Stability and scale help Japan’s real estate market hold a competitive edge

Japan remains the top choice in Asia-Pacific, despite tight cap rates and rising interest rates.

Japan remains the most popular destination in Asia-Pacific for real estate investors, even though low yields and the prospect of rising interest rates are making it ever more difficult for investors to hit their return targets. However, a mix of new sectors and recovering ones are maintaining the market’s investment appeal.

MSCI data shows transaction volumes in Japan fell 16 percent to $36.7 billion in 2023, with the third and final quarters being weaker than expected due to the prospect of higher interest rates in the future. Japan’s headline interest had been negative (-0.1 percent) since 2016, but increased in March for the first time in 17 years.

In early March, Japanese unions negotiated the biggest wage rises for more than 30 years, gaining workers increases of 4-6 percent, although much higher in some cases. Meanwhile, inflation appears to have settled at or close to the Bank of Japan’s 2 percent target.

The BoJ had already allowed more flexibility on the 10-year bond yield, allowing yields of up to 1 percent. Goldman Sachs economists said any rises would be “very modest” and most commentators had been predicting hikes of no more than 10-25 basis points.

However, even such minor rises are liable to put upward pressure on Japan’s tight real estate yields. CBRE puts prime Tokyo yields at 3-4 percent, depending on sector, for example. The positive gap between borrowing costs and real estate yields has been one of Japan’s biggest plus points for investors, especially in light of interest rate movements elsewhere – but it is set to fade.

Enduring allure

As other developed markets adjust to higher interest rates, they may start to offer more attractive opportunities. “For the past two years or so, Japan has been more attractive than most markets globally because of its interest rate policy,” says David Fassbender, head of Japan at PGIM Real Estate.

“That means we haven’t seen the kind of pricing adjustment we have seen in other markets. For foreign capital, this may mean markets such as Australia, where prices have adjusted, are starting to look more attractive.”

Nonetheless, the 510 investors that took part in CBRE’s 2024 Asia-Pacific Investment Intentions Survey collectively declared Japan to be their preferred investment destination in the region for the fifth year running.

Meanwhile, a March report from Colliers said Japan was the third most popular destination for cross-border real estate investment in the second half of 2023, behind only the US and UK. In addition to a positive yield gap, and thanks to higher inflation, Japan offers a large, liquid, stable and transparent market as well as the prospect of rental growth in some sectors.

For US dollar- and euro-denominated investors, Japan also offers a significant currency hedge, which was as high as 600bps for dollar investors as of July 31 last year, according to Savills Investment Management.

“Although we expect to see the spread narrow over the next few years, the fact that there is still a differential implies an additional return component via the hedging premium, on top of the robust underlying real estate performance,” says Shaowei Toh, Savills’ head of research and strategy for APAC.

Office is the biggest real estate sector in Japan, but it remains dominated by domestic developers and the listed and private real estate investment trust sector. The low cost of J-REIT capital makes those hard to compete with when it comes to core office assets.

Furthermore, the travails of office investments elsewhere may dissuade foreign investors, which have been targeting the multifamily residential sector in recent years. A number of foreign investment managers have built up large holdings in that sector and have driven substantial yield compression.

“Residential values in Tokyo in 2023 have exceeded the previous peak recorded in 1990,” says Koichiro Obu, DWS’s head of real estate research for Asia-Pacific and head of real estate for Japan. “Young couples are finding it difficult to buy. This is driving rental house demand and in turn rental growth, especially in the larger units, with renters seeking more space to meet the needs of working from home.”

Growing opportunities

Despite Japan’s overall falling population, Tokyo and some other large cities are seeing rising populations due to internal migration. Tokyo saw the migration of 50,000-80,000 people each year in the decade prior to the covid pandemic, and government data suggests migration resumed in 2023.

“We are not going to see further [cap-rate] compression, which means core investors need to either drive NOI growth or pivot toward value-add”

Louise Kavanagh

Even with positive fundamentals, a decade of foreign investment in multifamily residential has made pricing very tight. Louise Kavanagh, Nuveen’s chief investment officer and head of Asia-Pacific real estate, says: “There has been cap-rate compression for multifamily assets, but we are not going to see further compression, which means core investors need to either drive NOI growth or pivot toward value-add.”

Kavanagh says all-in finance costs for a Tokyo multifamily asset would be around 80bps, compared with cap rates of 2.9-3.2 percent.

PGIM’s Fassbender adds: “Capital flow into multifamily has resulted in pricing becoming quite sharp right across the sector, which has made a lot of institutional investors, including ourselves, take a little bit of a back seat and be much more selective in terms of what we do. On the other hand, we have seen smaller family office and institutional investors continue to target that sector.”

Some investors have begun to look at the senior living sector, which has huge demographic tailwinds behind it, thanks to Japan’s rapidly aging population. For example, Nuveen has raised $150 million for its Japan Alternative Living strategy, which focuses on senior housing. “Senior living is a more nascent sector which offers the opportunity to deliver return by aggregating portfolios or forward committing to developments,” says Kavanagh.

Foreign investors have also been targeting the hospitality sector and, to a lesser extent, retail, both of which have been buoyed by a strong recovery in visitor numbers. “We have been very focused in the past 12 to 18 months on the hospitality sector and, to some extent, the high street retail sector,” Fassbender says.

“There has been a strong recovery in visitor numbers and more growth is expected. However, hospitality pricing has already moved quite a bit. High street retail, meanwhile, is a more difficult sector to get into and harder to deploy capital.”

“Japan’s inward tourism is supported by the weak yen, and there is also a strong domestic travel market; the average hotel room rate has surpassed pre-pandemic levels,” says Kavanagh. “However, for investors looking at hospitality today, the question would be: have pricing expectations built in the upside already?”

Diverse options

Inbound tourists are spending more than before, and there is strong demand for luxury options, says DWS’s Obu. “Luxury branded and high-end hotels can charge higher room rates than they did before the covid peak; however these assets are tightly held and hard to access for institutional capital.”

The logistics sector has also been popular with foreign investors; both large global sector specialists and domestic companies have created considerable new space, especially around Tokyo and Osaka. This has given rise to fears of oversupply. However, it seems this may not be as serious as first thought.

Obu explains: “We have seen a huge increase in construction costs, 25-30 percent higher over the past two years, which has had a big impact, especially in the logistics sector. This is because the value of the building forms a relatively high proportion of the overall value with lower land values compared to the other commercial sectors. As a result, some construction projects will be put on hold.”

According to Savills data, average rents fell sharply in 2022 in both Tokyo and Osaka, but rose again in 2023, though remaining below their peak. Meanwhile, vacancy rates have continued to climb.

The future picture for the logistics sector is clouded somewhat by new labor laws, which are set to limit the hours of drivers and other workers. Logistics is already short of labor relative to the rest of a short-staffed Japan, so these new restrictions could have implications for how the sector operates.

Some logistics real estate investors have begun to move into data centers, where demand is supported by e-commerce, digitization of business and the growth of AI, as in other markets. Logistics giants GLP and ESR have both set up data center businesses in Japan, while PGIM has plans to invest $3 billion in the sector worldwide and is understood to be looking at Japan as part of this.

However, Japan’s data center market has considerable barriers to entry, says Kavanagh, “not least the difficulty in securing sufficient power.” This can sometimes take many years to achieve, she notes.

The outlook for Japan seems to justify the confidence expressed in CBRE’s investment intentions survey. Even as it moves into a different interest rate environment, the market’s attractions of stability and scale remain and will bring capital into a range of sectors.