COLLIERS RADAR OFFICE | | 9 OCTOBER 2018

Mari Kumagai Senior Director | Research| +(81) 3 4572 1009 [email protected]

CATCHING THE RHYTHM OF TOKYO Tokyo office market overview and outlook COLLIERS RADAR OFFICE | TOKYO | 9 OCTOBER 2018

Low net supply has enabled a market recovery better than we expected over recent years. We no Summary & Recommendations longer find much room left for occupancy gains; in our view, the current demand to supply dynamics remain tight enough to justify modest rental growth over several more quarters. A continued dip in available space with still- Since 2013, net absorption averaging 2.0% per annum has tracked above net new supply averaging strong corporate demand has led to a 0.8%, reducing the vacancy to cyclical lows. We highlight the current market status has some room for more competitive market outlook for most upward price movements as the vacancy rate hits cyclical lows. Past weak price recovery since 2012 tenants this year. should also help extend the ongoing slow yet stable market recovery. > For occupiers, we advise early planning and lease reviews given the anticipated Fig. 1: Market Cycle – Tokyo five central wards supply increase until 2021. Current demand to supply dynamics remain 15.0% tight. Lower-grade buildings in popular Feb. 2007 locations have seen faster price increases than prime office buildings. 10.0% This has prompted some landlords to reconsider their pricing strategy by fixing the lease term contracts at 5.0% current levels ahead of peers. Current > For most investors, the market outlook June 2012 0.0% should stay positive since we expect the yield gap compared to other markets to remain wide. We are confident that the Tokyo office market -5.0% provides enough depth, liquidity, and a sufficient track record to accommodate Y/Y Monthly Change Rent new money. -10.0% > In addition, more institutional investors are being pushed to replace their huge -15.0% bond investments by property Feb. 2010 investments. This is due to the minimal term premium available on their -20.0% investment horizon due to the likely 0.0% 1.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 9.0% 10.0% extension of the near-zero interest rate Vacancy % environment over the next few years. Source: Colliers International Japan Research 2 COLLIERS RADAR OFFICE | TOKYO | 9 OCTOBER 2018

TABLE OF CONTENTS

Page

Summary & Recommendations 1

UPWARD TRAJECTORY CONTINUES 4

ALTERNATIVE TREND SURGING 5

Key demand drivers 5

Focus on net supply figures 6

Pricing trend 11

Capital Market Implications 15

Appendix 21

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UPWARD TRAJECTORY CONTINUES Solid demand and lower-than-expected supply boost rental growth and capital value appreciation

Demand Rent We expect office demand will maintain an upward trajectory, keeping the We expect ongoing price growth to peak at around 5% within the next For the year ahead, same trend with the total occupied area in the central five wards expanding several quarters before tapering down to a more sustainable compound new buildings to by about 2% year over year since February 2011. Key demand drivers annual growth rate (CAGR) of 0.8%. We expect lower-grade buildings to remain the trends for functional consolidation in more convenient locations be completed are maintain faster price increases above the current 5.2% until their average within the Greater Tokyo Metropolitan Area. We expect net absorption to rents move closer to higher grades as the existing price gap in the same almost being filled, remain stable – tracking at around 2.7 % of existing supply or 150,000 tsubo districts offers up to a 40% discount. which is likely to (495,900 sq metres) on cyclical average – as more tenants are rushing to However, the overall price response remains weak especially on higher support a modest secure their future occupancy needs over the next eighteen months, leading grades. For the next twelve months, we expect the CBD prime rent index to upward trajectory to more immediate concerns about the lowest vacancy rates since 2007. in the overall rent stay flattish with limited upside as more tenants are reaching out for lower Supply grade buildings. We also do not expect the overall rent growth to outpace level; the latest inflation averaging 1.1% over the next five years. CBD prime office We expect increasing supply for late 2019-2021, with annual expansion rent index has averaging 2.8% of stock. However, we highlight that the impact of our Capital Value and Yield expected supply increase, after adjusting for withdrawal from demolition, is continued to We anticipate capital values to inch up at least 3% per annum as more old much less sanguine on a net basis averaging 2.1 % of stock. Our more bullish increase for 17 buildings are being redeveloped in central locations, an increasingly baseline forecast than market consensus has incorporated the demolition of consecutive prominent trend since 2003. Capital value appreciates in tandem with the older buildings that has already eliminated about 45% of new supply over better earning power investors expect on rising rents. quarters with the the past four years. We expect the scale of net new supply to decline to a latest annual more sustainable 1.7% after 2022, providing an interesting market entry Real estate investors can prevail over bond investors under the Bank of growth of 4.2%. opportunity for long-term investors. Japan’s zero interest rate policy. Massive government debt will also need to stay affordable in the interest of the government over a longer investment Vacancy horizon. Our baseline scenario thus does not assume a benchmark rate We expect the overall vacancy level to remain at the current record low and increase of more than 25 basis points over the next five years. below 3.0%, as the net new supply level is recovering closer to the net Looking ahead, a wider yield gap than in any other Asian market – reaching a absorption trend from mid-2019. With near-complete shutdown of available record level of nearly 4% – is prompting more money inflows to real estate new supply due to larger pre-commitment prior to building completion, investment. We expect this trend to continue at least for the next few years. vacancy should stay low even with minimal growth in demand. Our base case thus does not assume rising vacancy at least until the end of 2019. More tenants are reaching out for lower grade buildings, adding to the race to secure available CBD space at the same price range below their typical budget ceiling up to JPY30,000 per tsubo (USD80.3 per sq metre).

