MW-45 -- Cyclical vs Secular -- Not a Problem Until 2004

J@pan Inc Magazine Presents:
Weekly Financial Commentary from Tokyo

Issue No. 45
Thursday, September 25, 2003

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++ Viewpoint: Cyclical vs Secular -- Not a Problem Until 2004

The Bottom Line:
Top-Down: If this time is different, credit needs to expand.
o Whether the current economic recovery is cyclical or secular
makes no difference to the stock rally for the remainder of
2003. However, the answer to this question will have a
significant impact on the performance of Japanese stocks in

o For this economic recovery to become a secular recovery, Money
Watch believes that the ongoing shrinkage of credit will have
to be reversed. Since a re-expansion of credit through the
dysfunctional banks is not likely as they push to clean up
balance sheets and de-link their regulatory capital from the
stock market, it will have to come from the Bank of Japan
(BOJ), ostensibly by unconventional means. In addition, the
decline in property prices, in many respects the core of
Japan's nonperforming loan (NPL) problem, will have to be
reversed. Property prices and rents continue to decline,
although the rate of decline has abated.

* Bottom-Up: Real estate companies learn how to use other people's
o Contrary to the "domestics are back" scenario proffered by
pundits and the media, the Topix sectors leading the market
rally since the end of March are actually market proxies. The
reason these sectors are leading is somewhat circular.
Perceived financial sector risk is down, and stock markets are
going up. In turn, brokers, banks and the insurance companies
are going up because they have the most leverage to rising

o On the other hand, the rally in real estate stocks is similar
to the rally in broker stocks. In other words, what matters
most to the bottom lines of the brokers is trading volumes,
not stock prices per se. Similarly, while the top-down picture
for property is glum with falling prices and rents and growing
vacancy ratios in central Tokyo, the number of property
transactions has increased noticeably, with property investors
aggressively searching for deals.

o Real estate companies, while at the core of the NPL debacle
during the bubble, have learned that shrinking bank credit
need not stifle their development activities because there is
a growing pool of both overseas and domestic
institutional-investor capital that is eager to invest in
Japanese property. Indeed, even commercial property majors
like Mitsui Fudosan have come to learn that an "OPC" (other
people's capital) strategy can work to increase cash flow and
returns on assets through the use of investor consortiums,
real estate investment trusts (REITs) and other real estate
securitization schemes.

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++ Viewpoint: Cyclical vs Secular -- Not a Problem Until 2004

From our recent talks with foreign investors visiting Japan, it is
clear that the majority of both institutional investors and sell-side
investment banks that watch Japan are more bullish than ever on Japan.
They are increasingly convinced that this time it is different, that
Japan is, after a 10-year malaise, in the early stages of turning the
big corner.

Domestic investors are far from convinced, perhaps because they have
been repeatedly losing money on Japanese stocks -- to the tune of
trillions of yen over the past couple of years -- while their
investment of choice, government bonds, is no longer a "sure" thing.
It's not that they are complaining about the stock rally, mind you, as
it's been way too long since there was any good news on Japan in the
form of a sustainable stock market rally. Moreover, the stock market
rally has also given Japan's major banks a major reprieve from de
facto net negative equity and has significantly eased the
balance-sheet pressure on the financial markets, pulling Japan back
from yet another potential financial crisis.

Perhaps the biggest divergence in the views of domestic and foreign
investors is the sustainability of the current economic recovery. Is
this merely a cyclical recovery or is it the beginning of a secular
recovery in Japan? For the moment, whether Japan is experiencing a
cyclical or a secular recovery makes no difference to the stock
market. This is because both are perfectly capable of driving a
40-50-percent rally in stock prices for the time being. Where the
cyclical versus secular debate does come into play, however, is in
2004 equity market performance.

Cyclically speaking, the aggregate financial surplus of Japanese
corporations has swung from a deficit of over 40 trillion yen in
1990-1991 to over 20 trillion yen in 2002-2003. This is the direct
result of rationalization measures, including decreasing
interest-bearing debt, reduced capital expenditures and reduced
fixed costs. Japanese companies have also recently completed
drawing down the overhang of inventories that were the result of
the October 1999~October 2000 business expansion. Thus, just returning
inventories to more "normal" levels is enough to produce an uptick in
growth, but not a secular recovery.

