Investors will need to wait longer for the Japanese real estate markets to bottom out, writes Takahiro Okubo
The credit worthiness of Japanese real estate operating companies (REOCs) and real estate investment trusts (J-REITs), as well as of commercial mortgage-backed securities (CMBS) deals, will remain weak in the medium term, because cash flows from office buildings – which make up the majority of their portfolios – will continue to decline.
Figure 1 shows that floor supply for the overall market will stabilise after 2013. But it will be several years before the market bottoms because of the persistent weakness in floor demand.
New floor space has been increasing for the past 12 months in Tokyo’s business areas, while the number of employees has not grown. Since 2009, the growth in space has outpaced the growth in employees.
The supply-demand gap in the Tokyo office leasing market will continue for some time as economic growth remains anaemic, and even after an anticipated decline in new space after 2013.
If Japanese GDP growth proves weaker than expected, occupancy rates and rents, particularly for existing class-A and B buildings, will fall. There has been a huge rise in the supply of class-A buildings in non-prime areas, and their resultant low rentals will prove a strong attraction for tenants.
The occupancy rates for office buildings in portfolios managed by Moody’s-rated J-REOCs and J-REITs have recovered to more than 95%, better than market levels. And the turnover rate for existing tenants has fallen to levels in line with historical averages. As a result, landlords have had less need to offer large discounts or rent -free periods for new tenants since the second half of 2011. But it will be some time before rents bottom out because of the steady discounts landlords offer to existing tenants.
According to a survey of 23 wards in Tokyo in 2011 by Mori Building, the number of new tenants seeking office space with earthquake-resistant qualities increased to 35% in 2011 from 15% in 2010. And tenants seeking buildings that have made preparations for natural disasters increased to 19% from 10%, while those seeking lower-priced space declined to 38% from 43%. This trend is raising demand for class-A buildings and will prompt the landlords of class-B and C buildings to offer discounts and carry out upgrades.
Cap rates in the Tokyo real estate market have been steady for the last two years, following the large increase owing to the financial crisis in 2008 and then a moderate decline in 2010. We do not assume any further large decreases in cap rates for office buildings, certainly not to the lows accepted in the real estate trade market before 2008, and characterised by highly leveraged investments. A rise in the prices for assets in the portfolios of REOCs, J-REITs and CMBS transactions requires improvements in cash flows. It is not dependent on decreases in cap rates.
Given the recent stability in cap rates, and the rise in occupancy rates after a large drop in 2009-10, the unrealised losses of J-REITs, equal to the difference between total appraisal values and book values, have gradually decreased to around zero.
However, we are concerned that appraisal values can exceed actual sales prices, leading to mark-down risk for balance sheets. The reason for the latter is that J-REIT issuers appoint their own appraisers.
In the non-Tokyo office market, only Osaka shows a high level of supply after 2013. But vacancy rates in the largest four cities have remained high at 10-15% in the last three to four years owing to a poor macro-economy, especially for manufacturing. Except for high-quality buildings in prime locations, the high vacancy rates will continue to exert downward pressure on rents which, in turn, will result in lower cash flow.
However, the effects on the creditworthiness of J-REOCs and J-REITs from lower cash flows on non-Tokyo offices will be small because these companies have a large part of their assets in the Tokyo area. Geographic diversity diminishes the risks experienced in specific sub-markets. However, concentrations in areas that have robust real estate markets can offer benefits in terms of property marketability.
We therefore consider geographical concentration in Tokyo as advantageous for these companies.
Takahiro Okubo is a vice-president and senior analyst at Moody’s structured finance group