Is Japan the industrial world’s ultimate property bargain?

As seen in this month’s issue of Master Investor Magazine.

A 12-part series of articles by Swen Lorenz, reporting about easy-to-access investment opportunities in high quality real estate around the world.

Successful investing doesn’t necessarily require academic skills. Common sense, a healthy sense of observation, and an open mind are at least just as valuable as an ability to analyse policies of central banks and interest rate trends.

My colleague, Filipe R. Costa, has already taken care of analysing the macro environment of Japan’s economy. That’s why I’ll focus on what I do best: scoping the world for opportunities that I believe are undervalued and which offer a good risk/reward ratio. As it happens, the subject of our cover story, Japan, fits right into the profile I target for property investments. I even found a quoted company that offers pure, unadulterated exposure to Japanese property, and which currently pays a yield of 6.7%.

But more on that later. Let’s first look at some of the tell-tale signs of a property market being so undervalued that the only way for it is up.

Recollecting the German opportunity

Whether a property market is cheap and worthy of an investment can often be checked against a simple, but effective check-list:

– Can properties be bought for less than their replacement value?

– When you visit the country, does it appear “cheap” on the basis of day-to-day living expenses?

– Do rental yields offer a return of at least 5% or possibly even more than that?

All of these factors held true in Germany back in 2005. This was the time when the German property market started to gather steam for what was to become an incredible ten-year rally. Residential property in Berlin was cheaper than reconstruction cost, yields were incredibly attractive, and for buyers with more exotic taste, it was possible to buy a lake-side holiday dacha just 25 minutes from the centre of Berlin for less than $10,000. The market ticked all the right boxes.

Parts of the German property market have since then risen severalfold in value, and the market as a whole is up considerably no matter which area of the country you look at.

The problem was, few investors believed in the opportunity when prices were cheapest. Even those who did, often found it difficult to find the right investment vehicle to invest in the country’s real estate sector, outside of doing the cumbersome work to buy properties themselves.

Anyone who missed the bargain-basement prices of Germany in 2005 might now be interested in another opportunity to latch onto: residential property in Japan!

What happened after the 1980s bubble?

No analysis of Japan’s property market would be complete without looking at it in the historic context of the 1980s bubble. To this day, the bubble economy that Japan experienced three decades ago has profound economic effects on the country, and to some extend it provides the framework for today’s investment climate.

In the 1980s, following several decades of successfully rebuilding its economy after the end of the war, Japan entered what to this day ranks as one of the most outstanding bubbles of recent history.

Between 1984 and 1989, the Nikkei Index rose nearly fourfold. At its peak, the market capitalisation of Japanese companies made up nearly one third of the value of all public companies in the world. Curiously, in 1989 a survey of institutional investors showed that the majority of them did not believe that the Nikkei was overvalued! So much for the ability of institutional investors to assess broad market trends and identify warning signals.

The asset bubble in the Japanese real estate market was even more astounding. At one point, prime real estate in Tokyo was 350 times more expensive than comparable land in New York’s Manhattan. Anyone who lived through this period will remember how the international press noticed that the land underneath the Tokyo Imperial Palace was effectively worth more than the entire state of California.

Clearly, Japan had entered a bubble, and an almighty one for that matter. The subsequent deflating was painful and, in some ways, equally astounding. During the following 15 years, residential real estate in Tokyo lost up to 90% of its value. Prices for land in Tokyo’s Ginza district even dropped 99% compared to the 1989 peak. So much for property “only ever going up”!

Today, Japan simply appears cheap

Tokyo once was regularly listed as one of the world’s most expensive cities; however, nowadays the Japanese capital doesn’t even appear among the world’s Top 10. Indeed, as anyone who visited Japan recently will be able to attest, in comparison to other major world capitals Tokyo has actually become a bit of a bargain.

Quality hotels? Whereas in New York or London it costs $300 and upwards to get a decent hotel room, in Tokyo you can nowadays comfortably rest your head for less than $100 a night.

