Japan Real Estate Investment Corp

TSE:8952

Earnings Call Analysis

Earnings Call Transcript 2021-Q2

[Naoki Umeda, executive]

Hello, everyone. Good morning. I'm Naoki Umeda, CEO of Japan Real Estate Asset Management Company. Today's performance review will be held in a conference call format. And before we start the meeting, let me introduce our team to those of you who are participating in our performance review for the first time, although I know many of you are very familiar with it.

Please open to Page 35. Don't worry, we don't skip so many pages for nothing. I guess you're now looking at Page 35. This is the page of golf illustration, which should be very familiar if you've joined our meeting before. And almost 6 months ago, the image we showed you on this page was a storm because we were in the midst of the state of emergency. Now it's not raining any longer. It's still cloudy, and we are facing a substantial headwind, but we can play decent golf now. Well, the man with a pink cap on his head is me, Naoki Umeda. And the other man on your left with a blue shirt is Mr. Motooka, the Head of Planning Department.

Now in this picture, Mr. Motooka says that he's been practicing golf on a simulator recently, and he thinks he's improved his golf skills. But when he is actually out in the golf course, he finds himself in the deep rough not knowing how to get out. Of course, you can't simulate every possible situation. On the other hand, the guy with a pink cap that is me is saying as follows. Golf is a sport of self-discipline. There is no judge other than yourself. You have to keep score for yourself. You need to be tough to yourself, and you need to rely only on yourself to find a way out of whatever situation you are in. You also learn from other players a lot about golf manners and sportsmanship. In other words, you can't become a better player just by practicing on a simulator. I assume you're guessing what I'm getting at now.

Well, actually, there are 2 things I want to say. The first thing is very personal. I've been criticized by my wife for playing too much golf. But I want to say that I have legitimate reasons why I should play golf. It's not only playing but also training myself and staying fit both physically and mentally and also as a human being. I'm also learning a lot from playing golf, and it's a great opportunity for networking. Those are the things that I wish I could say to my wife, face to face, but because I can't, I'm thinking of showing this illustration to her for a change. The other thing I want to tell you is, and I know some of you have guessed right that there are still many things in this world that cannot be done virtually or replace real experience. That's the message I want to get across here. Because I'm often asked if office demand will be gone as more and more people work from home. But my tentative answer to this question is that physically working in the office has more pros than cons for now, for the same reasons why you should play golf on a real course.

It is true that many different companies will try new ways of working in weeks and months ahead. But when the pandemic is over or put under control, I think many people will recognize, once again, at least for the time being, all the benefits and comfort that real office brings to us. Having said that, however, nobody can predict for sure what will happen in the distant future. I guess that advances and innovations in information technology will continue to fill the gap between the virtual and the real. Also, there is a generational gap when it comes to working in the office or working from home. Those who are 20 years younger than I am, think differently about it. And those who are 40 years younger than I have probably vastly different opinions about the way we work. So the physical office, as we know it today, may be unnecessary in a very distant future.

Now coming back to the analogy of golf. This is an individual sport, for the most part. And you might think that there are many things that can be done virtually. You can practice on a simulator or in a driving range near home just like Mr. Motooka does in the picture. But in our real-world and in our real situations, a lot of us are playing team sport. We work in the team for the organization. We belong to. That's why we need to practice together. Of course, some of us work like playing an individual sport, and maybe that's the key difference.

If you play a team sport, think about international football, the Samurai Blue, for example, each and every member of Japan National Football team is a professional footballer in its own right. Some of them playing in elite clubs abroad. But they get together in a practice when they are called to represent their country for an international tournament. And if you apply the same analogy to a workplace, you usually work in a co-working space near your home, for example, sharing the same space with others who work for a different company. And you will only go to work in the head office when you are asked to join a project, for example. And if necessary, that could be a possible future as well. As always, it's been a long introduction to our performance review.

