Rising sun, fading distress

A lot can change in fifteen years. In 1990, the economic success of Japan was making the West distinctly nervous. On the back of four decades of apparently unstoppable growth, Japanese corporations had spent much of the eighties looking for profitable opportunities to invest their wealth abroad, and had bought up large quantities of prime real estate in other major economies – a trend that culminated in the 1989 purchase of New York's iconic Rockefeller Center by a subsidiary of Mitsubishi. The protectionist paranoia that such Japanese encroachments induced inspired George Friedman and Meredith Lebard's 1991 book, The Coming War With Japan, which argued that economic rivalry would inevitably spill over into military conflict.

Since then there has been something of a turnabout. The Japanese economy crashed in the early nineties, and the bubble in the country's real estate values began to deflate. The last few years have seen a near reversal of earlier trends, as foreign – mainly American – investors have bought up large chunks of Japanese property at distressed prices. Everything from retail malls to golf courses and prime Tokyo office space to spa resorts have attracted interest from international investment banks and private equity firms.

“US investors like the Japanese market,” explains Dennis Yeskey, national director, Real Estate Capital Markets in the real estate practice of Deloitte and Touche. “It's a stable country, a large economy that makes a lot of things, and they think growth will eventually pick up. They trust that the Japanese economy is not going away.”

As a result of these trends, however, the rules of property investment have changed in Japan and distressed opportunities are now giving way to new strategies and markets.

The root of this reversal of fortuneslies in the popularity of real estate acquisitions among Japanese corporations in the 1980s. At the time when Japanese corporations enthusiastically set about investing their balance sheets in property, interest rates were low, allowing them to engage in highly leveraged acquisitions. The acquired real estate was used as collateral for loans representing anything up to 90 percent of the total value of a transaction.

Nor were property-backed loans restricted to real estate deals: the steady growth in Japanese land values since the end of World War II had convinced the country's banks that property was the best possible collateral for almost any type of loan. “Historically real estate was not seen as an asset like it is today, but was just regarded as something positive to have on your balance sheet,” explains Dr. Leonard Meyer zu Brickwedde, the chief executive of specialist investment bank Hypo Real Estate Capital Japan Corporation. “If you wanted to borrow money you had to buy real estate on your balance sheet or the banks wouldn't lend.”

The result was that, when worldwide property prices fell during the recession of the early nineties, Japan was hit harder than most. Falling real estate values left its corporations with weakened balance sheets packed with unprofitable assets; and its banks buried in loans that could no longer be repaid.

If this was what knocked the economy down, then it was Japanese attitudes to property that prevented it from quickly righting itself again. Because property was viewed as the source of all bank loans, the corporations were loath to sell the portfolios they'd built up. According to Naoki Umeda, a director of Mitsubishi Estate Company in London, the situation was exacerbated by the historic trend of rising land values – potential vendors were convinced that their properties were worth more than the depressed prices buyers were willing to pay. As the last decade dragged on, property prices stagnated, loans failed to perform, and the economy remained sclerotic.

It took until 1997, when Japan was shaken by the Asian financial crisis, before the government took steps to deal with the country's non-performing loans, telling the banks, in effect, that they could either clean up their balance sheets or go down. “The government realized that the economy couldn't recover unless the financial system did,” explains Meyer zu Brickwede. “That meant fixing the NPLs, which at the time made up more than 10 percent of GDP.” (To put that figure in perspective, at the height of the US Savings and Loans crisis in the late eighties, bad loans made up around 3 percent of GDP.)

The government's warnings were heeded by the banks, which took the opportunity to both clean up their balance sheets and reduce their taxes through write-offs. Opportunistic investors, for their part, leapt at the chance to acquire real estate assets in a formerly impenetrable market at knock down prices. In October 1999, for example, Los Angeles-based real estate firm Kennedy Wilson paid less than $20 million for a portfolio of loans with a face value of $250 million. By 2001, Japanese banks had sold an estimated $600 billion of distressed loans.

