DEEPAK MOORJANI!

AUGUST 2006

J R EI T PM V
A Novel Way to Acquire Real Estate Assets in the Japan Market

JREIT Private Market Value Arbitrage

Investment Strategy The JREIT market provides a lowrisk, contrarian principal investment opportunity in the Japanese real estate market. For various reasons, certain residential JREITs trade at or below pubic NAV despite the fact that TOPIX is at 5-year highs and commercial JREITs trade at 40-50% premiums to NAV. Compared with the physical asset market, residential JREITs are fundamentally mispriced. This strategy has very little risk. In Japan, investors have the advantage of positive spead; the yield gap still remains, although it has been shrinking in recent years. At pricing of 0.9-1.0x NAV, a public market investor can generate approximately 3-4% on a current yield basis with some expectation of a capital gain. As it matures, the JREIT market will consolidate which will increase the opportunities to determine value on a PMV (private market value) basis rather than a pure NAV/liquidation basis. For a nancial sponsor, there are a number of ways to work with a JREIT asset manager to create a value-creating transaction, the most interesting transaction is a management-led buyout. An JREIT MBO simply capitalizes on private market/public market arbitrage when stock and/or sector valuations decline; nancial sponsor IRRs are greatly assisted by the increased leverage possible when compared to the trust structure. Note that the commercial JREIT sector has been studied and excluded at current prices; these stocks typically trade at a 40-50% premium to published NAV. Japans JREIT Market Japans Investment Trust Law, enacted in November 2000, established the REIT vehicle, and two JREITs were listed in September 2001. As of July 2006, there are 50 real estate trusts; of this total, 33 have already listed. In addition, there are an additional 500 or so real estate investment rms specializing in property. JREIT expansion has been aided by the JGB yield gap coupled with the liquidity, current income yield and transparency of the investment vehicle. In Japan, we expect to see a continuation of growth in the REIT sector given the secular shift from private to public ownership of real estate; however, the large and growing number of funds in Japan is not sustainable without some consolidation. As companies compete for deals, asset prices continue to rise and cap rates continue to fall thereby making

SUMMARY
JREIT CONSOLIDATION Consolidation in the JREIT sector seems inevitable. The timing of the property and market cycles will put pressure on the industry to consolidate RESIDENTIAL SECTOR A handful of residential JREITs already trade at or at a slight discount to NAV. This discount is due to fears of asset oversupply, limited liquidity, and market capitalizations too small to attract the larger domestic pension funds REFLATION TRADE Wall Street offers the chance to invest in real estate at lower prices than Main Street via JREITs trading below NAV. The risk of capital loss is fairly low, and a leveraged investment is self-nanced by the high-dividend. Investor should use equity ownership to build relationships and to convince asset managers to pursue value-creating transaction. LEGAL LOOPHOLE JREITs are not covered by Japanese TOB procedures. Thus, the usual prohibitions and restrictions on acquiring large blocks of stock do not apply
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DEEPAK MOORJANI!

