Since the amendment to the Law Concerning Investment Trust and
Investment Corporations of Japan (Law 198 of 1951) (the Investment
Trust Law) came into effect on November 30 2000, Japanese real
estate investment trusts (JReits) have been permitted in Japan. As
of December 5 2003, nine of these trusts have been listed on the
Tokyo Stock Exchange (TSE). At press time, according to a publicly
available prospectus issued by a JReit, another such trust was
expected to be listed on TSE by the end of 2003.
According to a specialist Japanese real estate magazine, the
aggregate value of the total assets of the nine listed JReits has
reached ¥1 trillion and each JReit continues to concentrate on
expanding the volume of its assets. Each JReit should increase its
asset volume by acquiring suitable properties, to maintain sound
growth of the JReit investment unit market. In particular,
attention must be given to the legal issues when selecting real
estate (that is, land and/or buildings) to be injected into JReits.
This article deals with these issues, focusing on the so-called
risk of avoidance as well as the function of private funds for the
expansion of JReits.
Selecting real estate
All of the existing JReits are of a low risk, low return type
intending to make stable distributions although a JReit could be
designed as a high risk, high return investment product. JReits
seem to have this characteristic because of the lower return ratio
of the investment products in general, certain regulations
concerning investment products (for example, bank deposits) and
other conditions surrounding the capital market in Japan. Also,
investors who purchase investment units in JReits are inevitably
include individuals unfamiliar with real estate or finance
transactions, and JReits have just a short history.
Being listed on one or more stock exchanges, investment units in
JReits are sold to the general public, as well as institutional
investors. JReit investment units are sometimes considered to be
one of the options for bank deposits and other low or medium-risk
investment products, but are not considered as a product similar to
stock also publicly traded (all the existing JReits mention in
their prospectuses their intentions to try to make stable dividend
distributions). Therefore, investors who purchase investment units
in JReits inevitably include individuals who are unfamiliar with
real estate or finance transactions or who have almost no
experience in investments with risks.
At this early stage of the history of JReits, the general public
is not familiar with the investment trusts or the nature of the
investment units of JReits that involve risks of real estate. It is
particularly difficult for such investors to understand the
complicated legal risks in relation to real estate purchased by
JReits even if all of them are fully disclosed. If a risk not fully
understandable to such individuals becomes a real problem and such
individuals suffer substantial losses, they may raise claims
against the JReit, its asset management company and the
underwriter.
Also, because of the short history of JReits, any trouble in
relation to real estate owned by such a trust could be confused by
the general public as trouble resulting from the JReit scheme in
general, rather than being identified as trouble in relation to the
particular real estate of the individual JReit.
Accordingly, the selection of suitable real estate to include in
a JReit investment portfolio is important not only for that trust
but also to ensure that the JReit investment unit market is
successful. Therefore, the parties involved in the formation and
operation of JReits (for example, licensed asset management
companies, originators (sponsors) and underwriters of investment
units in JReits) are sensitive to the risks involved in acquiring
real estate interests. Generally, JReits tend to be reluctant to
purchase real estate that: has title problems (including the risk
of avoidance); does not comply with the Building Standard Law, Fire
Service Law or other laws or regulations; has tenant lease
agreements problems; has low occupancy rates; has development
risks; and has complicated title structures, including
joint-ownership, condominium ownership or buildings on leased
land.
Before the JReit acquires real estate, the JReit asset
management company typically retains outside specialists (law
firms, accounting firms, tax advisers, real property appraisers,
construction companies and licensed real property brokers) to
review any significant risks or concerning factors in relation to
the real estate acquisition(s) from the view point of whether such
risks and factors can be adequately disclosed to and understood by
the general public.
Reviews by outside specialists are conducted on, among other
things, the seller(s) title to the target real estate, the chain of
title, ownership and usage right arrangements with respect to the
real estate, mortgages and other encumbrances existing on the real
estate, tenant lease agreements (if any), trust arrangement (for
entrusted real property), soil contamination, building, fire and/or
other regulation(s) compliance, boundary confirmation, and disputes
(if any) relevant to the real estate. One of the legal issues
focused on most frequently is the risk of avoidance by a bankruptcy
trustee of the seller(s) to a JReit or the previous seller(s) of
the real estate which is finally purchased by the JReit.