Now let's get started. Please go back to Page 3. Reddy? These are dividend results and forecasts on Page 3. The dividend payout for the period ended September 2020 was JPY 11,262 per unit, up JPY 652 per unit from the previous period. It was a huge jump, thanks to internal growth on the one hand and external growth on the other, roughly speaking. I will give you more detail later. Our DPU has been rising for the 13th straight period. If we look back, the dividend payout was JPY 7,633 per unit for the period ended March 2014. Since then, the DPU has been rising constantly for the past 13 periods at approximately 7.3% on an annualized basis. So the fact that it grew 6.1% in just 6 months this year is particularly significant.

Let me also talk about dividend forecasts. Please have a look at the 2 green bars at the right end of the graph. The dividend payout is expected to be JPY 11,030 per unit for the period ending March 2021 and JPY 10,740 per unit for the period that follows. The drops in the payout are in large part because we expect a negative internal growth as a result of higher vacancy rates with the properties in our portfolio. So our projection is that the payout will gradually fall in a couple of periods ahead. The question is, what should we take from these forecasts? Of course, that depends on who you ask, but here's the fact. The expected payout of JPY 10,740 per unit for the period ending September 2021 is still higher than the JPY 10,610 per unit, we paid for the period ended March 2020. It should also be noted that these dividend forecasts do not include any possible upside that we could see from external growth or a gain on sale of properties, if any. So you can potentially expect the final number to be somewhat higher than the current forecast.

Next, let's take a look at Page 5. I want to mention briefly the impact of the COVID-19 pandemic on our performance. When we look at how our office tenants have been doing during the pandemic, it has been almost in line with the estimate we announced 6 months ago. That is to say that the number of tenancy terminations remain steady despite the pandemic, but it's been taking more time to fill the vacancies, and that's why the vacancy rates have been rising slightly and gradually. I'd also like to note that no temporary rent reduction has been granted to any of our office tenants so far, although we have agreed to rent deferment with several tenants. Shop restaurant tenants account for 6.1% of our portfolio as shown in the pie chart below. As you know, they have been hit hardest during the pandemic, and we've agreed to and granted temporary rental reduction to some of these tenants. And the impact of the rent reduction amounted to JPY 34 million for the period ended September 2020, which actually pushed down the DPU by approximately JPY 24 per unit.

Please go to Page 6. Here, I want to talk about the outlook for office leasing market. Let me begin with the short-term outlook first. We expect the vacancy rates to rise gradually in the short term. This is firstly because companies struggling to recover from coronavirus fallout have already moved to terminate the tenancy or to ask for a reduction in the leased space. Secondly, even companies that have been doing good during the pandemic, tend to remain in wait-and-see mode because of lingering uncertainty about the economy and the virus. And thirdly, even if we are able to get the virus under control, more companies will probably experiment with new ways of working. And the buzzword here will be diversity in work styles. And as the experiment is going on, there will be new tenants moving in and existing ones moving out. But in the short term, we think that more tenants will rather relocate to a smaller office space. That's why the vacancy rates will go up.

If so, we think it will be harder to raise rent. In fact, when you look at the market rent today, it doesn't appear to be rising. Rather, it seems to have passed the peak as suggested by some data. We, too, assume that the market rent has passed the peak. And if so, we tend to focus on how far it's going down. But we are also hearing very positive news about the vaccine. And if the vaccine becomes available. As I said earlier, some companies will start to experiment with new ways of working probably next year. Then it is possible that those tenants that have had to wait and see so far may start to make a move. Earlier, I said there could be more vacancies in the market in general. But if those tenants start to make a move one way or another, that may potentially spell advantage for JRE because chances are that there will be more prospective tenants who are looking for an office building that sits on a prime location or office base that is cozy and maybe with excellent air cleaning capacity, for example.

If there are more selective tenants looking for high class or exceptional office space, our future is not necessarily all dark and dismal. And it's true that vacancies are on the rise right now. But once those vacancies are filled, we will have sizable internal growth. It's always harder to achieve internal growth just by raising rent upon lease renewals. So we can certainly hope that the current vacancies could be filled in the near future.

Having said that, I want you to take a look at Page 45 because I really want to touch on this point in relation to rent. This page shows how the average rent of our portfolio has been changing over the years. And as you can see, whether it is boom or bust, the impact on our portfolio average rent has been relatively moderate. So I know those of you who know this business pretty well, will understand that even if the market rent drops 10% or 20%, that will not immediately affect the portfolio rent, which will follow the similar trend, but in a more moderate way. That's what I wanted to get across on this page.

