Author: | Published: 5 Jan 2004
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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.

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.


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
Tokyo 102-0094
T: + 81 3 3288 7000
F: + 81 3 5213 7800
Web: www.noandt.com