Risk of avoidance
Generally, if a seller sells real property to a JReit while the
seller is insolvent or the sale would cause the seller to become
insolvent, there is a risk that the sale may be characterized as a
fraudulent conveyance and invalidated by the bankruptcy trustee of
the seller.
Once a bankruptcy, civil rehabilitation procedure or corporate
reorganization procedure has begun with respect to the seller, and
if certain criteria are satisfied, the right of avoidance is vested
exclusively in a court-appointed bankruptcy trustee under the
relevant proceedings. The right of avoidance (if available) allows
a bankruptcy trustee to invalidate a sale, such as the sale of
land, that prejudices the creditors of the seller (which generally
means diminishing the financial resources available for payment to
general unsecured creditors of the seller where the seller does not
have enough assets to make payments of all its debts) and to
restore the property to the bankruptcy estate if the counterparty
of the sale, for example, purchaser of the land, is aware at the
time of the sale that the sale prejudices such creditors.
Avoidance vis-à-vis subsequent purchaser(s)
This
right of avoidance is enforceable not only against the direct buyer
who purchased the land from the bankrupt seller, but also against
subsequent purchaser(s) of the same property, if the subsequent
purchaser is aware at the time of purchase that the criteria for
the bankruptcy trustee to exercise the right of avoidance against
the party from whom the subsequent purchaser bought the land are
satisfied. This means that even if sellers or originators who sell
real estate to JReits maintain sound financial status (that is,
negligible possibility of bankruptcy), there still remains a
possibility that a bankruptcy trustee of a party who is in the
chain of title of the real estate sold to a JReit (most
importantly, a seller to the party from whom the JReit purchased
the real estate) can enforce its right of avoidance vis-à-vis
JReits.
Results of avoidance
If a sales transaction is
avoided by a bankruptcy trustee, the real estate sold by the
bankrupt seller will be restored to the bankrupt estate. In such
event, unless the purchase price has been deposited in a special
account or has otherwise individually been placed in separate
custody from the other assets of the bankrupt seller, the
purchaser's claim to demand return of the purchase price is
generally treated as a bankruptcy claim, ranking in the same
priority as claims held by general unsecured creditors. As such,
the expected level of collection through the relevant proceedings
will be far less than full recovery of the purchase price.
In the case of avoidance against a subsequent purchaser, the
subsequent purchaser may generally claim for the return of the
purchase price against the party from whom it directly bought the
real estate (the direct seller). In addition, if the purchase
agreement between the subsequent purchaser and the direct seller
contains a suitable provision, the subsequent purchaser is able to
claim against the direct seller for damages resulting from the
avoidance seller. Thus, if the direct seller's financial
credibility is at an acceptable level and the purchase agreement
has a suitable provision, this risk may be substantially
reduced.
Fair-price defence not available for real property
sale
Whether or not the sale of real estate at its fair
value constitutes a valid defence against attempts to avoid such
sale has been a controversial issue. A series of Supreme Court
judgments have denied the validity of the mere fair-value defence.
This means that even an arm's length transaction between unrelated
parties at fair value is not completely safe.
But court precedents say that if real estate is sold at fair
value and if certain other criteria are met, for example, the sales
proceeds being used for the payments of debts equitably to all
creditors, and the sales proceeds being used for the payment of
debts secured by the real property (as in the case of Chapter 7
bankruptcy proceedings), then the right of avoidance may not be
exercised.
Time Bar
The right of avoidance cannot be exercised
20 years or more after the time of the act in question (that is,
sale of the land) or two years or more after the start of the
bankruptcy or similar proceedings.
