Kazaam! Pow! Boof! After a decade when the game seemed permanently over, someone finally hit the reset button on the Japanese economy, and the Tokyo office market is once again heading up, up, and away.

Until a few years ago, Tokyo real estate pros say that most tenants looking for a new office were trying to find someplace smaller. Now, they are in the market for bigger and better space, according to Mikihisa Hirai, president of Atlas Partners Japan Ltd., a major asset manager. Hirai believes the improving economy is behind the shift.

After more than a decade of weak performance, the Japanese business climate is on the rise again — exports were up about 15% in 2006 — and that sharp turnaround in what is still one of the world's largest economies is bringing the Tokyo market back to life. Rents in some high-profile properties have risen as much as 50% in the last three years. Vacancies are at 14-year lows, standing at 2.8% for all grades of office properties.

The rental market in the central wards is so tight now that even a savvy real estate player like Macquarie Global Property Advisors had a hard time last fall when it went looking for new office space. “Three years ago, we could have the luxury of comparing three to four properties and make a choice. But today, the thinking is that if the space is good enough, grab it,” says Shigeaki Shigemasa, a partner with Macquarie.

Rent growth may continue

Believing there's even more to come, investors in some cases are now paying double what they paid three years ago, according to CB Richard Ellis (CBRE) Japan data. “That sort of aggressive level of bids indicates people are pinning their hopes on quite aggressive rental growth,” says Ben Duncan, representative director, CBRE Japan.

Encouraged by results like these, foreign investment is flowing into Japan very quickly now — maybe too quickly for its own good, in a market that some say can still be tricky for Western investors to negotiate.

“Many new investors are coming from overseas, and I see some of them having a very difficult time placing their money,” says Shigemasa of Macquarie. “I see some of the players paying a bit too much money, or placing their investment in the wrong place.”

Investors like the prospect of more rent growth in a market which Hirai believes has minimal downside risk because vacancy rates are never very high in Tokyo. Even during Japan's worst recession in the post-war era, vacancy rates never rose above 15% because Japanese companies are much more reluctant to let employees go during a downturn.

Foreign investors, Hirai says, see Tokyo as both a good investment in its own right and also as a way to gain indirect exposure to Asia's fast-growing emerging markets, such as China, while avoiding the volatility that goes along with investing there.

American funds bought earlier, before the recent rise in real estate prices, according to Duncan. These days, however, Australian firms backed by pension money are leading the charge. “The Australians are having a pretty hard run at the moment,” he explains.

Japanese investors are also quite active. “The Japanese are very much back in their own market again,” says Duncan. J-REITs are contributing to the buying pressure. Since they were first launched five years ago, Japanese real estate investment trusts have grown dramatically.

There are now 38 J-REITs on the Tokyo Stock Market, which collectively hold more than 4.1 trillion yen in assets or $8 billion, according to a report by Colliers Hallifax, a Tokyo real estate advisory firm affiliated with Colliers International. Colliers and other experts predict continued growth for J-REITs.

Jones Lang LaSalle anticipates a doubling of the total J-REIT market cap in the next three years. This growth may have an even larger impact on prices than might be expected, experts say, because J-REITS are not allowed to build — only to buy — which limits their focus to existing building stock.

ramatic turnaround

The current excitement has been a dramatic change in a market that, until recently, seemed as if it would never recover. After years of 70% or 80% annual jumps in the late '80s, commercial real estate prices in Tokyo fell by more than 80% in the early 1990s, along with most of the shares on the Tokyo Stock Market.

Tokyo commercial real estate, like most of the Japanese economy, never really regained any positive momentum for a full 10 years, a period Japanese now refer to as the Lost Decade. Even near-zero interest rates were not enough to jump start real estate investment, or any other part of the economy.

Just a few years ago, some real estate market watchers were so discouraged that they had reportedly begun to worry that conditions would worsen even more as Japan's many Baby Boomers began to retire, according to Shigemasa.

By the time the office market recovery began in 2003, no one believed it at first. Gloom had prevailed for so long that local investors didn't understand that conditions really had finally changed, says Duncan of CBRE.

Returns are relative

Investment advisors say that despite the run-up in the world's largest office market, the buying opportunities are still relatively attractive compared to alternative investments. Although cap rates on Class-A properties have shrunk to less than 3%, advisors note that they are still higher than Japan's ultra-low borrowing rates, which are still among the world's cheapest. Current yield on the 10-year benchmark government bond is a mere 1.72%, compared with 4.78% in the U.S. and 4.91% in the United Kingdom.

At the same time, vacancies are tight, particularly for Class-A office space. As of the third quarter of 2006, Class-A office vacancy stood at 1.5%, according to CBRE figures, and all-grade office vacancies registered 2.8%, the lowest in 14 years.

One consequence of having the lowest vacancy rate in the world is that it's also one of the most expensive markets in which to rent. Average rents were $89.60 per sq. ft. in the third quarter of 2006, according to a recent survey by the International Tenant Representative Alliance Real Estate Group (ITRA). Among large cities ITRA tracked, only London was more expensive. Manhattan, by comparison, was a bargain at $44.50 per sq. ft.

