The 2020 Olympic Village in Tokyo is under construction. (Setsukon)

TOKYO—As we move forward to the much-­anticipated 2020 Tokyo Olympics, it is time for a reality check in Japanese real estate markets. Asset prices in Japan have risen strongly in recent years, fueled by influences including cheap and abundant capital, positive yield spreads, slow but steady economic growth, and a resurgent tourism sector that has proved to be a boon for local retailers. And, not least, positive sentiment around the 2020 Summer Olympics has been a factor, with many investors believing the market will remain buoyant until after the Games are finished.

Recently, however, perceptions have shifted, with a growing body of opinion gravitating towards the view that a correction may occur well before summer 2020. Whilst there is not necessarily a singular event that will cause this to happen, I see several factors that are likely to weigh on the market beginning this year.

Central Bank Policy

Perhaps the biggest concern centres on the economy. Unsurprisingly, the Bank of Japan (BOJ) announced early this year that it would extend its policies of qualitative and quantitative easing (QE) (including negative interest rates of –0.1 per cent for short-term debt and 0 per cent for 10-year Japanese government bonds [JGBs]). In addition, the BOJ increased the government’s Asset Purchase Program to an annual 6 trillion yen per year for exchange-traded funds (ETFs) and 90 billion yen for Japan real estate investment trust (J-REIT) shares. Nationalisation of Japan’s public equity markets therefore continues unabated.

But while the BOJ has maintained gross domestic product (GDP) growth forecasts at 2 per cent per year, ongoing economic expansion will clearly be challenging in light of a number of converging themes: global economic uncertainties, the ongoing trade war between the United States and China (Japan’s two largest trading partners), volatile public equity markets, and a strengthening yen.

Add to this the upcoming increase in the consumption tax from 8 per cent to 10 per cent, which will be effective starting October 1, and it becomes clear that the headwinds facing Japan’s recently positive economic performance are growing.

What’s more, after a prolonged period of QE, the government is running out of arrows in its economic quiver. With few alternatives other than to increase purchases of JGBs as the BOJ did most recently at the beginning of 2019, growth targets are likely to be revised downward to a range of 1.0 per cent to 1.4 per cent around the middle of the year. Indeed, some economists have suggested that Japan may slide into a recession during the fiscal year that started April 1.

Record Bank Lending

One major driver of rising asset prices in Japan has been an abundance of low-cost debt. Outstanding real estate financing from domestic banks reached 78.94 trillion yen (US$712 billion) at the end of 2018, the highest figure on record and the fourth consecutive annual increase, according to BOJ data.
But while ultra-low interest rates may be beneficial for investors, the impact on bank profits has been negative, and has driven some to adopt riskier lending strategies. The recent trend of regional

banks becoming active as direct lenders for assets located in Tokyo, in direct competition with Japan’s megabanks, is one example of this; before, regional banks would only participate in a syndication led by one of the major institutions.

Concerns over heightened risk have led many Japanese lenders to adopt slightly more conservative views on new loans, lowering loan-to-value ratios and slightly increasing spreads. Residential loans, in particular, have been affected by tighter underwriting standards following the recent Suruga Bank scandal, in which appraised values were artificially increased by the bank. Investors should therefore anticipate a tightened lending market for real estate assets in 2019 and into 2020.

Currency and Trade Wars

For several years, a weaker yen has been a boon to Japanese exports and the economy generally. But the recent shift in U.S. monetary policy has generated greater uncertainty over the yen/dollar exchange rate, and the signs going forward appear ominous, with U.S. trade representatives recently indicating they intend to push for a provision limiting Japan’s ability to devalue the yen.

In addition, Washington is pushing for Japan to open up its agricultural markets and to limit its auto exports to the United States. Indeed, a trade war may be looming in the near term, as the White House pushes for punitive tariffs on Japanese car makers—a prospect I see as one of the larger threats to the Japanese economy.

Declining Consumer Consumption

Another problem relates to declining consumer spending. Long a pillar of economic growth, private consumption accounts for roughly half of Japan’s economy. With consumer confidence dipping, however, that pillar may also be at risk.

One reason for this is an upcoming increase to the consumption tax, which is set to rise to 10 per cent from the current 8 per cent in October. Although the government is planning an 18 billion–yen stimulus package to offset its impact, the programme appears to be more a public relations campaign than anything else, featuring enticements like gift cards and 5 per cent cash-back programs. The impact on domestic consumption is likely to be significant.

Tourism

The first word that comes to mind regarding tourism in Japan is: finally! Finally, Japan has come to realize that culturally, it is a true tourist destination that has long been overlooked. In recent years, tourism has become increasingly important to the economy—more than 31 million visitors arrived in 2018, and the total is projected to rise to 40 million in 2019.