So let's go back to Page 6 to talk about the market outlook in the mid to long term instead. We have been aware, even before the pandemic that advances in information technology and the population declining in Japan are 2 big factors that function to keep the demand for office space from increasing without limit. And as corollary to that, I think perhaps that elements that have been desired so far for office space will become irrelevant in the future. What I mean by that is as the population, young population, in particular, continues to shrink in Japan, the race for talent will never end. Then with that as a context, what people want from office space will surely evolve, and we think that the market itself will become polarized. And that brings us to focus on offering office buildings of choice and building a portfolio of choice, if you will, as we described at the bottom of the page. More specifically, we believe it will be extremely important for us to think even more strategically and act more proactively when it comes to rebalancing our portfolio.

Now on Page 7. Here is our portfolio strategy, which is predicated on the awareness that we need to address those issues. And as I have just said, we need to think more strategically to rebalance our portfolio. And one of the reasons why the rebalancing is likely to take place is that, that is necessary to achieve our carbon emissions target by 2030. And it is within this context that we are proposing to change the current fee structure, and we will put this matter before the general unitholders' meeting to be held in December. Just to give you a heads up, we seek to change the DPU linked fee, which is #2 in the current fee structure shown at the bottom left to have 2 types of incentive fee. When you look at the proposed fee structure at the bottom right, we are proposing one fee component that is mainly linked to the profit from leasing business, which is recurring regularly.

And the other component linked to gains on sales of real estate, which is usually one-off. That is a new type of feed that we are proposing this time, and that's the broad outline for the new fee structure we try to put in place. We expect to see gains on sales of real estate as we move forward with rebalancing. So we believe that the proposed fee structure will provide a better incentive to the asset management company for working even harder to maximize the benefit of rebalancing, which is directly linked to the financial return for our investors.

Next, please take a look at Page 8. There may be some skeptics, wondering if those gains on sales of real estate will really translate into dividend instead of being held as retained earnings. But we can assure you that we are going to distribute a portion of our internal reserves and emergency fund, if you will, at each fiscal period as a return for our unitholders. As of the end of September this year, the amount of our internal reserves stands at JPY 3.7 billion, as you can see on the left side of the page. Of course, some of it will remain reserved for any contingency. But as we show on the right side of the page, we are going to distribute 1/20 of the period-end balance of our internal reserves in every 6 months. So basically, we are distributing our internal reserves over the next 10 years, and that is the guideline we will put in place going forward. From here, I want to fill you in more detail on our performance for the last period.

Please take a look at Page 10. The column surrounded by green solid line is showing the actual results for the September 2020 fiscal period. At first glance, it appears that there was a drop in both revenue and profit, but we should note the fact that we had a gain on sales of real estate properties, JPY 2.185 billion in the period before that. Please look at the third line from the top. So if you exclude this one-off item from the March 2020 fiscal period's results, you will see that our revenues and profit have grown strongly over the last period. And as I said earlier, half of that growth comes from internal growth and the other half from external growth, the acquisition of new properties. So what and how much change occurred from the preceding period? If you look at the right side of the page, first, you will see a big jump in rent revenues in existing properties, up JPY 348 million from the period before.

We were also focused on cutting expenses for the existing properties because of the pandemic, and I really want you to look at the repairing expenses, which dropped JPY 290 million from the period before because we postponed nonurgent repair and maintenance works as much as possible for the past 6 months. We increased revenue while decreasing expenses, hence, a big internal growth. We also acquired 5 new properties over the past 12 months, and that has led to more than JPY 1 billion increase in revenue, which certainly helped us achieve this healthy performance for the September 2020 period. As a result of all this, the dividend payout was JPY 11,262 per unit, up JPY 652 per unit from the previous period.

