Why Overseas Investors Are Lining Up for Japanese Commercial Real Estate

TOKYO—Japanese Prime Minister Shinzo Abe's far-reaching economic stimulus has helped keep interest rates near historical lows while encouraging private investment. Real estate investors have been among the biggest beneficiaries of Abe's policies to date, particularly those involved in Tokyo's commercial property market.

While there is no public or private aggregation of commercial property values in Tokyo, businesses are clearly on the prowl for more space. Office occupancy rates in the city are rising at a steady clip, and vacancies have fallen for 12 straight quarters. Increased demand is buoying rental prices, with office rents recently topping ¥17,400 per month after plumbing depths as low as ¥16,207 in December 2013.

Today, some market observers are questioning whether such growth is sustainable. We believe it is. For starters, Tokyo enjoys an investment edge other major international cities can't match. Recently, the gap between the average capitalization rate for Tokyo office space—a measure of how much income it is expected to generate—and 10-year government bond yields exceeded London's by at least 50 basis points. Tokyo's yield spread advantage over New York and Singapore was even more pronounced, and it has been far more stable in recent years.

This means that investors are benefiting both from the investment's yield on equity as well as the difference between the cost of funding and the earnings on those borrowed funds. This is a critical point, as this dynamic continues to make Japan's commercial properties more attractive on a relative basis and suggests the market may have more room left to run.

This development has not been lost on overseas investors, who are piling into what has become the third-largest real estate investment market in the world. In the first quarter of this year, foreign investors accounted for 30% of domestic real estate investment, up from 19% in 2014 and 12% in 2013. Big players in emerging markets are leading the charge. In October 2014, Singapore sovereign wealth fund GIC made a big splash with its ¥160-billion purchase of Pacific Century Place Marunouchi in central Tokyo. Early last year, China Investment Corp. led a ¥140-billion acquisition of the Meguro Gajoen commercial property complex..

In addition to near-term market dynamics such as the yield gap and rising rents, longer-term trends help explain the attraction. Japan's entrenched advantages include the size of its market, now about $1.1 trillion, or 9% of the global total; the transparency of its tax and regulatory regimes; and the stability of its political system and economy. These attributes make Japan a likely landing spot for real estate investors looking to allocate a certain portion of their portfolios to Asian markets.

That said, the recent influx of interest in Japan's commercial real estate market has made an already competitive environment that much more so. Overseas real estate investors have historically operated at a disadvantage in the Japanese market. Local players have been able to move more quickly because they have a better understanding of market conditions there and are often able to secure cheaper financing for deals. Newer entrants have typically found success by partnering with a local partner who speaks the language, knows the ropes and has a sizable stake in the market.

We see these relationships will be even more critical in the months to come as competition intensifies and viable deals are harder to come by. The rebound of Tokyo's commercial real estate market—and, to a lesser extent, that of Osaka, Sapporo and Fukuoka—now enters a phase in which property selection and due diligence will be critical to success. Increasing enthusiasm among major global property players suggests they still see room for growth in both rent and capital appreciation, but significant dispersion is likely. While caution is certainly warranted with any asset that has appreciated so much, it shouldn't dissuade investors from getting to know more about this market.

Hiroyasu Kaizuka is managing director of real estate investment for Goldman Sachs Asset Management in Tokyo. The views expressed here are the author's own.