On September 10 2001, the first two Japanese real estate investment trusts (J-Reits) were listed on the Tokyo Stock Exchange (TSE). In the five years since its inception, the J-Reit market has grown from two issuers with a market capitalization of about ¥260 billion ($2.2 billion), to 40 issuers with a market capitalization of about ¥4.7 trillion. Two issuers have dual listings (in addition to the TSE, the Osaka Securities Exchange and Fukuoka Stock Exchange) and one issuer has been listed on the Jasdaq Securities Exchange. Although the initial growth of the J-Reit market was slow (two issuers in 2001, and four issuers each in 2002, 2003, and 2004), the market experienced a sudden surge in 2005 adding 13 new issuers. This growth is continuing into 2006: so far the market has seen 12 additional issuers. According to statistics on real estate securitization published by the Ministry of Land Infrastructure and Transport (MLIT), of about ¥6.9 trillion real estate assets securitized in fiscal year 2005, about ¥1.7 trillion (25%) were real estate assets securitized through J-Reits.

So J-Reits have grown to become an important part of the real estate securitization and investment market in Japan. Against this background, 2006 witnessed various incidents and initiatives to strengthen investor confidence in J-Reits and to promote its growth.

Legal overview

J-Reits are structured as externally advised, passive and closed-end investment companies. It is possible to structure J-Reits using a trust structure, but all publicly traded J-Reits to date have been structured as investment companies. The TSE recently announced its intent to revise its listing rules, after a one-year review, to make trust J-Reits ineligible for listing.

An investment company (toshi hojin) is a passive vehicle, established pursuant to the Investment Trust and Investment Company Act (ITA), whose primary purpose is to invest in real estate and other specific types of assets. It is the shares, or the units, of the investment companies that are listed and traded on the stock exchanges. The activities of an investment company are limited, by the ITA, to the management of invested assets according to the investment policy set out in its articles; that is, essentially the acquisition, disposition and leasing of income-producing real estate. Development activities are not permitted. The investment company must also be passive, so must outsource its activities to external managers and administrators. An investment company's activities are carried out by an investment manager that is licensed under the ITA. The investment company also outsources its unit-transfer registration, dividend distribution, voting and other unitholder administration activities and custodian activities to trust banks. Corporate secretarial services are outsourced to either a trust bank or the investment manager.

An investment company is governed by its board (yaku-in-kai), which is comprised of an executive officer (sikkou yaku-in), who has the powers to represent the investment company, and supervisory officers (kantoku yaku-in) whose duties are to supervise the executive officer and to vote, as members of the board, on certain material transactions entered into by the investment company. The ITA requires that the supervisory officers, at all times, comprise a majority of the board. The executive officers and the supervisory officers are appointed by the unitholders at their general meeting. The unitholders meeting also has the power to appoint and dismiss auditors, to approve the appointment and termination of the investment manager and to approve the amendment of the articles of the investment company.

The investment manager (toshi shintaku itaku gyosha) is an entity licensed under the ITA to manage the assets of the investment company and is regulated by the Financial Services Agency (FSA). To engage in discretionary management of real estate, the investment manager is also typically licensed under the Land and Building Transaction Act and is regulated by MLIT. For the investment company units to be admitted for trading on the stock exchange, the investment manager must also be a member of The Investment Trust Association, a self-regulatory organization of investment managers, and is subject to the Association's rules. Unless otherwise permitted, its activities are limited to investment management and the investment manager is held to prudent manager standards and owes fiduciary duties to the investment company. The investment company must also appoint a certified public accountant or an audit corporation as its auditor (kaikei kansa-nin) whose duties include the audit of the company's financial statements and to report any material fact that constitutes violation of law or articles of the investment company to the company's supervisory officers.

Challenges for future growth

In April 2006, after regular inspection by the Securities and Exchange Surveillance Commission (SESC), the government body tasked with the inspection of financial institutions, the FSA issued a business improvement order against an investment company to improve and strengthen its compliance procedures after it failed to properly minute matters resolved by the board. In June 2006, another listed J-Reit, also after a regular SESC inspection, was sanctioned for failing to properly hold board meetings (the board members must meet physically in person to lawfully constitute a board but resolutions were adopted without a physical meeting). The investment manager of that J-Reit was also sanctioned for failure to hold the board meetings and, in addition, for failure to satisfy its duty of care as a prudent manager in connection with the company's acquisition of certain assets. In July one, and in October four, investment companies were sanctioned for failure to properly hold board meetings and minute their proceedings.

Investment companies are structured as special purpose, passive entities with a minimum number of officers and are under the day-to-day management of the investment manager. The above irregularities with respect to board meetings were, perhaps, attributable to a lack of recognition that investment companies should be managed and operated independently. The FSA orders sent a clear message to the market and its participants that investment companies are public companies and that they need to be operated independently from the investment manager's day-to-day business. It is likely that the FSA will continue to exercise its supervisory powers to ensure that proper independent controls are in place at the investment company level.

