M&A of J-Reits

Author: | Published: 1 Dec 2008
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Since the first listing of units of Real Estate Investment Trusts in Japan (J-Reits) on the Tokyo Stock Exchange (TSE) in September 2001, J-Reits have become widely accepted among investors as a new type of moderate-risk product with a stable return. Since then, the number of listed J-Reits has increased rapidly to 42. However, the J-Reit market became sluggish in the latter half of 2007 and declined sharply in 2008. The TSE Reit Index was at 857 points at the end of November 2008, dropping approximately 67% from its peak of 2,612 points in May 2007. Most J-Reits are now traded at a discount to net asset value. In addition, some J-Reit sponsors, especially emerging real estate developers, have also been severely affected by the global credit crunch since the second half of 2007. The refinance risk, which is inevitable for leveraged products with low liquidity assets such as J-Reits, is now seen as a realistic and serious problem. In fact, New City Residence Investment Corporation, the second largest residential J-Reit, filed a petition for civil rehabilitation proceedings (the first time for a J-Reit) in October 2008 and its units were consequently delisted from the TSE.

Structure of a J-Reit

An investment corporation commonly referred to as a J-Reit is a closed-end type structured collective investment scheme engaged in owning and operating real estate properties and their related assets under the Investment Trust Law. Under the Investment Trust Law, an investment corporation is not permitted to hire employees and is required to outsource most of its functions to external service providers. That is, the investment management function must be outsourced to a licensed asset management company, the asset custody functions must be outsourced to a custodian and certain other administrative matters must also be outsourced to external service providers.

An investment corporation must have one or more executive directors, supervisory directors (the number of which must be more than the number of executive directors) and a board of directors composed of executive directors and supervisory directors. A unitholders' meeting must be held at least once every two years for the election of directors. Also, an accounting auditor must be retained by the investment corporation. In addition, all J-Reits have one or more sponsors, although this is not a legal requirement. A sponsor typically acts as a promoter for the establishment of the asset management company or the asset manager, which in turn acts as a promoter for the establishment of the J-Reit, to which it provides asset management services. The sponsor also acts as a main supplier of properties to the J-Reit. In this manner, the sponsor's roles are crucial for the success of the J-Reit.

Another key feature of J-Reits is their tax status. A J-Reit is permitted to deduct distributions paid by it to its unitholders from taxable income for Japanese corporate tax purposes, subject to certain requirements. Such requirements are usually referred to as tax conduit requirements and include, among other things: (i) that more than 90% of the distributable income under tax regulations must be distributed by a J-Reit to its unitholders; and (ii) a J-Reit is not, as at the end of each fiscal period (normally a six-month period), a family owned firm (dozoku kaisha), meaning a firm of which more than 50% of its ownership is held by one unitholder and its affiliates. It is important for J-Reits to comply with the tax conduit requirements, as a failure to do so will lead to a significant decrease (by approximately 50%) in the amount of distribution to unitholders.

Possible M&A schemes

There are few methods available for J-Reit M&As because the schemes or measures that are commonly used in the M&A of ordinary corporations are not permitted in the context of J-Reit M&As. For example, corporate split (kaisha-bunkatsu), stock exchange (kabushiki-koukan) and stock transfer (kabushiki-iten) are not available for J-Reits. Also, J-Reits cannot issue class shares or rights under the Investment Trust Law. It is thought that the following are available or realistic schemes for the purpose of J-Reit M&As : (i) combination of acquisition of units of a J-Reit and shares of its asset manager; (ii) merger of two or more J-Reits; and (iii) acquisition of the whole portfolio of assets owned by a J-Reit. This article focuses on (i) and (ii). Regarding (iii), acquisition of the whole portfolio of assets is theoretically possible by entering into a sales agreement with a J-Reit. However, amendments to the articles of incorporation with respect to the investment policy will probably be necessary in order to incorporate provisions that will enable a J-Reit to sell all of the properties that it owns (which requires a super-majority vote at the unitholders' meeting). As at the time of writing, there is no precedent for this type of transaction.

Combination acquisition

An investor can take control of a J-Reit by acquiring its units, but that is not sufficient for an investor seeking to control a J-Reit's investment management function because it is mandatory that investment decisions are outsourced to the asset manager. For this reason, acquisition of shares of the asset manager will also take place. This combined transaction is used for the replacement of the sponsor or the participation of a new sponsor in addition to the existing sponsor.