For the bullish Japan scenario currently being suggested by foreign
investors to actually come to pass, Money Watch believes the BOJ will
have to actively intervene to provide the essential credit needed for
a sustainable recovery, given that the banking system remains largely
dysfunctional. Japan's economic malaise has already demonstrated that
it is impervious to interest rate and fiscal stimuli. The reason is
fairly straightforward: The availability of credit has continued to
shrink even amidst historically massive doses of interest-rate and
fiscal stimulus from the government.

Thus assuming that the nation's banks, either at their own initiative
or through the government's Financial Revival Program, will (as they
should) concentrate on cleaning up their balance sheets to the point
that their "real" (net of deferred tax assets) capital meets the
global 8-percent standard credit provision, and that they will de-link
their shareholder equity from the stock market by reducing their
holdings of stock to below their reported capital and to a point that
movements in the stock market no longer have major relevance to their
reported capital or their reported earnings, the BOJ will have to fill
the gap, ostensibly through unconventional means.

A Bottoming Out of Property Prices also Needs to be Seen
The total land area of Japan is approximately 94.4 million acres
(smaller than the state of California), but only 4.4 million
acres (4.7 percent) is developed land for residential, industrial and
other uses. Over 80 percent of the land mass is forestry (62.1 million
acres), just under 13 percent is agricultural (12.1 million acres) and
just under 7 percent is surface water, rivers, canals and roads.

On the other hand, the total population of 127 million ranks ninth in
the world, and the population density of 341 persons per square
kilometer ranks fourth among nations with a population of 10 million
or more. However, 44 percent of the total population is crowded into
three metropolitan areas: Tokyo, Osaka and Nagoya. In metropolitan
Tokyo alone there are some 12 million people, or roughly 10 percent of
the total population, and population density is 5,517 people per
square kilometer, or 16 times as dense as the nationwide average.

As Japan was rebuilding after World War II, the "baby boomers" were
still building their families, and there was mass migration from
agriculture to the manufacturing and service sectors. The Japanese
came to view property as even better than gold for storing value --
its value never went down. Indeed, as the bubble of excess credit grew
ever larger from 1983 onward, Japan's financial system itself came to
be based on a de facto real estate (as opposed to gold) standard.

The BOJ's policy of bank loan "window guidance" in the mid-80s made
things worse. In effect, the central bank was supplying more credit to
the banks than the banks themselves could profitably invest in
"productive" enterprises. Banks and their ability to create credit
with loans were the key to the speculative boom, and the tsunami of
credit created during this period explains the astronomical price of
Japanese stocks and property during this period. Japanese banks never
attempted to do a cash-flow analysis on their borrowers. They simply
granted loans based on the appreciating value of collateral.

Of all the problems facing Japanese banks, perhaps the most corrosive
has been the steady slide in real estate prices. This is because real
estate, directly or indirectly, supported as much as 80 percent of the
total loans of Japanese banks. As the bubble burst, banks were left
with collateral (both of property and stocks) worth a fraction of what
it used to be, and the volume of loans had long since exceeded the
cash flow of even once healthy firms to pay off the loans. In 1991
Japanese banks had reserves of only 3 trillion yen for total loans of
450 trillion yen. They have been struggling since to provide adequate
provisions for NPLs.

To the extent that property values formed the basis of much of the
recoverable value of bank loans and provided an unrealized asset-value
cushion for companies, their steady decline has exacerbated Japan's
bad-debt problem. As financially strong firms have been reducing their
debt and the banks have effectively ceased their traditional role of
creating credit through new loans, nationwide property values and
rents have continued to shrink for 12 consecutive years. The declines
are sharpest in the metropolitan areas, particularly Tokyo, and
especially in commercial property.

