Touchstone Capital Management | Understanding the Market
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Understanding the Market

Notable Characteristic

Every market is different and Japan is no exception.  The market has its own peculiarities.  We would like to share some of notable characteristics of Japanese real estate market.

Legal Stability

Japan has quite sophisticated and stable legal system to provide strong comfort to institutional core investors into Japanese real estate market.

Japan has one of the most advanced computerized nation-wide legal registry system including real estate ownership, liens and public figure, legal entities, resident register, and family register operated by Japanese Government.  Almost all the information in those registries (excluding resident register and family register because of privacy issues) can be accessed via internet. This nation-wide system provides quite transparent legal due diligence process for real estate acquisitions. Also, foreclosure process is a well established legal process and it is quite easy for financiers to foresee the consequence of exercising their mortgages, which is considered to be strong foundation for sufficient liquidity in real estate markets.

Not only stability and transparency in ownership system and property law, Japan has quite comprehensive financial related laws and regulations, which support development of real estate finance markets including CMBS and REIT markets, such as Financial Instruments Exchange Law, an equivalent of Securities Act of 1933 and Securities Exchange Act of 1934 in U.S., Asset Securitization Act (basis for TMK investment structure), and Act on Investment Trust and Investment Corporations (basis for J-REIT structure). Thanks to these laws and regulations, at the peak in 2007, annual real estate securitization transaction volume in Japan reached to USD100 billion (approximately 9 trillion yen) and the total market value of J-REITs at the peak in the end of May 2007 reached to USD75 billion (approximately 6.8 trillion yen).

Leasing Practice (Ordinary Lease v. Fixed-Term Lease)

After the 2nd world war, because of severe shortage of residential supply, Japanese government enacted a pro-tenant leasing law which is called Ordinary Lease Law (Futsu Shaku). Under Ordinary Lease Law, tenant rights are well protected and a landlord can evict a tenant only when the landlord can claim Justifiable Reason (Seito Jiyu) which is extremely narrowly defined under Ordinary Lease Law and court precedents, and payment of large-sum of eviction fee. Typically, lease period is 2-year period but the maturity of lease does not necessarily provide a landlord of power to terminate the lease contract because the mere maturity of lease does not constitute Justifiable Reason. As long as a tenant wants to stay and is willing to pay market rents, the in-place lease is virtually extended indefinitely. Practically, it is almost impossible to evict a tenant who continues to pay market rents. On the other hand, a landlord cannot set a cancellation notice period longer than 6 months. In other words, notwithstanding any terms of lease agreement, a tenant can terminate a lease agreement with 6-month prior notice.

However, in March 2000, Japanese government introduced a new type of lease called Fixed Term Lease to stimulate supply of new rental residential properties with higher quality. Unlike Ordinary Lease Law, no Justifiable Reason is required to terminate a fixed-term lease contract.  Simply, upon due, a fixed-term lease contract will terminate and a landlord can evict a tenant. In addition to that, except certain residential fixed-term lease, fixed-term lease can be non-cancellable and non-negotiable on rent terms. According to a survey conducted by Ministry of Land, Infrastructure, and Transportation, only 4.1% of residential lease contracts executed in FY2013 is with fixed-term arrangement even over 10 years have lapsed since the introduction of new law and the purpose of introduction of fixed-term lease has not been achieved in rental residential market.

On the other hand, for retail and office properties, fixed-term lease achieved certain popularity. Particularly, long term master lease agreement for retail and logistic properties tends to be fixed-term lease as it can secure more stable cash flow. More and more institutional owners, J-REITs and private real estate funds, of office, retail, and logistic properties are inclined to employ fixed-term leases.

Trading Market Practice

Conflict of interests is a key word for Japanese real estate trading market.

Under Building Lots and Buildings Transaction Business Act (Japanese real estate brokerage regulation) does not prohibit a licensed real estate broker from representing both a seller and buyer. Moreover, although the Act sets 3% of transaction price as the highest fee chargeable by a licensed broker for each party, 3% was used as quasi government blessed rate for brokerage and had been often charged fully as a market practice even in large scale transactions. If you represent both a seller and buyer, you could charge 6% of total transaction price as a licensed broker which represents significant portion of transaction economics. Therefore, brokers have made a tremendous effort to make a transaction upon negotiated basis to receive fees from both sides. After the entry of foreign capital and J-REITs into the property trading market, open bidding and auction for disposing real properties have become more popular in the last decade but still quite substantial portion of real property trades are done via negotiated sales.