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ALTERNATIVE TREND SURGING Fig. 2: Employment growth in Tokyo by industry (2008–2017) Growing employment as a hub of corporate Medical & Welfare headquarters in leasing sectors

The outlook for domestic demand is solid and should support growth in 2018 Professional Services and 2019. Stable employment inflows into Central Tokyo continue to act as a key demand driver for office space requirements (Fig. 2). We expect Tokyo’s Information & Technology net employment growth to continue, averaging 0.7% over the next five years according to Oxford Economics. Education Increasing labour participation from younger foreigners, seniors and women has also been a boon to a relatively inflexible labour market since the start of Abenomics in 2013. Additionally, more retiring baby boomers will likely need Insurance & Financial Serrvices to work and supplement their diminishing income. We see a small upside to the Central Tokyo office worker trend, forecasting negative employment Real Estate growth from 2022. In our view, a secular shift toward digitalisation will require more centralised Transportation & Delivery Services space requirements in each industry, a positive to Tokyo Office Markets. Over the past decade, Tokyo’s employment growth has remained high in Information &Technology (+35%) and Professional Services (+36%), followed Hotel & Hospitality by Banks, Insurance and Other Financial Services (+19%) and Real Estate (+18%). This contrasts with negative employment growth in Manufacturing (- 17%) and Construction (- 12%) as more processes are automated, reducing Retail & Wholesale the need to maintain the same space requirements within CBDs. More aging baby boomers have also pushed up labour-intensive Living & Enterntainment employment in Medical and Welfare (+50%), a trend which we expect to continue for another few decades. Reflecting Tokyo’s status as capital city Construction with many corporate headquarters, Trade, Transportation & Communication (38%), Business Services (23%), and Financial Services (10%) are also driving the city’s GDP trends. Manufacturing

Looking ahead, business services for productivity enhancement are likely to -30% -15% 0% 15% 30% 45% 60% remain the most powerful source of future job creation, with the unemployment rate edging lower from the current 2.9% to 2.7% by 2022. Source: Colliers International Japan Research, Metropolitan Government of Tokyo

5 COLLIERS RADAR OFFICE | TOKYO | 9 OCTOBER 2018

With a tight labour condition overall, it is not surprising to see more flexible Fig. 3: Tokyo Central 5 Wards: Demand and Supply (sq metres) work arrangements are lifting temporary office demand; almost 20% of major companies have started to offer alternative work-place arrangements New Supply Net Take Up according to the latest Nikkei market survey. New market players are tightening the market demand when available office area is increasingly 800,000 limited; the still-small area occupied by WeWork has increased by 12,000 tsubo (39,675 sq metres) per year, equivalent to as much as 10% of available 600,000 vacant stock as of August 2018. 400,000 All in, stable demand has outstripped tight supply since 2013 (Fig. 3). Adjusting for demolition which has been larger than we expected since 2005, 200,000 the net supply was negative enough to keep reducing the vacancy since 2012. Oxford Economics currently predicts real GDP to grow by 1.0% in 2018 0 and by 1.1% in 2019 before tapering off to a more sustainable 0.9% rate in later years. -200,000 A push to redevelop “vintage” office buildings in -400,000 Central Tokyo 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Source: Colliers International Japan Research Low supply growth has been the defining positive attribute to the ongoing market recovery (Fig. 4). Fig. 4: Tokyo Central 5 wards : Net Change in Leasable Area as % of We forecast that the overall net absorption trend will remain solid at least Existing Stock until mid-2020. Even though the previous cyclical peak in 2003 saw the addition of a record 5.4% new supply to existing stock, the scale of upcoming supply is more manageable, averaging 2.8% over the next three years (Fig. 4). The net supply - after adjusting for larger demolition planned during the same period - should further decline to 2.1%. New supply will likely then taper off to a more sustainable level of 1.7% before adjusting for possible demolition beyond 2022. The latest office building survey by the Japan Real Estate Institute revealed that annual demolition within the 23 wards has amounted to 670,000 sq metres, equivalent to as much as 80% of new supply. Even within the central five wards, the area eliminated due to demolition has averaged 45% of new supply over the twelve years from 2005. In relation to existing stock, assuming the average age of demolished buildings is 43.5 years/50 years/60 years, this will also reduce existing stock by about 2.2%/1.9%/1.6%.

