Tokyo Jul 1, 2020 (Thomson StreetEvents) — Edited Transcript of Japan Real Estate Investment Corp earnings conference call or presentation Friday, May 15, 2020 at 10:59:00am GMT
Japan Real Estate Investment Corporation – President & CEO of Japan Real Estate Asset Management Co., Ltd.
Naoki Umeda, Japan Real Estate Investment Corporation – President & CEO of Japan Real Estate Asset Management Co., Ltd. 
Hello, everyone. I’m Naoki Umeda, CEO of Japan Real Estate Asset Management Company. First of all, I want to extend my deepest condolences to those people around the globe who have lost loved ones to the COVID-19 pandemic.
Today is 15th of May. And here in Tokyo, we are still under the state of emergency, put into place over a month ago on 7th of April. And this dynamic situation with regards to COVID-19 makes it extremely challenging to judicially forecast what may occur. And all the more naturally, everyone who is watching this video wants to know more than anything else, I suppose, how this pandemic is going to affect our business. So let’s go straight at it.
Please take a look at Page 3. This is how we are responding to the coronavirus outbreak. The #1 priority is, of course, to protect the health of our employees and their families. We’ve set up remote working conditions using technologies such as web conferencing to make sure that our employees work from home as much as possible. Of course, our working from home would have been impossible without the support of the property management companies who take care of the daily management of the buildings. And my heartfelt thanks go to those who are working at the frontline of the property management.
The second point of our response is about standing together with the community. For instance, we are ready to offer a rent deferment for our cash-strapped tenants. So far, only a few of them applied for rent deferment and an agreement has already been put in place. However, we have been and remain reluctant about agreeing to rent reduction instead. Firstly, because the government has been considering to put in place some form of a rental assistance program; and secondly, because we must fulfill our fiduciary duty to be a good asset manager. And in relation to that, the Financial Services Agency of Japan issued a document on 8th of May, calling for flexibility in our response options as long as they are considered to be reasonable from a long-term perspective.
We will respond with flexibility and act in the best interest of our investors as we try to balance both short-term and long-term gains. And just as you know, our portfolio includes some properties which we are a minority owner. For such properties, we will respect as much as possible, the policy and procedure of the majority owners and other co-owners.
With respect to the employees of our contractors such as maintenance workers, we take their health and safety very seriously, and we will postpone nonurgent repair and maintenance works as much as possible.
I think you are already familiar with regards to our financial soundness. In addition to putting our finances on a sound conservative footing to begin with, we have JPY 60 billion unused committed line. So we remain financially rock solid in this time of uncertainty.
Let’s move on to Page 4. I’m going to talk about possible risks to our business due to the COVID-19 pandemic. First, there will be tenants who will put on hold their plans to relocate or expand their office space. We’ve had some tenants who tentatively agreed to sign a new lease contract and then canceled at the last minute. Second, we also expect that there will be requests for lease termination or leased space reduction from the tenants whose business is badly affected by the current pandemic. So far, we’ve received only a few requests for early termination, but we are going to monitor the situation very carefully. And thirdly, it will take longer than usual to fill up future vacancies, if any, because it is quite difficult and troublesome at this moment for prospective tenants to see inside the building in the first place or to do interior renovation at the property. And we should expect that the pace of new lease signings will almost grind to a halt.
These 3 factors I just mentioned may cause a slight increase in the vacancy rates within our portfolio. Also, it is possible that the pace of rent increase will slow down a little bit. Negotiating a rent increase with a hard hit tenant, while the state of emergency is still in place, is perhaps uncomfortable to say the least. Of course, there are individual cases where we can negotiate a rent increase, depending on how big a gap there is between the market rent and the passing rent. But generally speaking, it is possible that the pace of rent increase will slow this year. On the other hand, pushing back nonurgent repair and maintenance works which I mentioned earlier, is likely to lead to better earnings, at least in the short term.
Now keeping these risk factors in mind, I want to explain the basic assumptions that underlie our performance forecast. There are 3 of them, as you can see in the middle of the slide. The first one is the occupancy estimate. We expect the overall occupancy rate to drop by approximately 1 percentage point in the September 2020 period and another 1 percentage point in the March 2021 period. The second is that we take a more conservative outlook when it comes to the percentage of rent revision. And finally, the third assumption is that pushing back repair and maintenance works will reduce our repairing expenses accordingly, at least in the short term.
