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

Good morning, everyone. Welcome, and thank you for turning into our performance review for the period ended March 2023. My name is Shojiro Kojima. I am President and CEO of Japan Real Estate Asset Management. Let's get started. Let me begin with the dividend for the period. Please take a look at Page 3. The payout for the period ended March 2023 was JPY 11,667 per unit, up JPY 167 a unit from 6 months earlier and beating our own expectations by JPY 267 a unit. As the chart below shows the dividend rose for 18 consecutive period. The chart also shows the dividend forecast for the next 2 periods. It is JPY 11,500 per unit for the period ending September 2023 and JPY 11,550 per unit for the period ending March 2024. I will come back to the dividend forecast with more details later. Please go to the next page, Page 4. Let me talk about the public offering, which we decided to issue on March 28. Details are described in the chart on the left side of the page. We issued 37,654 units, including public offering and third-party allotment, raising approximately JPY 19.5 billion, and we acquired 4 properties at JPY 42.2 billion in total, as you can see the pictures on the right. The acquisition of the 4 properties caused the changes to some of the metrics of our portfolio, so please look at the chart at the bottom. By the way, the disposition of Harumi Front takes in 3 tranches with the last tranche in January next year. So these numbers are the ones up to the second tranche, which took place back in April. As you can see the right most column of the chart at the bottom, the asset size increased JPY 25.1 billion to JPY 1,116.3 billion. All the 4 properties we acquired this time are located within 3-minute walk from the nearest train station. That is why the percentage of what we call within 5 minute walk properties has gone up from 92% to 96.4%. The LTV at the bottom has also gone down from 42% to 41.5%. This public offering was issued despite uncertain financial markets at the price to NAV ratio of below 1 in the so-called below NAV situation. So we could have easily abandoned the public offering, but we didn't exactly because there is uncertainty in the financial market, and we should have a financial buffer as we acquired the 4 new properties. We will continue to look for suitable opportunities to achieve external growth and maximize value for our unitholders in the mid- to long term. Please go to Page 5. This is a summary of March 2023 results, our market observations and our management strategies. Let's take a look at them one by one, starting with external growth at the top. We acquired 4 new properties and completed the first tranche of the disposition of Harumi Front during the last period. All the 4 properties we acquired are high-quality office buildings located at the heart of the city. We decided to dispose Harumi Front because we knew that the tenant occupying a large space would move out, and we believe that the acquisition and the disposition enhance the quality of our portfolio. Our market observations with regards to external growth are that various investors, including foreign investors continue to show strong appetite for Japanese real estate despite a significant slowdown in demand among some U.S. Investors. Given the current interest rate trend in Japan, we need to anticipate potential correction. Our sponsor, Mitsubishi Estate announced in a press release on March 6 that they would expand their investment management business and set a really ambitious target of increasing their assets under management from the current JPY 5.5 trillion to JPY 10 trillion by the end of 2030. This announcement will surely provide us with a powerful tailwind. With these market observations as a context, our management strategy continues to dwell on achieving external growth mainly through pipeline support from the sponsor, while at the same time, utilizing our own network, which we've been working to make stronger since last year in order to grow our portfolio. Likewise, we continue to uphold our criteria for selling properties. We examine the profitability of each property for its competitiveness in the market and the level of capital expenditure required in the future, and we sell a property as part of the asset replacement strategy. Let's look at internal growth next. The occupancy rate improved from 93.9% to 95.5% over the last 6 months, thanks to our efforts to fill the large vacancy. The occupancy actually improved by 0.5 point compared to our outlook, which we announced during the last performance review. Because of this, the monthly contract rent due to tenant turnover was up JPY 87 million from the decline of JPY 200 million during the previous period. However, the monthly contract rent due to rent revision reduced by JPY 4 million. It is our judgment that we are in a territory where we may need to lower the rent in order to keep our current tenants. Our observations of the leasing market is that the market vacancy rates are trending flat. While the large supply of office space expected to take place in 2023 and 2025 gains much attention, vacancy rates are determined by the balance between supply and demand. When we look at demand, business activity in Japan is strong and more importantly, more and more office workers are returning to office, especially after the Golden