What Is The Outlook For J-REITs Going Into 2019?
By Christian Bernasconi, Managing Director, B&I Capital
Asian REIT markets have had mixed results thus far in 2018 with Japanese REITs (J-REITs) delivering total YTD (year-to-date) returns of 10.1% in USD versus declines of 7.17% for SREIT and 7.17% by the Australian REITs in USD terms. There are many reasons to be sanguine about REITs in Asia going forward as balance sheets are not overly stretched, and REIT managements have been locking in long-term debt to reduce earnings, volatility and refinancing risk in a potential rising-rate environment. Despite the strong performance year to date we continue to find many sectors in Japan that have appeal, and we will discuss them below.
Limited B-grade Supply
Within Japan, there has been an extreme divergence in performance within sectors, and we continue to favour smaller sized office markets as well as regional city exposure due to limited supply and strong demand. B-grade office is limited in new supply due to high land and construction costs, and as a result, vacancy levels for Grade B have gone done to historic low levels. Most new supply that is generated in Tokyo’s main 5 wards are A and S class (more than 5,000 Tsubo or 16,500 sqm total floor area), and rent levels are not affordable for many small or mid-size corporations.
Due to the strength of the economy, SMEs have been willing to pay higher rents and expect limited incentives in the current environment which is translating into strong net operating income growth for B-grade office REITs. While we remain positive, we also believe that valuations are now in some cases at a premium to NAV (net asset value) and expect to see some of the more aggressive REITs to come to market with secondary offerings, and our concern is that the underlying asset prices may already be pricing in future growth. We favour the groups that are focused on driving dividends higher through asset reshuffling or via rental increases over those REITs that may end up paying record prices for properties that are in scarce supply in the office market.
Undersupply in Osaka and Fukuoka
We believe investors should also consider the regional metropolitan cities outside of Tokyo. While it is quite well known that significant supply will enter the Tokyo market in 2020, this is not the case for the major cities outside Tokyo. Due to very high vacancy rates in the past few years, developers were hesitant to plan new developments, and as a result, the supply pipeline in cities like Osaka and Fukuoka are virtually empty at a time when vacancy levels are now back to historic low levels with both regions’ economies growing quickly.
Exacerbating the undersupply situation is the conversion of office buildings in Osaka into hotels and residential facilities which has led to weaker RevPAR (revenue per available room) growth for hotels in Osaka despite strong inbound visitors and lower rents on renewals for multifamily apartment owners. Osaka has benefited from a strong increase in inbound tourism which has helped the overall economy. It is likely to be selected for the first integrated resort which will be another attraction to the city that acts as a hub to Kobe and Kyoto. We believe that rents will continue to increase for the foreseeable future due to limited supply of office space until 2022 and 2024 and robust economic activity, and we favour Osaka-exposed J-REITs. Fukuoka, with the strongest demographic growth and steady job creation, has almost no new supply in the next couple years and according to Miki Shoji, the vacancy in its latest report fell to 2.4%, the lowest since it started its survey.
Logistics Supply to Peak in the Next Year
Logistic J-REITs, once a darling of the J-REIT sector due to solid acquisition growth and a firm backdrop of demand for modern logistics assets have suffered this year due to concerns about overbuilding in Tokyo and Osaka as well as large primary and secondary equity issuance and continued elevated vacancy rates in both markets. The acquisition growth story has lost its lustre, and this has led to investors searching for internal growth rather than equity-led acquisition growth. However, one could start to make a case for this sector due to its defensive nature and long term potential on the back of increasing demand for modern logistics facilities from third-party logistics, manufacturing and other e- commerce businesses. Supply will peak in the coming year, and given the high cost of land and construction, this should help to bring the supply and demand of the sector back into balance. For value investors with a longer time horizon, the sector has started to look attractive.
Retail J-REITs have like REITs elsewhere struggled due to concern about the viability of large format department stores and concern about closures. The J-REITs with suburban malls have been particularly impacted by this concern, and we also feel that the risk/reward in suburban malls is not attractive. On the other hand, urban retail located next to train stations and on high streets like Tokyo’s Omotesando and Ginza or Osaka’s Shinsaibashi are performing well. Like hotels, they have benefitted over the last year due to inbound tourism, and this has helped landlords achieve strong rental increase on renewals or on turnover rents. We also like neighbourhood shopping centres that tend to cater to daily necessities like grocery, services and other products that are not disrupted by e-commerce players. The yields on these assets are typically very high, and there is often some re-development or expansion potential. In addition, these types of centres could form part of the last mile for e-commerce deliveries and even provide some logistic support to retail operators.
Regional Hotels to Benefit From Repeat Visitors
Lastly, the hotel sector offers promise going into the Tokyo Olympics. A recent change in the Minpaku law (private residence rental) that negatively impact home-sharing platforms like Airbnb, has led to a recovery in overnight hotel stays by foreign visitors. Before the change, there was a discrepancy between inbound arrivals and overnight stays. It is well known that inbound numbers continue to rise and are likely to exceed the government’s upwardly revised target of 40 million visitors. However, due to the strong growth in arrivals, there has also been an increase in limited service hotels that cater to tourists particularly from Asia. As mentioned above, in many cases office buildings are being converted into hotels due to the higher expected returns, and this has led to a stagnation in RevPAR growth.
However, there are some bright spots. Roughly half of the arrivals to Japan are repeat visitors, and they are seeking new experiences in Japan and visiting areas that they have yet to visit before. Their focus is more on experience and less on purchasing of consumables. REITs with exposure outside of Tokyo, Osaka and Kyoto where most of the new development has been occurring are seeing decent RevPAR growth due to this new trend from repeat visitors and limited new supply of hotels in those locations. We think there will continue to be pressure on certain J-REITs with predominately Tokyo, Osaka and Kyoto based hotels despite the strong arrival growth and prefer the regional plays that also typically have strong domestic visitor demand as well.
Residential REITs Had Its Run
Residential REITs have performed reasonably well over the last year. Those with Tokyo concentration have seen strong uplift on tenant replacements and renewals. Cities like Nagoya and Osaka are not seeing the same increase due to the conversion of some small office buildings into multifamily apartments or hotels. The sector offers defensive growth, but asset prices have increased significantly so we are less positive despite the improving fundamentals because actual internal growth is typically much less than the office or urban retail markets. M&A (mergers and acquisition) will continue to be an interesting angle though, and we would not be surprised to see more combinations as we have seen over the past decade, which will lead to larger, more liquid trusts and some scale benefits. It is also likely that some other asset types like senior housing or student accommodation will find their way into residential REIT portfolios, which could offer some exciting opportunities.
Overall, we continue to prefer J-REITs over other markets due to strong leasing conditions especially in office and regional office and see limited risk of higher interest rates or refinancing risk due to the lenient stance of the Bank of Japan towards the sector. Japan’s economy continues to perform well, and we believe this will provide a tailwind to the sector even if interest rates start to edge up.
About the author:
Christian Bernasconi is a Founding Partner of B&I Capital AG based in Singapore with over 20 years of experience as an Asian and Japanese equities specialist and has been based in Switzerland and Singapore over his career. Prior to co-founding B&I Capital in 2007, Bernasconi was an Executive Director at UBS and established the Japan and Asian Equity Sales platform, and was part of the Global Real Estate (RE) Team in Zurich. Prior to joining UBS in 2000, Bernasconi was with W.I. Carr Far East Limited, Paribas Asia Equity and Yamaichi Securities. Currently, he is based in Singapore for B&I Capital.