Navigating the Japanese property market

The recent past is a testament to the unpredictability of Japan’s property market, and while the soft economic policies of the nation’s central bank have significantly influenced real estate stocks, investment success is not about riding a trend, it’s about understanding the fundamental factors that drive markets, explains Fidelity Portfolio Manager Guillermo de las Casas.

“Truth be told, in recent months I underestimated the ability of Japanese property stocks to generate cash flow, particularly as they benefited tremendously from moves by the Bank of Japan,” says de las Casas, who manages Fidelity^® International Real Estate Fund (FIREX). “It’s clear that relying too heavily on the economic perception of the country’s Board of Governors is not a sustainable investment strategy.”

In helming the portfolio of primarily non-U.S. real estate stocks since 2010, de las Casas emphasizes companies he believes have not fully achieved their long-term growth potential. Given the cyclicality and short-term nature that typically characterizes international real estate investing, he targets firms that are less reliant on short-term factors and more driven by a secular-growth business model.

Moreover, de las Casas believes the best strategy for repeatable, long-term success is to focus on companies with sustainable earnings growth that he considers underpriced. This principle, he notes, remains steadfast, even in the face of potential policy shifts by central banks.

“Recently, I have learned to recognize and appreciate the value in solid, sustainable cash-flow yield,” says de las Casas. “By ‘solid,’ I mean not based on either financial engineering and/or acquiring property that does not have a sustainable yield for at least one lease cycle, a feat that can be hard to discern without meticulous bottom-up research.”

The case for Japanese large-cap developers, in his view, is based on their ability to cultivate low-yielding office properties, either keeping them on the balance sheet or selling them to Japanese real estate investment trusts at an even lower yield.

The first option poses significant risk, especially given interest-rate uncertainty in Japan, whereas the second option is virtually nonexistent, as Japanese REITs have sold off in favor of higher yields available in government bonds, de las Casas points out.

He underscores that even if the monetary policy backdrop for Japan does not change, equity valuations for the nation’s property developers appear significantly out of sync with their earnings, stemming from record-low interest expense at the core of these profits.

“Although there have been some recent positive developments in the industry – including better corporate governance and the crystalizing of some cross-holdings – I remain skeptical about the potential for long-term sustainable cash-flow growth in these businesses,” de las Casas contends.

Furthermore, minimal barriers to entry, in addition to the considerable vulnerability of both office and mall assets to technological innovation, make these Japanese property stocks even less appealing, concludes de las Casas. Consequently, the fund is underweight Japan at the end of January.

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