Prices are high for several reasons. First, most companies want to be located in central Tokyo with easy access to the train lines that commuting employees rely on. Many are also quite conservative when it comes to site selection, and don't really consider the possibility of moving to suburban sites or to relatively nearby cities such as Yokohama.

The total amount of Class-A stock is also extraordinarily limited. Class-A represents only 16% of the market, compared with 50% to 60% in most major cities, according to Duncan, and there is a limited pipeline for new buildings.

Other Japanese cities have somewhat similar dynamics but to a lesser extent, according to Shigemasa of Macquarie. In Osaka, for example, there is only a 2% vacancy rate for Class-A office space.

Limited new construction

While some new Class-A space is expected to be completed this year, it's not likely to bring much relief to vacancy rates since most of the space that is now being built is largely pre-committed, according to Jones Lang LaSalle. The company forecasts more rent growth for 2007, but at a slower rate than in the past few years.

Another reason the market has not met the demand in the past is that the Japanese government has very weak powers of eminent domain. As a result, large parcels are almost impossible to assemble, even with city government support.

Historically, this made it difficult for a developer to assemble a large plot, says Shigemasa. It reportedly took Tokyo developer Minoru Mori over 14 years to acquire the hundreds of parcels he needed to create Roppongi Hills, one of Tokyo's largest and most successful mixed-use developments.

Often, developers avoid those hassles and risks to build what are called “pencil” buildings — narrow buildings with only one office per floor.

Upgrading Class-B space isn't a viable alternative in most instances. Not only is there a limited supply — roughly 20% of the market is Class-B — but many Class-B buildings are structurally impossible to upgrade. “Ceiling heights, floor loads and HVAC capacity are limited,” says Jon Tanaka, the Tokyo-based director of RREEF, the real estate investment arm of Deutsche Bank.

Older buildings also are less likely to meet the current building code for earthquake safety, which was last changed in 1995 — an important feature in a city where many believe a major earthquake is long overdue.

A few shortcomings

Despite all the advantages of owning quality office property in Tokyo, there are a few flies in the miso. For owners, the barriers to entry are good news. For investors, it's a mixed blessing since it means that although Tokyo has nearly 650 million sq. ft. of office space, according to ITRA figures, there's often surprisingly little good stuff for sale. “While it's the largest office market in the world, it's still rather concentrated in terms of the investment-grade property,” says Tanaka.

Most landlords miss out on the eye-popping rents that make headlines. While conventional office leases are only for two year-terms, the lease can be renewed permanently. Limited leases similar to the U.S. model are becoming more popular, but the renewable nature of the traditional lease gives tenants a lot of clout.

Once a tenant is in possession, a landlord can only raise rents modestly. “As long as the tenant is paying rent, you can't evict him. Unless the tenant leaves, you can't capture the market rent,” says Tanaka.

Tokyo is also not an easy city for Western investors to do business. For direct investment, a local partner is a must, investors and advisors agree. Unlike many international cities, very little information is available in English. There are other wrinkles as well that can create some confusion: rental rates are quoted by the tsubo, a 35.5 sq. ft. unit of measure equal to two tatami mats, the traditional Japanese floor covering.

More significantly, the Japanese tend to spell out real estate deals much less than Westerners do. Until a few years ago, a contract on a large office building might be four or five pages. Plus, relationships still count for a lot in Japanese business. Properties may or may not be for sale depending on who you are, not how large a check you're willing to write. The established contractors who control much of Tokyo building, for instance, often try to sell their new buildings exclusively to their own J-REIT subsidiaries.

Boom, Bust, Boom, then…

The wave of optimism has to make some investors wonder whether this cycle, too, will end with a bust. Buildings built to today's construction code may be better prepared for earthquakes now, but are their owners better prepared for financial shocks than they were in 1990?

Some elements seem to have changed. Mortgage debt securitization has grown, which spreads the financing risk beyond the banks and insurance companies where it was previously concentrated.

The government is trying to limit the risks brought on by the tendency of the business establishment to make deals driven by crony connections rather than objective value. Recently, for instance, some companies have been called on the carpet by securities investigators for their dealings with J-REIT subsidiaries.

But the market is still opaque in some respects. “Lots of deals are done under the radar,” says Guy Hollis, a Hong Kong-based analyst for Jones Lang LaSalle. “That's just the way they do business.”

However, investment advisors say that there is more transparency now than in the crazy years leading up to 1990, when at one point prices were so high that some analysts claimed that the grounds of the Emperor's Palace were worth more than the entire state of California. Asset securitization is forcing more disclosure of some deals, and more systematic risk management among investors. J-REITs are also reportedly making the market somewhat less opaque than it once was.

These companies must file regular public reports on their assets and acquisitions. Besides the requirement for public disclosure of assets, J-REIT executives are also required to disclose the risks they are taking. “It's still not easy,” says Shigemasa, “but it's much easier than before.”

Bennett Voyles is a Paris-based writer.