Week in early May when the downgrade of COVID-19's legal classification took place. So there is no reason to be overly pessimistic about the outlook, but we should continue to monitor how many tenants are going to move out to those newly supplied office buildings. At the same time, as businesses are finding more difficult to hire, creating an attractive workplace becomes an increasingly popular way to lower skilled workers. And it is obvious that high-quality office buildings in private locations become ever more sought after. That is exactly why our management strategy is aimed at improving the occupancy rates by seizing on the strong demand for more attractive office buildings. We successfully raised the occupancy rate significantly, and we will continue to seek improvement in occupancy rates and focus on flexibility in our leasing activities in anticipation of the large supply of office buildings. At the same time, we should have deep dive into each building's occupancy rate and its submarket situation. For a competitive property, we should be aiming for leasing terms that are more favorable to us. We are also taking actions to mitigate the impact of rising energy prices. As I explained in the last performance review, we've been trying to change the type of electricity contract from a fixed rate contract to a variable rate contract to lower the rates built by the owner to its tenants. And the action has already resulted in some increase in revenues. Finally, when it comes to our financial strategy, I would explain why we are showing the numbers as of May 15 this year instead of the numbers as of the end of March. It is precisely because we issued a public offering in April, and we want to give you a picture of our financial situation that is as accurate and timely as possible. The LTV rose to 44% at the end of March due to the borrowings to finance the acquisition of the 4 properties. But it came down to 41.5% as of May 15 because we paid off the debt with the funds raised through the public offering and the second tranche of the disposition of Harumi Front. The average rate hitched up from 0.38% to 0.41% over the last 6 months. But we believe that we could keep it to a very modest rise given the current situation of the market rates. The average maturity was extended from 4.37 years to 4.51 years as we continue to borrow long terms at fixed rates. More recently, the domestic interest rate has become less volatile, but the overall monetary situation remains uncertain. So we should continue to closely monitor the financial market environment and stick to the policy of borrowing long terms at fixed rates as much as the conditions allow. From Pages 7 to 9, I'm going to give you more details about the 4 properties we acquired from Mitsubishi Estate during the last period. We acquired a 50% share of ownership in the ARGYLE aoyama at the price of JPY 23.9 billion. This is a new acquisition and the largest acquisition among the 4 properties we acquired. This is a new building completed back in 2020 as part of the redevelopment of Aoyama Bell Commons building. It is a highly distinctive building and is certainly one of the landmarks in the area. It is primarily located within 3-minute walk from the nearest subway station, Gaienmae, walking distance from Omotesando and Aoyama-Itchome stations. We acquired an 8% (sic) [ 9% ] share of ownership in Toyosu Foresia at the price of JPY 8.1 billion. This is also a new acquisition and a relatively a young building completed back in 2014. It is an impressive building with a floor plate of approximately 4,500 square meters and a ceiling height of 2.85 meters. It is also an environmentally friendly comfortable building with the 44% green space coverage of the total site area and equipped with solar concentrators that bring abundant natural light into the atrium. It's located within 1-minute walk from Tokyo Metro Toyosu station, access through a green roof to walkway. Details about Shinjuku Eastside Square are on the left side of Page 9. We acquired an additional 4% share of ownership of the property at the price of JPY 8.5 billion. We had owned 35% of the property before. This is an extremely competitive property, and we continue to expect it to make significant contribution to our rent revenues. The right side of the page is about CIRCLES Hirakawacho. We acquired the entire building at the price of JPY 1.780 billion. This is a new acquisition. CIRCLES is Mitsubishi Estate's brand for compact office and its targeted customers are defined as growing start-ups looking for a more spacious office or corporations trying to establish a sales office or suboffice in key cities nationwide. This is our first acquisition of a CIRCLES brand property. Hirakawacho is located within 3-minute walk from Tokyo Metro Hanzomon Station and Kojimachi Station. Please go to Page 10. I'd like to briefly talk about the disposition of Harumi Front, although I did talk about it in the last performance review as well. As you know, the disposition takes place in 3 tranches over the 3 periods and the second tranche is now completed. And these are the benefits of selling this property. Firstly, we can avoid leasing risks. Leasing risks refer to the possibility of being unable to fill the vacant space with enough tenants on favorable terms. We know that the tenant renting the entire office space of this building will move