Alternative Investment Management Association
Stuart Porter and Jan-Erik Vehse
As a foretaste for the potential of U.K. REITs for investors and asset managers, this article briefly outlines the J-REIT market in Japan, which has grown exponentially over the five years since inception, providing a diversified alternative real estate asset class for retail and institutional investors, and contributing to the upturn in the Japanese real estate market.
What are REITs?
Real Estate Investment Trusts (“REITs”) are investment trusts with real estate as their underlying assets. Income is generated by rents and sale proceeds and distributed to investors in the form of dividends. Investors receive investment certificates (equivalent to share certificates), which can be traded like shares.
The policy behind REITs is that they create new financing sources and increase the liquidity and efficiency of the real estate market. They allow for investment diversification, are readily tradable investments under professional management, and seek to produce annual returns in the form of a stable flow of dividends.
Japan rapidly advanced to be the third largest REIT market in only a few years, in asset terms behind only the US (established since 1960) and Australian listed property trusts (since 1971). Japan was the first REIT market to emerge in Asia, and REITS have since been adopted more widely in Singapore, Hong Kong, Malaysia, Thailand and Korea.
What are J-REITs?
The Japanese REIT (“J-REITs”) investment vehicle was modeled on U.S. REITs. Like the U.S. REIT, distributions paid to investors are, under qualifying conditions, deductible from its taxable income, thereby providing a tax-efficient flow-through investment vehicle for investors.
Revisions in May 2000 (effective from 1 November 2000) to the Investment Trust and Investment Corporation Law permitted investment trusts to invest in real estate. Shortly thereafter, effective from September 2001, the Tokyo Stock Exchange (“TSE”) created a system for trading J-REITs. The first two J-REITs (Nippon Building Fund and Japan Real Estate Investment Corporation) were listed in September 2001, and the market has grown rapidly since, with a total value of listed J-REITs of more than JPY3.2 trillion by March 2006 and forecasted to top JPY4 trillion by year end.
Currently, there are 32 listed J-REITs, among them four listed in 2006 (with a total of 13 listed in 2005) with many more in the pipeline; 30 listed on the TSE and one each on the Osaka and Jasdaq stock exchanges. However, the size of the newer J-REITs does tend to be smaller than the early market entrants.
The first J-REITs invested mainly in office buildings, but the third J-REIT (Japan Retail Fund), listed in 2002, invested in commercial buildings and J-REITs now, as a class, mark the continuing segmentation and diversification of the overall real estate market, extending coverage to residential, commercial, logistics and hotel properties. Major investors are local banks, individual investors and foreign institutional investors, attracted by the high dividend yield. Apart from sheer growth, the next stage is witnessing the establishment and promotion of “fund of fund” and global REITs.
Figure 1: J-REIT Market Capitalisation
Source: Mitsui Fudosan Real Estate Investment Research Institute, Statistical Chart March 2006
Setting up a J-REIT
J-REITs are highly regulated and take approximately one year to establish. The first step is to establish an asset management company and acquire a Building Lots and Building Transactions Agent Licence and a Discretionary Transaction Agent Licence from the National Land and Transportation Ministry. Once obtained, the asset management company must apply for registration with the Financial Services Agency (“FSA”). During this preliminary stage, properties are often assembled using interim vehicles for subsequent transfer to the J-REIT, or transferred from fund vehicles that may have achieved above par returns and wish to arrange an exit from one class of investors to create an asset class for more retail and institutional investor demand and risk profile.
Under the Investment Trust Law (“ITL”), a J-REIT may be established in the form of a contract or company-type investment trust. Whilst certificates of both types are tradable on the TSE, J-REITs are exclusively the corporate type. When the first J-REITs were formed, the trust type was administratively cumbersome and more expensive to establish. In addition, corporate governance rules applicable to the corporate type were considered more attractive to investors.
As a result, the first publicly-listed J-REITs were all corporate type, despite the trust type having certain tax advantages. Although the tax law has since been amended to unravel some of the administrative requirements, business practice has continued to use corporate types since it is the accepted norm in the market.
The basic premise for the corporate type is that a special purpose corporation, established for the purpose of investing in and managing real estate assets, uses investors’ money and third party funding to buy real estate, in return for which investors receive investment certificates carrying ownership rights, including dividend entitlement. These certificates can be bought and sold on the Japanese stock exchange where they are listed. Although the corporation is technically responsible for owning and managing the real estate properties, in reality this function is sub-contracted to a third party manager.
