Morgan Stanley to Sell $2.9 Bln Japan Property Debt

Morgan Stanley plans to sell about 343 billion yen ($2.9 billion) of bonds backed by office buildings, hotels and other real estate in Japan, a record sale, according to two people familiar with the transaction.

The bonds will be sold with credit ratings ranging from AAA to BB, two levels below investment grade, said the people, who asked not to be identified as the sale hasn't been made public. The sale by New York-based Morgan Stanley, the world's biggest underwriter of property-backed debt in 2005, is almost as much as the firm raised in five Japanese transactions last year.

Land prices in Japan's three largest urban areas rose last year for the first time since the bubble economy burst in 1990, spurring increased property lending by investment banks. By packaging those loans into bonds that can be sold to investors, the banks can reduce risk.

``Real estate lending is a hot market in Japan,'' said Brett Hemsley, a senior director at Fitch Ratings. ``Loans to property investors and real estate companies have continued to expand and more banks are interested in participating.''

Morgan Stanley spokeswoman Sumiko Iwadate declined to comment.

Real estate funds in the world's second-biggest economy almost doubled their property assets to 7.8 trillion yen last year, according to STB Research Institute Co.

Growth Boosts Land Prices

Japan's economy grew 5.4 percent in the three months ended December, outpacing expansion in the U.S. and helping boost Tokyo land prices for the first time in 15 years. Tokyo office vacancies fell for the ninth straight month in March to 3.41 percent, the lowest since September 2001, according to broker Miki Shoji Co.

Investors including Goldman Sachs Group Inc., Morgan Stanley and Lone Star Funds were lured to Japanese real estate in the late 1990s as prices neared the bottom of a plunge that erased three- quarters of the value of property in the nation's six biggest cities. Goldman spent more than $6 billion on Japanese property since 1997 and Morgan Stanley bought $8 billion of Japanese real estate last year.

Tokyo is the world's largest office market with 840 million square feet, according to a report distributed by the Association for Real Estate Securitization in Tokyo. Rents for commercial properties in the city were the world's fourth highest, following Taipei, London and Beijing, according to a report by the Japanese Association of Real Estate Appraisal.

Tokyo vs London

Rents for new office buildings in Tokyo have started to rise as economic growth drives demand. Mitsubishi Estate Co., Japan's second-largest developer, said earlier this month the highest rent in its new 39-story building facing Tokyo's main railway station will be about $170 a square foot. Tenants pay an average $178.67 for equivalent space in London's West End, according to a report by CB Richard Ellis.

Morgan Stanley's sale will exceed a 230 billion yen offering by Citigroup Inc. in September, a record debt sale by an overseas company in Japan. It will also top Matsushita Electric Industrial Co.'s record 300 billion yen corporate bond offering in 2002.

The bonds are backed by more than 120 nationwide properties owned by local and overseas investment funds including a Morgan Stanley real estate fund, the people said. Standard & Poor's and two other rating companies will rate the bonds.

`Benchmark'

Morgan Stanley was the top global underwriter of commercial mortgage-backed bonds in 2005, handling more than $32 billion, according to data compiled by Commercial Mortgage Alert. The investment bank sold 361.6 billion yen of Japanese property-backed bonds last year.

``A deal of this size will create a benchmark to enhance liquidity of similar securities,'' said Howe Wu, a Tokyo-based portfolio manager for the MassMutual Financial Group.

Sales of commercial mortgage-backed bonds -- loans to investors and owners of Japanese commercial properties that are repackaged into bonds -- doubled to a record 1.42 trillion yen in Japan in 2005, according to Deutsche Bank's securities unit in Tokyo. Most such sales are less than 100 billion yen.

REIT market following resurgence in land prices

With land prices in key commercial areas finally turning upward after more than a decade in the doldrums, the market for real estate investment trusts has been expanding.

High-rise buildings dot the skyline in central Tokyo, where land prices are finally starting to increase.

REITs are securities that pool funds from investors to buy commercial and residential properties. They are more liquid and allow investors to buy and sell real estate in small lots more easily than unsecuritized real estate. They first appeared on the Tokyo Stock Exchange in September 2001.