Sponsor replacement

An investor may acquire units either by subscribing for new units to be issued or by acquiring existing units through market transactions or takeover bids (TOBs). All or most of the units would be acquired by subscribing for new units if the J-Reit needs additional money. It is common for the new sponsor and its group companies to acquire, in total, less than 50% of the aggregate outstanding units of the J-Reit for the purposes of complying with the tax conduit requirements. The asset manager, whose shares will be transferred from the current sponsor to the new sponsor, is a non-public corporation with a restriction on the transfer of its shares pursuant to its articles of incorporation. Because of this restriction, the investor cannot acquire shares of the asset manager without prior approval from its board of directors. Instead of acquiring shares of the asset manager, an investor with certain control over the J-Reit is able to switch the incumbent asset manager to another licensed asset management company that it owns by a resolution of the J-Reit's unitholders' meeting.

In addition, various transactions will be required to establish the new sponsor's control, which include changes in directors of the J-Reit and/or the asset manager, the execution of the sponsor support agreement, and amendments to the investment policy and other basic structures of the J-Reit and/or the asset manager. At the same time, the new sponsor often sells properties owned by it to the J-Reit.

There are two recent precedents that fall into this category:

  • LaSalle Japan Reit Inc (former eAsset Investment Corporation): the sponsor changed from Asset Managers to LaSalle Investment Management (November 2007).
  • Frontier Real Estate Investment Corporation: the sponsor changed from Japan Tobacco to Mitsui Fudosan (February 2008).
Additional sponsor participation

In this case, the additional sponsor often acquires a minority share in the asset manager without acquiring units of the J-Reit. When the additional sponsor becomes a shareholder of the asset manager, it is common practice for the current sponsor and the additional sponsor to enter into a shareholders' agreement for the purpose of coordinating their interests. Sometimes, the investment policy and basic structure of the J-Reit and/or the asset manager will be changed to incorporate the additional sponsor's investment philosophy. For this purpose, an agreement may be executed among sponsors to coordinate their interests.

The precedent transactions within this category are as follows:

  • Participation by CapitaLand in BLife Investment Corporation (February 2007).
  • Participation by GE Real Estate in LCP Investment Corporation (March 2007).
  • Participation by Morgan Stanley Group in Crescendo Investment Corporation (May 2007).
  • Participation by Sohgoh Real Estate Group in Premier Investment Corporation (March 2008).
  • Participation by Development Bank of Japan in Fukuoka Reit Corporation (May 2008).
  • Participation by OCM Netherlands Opportunities Coöperatief UA in re-plus residential investment inc (August 2008).
Special consideration in TOBs

In the transaction referred to above regarding re-plus residential investment inc, a TOB was carried out for the first time with respect to J-Reits. The board of directors of re-plus residential investment inc expressed an affirmative opinion towards the proposed TOB. Determining the kind of opinion they should express (affirmative, negative or neutral) is not a straightforward task for the board of directors of J-Reits. In light of fiduciary duties owed by each director to all of the unitholders, it is understood that the board of directors must take into consideration not only the price offered but also other critical factors including continuous listing in the market, compliance with tax conduit requirements and sufficient protection of interests of minority unitholders.

Hostile buyouts

Even though hostile TOBs against J-Reits have not yet occurred in Japan, a J-Reit whose units are traded at a deep discount to net asset value is subject to serious threats of hostile buyouts. In addition, there are limited defensive measures available in relation to hostile buyouts for J-Reits that cannot issue any class shares or rights. Assuming that the asset manager of the target J-Reit is not a publicly traded corporation, the acquirer must: (i) purchase units of the target J-Reit through market transactions or TOB; and (ii) call a unitholders' meeting to resolve: (a) the dismissal of directors of the target J-Reit; (b) the election of its own candidates; (c) the cancellation of the asset management agreement between the target J-Reit and the existing asset manager; (d) the approval of a new asset management agreement with the new asset manager controlled by it (which must be licensed); and (e) other matters necessary for the purposes of acquisition, such as amendments to the articles of incorporation or dissolution. Alternatively, the acquirer can submit the unitholder's proposal to such meeting to resolve items (b) to (e) at the unitholders' meeting called by the target J-Reit on a regular basis. However, the target J-Reit will lose its tax conduit status if the majority of the vote is held by one unitholder and its affiliates at the end of the fiscal period.


Because debt and equity finance are not realistic for J-Reits under recent market conditions, J-Reit mergers have been attracting particular attention as a strategy for growing portfolios, although at the time of writing there is no precedent for J-Reit mergers.