Source: Colliers International Japan Research

6 COLLIERS RADAR OFFICE | TOKYO | 9 OCTOBER 2018

Limited land supply within Central Tokyo means Fig 5: Net new building supply of Tokyo central five wards (sq metres) that most developers will need to redeploy the same land, rather than adding a new building in New Supply Demolition Net Change in Leasable Area outer districts, an important distinction to be 2,500,000 made from the previous supply peak reached 2,000,000 about fifteen years ago (Fig. 5). 1,500,000 We also think that the relative impact of our expected supply increase appears more 1,000,000 manageable; Singapore, for example, on the back 500,000 of better demand and supply fundamentals, should see new supply expanding to about 7% of - stock in 2021. This is much larger than Tokyo’s (500,000) past cyclical peak reaching a record 5.4% of

stock. (1,000,000)

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Looking at the source of future supply, more 2000

2018E 2019E 2020E 2021E 2022E older buildings in central locations are being redeployed as larger new buildings with Source: Colliers International Japan Research, Mikishoji Note: The above data is limited to office buildings with a minimum total leasable area of 3,000 tsubo or 9,900 sq m premium facilities; the average building size in CBDs has expanded - at a CAGR of 1.3% over the past eight years - to 2,870 tsubo or about 9,500 Fig 6: Average size of office buildings of Tokyo central five wards (sq metres) sq metres per building (Fig. 6). This is much smaller than other global cities on average. That # Buildings -lhs Average Leasable Area (Tsubo) said, increasing economies of scale in office buildings should be positive for future tenants 10,000 2,700 with more comprehensive office space requirements. 9,500 2,650 More new buildings are being built in central 9,000 2,600 locations with the proportion of new buildings 8,500 2,550 within the central three wards increasing to 67% from 51% during the previous market peak in the 8,000 2,500 buildings #

1990s. (sqm) NLA Average 7,500 2,450

7,000 2,400

Jul-03 Jul-06 Jul-09 Jul-12 Jul-15

Jan-02 Jan-05 Jan-08 Jan-11 Jan-14 Jan-17

Oct-02 Oct-05 Oct-08 Oct-11 Oct-14 Oct-17

Apr-04 Apr-07 Apr-10 Apr-13 Apr-16

Source: Colliers International Japan Research, Mikishoji Note: The above data is limited to office buildings with a minimum total leasable area of 3,000 tsubo or 9,900 sq m 7 COLLIERS RADAR OFFICE | TOKYO | 9 OCTOBER 2018

Fig. 7: Tokyo central five wards office project pipeline

# Project Name # Project Name

● 2018 ● 2020 1 Sumitomo Fudosan Onarimon Tower 35 Ekimae Plan 2 Taiyo Seimei Building 36 Trust Tower 3 Tokyo Midtown 37 Kita Shinagawa 5-chome (ex-SONY HQ site) 4 G-Base 38 Kasuga Korakuen Ekimae Area S-A Tower 5 Nippon Life Hamamatsucho Crea Tower 39 Takeshiba Area Redevelopment 6 Sumitomo Fudosan Osaki Garden Tower 40 Toranomon 1-chome Redevelopment Area B The following 7 Tamachi Station Tower S 41 Takeshiba Water Front Project business districts 8 Stream 42 D Tower Nishi 9 Otemachi 2-chome Redevelopment: A Tower 43 Kita Aoyama 2-chome Project designated as the 10 Otemachi 2-chome Redevelopment: B Tower 44 OH-1 Plan B Tower national strategic 11 JP Building 45 1-3 Project (Ginko Kyokai) special zone by the 12 Marunouchi Nijubashi Building 46 Toshima Project A Tower 13 I-Mark 47 Bayside Cross Tower A central government 14 Kojimachi 4-chome Project 48 Toyosu Bayside Cross Tower B will likely see a 15 4-chome Plan 49 Sumitomo Kojimachi Garden Tower notable net supply 16 Nihonbashi 2-chome Redevelopment C Area 50 Tamachi Station Tower N ● 2019 51 Kanda Nishikicho 2-chome Plan increase for the next 17 Kanda Neribeicho Project ● 2021 five years: 18 Hato Bus Konan Building 52 Nishi Shinjuku 5-chome Kita Area - A 19 Sumitomo Nishi Shinjuku 6-chome Plan 53 Sekai Boeki Center South Tower > Marunouchi 20 Seibu HQ Building 54 Tokiwabashi Redevelopment A Tower Dogenzaka 1-chome Redevelopment 55 Shinbashi Tamuramachi Area Redevelopment 21 > Nihonbashi/ (Tokyu Plaza) 56 Toranomon 1-2 chome Project (B Area) Nihonbashi Muromachi 3-chome Bekkan 22 57 Kabutocho Project > Shinagawa/Osaki Redevelopment 58 Toyosu 4-2 Area 23 Hotel Okura Office Project ● 2022 > Toranomon 24 Shibuya Eki Sakuragaoka Exit Redevelopment 25 Shinjuku Minamiguchi Project 59 Area A 26 Sumitomo Fudosan Udagawacho Project 60 Yaesu 2-chome Project North Area 27 Toranomon Hills Business Tower 61 Yaesu 2-chome Project (Yanmar Building) 28 Udagawacho 15 Redevelopment (Parco) 62 Tokiwabashi Redevelopment D Tower 29 Soto Kanda 1-chome A Tower 63 Kudan Kaikan Plan 30 SS Project ( Camera) 64 Hamamatsucho 2-chome Plan A-2 31 Nittetsu Nihonbashi Building Project Completion ● 2023 32 Shinbashi 1-chome Plan ● 2018 65 Toranomon 2-chome (Hospital Redevelopment) 33 Nagasaka Sangyo Kyobashi Building 66 1-chome S Tower ● 2019 34 Shibuya Nanpeidai Project (tentative) ● 2020 67 Toranomon Hills Station Tower ● 2021 68 Station Redevelopment ● 2022 69 TTM Project (Tamachi Bldg Redevelopment) ● 2020 70 Toranomon- Redevelopment Source: Colliers International, Japan Real Estate Institute, Mikishoji

