Thursday, 30 October 2014

Is it time to invest in Japanese housing?

And Japanese Residential Investment Company Ltd


View of Shinjuku Ward, Tokyo, courtesy Wikipedia
For the contrarian investor, the Japanese housing market is appealing. After all, could it be worse? House prices have been sliding for the last 24 years. The Japanese economy has not lost one decade, but two and a half decades. Deflation means that the consumer price index is below where it was in 1999. The yen has lost 27% of its value against the pound in the past year. The nation has the fastest ageing population in the world. And net public debt stands at 134% of GDP, which is second only to Greece. 
But the contrarian investor sees a cup half full. After 24 years of declining house prices, houses cost one-third of what they cost in 1990. Abenomics, as the Prime Minister's free spending and loose monetary policy is called, has pushed inflation* to 1.1% this year and unemployment is at a 17-year low. The pound buys more yen than at any time in the last six years. Household numbers continue to grow. Meanwhile property companies can borrow funds at less than one percent interest.
*Core inflation excluding taxes.
Residential Property
The bubble in Japanese house prices is captured in this dramatic graph:
Graph courtesy, click to enlarge
In the space of six years, house prices almost tripled. Then came the housing crash, which coincided with the crash in the Japanese stock market. Today, house prices are 67% below what they were at their peak, in 1990.
However, according to the Japanese land registry, the fall in house prices is levelling out. Condominium prices (in olive green) have staged a steady recovery since early 2009, while the price of detached houses (in blue) continues to fall:
Graph courtesy website, click to enlarge
The Japanese housing market has some special characteristics:
Ø  Between 1990 and 2010, the number of households has increased by 27%. Family units have become smaller and the population has continued to grow.
Ø  The decline in the size of families means that apartments are increasingly in demand, at the expense of family houses.
Ø  The rental sector at about 36% of households is large, more than double the UK's.
Ø  Housing has a short lifespan. People are concerned about how older buildings resist earthquakes and there is a fetish for things new. Concrete buildings are often replaced after thirty years or so. Then, the residual value of the property is its land value less the cost of demolition.
Ø  10-year mortgage interest rates are at an all-time low of 1.2% (as set by The Bank of Tokyo-Mitsubishi UFJ, Japan's largest mortgage lender).
Ø  Gross rental yields average between 5 and 6% in Tokyo for a 120m2 flat in a prime location. This is superior to London, where gross yields for a similar flat average little over 2% (Global Property Guide)
Ø  Tenants pay their rents. One residential property company reports that only 0.1% of its rents are in arrears.
According to the recent Economist survey of global property, Japan's house prices are undervalued by 37% when compared to rents and by 39% when compared to incomes. Japanese housing is the most undervalued of the 23 countries selected for the survey.
The value of the Yen
The yen reached its all-time high against the pound in January 2012. Since then it has devalued by 32%, and one pound currently buys 173 yen. The yen has not been cheaper in sterling terms for the last six years:
Graph of yen per GB pound courtesy Yahoo, click to enlarge
The weakness of the yen has more than one explanation.
1.       After the March 2011 tsunami and the meltdown at the nuclear reactor at Fukushima, the government closed down all the country's nuclear power stations. Japan had to import fossil fuels to compensate for the 26% of the nation's energy from nuclear plants that had been closed. Japan's traditional balance of payments surplus turned to a deficit in late 2013.
2.       One of Abenomics key policies was to reduce the value of the yen by monetary stimulus that included reducing interest rates to near zero. This was designed to favour exporters and encourage investment in capital equipment.
3.       The combination of a falling currency and ultra-low interest rates stimulated the carry trade. Speculators borrow in yen to invest in higher yielding securities in other countries, thereby further depressing the value of the Japanese currency.
While Japan is restarting most of its nuclear power plants and the balance of payments is expected to return to surplus, easy money, low interest rates and the carry trade will probably continue. The yen is unlikely to stage a comeback soon. While a cheap yen would depress the value of residential property when translated into sterling, it also seems to be reviving the Japanese economy. This would lead to a recovery in house prices.
With healthy yields and prices that are low by historical standards, Japanese residential property provides a good alternative investment for the individual investor. But one wouldn't want more than about 5% of one's portfolio invested in Japanese property.
It is one thing to identify a plausible investment in an alternative asset class, but it is another thing to identify a suitable investment vehicle for the individual investor. UK investors have an investment company that offers a straightforward way into the housing market in Japan. It is the Japanese Residential Investment Company.

