Japan’s regional opportunity: looking beyond Tokyo

Highly competitive pricing in Tokyo has led to growing interest in Osaka, Nagoya and Fukuoka, especially where there are demographic tailwinds.

As global investors continue to strengthen their foothold in Japan, many are starting to look beyond Tokyo and into the country’s regional cities in pursuit of higher investment returns. Greater Tokyo has traditionally been the first place for foreign investors to plant their flag and it remains the country’s largest real estate hub. However, Tokyo’s share of the country’s annual investment volume has decreased from as much as 90 percent in the wake of the global financial crisis – an all-time high – to roughly 70 percent today, according to CBRE.

Investors have shifted some of their allocation to regional cities, many of which – such as Osaka, Nagoya and Fukuoka – have been revitalized in recent years as a core pillar of Abenomics. Part of this has been a result of highly competitive pricing in Tokyo, which has led investors to seek value elsewhere.

“Acquiring core assets in Tokyo has become very challenging, especially in the open-bid process,” says Koichiro Obu, DWS’s head of real estate research APAC, noting that the cap rate in Greater Tokyo has compressed as more investors enter the market. “Usually there are more than 10, or sometimes 20, bidders. You have to price out the competitors and it is very difficult for funds with target returns,” he explains.

Although the cap rate is generally lower in Tokyo than in the regional cities, it can vary depending on the region and asset type. For larger cities such as Osaka or Nagoya, prime office yields’ spread over those of Tokyo assets would be about 50-60 basis points. Tokyo’s prime office expected cap rate is slightly below 3 percent in 2021 and it is expected to be further compressed by 10 basis points year-on-year, according to the Savills’ Japan Review 2022.

“It’s a matter of getting familiar with the market by having a local presence”
Danny Phuan
Allianz Real Estate

Chicago-headquartered Nuveen is among those firms looking beyond Tokyo. In 2020, it paid $140 million for a portfolio of 10 residential properties located across both Tokyo and Osaka after three years of only investing in the former. Today, eight out of Nuveen’s 54 Japanese assets, or around 7 percent of its portfolio, are outside of Tokyo.

Louise Kavanagh, chief investment officer and head of Asia-Pacific at Nuveen, says Osaka can offer around a 50-100 basis points spread to Tokyo. “Recognizing that capital will start to seek out opportunities outside of Tokyo as pricing got tighter, we benefited from a first-mover advantage by investing into Osaka at a time when the market was relatively under the radar for foreign institutional investors,” she says.

Shockproof during pandemic

Regional cities have also proven more resilient during the covid-19 pandemic. Although office vacancy rates increased in all major cities during this period, Tokyo’s climbed at a much faster clip.

According to DWS, the average office vacancy rate in Tokyo’s central five wards increased from a low of 1.5 percent in March 2020 to 6.4 percent in September 2021. Meanwhile, the vacancy rates increased from around 2 percent or below across all major markets in December 2019 to a range of 4-5 percent in Nagoya, Fukuoka, Yokohama and Osaka. The rate remained particularly tight in Sapporo at below 3 percent during the same period.

Mari Kumagai, Cushman and Wakefield’s head of research and consulting, Japan, says the adoption of work-from-home arrangements has been limited in the regional cities, which has kept vacancy rates comparatively lower than in Tokyo.

“Unlike the head office of the same company in Tokyo, the branch offices in these regional cities might not offer the same work-from-home options for the employees. Limited IT infrastructure, a short commute to office, smaller office size, cultural preference of in-person meeting supports these trends. The cities are much smaller, and a typical commute time can be around 20 minutes, instead of 75 minutes in Tokyo,” she says.

Apart from higher yields, diversification has also been a key driving force for investors to enter the regional market – an approach that has been validated by these cities’ resilience during the pandemic.

“With Osaka, we like the risk-return profile of value-add to opportunistic strategies”
Gilles Chow
CPP Investments

Allianz Real Estate is another firm that had previously focused mainly on Tokyo. After the launch of its first Japan office in 2020, it began to look further afield and now has additional direct exposure to Osaka, Nagoya and Fukuoka.

Most recently, the firm launched the $2 billion Allianz Real Estate Asia-Pacific Japan Multifamily Fund I to invest in multifamily assets across the country. The vehicle has received commitments from Canadian pension fund manager Ivanhoé Cambridge and Allianz affiliates.