8 COLLIERS RADAR OFFICE | TOKYO | 9 OCTOBER 2018

Fig. 8 Ranking of average rent growth – CAGR since 2010 Limited supply growth casts some mixed pricing impacts 8/31/2018 12/31/2017 12/31/2010 CAGR since 2010 (rhs) when tenants have more than enough capacity to pay with 35,000 3.5% their corporate cash flows hitting cyclical highs. 3.0% Ranking the rent growth since 30,000 2010, the growth has been 2.5% strong where growing IT industries tend to congregate. 25,000 2.0% Tighter demand to supply dynamics are driving up rent in 1.5% popular locations such as 20,000 Shibuya (+3.0 % p.a. since 2010) 1.0% and Ebisu (+2.4%) (Fig. 6) while 15,000 we have also observed price

(JPY per(JPY Tsubo) 0.5% discounts in outer districts such (CAGR since 2010) since (CAGR as Toyosu, Kiba and Toyocho 10,000 0.0% (- 1,1%). Prime office areas such as -0.5% Marunouchi (+0.2%) have not 5,000 seen much growth. The rent -1.0% level in Marunouchi is nearly twice as expensive as the 0 -1.5% average for the five central five

wards (+0.7%).

Ginza

5CBDs

Meguro-ku

Nakano-ku

Ueno Taitō

Ebisu Hiroo Ebisu

Setagaya-ku

Suginami-ku

Nishishinjuku

Ōmori Kamata Ōmori

Gotanda Ōsaki

Īdabashi Kudan Īdabashi

ShibauraKaigan

YotsuyaIchigaya

Roppongi

Akasaka Aoyama Akasaka

Kōjimachi Bancho Kōjimachi

Yoyogi

Uchikanda kajichō Uchikanda

Kinshichō Kameido Kinshichō

ShibuyaDōgenzaka

ShinjukuKabukichō

Waseda Waseda

Sugamo Ōtsuka erea Ōtsuka

Toyocho, Kiba, Toyosu Kiba, Toyocho,

ShinbashiToranomon

TakadanobabaŌkubo

MarunouchiŌtemachi

Sakuragaoka Nanpeidai Sakuragaoka

Yushima Hongō Kōrakuen Hongō Yushima

Ikebukuro Nishiikebukuro Ikebukuro

Sotokanda iwamotomachi Sotokanda

HamamatsuchōTakanawa

Tsukiji ShintomiKayabachō

Kyōbashi Yaesu NihonbashiYaesu Kyōbashi

Hatsudai Honchō Sasadzuka Honchō Hatsudai

Higashinihonbashi Shinkawa Higashinihonbashi

NihonbashihonchōNihonbashi

Kitashinagawa Higashishinagawa Kitashinagawa Higashiikebukuro Minamiikebukuro Higashiikebukuro

Source: Colliers International, Japan Real Estate Institute, Mikishoj

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Except in Shinagawa, where buildings average 18.5 years old, buildings in (Chuo-ku, Chiyoda-ku and Minato-ku), and of 22% in Marunouchi (Fig. 9). Tokyo’s five central wards tend to be older than in other global cities We Unsurprisingly, pricing implications will likely be different across various estimate the average age of office buildings in Tokyo to be 26.1 years based submarkets. Limited office withdrawal in Shibuya is likely to add more on the latest available disclosure from the Tokyo Metropolitan Government. pricing power for landlords to this popular district where most IT ventures The median age of demolished buildings in the 23 wards is about 43 years tend to congregate. Conversely, the greater supply ahead in Marunouchi for the year ended. Assuming that the buildings built before the 1970s will may proportionally reduce the pricing power where most financial service need to be redeveloped, this will withdraw new supply equivalent to 4.5% of tenants tend to congregate. existing stock in Shibuya, of about 12% in the three most central wards

Fig. 9: Selected Area : Proportion of GFA by vintage (%) Fig. 10:Tokyo 23 wards: All Grade Office GFA by vintage (,000m2)

~1969 ~1979 ~1989 ~1999 ~2004 ~2009 2009~ - 1959 - 1969 - 1979 - 1989 - 1994 - 1999 - 2004 - 2009 - 2015

20,000 Shibuya 18,000

16,000

14,000 Shinjuku 12,000

10,000

Central 3 Wards 8,000

6,000

4,000 Marunouchi ＊ 2,000

- 0% 20% 40% 60% 80% 100% - 1959 - 1969 - 1979 - 1989 - 1994 - 1999 - 2004 - 2009 - 2015

Source: Colliers International, the annual land survey - Metropolitan Government of Tokyo Source: Colliers International, the annual land survey - Metropolitan Government of Tokyo

