Schroders: Adding value in Japan

This article is sponsored by Schroders Capital

Japan is best known as the largest core real estate market in Asia-Pacific, yet the size and depth of the market also throws up plenty of opportunity to add value. Schroders Capital focuses on value-add strategies in the region and has recently set up a Japan real estate team, hiring former JPMorgan executive Keisuke Kusano to lead the new business. Kusano and Andrew Moore, head of real estate, Asia-Pacific, at Schroders talk about the Japanese market and the opportunities to add value to real estate.

How does the Japanese market differ from other real estate markets in Asia?

Andrew Moore: Kei and I would say that Japan is the opposite of the higher growth, developing Asian markets; it is already a mature economy, the world’s third largest, and Japanese companies and the population have high spending capabilities. It is also one of the world’s lowest interest rate risk markets. Its stability is valued by investors, particularly when there is volatility elsewhere in the world.

The property market is huge compared with any other market in Asia. It is the largest country in the MSCI Asia-Pacific Real Estate Index. And by floor area, Tokyo is the largest urban market in APAC by a long distance.

We also think Japan represents good value. Because of the nature of the market and the age of the stock, it has a relatively high stock of older non-grade A properties, which gives us an opportunity to apply our value-add strategy. For those reasons, we think it represents an exciting investment opportunity.

What is your view on the Japan real estate market?

Keisuke Kusano: Japan is following the global trend where many investors are chasing beds and sheds. The residential sector has proven its resiliency during the pandemic, given the high stability in rent and occupancy, while the logistics sector’s fundamentals remain very strong.

There had been concerns about the very high levels of supply in this sector. However, demand has kept up with the ample supply entering the market. Numerous domestic and international players continue to buy logistics assets.

Demand for quality space in primary areas has been firm. However, there has been some evidence in Tokyo of increased willingness to accept home or hybrid working practices, and satellite offices are growing in popularity. So we need to consider how the market will shift going forward or what alternative uses there might be for underutilized office space.

The hotel and retail sectors have been hit very hard by covid-19 and the lack on inbound tourism. Retail is also being affected by the move to online shopping. I would also expect hospitality to recover quickly once international visitors return and this will support retail too.

What opportunities are there in the market today?

AM: Kei and I are looking for opportunistic investment situations where we can physically create value for an asset; our style of investing is very much value-add. We see Japan as potentially offering some really interesting value-add opportunities. However, the key to generating high returns depends on the type of opportunity and where that particular market segment is in the cycle.

One area where we feel we can add value is in upgrading a building’s ESG performance. Whilst core investors might take the approach of only buying the best-rated buildings, there is an opportunity to really add value by improving the existing stock.

There is obviously a lot more older stock than new, so it is a big opportunity. Furthermore, extending the life of older buildings and making them more energy efficient is one of the most positive things a real estate investment manager can do. We are happy to buy environmentally underperforming buildings and set ourselves targets for their improvement.

KK: There is an opportunity to acquire underperforming older residential buildings and conduct refurbishment to target rental uplift. Perhaps another way to add value is by terminating a master lease arrangement with an operator. It may be a challenge as to how to remove the operator but there is definitely an opportunity in that space.

There is value in upgrading older logistics stock or in redeveloping to provide modern warehousing space. Due to Japan’s tight labor market, there is an opportunity to add value by improving the staff areas of these assets. There are also opportunities in emerging specialist areas, such as data centers and cold storage.

There is scope for upgrading Grade B and Grade C offices to create more modern space through refurbishment and retrofitting. As Andrew says, there is a very large stock of older office buildings in Tokyo, which have not been actively managed over the years. Those in good locations may be suitable for upgrading to modern standards.

Meanwhile, in retail, there may be irrationally low pricing for some retail assets following the pandemic and due to the continuing challenges from e-commerce. There may be attractive entry opportunities for value enhancement through repositioning, but investors in this space need to be selective and cautious. Hotel pricing has actually remained resilient, and we have seen very little in the way of distressed sales. Banks have been prepared to support owners and operators, and well-priced opportunities are unlikely to emerge while this remains the case.

We wouldn’t rule out any location in principle and will not limit ourselves to Tokyo. There are good opportunities in other large and dynamic cities, such as Osaka or Fukuoka.

How can a real estate investment manager differentiate itself in Japan?

AM: The ability to source opportunities off-market depends on personal relationships as well as expert knowledge, particularly in the more opaque parts of the market. Japan as a whole is not necessarily opaque but certain segments of the market are very hard to access without personal relationships and expert knowledge that someone like Kei brings. You can’t just parachute in and expect to see good deals, because you are just not going to be trusted by the local counterparties.

KK: There are many domestic and overseas players participating in the Japan market, but I believe our focus on value creation, on rolling up our sleeves and getting involved with the real estate is an advantage that differentiates us from managers who simply allocate client capital.

Although our real estate business is new in Japan, Schroders has been in Japan since 1870 and I have found people react warmly to this long-term commitment and also to the opportunity of collaborating with a manager which wants to add value at the real estate level.

The move towards flexible and home working has caused some caution toward the office market in other countries. Could moves in this direction hurt the Japanese office sector?

KK: I believe Japanese people value face time and want to come into an office and work in person. Since I joined Schroders, I’ve been having a lot of meetings and many people mention that they don’t like video calls and prefer to meet face to face. Sourcing deals in real estate, for example, means talking face to face, especially when establishing a new relationship. It is the same in other industries.

However, there will be a move to a more hybrid working model. This might not necessarily include working from home, as Japanese homes are not generally suited to home working. So there may be a need for flexible office space in suburban areas. Some hotels have been offering space for people to work remotely and there may be opportunities which follow from this development.

Are there opportunities for value-add projects in the data center space, such as converting office or industrial buildings?

KK: There are groups which are trying to do that, but it requires very heavy lifting. Data centers have particular requirements for factors such as ceiling height, floor load and things like that. To convert, say, an office building to a data center will be technically challenging. There are some groups looking at this sort of conversion but we haven’t seen many successes yet.

AM: Schroders Capital has actually carried out this sort of conversion on a former industrial building in Hong Kong, so it is possible. However, it is difficult and rare that a building designed for another use has all the physical characteristics a data center needs and – crucially – offers the power supply and back-up needed. There is also the question of whether such a project is worthwhile; it will depend on how many clear sites are available for data centers. Nonetheless, if such opportunities crop up in Tokyo, we have experience which can be brought to bear on them.