Is there still value in Tokyo real estate?

7th August 2015

The Japanese economy, despite being overshadowed by long periods of sluggish domestic demand (and subsequently losing its spot as the world’s 2nd largest economy to China) is still a global leader in many fields; it is highly innovative, technologically advanced with a well-educated workforce. As such, Japan still possesses many of the right ingredients to reassert itself on the world stage.

Continue to the other two articles in this edition of the Global Outlook...

Global monetary policy starts to diverge.

Continued monetary easing has been supporting a steady, albeit slow, recovery in the global economy.  Going forward monetary policies are expected to diverge, but at what pace? Brian Biggs, Research Analyst, Grosvenor Group, explores this further. Click here to read more.

Economic activity in Sweden is improving but do some risks remain?

The Swedish economy recorded solid growth in Q2 2015. What is driving this growth and are there any risks to the outlook? How is the real estate market responding? In this month’s “Questions & Answers”, Dr BĂ©atrice Guedj, Head of Research, Grosvenor Fund Management Europe, provides her insight . Click here to read more.

Recent economic weakness a short-term blip

Recently however, concerns over the country’s economic health have resurfaced.  While growth surged by an annualised rate of 3.9% in Q1 2015 (upwardly revised from the initial 2.4% estimate) recent data releases suggest that momentum has slowed once more.  It is likely the economy will contract in Q2 2015.  Industrial production contracted in May owing to renewed weakness in exports.  Cyclically, the slowdown in private sector capital expenditure in the US and moderation in the global technology cycle have weighed on exports of capital goods and IT-related products.  Structurally, despite weakness in the Japanese yen, manufacturers have not shifted production back to Japan, impeding a more notable improvement in private domestic final sales.

Consumer spending also remained muted despite the ongoing improvement in labour and income conditions (Chart 1).  Real retail sales growth has not recovered to pre consumption tax hike levels, which alongside sluggishness in other consumption-related data, such as shipments of consumption goods and the Household Survey in April and May, suggest that consumer spending in the June quarter will remain soft.  Against this backdrop, consumer price inflation excluding food and energy stayed low at around 0.4%, even as the yen depreciation helped drive up goods inflation.  Higher food prices continue to erode the real purchasing power of household’s nominal income, in turn limiting corporate sector pricing power.

Many positives underpin the medium-term outlook

Investors should however look past the short-term weakness in the economy.  There are still many bright spots underpinning Japan’s medium term outlook.  The first quarter outperformance for instance reflects especially strong capital spending and restocking, underpinned by record corporate profits and healthy balance sheets.  This trend is set to continue with the key business confidence diffusion index for large manufacturers in the Tankan survey rising from +12 in March to +15 in June (Chart 2).  Non-manufacturers are also boosting spending on expectations that private consumption will eventually recover following unevenness from last year’s consumption tax hike.

Meantime, there are emerging anecdotal evidence of Japanese manufacturers, taking advantage of the weak yen, shifting production back to Japan from China and elsewhere.  Record profits have also finally started spurring firms to increase capital investment.  Furthermore, the rapid expansion of online and mobile businesses is driving investment on distribution and inventory networks by retailers and wholesalers.  Hotels and theme parks are also renovating to draw in customers, including foreign tourists attracted by the weak yen. Increasingly over the coming years, it is likely that non-manufacturers may also be investing more on automation to meet a shortage of labour.

Ongoing structural reforms, the 3rd arrow of Abenomics, while taking time, will also help to complement the medium-term cyclical uplift.  The Cabinet of prime-minister Abe recently approved a reforms package, the “Basic Policies for Economic and Fiscal Management and Reform 2015”.  The key message of “no fiscal rehabilitation without economic revival” highlights the government’s belief that economic recovery is a necessary pre-requisite for restoring fiscal health.  Critics have consistently maintained that any fiscal rehabilitation plan should emphases tax increases and expenditure cuts which the Abe administration is deliberately avoiding. 

Indeed, given that the government is prioritising economic revival, there is also a high chance that the planned 2017 tax hike might be postponed especially if the LDP makes another clean sweep of the Upper House elections in the summer of 2016.  This will provide further breathing space for the economy to consolidate its upward trajectory

Tokyo real estate retains good value

Concerns that asset prices have run ahead of real economic fundamentals over the past year are exacerbated by recent weakness in economic momentum.  Such concerns (and that of a bubble) are however overblown.  For one, there is still positive momentum to the economy: according to Consensus Economics, growth will accelerate in the second half, averaging 0.7% on top of a further 1.5% growth next year (which is above trend).  The factors that have underpinned the remarkable performance of the real estate market so far also remain largely intact.  Despite a drop in the public opinion poll numbers due to prime-minister Abe’s defence and security policies, the LDP remains the most electable party.  A strong and stable political leadership with a consistent policy platform will continue to anchor and drive the economy ahead*.  

In turn a coherent and coordinated fiscal and monetary policy environment will be extended to underpin investment and market confidence.  In particular, very aggressive monetary stimulus of more than $2.2 trillion (more than 40% of GDP and twice as powerful as the Fed’s QE program) will continue to hold the yen down, drive up inflationary expectations, bolster exports and corporate profits and boost tourism, spending and investment.  Improving labour market conditions (rising real wage and employment growth) and rising asset values should in turn provide ongoing support to overall consumption heading into the 2020 Olympics.

Despite the sanguine medium term macro backdrop, the question remains whether real estate fundamentals are still supportive of an ongoing recovery in prices.  Since 2013, improving sentiment, supportive lending policies and growing JREIT appetite have pushed pricing higher across all property sectors in Tokyo and key secondary cities. 

Captalisation rates have moved inwards by 100-200 bps over the last two years and are now around 3.5% for Tokyo class A office buildings in prime CBD, close to levels last recorder back in 2007.  While this may be a sign of elevated pricing, it does not suggest that pricing has topped out. 

Office rents, although rising for slightly more than a year now, remain at about 30% below the peak of 2007 (Chart 3).  There is still significant room for rents to increase; with a traditional office lease contract averaging two to three years on a fixed term basis, a rollover from passing to market rent suggests that valuations will continue rising in tandem with income for some time.

In addition, lower leverage levels (around 60-70% versus 90% in 2007) and lower financing costs (the risk free rate is currently around 0.7% and 120 bps lower than the level in 2007) points to more attractive risk-adjusted returns, especially as the growing and vibrant JREIT market continues to provide liquidity and transparency to pricing.

Japan continues to experience the most positive confluence of factors for the real estate market in many years and fundamental support will persist over the medium-term heading into the Olympics.  Tokyo real estate is still well supported, stay on the bandwagon.

* Global Outlook January 2013 issue “Japan: this time will be different”

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