Externally managed Reits

Sponsors of J-Reits, that is, those that initiate the formation and structuring of the J-Reit, were initially large real estate property companies (the sponsors of the first two J-Reits were Mitsui Fudosan and Mitsubishi Estate). But sponsors have diversified and now include trading companies, financial institutions, railroad companies, real estate brokerage companies and real estate funds. J-Reits, to be credible, need to show a strong ability to continue to source quality income-producing real estate. So it is understandable that property companies, real estate funds and businesses with large real estate holdings have been the main drivers of the J-Reit market. Sponsors are also typically the parent of the investment manager, select the officers and service providers of the investment company and provide office space and other back-office resources required by the investment company.

Sponsors play an important role in the introduction and ongoing operation of J-Reits, but sponsor involvement carries with it the issue commonly seen in externally advised Reits – a conflict of interest between the Reit and the sponsor. Excessive sponsor dependence might also have adverse influence on the independence and separateness of an externally advised Reit as was shown by the FSA order mentioned above.

Conflicts of interest with sponsors

The ITA prohibits the investment manager from: (a) entering into transactions, on behalf of the investment company, with certain affiliates of the investment manager (an investment manager under the ITA, trust companies/banks, securities investment advisers, real estate brokers, and real estate syndication agents (fudosan tokutei kyodo jigyosha)) if the transaction would benefit the customers of the affiliate and harm the investment company's interests; (b) entering into any transaction that benefits its affiliates and harms the investment company's interests; (c) if an affiliate of the investment manager is an underwriter of a securities offering, entering into transactions, on behalf of the investment company, that manipulate market price to influence the terms of such offering; and (d) making investments, or acquisitions, on behalf of the investment company, in securities offerings, real estate syndication offerings, tokumei kumiai interest offerings, trust beneficiary interest offerings or distributions that are undertaken by an affiliate of the investment manager where there is insufficient interest in the offering or distribution and the investment is being made to prop-up the offering or distribution.

Publicly traded J-Reits have also adopted voluntary rules to ensure that transactions with related parties of the investment manager are fair and are conducted on an arm's length basis. These rules include, with variations, the requirement to: (a) obtain an appraisal and to prohibit acquisitions above appraised value and dispositions below appraised value; (b) appoint an independent third-party professional that have veto rights with respect to related party transactions; and (c) obtain approval of the board of the investment company for any related party transaction.

To further these aims, on October 1 2006, the TSE amended its rules to clarify that it will conduct strict review of the sponsor, the degree of a J-Reit's dependence on its sponsor, dealings by the investment company with the sponsor and the internal mechanisms in place to ensure that dealings with the sponsor are fair, at arm's length, and consistent with the J-Reit's investment objective and policy. To this end, J-Reits will be required to submit, both at the time of the listing application as well as on a regular basis a Report Regarding Operational Structure, which will also be made publicly available. J-Reits will be required, through the Report, to provide detailed information regarding the sponsor, the relationship between the sponsor and the company's main unitholders and the major shareholders of the investment manager. In particular, if the sponsor group provides asset-sourcing support to the J-Reit, the J-Reit must describe whether or not the sponsor group and J-Reit could compete with respect to business opportunities, how these opportunities will be prioritized between the sponsor group and the J-Reit, and the selection criteria that will be adopted by the sponsor group when determining which business opportunity to introduce to the J-Reit. J-Reits must also provide in the Report details regarding transactions with the sponsor. In particular, with respect to acquisitions and dispositions with related parties, J-Reits must disclose the price, date, reason for the purchase/sale and the reason for determining that the price is fair and reasonable with respect to each and all transactions up the chain of title to the original transaction with a non-related party.

The TSE at the same time implemented other amendments to the listing criteria for J-Reits and its disclosure rules. The amendment: (a) redefines real estate and the percentage threshold of real estate that must comprise the total assets of a J-Reit for it to be eligible for listing; and (b) redefines the listing criteria and provides that J-Reits must make distributions to unitholders on a continuous basis (failure to do so for one year will trigger the J-Reit's delisting). With respect to disclosure, the amendments will require: (a) the investment manager to be jointly liable for disclosure (previously the obligation was imposed only on the investment company); and (b) the investment company and investment manager to enter into an advisory agreement with a securities company, for two years after the listing, to receive disclosure advice.

