Japan office market shines as beacon of hope despite BOJ policy scare

Japanese monetary policy, once reassuringly predictable, is now a source of uncertainty for global investors, yet Tokyo is a bastion of stability compared to many of the world’s leading office markets

Nicholas Spiro

Published: 3:45pm, 31 Jul 2023

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In sovereign debt markets, Japan is the wild card. On July 28, the Bank of Japan (BOJ) spooked investors by unexpectedly loosening its grip on the country’s tightly controlled government bond market.

While its decision to raise its cap on the country’s 10-year bond yield from 0.5 per cent to 1 per cent was a minor tweak, it revived speculation about a more drastic unwinding of the BOJ’s decades-long ultra-loose monetary policy, a shift that could have far-reaching consequences for global markets.

Yet, when it comes to commercial real estate – in particular the office sector – Japan is a rare source of stability and resilience. This is remarkable given the severity of the deterioration in sentiment towards office properties since the Covid-19 pandemic erupted.

Three successive shocks – the pandemic-induced shift in working practices that has crimped demand for office space, the dramatic rise in interest rates and the recent turmoil in the US banking sector that has fuelled concerns about a credit crunch – have fanned fears of an “office apocalypse”.

A hard-hitting report published by McKinsey on July 13 captures the scale of the problem. It predicts that demand for office space in nine “superstar” cities – which include New York, San Francisco, London, Paris and Tokyo – will be as much as 20 per cent lower in 2030 compared with 2019, and by as much as 38 per cent lower in a worst-case scenario. Depending on the severity of the downturn, the value of office properties in the cities surveyed will drop by 26 to 42 per cent by 2030.

McKinsey also draws attention to what is seen as the biggest source of vulnerability in the office sector: older, unrenovated buildings often in peripheral locations. In New York, the value of grade A buildings – newer, high-quality, sustainable properties suited to hybrid work – rose 3 per cent between 2020 and 2022 compared with an 8 per cent decline for grade B offices.

The front of an office building is seen in New York City on July 7. In New York, the value of grade A buildings rose 3 per cent between 2020 and 2022, compared with an 8 per cent decline for grade B offices. Photo: Reuters

Tokyo, on the other hand, fares relatively well in the study. Not only is it one of the least-affected cities in terms of the change in office demand by 2030, it also has among the lowest projected vacancy rate among the cities surveyed in part because of its “general resiliency against the pandemic’s effects”.

The strong performance of Tokyo’s office market partly reflects the resilience and appeal of offices in many leading Asian cities. While transaction volumes in the office sector in the United States and Europe plummeted between 2019 and 2022, they were fairly stable across the Asia-Pacific region.

This is mainly because Asia leads the world in office re-entry. The average office occupancy rate in 10 leading US markets this month was only about 50 per cent, according to Kastle. In the UK, average occupancy rates in the first half of this year stood at only 30 per cent, according to data from Remit Consulting. However, CBRE estimates average occupancy rates in Asia are just 10 to 15 per cent below pre-pandemic levels.

In Japan, idiosyncratic factors are at work. According to data from CBRE, the average vacancy rate for grade A offices in Tokyo in the second quarter of this year stood at 5.7 per cent, the second-lowest in the Asia-Pacific region. Last year, vacancy rates in all other leading Asia-Pacific markets were above 10 per cent.

Henry Chin, head of research for Asia-Pacific at CBRE, said Tokyo’s office landlords view a 5 to 6 per cent vacancy rate with a sense of foreboding, a level landlords in other leading office markets can only dream of. Just as importantly, Japan’s negative interest rates have left the spread between yields on real estate assets and the cost of debt in positive territory, providing a major fillip to the investment market.

Yet, the most important idiosyncrasy of Japan’s office market is the strong performance of grade B offices. In stark contrast to other leading office markets – particularly in the US and Britain, where a bifurcation of the sector is causing leasing and investment activity to be concentrated in the high-quality segment of the market – older and smaller buildings in peripheral locations are enjoying robust demand.

This is because their tenants are small and medium-sized enterprises. In Japan, these firms account for 99 per cent of all companies and employ almost 70 per cent of the workforce. Not only are their levels of hybrid working low, their real estate requirements are modest, resulting in a strong and durable source of demand for grade B offices.

The Bank of Japan head office in Tokyo on July 3. The Japanese central bank’s decision to raise the cap on Japan’s 10-year bond yield has sparked speculation that more unwinding of decades of ultra-loose monetary policy could be in store. Photo: Kyodo

Moreover, premium grade A buildings in Tokyo rarely come to market. High land prices and owners’ strong holding power make vendors reluctant to sell. Koji Naito, head of research, capital markets, at JLL in Tokyo, said “90 per cent of Japan’s office investment market involves grade B properties”. Tellingly, the vacancy rate for grade B offices in Tokyo is slightly lower than it is for grade A buildings.

This does not mean that Tokyo’s office market is a safe haven. Although grade B offices do not appear to be at risk, grade A-minus buildings – properties whose specifications fall short of grade A space but are superior to grade B buildings – are susceptible to a “flight to quality” as larger tenants opt to upgrade.

Furthermore, Japanese monetary policy, once reassuringly predictable, is now a huge source of uncertainty for global investors. Yet, compared to many of the world’s leading office markets, particularly in the US, Tokyo is a bastion of stability. Given how bleak sentiment towards offices is these days, that is no mean feat.

Nicholas Spiro is a partner at Lauressa Advisory

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