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Beware: Japan Real Estate Investing Mistakes

Have you ever been told, “buy land, because they are not making any more of it”?. No doubt you have heard from other people that traditional brick and mortar investments into real estate are a “safe way” to get a return on your money- with none of the risk and uncertainty associated with stocks. Perhaps you know somebody who made a series of successful real estate investments and was then able to quit their day job. There is no shortage of success stories and old adages in favor of real estate investment, however, houses cost a substantial amount of money and when the stakes are high even small mistakes could cost thousands. Here are some of the most common mistakes made by first-time real estate investors in Japan.

Using Too Much Leverage

If you asked ten people if they thought that borrowing money to invest in a stock was a good idea more than 50% would likely tell you “no”. Half of those 50% would probably then tell you that it was in fact a terrible idea. If we then add the caveat that this borrowed money will have a rate of interest attached to it, so that the debt essentially grows each and every year during the period where you are repaying it, then we have a much more severe proposition. Now, if you were to exchange the word “stock” for “real estate investment”, or better yet, “house”, then the responses would likely be very different. Most people would recommend the purchase of a house to be sound. Houses are for most people, the most expensive purchases made in their lives, and more often than not with borrowed money. Although a downpayment will commonly be paid out of pocket, the buyer equity in the property will likely only be 10% or 20% of the total purchase price. This is leverage. This is no different to using 10,000 USD in your brokerage account to purchase 100,000 USD worth of derivatives.

QUESTION: What would happen to the initial investment (10,000 USD) our derivatives investor if the value of their 100,000 USD position went down to 75,000 USD?

If you are unable to answer the above question, or if it seems complex, then you should re-check your understanding of mortgages before making any large financial decisions. As a real estate investor, there are three potential scenarios where you could be subject to a margin-call of sorts:

1)a. Presently your building is (for example) 85% tenanted and this covers the mortgage repayments plus a nominal amount extra. If the occupancy then drops to (for example) 83% this nominal extra amount disappears. If occupancy drops to 80% the income produced by the remaining tenants is not enough to cover the repayments, and you have to pay out of pocket until you get occupancy back up.

1)b. You own a single apartment with a single tenant. Your loan repayment coverage is 100% or 0%. If the tenant moves out, you are responsible for the entirety of the loan repayment out of pocket.

2) The bank approves your purchase at an LTV (loan to value) of 80%. You pay 20% of the value of the property. The bank pays the other 80%. There is a market re-pricing, or worse, a crash. The value of the property has gone down by 10%. The bank accordingly has the right to reduce its exposure accordingly by asking you to top up your equity by the corresponding amount. Do you have the money? No problem. If not, bankruptcy and foreclose are your options.

3) The interest rate on your loan from the bank is variable. The rates are revised upwards. Whereas you previously required 83% occupancy to cover your repayments, this is now not insufficient. You pay out of pocket. Unable to pay? See above.

Not Understanding The Law

In recent decades there have been numerous revisions of building, fire and safety codes in Japan. The current landscape of buildings surrounding you represent a patchwork quilt of rules and regulations; determined at the time of construction. Elsewhere in the world, where frequently updated regulations are concerned, it is common for previously acceptable versions to be grandfathered-in to the current status quo; given a free pass by virtue of being compliant at that time, that it was constructed. In situations where this is not possible, the onus is on the owner to bring the property into compliance, or tear it down. Re-sale, of course, is out of the question and illegal.

Japan is different. There are hundreds of thousands of non-compliant or illegal properties on the market at any time. The illegality may be as a result of safety requirements, zoning rules or construction stipulations (e.g. structure to land coverage ratio). Selling a property which is currently non-complaint is completely legal. Certain infringements must be disclosed to potential buyers by law, but not all of them. Failure to understand where to look could transform your bargain acquisition into a rotten egg that you will be stuck with- because all other buyers can see that it stinks.

Not Calculating Yield And Return On Investment Properly

The difference between gross yield and net yield varies from property to property. For older properties which have higher maintenance expenses, the difference can be stark. When purchasing make sure that you inquire as to the net yield; this is what you are left with after all fees and expenses are paid. Once this figure is known (as well as having inquired as to how they calculated it) you should run your own calculations which take taxes into consideration, as well as a wear-n-tear allowance for maintenance and repairs. Some agents will be sneaky by quoting the gross yield at full occupancy, despite their being vacancies at present. If you have done your sums correctly, you should be able to see what your breakeven point is regarding occupancy. Once you have this number you are better able to quantify risk and ask yourself- is this worth it?

Not Understanding The Market

The property markets of other developed nations are the usual case studies for real estate investment conversations. Japan, despite being a developed nation and GDP goliath is markedly different to America, Europe and the UK where it comes to property. The idea of flipping houses is undermined by the absence of a history of capital appreciation in land and real estate. In contrast to this, Japanese accounting practice assigns all fixed assets a useful life– a period of time- over which any and all real estate structure loses value, concluding in the final year of usefulness with a value of zero. It is the land itself, which historically holds value and keeps pace with inflation.

So what is the point you may ask? Strong rental demographics, low payment delinquency, strong net yields, robust legal frameworks for landlords, foreign ownership acceptance and, as mentioned, the accounting treatment of fixed assets- which allows owners to utilise depreciation expense to reduce their taxable income. Japanese real estate is not better or worse than other markets. It is just fundamentally different.

Not Understanding Liquidity And Having No Exit Strategy

If you failed to consider any of the above points before taking the plunge, then you will most definitely be contending with the task of re-sale in the future. Liquidity is the ability to transact efficiently; in this instance- how easy is it to sell? The Japanese real estate market is efficient. There are no issues with the process itself, and there is no shortage of buyers, or capital. The issue that some owners may have is if they own property in an undesirable location or in an area with poor population demographics. It stands to reason that investors may be hesitant to deploy capital to purchase an asset if the cashflows (the rental income) are uncertain, or if there is a possibility that they may cease altogether in the future. For example, if you own an apartment building in Toyota, where the majority of the tenants are employed by the local automobile industry, what would happen to vacancy if there was a downturn in the industry, or certain employers became insolvent?

Although many people will be tempted to chase high-yield, it is important to consider yield in the context of re-sale ability. In short, is the high yield offering a sufficient premium to compensate for the extra liquidity risk in the future? If the only way to sell your property is to offer a 20% discount to purchase price, how many years of past rental income essentially vanish upon re-sale? There are many things to talk to your advisor about when considering a purchase, and perhaps more still if you are not sure if the investment you have already made, will prove to be beneficial in the long term.

 

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Japan Real Estate Investment Mistakes
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Avoid the most common mistakes made by expat investors in Japan
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