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Japan Real Estate: Volatility Up As Development Businesses Expand

Earnings are up at Japan's major diversified real estate companies. However, pressure looms over credit quality as they expand their more volatile real estate development businesses.

Rental income from new properties and gains on sales are increasing following the worst of the COVID-19 pandemic. The country's five major diversified real estate companies have a solid business presence, and their leasing properties are mainly in central Tokyo. They also have strong development capabilities. We expect their earnings will continue to remain strong in the next one to two years, despite a slightly weak office leasing market.

The five companies are Mitsui Fudosan (A/Negative/A-1), Mitsubishi Estate (A+/Stable/A-1), Sumitomo Realty & Development Co. Ltd. (not rated), Tokyu Fudosan Holdings Corp. (not rated), and Nomura Real Estate Holdings Inc. (not rated). They will continue to increase debt, in our view. We expect their free cash flow after shareholder returns will remain negative as they continue spending on growth investments and shareholder remuneration while business performance remains strong. So far, they have largely maintained a balance between debt and cash flow as the latter has also increased.

However, their earnings are now potentially more volatile due to recent changes in their business portfolios. Their profit growth is driven by property development and sales, where we see demand as highly susceptible to business cycles and financial market trends. Maintaining credit quality now pivots increasingly on management of business portfolios. This can include ensuring they have a high proportion of businesses that generate stable cash flow in addition to maintaining disciplined financial policies.

Cash flow ratios of Mitsubishi Estate and Mitsui Fudosan will likely remain weaker than major overseas peers with similar ratings. However, we believe their strong EBITDA interest coverage, backed by strong banking relationships and funding capabilities, will continue to offset such weak cash flow ratios.

Businesses Will Grow Moderately

The COVID-19 pandemic temporarily weakened the performance of the five companies. However, they reported record-high profits for fiscal 2022 (ended March 31, 2023). This is mainly owing to fading effects of the pandemic, earnings contributions from new properties, and increased gains on property sales. This trend will likely continue in fiscal 2023 and onward, and we forecast their earnings will remain strong in the next one to two years.

During the five-year period ended fiscal 2022, the companies expanded their businesses faster than Sun Hung Kai Properties Ltd. (A+/Stable/--) and Boston Properties Inc. (BBB+/Negative/--), which we regard as their overseas peers. Sun Hung Kai Properties is the largest real estate developer in Hong Kong; Boston Properties owns high-quality office buildings in major cities in the U.S. We attribute the faster growth of Japanese companies to low vacancy rates in leasing properties and a continued tight demand-supply balance for residential units. This is on top of growth in income from new leasing properties and profit contributions from real estate development.

Chart 1


The office leasing businesses of Japan's five majors will likely remain highly competitive, even in a sagging market. We assume vacancy rates for offices in central Tokyo, which stood at 6.5% at the end of 2022, will rise moderately through the end of 2023. We see some negative factors in the office building market. For example, we anticipate a moderate decline in demand due to changing workplace strategies, such as companies allowing employees to work from home and sharing offices. Additionally, a huge supply of new offices is scheduled to be opened in 2023. In our view, demand for high-grade properties in favorable locations will remain strong. Demand for less competitive properties, in contrast, will continue to weaken. The five companies' office properties are in sought-after locations and have a diverse range of tenants. This will likely alleviate the impact of deteriorating market conditions. Additionally, vacancy rates for office properties in Tokyo remain lower than for those in major cities overseas. Relatively strong demand for office space should underpin earnings from office leasing businesses. Furthermore, people are steadily returning to the workplace as the pandemic subsides.

In our view, the five majors mitigate the relatively high risks associated with residential property business. They face difficulties in increasing the number of units available for sale. This is due to intensifying competition stemming from a lack of land suitable for building condominiums. As a result, the supply-demand balance remains tight, allowing the companies to maintain strong profits. We expect the companies to secure relatively profitable project pipelines by focusing on long-term redevelopment projects, which are an area of strength. Interest rates on fixed-rate housing loans are increasing along with a rise in long-term interest rates. Rates on floating-rate housing loans, linked with short-term rates, are generally unchanged. New mortgage loans are typically of this type. Thus, we consider it unlikely that recent rate hikes will greatly affect demand for residential properties for sale. However, if the Bank of Japan shifts its policy toward raising interest rates, and rates on floating-rate loans rise, this may further pressure the five companies' performance in residential business. For example, the maximum affordable price for home buyers may drop.