10 COLLIERS RADAR OFFICE | TOKYO | 9 OCTOBER 2018

Rental growth expected to peak but with a time lag Fig. 11: Price Index of real estate leasing and corporate services (1985 for landlords’ sentiment to the actual market – 2017, 2010=100）

performance o/w Real Estate Leasing , Japan, All types We expect ongoing rent growth to peak at around 4.5% YOY within the next Corporate Service Price Index several quarters before tapering down to a more sustainable CAGR of 0.8%. 145 We also expect lower-grade buildings to maintain faster price increases, 135 averaging 5.2% YoY as they have several more quarters to go before 125 We suspect some reaching the ceiling of JPY30,000 per tsubo (USD80.3 per sq metre). 115 However, the price response remains weak especially on higher grades. For traditional 105 landlords remain the next twelve months, we expect the CBD prime rent index to stay flattish Most real estate business owners maintain a bearish sentiment compared to 95 unwilling to revisit actual performance. Market fatigue still seems to be prevalent many years 85 their outdated after the ending of the “bubble economy” in the early 1990s. The Bank of 75 market views, Japan’s latest real estate demand diffusion index, a diffusion index to

keeping their same measure the assessment of future business, continues to remain near static

Jan-85 Jan-90 Jan-95 Jan-00 Jan-05 Jan-10 Jan-15

Sep-86 Sep-91 Sep-96 Sep-01 Sep-06 Sep-11 Sep-16

May-93 May-98 May-03 May-08 May-13 May-18 low-price strategy at around +20. May-88 with limited Source: Colliers International Japan Research, Monthly Corporate Price Survey - Bank of Japan, Oxford Economics Indeed, long-term office rent increases are likely to remain subdued service offerings. compared to the overall price index (Fig. 9). Our base case assumes a modest rent increase averaging 0.8% with inflation averaging 1.1% over the Fig. 12: Price index of real estate leasing and office leasing in Tokyo next five years. and Osaka (1985 – 2017, 2010=100) We advise landlords to revisit their pricing strategy early to maintain an attractive tenant mix with more comprehensive service offerings ahead of o/w Real Estate Leasing, Japan, Office Leasing their peers. Over the past thirty years, the rent level - excluding ancillary o/w Tokyo Office Leasing o/w Osaka Office Leasing fees charged for building maintenance - has demonstrated a near-perfect 145 correlation to a few headline corporate inflationary indicators. We also note 135 steady price increases in warehousing (+ 6.5%) against a more cyclical price response in regional cities with higher financial leverage such as Osaka 125 (-5.4%). 115 96.9 105 95 85

75

Jan-85 Jan-90 Jan-95 Jan-00 Jan-05 Jan-10 Jan-15

Sep-86 Sep-91 Sep-96 Sep-01 Sep-06 Sep-11 Sep-16

May-88 May-93 May-98 May-03 May-08 May-13 May-18

Source: Colliers International Japan Research, Monthly Corporate Price Survey - Bank of Japan, Oxford Economics

11 COLLIERS RADAR OFFICE | TOKYO | 9 OCTOBER 2018

Historically, pricing power for real Fig. 13: Corporate service price components (2010=100, as of July 2018) estate services overall remains weak despite improving economic fundamentals, with no price Corporate service price index · Technical services 116.8 increase recorded for all real estate related services, and aggregate Rent Index- Parking Lot 106.7 negative growth of 2.6% for Tokyo’s average office rent since 2010 (Fig. 13). This is disappointing Rent Index- Warehouse 106.5 given that the overall corporate service price index during the same Corporate service price index · Total average 104.9 period has risen 4.9%, indicating most tenants are willing to pay Corporate service price index · - Finance & Insurance 104.7 more for all other services along with better corporate earning fundamentals. Rent Index- Other area · Office leasing 104.3 The only major service category with a larger price decline than real Corporate service price index – Professional Services 101.4 estate services is internet-related services, which simply reflects less Rent Index - Nagoya area · office leasing 100.5 capital deployment required through revolutionary technology Rent index - Retail 100.3 advancements.

Rent Index – All real estate leasing 100.1

Rent Index- Hotel 98.6

Rent Index - Tokyo area · office lease 97.4

Rent Index - Osaka area · office lease 94.6

Corporate Services Price Index- Internet related 91.1

0 20 40 60 80 100 120 140

Source: Colliers International Japan Research, Monthly Corporate Price Survey - Bank of Japan Note: The latest data as of July 2018, 2010 price level is indexed to 100 12 COLLIERS RADAR OFFICE | TOKYO | 9 OCTOBER 2018

Most tenants appear to give Fig. 14: Vintage building rent per tsubo per month (JPY in thousands) in Tokyo priority to popular locations over the age of buildings potentially due 60 to higher switching costs for future office relocation within Tokyo’s central five wards. For our analytical purposes, we classify buildings built more than forty years ago as “vintage buildings” as 50 we found little empirical evidence elsewhere to suggest age has diminished the earning power of a Vintage Building given building (Fig. 11). 40 Tokyo’s office buildings with good accessibility and professional management can command a high quality premium even though they were built more than twenty 30 years ago.

