Japanese Real Estate Attracts Global Investors

 

Investors interested in alternative investments may want to read yesterday’s FT.com article “Japan property revival catches foreign attention”. The claim is that rents in Japan are yielding a Net Operating Income (NOI) of 3.5% of property value but the yield on Japanese bonds is 0.6% so the spread between bond yields and rent is very high compared to other countries.

This may sound like a good investment. But to make risk reasonable it is important to fund the loan with a long term fixed rate bond or mortgage. The article didn’t mention if 30 year fixed rate mortgages are available. If the global markets decide that Japan has too much debt (which it does) then the Yen will become substantially devalued. This usually results in inflation which in turn results in the natural market based interest rates going up to offset losses caused by devaluation and inflation. Thus a 10% annual devaluation might result in a 12% interest rate. If someone bought a property yielding a NOI of 3.5% and financed it with an adjustable rate loan that went up to 12% then they would have a negative income of 8.5% before depreciation and income tax. In theory the rent could be raised to match inflation and thus the new NOI could be roughly 13%. However if financing costs become 12% this would still allow a much smaller profit before depreciation. But then when the property is sold and the funds are sent back to the U.S. then the Yen from the sale would be worth less in dollars. In theory the building’s value could go up to match the inflationary loss caused by devaluation but that is a speculative guess. It is possible the devaluation could be a more powerful impact than inflation so that a landlord’s gains from inflation would not offset devaluation losses. Also Japan could tax the inflation gain so the after-tax inflation produced capital gain might be less than the currency exchange loss resulting in net capital losses to a foreign investor, despite an improving economy.

When something is complicated like this then the best metric might be to remember that when inflation or devaluation occurs often the country becomes poorer and thus residents would react by reducing their use of rental real estate. If a reduction of demand occurs then prices would rise at a slower pace. In the U.S. when inflation increases, then interest rates rise, which suppress real estate prices. If new buyers can’t afford higher interest rates then they will make lower priced offers and the price will go down.

If Japan is truly getting out of its slump then its interest rates will rise to normal levels thus hurting their real estate. If Japan is merely trying to create massive inflation then that will trigger devaluation (which is what they want). Treaties prohibit or discourage devaluations so to devalue they must create a situation through inflation and Quantitative Easing where investors will sell off Yen denominated holdings and sell off Yen deposits thus devaluing the currency. Devaluation is needed to stimulate Japan’s exports.

Japan has been living off of its savings and borrowing capacity rather than increasing its earnings. Thus it has been moving into an economically weaker situation where its consumers and businesses would have a lower probability of affording rent increases. Thus I would be skeptical that Japanese real estate will go up enough to offset problems associated with increases in their inflation and devaluation. The article even mentioned that only the 13% of properties that are “A” quality are experiencing rising rents with other properties having declining or flat rents.

Investors need independent financial advice about the dangers of alternative investments. I wrote an article “Are Japanese stocks the best investment?

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About the author

Don Martin, CFP®

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