April's earthquakes on the southern island of Kyushu have heightened downside risks to the Japanese economy, which is already facing headwinds from uneven global demand, especially the slowdown in China, as well as financial market volatility and tightened U.S. monetary policy. Even though the quake will have a moderate negative impact on short-term economic momentum and growth, it is not likely to affect medium-term purchasing sentiment and capital interest in the Tokyo real estate market.
Compared to the Kobe and Tohoku earthquakes of 2005 and 2011, respectively, the damage this time appears to be much smaller. Furthermore, current economic conditions are better underpinned by the positive tailwinds from the 2013 onset of Abenomics. Investors this time are therefore not likely to react as negatively and will probably instead stay focused on the longer-term prospects of the economy, Abenomics and the property market heading into the 2020 Tokyo Olympics.
The appreciation of the yen is also not likely to sidetrack institutional investors' appetite: unlike retail investors, institutional funds looking at longer-term investment horizons are more focused on the fundamentals of project-level returns. Furthermore, most global investors use currency hedges which will mitigate any potential hit on returns.
In spite of global concerns, the Japanese economy remains on stable footing, and the political and policy landscape is supportive of investment demand. Tokyo real estate is a core and highly liquid institutional market which we believe offers strong safeguards to pricing in the form of a supportive lending policy, a robust capital market and deal appetite from Japan real estate investment trusts. According to transaction volume data from Real Capital Analytics, Tokyo ranked fifth globally in terms of property sales in 2015, following New York, London, Los Angeles and San Francisco. Also last year, growth in central Tokyo commercial land values led average land prices in Japan to rise for the first time in eight years.
Against the backdrop of firm institutional demand for office and retail property, two other factors will help to mitigate risk in Tokyo's real-estate market in the event of an unexpected economic downturn, namely: gearing levels that have fallen from average loan-to-value rates of 90% before 2007 to 50-60%; and borrowing costs that have dropped by as much as 1.5 percentage points from pre-crisis levels.
That said, modest rent increases over the past three years have been capped by rising supply, even as demand has also grown incrementally. With business conditions expected to stay firm, office rents should have room to grow by another 15-20% in select areas of Tokyo based on the current market environment. Such neighborhoods where rents have the greatest potential to rise due to infrastructure investment, tight supply or other strong fundamental factors include Akasaka, Shibuya and Shinjuku. Even though capitalization rates have narrowed over the past three years, investors still stand a reasonable chance of achieving geared returns of 8-10%.
While Japanese cities including Osaka and Nagoya are set to fall out of the ranks of the world's top 30 cities by gross domestic product by 2030, advisory group Oxford Economics expects Tokyo to remain No. 1. Other forecasts suggest that Tokyo will produce almost half of Japan's aggregate GDP growth over the next 15 years, underscoring the city's long-term economic sustainability.
Japan's aging population, shrinking workforce and overall population decline will lead to a clustering of people in major urban centers at the expense of less successful towns and cities. Under this scenario, Tokyo has the potential to remain perpetually younger than the rest of the country as graduates head to the capital city to start their careers; move to the outskirts when they start a family; and then settle in slower paced and less expensive towns as they approach retirement.
Thus, while Tokyo's population continues to grow, many other large Japanese cities are not doing so well. For example, Sapporo is forecast to lose 15% of its population over the next 15 years. This polarization is already being reflected in property markets. Real office rents in Nagoya are 25% below their 1996 level and have halved in Osaka. The inability to attract young, working-age residents is compromising some cities' vibrancy and tax base.
The strength of Tokyo's real estate market lies in the city's continually replenished young, working-age population and the knock-on effect of stable property market demand. Despite concerns over the Japanese economy and Tokyo's property market amid a global economic slowdown, the capital city remains a strong destination for real estate investment.
Harry Tan is head of Asia-Pacific research for investment management company TH Real Estate.