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

Good afternoon, everyone. Welcome, and thank you for joining today our performance review for the period ended September 2022. My name is Shojiro Kojima. I am President and CEO of Japan Real Estate Asset Management. We hold today's performance review via conference call as we did 6 months ago in light of the ongoing COVID-19 pandemic. It is regrettable that we are still unable to meet in person, but we made a decision out of an abundance of caution. Now let me walk you through the presentation starting with the earnings highlights. Please take a look at Page 3. The dividend payout for the period ended September 2022 was JPY 11,500 per unit, up JPY 100 a unit from 6 months earlier and just in line with our own expectations. The dividend rose for 17 consecutive periods. On the right end of the bar chart, you see the dividend forecast for the next 2 periods. For the period ending March 2023, it is JPY 11,400 per unit. And for the period after that, period ending September 2023, it is JPY 11,300 per unit. I will come back to this topic with more details later in my presentation. As for external growth at the bottom left of the page, we didn't acquire any property during the last period. So these are about the disposition of our properties. I will give you more details on that later as well. When it comes to internal growth, in the middle, the period-end occupancy rate declined from 97% to 93.9% for the period following the large vacancy. And consequently, the monthly contract rent due to tenant turnover dropped JPY 200 million a month. One bright spot is that we could raise the rent at the time of rental revision by JPY 16 million a month for the last period. The market rent in Central Tokyo has been trending down, and it is getting more difficult for us to raise our rent. Having said that, however, we still have leasing contracts with lower than market rents, so we continue to target those contracts to raise rent at least to the market levels. Our financial strategy remains unchanged. We borrowed JPY 25 billion to finance the acquisition of Toyosu Front, and LTV briefly climbed to 43.5% at the end of the March 2022 period. But we disposed the Harumi Center Building and paid back the JPY 25 billion debt on the same day. That brought back our LTV to 42% at the end of the period ended September 2022. We are seeing greater volatility in the current financial market, but we successfully continued to reduce interest cost by refinancing at lower rates. Our average interest rate edged down by another basis point from the previous period to 0.38% at the end of September 2022. Please go to Page 4. On this page, we describe for each growth driver how we see the current business climate and how we manage our portfolio going forward. Let's take a look at external growth. Many players, both foreign and domestic, continue to have such a strong appetite for real estate in Japan that you may as well describe it as overheated at least now despite some early signs of inflection in recent months. That allows us to keep searching the market for properties, and our strategy is to cautiously grow our assets by leveraging the sponsor pipelines. At the same time, it gives us opportunities to dispose some of our assets, taking advantage of the tight investment market. We will continue to monitor our portfolio performance in the market and pay attention to future downside risks as we explore our options in order to make a timely exit from some of the assets we manage. At any rate, we will stick to our policy of strategic portfolio replacement and raise the quality of our portfolio, either by sharing the proceeds of property sales with our investors or by saving them to ensure our ability to pay a stable dividend. When it comes to internal growth, the rise in the vacancy rates in the office market seems to have moderated, but the demand for office space remains lackluster as the Fed's aggressive rate hikes stoke fears of a global recession. Having said that, however, more and more companies are searching for prime commercial offices to bring back their employees from working from home in the post-COVID environment. So high-end offices in prime locations will continue to be sought after despite a slowdown in the overall demand. Our portfolio includes many high-end, high-quality properties, so it's highly likely to be competitive in the medium term given these market trends. I mentioned earlier that the occupancy rate declined 3.1 percentage points from the previous period because of the large vacancy. But we are seeing fairly robust signs of recovery as we are very much focused on carrying out our leasing strategy. We will continue leasing activities to improve the occupancy rate as quickly as possible. Also, as you all know, electricity costs keep going up as energy prices soar. We have put concrete measures in place to address this issue, and I will come back to that later as well. With respect to our financial strategy, you're all aware the major central banks around the world are raising interest rates. The Central Bank in the United States raised the federal funds rate by whopping 75 basis points at the November FOMC meeting. The Bank of England and European Central Bank have also raised rates. The Bank of Japan in contrast continues monetary easing, and it remains very unlikely that we will see a big spike in domestic interest rates. So we ought to take advantage of ultra low rates and continue to borrow domestically long term at fixed rates to make sure we remain in good financial standing. Last but not least, with regards to ESG. The war in Ukraine is fueling concerns about the return of fossil fuels in Europe, at least for short term. But we still believe that this geopolitical crisis will drive the efforts for carbon neutrality in the long term and that ESG will be an ever more important factor in making an investment decision. There are 2 critical points in the implementation of our strategy. First, we are focused on doing whatever we can to achieve the new