Last summer New City Residence Investment Corp. appeared to be on sound footing. An owner of apartments in upscale neighborhoods of Tokyo, the Japanese real estate investment trust (REIT) had enough cash flow to cover its interest payments four times over. It had lined up a group of lenders to finance an acquisition when a small bank abruptly withdrew its support.

Unable to finance its debts, New City sought bankruptcy protection in October, the first Japanese REIT to collapse since the credit crisis began. “Global economic problems are beginning to hit Asia,” says Steven Buller, portfolio manager of Fidelity International Real Estate Fund.

A year ago, it seemed that Asia might escape the storm sweeping real estate markets in the U.S. and Europe. Most real estate markets were prospering, with solid REITs in Japan, Singapore, and Hong Kong. REITs offered compelling yields, but in recent months trouble has arrived on Asian shores.

Total returns for Asian REITs lost 56% year-to-date through Oct. 27, according to the National Association of Real Estate Investment Trusts (NAREIT), compared with a loss of 47% for North American REITs. The precipitous fall followed a period of uninterrupted growth. Asian REITs returned a high of 44.83% in 2003, and went on to deliver double-digit annual gains through 2007.

This year's losses represent a big change from last year, when Asian markets seemed unfazed by credit problems afflicting property companies in the U.S. and Europe. During 2007, total returns for Asian REITs rose 14.8% in contrast to their North American counterparts, which lost 14.92%.

Much of the downturn can be attributed to selling by foreigners, says Peter Mitchell, CEO of Asian Public Real Estate Association, a trade group in Singapore. In recent years, hedge funds and pensions from around the world have allocated more assets to Asian real estate. In the U.S., a flurry of global real estate funds appeared, such as Aim Global Real Estate, Alpine International Real Estate, and Cohen & Steers AsiaPacific.

But investors began withdrawing money from such mutual funds and hedge funds as stock markets dove, forcing portfolio managers to sell Asian REITs. “After the subprime mortgage problems appeared, people left Asian REITs and they haven't returned,” says Mitchell.

In recent months, the decline of Asian REITs has accelerated. Investors feared that a downturn on Wall Street could hurt markets in Singapore and Tokyo, since U.S. consumers would buy fewer exports.

Rents heading down

Asian REITs have not been hit by the vacancy problems that trouble markets in Europe and the U.S. At the end of the second quarter, Class-A offices in Tokyo had a vacancy rate of 4%, while Singapore's central business district had just 1.7% vacancy, according to Chicago-based Jones Lang LaSalle. The U.S. Class-A office vacancy rate stood at 13.6% at the end of the second quarter, reports Los Angeles-based CB Richard Ellis.

But signs of weakening demand have appeared in Asia. After rising for 16 quarters, Tokyo office rents fell 1.3% in the third quarter over the previous quarter, reports Jones Lang LaSalle. “Demand is beginning to be hurt by what is happening overseas,” says David Fan, a Tokyo-based managing director of CB Richard Ellis. “In Tokyo, [failed] companies like Bear Stearns and Lehman Brothers are giving space back to the landlords.”

Tokyo vacancy rates will deteriorate in 2009, says Luke Sullivan, a portfolio manager for Cohen & Steers, a New York-based money manager. But Sullivan does not expect an office collapse in Japan because little supply will be coming to market in Tokyo. “We should see vacancy rates increase a percentage point or two,” he says. Vacancies could increase significantly in New York and London, he adds.

Retail REITs have been among the first to suffer serious problems in Japan, Fan says. Some shares now sell for an 80% discount to book value and investors fear consumer sales will slip. Amid sluggish same-store sales, some big retail tenants are requesting rent reductions, Fan says.

Singapore won't be able to maintain its super-low office vacancy rates much longer, says Mitchell of the Asian Public Real Estate Association. “More office supply is coming on line in the next couple years. We will probably see vacancy rising and rents falling quite a bit,” he says.

Hong Kong office markets also are likely to soften, says Sullivan of Cohen & Steers. In recent years, demand in Hong Kong has been strong, and the vacancy rate dipped to 2%. But demand is weakening, and rents are falling. Sullivan expects rents to drop 20% in the next several years. “Tenants are getting far more bargaining power, and landlords are becoming more flexible on leases.”

Sales volume collapses

As fundamentals deteriorate, investment sales also will dip, says Dan Fasulo, managing director of Real Capital Analytics, a New York real estate data firm. With the global market for mortgage-backed securities frozen, buyers everywhere are hard-pressed to find financing.

In Asia, the volume of investment sales has dropped 50% in the past year. While big portfolio deals have been put on hold, some have gotten the go-ahead, Fasulo says. Notable deals of the past year include the Resona Maruha Building, a 457,000 sq. ft. Tokyo office tower that sold for $1.5 billion, and Langham Office Tower, a 702,000 sq. ft. property in Hong Kong that sold for $1.1 billion. “The sales bubble has burst, and we are back to a more normal level,” Fasulo maintains.