Let's move on to Page 12. Here are the financial forecasts for March 2021 and September 2021 period. The first thing I want to draw your attention to is the occupancy rate at the end of each period, which is at the bottom of the table. Although it's not written here, the occupancy rate at the end of this March was 99.7%. So it was pretty much completely occupied, but the occupancy fell to 99% at the end of September this year. It's still pretty much fully occupied, but it's a drop of 0.7 percentage points. We expect the occupancy rate to fall by another 0.9 percentage points to 98.1% at the end of March 2021 and to continue to drop over the period that follows to the 97-plus percent range at the end of September 2021, although we are not showing that figure on this slide. And that, of course, basically means that our rent revenues will see a drop that is proportional to the decline in the occupancy rate in our portfolio, and that's why we forecast both revenues and profit to go down a bit.

To give you more detail on that, I want you to take a look at the upper right side of the page. Rent revenues from the existing properties are expected to decrease JPY 265 million for the March 2021 period because the impact of expected vacancies will outweigh an increase in rent revenues from upward rent revisions. Also, the repairing expenses, which were extremely small in the last period, will increase back to a more normal level, though it is still lower than historical levels. We expect the repairing expenses to go up by JPY 164 million. If you look down at the table below, rent revenues from the existing properties will go down JPY 370 million and the repairing expenses will go up about JPY 120 million for the September 2021 period for the similar reasons I just described for the March 2021 period. In addition to that, property and other taxes are expected to increase JPY 250 million for the September 2021 period, and half of that increase is due to the reassessment of the ratable value, which will take place in April next year. The other half is attributed to the properties we acquired this year.

Next, please have a look at Page 13. This page describes various factors that either push up or pull down DPU. But what I wanted to focus on is the light blue area of the bar found on the right side of the page. That's the part that represents the 1/20 of the internal reserves, which will be a return for our unitholders that I explained earlier. For the March 2021 period, the amount will be JPY 133. And for the September 2021 period, it will be JPY 126. So we've already included these figures into our dividend forecasts.

Now let's jump to Page 16. We are showing a number of data sets that describe the characteristics of our internal growth. And here, I want to draw your attention to is the top-left graph showing how much rent revisions have been pushing up our monthly rent revenues over the years. The rightmost bar represents an increase in monthly rent revenues, thanks to rent revisions for the September 2020 period. It is JPY 48.3 million. And as you can see, it is the biggest-ever increase in monthly rent revenue, thanks to rent revisions. The vast majority of that increase, in fact, comes from the upward rent revisions that were agreed on with the tenants prior to the pandemic. And that's why you see this huge figure. But of course, that's no longer sustainable out of the current circumstances, and we don't expect that kind of increase to continue for the next period and beyond.

In fact, we expect the increase in monthly rent revenue, thanks to rent revisions to moderate somewhat going forward. But the operating word here is moderate. We don't expect to see a drop in monthly rent revenue. We just expect the pace of increase to slow, and we are confident that rent revisions will continue to push up monthly rent revenue for the next period and the period after that.

What makes us confident about that? Take a look at Page '19 for the figures about the rent gap. When it comes to our monthly rent revenue, we are still 7.4% below the market level as of the end of September, and that's almost unchanged from 6 months ago. As you can see, the line graph, we are still below the market level, and we think we can still negotiate a rent increase with a number of tenants. We also assume that even if we begin to see a decline in market rent, it is very unlikely that the market rent will fall to a level that wipes out the rent gap that exists today.

I also want to touch upon the appraisal value of our portfolio, so please go to Page 28. As the figures in the table show, the appraisal value at the end of September 2020 was JPY 1,253.9 billion, up JPY 18.9 billion from the end of the previous period. And if you remember, we acquired a building in Shinjuku Link Square at JPY 17.3 billion. The overall figure is almost flat. And the net asset value now stands at JPY 578,857 per unit.

Last but not least, I also want to talk briefly about what we are doing around ESG. Please go to Page 30. As you can see, we published the first sustainability report for the company. We also redesigned our entire ESG website. So please do check it out later.

And finally, this is the last page, Page 31. We announced our KPIs for 2030, including the carbon emissions target earlier in the last fiscal period. I briefly talked about them in the last performance review meeting 6 months ago. Here, we are presenting a kind of interim report, if you will, showing how much progress we've made since then. So I really want you to take a look at that.

And that brings to an end of my presentation. Thank you very much.