MW-04 -- Real Estate: The Rest of the NPL Story

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J@pan Inc Magazine Presents:
M O N E Y W A T C H
Weekly Financial Commentary from Tokyo
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Issue No. 4
Tuesday, November 4, 2002
Tokyo

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Viewpoint: Real Estate: The Rest of the NPL Story

The Bottom Line:

o With the stock market hitting 19-year lows, the economy in a
10-year malaise, soaring corporate and personal bankruptcies,
and historically high unemployment levels, the current boom in
Tokyo office sites is puzzling on the surface. When these
mega-projects were on the drawing board, most analysts figured
that by the time they were built Japan would be growing again
and foreign companies would be flocking into Tokyo. The
reality is the opposite.

o The result will be a huge glut of Tokyo office space. In 2003,
no less than 1 million square meters of top quality office
space will come on the market, and vacancy rates have already
soared from 3.5 percent in early 2001 to 6 percent today.
Vacancies may rise to 10 percent over the next two years or
approach the 14 percent level reached in 1994. Moreover, a
significant amount of new space will be coming on the market
every year through 2010.

o The bottom line is that this is bad news for real estate
developers, construction firms and their financiers, the
banks. In fiscal 2001, the real estate sector accounted for
nearly 36 percent of risk-managed loans, while the sector is
one of the smallest employers among Japan's major industries.
Japanese property prices have been declining for the last 11
years and could well continue declining until the link between
bad debts and property collateral is completely severed. We
would not be surprised to see the Showa Depression's 14-year
record, reached in the 1920s, broken during the Heisei
Malaise.

o Yes, deflation needs to be eradicated, but MoneyWatch believes
that efforts to combat deflation with the introduction of yet
another bureaucratic boondoggle in the form of a new
Industrial Rehabilitation organization misses the point as
much as the poorly designed Resolution and Collection Corp.
(RCC), the Stock Purchasing Organization and the Development
Bank of Japan's efforts at corporate restructuring. In other
words, the government needs to step away and let the markets
do the work, rather than introducing more inefficient
organizations that will only suck up already stretched fiscal
resources while contributing little to solve the problem. If
true market principles, rather than socialistic theories, were
behind Japan's reform efforts, market prices for property,
stocks and companies would have fallen to levels that allowed
these markets (and the debt) to clear long ago, thereby
allowing, Japan's economy to adjust, regain competitiveness
and recover.

Even the casual observer can see that in nearly every neighborhood in
central Tokyo, huge new buildings are sprouting up. With the stock
market hitting 19-year lows, the economy in a 10-year malaise, soaring
corporate and personal bankruptcies, as well as historically high
unemployment levels, the current boom in Tokyo office sites is
puzzling on the surface. Ostensibly, the metropolitan Tokyo
government's easing of regulations governing the ratio of
floor space in 1996 was a big factor, while the 75 percent decline in
property prices since the early 1990s and near-zero interest rates
have also helped. But when these mega-projects were on the drawing
board, most analysts figured that by the time they were built Japan
would be growing again and foreign companies would be flocking into
Tokyo.

The reality is almost totally the opposite. With the government
lurching toward a tougher stance on the banking sector's nonperforming
loans (NPLs), bankruptcies and unemployment could well spike up
noticeably from here. The tentative recovery in Japan's economy has
already run out of gas.

THE NEW MEGA-BUILDING RUSH
Tokyo's skyline is changing daily. In Shiodome, the Tokyo Metropolitan
Government invested 146.3 billion yen in 31 hectares of land, where
huge office towers are sprouting up on the site of an old National
Railways freight station that will eventually accommodate 150,000
workers and have 210,000 square meters of new space. The infant
commercial district will be served by a new train station, scheduled
to open on November 2, connecting the Oedo subway line and the
Yurikamome monorail that runs to the chic Odaiba waterfront district.
Responding with gusto, the private sector has sunk more than 400
billion yen into the construction of buildings that will ultimately
accommodate 60,000 workers and 6,000 residents. The economic ripple
effect is estimated at 1.1 trillion yen. By 2009, a 1.35km Kanjo Route
2 will link Shiodome and Toranomon. The new residents of the complex
will include Kyodo News, Nippon Television, Dentsu, Nippon Express and
even Matsushita Electric Works, which is moving its headquarters from
Osaka. Mitsui Fudosan, Fujitsu, All Nippon Airways and Sumitomo Mitsui
Chemical will also be neighbors. The upper floors of the new Mori
Trust-Sumitomo Real Estate building (due to open in January 2005) will
by occupied by the first-class St. Regis Hotel. With three hotels
already in the district, competition for guests will be fierce.
Counting the St. Regis, there will be a total of 1,600 rooms to fill.