The Japanese Residential Investment Company LTD (JRIC)


Spacia Akihabara, Tokyo, courtesy JRIC
The Japanese Residential Investment Company (JRIC) was launched in 2006 to invest in completed units of residential housing in Japan, which it then rents out. The company is based in Guernsey and is currently listed on the Alternative Investment Market (AIM). In June it announced its intention to move its listing to the London Stock Exchange's Main Market.
At the offer price of 56p, the company trades on an 8% discount to net asset value and yields 6.4%. My valuation model does not work well for property companies.
JRIC is run as an investment trust, with a board of directors appointing an investment advisor to identify suitable properties for investment and to manage the estate. The advisor, K.K. Halifax Asset Management, is a sister company of Colliers International which was established in Japan in 1952.
The company owns 58 apartment buildings, the largest of which is Spacia Akihara in Tokyo. 94% were built in the last 5 to 10 years and 67% of the units are either studio or one-bedroom apartments. JRIC set out to concentrate on the main conurbations, where demand is highest, and 59% of its space is in Tokyo, while a further 29% is to be found in Osaka and Nagoya. All their buildings comply with the latest (1981) anti-seismic building standards.
Occupancy rates are high, at 95.1%, rent arrears are just 0.1%, and the largest single tenant accounts for just 0.4% of JRIC's rental area. Still JRIC had a rocky start. Soon after its launch asset prices were hit by the financial crisis and, as it was highly leveraged, it was forced into a deeply discounted rights issue. This is discussed by City Wire in a 2012 article. The shares (20-day moving average in red) crashed to one-third of their issue price:

20 day moving average JRIC share price Vs FTSE 100, courtesy Yahoo, click to enlarge
JRIC shareholders were hit by falling asset prices compounded by a yawning discount to the net asset value of its properties. This discount, briefly exceeding 60%, has now largely disappeared as investor confidence in the company has returned.
JRCI Premium/discount to NAV, courtesy the Investors Chronicle, click to enlarge
In terms of yen, JRIC is doing quite well. Consider:
·         By being wholly invested in modern apartment blocks, the type of residential property in most demand, JRIC's net asset value increased by 7% in 2013 and by an annualised 4% in the first half of 2014.
·         JRIC made a profit of 2.1 million pounds on disposals in 2013, which represented a 24% premium to their assessed value.
·         Operating earnings per share in yen from the rental business declined by 3.5% in 2013, but in the first half of 2014 it exceeded the comparative 2013 period by 21%.
·         The dividend payout of 21 million pounds in the past four years has been amply covered by net operating cash flow of 31 million pounds.
·         Loan to value is 59%, which is 12 percentage points below where it was pre-crisis. The company has reduced its weighted cost of borrowings to 0.9%, which gives it a huge margin compared to rental yields. In 2014, JRIC took out a seven-year 40-million pound loan (denominated in yen) with a maximum blended interest cost of 0.9%.
As the investment advisor receives a commission of 0.5% on gross assets and the cost of borrowing is so low, there is always the temptation to borrow more. Hopefully the directors are now much more cautious than they were in 2008, and if not, five institutional investors, holding 55% of the company's shares, are there to remind them. Ruffer, known for its total return fund, has held a major holding in the company since 2007 and now owns almost one-quarter of JRIC's outstanding shares. 
As an alternative investment to stocks, bonds and cash, JRIC offers the individual investor some real diversity:
1. Residential property is less volatile than commercial. JRIC's investment in apartment buildings puts it into the most favoured sector of the residential market. And by renting solely to individual tenants, the risk of default - tiny in any event in Japan - is further reduced. That Ruffer holds 23% of its outstanding shares is an indication that JRIC offers the investor a return that is largely independent of the financial markets.
2. Japanese housing is cheap, by historical standards, and at some time it seems likely to recover.
3. The combination of a 6.4% running yield and the 8% discount to net asset value is far superior to the average for its Japanese equivalents that yield 3.4% and trade at a 34% premium to NAV. Both the yield and the discount offer protection against adverse movements in the residential property market and borrowing costs.
4. While the yen might well remain weak for some time, it is likely to recover at some point, which would boost the value of JRIC's portfolio and earnings in sterling.
5. The company's move to the LSE's Main Market will undoubtedly be accompanied by further raising of capital to expand the business. This could be positive for shareholders. Its relatively small size - JRIC is capitalised at 117 million pounds - and its listing on AIM might explain part of the reason for its lowly valuation.
Investors will note that the risks are:
Ø  JRIC does not hedge the yen - pound exchange rate. Further yen devaluations would reduce both the NAV and earnings of the company's portfolio in sterling.
Ø  If Abenomics fails, the Japanese economy could slip back into deflation, which could hit both rental yields and property prices.
Ø  The Japanese place little value on housing that is over thirty years old. As JRIC's properties age, they become less and less valuable until they have to be replaced. This cost is not built into JRIC's accounting. However, "The fair values of investment property are determined annually by independent qualified valuers using the income capitalisation basis and the discounted cash flow method." (2013 Annual Report)
Ø  Interest rates are at an historic low. Given the high public debt to GDP ratio, it is likely that borrowing costs will rise once the present loose monetary policy ends. This would reduce the company's operating earnings.
Ø  JRIC over-extended itself before the financial crash of 2008-9, with disastrous results for its shareholders. Something similar could always happen again.
Disclosure: I hold a long position in JRIC.