Today, the stream of bad loans has begun to dry up as the largest, most lucrative opportunities have been exhausted. But a second element of Japan's attempts to rebuild its economy has also presented private equity real estate investors with potentially lucrative opportunities. Corporations have been encouraged to restructure their operations using Western techniques, focusing on their core business, disposing of non-core assets and cutting costs. In April 2003, for example, the government formed and funded the Industrial Revitalization Corporation of Japan (IRCJ) to acquire a portion of the debt owed by a select group of portfolio companies, thus giving the IRCJ leverage to demand change and, hopefully, turn the operations of these companies around.

A key element of the IRCJ's program for ailing corporations involves the sale of redundant property assets. “During the bubble, corporations invested heavily in real estate such as golf courses, condominums, hotels,” explains Setsuya Sato, a senior director at the IRCJ. “We encourage them to dispose of lowyielding assets as quickly as possible to deal with the overhang problem.”

The move by Japan's corporations to sell unnecessary real estate assets, however, goes far beyond the IRCJ's portfolio companies. Meyer zu Brickwede suggests that the corporate sector still holds more than $500 billion of non-core real estate, and expects most of this to be sold over the next 24 months. Sonny Kalsi, the managing director who heads Morgan Stanley

Real Estate's Japanese operations, suggests that as many as 70 percent of major Japanese corporations own their own real estate, compared to under 40 percent in Europe and only 20 percent in the US.

“If you look at the US twenty years ago, that figure was above 50 percent,” Kalsi says. “Then they figured out that, as non-real estate companies, they were better off not owning real estate. Lots of opportunities here are being driven by Japanese corporations making the same decision.” He cites the example of the firm's acquisition of a 32-story office block in Tokyo from Mitsubishi Motors in a $1.1 billion deal last June.

As these trends have accelerated, however, the opportunity to snap up quality properties on the cheap has diminished amid increased competition and the first signs of growth in property values, causing attention to move to less mainstream assets.

“Several years ago investment was almost entirely in offices in Tokyo, and some residential, but sectors and locations have diversified,” says Rio Minami, a managing director in The Carlyle Group's Asian real estate group. “Relatively new investment sectors in Japan, such as industrial or senior housing, will likely bring in benefits of arbitrage for opportunity funds in coming years.”

One sector that has seen a significant level of activity in recent years is leisure and hospitality. Goldman Sachs, which has invested more than $6.4 billion in Japanese real estate since 1997, recently acquired more than 50 onsen ryokan, or inns with hot springs. Unwinding by bathing at such resorts is one of Japan's most popular leisure pastimes; yet thanks to the economy's recent sluggishness the numbers of such inns have declined from over 83,000 in 1980 to only 60,000 today – and 80 percent of the survivors are thought to be in trouble.

Goldman has paid ¥30 billion ($268 million) to acquire a portfolio of such inns, and operating company Hoshino Resort Inc will be responsible for renovating the facilities. This, combined with the long awaited recovery of the Japanese economy, should help turn the businesses around. Goldman is hoping for a 10 percent return on its investment.

A large chunk of the bank's investment has also gone into becoming one of the country's largest golf course owners. Like the onsen ryokan, Japan's fairways have suffered in the downturn of the last decade as demand for a sport identified with the rich and successful has slipped. Goldman Sachs began acquiring distressed courses four years ago and now owns no fewer than 78, including the Manju Golf Club in the Nara prefecture and the Narashino Country Club in suburban Chiba. Since 2003 the clubs have been operated by the bank's Accordia Golf Company, which it hopes to list on the Tokyo Stock Exchange next year. Lone Star has taken a similar approach: its portfolio company, Pacific Golf Management, now has around 95 clubs in its portfolio, and is reported to be planning a listing in the next few months.

The profitability of such deals is based partly on expectations of economic recovery, and partly on the cost cutting measures that come from consolidation. IRCJ's Sato suggests that such deals are also a demographic play. “The baby boomers are about to retire – and they're rich people.”

Such deals illustrate another trend: that of opportunistic buyers purchasing struggling companies to get at their property.

“We're seeing the third wave of distressed investment right now,” explains Yeskey. “They started in the late nineties by buying up NPLs; then they came back in 2001 to 2002 for the equity. Now they're buying distressed operating companies with good real estate.”

