Published by the CIPS Network of the National Association of REALTORS®

Third Quarter 2000

The J-REIT - An emerging market for residential and commercial mortgage securitization in Japan
By George Green

After the "bubble economy" burst in the early 1990's, Japan entered severe recession. While other Asian economies have shown dramatic improvement since 1998, the Japanese economy is still struggling to escape the clutches of the prolonged recession. The general worldwide manufacturing overcapacity in the 1990s created frenzied competition between Asian countries that drove down the cost of many Japanese exports. This presented a severe blow to the Japanese economy, and created havoc in the banking system when loans on manufacturing facilities could not be repaid. During this time, savings conscious Japanese consumers chose to forgo major purchases, further curtailing demand for manufactured goods, and deepening the recession.

Real estate was also significantly impacted during the economic recession. In 1992, the speculative bubble on land pricing burst. Between 1993 and 1996, commercial land prices in Tokyo decreased by more than 18 percent per year. The rate of decline dropped to 7.2 percent in 1998 but increased to 8.9 percent in 1999. This trend is important because up to 70 percent of the development cost for commercial properties can be accounted for by the land price, and declining prices have put severe pressure on banks that had made commercial land loans.

Over the past several years, a series of economic and financial reforms were enacted into law to create a financial structure that would allow Japan to be more competitive with the rest of the world's financial markets. In order to rebuild a banking system that had been shattered during the Second World War, Japanese financial policy makers restricted the types of investments Japanese citizens could make, channeling most savings into either banks or government bonds earning rates of return far below international standards. The Japanese government's effort to liberalize investment policies now is intended to provide citizens with more investment options.

The introduction of the real estate investment trust (REIT) structure to Japan is part of this effort. The Japanese Finance Minister has recently introduced bill to amend the Law on Securitization of Specified Assets by Special Purpose Companies (SPC Law) and Related Laws. That bill contains a REIT provision. The Foreign Ministry describes the J-REIT as follows:

The REIT structure is anticipated to be widely utilized to dispose of assets Japanese financial institutions and companies are attempting to get off their books. Because Japanese real estate has relatively low returns, caps rates in the 2 to 4 percent range, the dividends paid by the J-REITs will be relatively low when compared to their U.S. counterparts. Unless the real estate contributed to J-REITs is steeply discounted, the initial J-REITs will probably be purchased domestically due to low dividend payments.

A drawback of the J-REIT is that it does not have an UPREIT provision. In the U.S., UPREITs allow companies to contribute assets to a REIT through an umbrella partnership that does not incur tax liability for the contributing organization. In Japan, a taxable event will be created by the contribution of an asset to a J-REIT. If the property was contributed to a REIT for less than the original purchase price, the transaction would have to be booked as a loss. Companies that are unwilling to face the consequences of booking major losses on properties may be slow to contribute parties into REITs.  Despite this drawback, the J-REIT represents a major step forward for Japanese real estate and one that will allow distressed property to be more easily securitized.

What is a REIT?

A REIT is a corporation or business trust that combines the capital of many investors to acquire or provide financing for all forms of real estate. A REIT serves much like a mutual fund for real estate in that retail investors obtain the benefit of a diversified portfolio under professional management. Its shares are freely traded, usually on a major stock exchange.

A Corporation or trust that qualifies as a REIT generally does not pay corporate income tax to the Internal Revenue Service. This is a unique feature shared only with mutual funds, and is one of the most attractive aspects of a REIT. Most states honor this federal treatment and do not require REITs to pay state income tax. This means that nearly all the income of a REIT can be distributed to shareholders, and there is no double taxation of the income to the shareholder. In exchange, a REIT must distribute nearly all of its net income to its shareholders. Unlike a partnership, a REIT cannot pass its tax losses to its investors.

The main benefit of being a REIT is one level of taxation. The main limitation of being a REIT is a restriction on earnings retained by the company. For a REIT to grow, capital must come from money raised in the investment marketplace as well as money generated internally.

In order for a corporation or trust to qualify as a REIT, it must comply with certain provisions within the Internal Revenue Code. As required by the Tax Code, a REIT must:
  • be a corporation, business trust or similar association;
  • be managed by a board of directors or trustees;  
  • have shares that are fully transferable;
  • have a minimum of 100 shareholders;
  • have no more than 50 percent of the shares held by five or fewer individuals during the last half of each taxable year;
  • invest at least 75 percent of the total assets in real estate assets;
  • derive at least 75 percent of gross income from rents from real property, or interest on mortgages on real property; and
  • pay dividends of at least 95 percent (this goes down to 90 percent in 2001) of REIT taxable income.

Source: National Association of Real Estate Investment Trusts

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