Metropolitan Tokyo commercial real estate prices have fallen over 80
percent from March 1990 peaks and are over 50 percent below March 1985
levels, when the property bubble was just beginning to form. But the
skyline in Tokyo's 23 wards is changing daily, as central Tokyo is
seeing a rush of new mega-building developments. Many of these
mega-sites currently being completed were on the drawing boards up to
a decade earlier, when most analysts and corporate planners figured
that by now Japan's economy would be fixed and growing again, and
foreign companies would be flocking to Tokyo.

Other factors fueling the building boom include:
a) Along with plunging real estate prices comes falling rents, but
as rent on existing contracts does not change until the contract
is renewed or cancelled, the lag in the decline in rents vis-・
vis property prices has meant rising yields.
b) The Tokyo metropolitan government eased regulations governing
the ratio of floor space in 1996.
c) Near-zero interest rates.
d) The introduction of REITs and more active real estate
e) Investment activity by foreign investors is very active.

In terms of overall rates of return, the Japan Real Estate
Institute surveys show that only the Marunouchi/Otemachi,
Shiodome and Shinagawa areas were expected to see stable rent
levels. In the other areas, including Ueno, Roppongi,
Shibuya/Ebisu, Shinjuku, Toranomon/Shimbashi and Nihonbashi,
rents were expected to decline by 2~10 percent over the next 10 years.

Overall rates of return on commercial property bottomed out around
1993, temporarily turned positive in 1997, and again began to
deteriorate with accelerating deflation, the exception being the
Marunouchi, Otemachi and Yurakucho areas of central Tokyo. The
rental market has also polarized markedly. Rents vary dramatically
between modern new buildings with larger usable office space and
smaller/older buildings, even if both are standing side by side. By
age, the spread between asking rents on new buildings and those over
five years old is 45 percent (19,690 yen per 3.3 square meters vs
13,590 yen per 3.3 square meters). The spread is 74 percent between
"small" and "large" buildings. That said, because of the sheer volume
of new Class A buildings coming on the market (i.e., those with space
of at least 10,000 tsubo -- a tsubo is 3.3 square meters -- that were
built after the new earthquake codes of 1982), vacancy ratios in these
buildings have risen to 8.8 percent versus an average vacancy ratio of
6.6 percent. Space in smaller, older and inconvenient buildings is
becoming virtually unrentable.

Consequently, the "recovery" in Japan's property market is as yet
extremely selective and focused on a narrow universe of the best
sites. Indeed, because of sharp polarization, even landlords with
substantial rental space in Tokyo's 23 wards are finding that unless
they own one of the new developments and their portfolio consists of
class A buildings, the so-called "recovery" remains as elusive as

Stock Market Proxies are Leading Performance
So far in the fiscal year that began in April, Topix sector
performance paints a different picture than what the pundits and the
media have been describing. In fact, it has largely been the
financials that are leading the market in terms of Topix sectors.
The best-performing sector is the brokers (which have outperformed
by +2.07x), while the banks (+1.78x) and the nonlife insurers (+1.72x)
are the third and fourth best performing sectors.

The reason these sectors are attractive is somewhat circular. These
sectors are proxies for the stock market -- stock markets are going
up, and therefore these sectors are rising because they have the most
leverage to rising stocks. In fact, the government's implicit promise
to back up the major banks without demanding too much in terms of
management responsibility that was indicated by the rescue of Resona
Bank was what helped to bring the banks back from the brink of de
facto net negative equity and, in turn, was a significant catalyst for
the current stock market rally, upon which relieved investors are
buying back the banks and insurance companies.

Consequently, the idea that it is the "domestic" undervalued sectors
that are leading the market is misleading. In reality, basically the
only good outperforming "domestic" plays with sound fundamental
stories are those driven by China demand, the most representative of
these being the steel sector, which has outperformed the Topix by
1.78x. Other domestic sectors such as chemicals, retail and services,
however, have noticeably lagged. Thus, the rally so far is not one
that has completely bought into the sustainable economic recovery
scenario carte blanche.