Of course, I will discuss more details about our performance forecast later. So before moving on to the next topic, let me tell you what I think will happen to the office leasing market in the post pandemic Japan that is in a couple of years from now. I expect that after the crisis is over, there will be even more demand for office buildings that are comfortable, health conscious, environmentally friendly and equipped with cutting-edge technologies. In fact, even before the pandemic, there has been strong demand for such high-quality office buildings with more and more companies starting to look at them as a tool to recruit and retain the best and brightest. In the years ahead, the need for such office buildings will continue to rise in the context of business continuity planning and also in the case where we may still be willing from the outbreak.
Also because more people and companies experienced a new way of working, such as working from home, I expect the thirst for high-spec, more technologically advanced office buildings to keep growing. In addition to that, there is going to be a limited supply of new office buildings in 2021 into 2022. So it seems very unlikely that the balance between supply and demand will change dramatically in the foreseeable future.
Okay. Let me start talking about the impact of COVID-19 for now and begin the discussion of our results from here. Please take a look at Page 6. These are the operating highlights for the March 2020 period. We had good external growth, acquiring 4 properties and disposing 2. Internal growth was also robust because there was almost to no coronavirus impact until mid-March. We saw excellent numbers for both tenant turnover and rent revision and ended the period with 99.7% occupancy.
At the bottom of the slide, you see our carbon emission target which is to reduce carbon emissions by 35% by 2030. We are committed to this target as part of our ESG initiatives.
Please go to Page 7. We filed for shelf offering of up to JPY 20 billion of investment units on 25th of March. Later, I’m going to provide an update on our performance forecast and dividend outlook. So here, let me say briefly that 32,380 new investment units will be issued by the end of September, and that will result in a 2.3% dilution.
Please take a look at Page 8 for the dividend results and forecast. The dividend per unit for the March 2020 period was JPY 10,610, JPY 413 higher than the previous period and beaten the forecast we announced 6 months ago by JPY 310 per unit. The DPU rose for the 12th straight period. We expect the dividend payout to be JPY 10,800 per unit for the September 2020 period and JPY 10,750 per unit for the March 2021 period. These projections are, as I said earlier, based on the assumption that we will have raised JPY 20 billion by the end of this September. So if for any reason, the public offering of the new investment units falls through, the dividend payout will be JPY 11,070 per unit for the September 2020 period and JPY 10,990 per unit for the March 2021 period, as described in the footnote #3 on this page.
Let’s move on to talk about internal growth. Please go to Page 10. We finished the March 2020 period with the highest-ever occupancy rate at 99.7%. The pace of tenant turnovers, as shown in the next graph to the right, has been slowing a little, but clearly, the rise in rent per space unit due to tenant turnover continues.
Please take a look at Page 11. As you can see the graph at the bottom left, the percentage of the contracts up for rent revision in the portfolio during the March 2020 period was somewhat smaller than the previous period. But this time, more tenants agree to a rent increase and in 67.3% of all the contracts up for rent revision, there was some increase in monthly rent, as indicated in the upper right chart. And as a result, the strong growth in rent increase upon rent revision continues, and you see that in the upper left chart.
Let’s move on to the next page. Page 12 explains about factors that led to the net increase in monthly contract rent over the last 6-month period. From left to right, the talent turnover brought our monthly contract rent up by 0.5%, while the rent revision lifted it by 0.7%. And when you add the 2 numbers, it is 1.1%. Our internal growth raised the monthly contract rent by 1.1% on net. And this will be 2.2% on an annualized basis. On the right side of the slide, you will also notice that we had a very strong external growth as well over the last period. And as a result, our monthly contract rent rose to JPY 5.115 billion at the end of the March 2020 period.
Let’s jump to Page 14 to talk about the market rent and the rent cap. On the left side of the slide, you see that the market rent rose in many of our properties, especially for those in downtown Tokyo, and there was no property in our portfolio whose market rent fell from the previous period. And with respect to the gap between the market rent and the actual rent, you can see from the chart on the right that the gap widened a little bit from the previous period to 7.7% on a monthly rent basis.
