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RREEF Research September 2007 The Outlook for Real Estate Markets in Japan Table of Contents 1. 1. Introduction………………….1 2. Economic Fundamentals…..2 3. The Case for Real Estate in Japan…………………………6 4. Investment Strategy……….14 5. Market Sector Outlook: Office………………………..18 6. Market Sector Outlook: Retail………………………..24 7. Market Sector Outlook: Industrial/Logistics………...27 8. Market Sector Outlook: Hotel………………………...30 9. Conclusions………………..33 Authors: Tan Yen Keng +852 2203 8062 [email protected] Koichiro Obu Introduction Over recent years there has been a surge of interest from both domestic and foreign investors in Japanese real estate markets. Investment transactions in Tokyo’s commercial real estate market have increased over 13-fold in four years to circa US$30 billion in 20061. As allocations to real estate have risen, investors have responded favourably to the broad-based recovery of the Japanese market. The maturation of real estate markets in Japan has increased the options available for investors. Within this context, this paper explores the opportunities associated with the recovery of real estate markets in Japan and the attractiveness of these markets to institutional investors. Because the drivers of real estate performance move in tandem with the Japanese economy, this paper begins first by exploring the sustainability of economic growth and the recovery of real estate and land prices. Second, the paper examines the opportunities presented by cyclical and structural drivers for investing in Japanese real estate. Third, the paper explores the relative attractiveness of various investment strategies. Finally, the paper outlines the opportunities and outlook for each of the four investible real estate sectors in Japan. The attractiveness of the Japanese real estate market is underscored by a large investible stock coupled with increasing demand from both domestic and foreign investors. Both of these trends are well-entrenched and are set to continue over the longer term. Clearly, Japan remains a highly attractive market, not just in terms of its performance but also for its liquidity and relatively low economic, political, and financial market risks. The options for investors appear ample for both the shorter and longer terms. With that in mind, this paper attempts to provide useful insights for investors seeking to participate in the Japanese real estate market. +81 3 5156 6000 [email protected] Peter Hobbs +44 (0)20 7547 4855 [email protected] Henry Chin +44 (0)20 7545 6611 [email protected] IMPORTANT: PLEASE SEE IMPORTANT DISCLOSURES AND ANALYST CERTIFICATION IMMEDIATELY AT THE END OF THE TEXT OF THIS REPORT 1 RREEF (2007) Global Real Estate Investment and Performance 2006 and 2007, March. JLL. RREEF Research 1 2. Economic Fundamentals Japan is well into a broadbased economic recovery that includes real GDP growth… Japan, the second largest industrialized economy in the world, has largely recovered from a slump that lasted for more than a decade. After the short-lived recovery in the early 2000s, Japan’s economy has resumed expansion at an average growth rate of 2% per annum since 2004. Going forward, real GDP growth is expected to average 2% p.a. for the next three years2, led by a steady expansion in consumption, exports, capital investment, and improvements in labour productivity. Chart 1: Japan’s Real GDP and Growth Rates 1995-2010F Total Real GDP (LHS) Tr n Yen GDP Growth (RHS) 700 7% F o r e c a st 600 6% 500 5% 400 4% 300 3% 200 2% 100 1% 0% 0 95 96 97 98 99 00 01 02 03 04 05 06 07F 08F 09F 10F - 100 - 1% - 200 - 2% - 300 - 3% Source: DB Global Markets Research …consumer spending, exports… Domestic private and composite consumption has been on the rise since 2003, at a CAGR of 2.4%, indicating the recovery and expansion of the domestic market. Exports have also climbed, with an increasing amount going to Asia, where economic growth exceeds that of the US. In 2006, China, South Korea, Taiwan, and Hong Kong together accounted for 34.5% of Japan’s total exports, compared to 22.5% to the US3. 2 3 RREEF Research Deutsche Bank Global Markets Research’s forecast Economist Intelligence Unit 2 Chart 2: Japan’s Private Consumption and Composite Consumption Indices and Customs-Cleared Export Volumes by Destination (2000=100) Private Consumption Index 105 Composite Consumption Index (2000=100) (sa, 3M m o v. avg.) 104 160 103 150 All Destinations U.S. Asia 140 102 130 101 120 100 110 99 100 98 90 97 80 96 70 95 Jan 00 Jan 01 Jan 02 Jan 03 Jan 04 Jan 05 Jan 06 Jan 07 60 Jan 95 Jan 96 Jan 97 Jan 98 Jan 99 Jan 00 Jan 01 Jan 02 Jan 03 Jan 04 Jan 05 Jan 06 Jan 07 Note: Private and Composite Consumption Indices are seasonally adjusted Source: Nikkei NEEDS, Japan Cabinet Office, Japan Ministry of Finance, DB Global Markets Research …capital investment… Capital investment has expanded to meet the rising demand. The ratio of capital investment to gross capital increased from 5.9% to 7.1% between 2002 and 2007. Labour productivity rose by an average of 1.8% between 2000 and 2007. This spurred new economic growth which in turn stimulated job creation. The rate of unemployment fell from the peak of 5.4% in 2002 down to 4.1% in 2006, and is forecast to decrease further going forward. Chart 3: Japan Labour Productivity and Unemployment Rate (%) 10 GDP Growth (LHS) Labor Productivity Growth (RHS) (%) 2 (%) 6 5 1.5 5 4 1 3 2 0 0.5 1 Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan 95 96 97 98 99 00 01 02 03 04 05 06 07 0 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07F 08F 09F 10F 0 -5 Source: Japan Cabinet Office, Japan Ministry of Internal Affairs and Communication, Japan Ministry of Health, Labour, and Welfare, DB Global Markets Research Although the short and medium term economic outlook remains strong, there remain a series of risks and structural challenges facing the Japanese economy. At a global level, the recent financial turmoil caused by the US sub-prime loan crisis poses the most immediate risk, with Japan’s exports being susceptible to a potential slowdown in US economic growth and consumption, as well as the rising Yen due to the RREEF Research 3 unwinding of carry-trade positions4. Domestically, Japan faces structural challenges associated with a declining population that will pose difficulties for sustaining stronger growth over the longer term. Despite these risks and weaknesses, the economic outlook remains positive, at least for the remainder of the decade. …and, finally, real estate. The economic recovery has also begun to impact property markets. Property and land prices in Japan fell into a severe and prolonged downturn following the collapse of the bubble economy in the early 1990s. The subsequent period was characterized by distressed debt restructuring in the nation’s banking sector accompanied by prolonged price deflation5. The stable recovery of the economy since the early 2000s has helped turn around the real estate market. Real estate returns trended positive in 2002 and have increased 40.5% since then. Land prices also have shown signs of upturn since 2004, most notably in the major cities. Chart 4: Japan GDP Growth, Land Price Index, and Property Total Return Japan Re al Es tate M ark e t Ove rvie w All-Property Total Returns (RHS) (1994 = 100) Land Price Index (LHS) GDP Growth (RHS) 120 10.0% 8.0% 100 6.0% 4.0% 80 2.0% 60 0.0% -2.0% 40 -4.0% -6.0% 20 -8.0% 0 -10.0% 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Source: Nikkei NEEDS, DB Global Markets Research, IPD, RREEF Research The commercial land price index for Tokyo and the other five major cities bottomed out in 2004 after 14 years of decline. The commercial land price index for these six major cities has since risen over 30%. Boosted by positive overall economic growth, the recovery of real estate markets in the six major cities is now spilling over to more peripheral markets. The result is a nationwide commercial land price index that at last shows signs of bottoming. 