Magnitude of risk of avoidance in JReits
Because of
the nature of JReits as investment vehicles, in practice, even a
small risk of avoidance of the real property transaction might be
unacceptable for a JReit. This contrasts with the case of private
funds in which the number of investors is limited, and all of the
investors in the fund have enough experience and knowledge about
real property transactions. In the case of such private funds, with
full disclosure of the avoidance risk, the potential investors are
able to evaluate the magnitude of such risk, decide whether to
invest in the fund and provide the fund manager and other related
parties with consents and waivers of claims.
In the case of a listed JReit, its investment units are sold to
the general public, including individual investors who do not have
enough experience or knowledge to properly analyze and evaluate the
risks. Therefore, it is practically impossible to have all buyers
fully understand the risk of avoidance and to obtain informed
consents and waivers from them. In practice, underwriters of JReit
investment units and other JReit related parties are relatively
sensitive about the risk of avoidance.
In general, because the period of time during which the right of
avoidance can be exercised is long, this risk logically exists in
relation to most of the real estate purchased or to be purchased by
a JReit to a greater or lesser degree unless it is clear that the
JReit can evidence that the criteria to exercise the right of
avoidance cannot be satisfied. Because a substantial number of real
estate sellers have financial difficulties in Japan, unless this
risk is somehow reduced, the number and type of real estate
available for JReit portfolios may become limited. In cases where
the possible existence of such risk is recognized, thorough,
careful and practical review of the factual matters and the level
of risk of avoidance are conducted and any possible way to reduce
the risk should be carefully considered.
Function of private funds
Reasons preventing JReits from buying certain
properties
Because investment units in JReits are
purchased by the general public, the trusts tend not to purchase
real estate that contains substantial risks. Also, JReits are
legally prohibited from developing a real estate, meaning, for
example, a JReit cannot become a party to a construction agreement
by purchasing a building under construction and assuming the
construction agreement.
And the asset management companies for JReits need to carry out
comprehensive due diligence investigations on any candidate
property before making a decision to buy. Therefore, JReits refrain
from purchasing real estate from sellers who cannot give enough
time or materials for such investigations, even if the JReit
believes the real estate is unlikely to involve material risks.
This often happens with sellers who need to sell assets quickly to
make up losses before the accounting term end or with bulk sale
projects.
A financial reason sometimes prevents JReits from prompt
acquisition. Each JReit has its maximum loan-to-value ratio (LTV)
standard. If the purchase of real estate with debt finance would
result in the violation of the maximum LTV standard, the JReit will
need to purchase the property with new equity finance. But because
of the internal procedures and public offering procedures, it
usually takes several months to issue additional investment
units.
Opportunities for private funds
A number of private
funds are primarily investing in real estate in Japan. Some funds
are of a low risk, low return type intending to make stable
distributions like JReits. But other funds accept higher risks and
seek higher returns, to be realized by capital gains. Various
investors join this type of private fund, including rich families,
banks, insurance companies, annuity funds, other institutional
investors and foreign funds. Those investors have enough knowledge
and experience to analyze the risks associated with real estate and
to understand the impact of such risks. Therefore, if the risks are
adequately disclosed to such investors, some real estate that is
unsuitable for the investment portfolio of JReits is acceptable to
private funds for sophisticated investors. Further, in general,
private funds need less time to generate funds to purchase. These
funds have more flexibility as to the level of due diligence
investigations to be conducted and have no legal limitation
preventing them being a party to a construction agreement.
It is said that an increase in the number and size of JReits
will remove investment opportunities from private funds. But this
may not be the case. There exist opportunities for private funds to
purchase the real estate which JReits refrain from acquiring
because of any of the reasons described.
Further, because all JReits intend to expand their portfolio and
will continue to acquire properties, there may be opportunities for
private funds to purchase real estate that is initially
unattractive to JReits and make it attractive by curing the
problems and to sell it to JReits. This means from the JReits'
perspective, private funds may act as a source of real estate that
meets the JReits' requirements.
Curing risks
Some of the risks that prevent JReits
purchasing real estate can be cured or reduced to an acceptable
level with time, cost and good management.