Debt Will Rise

Japan's five majors will continue to increase debt, in our view. We expect their free cash flow after shareholder returns will remain negative. This is because they will likely continue spending on growth investments, such as for business expansion, and shareholder returns for higher capital efficiency.

Mitsubishi Estate and Mitsui Fudosan have been investing aggressively to increase profits from redevelopment projects of office leasing properties, mainly in central Tokyo but also elsewhere in Japan and overseas. Especially at Mitsui Fudosan, debt has grown faster than at domestic peers and Boston Properties during the last five years. This was due to a series of large office building development projects, including Tokyo Midtown Yaesu and 50 Hudson Yards in New York. Additionally, it raised shareholder returns by pushing up the return ratio from 35% to 45% in 2022. Mitsubishi Estate has also repurchased shares regularly since 2019. It announced in 2022 that it would buy back ¥100 billion outstanding shares, the same as the amount repurchased in 2019.

Chart 2


The five companies have maintained a balance between cash flow and debt. With debt rising, earnings have also increased with growth in rental income from new properties and gains on property sales. Furthermore, they have maintained debt within certain levels relative to cash flow by using the proceeds of property sales. Their ratios of funds from operations (FFO) to debt deteriorated when operating performance worsened amid the pandemic but are now improving. However, we believe that the financial capacity of each company may shrink if real estate acquisitions and development investments are made amid sluggish growth in FFO. At Mitsui Fudosan, interest expenses increased by 75% in fiscal 2022 due to the completion of large office buildings and rising interest rates overseas. At Mitsubishi Estate, interest expenses increased by 20% in fiscal 2022 and it forecasts a decrease in EBITDA in fiscal 2023 due to the reconstruction of its flagship office building and the absence of large property sales.

Chart 3a


Chart 3b


Potential Earnings Volatility Will Pressure Credit Quality

We estimate aggregate gains on property sales of the five majors accounted for 35%-40% of their aggregate operating income in fiscal 2022, up from about 25% in fiscal 2016. We mainly attribute this to a rise in property prices and a focus on development and sales businesses. Japan's monetary policy remains accommodative, compared with those of other major economies. Lower interest rates have attracted global money into Japan's real estate market. Japanese real estate companies, with the exception of Sumitomo Realty & Development, have expanded businesses they intend to develop and sell for capital gains, as well as investments in leasing properties they intend to hold for a long time. We believe they will continue receiving sizable gains on sales of properties they acquired before recent hikes in property prices.

Potential earnings volatility is increasing for the five real estate companies, in our view. We base this view on a higher proportion of gains on sales of properties within overall operating income. Property development and sales business is generally risker than leasing, which generates stable cash flow. The five companies seek to report gains on property sales in the development and sales business stably by timing acquisitions and sales based on market conditions, and by diversifying their pipelines. However, we view earnings in this business as highly volatile because it is susceptible to business cycles and financial market conditions.

Chart 4


A substantial deterioration in the property trading market will likely put further pressure on the companies' financial health. In an environment where investor appetite for acquisitions is sluggish due to interest rate hikes and the economic slowdown, gains on property sales will likely shrink. This is due to a delay in collection on investment properties and a drop in sale prices. We estimate a 10% decline in gains on sales of properties would reduce FFO to debt by 0.2-0.3 percentage point.

In our view, neither Mitsui Fudosan nor Mitsubishi Estate have particularly large financial buffers for maintaining our current ratings on them. This is because their cash flow ratios are already weak for the ratings. If, amid deteriorating market conditions, the two companies make additional investments to acquire properties or they fail to reduce debt quickly using cash collected through property sales, it will put further pressure on their credit quality. That said, we believe the two companies will somewhat protect their creditworthiness by controlling debt through disciplined financial management, such as by investing for property development selectively and accelerating asset sales.

