Japan

Author: | Published: 3 Apr 2003
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The Law Concerning Investment Trusts and Investment Corporations of Japan (Law No. 198 of 1951, as amended) (Investment Trust Law) which came into effect on November 30 2000 provides for the creation of Japanese real estate investment trusts (JREITs). The Investment Trust Law provides for two types of JREIT investment vehicles - the investment corporation and the investment trust. The purpose of both vehicles is to permit the investment of funds into real estate and real estate related assets. As of February 28 2002, six JREITs were listed on the Tokyo Stock Exchange (TSE), all structured as investment corporations.

This paper deals only with JREITs in the form of investment corporations, unless otherwise indicated.

JREITs have the following main features:

  • they invest primarily in real estate and real estate related assets, including investing in beneficial trust certificates of real estate. Until November 2000, real estate was not a permitted primary investment under the Investment Trust Law;
  • the corporate governance of JREITs is constituted by its board of directors and supervised by its equity holders at meetings that must be held at least every two years;
  • the real estate investment business of JREITs must be out-sourced to asset management companies and certain other third parties;
  • conflicts of interest are restricted by the Investment Trust Law;
  • regulators supervise JREITs and asset management companies;
  • JREITs are in effect tax pass-through entities for taxable income purposes and may utilize other tax benefits with respect to acquiring and holding real estate;
  • JREITs are listed on the TSE if they are closed-end JREITs. No open-end JREITs can be listed on the TSE; and
  • JREITs are subject to the reporting requirements under the Investment Trust Law, and if listed on the TSE, the disclosure requirements under the Securities and Exchange Law and TSE listing rules.

Regulations

Supervision by regulators
Investment corporations must be registered with the Financial Services Agency (FSA) before commencing any investment activities, and are subject to the reporting and inspection requirements of the FSA and local financial bureau. The Investment Trust Law prohibits an investment corporation from placing any restrictions on the transfer of its units.

Mandatory delegation of management
Under the Investment Trust Law, an investment corporation must delegate the functions for the custody and management of assets and general administration. The investment corporation must delegate the management of its assets to a party licensed by the FSA as an asset management company, and a party licensed as a real estate broker and discretionary real estate investment manager by the Ministry of Land, Infrastructure and Transportation under the Real Estate Brokers Law of Japan.

Fiduciary duty of the asset management company
The Investment Trust Law provides that an asset management company has a fiduciary duty of loyalty to its investment corporation and must exercise its duties in good faith. In the event that an investment corporation incurs losses or damage as a result of a breach of these duties, the asset management company will be liable. The Investment Trust Law also specifically prohibits: (i) transactions between investment corporations managed by the same asset management company, except in certain specified circumstances; (ii) transactions under terms that differ from ordinary transactions that are contrary to the interests of the investment corporation; (iii) an asset management company acting for the benefit of third parties and not for the investment corporation; (iv) an asset management company acting for the benefit of related parties (being either those that control, or are controlled by, the asset management company) or customers at the expense of the investment corporation; and (v) an asset management company, directly or through a third party, compensating the investment corporation for losses arising from transactions involving the asset management company.

Conflicts of interest
Certain conflicts of interest may arise in transactions between investment corporations managed by the same asset-management company or transactions between an investment corporation and its asset management company.

Capitalization of the investment corporation
JREITs in the form of investment corporations are required to maintain a minimum amount of net assets at all times. The exact amount is prescribed in each investment corporation's articles of incorporation; provided that such amount must be at least JPY50 million ($402,000). Investment corporations are required to promptly notify the FSA if their net assets are likely to fall below JPY100 million. If the investment corporation's net assets fall below JPY50 million and remain below this threshold for three consecutive months after notice from the FSA, the regulator can revoke the investment corporation's registration.

An investment corporation is not permitted to make distributions if it will cause its net assets to fall below JPY100 million.

An investment corporation is required to establish a surplus contribution reserve under certain circumstances prescribed by the Investment Trust Law.

Financing of the investment corporation
An investment corporation may, with the approval of its board of directors, issue additional units from time to time to increase its capital. Unit holders have no pre-emptive rights in relation to an offering of new units. An investment corporation may, by a resolution of its board of directors, issue corporate bonds up to the amount specified in its articles of incorporation, and in accordance with the Investment Trust Law and the Commercial Code of Japan.

