Earnings Call: Q4 2024

May 16, 2024

Summary

March 2024 DPU was JPY 12,216 as occupancy and rent trends improved. Asset sales support distributions, while rising rates, construction costs and office supply remain key risks.

Hello everyone. Welcome, and thank you for tuning in to our performance review for the period ended March 2024. I am Shojiro Kojima. I am President and CEO of Japan Real Estate Asset Management. Let's get started. Please take a look at page three. I will begin by talking about the summary of the past period's results and our management strategies. The office market in Japan continues to recover moderately in the face of the large supply of office space in 2023, and people naturally pay more attention to what we are doing to boost rent revenues of our portfolio. That's why I'd like to begin by talking about our internal growth strategy. Please take a look at the upper left corner of the slide for the performance highlights of internal growth. The occupancy rate at the end of March 2024 was 96.6%, up 1.6 percentage points from the 95.5% six months earlier. The monthly rent at tenant turnover rose JPY 12 million, while the monthly rent at rent revisions fell JPY 1 million. I will give you more details on these figures later, but let me just say that both numbers are improving. Next to the right, I want to touch upon our market observations and management strategies. As I said earlier, the rental market continues to recover at a moderate pace. However, it becomes clearer that expenses are rising due to inflation. Based on the market observations, our management strategy, first and foremost, is to further boost rent revenues. Second of all, we will manage our costs better, particularly construction cost, which is more controllable than other cost items. We will optimize the spend and the timing. At the same time, we will invest more in renovations to prop up the value and the long-term competitiveness of our properties. Let's move on to discuss external growth. We acquired 3rd MINAMI AOYAMA in the last period. It was a new acquisition. We also acquired a more ownership share of Toyosu Foresia and the Seavans S Building. With respect to disposition of properties, the third and final tranche of the disposition of Harumi Front was completed in the last period. For your reference, I'd like to note that we signed an agreement back on March 7 for the disposition of JRE Dojima Tower over the next 12 months. The first tranche of the disposition was completed on April 1. We made these deals so that we own excellent properties in prime locations in Tokyo, which will remain highly competitive for long term, and at the same time, get rid of the properties that have profitability concerns, and thereby we believe we have raised the stability and growth prospect of our portfolio. I will share with you more details about those properties later. If you look at the bottom right of the slide, here are our market observations and management strategies with regards to external growth. The real estate market in Japan remains bullish with no significant changes in the past six months. But that doesn't mean that there is no possibility of a correction in the near future. As I noted in the last performance review, we continue to have the impression that the pace of foreign inflows is slowing down. The prospect of rising interest rates is increasing as Bank of Japan scrapped its negative interest rate policy. The price correction seen in foreign office markets such as in the U.S. may put a damper on the market here in Japan. These are the reasons why we need to monitor the real estate market even more closely going forward. These market observations inform our management strategies to basically pursue continuous improvement of our portfolio through acquisition and disposition of properties. We continue to invest in carefully selected properties, mainly coming through pipeline support from the sponsor, while at the same time utilizing other channels to acquire high-yield properties in regional cities. When it comes to disposition, we have already started thinking about the next move after the disposition of JRE Dojima Tower. In fact, we are now prioritizing the candidate properties for disposition for profitability, management risks, price, and the amount of unrealized gain. We are doing all this to continuously improve our portfolio and share the capital gains with our unitholders while the market remains bullish. Also, in order to achieve more external growth and dividend growth, we want to explore the opportunities to raise capital through public offerings, although that depends on the appetite of investors in the market. Please take a look at page 4. These are the main factors that either push up or pull down DPU or dividend per unit. There are four bar graphs. The first two bars on the left show the DPU figures for the period ended September 2023 and the period ended March 2024. The DPU for March 2024 was JPY 12,216. The two light-colored bars on the right represent our guidance, the DPU for the period ending September 2024 and the period ending March 2025. For each graph, the green area at the lower half represents EPU, that is, earnings from the property business, which constitute one source of dividend. The dark blue area above represents capital gains, which constitutes another source of dividend. Those