J-Reit merger procedures

Although two types of mergers (absorption and consolidation) are available for J-Reits, the absorption merger will usually be selected, as is the case in the mergers of corporations. The procedures for the merger of J-Reits are essentially the same as for corporations. Two or more J-Reits must enter into the merger agreement and the agreement must be approved by a super-majority vote (two-thirds or more) at the unitholders' meetings for each J-Reit. Moreover, certain disclosure procedures and creditor protection procedures must be adhered to. A dissenting unitholder may demand that the J-Reit purchase its units at a fair value. Assuming an absorption-type merger, the J-Reit to be absorbed merges into the surviving J-Reit and the unitholders of the J-Reit to be absorbed receive units of the surviving J-Reit on the effective date. However, if the number of units to be issued by the surviving J-Reit, upon merger, is within the number of authorised units, approval at the unitholders' meeting of the surviving J-Reit is not required. The Investment Trust Law does not impose any restriction on the number of authorised units, and the number of authorised units of the J-Reit is typically far larger than the number of issued units. Therefore, approval at the unitholders' meeting of the surviving J-Reit would not be necessary in virtually all merger transactions. In this case, the dissenting unitholders of the surviving J-Reit may not demand that their units be purchased, as opposed to the case of mergers of corporations.

In addition, the external service providers to which the surviving J-Reit outsources its functions following the merger (such as the asset manager) must be selected. For this purpose, the asset management agreement between the asset manager not selected as the asset manager of the surviving J-Reit following the merger must be cancelled with the approval by a majority vote at the unitholders' meeting. Alternatively, the asset managers of the J-Reits to be merged may also be merged with each other.

Merger consideration

The consideration for the merger is basically limited to the units of the surviving J-Reit under the Investment Trust Law. Accordingly, the cash-out merger that is available for corporations is not available for J-Reits. There is doubt regarding whether the surviving J-Reit can pay cash to the unitholders of the J-Reit to be absorbed, even for the purpose of adjustment of fractions under the Investment Trust Law. However, according to the proposed amendments to the regulations under the Investment Trust Law and the supervisory guidelines (which are undergoing public comment procedures as at the time of writing), the authority would permit cash payments upon merger for certain purposes, such as adjustment of fractions. This accomodation is expected to reduce practical difficulties regarding the merger of J-Reits.

Tax issues

One of the significant issues regarding the merger of J-Reits is the possibility of the recognition of negative goodwill and the amortisation of it under the tax regulations. In the present market situation, where the unit price is discounted to net asset value upon merger, the surviving J-Reit would be required to recognise negative goodwill, which must be amortised over five years unless the merger meets the requirements for a qualified merger under the tax regulations. If the merger is not a qualified merger, the surviving J-Reit would be required to substantially distribute all of the amortisation of negative goodwill following the merger in order to maintain its tax conduit status (although such amortisation is purely technical income that does not generate cash flow). In such a case, the surviving J-Reit would be forced to sell its assets or otherwise generate cash for distribution.

Also, if the J-Reit is to be absorbed, the period from the first date of the fiscal period of the merger to the date immediately before the effective date is deemed to be a tax period under the tax regulations. J-Reits cannot make any distribution for that period because it will be absorbed as of the effective date. Accordingly, the J-Reit to be absorbed cannot maintain its pay-through status for that period. A practical way to reduce tax for that period could be to shorten the period through an adjustment of the merger schedule or a change in fiscal period. However, a certain time period is necessary, after the close of the previous fiscal period, for the preparation and audit of the financial statements for the previous fiscal period and declaration of distribution.

Author biographies

Nobuhiko Shimose

Mori Hamada & Matsumoto

Nobuhiko Shimose is a partner at Mori Hamada & Matsumoto. His practice focuses on securities, finance and corporate transactions, particularly foreign investment trusts and J-Reits. He joined the firm in 1998.

Nobuhiko was educated at Hitotsubashi University (LLB, 1994), the University of Tokyo (LLM, 1996) and the University of Washington (LLM, 2003). He was admitted to the Japanese Bar in 1998 and the New York Bar in 2005. Nobuhiko worked at Sidley Austin in New York from 2003 to 2005.

Yasuhiko Fujitsu

Mori Hamada & Matsumoto

Yasuhiko Fujitsu is a partner at Mori Hamada & Matsumoto. His practice area focuses on corporate finance/capital markets and M&A transactions. He also has expertise in J-Reit transactions including domestic and global IPOs and other equity and debt finance.

Yasuhiko was educated at Waseda University (BA in economics, 1995) and the University of California, Davis (LLM, 2004). He was admitted to the Japanese Bar in 1999 and is also a junior certified public accountant in Japan. Yasuhiko worked at Debevoise & Plimpton in New York from 2004 to 2005.