Three real estate investment risks in Japan and what you can do about it
At its Monetary Policy Meeting last October/November, the Bank of Japan announced its intention to maintain its policy of negative interest rates.
Low interest rates due to Abenomics are clearly one factor behind the current surge in demand for Japanese real estate investment.
However, there are also other key drivers such as the Tokyo Olympic Games and Paralympics in 2020, a steady increase in invetment funds from overseas and a rush to buy ahead of the planned increase in consumption tax.
Taking all this into account, the market seems unlikely to quieten down any time soon.
On the other hand, there is still plenty of skepticism about the potential upside of investing in real estate. When considering property as an investment, one needs to at least be aware of the possibility of failure, and to understand the risks, and take precautions accordingly.
The risks involved with real estate investment fall into one of three categories.
1. Product risk
2. Lower than expected profit
3. Fall in asset values
Product risk primarily relates to the characteristics of the asset itself – real estate. Specifically, this refers to the fact that investment amounts involved are usually large but liquidity is low.
The price of real estate varies from several million yen for apartment blocks with split ownership to several hundred million yen for one apartment building.
Investing sums of this size naturally means you have a larger exposure to potential losses should the investment not work out, the large the amount, the more you have at stake.
For large investments, on top of your own capital, you often need to gear up or leverage your investment via borrowing. This naturally gives rise to risks relating to the repayment of principal and interest rate movements.
The larger the loan, the higher the principal repayment required, with interest obligations putting further continual pressure on cash flows.
Although this is not an issue with interest rates at their current level, the risks of cash flow and revenue pressure due to a change in monetary policy in the future are increasing.
Low liquidity is a key risk of real estate investment since it means that it could take time to convert your assets into cash. If circumstances require that you raise money quickly or you happen to decide that you want to withdraw from the market altogether, you could find yourself having to wait several months before being able to find a willing buyer and completing the sale transaction.
If the asking price is high, or the offers you receive are lower than expected, you may not be able to sell for some time.
The time lag from deciding to sell to actually cashing out might could in a significantly higher than expected loss if the investment environment deteriorates in the meantime.
Lower than expected profit
We consider several potential reasons why profits could disappoint versus your original expectations. Investment income comprises the continuous revenue that is generated from holding the real estate asset.
It is primarily rental income. The reasons why rental income may fall short of expectations include vacant rooms, downward pressure on rents, non-payment of rent, or management and repair costs rising.
If your investment consists of a single room only, if this room is empty or unoccupied you will have no income stream.
Even if you invest in a small apartment block of, say, 8 rooms, if only one room is vacant, then your income stream drops by 12.5%.
So clearly investors need to fully understand the severe impact on revenues that even just one empty room can have.
New build apartments or “mansions” command a higher rent than the market average, reflecting a premium for first-time use.
However, as soon as someone has lived there, the apartment is effectively “second hand” for the next tenant who comes in, so inevitably the rent will fall next time the apartment is let.
Obviously, the type of rents appropriate for new builds cease to apply as a property ages.
Even for previously used properties, rents inevitably fall as circumstances change – for example, wear and tear of fixtures and fittings, changes in specifications or increased competition from similar new build apartments in the neighborhood.
Moreover, no matter how carefully you select your tenants, unpaid rent is always a risk. Rental default has the same negative impact on your profit as an empty room.
In order to protect against the risk of vacant rooms and declining rents, it can be a sensible option to use a management company, who can help, for example, with maintenance and bringing in new tenants as needed.
However, this introduces a new set of risks, mainly related to the quality of the management company and the costs involved in using one.
For example, the management company may not do a satisfactory job of maintaining and managing the property, it may be unreasonably expensive, or it may even go bankrupt.
Also, when you initially buy a property, you may risk incurring unexpected repair costs. Even if the facilities are suitable for use right now, there is no guarantee as to whether they can be used next year without some investment in repair and upkeep.
You can’t pin responsibility on the seller for any deterioration in fixtures and fittings due to wear and tear.