Figure 2: J-REIT Structure
Custody of assets, more precisely custody of certificate of beneficiary and hard assets, is carried out by trust banks on behalf of the investment corporation. Other administrative duties, such as registration of investment certificate holders and issue of new certificates, are handled by investment trusts and securities companies, respectively, on behalf of the investment corporation. Real estate management companies handle all aspects of the direct management of the real estate assets, including physical management of the real estate properties and handling rental contracts and invoices (usually physical management is handled by property management companies).
Given that investors in J-REITs are doing so as a substitute for direct investment in real estate, the main focus of the TSE's J-REIT listing criteria is on the nature and proportion of real estate assets under management (AUM). The main requirements are summarised in Figure 3.
Figure 3: Listing Requirements
Attractiveness of J-REITs
The attractiveness of J-REITs among domestic and foreign investors is generally due to:
• credibility of sponsors
• comfort from strict regulation
• high yields compared to bond interest
• return stability; and
• opportunity to invest in a diversified Japanese real estate portfolio.
Performance of J-REIT market
Average yields are still well above bond yields, but have shrunk from a peak of more than 6% in 2002 to currently 3.5%, a spread below 200 bps. The following chart depicts the yield comparison between J-REITs and Japanese government bonds (“JGBs”) over the last four and a half years.
Figure 4: J-REIT Index, estimated dividend yields and comparison to 10-year government bonds
Source: Mitsui Fudosan Real Estate Investment Research Institute, Statistical Chart March 2006
Taxation at J-REIT level
J-REITs are not flow-through vehicles in the traditional sense where income is only taxed at the shareholder level. A J-REIT is taxable like any other Japanese corporation; however, the effective taxation resembles a flow-through vehicle, as deductibility of distributed dividends (albeit subject to detailed requirements) reduces the REIT tax liability of corporation tax to virtually zero. There are transfer taxes that may be applicable on the purchase of real estate, although there are concessionary rates for J-REITs and often by purchasing beneficiary interests in land and building through trust certificates, the imposition of transfer taxes is minimised.
Figure 5: Main requirements for dividend deductibility
Main continuing requirements
· Registration under the Investment Corporation Law
· Public offering in Japan (form and amount of investment unit)
· Total initial issue value at the set up of J-REIT should be publicly traded and at least JPY 100m; or shares held by at least 50 investors or solely by qualified institutional investors (“QIIs”) at every fiscal period end
· Shares mainly offered in Japan
· Fiscal period not exceeding one year
· Distribute more than 90% of distributable income
· Avoid family company characterisation
· Generally not hold 50% or more of equity of another company
· Not receive loans from parties other than QIIs
Taxation at J-REIT investor level for foreign investors
Foreign investors who do not have a presence in Japan are generally subject to Japanese taxation in J-REITs as follows:
• Withholding tax on dividends from REITs (currently 7% but scheduled to rise to 15% on or after 1 April 2008); and
• Taxation at the rate of 30% for corporations and 15% for individuals on capital gains on disposals (by reporting and filing Japanese tax returns) if investors and related parties’ holding exceed 5% of the listed J-REIT.
Investors resident in jurisdictions with a double tax treaty with Japan may be entitled to exemptions and reductions from the above Japanese taxes depending on the precise terms of the double tax treaty and whether the investor is duly entitled.
The J-REIT market is likely to continue growing in the medium term. The impact of J-REITs on the real estate market has manifested itself (in conjunction with the large and expanding unlisted real estate funds investing in Japan) in intensifying competition to acquire properties, contributing to rising prices, especially in central Tokyo, and driving down yields. J-REITs and other real estate investors in Japan have responded to these challenges by investing in development properties and increasing investment in new asset types or properties outside Tokyo. Real estate asset managers have been able to capitalise on the appeal of J-REITs, and earn profits on disposals to J-REITs and ongoing management fees on the J-REIT itself.
Now that the Bank of Japan has started to phase out its zero interest rate policy (known as quantitative easing), pressure on yields has started to materialise, especially for highly leveraged investments. However, these effects are being compensated by higher property and rental pricing due to Japan’s strong economic recovery.