objectives that we set forth back in March. And second, we are going to disclose more information in order to get more people to understand our ESG activities. I will give you more details about our activities and the outcomes later. From Page 5 through Page 8, I'm going to talk about exactly what we did during the last period based on the strategy I just explained. Let me begin with external growth on Page 5. As I said earlier, we didn't acquire any property in the previous period, so I'm going to talk about the disposition only. But I really want to emphasize that the disposition is part of the policy of strategic property replacement. And of course, we keep searching properties for acquisition, and there are some potential lease that could materialize during this fiscal period or beyond. Once again, I want to stress that the disposition of the properties is integral part of our grand strategy, which focuses on increasing our assets while enhancing the quality of our portfolio at the same time. Let me move on to give you more details about the disposition of Harumi Center Building, which I actually talked about the last time and the disposition of Harumi Front, which we announced in a press release just yesterday. Please also take a read on the table on the left side of the page. We disposed a Harumi Center Building at JPY 24,330 billion during the period ended September 2022, and we will dispose Harumi Front at JPY 39,110 billion in 3 tranches between the current period ending March 2023 and the period ending March 2024. As described on the page, one reason in common for the disposition of both properties is the termination of the leasing contract by major tenants. At Harumi Center Building, we knew that the major tenant occupying more than half of its leasable area would move out soon. And for Harumi Front, all of its office space will be returned because of just 1 big tenant. Of course, we have been working hard to find tenants to fill this vacancy for both buildings, but we haven't seen as much activity as we would have liked. There were just a limited number of inquiries, and they tried to negotiate rents that were way below the levels we need. Our goal is to bring our occupancy rate back to where it was as quickly as possible, so we have judged that keeping these properties in our portfolio poses a great risk. We also suspect that the office demand for Harumi district won't come back strongly in the medium term. Another thing both buildings have in common is that their disposition prices do or are expected to exceed their appraisal value and significantly eclipse their book value with signs of overheating in the market. As a matter of fact, the gain on sale was JPY 3.3 billion for Harumi Center Building. And for Harumi Front, its gain on sale is expected to be JPY 13.9 billion. Part of the gain on the sale of Harumi Center Building was shared with our investors in the form of dividend and the remainder went to internal reserves. When it comes to the disposition of Harumi Front, the gains will be posted in 3 tranches over the next 3 periods to make sure that we continue to pay stable dividend, but part of the gain from the third tranche will go to internal reserves. We can also expect that this phased disposition will slow the pace of our balance sheet reduction because we continue to seek opportunities for property acquisitions in the meantime. Please go to Page 6. Here, we explain why only the gain from the third tranche can be posted as retained earnings while the gains from the first and second tranches cannot with regards to the disposition of Harumi Front. If you read the first bullet point of the text highlighted in light green, you will notice that the special exception, allowing a gain on the sale of a specific asset for the purpose of replacement to be posted as retained earnings applies only to the asset owned for 10 years or longer from the next day of the acquisition to the beginning of the year when the disposition takes place. We acquired Harumi Front on January 7, 2013, so the special exception shall apply only to the part of the asset that we disposed on January 1, 2024 or after. It's very complicated, and that's why we prepared a slide to give you more clarity. Please go to Page 7. I'm going to give you a brief overview of our recent leasing activities. As I mentioned earlier, our current focus is on the occupancy recovery and our efforts are beginning to pay off, especially for the following 3 properties. For Kitanomaru Square and Shinjuku Front Tower, because we found several new tenants during the last period, we now feel more confident and optimistic about filling the large vacancy caused by the tenants move out. As for Shiodome Building, the actual pace of recovery is not as strong as we would have liked, but this property, in fact, receives more inquiries than others. The empty space still exists just because the prospective tenants eventually decided to opt for another property or to stay in their current location because of additional incentives offered by their landlord, but we still have several concrete leads at this moment. Shiodome Building is a high-end prime property, so we are really optimistic that its occupancy is going to improve as we keep negotiating with prospective tenants. Now please take a look at the bar chart at the page's bottom left. The light colored bar at the right end of the chart represents the newly leased and vacated office space for the current period, the period ending March 2023. And as you can see, the vacated office space will shrink to about 20% of what it was just 6 months before. The situation is clearly turning around and the number of termination is getting lower recently as well. So if the current pace of recovery continues, we expect that the occupancy rate will soon be on course to get back to the normal level. As the graph on the right side shows, we expect that the occupancy rate will go up 1.1 percentage point to 95% by the end of March 2023. Last but not least on this page, I really want to talk about how we manage costs. As