Taxis, food, train tickets – much of daily life in Japan nowadays compares favourably to the costs you’d have to pay in other major metropolitan areas around the world. That’s despite the fact that with 37m inhabitants, the greater metropolitan area of Tokyo still makes it one of the truly large capitals of the world.

The economy has also turned the corner, in some ways at least, and this long-term turnaround has started to show in residential property prices. In the past couple of years, the broad index for residential property in Tokyo has risen by about 20%, and by up to 50% in some of the swankier areas. Still, the market remains cheap, given how prices recovered from a low level. Altogether, prices for residential property in key areas of Japan are still only half of what they were in 1991. Whereas other parts of the world have seen prices rise significantly during the past 24 years, in Japan they have halved!

In some areas of Japan, you can actually get residential property at incredible bargain prices. Whereas Tokyo, Osaka and Nagoya are seeing a net inflow of residents, other parts of the country are suffering under negative population growth. In Kyoto, regularly cited as the country’s no. 1 city for tourists keen to experience Japanese history and culture, classic wooden “machiya” homes can now be picked up for $200,000 to $500,000. At the upper end of this price range, you get a fully refurbished two bedroom house in the historic district of Kyoto. Try buying a similar building in Bath or Edinburgh.

How to get in on the game, without having to travel to Japan and go through the hassle of purchasing a property and then renting it out?

An AIM-listed property fund

The aptly-named Japan Residential Investment Co. (JRIC) was floated in 2006 and offers investors an easy way to get exposure to the residential real estate market of Japan’s biggest cities.

At last count, JRIC owned 57 properties with 2,697 rentable units, spread mostly across Tokyo, Osaka and Nagoya. The average size of the rental units was 33 sqm, making them easy to rent out to singles and couples. Average monthly rent was £550, which is about a third or a quarter of what a comparable property would rent for in London. Occupancy stood at 95%, which is close to the maximum that any property company can achieve given that there is always a degree of fluctuation among tenants and the occasional need for refurbishment.

JRIC offers a pure and relatively low risk exposure to residential property in Japan. Gearing is 50%, and average interest cost for its outstanding borrowings is 0.9%. The company is effectively a conservatively managed portfolio of quality residential property in the major metropolitan areas of Japan.

Factors that influence the company’s performance (and its share price) include the fluctuation of the Yen. During the past three years, the Yen has lost about a third of its value compared to the British Pound Sterling. Had you invested into JRIC three years ago, currency loss would have eaten up much of the increased value of the properties. Not surprisingly, the share price is still trading at exactly the same level where it was in 2012, despite the appreciation of property values in Japan since then.

Anyone coming into the game now can benefit from the Yen essentially being an undervalued currency for buying into an undervalued market. Also, based on the most recent dividend payout, the share comes with a dividend yield of 6.7%. Dividends were 3.6p per share both for 2014 and 2013, compared to a current share price of 53p per share. The shares are trading slightly below the net asset value of the properties, further adding to the attractive nature of the investment.

Tokyo, Osaka and Nagoya are cities where long-term trends are likely to increase property values over the years to come. Supply of residential rental housing in these major population centres is constrained by factors such as limited land availability, and wage growth is stimulating the purchasing power of the population as well as construction costs. Add to this the ongoing trend of Japan’s population moving to the country’s biggest economic centres. The population of Japan is declining by almost 300,000 per year, yet Tokyo saw net inward migration of 590,000 people over the past decade (an increase of approximately 0.5% annually). Throw in the trend towards ever-more single person households due to delayed marriages and rising divorce rates. The number of households in Tokyo has steadily risen from 4.3 million in 1980 to 6.4 million in 2010 (a 49% increase) and is anticipated to continue increasing gradually through to 2025.

Conclusion: Low property valuations, the weak Yen and solid long-term trends make Japan one of the world’s best markets to get your foot onto the property ladder. JRIC makes it possible to invest (and sell) at the push of a button. Waiting for capital appreciation to take hold is made all the more bearable through the 6.7% p.a. dividend yield.

Next month: Swen pays a visit to Spain to check out opportunities on offer there.