Sales in Asia remained strong through the first half of 2008, and prices and valuations rose. Investors competed fiercely for properties in Hong Kong, where the supply of land is limited. In recent months, however, values have been dropping. “Now that banks are tightening mortgage requirements, sentiment is slipping and prices are falling,” says Sullivan.

Asian capitalization rates, or initial yields based on sale prices, fell from 5.5% in late 2007 to near 5% in the spring, says Real Capital Analytics. But since then, Asian cap rates have risen above 5.5% compared with 6.5% in North America.

Many American investors feel Asian prices are too high. Some who invested in Asia returned home, Fasulo says. “People couldn't see why they should accept a 5% capitalization rate in Singapore, when they could buy an office building in Chicago with a 7% return.”

Bargain-priced shares

Instead of purchasing properties in Asia directly, some Western investors have acquired REIT shares. Asian REITs are cheap by many measures, says Fan. Some sell at discounts of 50% to the appraised value of assets. In the U.S., REITs typically trade at 10% discounts.

Blue-chip REITs are even selling at a discount. The biggest Japanese REIT is Nippon Fund, an office owner with a market capitalization of $3.5 billion. It is selling for a 10% discount to its book value, notes Fan. Tokyo's second biggest REIT, Japan Real Estate, is selling for a 20% discount to its book value. The two REITs have no trouble accessing capital, Fan says. “The shares have dropped because there is a lot of fear in the markets.”

As prices of REITs have plummeted, the dividend yields have climbed. The average dividend yield on Asian REIT shares now exceeds 10.5% compared with 7% for U.S. REITs, according to NAREIT. The Asian dividend yield seems particularly rich at a time when Japanese government bonds are yielding around 1%.

The dividend yields make Asian REITs attractive investments compared with their U.S. counterparts, says Sullivan. But he says investors should beware of distressed Asian REITs yielding more than 20%. “Those dividends probably won't last,” he says. “The REITs will probably have to reduce their payouts in order to meet debt refinancing requirements.”

In some respects, conditions remain promising for Asian REITs. While their economies are expected to slow in 2009, China and India are projected to see GDP growth of more than 7%. In stark contrast, the U.S. and Europe are likely to post little or no economic growth in the year ahead, says Mitchell.

The Japanese economy could also grow. After suffering enormous debt burdens a decade ago, Japanese banks have strengthened their balance sheets, says Fasulo. Tokyo's new stability was demonstrated recently when Mitsubishi UFJ Financial Group, Japan's largest bank, invested $9 billion in New York-based investment bank Morgan Stanley.

“If you just read the newspapers every day, you can get depressed,” says Fasulo. “But deals are still being done, and many investors should consider putting a big bet on Asia.”

Stan Luxenberg is a New York-based writer.

Asian REITs could flourish with new laws

While REITs are being whipsawed by the economy, they still have the opportunity to grow in number over the long run in Asia, says Peter Mitchell, CEO of the Asian Public Real Estate Association (APREA), a trade group in Singapore.

Currently, there are 42 REITs in Japan, 21 in Singapore, and seven in Hong Kong. China and India have not yet permitted REITs, but officials plan to introduce legislation to allow REITs.

The first Asian REIT was listed in Japan in 2001. The next year, REITs appeared in Singapore. Perhaps the most dramatic initial public offering (IPO) occurred in 2005 when Hong Kong listed its first REIT, Link Real Estate Investment Trust. It was created to privatize shopping malls and parking facilities that had been owned by the government's housing authority.

Seeking to obtain shares in the $1.9 billion issue, 510,000 Hong Kong residents placed orders of $36 billion. Today, Link ranks as a solid REIT and carries an “A” rating from Standard & Poor's. With a market cap of $3 billion, the REIT operates 11 million sq. ft. of retail space and 80,000 parking spaces.

With the stocks slipping, no IPOs for Asian REITs have occurred in the past year. Several companies have attempted to achieve listings, but the deals were scrapped because of a lack of investor interest. “The IPO market is frozen,” says Mitchell of APREA.

Before the market began to head south in early 2008, 20 additional REITs were in the pipeline to be listed in Singapore. Many of those companies will again attempt to go public once markets normalize, Mitchell says.

Amid the current credit crunch and economic strife, there could be opportunities for consolidation of Asian REITs. But regulations discourage most mergers. Government frowns on hostile takeovers, and Asian REITs cannot issue convertible debt, a financial tool that is commonly used by U.S. REITs.

“There needs to be new legislation that would allow REITs to access capital and make acquisitions,” says Luke Sullivan, a portfolio manager with Cohen & Steers, a New York-based money manager. “When the rules are changed, REITs could expand substantially throughout Asia.”
— Stan Luxenberg