A substantial majority of the EBITDA generated by Mitsubishi Estate and Mitsui Fudosan comes from their leasing businesses, where cash flow is highly predictable. Thus, in our cash flow and leverage analysis, we assess their key financial ratios as commensurate with our current ratings on the companies, although these ratios are relatively weak. Sun Hung Kai Properties' FFO to debt is substantially higher than those of Mitsui Fudosan and Mitsubishi Estate. However, a high proportion of the Hong Kong-based company's EBITDA comes from its property development and sales business. This leads us to think that the volatility of cash flow is higher for Sun Hung Kai than for Mitsui Fudosan and Mitsubishi Estate, which focus on leasing. As a result, our assessments of the financial profiles of Mitsui Fudosan and Mitsubishi Estate are higher than that of Sun Hung Kai.

We expect Mitsubishi Estate and Mitsui Fudosan to continue generating the bulk of their EBITDA through leasing. We base this view on the two companies' intent to maintain a well-balanced portfolio to keep business risk manageable. We expect both companies to see their rental income rise in the medium- to long-term, as they are working on large redevelopment projects involving office buildings for leasing, mainly in central Tokyo.

Property management business will underpin the credit quality of Mitsubishi Estate and Mitsui Fudosan, in our view. Backed by high quality portfolios, property management businesses, together with leasing businesses, will help them generate stable earnings. Both companies focus on increasing earnings from such business and controlling debt by selling properties they develop to funds operated by group property management companies.

Cash Flow Ratios Are Weak For Current Ratings And Lag Peers Overseas

The FFO-to-debt ratios of Mitsubishi Estate and Mitsui Fudosan are likely to remain weaker than those of similarly rated overseas real estate companies in the 'A' rating category. Both companies own many office buildings in highly priced prime locations in central Tokyo. Thus, their return on invested capital tends to be low. To maintain and improve capital efficiency, they need to keep a certain level of debt in their capital structure. Thus, we expect their cash flow ratios will remain weak for their ratings. Their debt ratios are higher than U.S.-based real estate companies Mid-America Apartment Communities Inc. (A-/Stable/--) and AvalonBay Communities Inc. (A-/Stable/A-2). Additionally, their return on capital is less than half that of Public Storage (A/Stable/--), a U.S.-based self-storage provider.

Chart 5


Most of the leasing properties of Mitsubishi Estate and Mitsui Fudosan are in central Tokyo. We consider their locations and quality as more favorable than those of global peers including Boston Properties. The Japan-based companies' EBITDA margins are 20%-30%, substantially lower than 55%-60% for Boston Properties, which mainly engages in property leasing. We attribute this to the following:

  • Mitsubishi Estate and Mitsui Fudosan also operate development business, which is less profitable than leasing;
  • Their leasing properties are mainly in central Tokyo, which generate comparatively low yields; and
  • They also operate subleasing business.

Our assessments of the financial profiles of Mitsubishi Estate and Mitsui Fudosan are higher than that of Boston Properties. In our credit analysis of the two Japanese companies, we put more importance on their EBITDA interest coverage, because of their strong funding capabilities. The EBITDA interest coverage for Mitsui Estate stands at 13x-14x and at 6x-7x for Mitsui Fudosan, substantially above Boston Properties' about 3x. Mitsui Fudosan's FFO to debt has weakened to the same level as that of Boston Properties due to an increase in debt resulting from completion of large properties.

In our view, the two real estate companies' strong EBITDA interest coverage will continue to compensate for their weak cash flow ratios. We expect their EBITDA interest coverage ratios to remain favorable, given that the two companies can rely on low-cost funding, mainly long-term fixed-rate borrowing backed by strong relationships with financial institutions. Mitsubishi Estate has a high ratio of fixed-rate debt to total debt at 87.0%, and its average remaining maturity is as long as 7.8 years on an unconsolidated basis (as of March 31, 2023). Excluding nonrecourse which accounts for 16.7% of total debt, Mitsui Fudosan has a high ratio of fixed-rate debt at 89.6%, and its average remaining maturity is as long as 5.6 years (as of March 31, 2023).

Related Research

This report does not constitute a rating action.

Primary Credit Analyst:Yuta Misumi, Tokyo +81 3 4550 8674;
Secondary Contact:Hiroyuki Nishikawa, Tokyo (81) 3-4550-8751;

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