Let me move on to explain about our external growth in the last period. Please take a look at Page 16. We acquired 4 properties during the March 2020 period. The first property I want to tell you about is Seavans S Building. We acquired 13.45% interest in this property through a mutual transaction where we disposed of our Kodemmacho, Shin-Nihombashi Building to the seller. They are old properties, both completed almost 30 years ago. It was a mutual transaction because the other party was very interested in our property in Kodemmacho. Seavans S Building had major renovation work in 2012 and is as good as a newly built one, which we think is a big plus. As a matter of fact, this property is ranked as the highest rent in Japan’s CASBEE system.
Please take a look at Page 17. The second property I want to introduce to you is Otemachi Park Building. This is a state-of-the-art building, home to Mitsubishi Estate’s headquarters, by the way. It is located just across Imperial Palace with excellent transport accessibility as well as advanced green features. Not only that, the building is equipped with an exclusive lounge for tenants: a gym, nap room and child care facility. This is really a cream of the crop building. The sponsor decided to dispose of 49.9% of their co-ownership portion of the property, which includes office space, from level 9 to level 20, retail space and the DHC infrastructure. This time, we acquired 5% of that and that translates to 2.91% of the total building space if you performed a very complex calculation.
Let’s move on to Page 18. The third property we acquired is Shinjuku Front Tower. In fact, it was additional acquisition from the sponsor. We bought an additional 9.91%, and that brought our share of ownership of this property up to 37.16%.
Going to the next page, Page 19. The fourth building is Shinjuku Eastside Square. This was also additional acquisition from the sponsor. We acquired this time a 4% interest in the property, and our ownership of this property now becomes 35%.
Please look at Page 20. This is Link Square Shinjuku. This acquisition took place back in April. So technically speaking, it’s an acquisition in the September 2020 period. This is a newly built property directly connected to Shinjuku station by a pathway. We exercised our preferential right to negotiate and acquired a 37.34% ownership.
Please take a look at Page 21. This gives you an overview of the 2 properties we disposed in the last period. Please take out the material later for details. So let’s move on to talk about our financial results and forecast.
Let’s jump to Page 24. First, I shall explain details about the financial results for the March 2020 period. I’d like you to take a look at the upper right table that summarizes key differences between the September 2019 and the March 2020 periods. The largest item is, of course, the rent revenue which rose JPY 349 million, and it’s a very significant growth. With respect to external growth, we acquired 4 properties in the last period. But for the 3 of them, the acquisition took place near the end of the period, so the impact on NOI was very limited.
Also, we disposed of part of our ownership interest of Kawasaki Isago Building in the September 2019 period and had a gain of about JPY 1.6 billion on the disposition. For the last period, in addition to the gain of the second and the final disposition of this property, we had a gain of about JPY 600 million on the disposition of Kodemmacho, Shin-Nihombashi Building, which I mentioned earlier. There are some other differences between the 2 periods, but more important is NOI, which actually grew JPY 309 million. And in fact, operating profit was up JPY 860 million. And for this gain on sale of real estate property, we used a special tax exemption scheme concerning transactions of specified assets and reserved about JPY 1.6 billion. As a result of all that, the dividend payout was JPY 10,610 per unit, up 4.1% from the previous period.
Let’s move on to the next page, Page 25. This is our balance sheet. I don’t think it requires much explanation. So let me just point to the note, put out of the right table, which is about reserve for discretionary dividends. It increased to JPY 3.745 billion at the end of the March 2020 period, up JPY 1.6 billion from the previous period. All right. Let’s then turn our attention to the forecast.
Please go on to the next page, Page 26. But before I begin to present our forecast, let me briefly explain to what degree the impact of the coronavirus pandemic is reflected in our forecast. First of all, the big picture, if you will, that informs our forecast is this. I’m going to read you the text in the top box on the page. The chaos caused by the coronavirus pandemic will mostly settle down by the end of September 2020, and but its impact on the office leasing market will last to a certain degree into the March 2021 period.
