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Characteristics of Land Price Formation in Recent Years:
How Appropriate are Conditions in the Real-Estate Related Markets?

December 12, 2005

Overview

As an overall trend, land prices in Japan are bottoming out. Following a lengthy adjustment period, the perception of prices being too high even by international standards has been overcome, and the domestic economy has embarked on a slow but sustained recovery. As a result of the above two developments, expectations of return on investment in real estate (or the real estate industry) have seen a sharp rise.

Although land prices in recent years have shown a growing tendency to bottom out overall, the variation among regions has been considerable. In Tokyo and Aichi Prefecture, where prices were among the highest in the 2005 breakdown of official land prices (land for commercial use) by prefecture, the rate of fall has slowed significantly, but in Yamanashi, Akita, and other prefectures, where 2005 official prices were lowest, the year-on-year rate of fall is still in double digits. Among other factors, the gaps are due to differences in the level of concentration of urban functions and industry and the resulting differences in the ability of regions to attract population.

Variation in land prices may also be observed within a single region. A scatter graph plotting the level of the price of commercial land in five Wards of central Tokyo on the horizontal axis against the year-on-year rate of fall in price on the vertical axis shows the trend line remaining level until the 1990s. In other words, regardless of their actual level, land prices have tended to increase (or decrease) at the same rate across the board. Since 2000, by contrast, the trend line has risen steadily - in other words, the higher prices are in a given area, the less likely they are to fall (the more they are likely to rise). This probably due to the fact that whereas, in the past, land price formation tended to be based on the price of land in recent transactions, which resulted in a uniform rise or fall across the board, the mechanism has been replaced by one that accords greater importance to value in use. This trend is thought likely to continue, with decisions to invest in land based on strict criteria such as return on investment and brand value, and increasing "polarization" or "individualization" of land prices according to the features of the particular lot.

About 2000, when the change in the method of land price formation occurred, "SPCs (special purpose corporations)" and "investment corporations", i.e. the operators of REITs (real estate investment trusts), emerged as the new major players in the real estate market and the weight of both types of entity in the market has risen sharply in recent months. In a financial climate characterized by low interest rates and an abundance of cash, they have played a bridging role between the growing volume of investment money and real estate, and have helped to accelerate the establishment of a mechanism of land price formation based on the notion of "profit return" emphasizing value in use.

In recent years, the intensification of the real estate competition among REITs, private offering funds, etc. in urban area, and a sharp rise in REITs investment unit prices, among other developments have raised fears in some quarters of a second "bubble". An assessment of conditions in real estate investment using a number of REIT investment scales such as the gap between NOI yield and implied cap rate or yield spread, suggests that, although the market is overheating to some extent, the problem is not so great as to warrant the appellation " bubble".

However, it is important to realize that there is still a risk of partial or localized excess. Although the fact that REITs are subject to disclosure requirements designed to ensure high transparency and the likelihood that they will take a profit-return approach based on these requirements should help to prevent overrating, overconfidence should be avoided. Moreover, it is important to be aware of the risk that a rise in interest rates could put an end to the real estate investment boom. Estimates, based on the financial tables of listed investment companies, of the downward pressure on profits likely to be exerted by a rise in interest rates suggest that a rise of 25 bps would reduce current income by 3.1%, while a rise of 100 bps would reduce current income by 12.3%, and that if all other conditions remained constant and dividend yield were unchanged, the fall in profits would lead directly to a fall in investment unit prices. Furthermore, it is likely that the relative decline in attractiveness of yield resulting from a rise in interest rates would bring pressure to cut prices. For the very reason that they have evolved in an ideal climate of "extreme monetary easing", if the further growth and popularization of Japanese REITs as a viable alternative asset is to be promoted, one major issue will be how they are to survive the period of major rises in interest rates that must eventually come.

For more information on the content of this report, please contact: Tetsuo Okada the Japan Research Institute, Limited.

Tel: 03-3288-4237
E-mail:okada.tetsuo@jri.co.jp

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