Then there is Roppongi. Not too far away from Shiodome, Roppongi Hills
will dramatically change the face of the Roppongi neighborhood. The
11-hectare Mori Building Co. site in the middle of Tokyo's
entertainment district has more than 400,000 square meters of office
space, four residential towers with 840 apartments, a hotel and dozens
of stores and restaurants. In addition, halfway between Shiodome and
Roppongi is Atago Green Hills, another Mori Building site that offers
149,000 square meters of space. Moreover, Mitsubishi Estate has just
opened its 100,000-square-meter Marunouchi Building, while a 32-story
Chiyoda First Building will add another 62,000 square meters.

NEW SPACE CANNIBALIZES OLDER, LESS CONVENIENT SPACE
Given the weak economic environment that promises to get even weaker,
the net result of all this new space will be less than a zero-sum game
in terms of supply-demand. In other words, it is coming on line while
demand is shrinking. The result will be a huge glut of office space.
In 2003, no less than 1 million square meters of top quality office
space will come on the market, according to real estate consultants,
and vacancy rates have already soared from 3.5 percent in early 2001
to 6 percent today. Vacancies may rise to 10 percent over the next two
years, or approach the 14 percent level reached in 1994. While the
surge in office space by 2003 was anticipated for some time, there is
a significant amount of new space coming on the market every year
through 2010. Colliers Halifax estimates that new space for large
rental buildings in Tokyo will surge to 864,000 square meters in 2003,
22 percent higher than the previous peak of 706,800 in 1996. And 78
percent of this new space will be in Tokyo's three central wards. What
this means of course is that occupancy ratios in outlying areas such
as Kamiyacho and Shinjuku will soar, and rents will plunge even
further as tenants move to larger, newer, more intelligent, safer and
better located space. Indeed, the lowest quality older buildings will
become virtually unmarketable.

This trend favors those developers (such as Mori Building and
Mitsubishi Estate) that are the strongest in Tokyo's central wards,
but even they will be affected by falling rents and cannibalization of
renters who shift from older space operated by the same landlords.

OCCUPIED SPACE SHRINKS
Ikoma/CB Richard Ellis estimates that between July 2001 and July 2002,
637,788 tsubo (or 2.12 million square meters) changed hands. That
equals 7.6 percent of total office space in Tokyo's 23 wards. This is
down 2.1 percent from the previous year. In addition, occupied space
is down 21 percent from the previous year. In reality, Tokyo's office
market is at a turning point. While all of this new space is coming on
line, demand is weakening. The rate of tenant relocation due to
expansion of operations has diminished, while relocation due to space
reduction is on the rise. For example, while Mori Building claims all
of the retail space and 75 percent of the office space in Roppongi
Hills is already rented, to do this they have had to make rent
concessions of some 20 percent to high-profile tenants such as Goldman
Sachs. Moreover, Goldman Sachs will be moving from Ark Hills, which is
also a Mori Building.

Consequently, the average asking price for rent in Tokyo's 23 wards
has plunged 53 percent from 1992, when the average asking price per
3.3 square meters was 29,580 yen. Today the price is 13,970 yen. And
vacancy rates are on the verge of soaring to the peak of 9.6 percent
hit in 1994. Overall rates of return, which bottomed in 1994 at ・0
percent per annum, peaked in 1997 at just under 10 percent and are now
approaching zero even though annualized income gains are around 4
percent per annum.

EXPECT MORE BAD DEBTS
The bottom line is that this is bad news for real estate developers
and construction firms, and needless to mention, the banks and other
financial institutions that lend these companies money. To fund their
building spree, the privately owned Mori Building used $1.3 billion in
syndicated loans from lenders including the government's Development
Bank of Japan, which pushed their overall debt to $5.6 billion. That's
nine years of revenues for the company and 119 times the most recent
fiscal year's earnings. This is for a company that is probably
considered one of the better credits in the industry.

Indeed, Mori Building avoided the gold course and resort deals that
now burden other real estate developers. There are 2,430 golf courses
in Japan, and by most accounts, that's about 730 too many. Yet there
are about 20 new courses being built a year, despite soaring
bankruptcies among these golf courses. So far in this year, 67 courses
have gone bankrupt, leaving irrecoverable debts of over 1 trillion
yen. The pace of bankruptcies this year is already higher than last
year and about 3.5 times 1998 levels.

The Catch-22 is that soaring levels of convenient new space by the
strongest factors in Japan's property market plus an accelerated loan
cleanup by the banks will slam-dunk the weaker construction firms and
developers. In fiscal 2001, the real estate sector as a whole
accounted for nearly 36 percent of risk-managed loans on the books of
the major banks, while the sector is one of the smaller employers
among Japan's major industries.

Thus, if the banks are forced to jettison their dud borrowers by
fobbing off the bad credits to the RCC, the real estate sector would
be the first choice, right? Wrong! One must take into consideration
that organized crime in Japan at one point derived as much as 70
percent of its revenues from real estate transactions and related
"services." In addition, most of what is counted by the banks as
collateral backing NPLs is real estate.