Monday, 6 October 2014

Commercial Property - time to invest?

And UK Commercial Property Trust PLC


One Canada Square, courtesy Wikipedia
Commercial property can be a risky investment. Canary Wharf's One Canada Square bankrupted its developer, Olympia & York. And the financial crisis took a huge toll on property companies. The funding crisis forced many companies into emergency rights issues and the hasty sale of properties. As a result, commercial property prices plunged by 44% between June 2007 and July 2009. Some property companies went into liquidation. Shares in even the largest, British Land and Land Securities (Land), lost 75% and 79% of their value respectively.
Excessive leverage exaggerated the fall in property shares. When Lands' net assets fell by 58%, net debt, which in March 2007 seemed a reasonable 48% of net assets, suddenly became 131% of net assets. The company had to sell property in a falling market. And, to avoid breaking its loan covenants, Land resorted to a 756 million pound rights issue in February 2009 at the bottom of the stock market.
Commercial property prices staged a partial recovery, but the damage to property companies was long lasting. Land's share price is still 56% below its pre-crisis peak.
However, under normal conditions, commercial property offers the long-term investor a steady and growing source of income via rental reversions plus an increasing capital value - data from
% annual return on capital*
    1980 to 2013
    Last 10 years
All property
Property equities
UK Gilts (Barclays equity/gilt study)
                *Capital plus reinvested income. The all property figures are based on gross returns, not net.
In the wake of the financial crisis, leases were broken or renewed at lower rentals. Land Securities, which provides like-for-like rental returns for its own properties, suggests that rents, after five years of decline, have started to recover:
Year to March
Rental returns*
Real GDP/capita**
* Land's like-for-like rental income compared to the previous year. **Lagged one year.
The fall in rents appears to be over, as Land has reported for the 12 months to March 2014. How can the individual investor best capitalise on this turnaround?
1. Exchange traded funds (ETF). The only ETF in the UK Commercial Property sector is the iShares UK Property UCITs. This ETF tracks companies in the property sector, not underlying property values. Consequently, it adds another layer of costs to the sector (0.4%) and does nothing to reduce gearing. It also yields only 2.3%, compared to the FTSE Real Estate Investment Trusts Index of 3.3%. 
2. Open Ended Property Funds. The financial crisis laid bare the flaw in this model. Investors rushed to redeem their holdings, and the illiquid nature of property meant that many funds were forced to halt repayments while they sold their assets at knockdown prices. Investors had to wait six months for their cash and then it was much less than they had anticipated.
3. Property companies and investment trusts. Directly investing in quoted companies is the best route for the individual investor. However, when choosing a company, it would be wise to consider:
Ø  The level of debt. Managers are tempted to gear up a company in the often-justified belief that property values will increase at a greater rate than the cost of finance. However, as the last property crash illustrated, this can be very risky. This is particularly the case when the funding is short-term - property can be hard to sell in a crisis.
Ø  The share's premium or discount to net asset value (NAV). Evidently it is best to buy at a discount to NAV. However, the best run property companies command a premium to NAV while those that trade on a discount often do so for good reason. As share price premiums are fairly volatile, the current premium - or discount - should be compared to its historic average.
Ø  The dividend is paid out of net rental income. Property companies and investment trusts often pay a dividend that is well in excess of the net profit from renting properties. Paying part of the dividend from capital is not sustainable.
Ø  Market capitalisation. Given that properties are high value investments, companies require substantial funds to offer some degree of diversification. Anything less than 100 million pounds is small by this yardstick.
Ø  Retail, office or industrial? And location? Depending on a wide range of factors, property valuations vary between different sectors and different locations at different times. While the property professional expends much energy on the subject, the individual investor should accept a degree of ignorance and invest in a company that spreads its investments over all three sectors.
The prudent investor will note:
1. Commercial property has historically been a lot less profitable than residential property. Between 1980 and 2013 residential property, according to, returned four times as much as commercial property.
2. Data on commercial property returns assume that gross yields are all reinvested. This exaggerates the possible returns, as it ignores the cost of managing and maintaining commercial properties.
3. The pressure on retail businesses from the internet adversely affects rental yields. Internet retailers require very little space, and as the margins of traditional retailers are threatened, they spend less on their properties. However, according to IPD, retail property has performed better than offices but worse than industrial over the last 33 years. 