out. At first, we try to find new tenants. But given the vacancy rates of the neighboring buildings, the outlook of demand for office space in the entire Harumi submarket seemed very weak. If we wanted to improve the building's occupancy rate quickly, we would need to make significant concessions on the leasing terms, but that was not acceptable to us. Secondly, the disposition price exceeds both its book value and appraisal value. In fact, we sold the property at JPY 39.1 billion, which was JPY 1.1 billion higher than its appraisal value, and that was significantly higher than the book value as well, and we expect to post JPY 13.9 billion as a total gain on the sale of this property. This capital gain is already used to pay dividends starting from the period ended March 2023 over 3 fiscal periods, and part of the gain from the third tranche will go to internal reserves. Please go to Page 11. This is a brief history of our property acquisitions and dispositions since the previous public offering in 2018 and how each of the metrics changed because of the property replacements. As I said in the beginning, our strategy for external growth is a two-pronged approach to grow our portfolio in a sustainable manner, utilizing the pipeline support from the sponsor, Mitsubishi Estate and expanding our own network to acquire properties from the market. At the same time, we look into the property's long-term competitiveness when we decide to sell a property, and we do so as part of the property replacement strategy. Please go to Page 13 to discuss internal growth. Let's begin with the progress of our leasing activities to fill the large vacancy, which has been an issue since last year. As for Shiodome Building, I told you at the last performance review that the actual pace of recovery was not as strong as we would have liked. However, the occupancy rate, in fact, improved by 5 percentage points or so, thanks to the signing of new contracts during the last period. In addition, there are several new fairly large contracts that are certain to be signed during this period, and that means that the large vacancy is almost completely filled. And as I said before, this building being at a high-quality and a primely located property received more inquiries than other buildings we own. Its competitiveness obviously translated into new signings. Akasaka Park building had a relatively large vacant space 6 months ago, but now it is almost completely filled with 2 new contracts each for a 2,000 square meter floor space, thanks to our leasing activities. The same is true for Tokyo Opera City building. We could successfully convert the tenants' needs for better location or consolidating offices into contract signings. With respect to the portfolio occupancy rate, I said earlier that it improved 1.6 percentage points to 95.5% as of the end of March 2023. And our occupancy rate projections for the period ending September 2023 are indicated by the bifurcated dashed line. This is because we want to show 2 different scenarios for the occupancy rate projections, one that includes Harumi Front and the other that doesn't. As I said earlier, the tenant renting entire floor space of Harumi Front will move out by the end of June this year, and yet we are disposing the remaining 45% share of ownership of this building. The projection which includes Harumi Front suggests that the portfolio occupancy rate will decline from 95.5% to 95% because of the move out. However, in the projection that excludes Harumi Front, which is a more realistic scenario, of course, the occupancy rate will go up to 96.6%, thanks to the significant improvement in the occupancy rates of Shiodome Building and Akasaka Park Building, as I mentioned earlier. Let's jump to Page 17. The chart on the left side of the page shows changes in the market rent of each property in the portfolio over the past few years. The latest data showed that out of the 66 properties in the portfolio, 43 properties saw their market rent unchanged and 23 of them saw a drop in their market rent. Many properties in Tokyo Central 5 wards continue to see their market rent decline as in the previous period, but there were a fewer number of properties whose market rent fell than in the period before, and that means that the pace of decline is slowing down. The rent gap is shown on the right side of the page. Rent gap is defined as a gap between the actual contract rent and market rent. Over the past 5 years, the rent gap had always been negative until 6 months ago, meaning the rent we charged was lower than the market rent. For the period ended September 2022, the gap almost disappeared. And for the last period, we had a positive gap at last, meaning that our rent is higher than the market rent, which also means that it is now more difficult to raise rent. So we should rather focus on occupancy rate right now and start to consider how to keep our current tenants. Please go to Page 19 for our financial strategy. Interest rates rose somewhat during the last period, especially after the Bank of Japan tweaked its yield curve control policy, but we continue to refinance our debt by borrowing long terms at fixed rates. For the long-term loans at fixed rates, we borrowed JPY 30.5 billion at an average rate of 0.82% with the average maturity of 9.41 years during the last period. Similarly and consequently, the average maturity for the