When KK daVinci Advisors, which runs Japan’s biggest private property fund, bought an office building in central Tokyo last year for Y200bn – the most ever paid for a property in Japan – observers called it an act of irrational exuberance.

After all, the exorbitant price meant daVinci’s capitalisation rate – operating income divided by sale price – for the building hovered at 2.6 per cent, compared with an average return of 4 per cent in Tokyo.

But today, with rents rising, a dearth of good office buildings for sale in Tokyo and prices appreciating, it seems daVinci’s enormous gamble might pay off.

“With sustained growth of corporate profits, and with business expansion and recruitment on the rise, demand for office space is increasingly strong while rents are rising steadily,” says Satoru Aoyama, analyst at Fitch, the ratings agency.

Recent property transactions in Tokyo have signalled an end to the asset deflation that dragged the nation’s economy into recession in the 1990s. Foreign investment banks that had scooped up cheap property in Tokyo in the late 1990s have been selling for a handsome profit.

“Funds are willing to pay 20-30 per cent more for a building compared with a year ago,” says Curtis Freeze, chairman of Prospect Co, the parent company of Prospect Asset Management, which invests heavily in real estate investment trusts (reits). “Rents are finally starting to rise due to a shortage of A-class buildings.”

The dearth of such office buildings in Tokyo has exacerbated competition between reits and private funds.

Figures compiled by CLSA Asia-Pacific Markets show assets under management at listed reits grew from Y1,300bn to Y5,400bn between 2003 and 2006. The Ministry of Land, Infrastructure and Transport says the value of securitised property, including reits and commercial mortgage-backed securities, hit a record Y27,000bn at the end of September.

A wave of liquidity may have helped the price rise: property companies and private funds have been buyers and pension funds and foreign investors have increased their allocations to property.

In particular, foreign investors have been borrowing cheap yen and buying reits since November. In 2006, foreign net purchases of reits grew 340 per cent on the previous year, to Y263bn.

Reit returns range from 2 to 4 per cent, compared with 1.6 per cent for newly-issued 10-year Japanese government bonds.

“The weak yen makes Japanese assets look even more undervalued to overseas investors,” says Yoji Otani, property analyst at Credit Suisse in Tokyo. “As long as the yen carry trade keeps growing, prices of real estate sector shares could rise further.”

In January, prices of reits hit record highs, highlighting investor confidence that rents would trend upward. Meanwhile, shares of leading property companies have reached levels not seen since the asset bubble era. Shares of Mitsui Fudosan, the leading property company, in February surpassed a high reached in December 1989, while shares of Mitsubishi Estate and Sumitomo Realty & Development reached lifetime highs in January.

“If the carry trade unwinds then reits will be very vulnerable – the recent rally has been driven by foreign institutions,” says Andreas Schuster, property analyst at CLSA Asia-Pacific Markets.

Recent valuations have raised concerns that the market is overheating. The Financial Services Agency plans a regulatory tightening on lending to real estate funds. The FSA said it had amended internal guidelines used in its monitoring of financial institutions to put a higher priority on risk assessment by banks and brokerages on managing loans to reits and other types of property funds.

Its report said that, at the end of September, Japan’s 11 largest banks had outstanding loans to property investment funds totalling Y6,600bn, a 30 per cent rise from the previous year.

But observers say that after more than a decade of asset deflation, regulators should embrace property price increases.“It is foolish for the government to try to restrict this recovery,” says Mr Freeze of Prospect. “The recovery of real estate markets is important for the recovery of Japan.”