of the two bars on the left are the gains on the disposition of Harumi Front, and those on the right represent the gains on the disposition of Dojima Tower. There are several short bars in between the four bars, and I want you to look at the leftmost bar for rent and service charges from left to right. This may be big or small, but they are all green, meaning growth. These are indicating that rent revenues continue to rise, mainly due to rising occupancy. Next, please look at the bar labeled Property Related Expenses, two bars to the right. First, regarding repair expenses, in the last period, we spent a certain amount of repair expenses as a way to offset the gain from the third tranche of the disposition of Harumi Front. For the next two periods, because we know that we will post a gain from the sale of Dojima Tower, we plan to bring forward and execute some of the scheduled construction work. Regarding utilities expenses, fuel costs have remained stable since the second half of last year. However, the increase in renewable energy surcharges and the termination of the temporary mitigation measures after this spring have been factored into our cost projections. Additionally, interest payments are on the rise, reflecting increased interest rates. As you can see, while some of these expenses are due to our strategic decisions, overall costs are trending upwards. On the other hand, rent and service charges are increasing at a higher rate. Therefore, excluding the impact of increased repair expenses, I believe it is fair to say that the overall trend for EPU is generally positive. Next, please look at page 5. I will explain our approach to dividends from the September 2025 period onward. As mentioned on the previous page, the dividend per unit, DPU, is composed of EPU, shown in green, and the distribution from capital gains, shown in the dark blue. Currently, the dark blue portion accounts for about 20% of the total DPU. What we want to convey on this page is that looking forward, we aim to maintain the DPU as stable as possible while gradually increasing the proportion of EPU within it. Specifically, as mentioned on the right side, to achieve stable dividends, our policy for the time being is to utilize capital gains from asset replacements and internal reserves. To improve EPU, the first priority is to increase rent revenues. As I explained earlier, while aiming to maintain a high occupancy rate, we will also strive to maximize the top line by aggressively negotiating for a higher rent for certain properties. From the perspective of enhancing long-term competitiveness, it is necessary to undertake strategic additional investments, such as renovating common areas. At the same time, cost control is also a crucial aspect, so we will manage operations while balancing these factors. Next, regarding internal growth, I will focus on the key points. Please refer to page 7. Look at the trends in portfolio occupancy rate on the upper left. As mentioned at the beginning, the occupancy rate at the end of the last period rose 1.6 percentage points from the previous period, reaching 96.6%. This increase was largely due to the sale of Harumi Front, where a single-tenant lease had ended, but it was also attributed to the leasing of existing properties progressing more smoothly than expected. Looking ahead to the next few periods, while we anticipate a certain amount of leasing activity, including in regional areas, we also expect some notable cancellations at a few properties. Therefore, we forecast the occupancy rate at the end of the current period to be 96.5%, down a fraction from the end of the last period. Now, I want to explain one point about the tenant turnover rate graph in the upper-right corner. On the right side of the graph, the three lines have diverged, which is due to the tenant departure at Harumi Front. The light green line, representing Tokyo's 23 wards, has been trending upwards since October 2022, but without the vacancy at Harumi Front, it would have followed a downward trajectory similar to the gray line representing other cities. Since this somewhat stands out, I wanted to provide a supplementary explanation here. Next, please look at page 8, which shows the trends in rent revisions. Take a look at the graph on the top left. Rent revisions also show an improving trend. In the previous period, the net monthly rent change, accounting for both increases and decreases, was minus JPY 9 million. In other words, rent decreases significantly had outpaced rent increases. However, in the last period, this gap narrowed to minus JPY 1 million. As for the current situation, although it is just for one month since April, rent increases are surpassing rent decreases, so we believe that rent revisions are continuing to improve. Next, please look at page 11. The graph on the left shows the changes in market rents for each building within our portfolio. We commissioned CBRE to assess the market rent levels for each building every six months, and this graph shows the chronological trend. The far right bar in the graph represents the March 2024 period, indicating further increases in rent levels since the previous assessment. When it comes to the rent gap on the right side, the rent gap is the difference between the actual contract rent and the market rent. The rent gap for the last period is +1.4%. Although