We thought Japan's recovery had taken hold. But has it? For now at least property investors are bullish, as Paul Benjamin reports

While all eyes are on the US as the rumblings of a recession grow louder, investors would do well to keep a tab on the world's second biggest economy, Japan, which was hoping it had seen the last of the R word for a while.
Since globalisation really kicked in, the property markets of China and India have known only one speed: hyper. But Japan, the original Asian economic miracle, knows all too well what happens when the bubble bursts. Its popped in 1989, property prices slumped, and a decade of stagnation and recession followed. In 2003 the country started a tentative recovery and, despite a blip last year, growth has held up.
Looking ahead, the Economist Intelligence Unit (EIU) sees GDP growth of just 1.3% for 2008 and the same again in 2009, although exports are expected to grow at a healthier 6.8% this year. While the government seems to have totally nailed inflation, with consumer price index growth of 0.4% this year the lowest in Asia, there will be job cuts, and consumer spending is very flat. In fact, the EIU sees retail sales growth shrinking by 0.1% this year.
The economics give a mixed picture, but investors remain very interested in this key market. As Simon Treacy, CEO of Maquarie GPA, says: "Year-on-year growth of 1% in the world's second largest economy is still enormous. It's planet Japan. It's a different market. It's not comparable to anywhere else and is very easily misunderstood. If you are on the ground with the right partner you can play any sector and make good returns. We are positive about 2008."
He is backed up by January's IPE Real Estate expectations indicator, which revealed glowing figures for Japan. Some 88% of real estate managers predict a rise in the values of office assets in the next six to 12 months, and 12% predict stability. None predicts a fall. Though the news is less positive for residential, the figures are very strong for industrial (87% forecast a rise) and retail (60% forecast a rise). In stark contrast, 84% of respondents thought that UK office holdings would fall in value, and 37% said so of US office.
Matthew Creagh, associate director, CB Richard Ellis in Japan, says: "The outlook is still really positive as the fundamentals are strong, although consumer spending is a bit lacklustre and is lagging behind sentiment.
"There has been a bit of negative press recently about the possibility of recession, and in the wake of the credit crunch we are seeing a different sort of investor. Last year people were pouring in to spend money on anything. This year has seen a sort of reversal.
"There are some very good retail investment opportunities in Japan as big companies are looking to sell properties. We have noticed a big influx of German interest, as they typically have less debt, and interest from some of the big European pension funds. Japan is a good option to them. I think we will do as many deals this year as last, but they will be of a different nature."
Deals in Japan can dwarf the rest of the region. CB Richard Ellis reports six of the top 10 deals across Asia in the second half of 2007 took place in Japan, and five of them were in Tokyo. The megacity and capital, with a population of over 12m, remains the prime market and investors are attracted by the promise of growing rentals and the increasing spread between average yields and low base rates.
The majority of prime office space in Tokyo is found in the central five wards, and in 2007 Q4 Jones Lang LaSalle reported CBD A-grade office annual rental growth of 15.8% and an annual rise in capital values of 28.4%. The "extremely limited supply and solid demand" should ensure rents continue upwards in 2008, albeit it a slower rate, while capital value gains are expected to flatten. Rental growth is also forecast for the key sub-markets of Akasaka/Roppongi and Otemachi/Marunouchi.
CB Richard Ellis says vacancies were low in 2007 Q4, at 1.7% for all office types across Tokyo. However, a widening gap between landlords' rental expectations and tenants' willingness to absorb higher occupational costs saw A-grade vacancy increase 40 basis points quarter on quarter to 1.3%. There have been increasing signs of rental disputes as landlords try to up the rent to recover perceived undervaluation, though this aggressiveness may weaken as new prime office supply enters the market in the coming years.
Creagh says: "It is difficult to buy into the A-grade office market as it is sewn up by REITs. However, the retail sector is seeing a lot of movement of quality retail product. Rents have plateaued, as spending has not caught up with rents, and many landlords are seeing it as a good time to sell, so some very nice retail has come back onto the market.
"We're finding that in big cities like Osaka some of the big Japanese real estate funds are selling off quality stock and investors can access stock that they couldn't have accessed two years ago."
Yoshihiro Inuma, senior manager with Jones Lang LaSalle, says that new planning laws introduced in November 2007 would restrict new developments of large-scale retail outlets of over 10,000m2. The Japanese retail market broadly breaks into two camps: urban properties, including department stores and flagship outlets; and suburban centres that follow a much bigger, mall-type model. The latter have become increasingly popular in Japan since 2000.
Inuma adds: "Urban department stores are mainly owned by the department stores themselves. On the other hand, ownership of suburban shopping centres by real estate investment funds, such as J-REITs, is increasing."
Supply is particularly tight in Tokyo's showcase shopping district of Ginza, where western brands such as Abercrombie and Fitch, H+M and Zara have opened stores on the high street. Often sites in this area will be used to establish presence and brand identity, and the money will be made elsewhere, perhaps in standalone shops in lower-order sites, or a dedicated corner of a department store.