“We do have a fairly large exposure in Japan, so it is a move of balancing. I must say that the large proportion of investment would still be in Tokyo,” says Danny Phuan, head of acquisitions for APAC and head of China at Allianz Real Estate, noting, however, that some of the firm’s assets outside Tokyo were more resilient and performed better during the pandemic.

The chase for industrial

While office and multifamily have typically been the main draw in Japan’s regional cities, the industrial sector has emerged as one of the most highly sought-after sectors outside of Tokyo in recent years. According to CBRE data, industrial investments in Japan’s regional cities have grown significantly, from 10 percent of total investment volumes in 2016 to more than 25 percent last year.

Cushman’s Kumagai expects more new capital to pour into the industrial and data center sectors outside of Tokyo due to recent government policy and the lack of modern logistics facilities. In January 2022, Japan’s prime minister Fumio Kishida outlined plans for Digital Garden City Nation, which aims to achieve rural-urban digital integration and transformation initiatives, such as building more than a dozen regional data centers over the next five years.

“I think, for logistics assets, we’ll see a temporary increase in vacancies in response to lump-up supply in some regional cities such as Nagoya. However, the structural need to build modern logistics infrastructure will catch up with the supply, especially in an inflationary environment,” Kumagai adds.

Canada’s CPP Investments is among investors drawn to Japan’s industrial sector. In July 2021, it established a data center joint venture named Japanese Data Centre Development Fund (Mitsui Fund) with Mitsui & Co, one of Japan’s largest general trading and investment companies. The Mitsui Fund’s initial projects will be hyperscale data center developments in Greater Tokyo and Osaka.

“With Osaka, we like the risk-return profile of value-add to opportunistic strategies as they are consistent with our investment strategy,” says Gilles Chow, managing director, head of real estate North Asia, CPP Investments.

Vision for a digital garden city nation

There are four major pillars of the vision supported by individual actions and plans. Here is what they involve, as outlined by the government of Japan.

Building digital infrastructure

  • Building a digital superhighway using submarine cables surrounding the islands of Japan in three years
  • Building more than a dozen regional data centers in about five years
  • Making optical fiber a universal service by 2030, with 99.9 percent coverage of households

Developing and securing a digitally skilled labor force

  • Establishing a program to annually train 450,000 personnel to be responsible for the promotion of digitalization in local regions

Using digital services to solve rural issues

  • Practicing “smart agriculture” with advanced technology by 2025
  • Implementing new mobility service initiatives across about 40 percent of local governments nationwide, such as setting up mobile clinics to eliminate medical disparities among regions
  • Achieving digital transformation at approximately 70 percent of all logistics companies, including the use of drones and automated delivery robots by 2025
  • Providing an educational ICT environment for children by distributing a digital device to each student attending school
  • Working on revitalizing the country’s outlying regions through digital technologies
  • Utilizing digital tools to connect local small and medium-sized enterprises with overseas businesses

Launching initiatives to get up to speed

  • Establishing a human-resource support system to promote and realize a digital society

Entry barriers

Investing beyond Tokyo isn’t without challenges. Chief among them are a lack of information and local knowledge.

“If you are an international fund and want to present a regional city to your global investment committee [as a new investment opportunity], there is a higher associated information cost, which leads to a behavioral bias to invest in familiar markets such as Tokyo despite less attractive risk-adjusted returns in comparable assets,” says Kumagai. However, similar to other developed markets in the past, Kumagai also expects the universe of investable assets to expand in these local markets and for investors to build up their knowledge over time.

Liquidity is another barrier to entry into these markets, Kumagai notes. According to DWS, only six out of the 19 major transactions in Japan since April 2021 were outside Greater Tokyo.

“There are generally fewer institutional assets in the regional cities and traditional landlords don’t want to sell the assets because they do not have a better investment alternative to real estate other than cash,” Kumagai explains.

In order to gain access to the regional markets, it is important for international managers to have local teams on the ground or to partner with a local player. BentallGreenOak is among those finding success with this strategy.

The firm reportedly bought a landmark 21-story building in Nagoya from Japanese developer Mitsubishi Estate in March 2022. It is understood that the seller wanted a quiet transaction and BGO had access to it partly due to an existing relationship with the seller.

With appetites for these markets increasing, expect more buyers to follow suit.

“I think it’s a matter of getting familiar with the market by having a local presence,” says Allianz’s Phuan.