Economy: Cost-Push Inflation to Persist, Limiting Availability of Liquidity Buffer for Some Investors
Japan‘s real GDP is now expected to grow at around 1.3% in 2023, reverting to the level prior to the Abenomics era, as the ongoing recovery of exports and domestic services consumption since the end of 2022 have been offset by increasing cost pressures and negative real wage growth since early spring. However, the rapid rate hike cycle in the U.S., a sustained hawkish stance in the ECB, and tightening lending standards globally, are expected to limit advanced economy economic growth to around 0.5% p.a. until 2024. Furthermore, yen weakness is expected to continue at least until the 10-year interest rate, trailing at around 0.4%, reverts to 0.8%, with a neutral interest rate policy approach under BOJ governor Ueda in response to the prevailing low economic growth. Given the widening disparity in policy rates in major markets, the yen is currently expected to drift downwards to a historical low of 150 to the U.S. dollar.
Japan’s Positive Spreads Attracting Foreign Funds, Despite 22% Cyclical Dip in Transactions
Total transaction volume in the 12 months ending June 2023 totaled JPY6.3 trillion, down 22% y-o-y. The cyclical decline was attributed to an absence of large transactions, along with rising interest rates globally. In the lending environment, banks‘ outlook on real estate transactions remains supportive, raising the ratio of real estate loans to total loans to 16.7%. Even assuming the downside scenario of the 10-year interest rate rising toward 1%, Japan’s cash-on-cash return is expected to remain positive, unlike other major markets.
By investor type, the scope of market participants has been expanding, with non-domestic investors increasing their share of large-scale transactions, together with some retail investors. Summarizing the net transaction volume since the end of 2019, foreign funds / institutional investors have emerged as the net buyers, while JREIT corporations are now the net sellers as they seek to realize their capital gains. With growing concerns on the interest rate outlook, we expect JREITs with higher financial leverage to see limited upside to NAV in the coming quarters.
By asset sector, allocation to office property remains high, representing 43% of the total volume. In addition, allocation to hotel properties is expanding as more investors seek assets that are favorable to hold in an inflationary environment. The increasing allocation to the hotel sector mirrors the declining allocation to retail, as urban retail assets are yet to see a recovery in rent and capital values. Elsewhere, allocation to logistics remains unchanged at 16%, as some investors turn more cautious due to increasing cost pressures on logistics facilities. Allocation to the multifamily sector remains unchanged at 21% of total volume.
Widening Bid-Ask Spreads With Rising Cost of Capital
The inflation outlook resulted in little change in expected yields among domestic investors. However, with an anticipated rise in risk premiums, price expectations between buyers and sellers continues to diverge. By asset class, hotel cap rates remain elevated around the upper 4% mark, as their performance recovery is yet to be realized in cashflows. Office cap rates remain unchanged around the mid-3%, despite deteriorating cashflow yields due to weaker performance of less competitive buildings. By area, Tokyo‘s prime office cap rates also remain unchanged around 3%, maintaining the lowest level since 2007. Regionally, APAC office demand shows a similar trend, reflecting high office worker attendance rates, keeping office cap rates at low levels. This contrasts with U.S. gateway cities, with higher prevalence of hybrid and remote working and lower office attendance rates, tracking under 60%, resulting in elevated cap rates, tracking at 5.5% in Manhattan and 4.8% in San Francisco.
Notable investment transactions in H1 2023 include a series of large inflows from overseas funds. Two major domestic hotel assets were sold, to KKR and Bentall Green Oak respectively. Elsewhere, Blackstone sold its logistics portfolio to GIC, as the latter expand their core investment portfolio. Sekisui REIT also reported a rare sale of an urban data center to its sole tenant, converting the usage to an owner-occupied data center.