20 Monthly Rent Per Tsubo ( JPY in thousands ) ) thousandsinJPY ( Per Tsubo Rent Monthly

10

0 0 10 20 30 40 50 60 Years

Source: Colliers International Japan Research, TO-REIT Note:: sample is limited to the office buildings held by all listed REITs 13 COLLIERS RADAR OFFICE | TOKYO | 9 OCTOBER 2018

Tight availability in the Central Tokyo office Fig. 15: Average vacancy rate of Grade A office in Central Tokyo market should encourage landlords to test stronger 10.0% pricing power 9.0% Lack of overbuilding in the past fifteen years has eliminated excess supply to 8.0% cyclical lows as demand has continued to outstrip net supply (Fig. 15). 7.0% We expect the overall vacancy level will remain low or below about 3% at 6.0% least until the end of 2019. Limited vacancy should encourage more 5.0% landlords to demonstrate their better pricing power as vacant spaces are 4.0% being filled more quickly compared to the previous market cycle. 3.0% According to Xymax Real Estate Institute, the latest vacancy turnover rate, a 2.0% rate to measure the pace of take-up in available office lease space to let 1.0% across all grades, has risen to 42.8% from the cyclical average of 30.0%. 0.0%

Limited vacancy also means less adjustment to net effective rents, which

Aug-02 Aug-03 Aug-04 Aug-05 Aug-06 Aug-07 Aug-08 Aug-09 Aug-10 Aug-11 Aug-12 Aug-13 Aug-14 Aug-15 Aug-16 Aug-17 tend to exhibit a more procyclical nature than gross rents. The level of Aug-01 overall rent concession appears stable with the average free rent granted to Source: Colliers International Japan Research, Mikishoji new lease contracts remaining unchanged at around three months over the past four quarters. We plan to continue carefully monitoring the level of the various concessions granted to new tenants given that in recent years more Fig. 16: Comparing Average vacancy rate of Grade A office than half of new lease contracts have contained a free rent provision. 16.0% 14.0% 12.0% 10.0% 8.0% 6.0% 4.0% 2.0%

0.0%

Seoul

Tokyo

Beijing

Sydney

Shanghai

Singapore

Shenzhen Hong Kong Hong

Source: Colliers International Japan Research, Mikishoji, Data as of 2Q18

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Fig. 17: Capital value index by Grade (2013 – 2018, 2013=1.0) Capital Markets Implications

Grade A Buildings Grade B Buildings Grade C Buildings The overall market conditions are generally priced to low risk taking with the latest average 1.60 gross yield across all office building classes 1.50 edging down to 5.7%. Our base case assumes average gross investment yields of about 5.9% 1.40 with the capital value increase averaging 2% at least over the next two years. Investment 1.30 Looking at historical trends, lower grade sentiment is 1.20 buildings have demonstrated more volatile yet turning cautiously stronger performance since 2013 (Fig. 17). High- optimistic due to 1.10 grade buildings also continue to attract more recovery in capital conservative investors, with the unit price for values and the 1.00 Grade A buildings reverting to JPY2.7 million near-zero interest 0.90 (USD 23,900) per sq metre after hitting a cyclical rate policy. ’13Q4 ’14Q2 ’14Q4 ’15Q2 ’15Q4 ’16Q2 ’16Q4 ’17Q2 ’17Q4 ’18Q2 low of JPY1.2 million (USD 11,210) per sq metre around Q3 2011. We see relative strength in future income growth Fig. 18: Income, capital and total returns in Tokyo Office central three wards (2007 – 2018) given past price recovery has been modest. Unfortunately, good income growth will likely face higher hurdles from higher purchase prices Income Return Capital Return Total Return in higher grades. We expect that ongoing cap 20% rate compression – with cap rates likely to dip 15% below 3% for leading business districts such as 10% Marunouchi - will prompt more investors to look 5% for lower-priced assets in other districts at least over the next several quarters. 0% -5% -10% -15%

-20%

244906 244907 244907 244910 244910 244910 245001 245001 245001 245004 245004 245005 245008 245008 245008 245011 245011 245011 245102 245102 245102 245105 245106 245106 245109 245109 245109 245112 245112 245112 245203 245203 245204 245207

Source: Colliers International Japan Research, ARES, TO-REIT, J-REI

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Fig. 19: Measuring capital value against total leasable area – Central five wards (in JPY) Historically, large building transactions, defined as total leasable area of 30,000 sq metres or greater, have tended to see some overpriced 180,000 deals. As market competition for larger buildings has become intense, more sellers have been standing on the sidelines. 160,000 y = 1.6005x + 670.95 This has offset positive sentiment from R² = 0.7252 increasing market participation of non-domestic For long-term investors and larger net investment inflows from 140,000 investors, we J-REIT investors. recommend owning middle- sized buildings 120,000 within the central three wards as we expect their stable 100,000 NOI growth to remain intact – even in older million) (JPY Value 80,000 buildings – during our forecast Capital horizon. 60,000

40,000

20,000

0 0 20,000 40,000 60,000 80,000 100,000 120,000 Total Leasable Area (m2)

Source: Colliers International Japan Research, TO-REIT, J-REIT

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Fig. 20: Measuring capital value against monthly rent – Central five wards Generally speaking, in our view, changes in institutional property values are driven by changes in the outer-year forecast in earning 18.0 fundamentals. With these regards, since y = 0.3406x - 2.3357 2013, there have been few surprises to our R² = 0.6995 baseline forecast other than greater-than- 16.0 expected demolition downsizing the net new supply, a positive to real estate investors. Rental income growth since the start of 14.0 Abenomics in 2013 remains solid, with the NOI yields averaging around 5.1% per annum. The majority of buildings with a net leasable area of 3,000 tsubo (9,920 sq metre) or greater, 12.0 generate monthly rental income per tsubo of around JPY20,000-28,000 (USD53.5-75.0) per sq metre. 10.0