AUGUST 2006

it more difcult to generate the returns demanded by public shareholders. The pressure to reach critical mass will increase: with size comes the ability to cover wider territory, to save on expenses, to lower the cost of capital, and to increase liquidity. Couple this with the changing of the guard at many private empires, and consolidation is likely to occur. Naysayers might argue that management entrenchment, tax concerns, poison pills, and a variety of other factors will prevent consolidation. These issues do exist and are real barriers. In addition, JREITs are not cheap enough in the aggregate for the LBO/M&A business to grow dramatically at current valuations. However, we believe consolidation forces will overcome these impediments; the structure of the JREIT group and the timing of the property and market cycles will put enough pressure on the industry to consolidate (and decapitalize) over the next several years. Comparison with US More and more Japanese investors nd the appeal of JREITs attractive. Creatures of tax law, JREITs provide transparency, liquidity, more permanent management and corporate structures, easier access to all forms of capital including unsecured debt, and greater overall property market efciency. Consolidation in the JREIT sector seems more than likely when valuations fall. As a comparison, the overall market capitalization of US REITs grew from $44.3 billion to $224.2 billion during 1994 through 2003, but the number of REITs declined from a peak of 225 to less than 175. Australia provides another data point. In
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Australia, there are 80 listed LPTs and other property rms with a total market cap of over $50 billion, and LPTs control nearly half of the institutional quality commercial real estate in Australia. However, the sector is dominated by ve LPTs which account for 40 percent of the sector's market capitalization. The top 10 LPTs make up more than 65 percent of the sector. The U.S. has seen two waves of REIT M&A activity, including the current wave. In the 1990s, U.S. premiums hit peak highs in 1997-1998 at nearly 25-30% premiums to NAV. These numbers declined in the REIT bear market of 1999-2000 when REIT stocks signicantly underperformed the overall market. In early 2000, REITs valuations hit bottom and were trading below a 10% discount to NAV. In this environment, a number of large LBO/MBO transactions were consummated in the REIT sector including Berkshire Realty, Sunstone, Irvine, Walden Residential and Patriot American. More recently, Capital Automotive, Gables Residential, CRT Properties and AMLI approved plans to go private at 9-21% premiums over market prices in 2005. This proved the point that a discount to NAV is not the only way to discern value; REITs are not just a collection of assets. Goodwill can typically be justied by two factors: (i) a high-quality management team that has created and operates a strong platform and (ii) a change in business strategy that was eliminated by the previous trust structure, such as an apartment-tocondo conversion.

DEEPAK MOORJANI!

AUGUST 2006

Investment Strategy Most investors have ignored this potential transaction in Japan. To date, the local market has not seen a LBO/MBO in the JREIT sector. In fact, this might be why the FSA regulations are silent on a JREIT TOB; the possibility was probably not considered when JREITs were created. Step 1: Begin to accumulate shares in the public market for select residential JREITs in order to accumulate 5-10% of a targets market value. The risk for this public market purchase is fairly low. Of course, a discount to NAV is not always a strong buy signal; the valuation gap might be closed by an increasing cap rate. In other words, falling real estate values might close the gap. However, it is hard to imagine that cap rates will increase in the short-term. Cap rates have been decreasing rapidly since 2004 due to the decreased risk of real estate investing. Remember, cap rate = risk free rate + risk premium, and increased transparency coupled with increased liquidity have effectively lowered the risk premium. JREITs are priced by public market investors on current yield, and while the average yield has declined from approximately 7% to 3.5% since the markets inception, the overall JREIT yield spread over the local government bond remains larger than anywhere else in the world. Regional banks, life insurers and corporate pension funds are expected to increase their alternative asset allocations. Also, residential JREITs are fundamentally mispriced. In most markets,

residential real estate trades at a lower cap rate than commercial real estate, justied by more stable rental revenue rates and a lower risk of rental uctuation. This is also true in Japan: by property type in 2004, the appraised cap rate in central Tokyo was 5.8% for ofce properties and 5.3% for residential properties. Similar differences were found in the rest of Tokyo and elsewhere in Japan. Thus, residential properties are consistently 0.3-0.5% lower than commercial cap rates, reecting their lower risk premium. However, the opposite is true in the JREIT market. Commercial JREIT typically trade at 40-50% premiums to NAV which implies that pubic market investors expect commercial cap rates to fall. While more ofce than residential properties trade at cap rates under 5%, commercial cap rates are more widely dispersed, and the extreme examples do not represent the greater market. Residential properties have cap rates that are generally lower in the physical asset market, and it is inconsistent for the opposite to be true in the nancial asset market. As closed-end funds, JREIT pricing depends on overall supply and demand of stock which is sometimes removed from fundamentals. In another sense, the public market perception indicates a fear of falling residential rental rates due to expected property oversupply and a gradually shrinking population. However, these fears are overemphasized: Japan will see continued urbanization, especially in Tokyo, and the number of households is expected to increase over the next 10 years with