One firm that has made the transition from distressed loans to distressed companies is Cerberus Capital Management. As far back as the autumn of 2000, the firm acquired a 24 percent stake in local real estate developer Dia Kensetsu through the acquisition of ¥4 billion of convertible bonds. The intention was for Dia to grow its condominium business by developing new properties on Cerberus-owned land. (Things didn't go to plan, however: in March 2002 the firm took over Dia in its entirety in a ¥100 billion debt forgiveness deal.) More recently, in November 2004, the firm bought a 65 percent stake in real estate group Kokusai Kogyo, simultaneously acquiring loans with a face value of ¥500 billion at a cost of ¥250 billion.

The New York-based private equity real estate investor Aetos Capital, which launched its second Asian opportunity fund earlier this year, has also taken a piece of the action. In February it agreed to a deal with Matsushita Investment and Development (MID), the distressed real estate arm of the Matsushita Electric Industrial Group, under which it would contribute ¥15 billion in exchange for preferred shares in a new company that would operate MID's profitable office and condominium arms; it also purchased its unprofitable golf course and resort assets.

One firm that has been active in Japan's distressed market right from the NPL era to the present day is Morgan Stanley, a familiar strategy for the investment bank, which started its US real estate operation in the aftermath of the Savings and Loan crisis. Its investments in Japan have ranged widely across different sectors and deal types, including a $150 million air-cargo industrial park near the Tokyo airport and a 36-story hotel purchased for $109.5 million. It has also created Promena Retail Properties as a mall acquisition vehicle, the luxury apartment development company Glen Park, and hopes to create a chain of branded Japanese lodges.

“We started investing in Japan seven or eight years ago, when we focused on NPLs secured on real estate collateral, which we'd often take back,” explains Kalsi. “We then started to expand into buying smaller real estate assets on a direct basis, before our business shifted to bigger assets, and operating businesses. Now we have a $10 billion portfolio diversified between all major asset classes, and a team of 200.”

Most of that team are hands-on asset managers. Kalsi emphasizes that, despite the first signs of rental growth and the widespread expectation that, thanks to Prime Minister Koizumi's reforms, the economy may at last be picking up, the best way to make a profit in Japan is still to improve the fundamentals. “Some investments do wind up being a market play, but you can't know that until after the fact,” Kalsi says. “We focus on reducing operating expenses, working with leasing agents, seeing if the property needs investment, and interacting with tenants because happy tenants pay more rent. Then we actively work the market when it's time to sell. All these things add up.”

This may be a good thing, because buying cheap is becoming harder – and while those with investments to exit may be rubbing their hands together, those hoping to make acquisitions at fire-sale prices are likely to be disappointed.

In fact, for the first time in years, property prices seem to be rising (see chart). Between March 2004 and March 2005, Tokyo land values increased by 1.2 percent – their first gain since 1990. As a result, cap rates have declined from around 6.5 percent for much of the last decade to under 5 percent today according to figures from Richard Ellis. Despite the number of corporations disposing of their property portfolios, demand is still picking up due to the rise of the Japanese real estate investment trusts.

“Since the first J-REIT started in 2001, the sense that real estate is a commodity has taken hold among investors,” says Carlyle's Minami. “As of today, there are 23 J-REITs, and their market capitalization is approximately $23 billion. US REITs have a market capitalization of approximately $300 billion, more than 10 times larger. Considering that US GDP is only 2.5 times larger than that of Japan, there is plenty of room for JREITs to grow.”

The competition from domestic capital has inevitably lowered the returns that opportunity funds can hope for – to the extent that Carlyle, which only began its Japanese real estate operation last year, says that it does not engage in distressed investing in Japan at all. “The distressed asset opportunities ended a while ago,” Minami says simply. “Instead the Japanese property market is entering a new era as the J-REIT market is growing. In such circumstances the ‘exit liquidity’ will improve more, which gives greater comfort to opportunity funds like us.”

There are other reasons for real estate buyers to look on the bright side. Not only do interest rates remain significantly lower than cap rates, but rents could be about to rise: vacancy rates for large scale offices in Tokyo are now below 2 percent.

Kalsi, for one, remains optimistic. “The fact that more capital is rolling into the market will clearly bring returns down, no question,” he says. “But it's a natural thing. Real estate is a lagging index, and the economy is doing better. And no real estate market has recovered until it's mostly made up of domestic money.”

Japan's time as a haven for distressed real estate investors may be coming to an end – but the country's property investment market could be just beginning.