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.