8.0

(Capital Value per Tsubo, JPY Millio) JPY Millio) per Value (Capital Tsubo, 6.0

4.0

2.0

- - 10.0 20.0 30.0 40.0 50.0 60.0 (Monthly Rental Income per Tsubo)

Source: Colliers International Japan Research, TO-REIT, J-REI

17 COLLIERS RADAR OFFICE | TOKYO | 9 OCTOBER 2018

Cap rates applied to transactions have stayed in a range of about 3.5% to Rising trade tension and geopolitical risk are likely to keep Japanese interest 4.0% over the past year and are tracking slightly lower than historical means rates very low due to the yen’s status as a safe-haven currency. With the (Fig. 16 & 17). However, it is evident that the majority of investors remain consensus estimate calling for only a 25 basis point increase through 2020,, very cautious in engaging in expensive deals so as not to repeat the same our base case assumes the nominal ten-year interest rate will only increase mistakes as in past market failures. to 1.0% to 1.3% over the next five years with core inflation approaching 1% by end-2021. Investment sentiment is also turning cautiously optimistic with low real interest rates. Central bankers remain hawkish in Japan, providing ample ground to maintain a near-zero interest rate policy for at least several more years.

Fig. 21: Capital value and capitalisation rate in 2018 Fig. 22: Capital value and capitalisation rate (2002 – 2018)

600 600

500 500

400 400

300 300 ( m2) (

200 200

Capital Net / Area Leasable Capital Value Capital Value / Net Leasable Area ( ( m2) Net / Area Leasable Capital Value 100 100

0 0 0.0 5.0 10.0 15.0 20.0 0.0 5.0 10.0 15.0 20.0 Capitalization % Capitalisation rate (%)

Source: Colliers international Japan Research, TO-REIT, J-REIT Source: Colliers international Japan Research, TO-REIT, J-REIT

18 COLLIERS RADAR OFFICE | TOKYO | 9 OCTOBER 2018

According to the latest data from Real Capital Fig. 23: Quarterly Transaction Volume – Tokyo C5W Office Markets Analytics, total transactions of completed properties worth over USD10 million declined 23% in Japan as a whole over H1 2018, to Rolling 12-mo. Total Quarterly Vol USD14.8 billion. Tokyo, however, saw a 9% 2,500 increase to USD8.5 billion. About 25% of capital is attributed to offshore investors, which we 2,000 expect to hit a cyclical high of around 32% over the next several quarters. 1,500

1,000 (JPY Billion) Billion) (JPY

500

0 Q1 '14 Q1 '15 Q1 '16 Q1 '17 Q1 '18

Fig. 24: Changes in Quarterly Transaction Volume – Tokyo C5W Office Markets

Sales Change 200%

150%

100%

50%

0%

-50%

-100% Q1 '14 Q1 '15 Q1 '16 Q1 '17 Q1 '18

Source: Colliers international Japan Research, RCA 19 COLLIERS RADAR OFFICE | TOKYO | 9 OCTOBER 2018

With stable NOI growth and predictable low real interest rates, the focus high risk premium to solid earning fundamentals with the latest risk then turns to the growing risk premium relative to other markets. In our premium tracking around 450 bps (as indicated by the risk premium for view, the current risk premium offers an attractive value relative to Japan property market illustrated on Fig. 18). This compares to the average investments in other asset classes of similar credit quality. High-grade real RMBS/CDS¹ spread around 30/45 bps and the same-issuer’s equity risk estate investment has become a popular destination to replace massive premium averaging 420 bps according to the latest NYU Stern Business bond investment with better market liquidity and depth and a longer track School survey. records of stable cash flows. Tokyo office building markets offer an unusually ¹ Residential Mortgage-Backed Securities / Credit Default Swaps

Fig. 25: Yield spreads over risk-free rates of office market in different countries (bps) Fig. 26: Historical Yield Spreads for Office Markets (bps)

Tokyo 5CBDs HK Major U.S. Metro Germany 600

Japan 500

United Kingdom

400 France

Canada 300

Spain 200

United States 100 Australia

- South Korea

Hong Kong (100)

3Q08 1Q09 3Q09 1Q10 3Q10 1Q11 3Q11 1Q12 3Q12 1Q13 3Q13 1Q14 3Q14 1Q15 3Q15 1Q16 3Q16 1Q17 3Q17 1Q18 3Q18 0 200 400 600 800 1Q08

Source: Real Capital Analytics, Colliers International Japan Research Source: Colliers International Japan Research, Real Capital Analytics 20 COLLIERS RADAR OFFICE | TOKYO | 9 OCTOBER 2018