4 Deutsche Bank (2007), Risk of sub-prime contagion to the Japanese economy, August Deutsche Bank Global Markets Research (2007), Japan Economics Weekly – Macroeconomic Conditions for Rise in Japanese Property Price, April 5 RREEF Research 4 Chart 5: Japan Commercial Land Price Indices (2000.3.31=100) 600 Nationwide: Commercial Six Large Cities: Commercial Tokyo 23 Wards: Commercial 500 400 300 200 100 0 Source: Nikkei NEEDS, DB Global Markets Research RREEF Research 5 3. After a prolonged decline, the Japanese real estate market has now moved well into a new growth phase. The Case for Real Estate in Japan Japan’s investible commercial real estate stock is estimated to be around US$1.8 trillion6, making it the largest in Asia and the second largest in the world. The sheer size of the Japanese real estate market accentuates the significance of Japan in the regional and global portfolio. The major participants in the market include listed real estate companies, J-REITs, private funds, foreign investors, and financial institutions. Large listed real estate companies, which are called ‘developers’, have strong positions in the Japanese market, and the market capitalisation of some of the companies’ amount to US$20 billion to US$40 billion. The lacklustre performance of the Japanese real estate market during the decadelong economic recession deterred investors, and new construction starts have declined since the early 1990s7. When the Japanese economy resumed steady recovery in 2003, the low levels of new good quality real estate supply during the prior period resulted in a structural shortage of quality modern space in contrast to newly rising demand. As vacancies declined and rents started to rise, the Japanese real estate market began moving out of contraction into the growth phase of its cycle. Compared with other real estate markets in the UK, US, and several dynamic markets in Asia, Japan is currently well into the sweet spot of this cycle (Chart 6). In addition to the structural shortage of quality modern space, several other structural changes are currently underway that provide significant opportunities. The J-REIT market has been successfully expanding and currently 41 REITs are listed. This helps to increase the market transparency significantly. As the Japanese market has matured, the opportunities available to investors have increased to include the less risky core-type and value-added investment strategies. Chart 6: Position of Office Market Fundamentals through the Cycle USA Czech Rp Hong Kong UK China Singapore Hungary/ Romania Japan Portugal Thailand S.Korea Taiwan/ Malaysia Source: RREEF Research 6 7 RREEF Research RREEF Research (2007) The Future Size of the Global Real Estate Market, July Japan Ministry of Land, Infrastructure, and Transportation 6 Japan accounts for half of the Asia Pacific region’s commercial real estate stock With over US$1.8 trillion of investible commercial real estate stock, Japan accounts for 11% of the global commercial real estate stock and dominates half of the Asia Pacific market. Despite the enormous stock, the level of owner occupation remains high relative to other mature real estate markets such as Hong Kong, and Singapore in the region (Chart 7), and the US and UK globally. and 11% of the worldwide market. Chart 7: “Invested” and “Investible” Real Estate Stocks (US$ Bn) 2000 Invested (LHS) Difference btw Investible and Invested Stock Owner-Occupation Ratio(RHS) 1800 1600 100% 90% 511 80% 1400 70% 1200 60% 1000 50% 800 40% 600 30% 535 400 20% 77 200 134 100 0 Japan China Australia S.Korea India 11 11 Hong Kong Singapore 10% 0% Source: RREEF Research Note: As of year-end 2006 A number of factors converge to underpin Japan’s market opportunities. These include: • increased maturity of lease legislation8; • pressure to improve capital and operational efficiencies; • a high owner-occupation ratio; and • over US$500 billion investible commercial real estate that is currently available in the market. With these structural changes in progress, prospects exist for significant sale and leaseback activity. There are opportunities for institutionalising and securitising real estate within Japan’s large investment market. This process should gain momentum as assets are transferred from owner occupation to the more professionally managed institutional market (Chart 8). 8 Japan’s lease law was revised in March 2002 to allow for fixed-term lease contracts. Because a landlord is not required to renew a fixed-term lease contract at expiry, this equalizes the legal standing of landlords and tenants. In the conventional lease contract, landlords are required to renew tenancy contracts in the absence of ‘reasonable’ reasons for not doing so. RREEF Research 7 Chart 8: “Investible” Market, Owner Occupation Ratios, and Recent Transaction Activity Owner-Occupation Ratio (%) 100 China India Substantial potential for sale and leaseback deals as market matures South Korea 80 Emergent Group Japan 60 Australia 40 Hong Kong 20 Small size of the investment market, but large investment transaction volume Mature Group Singapore 0 0 500 1000 1500 2000 2500 Investible market size ($bn) Notes: Size of bubble represents total transaction activities in 2006. Source: RREEF Research, JLL The recent strong performance of real estate has led to increased interest in the asset class from a wide range of investors9. Across the world, both institutional and retail investors have sought to increase the real estate allocation of their investment portfolios.10 This evolving shift toward real estate has been driven by structural factors such as: Foreign investors are showing renewed interest in Japanese real estate. • aging populations; • higher dependency ratios; • greater exposure to “alternatives”; and • ongoing maturity of the real estate asset class (i.e., broader options for investors seeking to invest in real estate)11. Investor intention surveys by INREV12 and IREI/Kingsley Associates13 demonstrate that demand for foreign real estate by European and US investors continues, and Japan tends to come at the top of the buying list. These surveys partly explain the ongoing strong capital flow into the Asia Pacific region, where investment activity has increased each year since the 2003, reaching US$63 billion in 2006. The scale of the market means that Japan represents close to 50% of all investment activity in the region14 (Chart 9). Since the burst of the bubble economy, Japanese pension funds have been very cautious and resistant to real estate exposure. The current average allocation ratio of real estate to total assets by pension funds is only 1.6% in Japan, compared to 5.0% in the UK, 7.0% in Australia and 8.3% in the US. However, the ratio is expected to increase steadily over the coming years in accordance with the rapidly growing transparency of the Japanese market. 9 RREEF Research (2007), Global Real Estate Investment and Performance 2006 and 2007, March RREEF Research (2007), Global Real Estate Securities, January 11 McKinsey (2006), The Asset Management Industry in 2010 12 INREV (2007), Investment Intention Survey 13 IREI/Kingsley Associates (2007), 2007 Plan Sponsor Survey, January 14 JLL Jones Lang LaSalle, REIS Services 10 RREEF Research 8 Chart 9: Real Estate Investment Activity, by Destination of Investment (US$ Bn) 70 Australia China Hong Kong Japan Singapore S Korea India Others 60 Singapore 50 Singapore 40 Singapore 30 20 Japan Japan Hong Kong 10 Japan Japan Hong Kong Hong Kong China Australia Australia Australia Australia 2003 2004 2005 2006 China 0 Source: RREEF Research, JLL The steady, ongoing maturity of the Japanese real estate market spurs confidence among investors. The weight of capital to real estate continues to grow with an increasing number of domestic, regional, and international investors seeking to access the market. The robust level of investment activity in Japan is highlighted by two key indicators. First, the growing scale and sophistication of the listed real estate market (and J-REITs in particular) has blossomed. And second, the unlisted markets have grown as well. In 2006, the J-REIT market cap rose by 40%, and the unlisted market cap soared 60%.15 The announcement in August of the Pension Fund Association in Tokyo to allocate 5% or ¥650 billion (US$5.6 billion)16 to Japanese real estate investments further strengthens the confidence in Japan’s recovering real estate market17. Although domestic transactions dominate with about 80% of all investment, crossborder investment in Tokyo’s commercial real estate market increased 23-fold in four years to around US$6.3 billion in 2006. The significant increase in investment activity occurred not only in Tokyo, but also in many regional cities such as Yokohama, Osaka, and Nagoya, where domestic (J-REITs and domestic funds) and foreign (Australian LPTs, some US REITs, and international funds) institutions are also investing. This strong weight of capital coupled with the expansion of J-REIT, CMBS and non-recourse bank finance have helped the Japanese real estate market to mature by increasing the scale and liquidity of the market. 