 UK Commercial Property Trust PLC


Junction 47 Leeds, from
UK Commercial Property Trust PLC (UKCM) floated on the stock market in September 2006, a year before the collapse in commercial property prices. UKCM invests in 41 properties, with the largest, the Junction 47 Leeds retail park, representing 5.9% of its value.
Sector weightings are as follows (from the 2013 annual report):
% of portfolio
Property - Retail
Property - Office
Property - Industrials
Property - Shopping Centre
Net Current Assets
All UKCM's properties are located in the UK and they are spread around the country. The property portfolio has been managed since launch by Ignis Investment Services, a subsidiary of Standard Life PLC. The company has a market capitalisation of 1 billion pounds, trades on a 4.5% premium to net asset value and yields 4.5%.
The directors' decision to limit the trust's debt helped it to weather the financial crisis much better than the majority of its peers. UKCM's share price (in red) has declined far less than iShares UK Property ETF (in blue) that I have used as a benchmark.
      Chart courtesy Yahoo, click to enlarge.
UKCM offers the investor a fairly secure route into the commercial property market. Consider:
1.       Net debt is just 17% of net assets, which UKCM claims is the lowest gearing in the sector. Loans are long term and their weighted cost is 3.85%. As Standard Life Investments owns 55% of the trust, it should ensure that this conservative approach to financing continues.
2.       The property portfolio is well diversified, both by sector and by region, though the concentration on wealthier parts of the UK means that Southern England has a much larger weighting than elsewhere.
3.       Vacancy rates of 3.7% are low by the standards of the sector and 99% of rents are received within 28 days of becoming due.
4.       The directors decided in 2014 that the dividend should be covered by net rental earnings. As a result, they reduced the dividend for 2014, but the shares still yield a healthy 4.5%.
5.       Revenue earnings per share have been stable over the past five years. Total costs, which include a 0.65% management fee, amount to 1.8% of the trust's total assets.
6.       The NAV per share reported as of June, was 7% higher than December and UKCM expects it to be higher again at the year-end.
The main valuation tool for property companies is to compare the share price to the underlying net asset value. Currently, UKCM trades on a 4.5% premium to net asset value, which is about average for the past five years:
                                     Chart courtesy Investors Chronicle, click to enlarge.
It is likely that the NAV per share of 78p in June will soon reach the current share price of 81.5p.
Both the directors and the managing agents are unreservedly optimistic about the future of UKCM's business. Two directors have backed this judgment by buying shares at 76p in February and 81p in August.
Nevertheless, prospective investors will note:
·         Rising rents and commercial property prices depend on a continuing recovery of the UK economy.
·         Investors are attracted to commercial property for its steady income. An increase in yields in other asset classes could depress the value of property company shares. And UKCM's premium could disappear or turn to a discount, as it did in late 2011.
·         Property companies provide limited diversification from other equities. A study by Rick Ferri in the US suggest that the correlation between Real Estate Investment Trusts and the stock market has been inconsistent over the last 32 years. At times it approaches one and at times it approaches zero.
Disclosure: I hold a long position in UKCM.