At the same time, however, tourism is something of a double-edged sword. From a social perspective, it can create lifestyle changes for people who reside in heavily visited tourist areas such as Kyoto. Economically, too, tourism revenue tends to be unstable since global economic and political issues can cause abrupt decreases in visitor numbers and associated spending. Indeed, 2018 saw a significant decline in Japanese per-capita tourist consumption—particularly among Chinese visitors—as a result of a stronger yen. The fact that some 74 per cent of visitors to Japan originate from Greater China and South Korea, both of which have ongoing disputes with the Japanese government, creates another significant risk to incoming tourist flows.

Property Markets

How will these issues affect real estate? For now, the fundamentals in Tokyo remain strong, particularly in the office sector, where vacancies stood at less than 2 per cent at the end of 2018, with surprisingly quick uptake of new supply. In newly developed buildings, vacancies are a mere 3.5 per cent, down from a level of almost 30 per cent as recently as May 2017. Expect the office market to remain tight, with moderate rent growth through 2020.

That said, a total of 1.2 million square metres (12.9 million sq ft) of new office space will be added in Tokyo in 2019 and 2020, increasing total stock by approximately 9 per cent. This may weigh on the market going forward. As for capital values, prices of new class A buildings in Tokyo are around 31.4 million yen per square metre, with net operating income (NOI) cap rates averaging around (or just below) 3.0 per cent, when available. Class B office buildings are trading between 3.5 per cent and 3.8 per cent in the five major wards, depending on age.

Residential Markets

Driven primarily by foreign buyers as well as Japanese from outside the capital, prices of Tokyo’s for-sale residential condominiums (bunjyo) are reaching record levels. According to the Real Estate Economic Institute, the average price per square metre of condos in Tokyo’s 23 wards increased by 22 per cent during the course of 2019 to 1.198 million yen. With per-square-meter prices of new condominiums up 41.3 per cent since January 2015, increased values have effectively priced middle-class buyers out of the market in central Tokyo.

The multifamily market, meanwhile, has seen similar price increases and a corresponding decline in investment returns. In fact, the multifamily sector has become the sector du jour for many foreign and domestic investors, increasing competition for assets and driving values up. Pricing per square metre varies by submarket, but two things are clear: pricing reflects a premium to replacement cost; and in some markets, the price per square metre for rental assets exceeds the price per square metre of condos.

With NOI cap rates in most submarkets in Tokyo now between 3.0 per cent and 3.5 per cent, investors have little room to maneuver should occupancy and/or rental rates decline. Newer assets located in submarkets with strong demographics have recently seen significant rent growth (i.e., upwards of 5 per cent year-over-year), but this has been driven by strong demand and limited new supply rather than wage growth. Low yields also raise concerns if the Japanese economy contracts, as many economists have predicted. Given the overall dynamics of the multifamily market, I don’t think that investors need to be concerned about a dramatic drop in values or rents. They should, however, be wary of underwriting overly aggressive rent growth.

Logistics Market

The logistics market continues to be an investor favourite, and rightfully so, given strong demand, good rent growth, and a supply pipeline that has kept pace with demand without creating oversupply. If you are an existing investor in the sector, prospects are good. If you are looking to gain exposure, however, it is not easy to find deals given that the major logistics developers now have such a strong foothold in the sector. As a result, investors are looking at ancillary logistics facilities such as self-storage, cold storage, and smaller, single- or two-level projects that are often overlooked by larger players.

Retail Market

The retail sector, particularly urban retail, has been reaping the gains of growing consumption by both domestic shoppers and tourists for several years. Suburban retail is the exception, as it struggles to fight off e-commerce players as well as competition from retail giant AEON, whose rapid expansion has created a very bifurcated market for suburban centres: i.e., those that contain AEON properties and those that do not. This phenomenon has been exacerbated by the advent of AEON’s J-REIT vehicle, which will acquire any mall doing well while also litigating to reduce rent in malls where they are a tenant. In broader terms, investor interest in retail continues to decline generally with the exception of urban high-street assets, which currently trade in the high–2 per cent/low–3 per cent cap rates when available. The aforementioned increased consumption tax will undoubtedly have a negative effect on the retail sector going forward, however.

Conclusion

On the surface, the Japanese real estate market looks to be humming along nicely, buoyed by a long track record of generally good fundamentals, low-cost debt, and an abundance of both domestic and foreign investment capital. Scratch the surface, though, and you find several issues that are beginning to cause concern. Most of these on their own are unlikely to cause a reversal. Seen in their entirety, however, they suggest that a market correction is likely to occur soon—and quite possibly before the 2020 Olympic Games. That may be worrying for some, but for many investors it would be welcome news.

KENNETH FRIDLEY is president of Capbridge Investors K.K., a real estate investment advisory firm based in Tokyo.