greater numbers of young people living alone, greater incidence of divorce, moving out of the nuclear family at an earlier age, etc. Also, rental unit demand should increase if interest rates rise; the attractiveness of buying condominiums will lose relative appeal. Step 2: Begin a conversation with management on a friendly basis. For the nancial sponsor, the best case scenario is an MBO (discussed in Step 3), and DB should be prepared to roll-over the equity position acquired in Step 1 into the MBO. However, a going private transaction is not the only value-generating outcome. Among other options, management can consider a merger with another JREIT. This tax-efcient share-for-share combination will lead to critical mass for smaller JREIT entities, a lower cost of capital, greater liquidity and perhaps sector diversication (ofce, retail, etc.). With a merger, holders of JREIT shares can expect a more favorable stock valuation and a possible change of control premium. Weak sponsorship may be another reason for certain JREIT NAV discounts. If the value-added by the management team is less than the cost of maintaining the team, then management can be viewed as an offbalance-sheet liability. Many closedend mutual funds, real estate companies, and oil companies often sell at prices below what is justied by the assets. In these situations, a change of management often seem to be the solution. Our ability to manage this process is quite low; as such, any

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DEEPAK MOORJANI!

AUGUST 2006

JREITs run by less-than-average management teams should be avoided. Corporate governance issues need to be seriously considered, and any corporate transaction (MBO, merger, leveraged recapitalization, etc) might provide the opportunity to improve the management team. Corporate governance is discussed more closely in Appendix B Step 3: For a nancial sponsor, the best possible outcome is to convince the JREIT manager to execute an MBO. A private market buyer must account for a number of items in a potential transaction: potentially higher cap rate assumptions, debt prepayment penalties and origination costs, and transaction fees. Together, these items could amount to 5% of NAV and must be included in any analysis of private market value. Like most discounts, the buy-side will probably be ahead of the sell-side and BODs on this issue. Appendix A details the nancial analysis, and it is important to remember that a private market value (PMV)/LBO valuation may not equal net asset value; in general, it is likely higher. As a simplifying assumption, we have assumed that a discount to NAV is necessary for an attractive transaction; however, this is a limiting and potentially misleading assumption as shown in Appendix A. Even with transaction costs and an assumed higher cap rate (a discount to NAV), a JREIT MBO makes nancial sense. As an example, an MBO with a 100 bps cap rate premium produces IRRs of 29.4%, an equity
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return multiple of 2.74x, and cashon-cash yields of 21.8%. A similar JREIT structure produces IRRs of 7.6%, an equity return multiple of 1.4x, and cash-on-cash yields of 5.1%. In a going-private transaction, there are three sources of value:
! Financial

Our nancial analysis assumes that unlevered cash ows grow at a modest 3% per year. Potential Targets We have identied some of the likely candidates who have been selected based on sponsorship identity (generally foreign), market pricing and size. Foreign sponsors are generally more price-sensitive and willing to entertain a discussion. These targets will be discussed in more detail.

arbitrage: Trusts generally limit leverage to 30-40% of total assets. JREIT investors want highcurrent income, and JREITs typically must leverage in order to maintain high-dividend payments. An MBO with 75-90% leverage is a signicant nancial restructuring with an investor base that does not need and does not want the current income stream. ! Wholesale-to-retail mispricing: Public market valuations are not the same as private market valuations, and public NAV is often dated and/or inaccurate. Appraisals are done twice a year, and in an environment of rising prices, public NAV numbers tend to underestimate value. Also, inherent value depends on the private buyers view on expected future prices. ! Management arbitrage: This depends on the identity of the management team which can be improved with an outside sponsor. Also, a private company structure can enable the execution of a different business plan/strategy that might not be available in the public market, such as an apartment-tocondo conversion. Our analysis only considers nancial arbitrage and does not ascribe any value to management arbitrage, a potentially signicant value depending on the identity of the partner.

Conclusion As a private buyer, the nancial restructuring of a JREIT can create substantial value, and it is a very efcient way to acquire an equity stake in a large portfolio of assets. It need not be the nal step: the exit might be a new JREIT offering when market perceptions improve and when the portfolio has been increased, improved and/or reengineered during the portfolios period of private ownership.