Rights of unit holders and corporate organization

The organization of an investment corporation consists of (i) general meetings of unit holders; (ii) a board of directors consisting of executive director(s) and supervisory directors; and (iii) an independent auditor. A unit holder holding one or more units is entitled to one vote for each unit held. The voting rights of unit holders apply to, among other things (i) the appointment and dismissal of the executive directors, supervisory directors and independent auditors; (ii) the approval and termination of the asset management agreement; (iii) the consolidation of units; (iv) mergers and dissolution; and (v) an amendment to the articles of incorporation and any other matters so required by the Investment Trust Law or the articles of incorporation. In addition, unit holders have the right to receive dividends, institute derivative actions, inspect books, make submissions to unit holders' meetings and convene general meetings of unit holders.

The board of directors of an investment corporation consists of executive director(s) and supervisory directors. An investment corporation must have at least one executive director and at least one more supervisory director than the number of executive directors. Executive directors are authorized to represent the investment corporation and to carry out its functions. The supervisory directors supervise the performance of the executive directors' duties. Investment corporations must appoint an independent auditor (which must be a certified public accountant or a recognized accounting firm) by resolution at a general meeting of unit holders. The independent auditor is responsible for preparing an audit report following the end of each fiscal period.

An investment corporation may (i) consolidate units upon resolution of the general meeting of unit holders; or (ii) split units into a greater number upon resolution of the board of directors. In the case of a closed-end investment corporation, unit holders are not entitled to demand that the investment corporation redeem or repurchase any units.

Legal considerations regarding acquisitions of real estate in Japan

Due diligence for JREITs
Real estate and real estate related assets are the main investment targets of JREITs. Asset management companies for JREITs are required to conduct a certain level of due diligence on the target real estate either by themselves or by retaining outside specialists, and to obtain additional relevant information for the purpose of informed investment decision-making by the board of directors of the investment corporation. Before an acquisition of real estate by a JREIT, a typical due diligence team would consist of:

  • a law firm for legal matters;
  • an accounting firm for accounting matters;
  • a tax adviser for taxation matters;
  • a real estate appraiser for the valuation of the real estate;
  • a construction company for building and environmental related matters, especially regarding aseismatic structures and earthquake resistance; and
  • a licensed real estate broker or other specialist for other matters related to site inspection.

An asset management company is required to report the results of the due diligence to the JREIT, including disclosing the appraised value of the target real estate. It is likely that the JREIT will acquire the real estate for a price equal to or less than the appraised value in the report provided by the real estate appraiser, unless there is specific justification to acquire the real estate at a higher price.

The due diligence conducted by the law firm usually covers various legal matters relating to real estate, such as title searches, review on risk of fraudulent conveyance, mortgages and encumbrances, tenant agreements, property management and other relevant agreements, licenses and permissions, and disputes.

Legal issues relating to the acquisition of real estate
The following due diligence topics are of particular importance in relation to real estate acquisitions in Japan:

Title
In Japan, a real estate registration system records title as well as certain other forms of title-rights, such as certain types of leaseholds or mortgages and other security interests over real estate. However, registration does not necessarily create title and other rights over real estate and the relevant land register does not necessarily reflect the true title or right of holders. Nonetheless, the land register remains the best indicator of title and related rights, and parties intending to enter into real estate transactions in Japan usually rely upon it. Protection from lack of title may be a prescription of title rights, requiring 10 or 20 years. Accordingly, a title search would be required to establish a chain of past owners. No title insurance practice exists in the Japanese real estate market.

Risk of fraudulent conveyance
If a seller sells 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 would be characterized as a fraudulent conveyance and set aside. Even where the purchase price represented fair value, Supreme Court judgments have set aside the sale by the insolvent seller as a fraudulent conveyance. Because of the nature of a JREIT as an investment vehicle, even a small risk of setting aside the real estate transaction might be unacceptable for a JREIT as a matter of practice.

Tenant lease
Building leases in Japan are usually for a relatively short term (commonly two years) and are subject to automatic extension, unless either party provides advance notice of termination.

However, under the Land Lease and Building Lease Law, unless a tenant lease agreement expressly provides that the term of the lease is for a fixed term and that no renewal is available, the non-renewal provision of the lease is usually restricted. On the other hand, building leases typically contain a provision allowing for termination by the lessee before the expiry of the term upon six months' prior written notice. To avoid these situations, it is advisable for tenant lease agreements where the JREIT is the lessor to be prepared in a form of a fixed term lease without any early termination right by tenants. However, in practice, such fixed term lease agreements are less attractive to existing or potential tenants.

Upon the execution of a building lease, the lessee usually provides a security deposit (shiki-kin). Under Japanese case law, the obligation to return the security deposit is automatically assumed by the transferee of the leased property. This means that where a JREIT acquires a building, for which the lessor previously received security deposits, the JREIT will automatically assume the liability to return such security deposit to tenants in the future.