Fall in asset values
In terms of the building itself, the longer it is since the structure was built, the greater the depreciation in value. When a property is a new build, its sale value is the cost of construction plus the applicable sales margin.
As soon as it starts to be lived in, its value falls by 30%. For wooden buildings, the value of the asset as collateral is generally written down by financial investors to 0 over a period of 20 years.
Separately-owned mansion apartments are typically valued on neighborhood property transaction values. New builds can be valued by breaking down their separate profit streams and assessing how much income can be generated.
However, since rent is determined by market values, the risk of asset deprecation remains. Although the asset value of the land itself is not as great as that of the building, its value still remains vulnerable to economic fluctuations.
There is even the risk that the building itself could be wiped out in the event of a disaster, such as an earthquake or fire.
Measures to deal with investment risk
The easiest way to deal with product risk is actually not to leverage your investment at all. However, this severely constrains your ability to invest, and means you do not get to take advantage of low interest rates.
Therefore the best course of action is to work out the funds you have immediately available for yourself, and then put together a business plan to take on leverage of 3x your initial capital amount.
If you have surplus funds available from your cash flow, using this to pay down some of this debt ahead of schedule also helps reduce risk.
Many people choose floating interest rates to take full advantage of low interest rates at the time of financing. However, you should bear in mind that rates are already at historical lows: therefore, selecting a fixed rate loan will hedge out the possibility of rate rises in the future.
As a response to the risk of profit shortfalls versus expectations, the best hedge is to select property in an attractive location.
For many high-yield properties, the land itself is cheap and the value of the investment is highly dependent on continued demand for leases from specific tenants, such as universities, factories, or shopping malls.
You should be wary about the sustainability of this type of demand and the possibility that the demand declines in due course.
However, if you choose a city center area with good transport links (stations for example), such as Tokyo or any city center area with governmental or prefectural offices with a concentrated population, the risk will be much lower, even if the yield is less attractive.
Maintenance of facilities and adherence to required specifications is also important. In this case, a contract with a reliable management company helps reduce your risk.
They arrange repairs cheaply and are also familiar with the types of buildings and facilities that are popular at present, so they are useful for bringing in new tenants as well.
Some management companies also offer guarantees against rental non-payment or empty rooms. If the management company is registered in the rental housing management registration system, then it should be reliable.
Looking at a company’s credentials in terms of number of units managed, or the number of years it has been in business when deciding to work with a management company will lead to a reduction in risk.
As for the risk of a fall in asset values, location is critical. There is little risk that asset values fall significantly if the property is well-situated.
It is also much easier to sell a property in a popular area when you wish to exit. In terms of the risk of natural disasters, if you want to reduce earthquake risk for example, you should look for properties that meet the new earthquake resistance standards put in place after 1981.
Checking whether a building has an inspection certificate issued since 1981 is a good way of determining earthquake risk. It is better to avoid investing in buildings without the requisite inspection credentials.
Certainly, it will be much harder to raise financing from financial institutions when buying a property which does not meet the standards.
For reducing fire risk in buildings, steel structures are clearly preferable to wooden structures. Also, in terms of location, areas with wide streets are a good idea from the point of view of easier access for fire engines.
Try to avoid areas with a high concentration of wooden houses.
If you have the funding available, it is a good idea to diversify your portfolio as much as possible.
Using REITs as a risk hedge
If you are trying to hedge a large real estate investment, you should consider REITs (Real Estate Investment Trusts). You can buy these as retail products, which means you can control the amount of money you spend.
Since REITs are financial products traded on an exchange, you can sell REITs and go short if you are bearish on the outlook.
Then you can make a profit by buying back your REITs if the market falls. This makes them an ideal way of hedging risk. Astute investment in these can protect you if you are worried about the value of your assets.
Compared to investing in equities or FX, property can offer consistent income over a long-term time period. You can also leverage your investment by borrowing money in addition to your initial capital.
If you are overly concerned about the risks, then you shouldn’t invest. But you should think carefully about what sort of risk you are comfortable with, compare the returns involved, and then make your decision.