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A Cautious Comeback in Japan

Japan’s economy is finally reviving from its long swoon. GDP grew by 2.7% in 2005 and growth is expected to approach 3% this year. Companies are hiring, labor markets are tightening and domestic consumption is up. “Those factors directly benefit the office sector,” says Nancy Muscatello, a senior research economist who specializes in Asia market research at Boston-based Property and Portfolio Research.

The Tokyo office market has already experienced a rebound. Vacancy rates in central Tokyo have fallen to below 3%, from 8.18% in March 2003, according to the Japanese Real Estate Intitute. Meanwhile, with sale prices rising, cap rates on Tokyo office properties have compressed from 5.3% in March 2003, to 4% today.

A 4% might look like a market top in other parts of the world, but in Japan, where government is still debating whether to end the zero interest rate policy that the Bank of Japan instituted in 2001, that provides a comfortable margin. In March this year, the government had set forth a policy to raise the discount rate, which has been .01% since 2001, but the BOJ has not yet acted and may be putting off a move in the wake of weakening equity markets.

Tokyo Office Metrics
8.18% 8.44% 7.98% 7.15% 5.51% 4.44% 3.41%
Mar-03 Sep-03 Mar-04 Sep-04 Mar-05 Sep-05 Mar-06
Tokyo Office Vacancy Rates | Source: Office Market Report by Miki Shoji
Tokyo Land Price Index
83.7 82.3 81.4 81.3 81.7 83.3 86.6
Mar-03 Sep-03 Mar-04 Sep-04 Mar-05 Sep-05 Mar-06
Source: Urban Land Price Index by JREI

Tomoyuki Yoshida, President of GE Real Estate - Japan, says he is not concerned about rising rates. “With 10-year government bonds now yielding less than 2%, the spread makes sense to everyone,” he says.” Besides, the BOJ is unlikely to increase dramatically, at least this year, in any case.”

Meanwhile, the performance of top properties continues to improve. This spring, large landlords such as Mitsubishi Estate announced plans to raise office rents by 5% to 10% percent. That hike tops an increase from $53.93 to $55.47 per square foot (on average) in the past year in the five central wards of Tokyo.

The increases, however, are likely to slow as more new capacity enters the pipeline. “We expect a pop in 2007, and then some moderation,” Muscatello predicts. “Increasing supply in 2009-2010 should put a damper on vacancy rates, which will filter through to rents,”

As in other major cities, there is a big difference between Class A trophy properties and lesser buildings. “We see a two-tiered market emerging,” adds Scott Girard, Associate Director Investments at Jones Lang LaSalle in Tokyo. Strong demand from multinationals and major corporations, looking to expand, are driving down vacancies and increasing rent and sale prices for Class A buildings. But the market for Class B office space, used by smaller domestic corporations, “lags by 18 months and is only just beginning to experience rental growth,” Girard says.

Suburban and regional land prices may not yet have caught up, according to the index compiled by the Japanese Real Estate Institute. However, the Bank of Japan has recently started converting official data from a simple to a weighted average, indicating a 4% rise in the year to 2006. “So headline surveys give a misleading impression,” says Richard Jerram, Chief Economist for Japan at Macquarie Securities. “Since the major urban areas around Tokyo, Osaka, Nagoya and Fukuoka comprise two thirds of all economic activity, what happens across the rest of the country is not particularly important.”


Developers are responding to the strengthening market with an array of new projects and renovations, which often include “green building” techniques. “Buildings must keep competitive, with modern equipment and energy efficiency,” explains Yoshida. That means overhauling air conditioning systems, raising floors to accommodate cables for communications and, of course, earthquake protection.

One of the high-profile projects in the pipeline is Tokyo Midtown, developed by Mitsui Fudusan Co. It’s a mixed-use office and retail project, with completion scheduled for this December. Its 1.9 million square feet of net leasable office space will account for one quarter of the entire market’s new office space.

Another important project is the Yaesu redevelopment, consisting of two buildings near Tokyo station. “Rail transport is so integral to commuting, that any real estate near the stations becomes attractive,” says Girard.

Overall, however, Tokyo remains a challenging venue for redevelopment projects. “Land is limited, and the city is congested,” says Yoshida. A fragmented ownership basis makes it hard to attain the required critical mass for economic efficiencies. “It takes longer here than in other major world markets,” Girard says.

Investment Vehicles

What has become more efficient in Japan are real estate capital markets. The Japanese REIT market, known as JREITs, has added to transparency, efficiency pricing and forecasting in all property sectors. The first JREITs, Nippon Building Fund and Japan Real Estate Investment, were launched in September 2001. There are now 34 listed REITs, with one or two added each week, paying dividends running from 4 to 4.5%.

With their gargantuan appetites, the REITs are now running out of prime urban real estate to buy and pushing beyond Tokyo.

Private equity REITs, which employ higher leverage, command an even larger share of investment. Where JREITs account for about ?2 trillion, the privately placed trusts add up to ? 6.1 trillion yen, and are expanding all the time.

Securitization has provided another avenue of liquidity into the sector. “Capital from securitization has facilitated the feverish trading of assets,” notes Clay Hunt, managing director at Standard & Poor’s. Japanese CMBS activity began in 1999, with volume of about one trillion yen. Although issuance remained meager until 2002, it has exploded since 2005.

Bubbling Over

Even as the Japanese office market rebounds, real estate investors remain painfully aware of the real estate bubble of the 1980’s that took down the entire economy when it collapsed. This time, they say, a more transparent and liquid market for real estate assets, securitization and the presences of international players, should help keep the markets sane. Back then, retailers and railroads, and major corporations were speculating in real estate. Today’s investors, by contrast, says Kaz Fujiki of the JREI, are mainly the JREITs and specialized funds. “At least they know what they are doing,” he says. .

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