Japan Real Estate Investment Corporation (8952) Earnings Call Transcript & Summary

Hello, everyone. I'm Naoki Umeda, CEO of Japan Real Estate. Thank you very much for joining us today. In Japan, the COVID-19 pandemic appears to have abated in recent months following the rapid vaccinations with close to 80% of the population fully vaccinated right now according to some news reports. But I think that there are still many people in the country who keep the guard up against COVID-19. So we are just beginning to see activity pick up again, and I believe many more people will gradually go out in weeks and months ahead. When it comes to office working, until very recently, the prevailing argument has been that there will be no need for office anymore because everybody is happy and comfortable working from home. I think only a few people are saying that today. But let's imagine for a moment, what would happen if about 70% of the existing office space in Japan suddenly became unnecessary. That would be quite a horrible scenario surprisingly or not. A lot of office REIT companies like us might go bust, and there would be so much empty space in office buildings in the middle of Tokyo in the first place. Those office buildings would no longer be properly maintained or simply be abandoned. The Central Tokyo might look like a ghost town. And I'm pretty confident that it would be prone to crimes and unsafe to live or work. Moreover, most of bars and restaurants that cater to the office workers would shutter permanently. Railway workers, subway workers, taxi drivers would most likely lose their jobs. Property values in the Central Tokyo would plummet and probably become dirt cheap, wreaking havoc on banks and other financial institutions. Stock prices across many sectors would certainly plunge, making a lot more people unemployed, devastating the entire Japanese economy, creating a dark vicious circle spiraling down to the bottomless hole, scary huh? That is why I want as many businesses as possible to lease an office space and have their employees work in the office once in a while. And I say this half jokingly and half seriously because to stop office working may only invite troubles to ourselves in the long run. With that said, let me walk you through our performance review for the period ended September 2021. Let's get started. Please take a look at Page 3. The dividend payout for the period ended September 2021 was JPY 11,356 per unit, up for 15 consecutive periods. The dividend payment for the period ending March 2022 is expected to be JPY 11,400 per unit. And therefore, the period after that will be JPY 11,500 per unit, as you can see at the right end of the chart. Let's move on to Page 5. I want to talk about what was happening to our portfolio during the past 6 months between April and September this year. We were operating under the state of emergency for almost entire period. So there was only very limited activity in terms of new demand for office space. That is why vacancy rates of both our portfolio and the market continued to rise gradually in the past 6 months. Airport rent revisions also continued during the period because there was still room for us to raise rent thanks to the rent gap. But the pace of increase seems to have somewhat moderated from what it used to be. If you look at the bottom half of the slide, this is where we think the office market in Japan is probably headed in the near future. First of all, after the intense summer wave of infections may have finally ebbed in Tokyo, we think that many employers, including our tenants will start to explore more seriously new ways of working. And what we think is going to happen is that some of our tenants may begin to reduce their office space. In fact, we have quite a number of tenants who lease more space than they need in anticipation of future growth of their business or some of our tenants are already talking about reducing the space by 20% to 30% because they adopt a hybrid work model, a mix of remote work and in-office time. So in the near future, we think it is very likely that the leased space made redundant will be returned or that may be already happening today. And that returned space will be sought after by prospective tenants looking for better locations or trying to upgrade their office space in high-grade office buildings in prime locations. That's what we think will happen following the round off rightsizing the office space. In addition to that, as I said before, the tenant demand for greener office building or health and well-being has been rising and will most likely become even bigger going forward. Many tenants and employees already prioritized these aspects when choosing where to work. I'm just saying that many more will do so in the future. For a medium term, we expect that the office market will be divided into 2 extremes: office buildings that are chosen and loved by tenants and those that are not. These are the factors that we think will affect the outlook of Japan's office market. Please go to the next page, Page 6. We have been moving ahead with the strategic property replacement for about a year or so, so that the properties in our portfolio remain leading office buildings of choice, and we realize