Foreign Capital in Japan's Property Markets Face Currency, Tax Challenges

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These are heady days for Japanese real estate, particularly in the country's two largest cities, Tokyo and Osaka. Many major investors have pegged the country as one of the best, if not the best, place to put money to work this year.
 
Buying Tokyo real-estate is the second-best idea for what to do with your money in Japan, according to the investment house BlackRock, which noted in its report "Rising Sun, Setting Sun" that the situation in the Japanese capital is very similar to that in the 1980s. Vacancies are falling, which points to rising commercial rents.
 
Some go further. Tokyo has the best prospects among the world's major cities for residential returns in the next five years, according to Real Estate Foresight, an independent property research company based in Hong Kong.
 
But a recent consumption-tax hike and a pause in the yen's weakening is giving some Japan watchers pause for thought. International investors are beginning to question whether Prime Minister Shinzo Abe's program of "Abenomics" designed to re-inflate and reform Japan's economy will really work.
 
For now, the fundamentals look good for bricks and mortar. Borrowing costs are low, and offer an attractive spread when compared with rents, which are now rising. Residential occupancy in Tokyo has been above 95 per cent for more than four years. Tokyo condo prices are climbing again, and land prices in the biggest cities have risen for the first time in six years.
 
The yen depreciated 35 percent between Abe's election as his party's leader and the end of last year. That supercharged the country's stock markets, with the Nikkei 225 index rocketing up 52 percent last year, the best performance by a developed market by some stretch.
 
The weaker yen is good news for the growing number of residents in Tokyo and Osaka. Those two cities used to top a worldwide cost-of-living survey compiled by the Economist Intelligence Unit (EIU). But they have fallen dramatically in the last 12 months, with Tokyo sliding to joint-sixth place, and Singapore taking over at the top of the ranking. Singapore's currency has risen 40 percent over the last decade, explaining much of its rise.
 
In February, Economist Intelligence Unit chief economist Simon Baptist noted that welcome mild inflationary pressures "are looking more entrenched" in Japan, with corporate profits strong, encouraging the group to forecast GDP growth of 1.7 percent in 2014, the same rate as last year. While not stellar, that level of growth is at least progress after two decades of aimless wandering in the economic wilderness.
 
Hard assets such as property are great hedges against inflation, which should also drive prices higher. However, the yen has stopped its selloff, and has in fact gained 2.5 percent this year. In response, the Nikkei has fallen 11 percent through April 23. That's now the worst performance among developed equity markets - both the S&P 500 in the United States and the Euro Stoxx 50 are slightly in the back so far this year.
 
The yen's pause and the poor stock performance have coincided with a deterioration in investor confidence and expectations.
 
"Time is running out for Mr. Abe to implement reforms," Société Générale warns, noting that sentiment among Japan investors is at its lowest level since Abe's election in late 2012. Even if Japan's central bank pumps even more money via quantitative easing in the second half of this year, "the big adjustment to the yen's value may now be behind us," the bank says.
 
It's also not yet clear what impact the increase of Japan's sales tax to 8 percent, up from 5 percent, will have - it only went into effect this month after the end of Japan's fiscal year in March. The government plans to hike the tax again in October 2015, to 10 percent.
 
Abe says a supplementary budget to be implemented later this year will offset two-thirds of that impact, and policymakers see little impact. "We are less confident," BlackRock's team says. "Around 40 percent of the spending is based on slow-moving public works projects," and consumers simply moved spending forward to beat the tax, masking the negative impact likely to become clear in the rest of the year.
 
Japan watchers have their eye on two potential "game changers" that could revitalize sentiment. Abe is considering a corporate tax cut to offset the sales tax hike, in a country where the 35.6 percent rate is much higher than the developed-world average of 25 percent. Economists are watching to see if companies will raise wages - as Toyota recently did - step up capital expenditures, and take on more risk.
 
Abe also likely has the political capital necessary to push through Japan's involvement in the Trans-Pacific Partnership (TPP).  The TPP represents a potentially tectonic level of shift in Japan's overseas trade relationships. An entrenched agricultural lobby of small-time farmers and a massive structure of farm co-operatives that administer subsidies have blocked any attempt to increase food imports into Japan, reduce prices and improve productivity. Rice has tariffs of close to 800 percent, for instance, even though most Japanese rice farmers are now over 60, farm small plots part-time and produce worse-quality rise than in Japan's heyday.
 
The United States, a main driver of what would become the largest trade agreement in the world, is pushing for the removal of duties on dairy product, beef and pork, and greater customs-free imports on rice and wheat. In exchange, Japan is pushing for car-import tariffs into the United States to be removed.
 
Japan's urban population is beginning to realize the country can't retain the status quo, and the "feel-good" factor over Abe's election and decent majority may give him the clout to change policies that have resisted any reform efforts in the past, under a string of weak, poorly supported prime ministers (including Abe in his first term)
 
Investment properties in the center of Tokyo and Osaka look particularly attractive, even if Abenomics stalls. Smaller units that target single occupiers generate better rents than their larger counterparts, and the three central wards command a 19.5 percent rental premium compared to the rest of the city.
 
Japan is an interesting investment target. Tokyo and Osaka have shot to the top of the attractiveness rankings after two decades as ugly stepchildren. Abenomics has been a major reason behind the makeover ever since Prime Minister Shinzo Abe's election in late 2012, and the extra government spending that has pumped into the economy. But low borrowing costs, rising rents and security of ownership are positive longer-term trends.
 
Japanese real estate, like that in South Korea, Hong Kong and Malaysia, allows foreigners to own free title on real-estate holdings. That protection and the economic stability of Tokyo and Osaka make a compelling argument for bricks and mortar in what is still the third-largest economy in the world.
 
While Japan as a whole has a shrinking, ageing population - both extremely negative factors when considering prospects for real-estate prices - Tokyo and Osaka continue to attract residents. The population of the three-most-central of Tokyo's 23 wards (Meguro, Minato and Shibuya) rose 1.2 percent last year, double the rate of the city as a whole, which now has 13.3 million residents. Japan is getting increasingly urban, and household size continues to shrink, driving demand for apartments.
 
Average rents in those three central wards rose 1.9 percent last year, according to Savills, to ¥395 (US$3.87) per square foot, while rents in the city as a whole were flat. A 500-square-foot mid-market apartment would therefore command a rent equivalent to HK$15,000 per month.