Generally, under the Land Lease and Building Lease Law, any party to a valid building lease may be entitled to demand that the rent be increased or decreased as market conditions change, irrespective of any provision in the lease agreement. If the parties cannot come to a mutual agreement after such a demand is made, a court may order an adjustment to the rent. If the court determines that the rent should be decreased, the lessor will be ordered to return any excess rent previously collected, together with interest at a rate of 10% per annum on the excess amount. In terms of a fixed term lease where both the term and amount are fixed, the rent is not subject to this adjustment.

Trust arrangement
JREITs are permitted to acquire beneficial interests in real estate trusts. Under the Trust Law of Japan (Law No. 62 of 1922, as amended), a trustee has a statutory preferential right to collect its fees, expenses and any damages relating to a trust out of the trust assets. The trustee also has the right to retain possession of the trust assets after the underlying trust agreement terminates or expires, until any outstanding fees, expenses and damages are paid in full. In addition, the underlying trust agreement usually gives the trustee the right to dispose of the trust assets if the fees, expenses and damages are not paid after the lapse of a specified grace period. The trustee's rights need to be disclosed to investors and other related parties to the JREITs as a risk not involved in the scheme of non-trust arrangements.

Taxation

JREITs are subject to Japanese corporation tax so long as the JREIT is formed as an investment corporation. However, JREITs may, pursuant to the Special Taxation Measures Law, deduct dividends paid to its investors from its taxable income if the JREIT complies with certain criteria, such as paying in excess of 90% of its taxable income as dividend in each fiscal period. In such cases, taxable income of JREITs so distributed as dividends are not subject to corporation tax. This means that JREITs may in effect be a tax pass-through entity in terms of such taxable income. In addition, some taxes applicable to the acquisition and holding of real estate are charged at a reduced rate if JREITs can satisfy certain criteria.

Certain tax benefits for individual investors may be introduced in Japan as from April 2003, favourable to the growth of JREITs.

Legal reform may produce other challenges for JREITs, such as Umbrella Partnership REITs (UPREITs), which are not yet permitted under the Investment Trust Law. UPREITs in the US can issue units upon and in exchange for the acquisition of real estate as equity contribution in-kind from a seller directly. If the UPREIT system is adopted and the tax deferral of realized capital gains of sellers of real estate is permitted in Japan, then this may encourage potential sellers to sell real estate to JREITs.

Tokyo Stock Exchange listing requirements

The TSE introduced its listing rules for units of JREITs in March 2001. The rules provide that, at the time of listing: (i) JREITs must be structured as either closed-end investment corporations or closed-end investment trusts; (ii) the number of units must be at least 4,000; (iii) the expected number of unit holders must be at least 1,000 (excluding the 10 largest unit holders); (iv) the 10 largest unit holders must own 75% or less of all of the outstanding units; (v) the total assets, aggregate net asset value and net asset value per unit should be at least JPY5 billion, JPY1 billion and JPY50,000 respectively; (vi) at least 75% of the total assets must be invested or must be expected to be invested in real estate and real estate equivalents; (vii) more than 50% of the total assets must be invested or must be expected to be invested in real estate that generates or is expected to generate stable income and not planned to be sold within one year; and (viii) JREITs must operate in compliance with the JREIT rules of the Investment Trusts Association of Japan.

Item (vii) means a JREIT will not satisfy TSE listing requirements if more than 50% of the real estate that the JREIT acquired or expects to acquire is not able to generate income because of development or otherwise. Accordingly, JREITs cannot be involved in development-type real estate transactions where income is not generated at the time of acquisition or soon after in excess of 50% of the asset value.

Conclusion

Many industry commentators believe that a greater number of real estate properties in Japan will be put up for sale, mainly because of the financial burdens facing many restructuring Japanese corporations that are planning to sell non-essential assets, including real estate, and because of the expected introduction under Japanese GAAP of asset impairment accounting policies on real estate.

These factors may provide an opportunity for the use of JREITs in the coming years. However, these commentators also argue that the year 2003 problem may cast a shadow over the Japanese real estate market. Reportedly, the so-called year 2003 problem is associated with the large number of AAA building projects that are scheduled to start commercial operation in Tokyo in or around 2003. Excessive competition and high occupancy rates, if any, could seriously affect the number of JREITs in future years. Even though JREITs face a changing future, it is safe to assume that JREITs will continue to be an effective investment vehicle for years to come.


Nagashima Ohno & Tsunematsu
Kioicho Building,
3-12 Kioicho,
Chiyoda-ku
Tokyo 102-0094
Japan
Tel: +81 3 3288 7000
Fax: +81 3 5213 7800