15 STB Research Institute (2007), 2006 Market Survey Results, January US$ 1 = ¥116, as at 31 August 2007. This exchange rate is used throughout the report. 17 Nikkei Business Daily, 15 August 2007 16 RREEF Research 9 Chart 10: Investment Activities in Tokyo (Office and Retail) (US$ Mn) 35,000 Domestic Foreign 30,000 25,000 20,000 15,000 10,000 5,000 0 2002 2003 2004 2005 2006 Source: RREEF Research, JLL The office sector remains a favourite choice of investors in Japanese real estate. According to the actual investment transactions compiled by JLL and DTZ, office remains the favourite sector in Japan, and it accounts for over 50% of investment activities. The office sector has traditionally been followed by retail and residential as an investment preference (Chart 11). By 2006, however, the share of industrial investments had grown to represent 20% of total activity. This increase is due to the structural changes underway in this sector (which will be discussed in detail in the subsequent Industrial/Logistics section). Chart 11: Real Estate Investment Activity in Japan, by Sector Office Retail Industrial Residential 100% 90% 80% Industrial 70% 60% 50% 40% 30% Office Office Office 2003 2004 Office 20% 10% 0% 2005 2006 Source: RREEF Research, JLL, DTZ RREEF Research 10 Strong appetite for real estate has also led to significant cap rate compression in recent years (Chart 12). Falling cap rates and rising bond yields have squeezed the spreads. In Japan, these tight spreads are supported by the recovery in rental levels and the strong weight of capital from an increasingly broad-based set of investors. Cap rate compression has characterised many global financial centres in recent years, but spreads in Tokyo still remain attractive. Cap rates for Grade A office in Tokyo have compressed 150 bps to 3% since 2003. Although the current cap rate is low on a nominal basis, the positive spreads of 110 bps are attractive compared to other major global markets (Chart 12). The upward pressure of rising interest rates on the cap rate is more muted in Japan than in other markets. In the US and the UK, by contrast, the narrowness of spreads means there is an increasing risk of an upward movement in cap rates. Chart 12: Cap Rates and Bond Rates for Key Global Markets (%) % Bond Rates 8 Cap Rates 7 6 5 4 3 2 1 0 2003 2004 2005 2007* London City 2003 2004 2005 2007* Paris 2003 2004 2005 2007* Frankfurt 2003 2004 2005 2007* New York 2003 2004 2005 2007* Tokyo Note: Year end data points except 2007 where Q2 cap rates and June 29th bond yields Source: RREEF Research; CBRE; JLL; NREI; Deutsche Bank Global Markets Japanese real estate provides diversification benefits for foreign investors. One of the main reasons behind the rise in cross-border investment relates to the potential diversification benefits from investing in overseas markets. Although there are diversification benefits from investing across property sectors, the advantages are greater still when exploiting the differences in market behaviour across the global markets18. Differences persist across a range of economic, financial, and particularly, real estate factors such as planning regimes and leasing practices. This means that real estate markets remain very local and display significantly different patterns of performance, and this results in low cross-correlations in real estate total returns (Chart 13). Cross-border investment strategies, therefore, can reduce risk significantly. The lower the correlation, the greater the benefits of cross-border diversification. Japan’s particularly beneficial regional pairings are shown in bold (low correlation) with Western Europe and North America. Even within the Asia Pacific region, the inclusion of Japan in the pan-Asian portfolio will yield some diversification benefit. 18 Webb, J., Curcio, R., and Rubens, J. (1988), Diversification Gains from Including Real Estate in Mixed-Asset Portfolios, Decision Sciences; Stevenson, S. (1999), Real Estate's Role in an International Multi-Asset Portfolio: Empirical Evidence Using Irish Data, Journal of Property Research; Conover, M., Friday, S. and Sirmans, G. (2002), Diversification Benefits from Foreign Real Estate Investments, Journal of Real Estate Portfolio Management; Hoesli, M., Lekander, J. and Witkeiwicz, W. (2004), International Evidence on Real Estate as a Portfolio Diversifier, Journal of Real Estate Research RREEF Research 11 Chart 13: Correlation Matrix for Direct Real Estate Total Returns of Japan, Western Europe, North America and Asia-ex-Japan (1997-2006) North America Western Europe Asia ex Japan North America 1 Western Europe 0.68 1 Asia ex Japan 0.35 0.41 1 Japan 0.43 0.44 0.80 Japan 1 Source: Datastream, RREEF Research 2007 The significance of these diversification benefits is demonstrated by optimisation analysis. The inclusion of Japan in a global real estate portfolio improves the riskreturn profile of the global portfolio. The new efficient frontier is shifted upward generating around 40 bps of additional return for the same level of risk as a predominantly ex-Japan portfolio. Chart 14: Efficient Frontiers for Global Real Estate Portfolio with and without Japan 9.0% Global Portfolio including Japan Portfolio Diversification Benefit Portfolio Return 8.5% 8.0% Global Portfolio ex-Japan 7.5% 7.0% 6.5% 2.0% 2.5% 3.0% 3.5% 4.0% 4.5% 5.0% Portfolio Risk Note: The portfolios are based on the historical risk and covariance for the 1997-2006 period and the average expected return for 2007-2011. The average expected return is based on RREEF Research forecast Source REEF Research RREEF Research 12 The still-emerging maturity of many Asia Pacific markets means that alongside their strong growth prospects are significant risks associated with investment (Chart 15). Japan is one of the few exceptions in the region, given its relatively low risk compared with other major Asian markets. Japanese real estate markets have matured markedly in recent years, reducing the risks associated with investing. The revision of the Japanese lease law in 2002 has been followed by the introduction of the Financial Instrument Exchange Law (effective September 2007) to regulate the real estate fund business under Japan’s Financial Supervisory Agency. Both of these legal changes have contributed to the maturity of the market, and this maturation has, in turn, increased the options available for investors (as well as their confidence in the asset class). Chart 15: Risk Analysis, By City 5 Transparency Liquidity Economic Risk Tenancy/Income Risk Political Risk Country Risk Asia Average Risk Score 1= The Lowest Risk 4 3 Global Average 2 1 Shanghai Bangkok Dehli Taipei Seoul Kuala Lumpur Auckland Tokyo Hong Kong Singapore Melbourne Sydney 0 Source: RREEF Research Despite rising maturity, risks associated with transparency and liquidity remain an issue. Despite these improvements, the risks associated with relatively low liquidity and poor transparency remains significant from the international perspective. For instance, although these markets have improved in transparency in terms of data reliability and availability, the limited availability of robust performance measures19 and lack of widespread reporting of transactions increases market risks. 19 RREEF Research IPD Japan real estate performance data is only available from 2003. 