market rent is still below actual contract rents, the gap has been narrowing for two consecutive periods. All things considered, we can say that the rent levels in JRE's portfolio hit bottom a year ago and have been trending upward, particularly for central urban properties. Next, please look at page 12. Here, I would like to explain our approach to repair and maintenance work. Reflecting on the past few years, since the onset of the COVID-19 pandemic in 2020, difficulties in procuring construction materials have disrupted our repair schedules. Additionally, construction costs have risen, leading to an increasing trend in our current repair expenses. On the other hand, there is a growing emphasis on the selection of office buildings based on their quality. So it is becoming increasingly important to actively engage in value-enhancing projects and energy-saving renovations to improve competitiveness. To address these challenges, we have strengthened our internal engineering team over the past year. This team is central to our efforts to optimize our construction plans and to pursue proactive renovation investments. Specifically, we are meticulously managing costs by closely examining the details of individual projects and timing the peak of repair expenses to align with periods when capital gains are expected. This helps to smooth out our financial performance as much as possible. If you look at the graph at the bottom, you will see that the three bars on the right, representing the last period and the next two periods, are higher compared to the previous periods. This increase is due in part to advancing planned projects in anticipation of expected capital gains. Therefore, the height of these bars does not necessarily indicate the standard level for the future. Moving forward, we will continue to manage repair costs with consideration for the presence or absence of capital gains and other factors. Next, let's discuss the properties acquired in the last period and those to be disposed from this period onwards. First, on page 14, we have 3rd MINAMI AOYAMA. We acquired a 77% ownership share from Mitsubishi Estate for JPY 21 billion. This is a newly constructed property completed in 2023. As you can see from the photo, it has a somewhat distinctive facade, but inside it features a regular-shaped floor plan of 250 tsubo per floor, with wide windows facing both east and west, making it a comfortable office building. Regarding its location, it is a 4-minute walk from Gaien-mae Station on the Tokyo Metro. Facing Aoyama-dori, the property has high visibility, making it a stable and attractive option for a wide range of businesses, including fashion-related industries like apparel and design, as well as IT companies. Additionally, it is just under 2 kilometers from Shibuya Station, meaning it benefits from spillover demand from the highly competitive Shibuya area. We believe we have acquired a very good property that can demonstrate high competitiveness in the long term. With regards to the next pages, Toyosu Foresia and the Seavans S Building, both are additional acquisitions of existing properties we already hold, so I will skip the detailed explanation. Please look at page 17. As for the disposition of Harumi Front, we have mentioned it several times in past briefings, so I will skip the details. However, the final and the third tranche was completed in January 2024. Next, please look at page 18, which covers the JRE Dojima Tower, a property slated for disposition from this period onward. We will be selling this property in two parts over the current and next periods. On the right side, we have summarized the key points of this disposition. First, it helps us avoid leasing risks. In Osaka, the largest new supply in history is scheduled for 2024. A substantial level of supply is also expected in 2025. Although this property has maintained a relatively stable occupancy so far, the new supply in 2024 is primarily concentrated in the neighboring Umeda area, which is likely to be affected by secondary vacancies. Additionally, considering that this property is approaching 30 years since its completion, we anticipated an increase in additional investment for equipment upgrades. The second point is that the disposition price significantly exceeds both the book value and the appraised value. We expect to record a total gain of JPY 13.2 billion from the sale over the two periods. This capital gain will be partially retained, and approximately JPY 4 billion from each period will be distributed to our unit holders as part of the dividend for the current and next periods. Next, please look at page 20, which covers our financial strategy. In the last period, we continued with our policy of primarily long-term fixed borrowing, while also incorporating some medium-term fixed and long-term variable borrowings. As a result, the average interest rate on interest-bearing debt slightly increased from 0.40% in the previous period to 0.44%, and the average maturity cut short slightly from 4.39 years to 4.32 years. As the negative interest rate policy is lifted and BOJ's monetary policy moves towards normalization, domestic interest rates are expected to continue rising. Therefore, without making significant changes to our existing borrowing strategy, we will continue to focus on long-term fixed borrowings. However, we will