Deutsche Bank Group Markets Research Industry Date Real estate sector 4 August 2015 Japan Real Estate Yoji Otani, CMA Akiko Komine, CMA Research Analyst Research Analyst (+81) 3 5156-6756 (+81) 3 5156-6765 [email protected] [email protected] F.I.T.T. for investors Last dance Bubbles always come in different forms With the big cliff of April 2017 in sight, enjoy the last party like a driver careening to the cliff's brink. Japan is now painted in a completely optimistic light, with the pessimism which permeated Japan after the Great East Japan Earthquake in 2011 forgotten and expectations for the 2020 Tokyo Olympics riding high. The bank lending balance to the real estate sector is at a record high, and we expect bubble-like conditions in the real estate market to heighten due to increased investment in real estate to save on inheritance taxes. History repeats itself, but always in a slightly different form. We have no choice but to dance while the dance music continues to play. ________________________________________________________________________________________________________________ Deutsche Securities Inc. Deutsche Bank does and seeks to do business with companies covered in its research reports. Thus, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MCI (P) 124/04/2015. Deutsche Bank Group Markets Research Japan Industry Date 4 August 2015 Real Estate Real estate sector FITT Research Yoji Otani, CMA Akiko Komine, CMA Research Analyst Research Analyst Last dance (+81) 3 5156-6756 (+81) 3 5156-6765 [email protected] [email protected] Bubbles always come in different forms Top picks With the big cliff of April 2017 in sight, enjoy the last party like a driver Mitsui Fudosan (8801.T),¥3,464 Buy careening to the cliff's brink. Japan is now painted in a completely optimistic Sumitomo R&D (8830.T),¥4,300 Buy light, with the pessimism which permeated Japan after the Great East Japan Source: Deutsche Securities Inc. Earthquake in 2011 forgotten and expectations for the 2020 Tokyo Olympics riding high. The bank lending balance to the real estate sector is at a record high, and we expect bubble-like conditions in the real estate market to heighten due to increased investment in real estate to save on inheritance taxes. History repeats itself, but always in a slightly different form. We have no choice but to dance while the dance music continues to play. Japan heading towards its fourth bubble Japan has seen three bubble-like rises in real estate prices; in the early 1970s, the late 1980s, and the mid 2000s. We are now jumping into a fourth bubble. The three preconditions needed for a real estate bubble are: 1) a plausible scenario that supports the bubble, 2) more aggressive bank lending to the real estate sector, and 3) tax reforms that boost real estate prices. We believe that current conditions neatly meet these requirements: 1) a plausible scenario – although we see no reason to believe that everything will be fine until the Tokyo Olympics, it sounds plausible on the surface; 2) record-high bank lending to the real estate sector; and 3) widespread real estate investment to save on inheritance taxes which were raised. We currently have no choice but to continue dancing The Japan Revitalization Strategy, announced as the government's new growth strategy, includes many policies which push Abenomics' bedrock philosophy of survival of the fittest, and thus Japan's globalization seems right around the corner. As a result the middle class will likely be greatly segmented, with the gap between the rich and poor widening. An increase in high-net- worth individuals will boost savings, which will keep interest rates declining. This will likely push up real estate prices as many investors seek higher yields. Moreover, Japan's promotion of English language education is also likely to increase Japanese real estate investment by overseas high-net-worth individuals. It is uncertain whether these strategies will prove successful. However, the party music is currently high and loud in Japan and we can only continue to dance – even though we know it would be the last dance. Mitsui Fudosan and Sumitomo R&D are our top picks Physical property investors’ expected cap rates have declined to the same or lower levels as those of the mini-bubble around 2007. In such an environment, it is easy for physical property investors to generate abundant capital gain. However, we believe that real estate majors’ share prices have not currently factored this in. Mitsui Fudosan and Sumitomo R&D, which have pipelines bursting with development projects, seem markedly undervalued. We determine our target prices for the real estate sector by using a residual income model. We also take NAV into account. Downside risks to the real estate sector include: 1) higher risk premiums due to lower bank lending to the real estate sector, 2) tax hikes (e.g. consumption tax and income tax) and lower government spending due to a rush toward fiscal restructuring, and 3) tax revisions or regulations that inhibit real estate liquidity. Upside risks include: 1) sharp increases in private sector wages and 2) clarification that fiscal stimulatory measures such as lowering income tax will be taken. ________________________________________________________________________________________________________________ Deutsche Securities Inc. Deutsche Bank does and seeks to do business with companies covered in its research reports. Thus, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MCI (P) 124/04/2015. 4 August 2015 Real Estate Real estate sector Table Of Contents Overview ........................................................................... 5 History repeats itself but in different forms ........................................................ 5 2% inflation target brings a fourth bubble .......................................................... 5 Spurring Japan's globalization ............................................................................ 6 No choice but to continue dancing, even knowing it would be the last dance .. 7 History of real estate bubbles............................................. 9 Three periods of asset inflation........................................................................... 9 Mini-bubble in 2003-2007................................................................................. 10 Lessons from the past on how to bring about real estate market recovery after collapse ......................................... 13 Implementation of an emergency economic package ...................................... 13 Shizuka Kamei’s (then-financial services minister) keen eye ............................ 14 Establishment of the Real Estate Market Stability Fund ................................... 15 Developments since the end of the ‘mini-bubble’ ............................................ 15 BoJ started buying J-REITs in October 2010 .................................................... 16 Full recovery of real estate market brought on by policies following the 2011 earthquake ........................................................................................................ 17 Driving forces behind the real estate bubble .................... 19 The second ingredient after a plausible scenario .............................................. 19 Real estate loan balance doubled in the late 1980s .......................................... 19 Why the mini-bubble burst ............................................................................... 21 Recovery following the burst of the mini-bubble .............................................. 22 Loan balance to the real estate sector hits a record high ................................. 23 Higher tax drives bubble .................................................. 25 Real estate investments to reduce inheritance taxes ........................................ 25 High-net-worth individuals drive the real estate market ................................... 26 Globalization and changes it brings to the real estate market ............................................................................. 27 Revised Worker Dispatch Law to be enacted ................................................... 27 Japan Revitalization Strategy includes policies to enhance ROE ...................... 28 Developments favoring large companies gathering pace ................................. 28 Further strengthening of Corporate Governance Code ..................................... 29 Japan globalization close at hand ..................................................................... 30 Reform is progressing steadily ......................................................................... 32 Prime Minister Abe’s 11 policies to bore through Japan’s ‘regulatory bedrock’ ......................................................................................................................... 32 Global standards eliminating excessive profits ................................................. 34 Sony Real Estate looses an arrow at the industry ............................................