So the question is, to what degree? And more specifically, what kind of assumptions we have reasonably made? We’ve made 3 assumptions and put them together in the middle box. The first assumption is that occupancy is expected to slow down. We have taken a more conservative outlook for the occupancy rate. But precisely, we anticipate that the vacancy rate will go up 1 percentage point during the September 2020 period, and that it could go up another percentage point by the end of the March 2021 period. Secondly, we have taken a more conservative outlook for the range of rent increase upon rent revision. And thirdly, our repairing expenses will slightly decrease, thanks to pushback or cancellation of nonurgent repair works.
Now for those 3 assumptions I’ve just explained, we may not have to worry too much about the occupancy rate because realistically speaking, 6 months’ notice is still required to terminate a lease. In addition, over 60% of our portfolio lease contract is a fixed long-term contract. So it seems highly unlikely that the occupancy rate will spike another 1 percentage point from the current outlook in just 6 months or less from today. Of course, there will be some tenants, mostly retailers, I presume. They will be asking for rent deferment or rent reduction, and that is why we have taken a more conservative approach. In a similar way, the risk to rent increase upon rent revision should not be overstated. Because actually, we have already agreed with a significant number of our tenants on the upcoming rent increase for the September 2020 period, with many of them having signed before the end of this March.
So all things considered, the impact of COVID-19 on our September 2020 period will be somewhat limited, and possibly a more practical impact will be felt during the March 2021 period instead. So the real question is how much of our forecast will be impacted based on these assumptions? And I believe the best way to answer this question is to compare the current forecast with the forecast we revised on 25th of March. Any difference from what we announced just 6 weeks ago will be the possible impact of the pandemic on our future performance. And we put the numbers in the last box.
Firstly, there will be an impact on our rent revenue because we have lowered our outlook for occupancy and the range of rent increase upon rent revision. For these, we now expect that rent revenue will slide JPY 110 million by the end of September 2020, and JPY 460 million by the end of March 2021 from the forecast we revised on 25th of March. In contrast, repairing expenses are expected to go down JPY 230 million and JPY 200 million, respectively, from the revised forecast. And just for your reference, both utilities expenses and reimbursements are also expected to fall due to more people working from home and stores being closed. On net, the impact of utilities is quite limited.
And in light of what we just discussed, on Page 27, we are comparing our latest forecast with the forecast we revised on 25th of March. You will notice some key differences, which we described on the right side of the slide. Of course, the major ones are rent and repairing expenses. Just briefly, for the September 2020 period, the decline in repairing expenses is expected to be slightly bigger than the drop in rent revenue. So the DPU will be better than the revised forecast by JPY 50 per unit at JPY 10,800 per unit. And for the March 2021 period, we expect that a slightly bigger impact on rent revenue will lower the DPU by JPY 100 per unit to JPY 10,750 per unit from the forecast revised on 25th of March.
On the next page, Page 28, we are comparing the latest forecast with the actual results of the March 2020 period. Let’s take a look at the September 2020 forecast first. Again, the key differences are described on the upper right side of the page. We expect that rent revenue from our existing properties will increase JPY 330 million. This is thanks in large part to the fast pace of rent increase due to rent revisions and tenant turnovers that took place during the previous period. Also, our external growth will push operating revenue up JPY 1.1 billion because we acquired 4 properties in the previous period, and another property, Link Square Shinjuku, back in April. On the other hand, the gain on sales of real estate properties of JPY 2.185 billion, which we posted in the March 2020 period will be gone. So in totality, operating profit is expected to slide, but NOI is expected to soar by close to JPY 1.3 billion, thanks to both internal as well as external growth.
And just for your reference, we are going to post an JPY 80 million nonoperating revenue, which is a gain on donation of noncurrent assets. What is this? It’s an underground walkway, which is going to be constructed and connected to our premises and is considered a donation because it’s free of charge. This walkway is supposed to connect the building being under construction right now with the headquarters of Mitsubishi UFJ Trust Bank because they were standing next to each other in the Marunouchi area.
I’d also like to point out that nonoperating expenses include public offering expenses of JPY 40 million based on the assumption that JPY 20 billion will be raised through public offering by September. So accordingly, with the offering of 32,380 new units by September and a 2.3% dilution expected, the DPU for the September 2020 period will be JPY 10,800 per unit, up JPY 190 a unit from the previous period.