13 4. The risk-return spectrum offers a number of investment strategies. Investment Strategy Real estate investment strategies may vary significantly according to the objectives of investors, where selection and allocation decisions have to be made within a broader portfolio context. The range of real estate investment strategies are summarized in Chart 16 in the conventional risk-return spectrum. On the one hand, core/core+ strategies are generally lower risk with an emphasis on delivering a long-term stable income stream. Such strategies tend to track broader market risk and mirror the construct of the market in terms of geography and sector. In contrast, opportunistic strategies tend to have the highest proportion of return coming from non-rental income sources and, due to their high leverage and focus on more volatile and emergent markets/sectors, are much riskier than core-type strategies. Falling in between these two extremes are REITs and value-added strategies. Both REITs and value-added strategies aim to enhance total returns through active asset management. Value-added strategies seek to enhance returns by identifying and anticipating cyclical change; exploiting structural change; and through the possession of a deep understanding of real estate assets in the context of such change, adding real value through asset management strategies that anticipate rather than respond to market change20. In contrast, REITs are bound by regulations on exposure to nonincome-producing investments, debt-to-equity ratios, and payout ratios. This places REITs on a lower risk spectrum than a value-added strategy. It should be noted, however, that due to the listed nature of REITs, they can be exposed to far higher volatility, especially over the short term21. Chart 16: Schematic Representation of Real Estate Investment Styles Potential return Opportunistic High risk High return requirement Value Added Moderate risk Enhanced return requirement J-REIT Medium risk Moderate return requirement Core/Core+ Low risk Low return requirement Note: for illustrative purposes only Source: RREEF Research 20 RREEF Research (2007), European Value Added Investing: Leveraging structural and cyclical real estate opportunities, March 21 Liang, Y. and McIntosh, W. (1998), REIT Style and Performance, Journal of Real Estate Portfolio Management; Seiler, M., Webb, J. and Myer, F. (1999), Are EREITs Real Estate? Journal of Real Estate Portfolio Management; Ling, D. and Naranjo, A. (1999), The Integration of Commercial Real Estate Markets and Stock Markets, Real Estate Economics; Newell, G. (2001), Listed Property Trusts: A Matter of Style, Property Australia; Chau, K. W., Wong, S. K. and Newell, G. (2003), Performance of Property Companies in Hong Kong: A Style Analysis Approach, Journal of Real Estate Portfolio Management RREEF Research 14 Japan’s interest rate differential allows foreign investors to boost returns by 200 bps through hedging In general, the return (IRR) expectation for a core strategy is high single digits with a relatively high income component. This compares with value-added (low teen returns and 30-70% gearing) or opportunistic (18%+ return, most of which is value growth, and 60-100% gearing)22. In a relatively low-interest environment (Chart 17), the expected return in Japan is generally lower. Expected returns in Japan range from 45% (core strategy) to 10-12% (value-added) to 15%+ (opportunistic). However, the interest rate differential between Japan and other countries allows foreign investors to boost returns over 200 bps through hedging23. Chart 17: 10-Year Bond Yields in Major Global Economies Le nding Rate s in M ajor Global Economie s % Japan 12 Euroland UK Australia US Germany 10 8 6 4 2 2007 2Q 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 0 Source: DB Global Markets Research, Datastream Given the range of real estate investment strategies, a systematic framework is necessary to help identify different types of opportunities and strategies in the Japanese real estate markets. Appropriate strategies can be determined along the two dimensions of performance drivers and real estate risks (Chart 18). 22 INREV (2007), Investment Intentions Survey Based on the assumption that the exchange rate between the Japanese yen and foreign currencies remains stable 23 RREEF Research 15 Chart 18: Real Estate Performance Drivers and Risks Determining Market Attractiveness Performance Drivers Market Attractiveness Emerging Geographies Structural Drivers Cyclical Drivers Opportunistic Emerging Products Demand, Supply, Rents Cap Rates & Performance Sale and Leaseback Value Added Market Fundamentals Core Performance & Pricing Real Estate Risks Country & Economic Liquidity, Transparency Market Volatility Institutional Risks Note: for illustrative purposes only Source: RREEF Research Structural and cyclical factors drive performance… Performance is driven by two distinct factors, structural and cyclical. Structural drivers are normally associated with the emergence of real estate markets, such as new real estate products, new geographic markets, or sale and leaseback opportunities. As presented in the earlier sections, Japanese real estate markets have matured with accumulated stocks of older and lower quality products. Through refurbishment, redevelopment, repositioning, and effective asset management, the return performance of the older sub-standard products can be enhanced. According to CBRE’s estimate, only 17% of the office stock in Tokyo is Grade A space. The remaining 83% is of lower quality. This provides a window for asset-enhancement opportunities. With high owner-occupancy ratios and over US$500 billion in privately owned commercial real estate, the structural drivers point toward opportunistic and value-added investment strategies. Real estate markets are highly cyclical. Cyclical factors are important in determining the changing attractiveness of markets at various points within their market cycles. As pointed out in the earlier section, the Japanese commercial real estate market is in its growth cycle. Demand for quality space from both local and foreign companies is supported by the steady economic recovery. Vacancy rates are declining and rents are rising in Tokyo (recovering in regional markets). Cap rates for Grade A office buildings in Tokyo have compressed significantly since 2000 to the current level of 3%. Despite cap rate compression, the spread between 10-year government bond yields and cap rates remains positive24 making Japan one of the few major markets in the world where real estate yields are clearly above the cost of borrowing. The positive spread not only cushions marginal interest rate hikes, but also enables higher leverage to enhance total return. …but investors must also consider the associated risks. Beyond the structural and cyclical drivers of performance, investors need to consider the risks associated with investing in different markets and product types. As discussed in the previous section, these risks involve the volatility of market performance and institutional risks. Institutional risks involve the economic maturity of 24 RREEF Research About 110 bps as at the end of July 2007 16 a country, as well as more real estate-specific factors such as transparency, liquidity, and income security25. Japan offers opportunities for enhancing a global real estate investment strategy. Coupled with structural and cyclical factors, the recovery of the Japanese economy offers a range of real estate return enhancement opportunities that can be exploited. The major challenge to this investment strategy is to capitalise on these opportunities to deliver true value-added returns. The following sections provide an overview of the office, retail, industrial/logistics, and hotel sectors in Japan. For each market sector, the performance drivers, the opportunities, and the market outlooks are discussed in detail. 25 RREEF Research (2007), The Case for Europe: Issues and Options for UK Investors Considering the European Property Market, April RREEF Research 17 5. Tokyo’s robust office demand has not yet diffused to Japan’s more peripheral markets. New office construction in Tokyo is largely committed and office shortages are anticipated. Market Sector Outlook: Office After a prolonged economic slump since the early 1990s, the Japanese labour market began to show signs of turnaround in 2003 with an expansion of part-time jobs, and a strong recovery in full-time employment in 2006. Office demand has finally regained momentum – first in Tokyo and now in other major cities. Further economic growth is still underway, pushing the unemployment rate down to 4.1% at the end of 2006 from a peak of 5.4% in 2002. According to the Miki Office Report (July 2007) , the vacancy rate in Central Tokyo fell to 2.9% for all offices and 0.9% for grade A offices in 2Q 2007. The outlook for office demand is supported by an uptick in private-sector hiring. Employment for new graduates hit a 10-year high in 2006 with no sign of slowing in the near future. Although this robust recovery is clearly apparent in Tokyo and other major cities, it has yet to be become visible in smaller regional cities due to the lagging effect of improving demand. After the collapse of land prices in the early 1990s there was a stagnation of development activity with a sharp fall-off in the level