This week, two smaller construction companies -- Kotobuki Industry, a
Japanese building material supplier, and Nisseki House Industry --
filed for court protection from creditors with debts of 18.6 billion
yen and 17.5 billion yen, respectively. Both of these companies have
lost money in most of the past seven years. This is only the tip of
the iceberg. Japanese construction companies have been hit hard by the
slide in property values, shrinking demand and shrinking public works
projects. During the first half of the Heisei Malaise, generous
government public works allowed the construction sector to provide an
employment cushion, while padding the election coffers of key Liberal
Democratic Party politicians.

Even here, however, the structural malaise is taking its toll. Indeed,
the domestic construction industry has shrunk by 30 percent to 60
trillion yen over the past five years. The construction sector
employed 6.32 million workers in fiscal 2001, which is down only 6
percent from five years earlier.

A group of eight mid-tier general contractors and real estate firms
that have already received financial assistance from creditor banks
will require a total of 750 billion yen in further debt cuts in order
to bring their interest-bearing liabilities down to industry-average
levels. The eight firms registered interest coverage multiples of 1.4
to 3.9 -- in most cases significantly below 4, which is the average
for both the 147 listed construction companies and listed companies
across all sectors. Conversely, the four major general contractors
have an average interest coverage ratio of 4.7, while the mid-tier
general contractors have a ratio of 5.6. Usually on the short list of
those not expected to make it are Kumagai Gumi, Sumitomo Construction,
Mitsui Construction, Hazama, Daikyo and Towa Real Estate.

While the banks continue to coddle these dud borrowers, the government
is drawing up guidelines aimed at reducing the number of construction
companies and other businesses in sectors considered overcrowded. The
construction market is expected to shrink to less than 60 trillion yen
for the first time in 16 years in fiscal 2002. Yet the industry has a
glut of about 590,000 domestic construction companies, no less than
some 300,000 of which are essentially paper companies. The failures of
Aoki and Sato Kogyo after having received large cancellations of debt
underscore the limits of the old approach to supporting collapsing
businesses.

Consequently, as with vast swaths of the Tokyo stock market, capital
destruction in the construction sector is occurring in historical
proportions. The total market capitalization of the four leading
general contractors -- a group that includes Taisei and Obayashi -- is
now about 1 trillion yen, one-seventh of what it was during the peak
of the bubble economy in 1989.

THE REST OF THE BAD DEBT STORY
Japanese property prices have been declining for the last 11 years
and could well continue declining until the link between bad debts and
property collateral is completely severed. During the great Showa
Depression in the 1920s, Japanese property prices declined for 14
consecutive years. We would not be surprised to see the record broken
during the Heisei Malaise.

As they are pressed harder to clean up their loan books, the banks are
wimpishly beginning with the smallest fish, while in reality their
biggest problems lie elsewhere -- in the real estate, construction and
retail sectors. Conversely, most of the debate (particularly from the
LDP and the banks) about the banks' bad debts centers on manufacturers
and small- and medium-sized companies, which only befuddles the issue.

MoneyWatch believes that the Koizumi Administration is only being
realistic in introducing discounted cash flow valuations for NPLs,
especially if they begin with discounted cash flow valuations of the
property held by the banks as collateral, then move on to the debtors
themselves.

However, efforts to combat deflation with the introduction of yet
another bureaucratic boondoggle in the form of a new Industrial
Rehabilitation organization misses the point as much as the poorly
designed RCC, the Stock Purchasing Organization and the Development
Bank of Japan's efforts at corporate restructuring. Powerful LDP
politicians and the ministries are already fighting over who gains
control of both the Industrial Rehabilitation organization as well as
a souped-up RCC-Development Bank of Japan combination. How these new
schemes actually function will hinge on who eventually has control,
the reformists or the protectionists. If the protectionists get the
upper hand, both schemes will become essentially another bureaucratic
boondoggle to support Japan's loser companies. In other words, it
shouldn't be the government's job to determine which companies survive
or fail; it should be up to the marketplace. The government needs to
step away from direct intervention and let the markets do the work,
and government policy should merely provide an environment where
market forces can work most efficiently and quickly.

New bureaucratic, inefficient organizations will only suck up already
stretched fiscal resources while contributing little to solve the
problem. If true market principles, rather than socialistic theories,
were behind Japan's reform efforts, market prices for property, stocks
and companies would have fallen to levels that allowed these markets
(and the debt) to clear, and Japan's economy would have adjusted and
recovered long, long ago.

-- Darrel Whitten

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STAFF
Written by Darrel Whitten info@asianbusinesswatch.com

Edited by J@pan Inc staff (editors@japaninc.com)

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