Up until collapse of bubble economy in early 90’s, Corporate Japan believed in the myth of ever-rising land prices and selling real estate was considered to be a shame and still elder senior management of Japanese companies remembers this myth. In many cases, selling corporate real estate may create negative image for a corporate seller. Disposition of CRE is often forced by your corporate lender under tough financial situation to reduce debt amount. Therefore, if you are found to sell your real property, you may be considered to have financial problems. To avoid unnecessary image issue, corporate sellers (non real estate companies) tend to have confidential negotiated deals to dispose real properties.

As well represented by cross-share-holding system (Kabushiki Mochiai) in Japan, relationship among company groups mean a lot to Japanese companies. Groups of companies like Mitsui, Mitsubishi, and Sumitomo, sometime long-term relationship among group companies means more than mere sales prices. Therefore, price you get is one of important factors in determining the winner but not necessarily the only factor. This corporate culture provides significant room for real estate brokers to play negotiated deals. This is also true even for J-REIT related transactions.  Unlike US, there are many listed large-scale real estate developers in Japan such as Mitsui Fudosan (TSE 8801), Mitsubishi Estate (TSE 8802), and Sumitomo Realty (TSE 8830).  Many of them are sponsoring J-REITs. For instance, Mitsui Fudosan sponsors three listed J-REITs, Nippon Building Fund, Japan Accommodation Fund, and Frontier Real Estate, and two private REITs. Mitsui Fudosan has sold many properties from its balance sheet to those REITs without auction or bidding process. Interestingly, Japanese REIT investors regard this practice as quite favorable because Mitsui Fudosan sponsored REITs can continue acquiring excellent properties developed by Mitsui Fudosan and achieve stable growth of asset size. Many large companies sponsoring REITs have done the many similar transactions.

Moreover, oligopolized banking groups with trust banks play very important role in the trading market. After oligopolization advanced at nation-wide commercial banking sector in 90’s, now we have only three money-center banking group in Japan. Sumitomo Mitsui Banking Corporation (SMBC), Mizuho Financial Group, and Mitsubishi UFJ Group. Each group is equipped with a trust bank affiliate which can provide licensed real estate brokerage services. During the recovery process from massive non performing loan troubles in late 90’s and early 00’s, those financial groups directed collateral disposition and CRE sales activities to reduce debt to their group trust banks as a licensed real estate broker. For example, if a main lender to one company is Mitsubishi Tokyo UFJ Bank and they want to have the borrower to sell CRE to repay loans, they introduced Mitsubishi UFJ Trust as a broker to handle the collateral sale or CRE sales activities. Often, the sales were directed to potential clients who Mitsubishi Tokyo UFJ Bank can advance new acquisition loans. Through this process, Japanese trust banks with real estate brokerage license has started playing significant role in the trading market in 90’s.

Finally, we need to mention to a real estate transaction structure in a form of trust beneficiary interest (TBI). In Japan, taxes charged upon transfer of real estate are quite significant, over 4% of tax assessment value. However, if you entrust real estate into Real Estate Disposition and Administration Trust (Fudosan Kanri Shobun Shintaku), obtain TBI in exchange from a trust bank, and then, transfer TBI to a buyer, you can enjoy significant tax saving compare to real estate sales because the transfer is treated as TBI which is not subject to high taxes upon transfer while the economics of owning real estate is passed-through to a TBI buyer, i.e., beneficiary. Because of this saving, almost all of institutional real estate property trades is done in a form of TBI and the balance of Real Estate Disposition and Administration Trust reached to USD220 billion (26.4 trillion yen) as of March 2014. This means Japanese trust banks hold legal title of 26.4 trillion yen worth institutional real estate as a trustee and get involved in almost all the institutional real estate transactions occurred.

As both broker and trustee, although they have conflict of interests issues, Japanese trust banks hold quite strong market power in institutional real estate trading market and again are trying to get paid from both sides of transactions which provides room for investors to participate in negotiated transactions.