of new construction that persisted for more than a decade. Although Tokyo experienced a surge of new supply in 2003 (the “2003 problem”), net completions were only half of the peak in the early 1990s. Tokyo is also currently in the midst of a major development boom, with a large number of Grade A office projects completing in 2007. Despite this, most of the new space has already been fully occupied (or committed), and the current pent-up market demand has yet to be thoroughly satisfied. This is evident by the improving employment figures and the low replacement rate26 (circa 2%) in recent years compared to 6-8% during the early 1990s. Furthermore, there will only be limited uncommitted new supply in 2008 and 2009 in the pipeline, so the office shortage is not expected to be resolved in the foreseeable future. Chart 19: New Office Supply and Replacement Rate in Tokyo (Million sqm) 8.0% 5.0 Grade A Office Completion (LHS) 4.5 Grade B and Other Offices Completion (LHS) Replacement Rate (RHS) 4.0 6.0% 3.5 3.0 4.0% 2.5 2.0 1.5 2.0% 1.0 0.5 10E 09E 08E 06 07E 05 04 03 02 01 00 99 98 97 96 95 94 93 92 91 0.0% 90 - Source: ‘Tokyo no Tochi’ by Tokyo Metropolitan Government, JLL, RREEF Research Because of strong demand and lack of office space, rents have been recovering strongly in Tokyo. According to Miki, average rents increased by 8.8% in 2006 and continued to accelerate in 1H 2007 (see Chart 20). The most significant increase observed was for large new buildings, where rents surged over 20% in the first six 26 RREEF Research Defined as the percentage of new completion to total stock 18 months to June 2007. Given the structural shortage of quality stock and limited new supply, we expect further rental growth for large floor-plate buildings, which include Grade A and higher quality Grade B offices, of 6%-9% p.a. in the next five years (Chart 20). The rental differential between Grade A and nonGrade A space in Tokyo has widened. Small and mid-size floor-plate office rents were relatively stable in the past two years while large office rents rallied. The rental differential between large and mid-size space has widened substantially and is becoming more attractive to cost-conscious tenants. With large floor-plate (Grade A) office rents expected to continue rising, the better quality mid-size floor-plate offices (especially better quality Grade B office between 50-100 tsubo) will benefit the most from the spill over demand and low-rent advantage. Similarly, upside potential exists for other major cities, including Osaka and Nagoya, where yields have not compressed as much as in Tokyo. These cities could become targets for yield-accretive investment. Currently yields in Osaka and Nagoya are 110 to 120 bps higher than that in Tokyo as shown in Chart 21. Chart 20: Rent Trends by Building’s Floor Plate Size in Central Tokyo (Yen/tsubo/month) (1 tsubo = 3.3 sqm) Large, Newly-built Large (over 100 tsubo) Mid-Size (over 50 tsubo) Small (under 50 tsubo) 30,000 20,000 10,000 98 99 00 01 02 03 04 05 06 07 08F 09F 10F Source: Miki Office Report (historical), RREEF Research (forecast) Chart 21: Cap Rates of Offices in Major Cities Sapporo Fukuoka Nagoya Osaka Tokyo 9% 8% 7% 6% 5% 4% 3% 2% 2H 02 1H 03 2H 03 1H 04 2H 04 1H 05 2H 05 1H 06 2H 06 1H 07 Source: Japan Real Estate Institute RREEF Research 19 The recovery first observed in Tokyo is now showing signs of spreading to other major cities like Osaka and Nagoya. The office market recovery was first observed in Tokyo. Other major cities are following suit, but with several years of delay behind the trend in Tokyo. In Osaka and Nagoya, vacancy rates dropped to 6% in 2006 with office rents picking up slightly by 0.2% and 1.9%, respectively – the first increase in either city in 15 years (see Chart 22). We expect these upward trends to persist going forward due to the growing demand and structural shortage of quality stock. Grade A rental growth in both cities should average 3-5% p.a. over the medium term. As this trend broadens geographically, other regional office markets are expected to recover as well. Chart 22: Office Rents and Vacancy Rates in Major Cities in Japan 0 10,000 5,000 - Vac ancy Rate (% ) 15,000 Yokohama Vacancy 18,000 12 15,000 10 12,000 8 9,000 6 6,000 4 3,000 2 - 0 Vacancy Rate (%) Average Rent 96 97 98 99 00 01 02 03 04 05 06 07 08 F 09 F 10 F Avg. Rent (Yen/tsubo/month) Osaka 20,000 16,000 14,000 12,000 10,000 8,000 6,000 4,000 2,000 - A verage Rent V acancy 14 12 10 8 6 4 2 Vacancy Rate (%) 2 9 8 7 6 5 4 3 2 1 0 25,000 96 97 98 99 00 01 02 03 04 05 06 07 08 F 09 F 10 F 4 V acancy 0 96 97 98 99 00 01 02 03 04 05 06 07 08 F 09 F 10 F 6 Avg. Rent (Yen/tsubo/month) 8 Average Rent Avg. Rent (Yen/tsubo/month) 14,000 12,000 10,000 8,000 6,000 4,000 2,000 - Tokyo V acancy 10 Vacancy Rate (%) A verage Rent 96 97 98 99 00 01 02 03 04 05 06 07 08 F 09 F 10 F Avg. Rent (Yen/tsubo/month) Nagoya Source: Miki Office Report (historical), RREEF Research (forecast) After years of restrained construction levels, Tokyo’s stock of Grade A office space is relatively limited. RREEF Research Despite its position as the world’s largest office stock, Tokyo is also characterized by a scarcity of quality buildings. According to CBRE, aggregate floor space of Grade A buildings in Central Tokyo accounts only for 17% of the total stock in the region, compared to 50-80% in both Central London and Manhattan. 20 Chart 23: Share of Tokyo Office Stock by Quality Grade A 17% Grade B and C 83% Source: CBRE 2007 Owners of existing Grade A office properties tend to be reluctant sellers. Due to the structural shortage of quality office buildings, it is very difficult to acquire Grade A buildings in prime locations in Tokyo. This limited stock of quality buildings is held almost exclusively by major property developers who have no incentive to sell their prime investment properties. Therefore, real estate investors tend to have to pay a premium for acquiring from a very limited pool of prime property. Recently, an increasing number of companies have tried to shift their real estate assets “off-balance sheet,” not only to focus on their core business activities but also to improve their capital structures. This movement has been streamlined by rapid structural changes in the property sector, such as the growth of the real estate fund market and the growing popularity of non-recourse finance in Japan. According to STB Research Institute, the Japanese real estate fund market expanded to ¥12.8 trillion, or US$110 billion, in 1H 2007 (see Chart 24). This is a 28% increase from the previous year or over four times the size of three years ago. The amount is even larger, ¥16.3 trillion or US$141 billion, if identifiable foreign funds investing in Japan are included. RREEF Research 21 Chart 24: Size of Real Estate Fund Market (Bn Yen) J-REITs Private Placement Foreign Funds in Japan 6,000 4,000 2,000 0 1H03 2H03 1H04 2H04 1H05 2H05 1H06 2H06 1H07 Note: No data available for the size of foreign funds investing into Japan in 2H 2006 or before. Source: STB Research Institute Foreign investors have responded to Japan’s increasing transparency as well as the successful expansion of the J-REIT market. RREEF Research Japan’s relatively wide yield spreads and the structural and cyclical opportunities discussed in the previous sections have increasingly attracted foreign investors since 2004. This trend was further fuelled by the successful expansion of the J-REIT market as well as by the growing transparency of the Japanese real estate market in general. As a consequence, significant capital growth was observed in Japanese properties in the last two years, with total returns jumping from 6.4% to 15.8% in 2006 (Chart 25) according to Ikoma. The relatively stable income return means the surge in returns was driven by rental growth and cap rate compression. 