total interest-bearing debt was also extended to 4.51 years, making us more resistant to rising interest rates. Next, please take a look at our credit ratings on Page 20. We asked Moody's to withdraw its credit ratings starting from the end of the previous period and instead obtained ratings from JCR. We received AA+ credit rating from JCR, and this is at the highest level among J-REITs. Let's jump to Page 24 and take a look at the bar chart at the lower right of the page. It's about net asset value per unit. The third bar from the right, the rightmost green bar represents the net asset value per unit for the period ended March 2023. There are 2 more orange bars to the right, the rightmost bar represents the latest net asset value per unit after the PO and dilution. The second part from the right is the net asset value per unit as of April 3, which is immediately after the second tranche of the disposition of Harumi Front and before the PO. And it is to show exactly how much the net asset value per unit decreased because of the disposition of Harumi Front. So as of the end of March 2023, the net asset value was at JPY 597,423 per unit. This is the third bar from the right. After the second tranche of the disposition of Harumi Front was completed and a part of this gain was used to pay dividends, the net asset value per unit decreased to JPY 594,536 as of April 3. And then because of the PO and dilution, it further declined to JPY 592,504 per unit. In other words, the impact of the PO was to reduce the net asset value by JPY 2,032 per unit, and that is the gap between the 2 orange bars. Let's move on to talk about ESG. Please go to Page 26. We have been consistently expanding the scope of disclosure since we became the first TCFD supporter in the J-REIT industry in 2019. And back in 2021, we announced our results of the scenario-based qualitative financial impact analysis. In fact, we did it for both 1.5-degree world and a 4-degree world. This is about how much we are going to limit global warming compared to preindustrial levels. And as you know, this qualitative analysis allows the company to focus on key risks and opportunities from climate change. Just last week, we announced for the first time our results are the quantitative financial impact analysis based on the qualitative analysis. The results are shown on Page 27 and 28, respectively. And they are actually an excerpt from the page on climate change initiatives of our website. The results from a 1.5-degree scenario are shown on Page 27 and the results from a 4-degree scenario are on Page 28. But I'm going to touch upon the results from the 1.5-degree scenario because that's most frequently used globally. And just so you know, our actions and targets, including the [ 1/4 ] carbon emissions are all based on the 1.5-degree scenario. On Page 27, you see the left most gray bar, which is our operating profit at JPY 35.5 billion in 2021. And there are several orange color columns to push down our operating profit. These columns represent negative impact on our operating profit created by transition risks and physical risks to be materialized by the year 2050 in the 1.5-degree world. In other words, we will have that much negative impact because of these risks. And if we do nothing at all to mitigate them, our operating profit will end up being reduced to JPY 23.2 billion, as you can see in the middle of the chart. However, if we take actions to mitigate these risks, we can turn them into opportunities and create a positive financial impact, as indicated by the blue collar bars on the right. If we address these risks properly, our operating profit will increase JPY 3 billion from JPY 35.5 billion to JPY 38.5 billion. Of course, this quantitative analysis produces only an estimate that is based on many assumptions, and we don't think that our model is necessarily accurate. That said, however, the results of this analysis clearly suggests that our efforts to make our buildings more energy efficient and turn them into net zero energy buildings will boost profit in the long term, though they cost us money in the short term. So I think that this kind of analysis is extremely important as well as significant. And that's a nice segue to Page 30. This is about ZEB certification. Back in March this year, we had the third and fourth ZEB certified buildings. And when you look at the right side of the page, our JRE Omori-Eki Higashiguchi Building received the highest ranking, S rank under CASBEE real estate certification. In the past, we acquired buildings that were already CASBEE certified, but we have never had a building in our portfolio, which was chosen to receive the highest CASBEE ranking until now. Let's jump to Page 37 and talk about the financial results and performance forecasts. It's going to be the last topic for today. There are 4 bars on Page 37. Each one indicates the DPU and from left to right for September 2022, March 2023, September 2023 and of March 2024. The 2 right most bars are colored in light green to show that these are forecasts. And next to each bar, there are several columns, which represent factors that drive up or down the DPU for each period. The green area of the bar represents a dividend source that comes from the property-related revenues, and the area in Navy blue represents a dividend source that comes from gain on sale of real estate property. I'm sure