Japan’s institutional investors have traditionally invested in alternatives via hedge funds but that may be changing as opportunities open up in the real estate space, delegates at an AsianInvestor conference heard on March 15.
At 118, Japan had the second-highest number of institutional investors allocating to hedge funds in the Asia-Pacific region after Australia, a July 2017 report by Preqin shows. In the report the alternatives asset data provider also estimated that Japanese institutional investors accounted for around 22% of all capital invested in hedge funds across the region.
However, the tide is shifting, according to a panel of Japanese alternatives investment professionals at the 7th annual Japan Institutional Investment Forum.
“Hedge funds are decreasing now,” Katsuyuki Tokushima, chief pension adviser of the Pension Research Center at the NLI Research Institute, told the audience.
“[Institutional investors in Japan] do mainly invest in hedge funds for alternatives, but there is a little change and real estate and other kinds of illiquid assets should be considered the top-rising for alternative investments,” Tokushima said.
In 2017, the average allocation to hedge funds as a percentage of assets under management among Japanese institutional investors was 7.3%, down from 9.2% in 2016, Preqin data shows, while allocations to real estate increased from 3.0% to 3.6% in the same time period.
We are seeing increasing demand for real estate, particularly among life insurance companies, Hidetoshi Ono, managing director of Japan real estate at Manulife Life Insurance, said on the same panel.
“They are more stable assets and we at Manulife recently reviewed our investment allocation and came up with $2.5 billion of allocation in pan-Asia real estate,” Ono said. The $2.5 billion will be invested over the next couple of years into core property markets in Asia, including Japan.
The duration of these investments is almost as long as the building’s economic life, Ono said, which could be anywhere from 20 to 40 years, but they typically focus on a 10-year total return.
PRIVATE REIT OPPORTUNITIES
An increasingly favoured wrapper for these property investments are private real estate investment trusts (Reits).
In the past 5 to 6 years, Japanese institutional investors have shown an increasing interest in these unlisted domestic Reits, which typically produce a net investment return of approximately 4%.
Publicly traded J-Reits were popular after the financial crisis but their high correlation with Japan's stock market generated unwelcome volatility in investor portfolios, unlike private Reits, which are open-ended and provide better diversification opportunities and more stable yields, according to Ono.
“Open-ended funds are primarily focused on the yield, and for pension funds and long-term investors, yield is more important than a one-time gain,” he said.
Another advantage for investors is that the value of private Reit assets are appraised by independent third parties, so investors are buying in at the appraised value instead of the market value. “Usually the appraised value lags the market value of the real estate when the price is rising. So if you’re investing in the fund today, you’re investing in the price yesterday, so you can benefit by taking the appraised value into the funds,” Ono said.
Japan Post Bank (JPB) invests in both open-ended and closed-ended funds, Tokihiko Shimizu, senior managing director and head of private markets investment for JPB, told the audience, but for generating cash flow it too prefers open-ended funds.
That said, Manulife’s Ono sees more opportunities in overseas open-ended private real estate investments than in the domestic market. “I would recommend looking at regional or even global-focused private core funds, where you can get [the] benefits of diversification as well as stable income, but with less volatility,” he said.
The real estate market in Australia is particularly attractive for Japanese institutional investors. “We are seeing increasing interest in the Australian real estate market, which is growing. It gives about a 7% return,” he said.
But a home bias that prioritises higher returns in overseas investments among many Japanese institutional investors presents a barrier for investment in the US and Europe, where the ratio of operating income to the total value of properties -- capitalisation rate -- has been shrinking.
“The private Reit produces 4%, so people are asking 5% or higher,” Ono said. “It is difficult to even gain 5% return only investing in US core cities, which includes New York, San Francisco, and Los Angeles.”
Class A central business district office properties in New York, San Francisco and Los Angeles had capitalisation rates ranging from 4% to 5.25% in the first quarter of 2018, according to data from real estate services firm JLL.
The challenge for institutional investors is how to find assets worth investing in, both domestically and globally. “There’s an increasing appetite for real estate, and a shortage of products which are available to meet institutional investors’ increasing demands,” Ono said.
If you factor in hedging costs, structuring costs, and tax losses, which can eat into already thin returns, it becomes even more difficult to meet the return hurdles of Japanese institutional investors, he added.
The NLI Research Institute’s Tokushima preaches patience, advising his pension fund clients not to rush into real estate investments, which tend to be very long duration investments. “If you find a good investment chance, let’s go. But as long as there is no investment chance, just wait and see,” he told the audience.
However, this “wait and see” attitude could also be to the detriment of investors, Manulife’s Ono said.
“One of the very unique features of Japanese institutional investors is [that] they want to see the asset before making the investment decisions, while most of the European and American institutional investors allocate for real estate, select the investment manager, and then do an almost blind pool,” he said.
That strong resistance to blind pool investments hinders investors from getting the best opportunities in the market, Ono said. He encourages institutional investors to be more proactive. “Obviously you don’t want to put the money into a blind pool. However, if there’s a strong tactic with a good sheet of assets, then giving them the money with some room to grow would be a good idea,” he said.
“In terms of timing, there is never a best time to invest in anything,” Ono added.