some of those unrealized gains and share them with our unitholders in the form of dividends. So what's written in this slide should be considered as a first step or sort of a glimpse of what is to come going forward. The latest case of replacement is this. We disposed and are going to dispose these 2 buildings on the left side. The leftmost property is Otsuka Higashi-Ikebukuro Building, which we sold on August 31. The transactions of the other 3 buildings belong to the period ending March 2022. We have acquired a share of ownership of Grand Front Osaka and are going to acquire a co-ownership interest in Otemachi Financial City North Tower, while we are going to dispose Nagoya Misono Building on March 1, 2022. The gains on dispositions are approximately JPY 3.8 billion, as you notice at the bottom of the slide. Next, please take a look at Page 8. Here are the financial results for the period ended September 2021. First, both revenues and profit rose from the period before because of the gain on disposition I just mentioned. The JPY 2.546 billion gain on the sale of Otsuka Higashi-Ikebukuro Building, the third line from the top in the table. Let me give you a little bit more detail about our results. Property-related revenues fell JPY 589 million from the period before. And the biggest reason for that is because rent and service charges for our existing buildings declined JPY 350 million due to a rise in vacancy rates. There are other factors, and you can read them in the upper right table on the slide. That brought down the NOI by JPY 621 million, but both operating and ordinary profits were up by about JPY 1.9 billion, thanks in large part to the gain on disposition. Ordinary profit came in at JPY 17.477 billion. You see the number JPY 611 million just below the ordinary profit number, and you see JPY 1.135 billion 2 lines below that. These 2 numbers about JPY 1.7 billion when combined were the amount added to the internal reserves for the period ended September. When you subtract this JPY 1.7 billion from the JPY 17.477 billion, you will have JPY 15.730 billion, which is the total dividends and that is JPY 11,356 per unit. The last 2 columns on the right show the forecast we announced 6 months ago and the variance from the actuals. Operating revenues came in almost in line with the forecast. Operating expenses were, on the other hand, lower than expected because we saved a lot more on utilities and repairing expenses, as shown in that small table at the lower right of the slide. And that is why both the NOI and operating profit beat our expectations by a little over JPY 300 million. When it comes to ordinary profit and the lines below that, the amount added to the internal reserves was about JPY 320 million more than we had planned, meaning that a profit in excess of what we had expected about JPY 300 million was added to the internal reserves. And that is why the DPU was also in line with expectations, up JPY 6 per unit at JPY 11,356 per unit. Next, please go to Page 9. This is our balance sheet. Here, I just want to reiterate the fact that we added about JPY 1.7 billion to the internal reserves, which amounted to JPY 5.257 billion as of the end of September. This is the part which reads referenced the small table you see at the bottom right of the slide. Please take a look at the next page, Page 10, for our forecast for the period ending March 2022 and the period ending September 2022. Let me start with the March 2022 forecast. Please look at the left side of the slide. The first item I want you to look at is the gain on sales of real estate property, JPY 1.3 billion. This is a gain on disposition of Nagoya Misono Building. Now for the March 2022 period, both revenues and profits appear to fall from the period before because we will post a lower amount for the gain and disposition than we did in the September 2021 period. However, the reality is not what it looks like. Let me explain. First of all, property-related revenues are expected to go up by JPY 575 million, where will that come from? Most of the gain will come from additional revenues from external growth, the new properties to be acquired during the March 2022 period, namely Grand Front Osaka and Otemachi Financial City North Tower. You see details in the small table at the upper right of the slide. Operating expenses will also increase. We will see a big jump in repairing expenses, in particular, up JPY 411 million from the period before. But it is only getting back to more normal levels. The repairing expenses for the September 2021 period were exceptionally lower compared with other periods. So it's not that we are going to spend more on repair and maintenance, it's just getting back to the normal level. As a result, the NOI is expected to drop slightly down JPY 124 million from the period ended September 2021. But ordinary profit is expected to be JPY 16.230 billion for the March 2022 period, and operating profit is also going to be not that bad because of the gain in disposition, although it is not as big as we did in the preceding period. You will also see the number JPY 150 million, just 1 line below the ordinary profit line and JPY 270 million, 2 lines below JPY 150 million. When combined, it will be about JPY 400 