Growth strategies

Overseas assets

Most jurisdictions with Reits permit investment in overseas assets, but J-Reits cannot invest overseas. The ITA does not prohibit acquisition of overseas assets, but it requires an appraisal upon acquisition or disposition of real estate and practitioners are unsure how this appraisal should be made for overseas real estate. The July 2006 Final Report of the Real Estate Investment Market Sub-Committee of the National Land Development Council (the MLIT Report) recognizes the importance of enabling J-Reits to invest overseas so they are not competitively disadvantaged against Reits in other jurisdictions. It also highlights the importance of allowing J-Reits to have a more diversified and attractive portfolio (citing hotel Reits and logistics Reits as examples of Reits that may benefit from overseas diversification). The MLIT Report accordingly recommends that guidelines be formulated for appraisal of overseas real estate. However, TSE listing rules expressly exclude overseas assets from real estate in which a J-Reit may invest. TSE has expressed that it will appraise the possibility of overseas asset investment but has stated that this is unlikely to occur until issues relating to overseas assets such as appropriate appraisal standards and effective means to hedge against risks are addressed.

UpReit

UpReits (umbrella partnership Reits) have greatly contributed to the growth of Reits in the US, through their ability to allow real estate owners to defer taxation on capital gains upon transfer of assets to a Reit. The MLIT Report states that the introduction of capital gain deferral will help to revitalize the local economy in non-metropolitan areas of Japan. It would encourage existing owners of underused real estate to transfer their real estate to Reits and other proprietors, who are able to make more effective use of the real estate. The MLIT Report recommends that official consideration be paid to introducing Japanese UpReit taxation. The introduction of J-UpReits is still in its preliminary stage and amendments to the ITA are required to allow assets to be contributed in kind to J-Reits.

Reit M&A

The US saw much Reit M&A activity in the 1990s. As the number of publicly traded J-Reits increases and the market expands, M&A might also become an effective strategy for Japanese Reit growth. However, a J-Reit is externally advised, as opposed to US Reits, which are dominantly internally advised. Any M&A attempt will need to take into account the acquisition or replacement of the investment manager. The following factors will also need to be taken into account when considering J-Reit M&A: (a) acquisitions of investment companies may only be carried out through acquisition of units, and merger (stock-for-stock exchange and spin-offs are not available); (b) J-Reits will lose their tax transparency or pass-through treatment if they own more than 50% of shares or units in another corporation (including Reits) or if three or less of its unitholders hold, in aggregate, more than 50% of the units it issues; (c) the ITA prohibits J-Reits from holding more than 50% of the voting rights in another corporation; and (d) if an acquisition of units exceeds the one-third threshold, the units must be acquired through a tender offer bid. Merger will require two-thirds approval of unitholders, will require purchase of units from dissenting shareholders and will require that certain creditor protection procedures be complied with. So although there has been some market discussion regarding J-Reit mergers, there has been no publicly announced mergers to date and no public initiative has been designed to facilitate J-Reit M&A.

Author biographies

Naosuke Fujita O'Melveny & Myers Gaikokuho Kyodojigyo Horitsujimusho Naosuke Fujita is a partner and co-head of O'Melveny & Myers' Tokyo office. He is a member of the Asia practice group. His practice focuses on principal investments in non-performing loans and real estate assets; strategic mergers and acquisitions, corporate restructuring and work-outs; as well as non-recourse loans, securitization and related financing for these assets. Fujita worked as the core legal team member on the launch of the distressed asset business by Goldman Sachs in Japan, including the creation of investment structures and servicing platforms. He has been involved in ongoing investment activities in such assets as office buildings, hotels and non-performing loans, and related debt financing. In 2006, Fujita worked on the structuring, licensing, listing and IPO of the first J-Reit dedicated to hotel assets. Fujita received his BA degree in law from Waseda University School of Law in 1985, graduated from the Legal Training and Research Institute of the Supreme Court of Japan in 1987 and received his LLM degree from University of Michigan, School of Law in 1991. He is a member of Dai-ni Tokyo Bar Association. Noriko Sakai O'Melveny & Myers Gaikokuho Kyodojigyo Horitsujimusho Noriko Sakai is a counsel in O'Melveny & Myers' Tokyo office. Sakai focuses on financial law issues, in particular, real estate and non-performing loan financing, and trust law. She has profound experience in cross-border acquisitions, joint venture projects, and international litigation, including sovereign immunity disputes, government procurement complaints, and enforcement of arbitration awards pursuant to the New York Convention. In 2006, Sakai worked on the financing, listing and IPO of the first J-Reit dedicated to hotel assets. Before joining O'Melveny, Sakai worked at Nagashima Ohno & Tsunematsu and Paul Hastings, representing Japanese and foreign clients. Sakai received her BA degree in law from Sophia University. She graduated from the Legal Training and Research Institute of the Supreme Court of Japan in 1997 and received her LLM degree from Stanford Law School in 2002. She is a member of Dai-ichi Tokyo Bar Association.