There are now 30 REITs trading on the TSE with the addition of three new trusts in March. In all, the market capitalization of Japan REITs totals some 3 trillion yen, up by roughly a third from just one year ago.

"Although it took about three years for REITs to earn recognition, the type of investor (buying REIT products) has broadened," said Hidekazu Sano, general manager of the structured finance department at Daiwa Securities SMBC Co. "The growth seen last year is not just a one-time thing, and it's likely to continue in 2006."

But REITs got off to a slow start in Japan. One day after the first listing, terrorists brought down the World Trade Center in New York, dealing a blow to financial markets worldwide and highlighting the risk of investing in buildings, REIT industry officials said.

Japanese investors also had looked askance at real estate after being badly burned by the collapse of the asset bubble the early 1990s.

Undaunted, two REITs went public in 2001. Then, from 2002 to 2004, the number of listed REITs on the TSE rose by four per year. Last year, the trusts took off, with 12 new REITs entering the market, nearly doubling the number of REITs from 2004. So far this year, four REITs have listed.

One reason behind the rapid expansion of the REIT market is a change in people's attitude to real estate investment, Sano said.

"We used to receive many questions about what we would do if prices kept falling" when REITs first appeared in Japan, Sano said.

People were cautious about buying real estate at first, but in the past few years, things have changed for the better, he said.

According to a recent government survey, commercial land prices in the Tokyo, Osaka and Nagoya areas on Jan. 1 rose over previous-year figures for the first time in 15 years, suggesting the country's stubborn deflation is finally coming to an end.

Although some market watchers worry that soaring land prices in fashionable districts, including Roppongi and Aoyama in Tokyo, presage a new bubble, others say there is a big difference in the way people invest in real estate today compared with the bubble years.

"During the bubble period, there was a so-called land myth, under which people almost blindly believed that land prices would (only) go up," said Kazuhiro Hirano, senior analyst at Tokai Tokyo Research Center.

Back then, people invested in real estate to make a profit by selling at a higher price than they paid, but real estate investors today look for profits from rents, which provide dividends to REIT holders, Hirano said.

REITs are often thought of as an intermediate financial product between bonds and stocks. Their prices tend to be less volatile than stocks, while their dividend yield tends to be higher than for Japanese government bonds, industry officials said.

Investing in REITs also has a tax advantage: REITs are exempt from corporate tax on revenues distributed to investors if they pay 90 percent or more of those revenues as dividends.

Of course, REITs carry risks -- price falls, dividend cuts and the possibility of natural disasters hitting investment properties.

At the moment, higher interest rates are a cause for concern, some REIT industry officials said, referring to the Bank of Japan's decision to end its ultraloose monetary stance last month.

The central bank has switched back to a conventional interest-rate target policy, lifting its five-year-old "quantitative easing" policy.

The BOJ has pledged to maintain the so-called zero-interest-rate policy for the time being by holding the benchmark short-term rate near zero, but financial markets are waiting to see when the BOJ will start raising short-term rates.

Some are concerned that higher interest rates will cut into REIT dividends, causing them to lose their luster. There are also worries over the weak debuts of some recently listed REIT issues.

But others in the industry argue the recovery of the economy is likely to boost REITs' popularity by driving rents -- and dividends -- higher.

Hiromasa Takakura, managing director of the investment banking division at Nikko Citigroup Ltd., said the market is likely to continue to grow due to the trend to monetize real estate assets, while prices will see ups and downs. He noted there is ample room for further growth, as the current REIT market represents less than 1 percent of Japanese real estate assets.

Takakura said that although the image of real estate was hurt after the bursting of the economic bubble, "it appears that the REIT market has finally come to the threshold of normal growth."

Tougher Times for Japanese Real Estate Trusts

Are Japanese real estate investment trusts about to turn a page? Since their creation nearly five years ago, the trusts, which buy big properties like office buildings and shopping malls and distribute rental income to investors, have thrived in the low- interest-rate environment of Japan by giving individuals in search of income a cash-yielding investment. The recent decision by the Bank of Japan to abandon its ultra-loose, zero-interest-rate monetary policy has raised the specter of higher rates and, with them, the end of the party for the J-REIT market and a possible shakeout of the real estate investment industry. Higher interest rates mean tougher times in general for the underlying real estate investments that make up the trusts: higher cost of capital for development, higher cost of borrowing for purchase and higher operating costs for landlords until rents start rising. In Japan, higher interest rates will mean higher yields on government bonds and other yen-denominated instruments, which means competition for investors' attention.

