https://www.wsj.com/articles/SB89309938856520500　

By Nicholas E. Benes　　　April 21, 1998 12:01 am ET

TOKYO–In the fast-paced world of real-estate investment and loan sales, Japan is beginning to feel something like an emerging market. The atmosphere here in the world’s second-largest economy is a bit like Berlin when East German assets were being privatized, or Mexico City in 1990, when Wall Street’s biggest names were brokering deals in the breakfast rooms of the best hotels. Famous U.S. institutions have investment budgets of more than $20 billion targeted for Japan, and are bidding aggressively. For the first time in years the smell of risk-taking is in the air.

Recent major-league deals range from purchases of single buildings, such as Goldman Sachs’ acquisition and immediate securitization of Yamato Mutual Life’s headquarters (at a 5% “cap rate,” or how much a property yields per annum) to acquisitions of property portfolios, such as Morgan Stanley’s purchase from Daikyo of some 1,200 condominiums (at an 8% cap rate). There have also been transactions of large loan portfolios, often collateralized by real estate, such as the sale by Nippon Credit Bank of loan portfolios totaling roughly $2.2 billion at about 10% of face value.

In addition to sheer financial necessity, the main reason for the accelerating pace of transactions is that Japan’s almighty Ministry of Finance has finally admitted that burying the huge amounts of distressed loans weighing down Japan’s balance sheets will not solve the problem. The MoF has effectively instructed banks to recalculate their bad loans–this time with more honesty–and start writing them off. The ministry has also slowly begun to clarify the tax deductibility of write-offs from bulk sale and securitization deals, albeit six years too late.

These policy changes, combined with the so-called Big Bang reforms and the need to meet the capital ratios established by the Bank of International Settlements, mean that Japanese financial institutions now have more incentives and ways to shrink their balance sheets. Certainly, innovative securitization techniques would help the banks replace other sources of funding that are becoming increasingly costly.

Early bird–or “vulture,” depending on your perspective– investors have recognized this trend and begun flocking in. They are betting that real-estate and loan markets have bottomed out. And, in a classic “virtuous cycle,” their migration here increases the probability that their investments will pay off. The restructuring process itself also holds the promise of big fees. If they can build an experienced team early, foreign firms reason, they can cash in on services which are currently in short supply or nonexistent.

But given the lack of domestic investors getting in on the game, one can’t help but wonder whether the Japanese firms know something the foreign firms don’t. Are recent transactions being priced at the right level? Has the market really bottomed out? It depends. The odds are quite high that rent-generating real-estate investments will produce abnormally high returns. Loan portfolio acquisitions, however, are a bit more “iffy” and depend on the fine details of a deal.

Take, for instance, the Morgan Stanley deal mentioned earlier. The portfolio of condominiums that Morgan Stanley purchased from Daikyo yielded close to 8%–more than five times the rate of long-term Japanese government bond yields, which are now hovering at a yield of about 1.55%. Normally, real-estate cap-rates trade at levels near or below long-term bond yields, because the market adds a premium to the price to account for the expected future capital gains. But the inverse is now occurring in Japan.

Because an oversupply of real estate looms large, domestic investors are implicitly discounting future capital losses. As a result, Morgan Stanley is most likely getting a peach of a deal. The condominium market appears to be picking up, but even if it dips or is sluggish for the next few years, Morgan can just sit back and enjoy a yield which is five times JGBs and three times corporate bond yields (a proxy for Morgan’s funding cost). If it wants, it can even swap the 8% yield into a dollar yield, which is likely to be near 20% or more.

Purchases of Japanese loan portfolios present much more complex issues. Many portfolios contain a significant proportion of what the selling banks consider to be “worthless” loan assets. These assets suffer from one or more of the following characteristics: (a) second, third or even lower mortgage rights; (b) no current interest payments; (c) few or no tenants; and (d) the possibility of yakuza (gangster) ties.

In most cases, a buyer will have to wait two or more years before a public auction for this type of asset will take place. During this time no interest payments will be made. In the worst- case scenario, the first mortgage holder might take all the value away from the property before auction, especially if the real-estate market remains weak. In most portfolios under discussion, assets like these are mixed together with a modicum of “good” (or at least, better) assets, resulting in a positive yield overall. The banks bundle these assets with others because they would rather receive some cash for them than write them down to zero and still be forced to continue with the collection grind. To the bank, the value of these assets is infinitesimal compared to the magnitude of their total assets and the other problems they face.

Foreign investors purchasing portfolios such as these do not have any magic formulas to speed collection processes or evict undesirables. That said, in most cases their investment strategies do not require them. Depending on the details and the long-term direction of the market, they may still be making very good trades, even if they include “worthless” assets. Essentially, they are buying “options” at low prices in a market that can be expected to exhibit extreme volatility, which greatly increases the possibility of big payoffs on the upside. It is no coincidence that some of the largest option traders, such as Cargill and Bankers Trust, are among the early participants.

Savvy investors know that when assets are priced at 10% to 15% of face value, the odds are in favor of a positive return, and the best returns from the loans that pay off might be on the order of 600% to 1,000%. While volatility on this sort of loan paper is high, mathematically this is likely to benefit them more on the upside than it can possibly hurt them on the downside.

For instance, suppose the seller of a 1 billion-yen loan values the core real estate at 20% of face value, and only attributes 50% probability to being paid out because it is a second mortgage waiting for payoff after a 3 billion-yen first mortgage. To discount for this risk and the carrying costs, the investor might buy the loan asset at 10% of its face value. If and when the economy picks up and the collateral real estate is worth twice what it was valued at the time of the sale, the probability of being paid out might increase towards 100%. In this scenario the value of the loan will be closer to 100% of face value. This would imply a simple return of 1,000%, even though the property has merely risen to a level which is perhaps 40% of its value during the “bubble” economy. It is important to note, however, that in the same scenario, the investor might lose its entire investment if the loan in question is a third, fourth, or lower-level security claim. This would imply a return of negative 100% on that loan (but note, it can’t get worse than that). Clearly, the details matter a great deal.

Early birds can expect to get fat when domestic institutions begin entering the market in a major way. Given the amount of money that domestic institutions have, this is inevitable. In the long-run, however, transactions such as these are paving the way for the re-emergence of market pricing for corporate finance in Japan. Close on their heels are private equity and M&A transactions, which are also beginning to pick up. Since many Japanese companies are trading at less than their liquidation value and have huge holdings of real estate and equities, many can be viewed as prepackaged securitizations or bulk options sales just waiting to happen–and at very attractive prices. Such transactions will be available to those investors who have the know-how, global-market position, or products needed to overcome Japan’s formidable corporate governance hurdles and win the hearts and minds of management on these sensitive issues, thereby unlocking further value.