22 Chart 25: Performance of Office Properties in Japan (%) 20 Total Return Income Return Capital Growth 10 0 -10 -20 -30 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Source: MTB Ikoma RREEF Research 23 6. The Japanese retail market has been relatively slow to recover. Market Sector Outlook: Retail After Japanese consumer spending peaked in 1992, the retail market faced general downward pressure for more than a decade, as shown on Chart 26. This led to a string of bankruptcies among retailers, along with major restructurings and mergers and acquisitions. However, the recent economic recovery, record profits in the private sector, and generally strong business sentiments led the Bank of Japan to end its zero-interest rate policy in July 2006. This was a symbolic gesture, indicating that the threat of deflation may finally have lifted and that the economy has entered a growth cycle. Yet the long erosion of consumer confidence has been slow to reverse, with Japanese consumers taking a long time to change their restrictive spending habits. Although retail sales have been growing for four consecutive years, the volume is up only 2.2% from the trough in 2002. This contrasts with GDP growth of 8.5% in the same period. In the longer term, growth in the Japanese retail sector should gradually align with broader economic growth. One perceived obstacle has been the income disparity between the rich and the poor – a gap that has widened since the 1990s. This polarisation has resulted in a ‘working poor’ class, which has become a widely discussed political issue in Japan. Chart 26: Retail Sales in Japan and Share of Shopping Centres (Yen Mn) DISPOSABLE INCOME 350,000,000 300,000,000 250,000,000 200,000,000 150,000,000 100,000,000 50,000,000 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990 1989 1988 1987 1986 1985 1984 1983 1982 1981 1980 0 Source: Ministry of Economy, Trade, and Industry; Japan Council of Shopping Centres Japan is inching toward larger scale retailing, but the market is still more fragmented than Western Europe and North America. RREEF Research The Japanese retail market has been very fragmented, with the market share of the top three retailers (Ito-Yokado, Aeon, and Daiei) accounting for only 9% of the total retail food sales in Japan, compared to 53% in France (Carrefour, Intermarche, and E.Leclere) and 27% in the US (Kroger, Wal-Mart, and Albertsons) in 2003 (see Chart 27). The latest trend in the sector, however, is the growing popularity of large-scale shopping centres, with the leading retailers increasing their market shares through organic growth and M&A activities. The sales share of shopping centres against the retail market in Japan has almost doubled in the last 15 years according to Japan Council of Shopping Centres. Their market share rose from only 11.4% in 1991 to 20.6% in 2005 (see Chart 26) while sales of department stores and traditional independent mom-and-pops steadily declined. In the last decade, 70-80% of new 24 shopping centres were developed in suburban areas, typically alongside major roads. This trend coincided with the depopulation of city centres and the rapid development of suburbs. Competition has pushed Japan’s department store chains toward consolidation. Department store sales fell 0.7% to ¥7.8 trillion, or US$67 billion, in 2006, making it the ninth straight year of decline, according to the Japan Department Stores Association. In order to stay competitive, consolidation is rapidly taking place among major department stores. Seibu Department Store and Sogo joined forces in 2003 to create Millennium Retailing, now part of Seven & I Holdings. Daimaru has agreed to take over Matsuzakaya to create the largest department store in the country. Furthermore, Mitsukoshi and Isetan are also in talks to create an even bigger chain. Chart 27: Share of Top 3 Retailers in National Food Retail Markets (Share %) 60 53 51 47 41 40 27 21 20 14 9 Japan Italy Korea US Germany UK Canada France 0 Source: IGD, Global Retailing Note: As of 2003 Chart 28: New Completion of Shopping Centres Town Centre Number of new SC 160 Fringe of Town Suburb New regulation enacted in June 2000 120 80 40 0 94 95 96 97 98 99 00 01 02 03 04 05 06 Source: Japan Council of Shopping Centres Due partly to the polarisation of rich and poor, sales of luxury goods in Japan were not battered – even during sluggish economic conditions. Leading European and RREEF Research 25 domestic retailers opened flagship stores in Ginza and Omotesando (both in Tokyo) and in Shinsai-bashi (Osaka) in order to increase brand prestige and market share. Accordingly, investment in retail properties expanded, with the Japan Real Estate Investor Survey (by Japan Real Estate Institute) reporting the expected cap rate for high-street retail properties at just 4% in Central Tokyo in 3Q 2006, a level where it has since stabilized (see Chart 29). Chart 29: Expected Cap Rates of Retail Properties in Japan (%) 11 10 9 Urban Speciality Stores (%) Tokyo Ginza Tokyo Omotesando Sapporo Sendai 12 Yokohama Osaka Nagoya Fukuoka 11 Suburban Suburban Shopping Shopping Centre Centers Within 1hr to Cent. Tokyo Sendai Nagoya Fukuoka Sapporo Yokohama Osaka 10 8 9 7 8 6 7 5 6 4 5 4 3 Apr-02 Oct- Apr-03 Oct- Apr-04 Oct- Apr-05 Oct- Apr-06 Oct- Apr-07 Oct-02 Apr-03 Oct-03 Apr-04 Oct-04 Apr-05 Oct-05 Apr-06 Oct-06 Apr-07 02 03 04 05 06 Source: Japan Real Estate Institute New national planning laws adopted in 2006 discourage shopping centre development in greenfield suburban areas. Amendments to Japan’s City Planning Law, adopted in May 2006, will regulate development of large-scale commercial facilities such as shopping centres, outlet malls, and cinema complexes in suburban areas. This is the second major regulatory change in seven years. In June 2000, the Large-Scale Retail Store Location Law was enacted with many local governments implementing additional requirements on retailers that opened large-scale stores. When the new law adopted in 2006 comes into effect by the fall 2007, opening new shopping centres will be limited within city centres. This change has made existing store portfolios in the suburbs extremely valuable, and shopping centres have become a popular asset class for developers, private funds, and J-REITs to acquire. Owner occupation is being gradually replaced by sale-and-leaseback, which also helps strengthen the balance sheets of debt-laden retailers27. The introduction of the impairment valuation rule on fixed assets in March 2006 also accelerated leaseback transactions. As a result, investment opportunities for foreign and domestic investors in the Japanese retail sector are gradually increasing. However, it should also be noted that a single key tenant (usually a large-scale supermarket) that has a master lease contract with the owner of the shopping centre tends to control the sub-letting process for the in-line tenants rather than the shopping centre owner. Lease contracts are still very rare for department stores. Currently, there are several J-REITs dedicated to investing in retail properties. The expected cap rates for assets in suburban Tokyo fell from 9% in 2002 to 5.5% in April 2007 (see Chart 29). Relatively little difference is observed between expected cap rates for shopping centres in the Tokyo area and other major cities. Because of the relatively short history of the retail property investment market in Japan, retail market coverage by consultants is limited, and there are no established data or statistics for fundamentals such as rents or vacancy rates. As Japan’s retail investment market matures, data availability and transparency should follow. 27 A recent sale-and-leaseback case is the restructuring of Daiei Inc., one of the largest retailers in Japan. RREEF Research 26 7. Japan’s industrial/logistics sector has only recently emerged as an investmentgrade property type. Market Sector Outlook: Industrial/Logistics Since the beginning of 2000, Japan’s industrial/logistics market has undergone a series of structural changes. Previously, industrial/logistics property was not regarded as an investment grade property type, so coverage by property consultants lagged. Investment and lease markets were undeveloped because the majority of the logistics facilities were owner-occupied. Most of the existing properties were old, small, and not well-suited for modern logistics purposes. The collapse of the Japanese property market in the 1990s was followed by increased competitive pressure to improve distribution efficiency and flexibility. During this transition process, domestic corporations started to adopt new, for-lease logistics facilities. Because the revision of the lease law in 2002 equalised the legal standing of landlord and tenant, it contributed to the development of the lease market in Japan. More Japanese corporations are shifting to modern logistics facilities and sale and leaseback is becoming a popular option. Developers – both domestic and foreign – are actively delivering modern, build-to-suit distribution properties28. New construction of large facilities has