million or JPY 420 million, and that is the amount to be added to the internal reserves for the March 2022 period. The remainder of the profit will be distributed as dividends and the DPU is expected to be JPY 11,400 per unit. Let me move on to explain the forecast for the September 2022 period. Please take a look at the next 2 columns to the right. For the period ending September 2022, you see 0 for the gain on sales of real estate property. We are not expecting to post any gain on disposition for now. Property-related revenues are expected to go down by JPY 1.2 billion. And the biggest reason for that is that rent and service charges for the existing buildings will decrease by JPY 940 million. Please check the numbers in the table at the lower right of the slide for details. Large-scale vacancies from Shiodome Building are expected for that period and that's the main driver of the drop in property-related revenues. When it comes to expenses, you see property and other taxes going up JPY 180 million. Please look at the numbers below. This is because there will be another reassessment of the ratable value for the land and building taxes in April next year. The new tax rates are not yet confirmed, but we expect to pay higher taxes next year. All in all, operating profit is forecast at JPY 14.880 billion, and ordinary profit is expected to be around JPY 14 billion. This time, we will use the tax purpose reduction entry reserved to fund the dividend payments. How much of that reserve will be used, you may wonder? There will be a sum of JPY 660 million and JPY 1.270 billion. So we are expecting to spend about JPY 1.9 billion from the reserve. And if we do that, the DPU will be JPY 11,500 per unit for the period ending September 2022. Of course, this is all an assumption. We are talking about a year from now and many things can happen over the next 12 months. For example, we may have an opportunity to sell a property in oppose to gain on disposition or there may be external growth. These potential developments are not priced in, in this assumption. So if any of that or something that can alter our assumption happens, of course, we are going to adjust the amount we will spend from the reserve accordingly. Next, I want to talk about external growth. Let's jump to Page 13. Let me start with the properties that we acquired. We acquired a 4.9% co-ownership share of Grand Front Osaka from Mitsubishi Estate, our sponsor at JPY 21 billion on October 1, 2021. This property doesn't require much introduction, it's obviously in front of JR Osaka Station. Please go to the next page, Page 14. This is Otemachi Financial City North Tower. We have acquired an additional share of co-ownership for different floors of this building than we already have owned. The transaction is scheduled to be completed on November 30. We are to acquire additional share at JPY 6.380 billion. This time, the share of co-ownership to be acquired is 1.42%. But this is not the 1.42% of North Tower, but of the entire complex, including both North Tower and South Tower, which you may be able to see in the picture here. I just wanted to make sure that we are on the same page about this. We acquired additional share from Sankei Building. Page 15 gives you details about the properties we disposed and are going to dispose. The building in the left picture is Otsuka Higashi-Ikebukuro Building, of course, I've mentioned this building several times already. The transaction was completed on August 31, and we sold it at JPY 6.025 billion. The building on the right is Nagoya Misono Building. The transaction is scheduled to be completed on March 1, 2022. The scheduled price of disposition is JPY 2.629 billion. Please read the slide for more details. Next, let's move on to discuss internal growth. Please take a look at Page 17. The chart on the upper left side of the page is showing historical occupancy rates of our portfolio. The occupancy rates of the properties in our portfolio were hovering at very elevated levels close to 100% full occupancy until a couple of periods ago. But since then have come down gradually to 96.5% as of the end of September, so the vacancy rate is at 3.5%. Now if you go back in history, around 2009, the vacancy rates of the properties in our portfolio were about 8%, which was actually the highest vacancy figure in the history of our portfolio. Today, it is 3.5%. Let's go to the next page, Page 18. Please take a look at the chart on the upper left side of the slide, which is showing the amount of rent revisions. The latest figure is, of course, JPY 22 million on the upside. We had another period of a net increase in monthly rent revenue, thanks to upward rent revisions. But as I said earlier, the rate of increase seems to be slowing down a bit lately. Please go to Page 20. We changed the colors for the bars in the graph, so it may become a little harder for you to understand what this tries to show. The yellowish bars represent a net change in monthly contract rent by rent revisions and the green bars indicate a net change by tenant turnovers. As I have explained earlier, the yellow bars have been consistently above the line for the past 13 periods, which means a net increase in monthly contract rent by rent revisions