Lower yields and higher expectations

Investors’ sentiment towards Tokyo’s multifamily assets (a block or complex with multiple flats) appears more bullish. According to CBRE’s June survey, the expected yield for a studio apartment within Tokyo’s central five wards fell to an average of just 3.7%. It had already been low at 3.8% during the previous three quarters.

Investors’ return requirements have increased along with higher risk-free rates. The lower expected yields suggest investors are confident that Japan’s financing conditions will remain accommodative. Being able to extract higher value from these rental apartments, through either organic income growth or asset enhancement, seems increasing likely.

Rising demand and lower vacancy rates

The rental growth outlook for Tokyo’s multifamily assets has improved materially, now that Covid is behind us. Net migration into Tokyo during the first seven months of 2023 jumped 56% year-on-year (y/y), which was just 12% below pre-Covid levels1. Importantly, the rebound was led by those aged 20-29, which is arguably the most important demographic when it comes to leasing demand for studio apartments.

As a result, the average vacancy rate for rental apartments in Tokyo’s 23 wards fell below 3% in the first half of 2023 (from 3.6% a year ago)2. This drove an average rent increase of 2.3% y/y in the second quarter of 20233. Crucially, rental growth is increasingly matched by earnings growth, with Japan’s average wage growth accelerating to 1.9% in the 12 months to June4.

Chart: Tokyo 23 Wards’ rental apartments: rent growth (%y-y) vs. vacancy (%)

Source: ARES, SMTRI-At Home, abrdn; September 2023

Expecting more from value-add amid shifting demand

Our research in 2020 evaluated the effectiveness of using a value-add strategy to invest in Japan’s rental apartments. We did this by conducting a survey of Advance Residence Investment Corp’s (ADR) portfolio in Tokyo. For context, ADR is the largest Japanese residential real estate investment trust (REIT) by market capitalisation. We concluded that there was convincing evidence that a value-add strategy could deliver superior returns. Around 70% of the properties we classified as ‘value-add’ reported a higher increase in passing rents and improved net-operating margins.

Nearly four years and a pandemic later, the investment case has strengthened for using a value-add strategy to invest in Japan’s rental apartments, especially those in Tokyo.

The 30% of value-add properties that underperformed in our survey shared three common characteristics: they were relatively old, large and in less-accessible locations. But demand dynamics are shifting, especially with regards to larger units. Understandably, rental growth for family-sized homes (5%) outpaced those of single-person homes (0.2%) during the pandemic, as people spent more time at home3. This outperformance continued into the first half of 2023, as hybrid-working arrangements became more common.

Meanwhile, the rent premium based on building age appears to have widened, which further justifies asset-enhancement initiatives. For instance, our estimates indicate an increase in the average premium of rental apartments that are less than five-years old, over those aged 11-20 years, from 22% in 2019 to 26% during the first eight months of 20235. With nearly 60% of Tokyo’s rental housing stock built before 20016, there is a sizable pool of potential candidates for retrofitting to tap into the rental upside.

Expect more office-to-residential conversions

Besides applying a value-add strategy to retrofit older apartments, the case is building for converting older offices in Tokyo into rental apartments. According to Sanko Estate’s data, the average vacancy rate for offices in Tokyo’s 23 wards rose to 5% in the second quarter of 2023. This was the highest level since 2015. While new supply of office space scheduled for completion is on track to drop to 0.73 million square metres (sqm) in 2024, from the 1.26 million to be delivered in 2023, supply is expected to rise again to 1.36 million sqm in 20257

There was a wave of converting vacant office buildings into residential assets in the early 2000s, when Tokyo’s office market was similarly facing a supply glut amid high vacancy rates. Vacancy rates reached a high of 8% in 2003 when 2.16 million sqm of new office space was completed. Fortunately, the current occupier market appears to be in better shape than then. But there are new variables affecting offices, including hybrid-working arrangements.

As vacant office space in Tokyo – particularly older and less competitive stock – struggles to find tenants, it may make sense to convert some of these into rental apartments. This is especially the case given the smaller difference between the average office rent and new apartment rent in Tokyo’s 23 wards over the last five years.

  1. Haver, citing data from Japan’s Ministry of Internal Affairs and Communications
  2. Association of Real Estate Securitisation (ARES), citing data from listed REITs
  3. Sumitomo Mitsui Trust Research Institute (SMTRI) and At Home Co.
  4. Haver, citing data from Japan’s Ministry of Health, Labor & Welfare
  5. Tokyo Kantei’s data
  6. Savills Japan’s data
  7. Mori Building’s survey