Next, let’s look at the forecast for the March 2021 period. Once again, the key differences from the preceding period are shown in the table at the bottom right of the page.
First, our rent revenue is expected to fall JPY 100 million from the September period. Many of the rent revisions that are to be confirmed during the September 2020 period have already been agreed and signed upon and will certainly push our rent revenue up for the March 2021 period. But because we took a more conservative outlook for the occupancy rate, we forecast that the rent revenue will slide JPY 100 million.
When it comes to repairing expenses, they will be fewer than usual, but compared to the big drop we expect for this period, the repairing expenses are expected to go up by JPY 130 million. And as a result of all this, NOI is expected to slide JPY 190 million, and the DPU is expected to be JPY 10,750 per unit, down JPY 50 a unit from the forecast for the September 2020 period. If, for any reason, the public offering falls through, the dividend payout will be JPY 11,070 per unit for the September 2020 period and JPY 10,990 per unit for the March 2021 period.
Let’s move on to talk about our finances next. Let’s jump to Page 30. Our interest expenses are likely to continue falling moderately as shown in the middle chart.
Please go to the next page, Page 31. The latest LTV stands at 40.9% on a book value basis and at 32.6% on a market value basis, which takes into account the appraisal value. In either way, we are maintaining a really sound financial position.
Let’s then move on to Page 35 to talk about the appraisal value of our portfolio. The appraisal value at the end of March 2020 was JPY 1.235 trillion, up JPY 32.2 billion from the end of the previous period, thanks in large part of the 4 properties we acquired. And if I dig a little deeper into that, I point out that there are properties with higher appraisal value and others with low appraisal value when I look at the 71 properties, which have been in our position at least since the September 2019 period. The biggest reason why certain properties saw their appraisal value go down is that higher land and building taxes were priced in the appraisal value in anticipation of the reassessment of the ratable value which will take place in April next year. As a result of all this, the unrealized gain was JPY 279.7 billion at the end of March 2020, and the net asset value, which is calculated from the appraisal value, now stands at JPY 573,321 per unit.
Let’s move on to talk about our commitment to and actions towards ESG. This time, I will focus on just 2 things.
Please take a look at Page 37. The first thing I want to tell you is that we set a series of targets and KPIs for 2030 and posted them on our website. These targets are not lofty aspirations, but more realistic ones that came out of our research and discussion with the engineering team of the design firm we work with. We will cut our carbon emissions by 35% on an intensity basis, and we will reduce our water consumption by 20% and recycle more than 90% of our waste. Also, we will include 5 to 10 zero-energy buildings, or ZEBs, in our portfolio. For this target, we will not only acquire new properties that are ZEB-ready but also turn our existing properties into ZEBs through innovation.
Please take a look at Page 38. We also published our actions towards climate change on our website. JRE was the first among JVs to join the TCFD and became signatory last year. Following the principles of the TCFD, we disclose on our website the financial impact of climate change on our business, but also talk about potential business opportunities to be brought about by climate change. So be sure to check our website later. I believe one of the groundbreaking ideas that the TCFD has provided is the disclosure of business opportunities in addition to risks posted by climate change.
Last but not least, please take a look at Page 48. It’s been 4 years since I took the helm of the asset management company, and it is the eighth time that I show you this cartoon picture of me playing golf. In the past 7 pictures, the weather was basically described as fine or sometimes a little windy perhaps. This time, it’s a storm. And besides, nobody can predict exactly how long it will last. Whether it’s 6 months, 12 months or longer, nobody knows for sure. But from a longer perspective, I think it would look like a temporary score. And after this score passes, I’m sure that a beautiful blue sky awaits us all.
Because we are still in the state of emergency, we’ve changed the format of our earnings presentation. We posted this video message at the same time we announced our results. In a physical meeting format, we used to take your questions and answer them on the spot. But this time, of course, we can’t do that. So instead, we prepared and published on our website our answers to a set of likely questions, which we think you may want to ask us. Be sure to check this out as well. We really hope that we can get back to some sense of normalcy as soon as possible.
With that, I’d like to end my presentation. Thank you very much for watching.