welcome more political certainty."