APPENDIX (1) NEW SUPPLY COMMITMENT 2018

Floor Size Total Rentable Pre-Commitment # Project Name Completion KeyTenants Sqm Tsubo Sqm Tsubo Tsubo % of Total 1 Sumitomo Fudosan Onarimon Tower 2018.4 1,025 310 18,175 5,498 5,498 100% Mitsui Sumitomo Trust AM, Fuji Kagaku 2 Taiyo Seimei Nihonbashi Building 2018.1 1,217 368 22,056 6,672 5,900 88% Japan Securities Dealers Association 3 Tokyo Midtown Hibiya 2018.3 3,207 970 86,248 26,090 20,000 77% E&Y, Asahi Kasei. GruNavi, LIXIL 4 G-Base Tamachi 2018.1 747 226 11,967 3,620 3,620 100% Mitsubishi Auto Lease 5 Nissay Crea Tower 2018.8 2,612 790 50,000 15,125 15,125 100% Shiseido, NRI, Shinoken, Asahi Hoso 6 Sumitomo Fudosan Osaki Garden 2018.1 5,445 1647 120,473 36,443 36,000 99% Sega Sammy, JR East 7 Tamachi Station Tower S 2018.5 2,975 900 77,355 23,400 23,400 100% Mitsubishi Motors, Familymart 8 (B-1 area) 2018.8 2,116 640 46,122 13,952 13,952 100% Google 9 Otemachi Place West Tower 2018.7 3,306 1,000 99,174 30,000 30,000 100% Japan Post, NTT group 10 Otemachi Place East Tower 2018.7 2,975 900 79,339 24,000 24,000 100% Sumitomo Corp, Azusa Audit 11 New JP Building 2018.6 1,488 450 8,595 2,600 2,300 88% 12 Marunouchi Nijybashi Building 2018.10 2,793 845 67,071 20,289 20,000 99% MHI, Delloite, Estee Lauder 13 Akihabara I-Mark Bldg 2018.3 992 300 11,339 3,430 3,430 100% Mitsubishi Materials 14 Shin Tora-Dori CORE 2018.9 860 260 9,388 2,840 2,840 100% Creeek and River 15 Nihonbashi Takashimaya Mitsui Building 2018.6 2,479 750 86,777 26,250 25,000 95% TDK, SMBC Nikko TTotal:otal: 2240,20940,209 2231,06531,065 996.19%6.19% Source: Colliers International Japan Research, Nikkei

21 COLLIERS RADAR OFFICE | TOKYO | 9 OCTOBER 2018

APPENDIX (2) NEW SUPPLY COMMITMENT 2019

Floor Size Total Rentable Pre-Commitment # Project Name Completion KeyTenants Sqm Tsubo Sqm Tsubo Tsubo % of Total 1 Sumitomo Fudosan Akihabara Ekimae Project 2019.5 1,091 330 16,860 5,100 0 0% 2 Shinagawa Heart 2019.2 1,114 337 13,369 4,044 3,000 74% 3 Sumitomo Nishi Shinjuku 6-chome Plan 2019.3 1,322 400 30,545 9,240 0 0% 4 Seibu HQ Ikebukuro Building 2019.3 2,116 640 31,736 9,600 2,560 27% Seibu Group 4 floors 5 Dogenzaka 1-chome Redevelopment (Tokyu Plaza) 2019.1 2,109 638 18,995 5,746 5,746 100% GMO 6 Nihonbashi Muromachi 3-chome Bekkan Redevelopment 2019 4,298 1,300 90,926 27,505 15,000 55% Boston Consulting, Mitsui Fudosan 7 Hotel Okura Office Project 2019.6 2,274 688 40,856 12,359 6,000 49% IWG (No 18) 8 Shibuya Scramble Square 2019.8 2,836 858 73,015 22,087 22,087 100% Mixi, WeWork 9 Shinjuku Minamiguchi Project 2019.8 1,861 563 24,179 7,314 6,200 85% Relia, JA, Aiming, WeWork 10 Sumitomo Fudosan Shibuya Tower 2019.6 1,488 450 19,339 5,850 5,850 100% Cyber Agent 11 Toranomon Hills Business Tower 2019.12 2,975 900 92,562 28,000 25,000 89% Facebook, Hitachi Hitech, Shinittetsu Solutions 12 Udagawacho 15 Redevelopment (Parco) 2019.9 1,633 494 11,451 3,464 3,464 100% Digital Garage 13 Sumitomo Fudosan Akihabara Manseibashi Project 2019.8 793 240 16,876 5,105 0 0% 14 Nittetsu Nihonbashi Building Project 2019.3 1,021 309 12,893 3,900 0 0% 15 Shinbashi 1-chome Plan 2019.6 1,091 330 14,182 4,290 0 0% 16 Museum Tower Kyobashi (Nagasaka Sangyo) 2019.7 1,322 400 15,048 4,552 2,000 44% 17 Shibuya Nanpeidai Project (tentative) 2019.3 1,749 529 27,779 8,403 8,000 95% Tokyu RE, Voyage 5550,60850,608 1166,55966,559 1104,90704,907 662.98%2.98% Source: Colliers International Japan Research, Nikkei Note : Above data is as of June 2018

22 Primary Authors: For further information, please contact:

Mari Kumagai Katsuji Tokita Senior Director | Research| Japan Managing Director | Japan +(81) 3 4572 1009 +(81) 3 4572.8607 [email protected] [email protected]

Contributors: Hideki Ota Executive Director | Capital Markets & Investor Services | Japan Stephanie Sun +(81) 3 4572.1005 Director | Research| Asia [email protected] +(65) 6531 8635 [email protected] Hazumu Iwase Executive Director | Office Services | Japan Andrew Haskins +(81) 3 4572.8603 Executive Director | Research | Asia [email protected] +(852) 2822 0511 [email protected] Masahiro Fuse Executive Director | Valuation & Advisory | Japan +(81) 3 4572.8612 [email protected]

Alistair Walker Senior Director | Occupier Services | Japan +(81) 3 4572.8617 [email protected]

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