been concentrated in Japan’s largest metropolitan areas — Tokyo, Osaka, and Nagoya. The industrial land price index for the six major cities bottomed out in 2006 after continuous decline since 1991. The industrial land price index for the six major cities edged up 2.5% in 2007, whilst the nationwide industrial land price index is now showing signs of bottoming. Chart 30: Industrial Land Price Index Nationwide Industrial 250 6 Large Cities Industrial 200 150 100 50 0 1985 1990 1995 2000 2003 2004 2005 2006 2007 Note: The interval of the index between 1985 and 2000 is 5-year Source: Japan Real Estate Research Institute Significant pent-up demand exists for modern, efficient logistics facilities. New warehouse construction has picked up since 2004, though it is still relatively tepid compared to the early and mid 1990s (see Chart 31). Since 2000, about 7.7 million sqm of modern warehouse space has been added to Japan’s total stock annually. Although this new supply is far below the 10-year annual average of 12.1 million sqm in the 1990s, construction of quality warehouses with large floor plates and high specifications is becoming extremely popular. According to a survey conducted by Japan’s Ministry of Land, Infrastructure, and Transport, the average size of new 28 RREEF Research CBRE Research (2007), Asian Industrial Property Market Flash, Q1 27 logistics properties increased as much as 72% between 2002 and 2006. This increase is driven by construction of multi-tenant facilities, typically with over 100,000 sqm, which are often developed by firms with expertise in industrial warehouse construction. Obsolescence of existing logistics properties has produced pent-up demand for modern and efficient facilities, so there is currently ample demand for more new space. According to ProLogis29, at the current pace of new warehouse construction, it will take at least 20 years to replace the existing obsolete stock with modern facilities. Chart 31: Warehouse Construction Starts in Japan (Ths sqm) 20,000 15,000 10,000 5,000 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Source: Japan Ministry of Land, Infrastructure, and Transportation Asking rents are trending upward again in Tokyo and Nagoya. In line with the broader market recovery, asking rents for warehouse space in the major metropolitan areas has begun to recover. In Tokyo, warehouse rents bottomed out in the first half of 2004 and rose 10% to ¥6,590 per tsubo per month, or US$207 per sqm per year, in 2006. A similar recovery trend has been observed in Nagoya where asking rents rose 11% over the same period. However, the asking rent in Osaka slipped slightly after levelling off in 2004. 29 ProLogis (2007), Global Property Market Review-Asian Distribution and Warehouse Markets, Winter-Spring RREEF Research 28 Chart 32: Average Asking Rents for Warehouses in Tokyo, Osaka and Nagoya (Yen/tsubo/month) Tokyo 23 Wards Osaka Prefecture Nagoya Region 9,000 7,000 5,000 3,000 1,000 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Source: CBRE With the structural changes underway and with Japanese companies striving for greater efficiency and flexibility, the industrial/logistics market will continue to evolve and mature along with the recovering economy. The industrial market has ample room to absorb steady construction of new, modern, and efficient logistics properties as the older and more obsolete products are gradually replaced. RREEF Research 29 8. Investors have shown keen interest in Japan’s hotel market since 2001. Market Sector Outlook: Hotel Japan has been the focus of hotel investment activity in Asia since 2001 and continues to attract high levels of investor interest from abroad (mainly US opportunity funds) as well as from domestic sources (opportunity funds and J-REITs). Japan’s recovering economy and its low-interest-rate environment continues to offer attractive leveraged investment opportunities despite narrowing yield spreads. The growth of hotel J-REITs has generally fallen behind office REITs so far. This is because of the limited scope for rental increases due to long-term fixed price contracts and due to the volatility and seasonality of the hotel business. However, the introduction of an impairment valuation rule on fixed assets in March 2006 is expected to trigger more non-core assets to be released into the market by Japanese companies and we can expect a high level of investment activity going forward. Chart 33: Number of Hotels and Rooms Sold in Japan 1999-2006 Number of Hotels Sold No. of Rooms Sold (RHS) 16,000 70 14,000 60 12,000 50 10,000 40 8,000 30 6,000 20 4,000 10 2,000 0 Number of Rooms Sold No. of Hotels Sold (LHS) 80 0 1999 2000 2001 2002 2003 2004 2005 2006 Source: JLL Hotels Note: based on publicly available data The Japanese government has launched a targeted campaign to attract international tourists. The travel and tourism industry in Japan, which is the underlying demand driver for the hotel market, is improving due to government initiatives and the sustained recovery of the domestic economy. To promote inbound tourism, the Japanese government initiated a ‘Visit Japan’ campaign that targets 12 countries30 (including many high-growth Asian markets). The campaign target is for ten million international arrivals by 2010 (CAGR 9% p.a.). 30 South Korea, Taiwan, China, Hong Kong, US, UK, Germany, France, Singapore, Australia, Thailand, and Canada RREEF Research 30 Chart 34: Composition of Travellers Visiting Japan Inte rnational Trave lle r 100% Bus ine s s Trave lle r 90% 80% 70% 60% 50% Dom e s tic Trave lle r 40% 30% 20% 10% 2016F 2014F 2012F 2010F 2008F 2006 2004 2002 2000 1998 1996 1994 1992 1990 0% Source: World Travel & Tourism Council 2007 Note: F: Forecast Future demand growth is anticipated to comprise domestic, business, and international travellers. Historically, the travel and tourism industry in Japan is dominated by domestic and business travellers (over 95%). Through the government’s initiatives, the low value of the yen and the rising wealth of neighbouring countries, inbound visitors in Japan have already been boosted. According to the World Travel and Tourism Council (WTTC), spending by international travellers is projected to grow at 7.2% p.a. over the next ten years, compared to 2.6% p.a. for domestic and business travellers. However, the possibility of the continued strengthening of the Yen could reduce the scope for Japan to attract international visitors at the rate projected by the WTCC. Two-thirds of the international tourists visiting Japan come from within the increasingly affluent Asia Pacific region. The fast-growing number of international travellers (66% of which come from Asia) is expected to improve the trading performance of high-end (4 and 5-star) hotels because 20% to 50% of the hotel clientele are international travellers. Cities that will benefit from an increase in inbound international travel include Tokyo, Osaka, Kyoto, Nagoya, Yokohama, Fukuoka, Nagasaki, Sapporo, Hiroshima, Okinawa, Narita, Chiba, Kobe, Hakone, and Nara. These cities feature a concentration of tourist attractions, efficient transportation, and accommodation facilities that are convenient for foreigners31. Though Tokyo was historically under-represented by foreign hoteliers, an influx of world-class luxury chains has been witnessed in the city since 2002. This includes the Four Seasons Marunouchi (2002), Grand Hyatt Tokyo (2003), Conrad Tokyo and Mandarin Oriental Tokyo (2005), and Ritz-Carlton and Peninsula Tokyo (2007). The aggregate number of rooms of these hotels is about 1,600 – which effectively doubled the room stock held by foreign luxury hotels in Tokyo. On top of this, InterContinental Hotels Group agreed to join forces with ANA Hotels under an operating joint venture agreement in 2006. 