you will immediately notice that the green area is shrinking gradually. But if you look closely, there are some signs of turnaround. First of all, let's take a look at the short column right next to each green bar, which is rent and service charges. Rent and service charges pushed down the DPU by JPY 192 for the March 2023 period, and it is going to push down by JPY 41 for the September 2023 period, but it is expected to swim back to positive territory, pushing up the DPU by JPY 351 for the March 2024 period. These changes in rent and service charges are clearly reflecting the journey from the fallout of a large tenant move out to the strong recovery in rent revenues on the back of the rising occupancy rates. The column right next to rent and service charges is other property-related revenues. This is already green for the March 2023 period, meaning that it is going to push up the DPU. This is because, as I explained earlier, electricity revenue from our tenants is already increasing, thanks to our efforts to switch the electricity contracts from fixed rates to variable rates. The column next to that represents property-related expenses. This is the longest column for the March 2023 period as well as the September 2023 period. And the one that significantly drives down the DPU, but you can also see that it is getting shorter. Property-related expenses include utilities expenses. And today, the biggest driver of that is the price of electricity. Electricity costs has spiked more recently following the rate hikes by the local power companies in April and due to the rising energy prices in general. However, the impact of utilities expenses on the DPU is expected to reduce gradually in the next few periods. That's what the waterfall chart suggests. The last column I want to focus on is external growth. This is something that tends to bring down the DPU until the disposition of Harumi Front is completed end of March 2024 period. However, as I said several times before, we raised funds through the PO and are looking for opportunities to acquire properties. So we expect that external growth will be a factor that drives up the DPU going forward. To sum it up, we can reasonably say that the dividend source that comes from the property-related revenues will soon stop shrinking and it gradually get back on track for recovery. And that almost brings an end to my presentation. But before I finish, I'd like to once again talk about the current market situation. 6 months ago, I said at the last performance review meeting that the uncertainty envelop the office leasing market, real estate market and capital market, making it increasingly more difficult to predict the future. So 6 months later, I want to share with you our view of the current situation. What's changed and not changed since then. Well, first of all, I should say that the outlook of financial markets remains uncertain. As you're all aware, U.S. and European markets is still unable to shake off the uneasiness about rising interest rates as well as the stability of the banking system. And as market participants are rarely looking for any little sign of a possible credit crunch, they are naturally focused on real estate financing as well. That seems to drive the real estate prices further down. In Japan, given the fact that it remains very unclear when and how much interest rates will rise, coupled with the spillover of the credit uneasiness from the Western markets, the financial market outlook is even more uncertain. In contrast, however, there is a little bit more clarity than before with regards to the investment market and the leasing market. In the investment market, there are still players with deep pockets, including some foreign buyers, but they become noticeably less active these days. That is why there are definitely more opportunities today to buy low than before. The leasing market, too, seems to regain momentum with more workers returning to office, especially after the Golden Week when the Japanese people began to feel collectively that the pandemic was officially over. And we should also remember that Japanese companies are doing quite well. We didn't hear much that tech companies are slashing their workforces in Japan. We rather hear the wages are rising or it's getting harder to hire in Japan. Also, we are seeing strong recovery in tourism and retail industries. All of these will provide a spurt to the entire Japanese economy in the months ahead. So the climate of the leasing market in Japan is fundamentally different from the one in the U.S. or Europe. As you're all aware, financial markets and investment markets are globalized. Money transcends national borders easily. But when it comes to leasing markets, they are local in nature. The shockingly high vacancy rates in the key cities in the U.S. or in Europe do not directly affect the leasing market in Japan. In this respect, I believe that office J-REITs grossly underestimated for their potential. At any rate, we remain committed to drive internal growth in this environment and at the same time seize opportunities to buy good properties with the funds we raised through the PO back in April. And we also remain committed to maintain our strong financial foundation so that we continue to be the most financially stable REIT in Japan despite the ongoing market uncertainties. That's all for me. Thank you very much.