The best value to be found in Japanese real estate is in small-cap real-estate investment trusts (Reits), says Dan Kerrigan, Honolulu-based CEO at Prospect Asset Management.

Prospect, founded in 1994 with $70 million, now manages $938 million in Japanese equity and real-estate assets (as of January 31, 2008). Prospect Residential Advisors is an affiliated Japanese Reit asset manager that launched a J-Reit in 2005, the Prospect Residential Investment Corporation, and now has Ñ74.5 billion ($701 million) of assets.

Kerrigan is optimistic the Japanese government will allow the first mergers and acquisitions to take place among J-Reits, which would allow many of them to unlock intrinsic value û because there is often a huge discrepancy between heavily discounted share prices and high-quality underlying assets. This discrepancy has only widened amidst the carnage of the American subprime crisis.

There are now 42 listed J-Reits, and some trade at 40-50 cents on the dollar, particularly smaller ones that are most exposed to the domestic-demand story. The best value is found among small-cap residential Reits, Kerrigan argues.

These so-called ôorphanö Reits are fragmented and lack a sponsor from one of JapanÆs big conglomerates, and therefore have no obvious single source of supply of new properties. That puts their share prices at a discount to net asset value. But the physical market in metropolitan Tokyo has fared well.

Prospect is happy to own many of these orphans because the dividend yields are high, thanks to high occupancy rents and the reliability of middle-class tenants to pay their rents. Such cash flows easily cover the ReitsÆ cost of debt as well as provide for a decent dividend.

The US subprime crisis has hurt Reit shareholders, by reducing investor appetite for global real-estate assets and other risk assets. Foreign investment banks that once were prepared to lend to Reit managers or property developers are curtailing such activity û or simply exiting the Tokyo market, as in the case of Bear Stearns and other hard-hit investment banks.

Although the conditions in the US that led to the subprime crisis (overbuilding and too much easy credit) are not found in Japan, Japanese real estate has suffered anyway. J-Reits can no longer raise fresh capital û the last such deal was in November 2007.

Meanwhile high-quality private Reits have cancelled intended listings, including ones owned by AIG (December 2007) and Daiwa House Industry (June 2008). Meanwhile, smaller developers that had expected to sell their projects to Reits no longer can, so these projects end up on their balance sheets where their value plummets.

This situation is making the government uncomfortable. Many pensioners have invested in J-Reits in the expectation that these would be high-dividend, low-volatility assets and a better bet than a corporate bond fund.

But small-cap Reits exposed to the lease market remain fundamentally sound and are paying dividends, even if the share price is in the dumps. The fact that the assets are worth more than the ReitÆs price is attracting global investors, who are ready to buy, provided they can unlock this value.

But for such an investment to pay off Reits would need to consolidate, a move that until recently regulators and stock-exchange officials had frowned upon. The recent pain felt by retail shareholders, however, has led many industry executives to believe the Financial Supervisory Agency will allow M&A in the sector, perhaps this year. The domestic media has cited unnamed FSA and Tokyo Stock Exchange officials as being open to the possibility.

There remain technical challenges, as JapanÆs investment trust law has no provisions for M&A involving Reits, which in Japan are structured as corporations not joint-stock companies, as they are in the United States, where Reit M&A is commonplace.

More global private-equity players have expressed an interest in Japanese physical real estate, which should also put a floor beneath Reit prices, Kerrigan says.