General Market Overview

Background of Real Estate Securitization in Japan
With the collapse of the bubble in the late 1980s, Japan’s “land myth” of eternally appreciating land and real estate asset values was crushed. The plunge in asset prices that followed this collapse, as well as the outbreak of the Asian financial crisis several years later in 1997 generated a massive amount of non-performing loans (NPL) in the Japanese economy and led to the bankruptcy of several large securities firms, banks and other institutions with weak financial positions. These events precipitated a general call for financial reform, which led to Japan’s “Big Bang” of financial deregulation, aimed at liberalizing and globalizing Japan’s capital markets and financial systems, heightening standards of financial control and management, and broadening the scope of financial business to, among other purposes, facilitate the development in Japan of finance techniques such as securitization that had further evolved in other parts of the world.

Legislation that was to form the foundation of real estate securitization in Japan was first enacted in the mid-1990s, the primary significance of which was to enable issuances of asset-backed securities in 1996, to facilitate the disposal of NPLs in 1997 and to provide overall protection for investors. Entering 1998, the financial “Big Bang” came into full swing with such events as the launch of the Financial Services Agency (FSA), Japan’s chief financial regulatory body, the enactment of legislation regulating the operations of loan servicing companies and the establishment of a registration system for real estate investment advisors. With these developments, the number of major transactions involving securitized real estate soon began to soar.

Growth of Securitized Real Estate and Emergence of the J-REIT Market
With the bankruptcies and general reluctance among lenders to supply funds to real estate following the Asian financial crisis, indirect financing such as non-recourse loans came into general disfavor, and preference grew for direct financing or asset-backed financing, whose interest rates and terms were determined by the risk-return characteristics of the underlying asset (often, real estate) rather than those of the company holding the asset.

Although Japan was relatively new to the global REIT stage among leading industrialized nations, the growth of Japan’s REIT (J-REIT) market exploded soon after its beginnings in late 2000 with the enactment of the Investment Trusts and Investment Corporations Law and the establishment of a J-REIT market on the Tokyo Stock Exchange. Within a few years, the J-REIT market expanded to become the world’s fifth largest market in terms of market cap and fourth largest in terms of number of listed issues. J-REIT shares gained acceptance across a broad spectrum of domestic and overseas investors, primarily for their high returns against bond yields, credibility due to tight regulation and backing from major Japanese real estate conglomerates and low correlation with more traditional equity markets. At the same time, securitized real estate products such as mortgage bonds and other securitization vehicle types such as TMKs (special purpose companies) came into the fore, and securitization’s importance for the development of Japan’s real estate market was firmly entrenched.

As the real estate securitization market expanded, so did the scale and scope of its investment targets. Initially, J-REITs primarily focused on office properties, but soon J-REITs specializing in residential properties, retail facilities, hotel and other leisure properties, and industrial, logistics and infrastructure assets began to appear. Private funds, which had also focused on office property as well as securitized debt products backed by such properties, began to branch out in similar fashion. A tendency toward portfolio diversification also strengthened as the market expanded, with many J-REITs and funds investing in multiple property types, product types and geographic areas.

The astounding growth of the real estate securitization market abruptly halted when banks and other lending institutions began to tighten their flow of capital in the wake of the Lehman Shock and the ensuing financial crisis. A series of real estate related companies then fell into bankruptcy, including the first bankruptcy of an actual J-REIT in October 2008. An industry shakeout began to knock off the more highly levered and less cash prudent companies, calling attention to the importance of strengthening financial management, asset management and prudent governance.

Recent Developments in Japan’s Real Estate Market
While both acquisitions by J-REITs and trading of J-REIT shares have declined significantly since the onset of the crisis due to heightened competition over existing properties, slumping J-REIT share prices and a severe credit crunch, the activities of private real estate funds actually grew slightly through increased holdings of existing funds and launches of new funds. Notably, development activities among these funds have increased, and more overseas investors, particularly pension funds and sovereign funds, are investing in these funds, compensating for the shortfall in funding from domestic banks and other domestic institutions, to capitalize on opportunities created by the crisis as real estate prices adjust and weaker J-REITs and funds begin selling off assets. In addition, both private funds and J-REITs are making concerted efforts to deleverage their balance sheets, with average LTV (loan to value) ratios falling by several points for both types of investment vehicles.

The tough times have also given rise to a spate of consolidations among corporations in terms of their real estate holdings in Japan. Corporations looking to reign in operating costs are consolidating offices, and in the near future expectations abound that even more corporations will look to outsourcing key aspects of management of their real estate, such as asset management, property management and brokerage services, to specialized real estate services firms.

The Japanese government enacted a number of measures in 2009 in step with its efforts to revive a battered economy still reeling from the global financial crisis. These measures included the establishment of a Public-Private Fund (Kanmin Fund) to stimulate new lending to the real estate market and a revision to tax laws to facilitate more M&A activity among REITs to spur industry consolidation and more efficient utilization of capital. Although securitized real estate products, particularly CMBS issuances, have plummeted since the onset of the crisis, real estate fundamentals in Japan are still relatively solid, especially in the office markets of major urban areas, and investor interest in Japanese real estate remains solid with expectations for a sudden increase in activity once prices bottom out.