All of this, analysts say, means that the Japanese REIT market 32 trusts with a combined 3 trillion, or $25.5 billion, in capitalization may be facing a shakeout and consolidation. "If interest rates start to grow 25 to 50 basis points over the next year, that would start putting some pressure on the share prices" of Japanese REITs, said Sam Lieber, chief executive of Alpine Woods Investments in New York, which runs global real estate investment funds.

Real estate investment trusts typically thrive after an economic bust, as a crash in real estate prices allows investors with cash to invest their money in big properties like office buildings and shopping centers through a listed vehicle. The fact that REITs must distribute all their income in the form of dividends is also an attraction for investors, since interest rates are often held low after an economic bust. That is what happened in Japan after the collapse of the real estate bubble in the early 1990s and in the United States after the savings and loan crisis of the 1980s. When the economy recovers, though, share prices of real estate investment trusts can suffer, highlighting the quality of the individual trusts.

While the real estate market was booming, many companies created REITs as a way of maximizing the return on their properties. Initial public offerings of REITs traded on average 40 percent and as high as 70 percent above their net asset value. The sponsors, usually developers or other companies with large real estate holdings, are the originators of the REITs, which also create the management firms and transfer their holdings into the REIT.

"Some companies are utilizing REITs as a sort of a dust bin" for properties they want to unload, said Daisuke Fukushima, a real estate analyst at Nomura Securities in Tokyo. He added that because the properties in some REITs "tend not to be so competitive in the market," the ability of the property owners to raise rents to cover the higher interest costs will be limited. Takashi Ishizawa, chief real estate analyst at Mizuho Securities, said that the Japanese real estate trusts have been preparing for higher interest rates by readjusting their debt portfolios. "On average 70 percent of their debts have been repackaged into long-term debt," which is less sensitive to short-term movements in interest rates, he said. And at many of the trusts, "cash flow is 10 times their annual debt servicing levels," he added.

Yosuke Koi, chief financial officer at Tokyo Real Estate Investment Management, which manages office and retail properties in the Tokyo area, said that 77 percent of his trust's debt load was now at fixed rates and with an average duration of more than four years.

"In September 2003, when we went public, virtually all of our debts were short term," Koi said.

Other analysts point to the fact that the yield on Japanese REITs, close to 4 percent on average, is still comfortably higher than the 1.7 percent yield on 10-year Japanese government bonds. Nevertheless, the prospect of higher obstacles to profit, Lieber said, will spur the managers of the real estate trusts to seek new strategies to keep investor money coming in. Here, the experience of REITs in the United States and Australia, both mature markets, might be instructive. Top REITs sponsors like Westfield Holdings, an Australian operator of shopping malls, and Prologis of the United States, which owns industrial facilities, have cultivated strengths in niches. For Japanese REITs to follow in their footsteps, two things may have to happen, analysts said. First, the law governing real estate investment trusts will need to change to allow the trusts to develop property. Currently, Japanese REITs are exempt from corporate tax so long as they pass more than 90 percent of its net profits along to investors and refrain from development activities to reduce risks. These rules, which have applied to virtually all REIT markets in their initial phase of development, generally are loosened as the market matures and investors and regulators grow more comfortable with risk. Next, they said, Japanese REITs need to shed their current structure, in which all functions, including the management of assets, are handled by outside providers in exchange for fees. That structure, which was designed to keep costs low, has also kept dividend payouts low because "compensation does not come from the performance of the underlying company," Lieber said. An internally managed structure, similar to the way REITs in other countries are managed, would have the trusts hire directors and managers, who report to shareholders. An internally managed REIT, where directors' pay is directly monitored by shareholders, may be more eager to show increases in dividend payouts, Lieber said. "The goal of the internal management is to get the managers aligned with the interests of the shareholders," Lieber said. "And it is best to do that."