31 RREEF Research Euromonitor International (2006), The Market for Travel and Tourism in Japan, October 31 Occupancy rates for high-end hotels in Tokyo were sluggish between 2000 and 2005 due to the surge of new supply during the period. Nonetheless, occupancy levels have improved in recent years and they are expected to grow further to about 80% in 2007. This is due to an improving economy and anticipated growth of inbound arrivals. With only two major new hotel developments expected to complete between 2008 and 2010, the delivery of new supply will be limited32. Chart 35: ADR, RevPAR and Occupancy for High-End Hotels in Japan Yen ADR (LHS) RevPAR (LHS) Occupancy (RHS) 25000 82% 80% 20000 78% 15000 76% 10000 74% 5000 72% 0 70% 2000 2001 2002 2003 2004 2005 2006 Source: JLL Hotels, RREEF Research 2007 RevPAR has improved since 2004 on the heels of three consecutive years of rising occupancy levels. Though the average daily room rate (ADR) has remained flat over the same period, it appears to have bottomed out. Going forward, we anticipate that the ADR will remain flat (or improve slightly given that many hotels are undergoing renovation). RevPAR is expected to grow modestly on the back of sustained occupancy levels. Renovation and refurbishment will emerge as a necessary strategy to remain competitive. Renovation will play a key role for the future trading potential of older hotels. The appearance of new modern hotels and recently renovated hotels in the market is expected to exert downward pressure on the trading performance of the older hotels that do not undertake renovation or refurbishment. 32 RREEF Research The number of new rooms will only account for about 4% of total hotel room stock in Tokyo. 32 9. Conclusions After a prolonged economic recession since the early 1990s, Japan has finally emerged to enjoy gradual but sustainable economic growth that is supported by rising levels of capital investment, consumption, exports, and labour productivity. This positive trend has been followed by the more recent recovery in the real estate market. During the past few years, the property market has experienced dynamic structural changes as well as a cyclical recovery in major cities, especially in Tokyo. The optimal combination of performance, size, liquidity, and relative risk make Japan an attractive investment option. With half of the investible real estate assets in Asia, it is too big to be ignored in a global or regional portfolio. Moreover, the market is rapidly maturing with structural changes that have stimulated greater liquidity and transparency while increasing investment options and vehicles. The timing of structural and cyclical changes has positioned Japan in a “sweet spot” of positive developments relative to other markets. Some of these converging factors include: • A structural shortage of quality stock (following years of limited construction); • A string of investor-friendly regulatory changes affecting lease contracts, city planning, and real estate funds; • A large investible stock with sale-and-leaseback activity, securitisation, and institutionalisation; • A positive yield spread and interest rate differential that compares favourably against other major global cities; • Low cross-correlations with Western Europe and the U.S. (indicating substantial portfolio diversification benefits); • A limited supply pipeline that is expected to lag demand for the next five years; and • Relatively low economic, political, and financial risk. Traditionally a somewhat opaque market for real estate investors, transparency is now improving in Japan, although it is not yet comparable to most Western European or North American investment markets. A robust history of fundamentals, performance, and transaction data that is widely accessible to investors will emerge only as the various property sectors transition toward greater liquidity and efficiency. Again, that is a trend that is in process that will not fully develop for some time to come. For investors who wish to include Japanese property in their global strategies, the current cyclical and structural position of the market points toward a value-added strategy, at least for the intermediate term. Across the major property types, there are key points for investors to consider: • • RREEF Research In the office market, vacancies are declining and rents are recovering in the major urban markets as corporations are once again hiring and expanding operations in Japan. Solid fundamentals of steady demand and a limited supply of high-quality space will allow office rents in Tokyo to maintain upward momentum. Small Grade A properties and relatively old office stocks provide opportunity for asset-enhancement strategies. The limited supply of Grade A office stock in Tokyo will encourage spill over to Grade B (with a pull-effect on rents) and a ripple effect across regional Japanese cities as office-users rationalise the increasing costs of occupancy. The retail market will benefit from a growing consumer preference for shopping centres that coincides with restrictive new planning laws for 33 • • suburban commercial development. Retail sales growth should eventually align with Japan’s economic growth. Structural changes in the industrial/logistics market are spurring demand for modern, efficient facilities to replace obsolete distribution buildings. The hotel market benefits from the steady economic recovery, but even more so from the Japanese government’s successful targeting of international tourists. New openings of luxury chains stimulate domestic demand as well. Japan is well-positioned in a converging “sweet spot” of both cyclical and structural change. Foreign investors in Japan will find a range of options – across property sectors and investment vehicles – that may fit with their global or regional diversification strategies. RREEF Research 34 ANALYST CERTIFICATION The views expressed in this report accurately reflect the personal views of the undersigned lead analyst. In addition, the undersigned lead analyst has not and will not receive any compensation for providing a specific recommendation or view in this report. (Signed) Peter Hobbs RREEF Research 35 Important disclosure © 2007. All rights reserved. No further distribution is allowed without prior written consent of the Issuer. RREEF is the brand name of the real estate and infrastructure division for the asset management activities of Deutsche Bank AG. In the US this relates to the asset management activities of RREEF America L.L.C.; in Australia: Deutsche Asset Management Australia Limited (ABN 63 116 232 154) Australian financial services license holder; in Hong Kong: Deutsche Asset Management (Hong Kong) Limited (“DeAMHK”); in Japan: Deutsche Securities Inc.; in Singapore, Deutsche Asset Management (Asia) Limited (Company Reg. No. 198701485N) and in the United Kingdom: RREEF Limited, RREEF Global Advisers Limited, Deutsche Asset Management (UK) Limited, and DWS Investment Trust Managers Limited; in addition to other regional entities in the Deutsche Bank Group. Key RREEF research personnel, including Asieh Mansour, Chief Economist and Strategist and Peter Hobbs, Head of Real Estate Research are voting members of the investment committee of certain of the RREEF Alternative Investment Funds. Members of the investment committees vote with respect to underlying investments and/or transactions and certain other matters subjected to a vote of such investment committee. Additionally, research personnel receive, and may in the future receive incentive compensation based on the performance of a certain investment accounts and investment vehicles managed by RREEF and its affiliates. This material is intended for informational purposes only and it is not intended that it be relied on to make any investment decision. It does not constitute investment advice or a recommendation or an offer or solicitation and is not the basis for any contract to purchase or sell any security or other instrument, or for Deutsche Bank AG and its affiliates to enter into or arrange any type of transaction as a consequence of any information contained herein. Neither Deutsche Bank AG nor any of its affiliates, gives any warranty as to the accuracy, reliability or completeness of information which is contained in this document. Except insofar as liability under any statute cannot be excluded, no member of the Deutsche Bank Group, the Issuer or any officer, employee or associate of them accepts any liability (whether arising in contract, in tort or negligence or otherwise) for any error or omission in this document or for any resulting loss or damage whether direct, indirect, consequential or otherwise suffered by the recipient of this document or any other person. The views expressed in this document constitute Deutsche Bank AG or its affiliates’ judgment at the time of issue and are subject to change. This document is only for professional investors. This document was prepared without regard to the specific objectives, financial situation or needs of any particular person who may receive it. 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