we are all aware, the electricity cost keeps rising. To make things worse, some of the new entrants to the Japanese electricity retail market, which was liberalized in 2016, now readily pass on the soaring costs to their customers or even simply terminate the contracts and stop supplying the power. We are largely immune from such extreme cases because more than 60% of our electricity contracts are with traditional electricity utility companies such as TEPCO. But of course, we are asked to pay higher electricity bills at some of the properties, so we recognize this rising energy cost to be a risk that we have to manage. One of the actions we are taking right now is change the type of the electricity contract to lower the rates billed by the building to its tenants. There are several different types of electricity contract between the building and its tenants. We are working to change the fixed rate contract to a variable rate contract so that the tenants will pay lower bills to the building, if the building pays lower bills to the utility company. We also have to expect repairing costs to be rising due to the supply chain issue as well as labor shortage. That is why we are currently updating our entire quote and project review processes as well as working with the property management companies to improve the project management system for better control over cost in time. Please go to Page 8. Our financial strategy is described in the upper half of the page. As I mentioned at the beginning, we continue to reduce interest cost by refinancing at lower rates despite the volatility in the current financial market. The long-term borrowings we made during the last period are for refinancing of existing borrowings, and we borrowed for 10 years at fixed rates. The average interest rate of the long-term borrowings during the last period is 0.48%. We could borrow at this really low rate because we maintain good relationships with our banks. The average maturity of our entire interest bearing liabilities is getting longer as indicated in the graph, and we are well prepared for a possible rise in interest rates. The lower half of the page describes 3 outcomes of our ESG activities during the last period. From left to right, our 80% carbon emissions reduction target is now SBTI certified. This is one of the new KPIs. And in the middle, we are the first J-REIT to join RE100, a global corporate renewable energy initiative aimed at getting businesses to match 100% of the electricity used with electricity produced from renewable sources. We are committed to 100% renewable electricity. And thirdly, as a token of the recognition of our ESG activities, Japan Real Estate was added to MSCI Japan ESG Selected Leaders Index back in June. This is a market index of prominent companies known for great leadership in ESG activity. So having been added to the index itself is such an honor, and it creates a lot of publicity for us. In addition, it is one of the indices used by Japan's government pension investment fund for passive investment. It's also going to make us a more attractive investment destination. So that's an overview of our management policy and the recent developments of our activities. The next topic I'd like to talk about is our earnings results and forecast. Please take a look at Page 10. I'm going to give you details later when we discuss what factors drive up or down the DPU, so I want to focus on just 1 thing here, and that is about repairing expenses. Please take a look at the small table which says reasons for change from forecast at the bottom right on the page. As you can see, the biggest factor that pushed up property-related profits is the greater-than-expected decline in repairing expenses. The actual spending of repairs was JPY 263 million lower than anticipated because a lot of the repairing projects had to be postponed due to part shortages. Please go to Page 11. This is our balance sheet as of the end of September 2022. Let me just touch upon the internal reserves. Please take a look at the small table at the bottom right of the page with title reference in parenthesis. The period-end balance of internal reserves increased JPY 1.3 billion to JPY 6.9 billion, following the transfer of part of the proceeds of the sale of Harumi Center Building to the internal reserves, and this translates into JPY 5,025 per unit. On Page 12, you see our forecast for the next 2 periods, but I'm going to talk about these numbers on the next page, Page 13, by explaining this waterfall chart that shows what factors drive up or down the DPU. So let's take a look at the period ended September 2022 and compare that with the leftmost bar, which represents the DPU for the period ended March 2022. Rent and service charges pushed down the DPU by JPY 727 from the March 2022 period, and it is largely due to the vacancy caused by the big tenants move out from Shiodome Building. Property-related expenses actually pushed up the DPU slightly by JPY 43 because, as I mentioned earlier, the decline in repairing expenses due to the postponement of the repair works and a decrease in property management expenses were bigger than the increase in utilities expenses, which is driven by higher energy prices. Please take a look at the numbers within the green call-out box on the left. The impact of external growth on the DPU is JPY 106, and that is the full period contribution of Toyosu Front which we acquired at the end of March, minus the lack of rent revenue due to the disposition of Harumi Center Building at the end of May. The dark blue area of the bar represents the gain on the sale of Harumi Center Building, which excludes the portion that went to the internal reserves and its impact on the DPU is JPY 1,176. As a result of all this, the DPU for the period ended September 2022 was JPY 11,500. Let me then talk about the forecast for the period ending March 2023. Please take a look at the second and third bars in the chart. Rent and service charges will push down the DPU by JPY 255 following the lack of rent revenue for the whole 6 