maintain a flexible approach to financing, balancing the impact of rising borrowing costs with financial stability. Next, please look at page 21. The line graph at the top shows the LTV levels. Due to the borrowings associated with the acquisition of Toyosu Foresia and 3rd MINAMI AOYAMA, the LTV at the end of the last period increased to 44.0% on a book value basis. However, by the end of March 2025, following the second tranche of the disposition of Dojima Tower, it is expected to decrease to 42.5%. Please skip ahead a few pages to page 26. The unrealized gains in the upper section show a decrease of JPY 1.8 billion compared to the previous period. This is due to the impact of the third tranche of the disposition of Harumi Front, which caused the unrealized gains to drop. As a result of this impact, the net asset value per unit decreased by approximately JPY 400 compared to the previous period. However, the unrealized gains for existing properties other than Harumi Front have increased overall. Next is ESG. Please look at page 28. We have set goals regarding the acquisition rate of environmental certifications, and in January of this year, we raised the target level for this rate. The previous goal was to maintain a certification acquisition rate of over 70%, but as shown in the upper graph, due to our efforts to green our portfolio, we have consistently achieved over 70%. That is why we have set a new goal to maintain a certification acquisition rate of over 90%. In the lower right section, there is an excerpt from a survey conducted by an external organization. The survey indicates that buildings with high-level environmental certifications tend to command higher rent premiums. We have observed that tenants increasingly prioritize factors such as high environmental performance, comfort, and safety. We have conveyed on various occasions that JRE is committed to improving sustainability. The survey results we are presenting this time clearly show how these efforts align with your economic interests as investors. Next, please look at the lower section of page 29. In April of this year, our company, Japan Real Estate Asset Management, significantly revised its personnel system. As an asset management company, we consider maintaining excellent personnel as a critical management issue in order to continuously provide advanced asset management that earns the trust of our investors. In line with this, we have implemented various initiatives related to investing in our people. This latest revision of our personnel system is part of those efforts. By strengthening the employee evaluation process and extending the retirement age, we have created a system that enhances engagement and enables employees to work for a longer period. We expect this new system to maximize the potential of individual members, thereby further enhancing the overall operational capability of our organization. This concludes the explanation of the materials. Finally, I'd like to make some additional comments about the current operating environment and future outlook. First, regarding the financial environment. Interest rate trends have been a significant source of concern for J-REITs over the past two years. However, there has been a temporary calm following the decision made at the Bank of Japan's monetary policy meeting held in March to lift the negative interest rate policy and abolish YCC, or yield curve control, as well as the fact that BOJ maintained its outlook for inflation. It is encouraging that market concerns have eased, but there is no doubt that borrowing costs are rising. Therefore, we need to approach financing with more caution than ever before. Next, regarding the office rental market, there has been a significant improvement over the past six months. In Tokyo, not only has the vacancy rate stabilized due to office floor demand surpassing the large-scale supply in 2023, but there has also been a clear trend of rent increases over the past few months. Of course, the concerns about the new supply in 2025 have not disappeared, but if demand continues as it is now, it is likely that the supply will be absorbed in the market as it happened in 2023. On the other hand, a market with a 99% occupancy rate like before the pandemic will not return for a while, so we expect the selection based on the quality of office buildings to become more pronounced in Japan. Additionally, as we transition into a world with inflation, operating costs will increase. In such an environment, the expertise of asset management companies in maintaining and improving the value of buildings will become increasingly important. Furthermore, we need to continue to pay attention to the real estate market. Despite the uncertainty of fundamentals such as the financial environment, real estate prices remain consistently high. Particularly, the fact that the cap rate does not increase at all is somewhat difficult to explain. In any case, we believe it is necessary to anticipate that the market may enter into a correctional phase. Based on this understanding of the business environment, JRE aims first and foremost for steady internal growth. In terms of financing, while maintaining the same flexibility and caution as before, we will continue to focus on strategic asset replacement as an external growth strategy. That concludes my explanation. Thank you very much.