Embattled Japan REIT sector may see uptick in M&A as result of tax changes

This article is provided to FT.com readers by mergermarket—a news service focused on providing actionable, origination intelligence to M&A professionals. www.mergermarket.com
--------------------------------------------------------------------------------------------------------

Changes in the way Japanese Real Estate Investment Trusts (J-REITs) account for their profits could kick-start consolidation in the embattled sector and lead to an increase in M&A, sources told mergermarket.

Among other consequences, the changes should free J-REITs from the burden of distributing profits that exist only on paper to their investors, and may also help J-REITs avoid capital gains tax resulting from M&A transactions.

Sources and market practitioners contacted by this publication all agreed that the changes would be welcomed by the embattled J-REIT sector, and that they could eventually lead to an uptick in M&A activity.

Chris Swift, a partner at Allen & Overy, estimates that up to one third of J-REITs are in financial difficulty or have distressed assets, with companies such as New City Residence already being forced into civil administration.

”Although there’s no real consensus on which parts of the market will be of interest to buyers, we have witnessed an immediate resurgence of interest in real estate assets,” he said. ”There’s also renewed interest from advisors on pitching for deals in the sector, which is usually a sign that deal heat will increase eventually. What’s less certain is the timing: it could be six, 12 or 18 months before we start to see deals coming through.”

On potential bidders in the sector, Swift declined to comment other than to note that Mitsui Fudosan has said it is not interested in acquiring J-REITs. In this case, the company ruled out any interest in bidding because the J-REITs that are for sale hold mostly distressed assets, and would need to be sold at a significant discount for any deal to be worthwhile.

Nick Walters, a director in the Financial Transactions and International Tax Services unit of Deloitte Touche Tohmatsu, meanwhile, describes the changes to J-REIT regulation as “exciting and positive,” with the potential to help the J-REIT market.

“Together [they] make it possible for there to be J-REIT mergers,” he says. “Before the changes there were too many risks and too many unknowns for companies to feel confident that mergers would make sense, which discouraged consolidation in the sector.”

He adds: “What is clear is that some of the less strong J-REITs would benefit from the synergies and access to capital that would be created through M&A. However, just because something’s possible it doesn’t necessarily mean it’s attractive.”

Daisuke Seki, CEO of J-REIT specialist consultancy IB Research and Consulting, agrees that the recent tax changes have helped prepare the ground for a “wave” of potential M&A deals in the J-REIT space and pointed to Nomura Real Estate Residential Fund, Advance Residence Investment, United Urban Investment and BLife Investment as potential acquirers.

He noted that the loan-to-value ratio (LTV) of Nomura Real Estate Residential Fund and Advance Residence Investment stands at about 60%, meaning they will be unable able to increase their debt any further. “They don’t appear to be in good shape for public offerings either… hence acquisitions appear to be the sole way for them to increase their size,” he observed.

On potential targets, Seki highlighted Nippon Residential Investment – sponsored by defunct property operator Pacific Holdings. Here one potential acquirer could be Nomura Real Estate Residential Fund, since it also focuses on residential property. Mitsubishi Estate also appears to be a leading candidate for the role of acquirer, according to Seki.

On the timing for potential deals, one possible trigger could be if the ailing J-REITs are able to redeem bonds that are coming due over the next few months, he said. Of these, J-REIT bonds issued by Nippon Residential Investment for JPY 6bn (USD61m) and JPY 12bn will be due in September and October respectively, while a bond by Crescendo for JPY 20bn (USD204m) matures in October.

“If they can’t find funds for redemptions, they will have to seek a possible acquirer to help them out,” said Seki. “Once this happens, it could affect other industry peers who are taking a ‘wait-and-see’ stance now. It could result in a rush to get along with others.”

The reforms outlined above were enacted by the Japanese financial services authority on 1 April, and among other things allow J-REITs to pay dividends to their investors based on their accounting income rather than on their taxable income. This should make it easier for them to qualify as “pass-through” entities, which are entitled to avoid paying a corporate tax rate in excess of 40%.

Deloitte Touche Tohmatsu’s Nick Walters, noted that a lot of the changes revolved around the “90% rule”, whereby J-REITs were obliged to declare 90% of any profits each year as a dividend to investors in order to qualify for tax beneficial status.

Following the recently enacted regulatory change, the 90% rule will now be based on accounting income rather than taxable income, a change in rules which frees J-REITs from the burden of potentially being obliged to distribute profits that exist only on paper to their investors.

One further change involves the way J-REIT M&A deals can qualify to avoid capital gains tax. Under previous guidelines laid down by the Japanese tax authorities, these so-called tax-free mergers would only be approved if the resulting post-merger entity complied with a number of specific criteria. One criterion, for example, was that a merged entity would need to retain 80% of employees from before the merger.

In practice, however, J-REITs have been unable to comply with many of these criteria because of the way they are structured. As an example, J-REITs typically have no employees and so cannot comply with the requirement to transfer a certain percentage of staff. As a result, legal and tax counsels were unable to sign off on tax-free merger proposals for J-REITs, which had the effect of discouraging potential mergers.

Since then, however, the Japanese FSA has asked the relevant tax bodies for clarification of J-REITs’ status under tax-free merger rules; with the result that the tax authorities have since made it clear that J-REITs can be treated as a special case and do not need to fulfill all the criteria to qualify for tax-free mergers.

When asked about industry consolidation, one source speaking off the record agreed with Seki above that weaker REITS – especially those holding residential assets – could be considered targets. However, he said that because of the “baggage” associated with weaker J-REITs, direct real estate investment rather than the acquisition of a J-REIT would often be seen as a more attractive option. A second industry source said he believed the Japanese FSA had been pushing for consolidation in the J-REIT sector, desiring companies with strong financial backing to merge with weaker companies in the sector.

This source pointed to the likely emergence of two clearly distinguished markets in the sector: “blue chip” J-REITs, such as Japan Real Estate Investment Corp, with a strong financial sponsor behind them (Mitsubishi in this instance) and J-REITs without strong financial backing “that are on the brink of going bankrupt.”

“The latter are ripe for the plucking and the Japanese FSA would like the ‘blue chip’ J-REITs to come along and swallow them up,” the source said.

--------------------------------------------------------------------------------------------------------

For more information or to inquire about a trial please email sales@mergermarket.com or call EMEA: + 44 (0)20 7059 6105 Americas: +1 212 686-5277 Asia-Pacific: +852 2158 9730