for almost 7 years in a row. The green bar on the other hand, has plunged below the line since the September 2020 period, showing a net decrease in monthly contract rent by tenant turnovers. This is in large part due to the rise in vacancy rates. And since the period ended March 2021, we've had an overall net decrease in monthly contract rent, meaning that we've had negative internal growth since then. Next, please take a look at Page 21. These 3 bar charts on the left are showing market rent for the properties in our portfolio. As you can notice, a big majority of our properties in Tokyo saw their market rent going down and more of our properties in other cities and regions have begun to see their market rent decline a little. Just next to the right of the graphs, you see the latest rent gap, which is at negative 4.9%. That means that our actual rent is 4.9% lower than the market rent. So we still have some room to raise our rent. But the gap has significantly narrowed from the 9.3% we previously saw. Next, let me briefly talk about our financial situation. Please take a look at Page 25. I wanted to see the middle graph on the upper half of the slide showing interest expenses. Interest expenses have come down gradually but consistently and are expected to keep going down for some time to come. Okay. Now please jump to Page 30. This is the latest appraisal value of our portfolio. The total appraisal value of our portfolio was JPY 1.2466 trillion at the end of September 2021, down JPY 7.3 billion from the period before. This drop in the appraisal value was largely due to the disposition of Otsuka Higashi-Ikebukuro Building, which brought down the appraisal value by about JPY 5 billion. Also, this was only a snapshot as of the end of September, and we acquired Grand Front Osaka on October 1, the next day at JPY 21 billion. So I think it's only a matter of when the cutoff date is set. Next, let's go to Page 32. Here, I want to take a few minutes to talk about our efforts of promoting renewable electricity for our properties. There are 41 properties in our portfolio that we own 100% and are under our full control. And we recently announced that all the electricity used in those 41 properties will be generated from renewable energy sources. We are in the midst of the transition and the switchover to renewable electricity will be completed for about 80% of those properties by next April and for all the 41 properties by September next year. The most crucial aspect of this project is that the entire building, not just limited to its common area, is switched to renewable electricity. And therefore, all the tenants in that building can claim that all the electricity consumption comes from renewable sources and that they are carbon neutral as long as their activities in the building are concerned. We are, of course, expanding the scope of this project to the rest of the properties in our portfolio, one by one. If you look at the second row of the table below, which says as of September 2022. Then on the right, at the end of the table, you will see 67% highlighted in yellow. That means that we will cut our CO2 emissions by 67% compared to the 2013 levels by the end of September 2022, if we successfully convert 45 of our properties, including the 41 properties I just mentioned and 4 more properties, which we own partially to renewable energy-powered buildings. So this 67% reduction target that we are likely to achieve next year actually far exceeds our original target, which was to reduce emissions by 35% by 2030. Last but not least, let's jump to the final slide for today, Page 39. As always, we want to finish with the cartoon picture of me playing golf. For this time, I'm on a golf course with robot caddy. This robotic gulf assistant provides a player with advice about the next shot with AI-powered analytics that considers the wind speed and direction, the distance to the hole, of course, and even players' golf skills and performance. But I let out a sigh of grief saying, "Don't tell me the odds. What I miss is a human caddy." The message of this cartoon is rather profound, I must say. Are we happy? And will we be happier with the evolution of information technology? As I said in the beginning, many companies will start to explore new ways of working going forward. Efficiency, productivity or cost, these are perhaps some of the metrics that are being focused right now when we talk about new style of working in the age of new normal. But in the end, nothing is sustainable unless people become happy. So it's always about finding the right balance, I think. The world of information technology continues to move at breakneck speed. But so does office working, I should say. The office space itself is going to evolve dramatically. There will be no office in the traditional sense. Instead, there will be more innovative office space that makes people working there happy and cares about their well-being. And that's exactly what employers need in order to attract good, talented people going forward. And that's exactly what Japan Real Estate offers and continues to offer in the future. We are continuing to be the office provider of choice in Japan. That brings to an end of my presentation. Thank you very much.