Despite continued declines in property prices, falling rents and
rising vacancy ratios, the real estate sector has been the
sixth-best-performing Topix sector year to date. From April 28 lows,
the real estate subsector of the Nikkei 225 has surged over 80
percent, a gain surpassed only by the broker subsector of the Nikkei.
Despite this performance, "street" ratings on the three blue chips in
the sector are "neutral" to "slightly bullish." Short-term, these
stocks may have gotten a little overheated, but the performance of
these stocks certainly belies the glum top-down view of real estate

A survey of Japan real estate investors by the Japan Real Estate
Institute in May of this year showed that 30 firms (out of 76
respondents) were "aggressively" searching for investment properties,
and that 68 percent had been involved in a real estate transaction in
the past six months. Moreover, companies are on the move, with roughly
2 million square meters of space bought during the January-August
period, a level already 33.6 percent higher than in 2002. In other
words, trading "volume" in Japanese real estate has picked up, and for
real estate brokers (like stock brokers), it's the transaction volume
that really counts.

Major real estate firms that are developing the mega-sites are also
pushing for construction of alternative rental space so they can
obtain a favorable ratio of floor space to land area when building
multi-use buildings. For example, Sumitomo Realty is constructing an
office-hotel building with Mori Trust in Tokyo's Shiodome district.
The company says the Tokyo metropolitan government assigned a
900-percent floor-space-to-land-area ratio to the property on the
condition that almost 30 percent of the floor space be used for
purposes other than offices. The normal floor-space-to-land-area rate
is 400 percent.

The developer has thus lured Starwood Hotels & Resorts Worldwide of
the US to build a St. Regis hotel on the property. Indeed, the top
four luxury hotels in the world are expected to begin operating hotels
in central Tokyo by 2008. Tokyo already has eight domestic and foreign
luxury hotels, including the Grand Hyatt Tokyo that opened in April.

As restructuring companies like Toyobo move to sell their headquarter
buildings and related properties, foreign firms are among the first in
line for the bidding. Their activities are not limited to commercial
buildings, as they are purchasing rental condominiums, bankrupt golf
courses, shopping center sites, warehouses and even baseball stadiums.
Thus the real estate sector, while a heavy user of bank borrowings
during the bubble, does not seem phased by the shrinkage of credit.
This is because real estate firms have begun to tap the abundant pool
of domestic and foreign institutional funds that are interested in
buying Japanese property.

Change of Strategy among the Major Developers
Major Japanese developers have been bought as asset plays with highly
leveraged balance sheets in the past. Their "unrealized profit"
management styles were at the core of the "property standard"
financial system that was prevalent during the 1970s and 80s. But
Mitsui Fudosan, Japan's largest real estate company, is changing its
strategy and moving to de-leverage its balance sheet, adopting a new
policy under which it will try to own as few properties as possible.

The company is attempting to spread the risk involved in owning
and developing real estate by forming development consortiums with
institutional investors at home and abroad, while moving to increase
its fee income by enhancing services to manage and maintain buildings
and other properties for corporate customers. This reflects the
lessons learned from the consecutive losses posted over the last few
years due to plunging values of real estate. Under a six-year business
plan drawn up this spring, the company intends to pare its
interest-bearing debt by 400 billion yen to 990 billion yen over the
same period, targeting a ratio of debt-to-net-assets of 1.2 in fiscal
2008, compared with 2.2 in fiscal 2002.

However, many analysts are still valuing companies like Mitsui based
on the value of assets held. If majors such as Mitsui are successful
in significantly de-leveraging their balance sheets and converting
their businesses into fee-based business models, the shift to a
cash-flow discount valuation approach could result in a significant
re-rating of these companies as a lower leverage, less directly owned
assets and growing fee income lead to what has historically been a
pitifully low return on assets.

At the same time, there is a new crop of "asset-less" real estate
firms that focus on real estate securitization, real estate
property management and loan servicing. These real-estate-related
"service" firms are attracting funding from domestic pension
funds that are increasingly interested in real estate investment.

-- Darrel Whitten

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Written by Darrel Whitten

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