Real estate investors are unfazed by Japan’s historic rate hike

Real estate investors are unfazed by the end of Japan’s negative interest rate policy amid expectations for rates to remain stable.

Last week, the Bank of Japan terminated its negative interest rate policy and increased its interest rate for the first time in 17 years. According to a statement, the country raised its short-term rate from between -0.1 percent and zero to zero and 0.1 percent. Japan implemented NIRP as part of its monetary easing program to combat deflation, which has effectively come to an end following 23 straight months of inflation standing at or above the BoJ’s 2 percent target.

While this was a milestone in Japan’s banking history, real estate investors had already priced in the lifting of NIRP since last year. Milan Khatri, head` of research at pan-Asia real estate investment firm Phoenix Property Investors, noted the rise in interest rates had been expected for the past nine to 12 months. “The central bank had already been setting us up for a potential change in interest rates since last year,” he said.

Prior to the announcement last week, the BoJ adjusted its yield curve control policy three times in December 2022, July 2023 and October 2023, respectively. Specifically, it gradually expanded the allowable band for long-term interest rates from zero percent to over 1 percent.

As these adjustments sparked speculation over the termination of NIRP, some foreign investors turned more cautious in the second half of last year. Foreign investment in Japanese real estate fell by approximately 80 percent year-on-year in both Q3 2023 and Q4 2023, according to a CBRE report.

Despite announcing an interest rate hike, the BoJ reiterated in a statement the importance of having accommodative financial conditions, given the current outlook for economic activity and prices.

“The BoJ doesn’t seem to be embarking on a prolonged tightening cycle. There was no guidance or hints that the BoJ will implement additional rate increases,” a spokesperson from Singapore-headquartered real estate investment firm SC Capital Partners told PERE.

In addition, Khatri noted that the interest rate in Japan is still “extremely low” compared to the rest of the world and there is a “significant” spread between the borrowing costs and yields in the country.

Tokyo was the most attractive location for prime assets across all sectors in Q4 2023 based on the yield spread against borrowing costs, according to the CBRE report. “While there is a possibility that Japan may relinquish its position as the number one yield spread destination, the relative attractiveness of cash-on-cash returns, considering leverage and other factors, is unlikely to significantly decline, as long as interest rate hikes remain gradual,” senior director Chinatsu Hani wrote in the report.

Gary Kwok, founder and chief executive officer at pan-Asia real estate investment firm AXE Management Partners, noted the BoJ is generally expected to increase the base rate gradually while closely monitoring key economic indicators.

“Given the existing low base of the borrowing rates, even increasing the base rate by a meaningful amount of say 50 basis points would not significantly increase your interest expenses, and thus impact your returns by a large margin,” he added.

No change in underwriting

With this in mind, Kwok chose a floating rate for his latest transaction. Last week, AXE bought three hotel properties in Japan from CapitaLand Ascott Trust for 10.7 billion yen ($75 million; €69.3 million). “When I evaluate this deal, the price for a five-year fixed rate would be 70 or more basis points higher than a floating rate. I would rather do the latter and continue to capitalize on an attractive rate in the foreseeable future,” he explained.

Similarly, Phoenix Property Investors’ underwriting of financing terms in Japan also remains unchanged. “We borrow on a fixed rate basis of five years, and we will continue to do so. We are locking in the current interest rate so we are not taking that interest rate risk. But it could be different for other managers. It all depends on your overall strategy,” Khatri said.

While the monetary policy shift should have a limited impact on Japan’s real estate investment market, investor preferences and strategies have been changing as the country’s negative interest rate era comes to an end.

In his report, Hani noted investors would be pivoting toward core-plus and value-add strategies that aim for “higher value creation” in the face of the potential narrowing of yield spreads due to rising rates.

Kwok added AXE has not altered its underwriting for investments in Japan because the firm’s strategy is focused on adding value through repositioning and operational uplift. “Identifying the right opportunity and executing [the] strategy is more important than the interest rate. The interest rate is important, but number two here,” he said. For his latest transaction, he is looking at a value-add strategy with an IRR of more than 20 percent.

What also helps to keep investor sentiment unchanged is Japan’s central bank has not communicated any plans to further increase rates. “At the end of the day, what would have maybe changed things potentially or had a bigger impact is if the BoJ had signaled that they were ready to hike interest rates even further. And that was the missing part here,” Khatri noted.