As for the avoidance risk, depending on the circumstances, it
may be possible for a private fund to hold the real estate with
such risk until the right of avoidance is time-barred. Further, if
a private fund holds such real estate until the seller is
liquidated and loses the substance of a corporation, or until the
bankruptcy trustee cannot include such real estate in the
reorganization or rehabilitation plan, the avoidance risk can be
considerably reduced.
Some types of non-compliance with the Building Standard Law,
Fire Service Law or other technical restrictions can be cured, or
the associated risk can be considerably reduced by repair works.
Private funds may be able to lessen the cost of curing by careful
selection and management of the constructers and setting up
sophisticated arrangements among the relevant government agencies
and tenants.
In the case of jointly owned or condominium property, it is
possible to cure or substantially reduce risks by way of careful
negotiation with the other co-owners or the unit owners and
entering into suitable agreements.
In the case of real properties with tenant lease problems (for
example, tenants who have not paid rent for some time) or
threatened disputes relating to the real property, such problems
may be able to be solved by taking legal proceedings or through
negotiations.
Due diligence
A JReit needs to conduct an extensive
due diligence investigation before buying real estate and,
accordingly, it is difficult to purchase from sellers who seek
quick sales or who cannot provide enough materials to enable a
thorough due diligence. Private funds may have more flexibility to
deal with such types of sellers by entering into specific
arrangements (for example, reflecting such to the price, with a
holdback arrangement) and may be able to conduct investigations
after the acquisition of the real estate.
Generating funds to purchase real property
Private
funds may have an equity structure much more flexible than that of
a JReit.
Development
Private funds are not legally prohibited
from becoming a party to a construction agreement, and therefore
may be more flexible in buying real estate under development by
succeeding the relevant construction and other agreements. They
would subsequently be able to sell the completed real property.
Financial reasons
When, for financial reasons, a
JReit cannot buy certain property that matches the investment
criteria, a private fund can buy the property and hold it in
expectation of re-selling it to the JReit after the next public
offering, issuance of bonds or a new commitment line from
lenders.
Conclusion
It is expected that additional JReits will soon be set up and
listed on the TSE, and that each JReit will continue to buy real
estate. This should heighten the competition among JReits to
acquire real estate and also make the sources providing real estate
capable of meeting the JReits' investment criteria and timing
requirements increasingly important. Private funds are likely to
provide these important functions to the JReit market.
Author
biographies
Shunpei Tanaka
Nagashima, Ohno &
Tsunematsu
Shunpei Tanaka, a partner of Nagashima, Ohno & Tsunematsu,
is a graduate of the University of Tokyo (LLB 1986), the Legal
Training and Research Institute of the Supreme Court of Japan
(1989) and the University of Illinois, College of Law (LLM 1995).
Tanaka joined the then Nagashima & Ohno in 1989 and specializes
in a variety of international and domestic corporate transactions
with emphasis on real estate finance, investment, development and
other transactions, mergers and acquisitions, joint ventures and
licensing.
Kenji Utsumi
Nagashima, Ohno &
Tsunematsu
Kenji Utsumi, a partner of Nagashima, Ohno & Tsunematsu, is
a graduate of the University of Tokyo (LLB 1992), the Legal
Training and Research Institute of the Supreme Court of Japan
(1994) and the University of Pennsylvania Law School (LLM 1999).
Utsumi joined the then Nagashima & Ohno in 1994 and specializes
in real estate law, corporate law and pharmaceutical affairs
law.
Mami Ikebukuro
Nagashima Ohno &
Tsunematsu
Mami Ikebukuro, a special counsel of Nagashima Ohno &
Tsunematsu, is a graduate of the University of Tokyo (LLB 1986) and
the Legal Training and Research Institute of the Supreme Court of
Japan (1988). She practices in the areas of real estate finance and
securitization, structured finance, banking and mergers and
acquisitions.
Nagashima Ohno & Tsunematsu
Kioicho
Building
3-12, Kioicho
Chiyoda-ku
Tokyo 102-0094
Japan
T: + 81 3 3288 7000
F: + 81 3 5213 7800
Web: www.noandt.com