months caused by the move out of the big tenants that happened in the previous period. Property-related expenses will also push down the DPU by JPY 698 as utilities and repairing expenses are expected to increase. As you can read the numbers within the orange call-out box, utilities expenses will push out the DPU by JPY 276 because of higher energy prices and the increase in electricity bills due to the contract renewal for some of the properties. Repairing expenses will further push down the DPU by JPY 363 because a lot of the repair works that were postponed are scheduled for this period. The impact of external growth will also push down the DPU by JPY 167 because of the lack of rent revenue for the whole 6 months due to the disposition of Harumi Center Building and the first tranche of the disposition of Harumi Front. The DPU forecast for the period ending March 2023 is JPY 11,400, and that includes the gain of the first tranche of the disposition of Harumi Front, which translates into JPY 2,122 per unit. Lastly, let's look at the forecast for the period ending September 2023. I want you to take a look at the third and the fourth bars of the chart. Rent and service charges will not impact the DPU as much, but property-related expenses are expected to push down the DPU by JPY 368 following the rise in utilities expenses and property and other taxes. Utilities expenses will increase because it is summertime. Electricity bills are also expected to rise because many of our properties are going to switch to new plans to be launched by TEPCO and others in April 2023. Property and other taxes are also expected to increase as the current COVID tax relief programs come to an end. This will push down the DPU by JPY 137. The impact of external growth will also push down the DPU by JPY 238 due to the lack of rent revenue following the first and second tranches after disposition of Harumi Front as well as the expected move out of a big tenant from this building. The DPU forecast for the period ending September 2023 is JPY 11,300, and that includes the gain on the second tranche of the disposition of Harumi Front, which translates into JPY 2,591 per unit. The next topic I'm supposed to talk about is external growth, but I've already explained the disposition of the properties, so let's skip Page 16 and jump to Page 18 to talk about internal growth. I talked about our occupancy rate at the beginning, so I'd like you to take a look at the tenant turnover rate on the right. It's been going up over the past year, thanks to an increase in cancellations and replacements. The latest figure is 7.1%. Please jump to Page 22 for the market rent and rent gap. As you can see the graphs on the left, out of the 66 properties in our portfolio, 35 properties saw their market rent unchanged and 31 of them saw a drop in market rent. Many properties in Tokyo Central 5 wards continue to see their market rent falling as in the last period. And as a consequence, the rent gap has finally gone, which means that the average rent we charge is almost the same as the market rent. The data actually supports our intuition, and we believe that we are moving into a phase where we should focus on raising the occupancy rate rather than rent by offering some temporary incentives to our tenants to stay with us. Please skip 10 pages or so and jump to Page 32. The last topic I want to talk about is ESG. I mentioned the RE100 initiative earlier. You see at the bottom of the page how many of our properties are powered by renewable electricity as of the end of September 2022. All the 39 properties that JRE owns 100% and manages are fully powered by renewable electricity, and 58 properties out of the 72 properties in our portfolio are completely powered by renewable electricity today. Please go to Page 33. Last month, we announced the results of this year's GRESB survey in a press release. We were awarded 5 stars 5 years in a row and a green star 7 years in a row. Both are the highest ratings in the respective categories. As I mentioned earlier, the relevance of ESG to investing most certainly continues to grow worldwide. It's already one of the accepted criteria for making investment decisions and will increasingly become a determinant of choosing an office building among businesses. There will be a clear division between buildings that are selected and sought after and those that are rejected and left behind. And as I said many times over, JRE is fully committed and continue to lead the industry in the area of ESG. On Page 34, I want to briefly introduce to you our latest sustainability report 2022. This report gives all the details about our ESG activities I just talked about and more. You can access the report on our website or via QR code on this page. Please take a read. And that almost brings to an end of our performance review. But before we officially close this briefing, I want to stress just 1 word that best describes the current market situation, and that is uncertainty. The uncertainty envelops the office leasing market, real estate trading market and capital market, making it increasingly more difficult to predict the future and the situation is likely to remain fluid as there are many macroeconomic variables, domestic and global. And consequently, it becomes harder to predict the future of the J-REIT market, which is a combination of those 3 markets. Of course, it is still important and necessary, without a doubt, to pay attention to where the market is going. But what is more critical for asset management companies like us is stay competitive and keep winning in the market. In other words, we will always strive to be a chosen and trusted partner to our investors who have decided to invest in office properties in Japan. And even though I sound like a broken record, I just want to repeat once again. We remain committed to taking a long-term view to maximize value for our unitholders and to have the ability to absorb any short-term volatility in order to ensure stability in asset management. And that's all for me. Thank you very much.