For international retailers, the maturity, sophistication and spending power of the Japanese consumer market counts for a lot. Creagh says: "In China the luxury brands are selling well in the big cities, but there are a lot of headaches and it's a bit of a mystery to many. In Japan, companies can come here and set up a strategy and know that products will sell well because it's a developed market. In the near future more of the mid-level European casual brands will start looking to Japan and Asia in general."
Shifting demographics will have an increasing impact on the retail sector, making effective targeting a must. Japan is alone in Asia in being the only country that will experience a declining population over the next 20 years. Between 2005 and 2025, the proportion of Japanese aged 65 or over will rise from 19.5% to 28%, signalling a change in consumer tastes, and placing more pressure on those of working age.
Japan is already highly urbanised, and unlike China, India and Vietnam, it cannot rely on turning farmers into office or factory workers as a way to drive the economy. However, Inuma believes that workers will continue to migrate away from rural sub-centres to Tokyo.

The nation's two other significant markets are the major cities of Nagoya and Osaka - Japan's second city, which for investor purposes also includes Kyoto and Kobe. Competition to invest in these primary locations has become intense, so secondaries, such as Sapporo, Sendai, Yokohama, Hiroshima and Fukuoka, are enjoying attention. Some of these are located near primaries, absorbing their overspill, while others are more remote regional centres.
Growth in secondaries has filtered down to offices and residential, often setting new standards - for example, the northern capital of Hokkaido unlocked latent demand for top office space when its first A-grade office was completed in 2006. And considering the retail outlook, Creagh says: "Once you get out of Tokyo the main cities are quite a simple play - there's one main shopping area and then it's a case of rolling out to outlying centres.
"Nagoya is interesting. It's a bit of an industrial town but it's prosperous. Gucci, Prada, Apple, Zara have all opened a big store in Nagoya in the last five years. There's a lot of opportunity now and a lot of under-utilised demand."
Treacy adds: "Sapporo has surprised us with its strength, and our residential buildings have performed very well there. And Osaka has rejuvenated itself after a lot of its capital-intensive base got outsourced to China. Fukuoka is the capital of the southernmost island and has strong trading links to Korea and China. It was the first city to rebound after Tokyo when the recession ended."
The southernmost island of Kyushu is Japan's prime touchpoint in the Yellow Sea economic basin - a regional dynamo with a population of 200m that encompasses swathes of industrial north eastern China, South Korea and Japan. Fukuoka depends on this zone for 16% of its exports and almost a third of its imports, which means that it is well placed to feed off China's growth, which is tipped to remain high (10.1% in 2008 and 9.6% in 2009 GDP growth, according to the EIU).
Since Japan is an island nation and a major exporter, effective logistics and infrastructure are essential if it is to stay competitive. Treacy points to the Tokyo logistics sector as an overlooked area that is ripe for renewed investor interest. He says a lack of investment during the recession, such that some stock no longer meets earthquake regulations, meant that supply had to be improved.
The well-sited Tokyo Bay area, which offers good access to customs facilities and to the Narita and Tokyo international airports, has been drawing tenants away from the higher rents around Narita. Takeshi Akagi, director of research and advisory at JLL, says Bay annual rental growth was 16.1% in 2007 Q4, and capital value growth was almost 30%. Looking ahead, JLL warns that rising oil prices may harm logistics companies, who will have less money to spend on higher rents.
Where Japan does differ from its Asian neighbours is in the diversity and scale of its REIT offering. By the end of 2007, there were 42 listed J-REITS, with a market cap of ¥5.1trn, and total assets of ¥6.7trn. The dividend yield stood at 4.09%. But this is one area of the Asian property world where the credit crunch has had a big impact. Akagi of JLL says that new listings fell sharply after the squeeze, and that the J-REIT Index went from a record high in May to a drop of a third and a record low by the end of November. Despite that, Japan leads Asia in REITs, and Akagi says there is discussion in government of freeing them up by allowing them to include overseas real estate in their portfolios.
Treacy says that J-REITs have enjoyed some ‘golden years' of double-digit performance, but they are now going through a tougher period, and he expects some consolidation over the coming year.
He adds: "Japan led the way with two REITs in 2001. In Japan, REITs have been successful because the alternative to a 3.6% dividend yield at that time was a 0.01% interest from the bank.
"J-REITs today are trading at huge discounts to net asset value, so total returns in this environment could be a sobering negative or a ‘give me a high-five' high. The bottom line is that the J-REIT market will go through a consolidation over the coming years as there are too many, period. It's definitely one to watch.
"Consolidation is like a bag of mixed lollies - there will be winners and losers. But in the medium term the market will mature and governance will flourish, which is good for retail investors.
"This is an exciting period in Asian institution real estate because the region is the world's growth engine, and the fundamentals are compelling, both economically and from a property perspective. Japan, and Asia as a whole, present great opportunities for those fund managers that have real estate skills, rather than screen jockeys doing financial gymnastics...but it is still about location, location, location."