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The Japan residential sector has been hit hard the last half year:

1) Smaller J-REITs with a market cap under JPY 30 billion initially have had trouble from the start convincing the market they could grow and boost liquidity so received a discount to the other sectors.

2) This year even the larger resi J-REITs got pushed down over the higher rent growth seen in office and retail, continued emersion of assets with questionable earthquake resistance remant from the Aneha incident last year, and rising construction costs.

3) The overall market has been pushed down on global credit concerns but coincidentally regulators began to cut the money supply to real estate on concerns over an asset bubble… strange timing!

4) The result is that the sector has dropped 50%, some are discounted to near 50% of NAV, sector yield is averaging 8% with some over 10% and average implied cap rates are now at 6% – that`s about 5% over the 10 yr bond yield folks.

So there is a big discount for residential, is it justified?  Well, we would think otherwise…

1) Rents and occupancy in the central cities have not moved, but actually trended upwards.  Virtually 100% occupancy when accounting for normal turnover – how does that compare with other major global cities!  Even as some weakness is being seen in the overall Japan economy, if it continues urban residential rents will be the very last sector to suffer and it will take several years of a serious recession to have an impact.  So this is not the problem.

2) Architectural worries, economic worries and issues with developers have cut consumer demand so strata sales have declined.  Overregulation after the Aneha scandal and increased construction costs has  nearly halved new supply just this year, and new construction start figures show the supply will continue downward.   With the urbanization to central areas continuing to move population up and the drop in supply, rents (and prices) should theoretically go up in the coming years.

So what is the big issue, and is it sustainable?

Debt financing has dried up, J-REITS can`t buy, so developers with projects in the works and funds with refinancing terms pressing must cut prices to create liquidity or they are out of luck like Urban and Zephyr, Sohken Homes, Sebon falling the last few weeks and more in the pipeline.

The solution comes down when will financing become readily available again, which is unforeseeable at this point but the pressure for policy change and deregulation is coming on very strong now.  Meanwhile, those willing to buy at conservative LTVs will enjoy a very nice yield indeed…

Where else in the developing world, yet a major city, can you find yield spreads at 5% and above?  It was about this level in Tokyo when the foreign investment banks and `vulture` funds started looking at Japan last and spurred development of the securitization market reaping huge profits on low borrowing rates and normalization of the spread over several years.

Do I hear hovering?


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