Description

Ichigo Office REIT (“8975 JP”) trading at 14.5x FFO and a 5.6% dividend yield is a compelling investment as technical selling due to an index rebalancing has caused the share price to underperform peers.  Similar Japanese office REITs currently trade at 18.9x FFO and a 4.2% dividend yield, providing average upside of 32.9% to an investment in 8975 JP if it trades back in-line with peers. 

8975 JP’s historically strong trading correlation with peers broke this year as the TSE REIT Index transitioned from a market capitalization weighting to a free-float weighting and 8975 JP has the least float among all office peers (8975 JP has 64% free-float versus peers of 88% free-float on average).  This rebalance resulted in forced selling of 8975 JP by several Japanese REIT ETFs systematically at the end of each month between January 2017 and May 2017 (note the end of month volume spikes for 8975 JP beginning in January 2017).  As of the end of May 2017, this rebalance has officially concluded and we believe 8975 JP will shortly re-rate back to peer levels.

Business Overview:

8975 JP is a Japanese REIT focused on acquiring and leasing small to medium size office buildings, also referred to as Grade B offices, in Tokyo’s central business district.  It owns a portfolio of 85 buildings at a 98.6% occupancy rate and has increased its dividend for 15 consecutive periods.  Fundamentally, 8975 JP has been improving earnings and occupancy faster than most peers allowing them to grow their dividend at a faster rate as seen in the summary table above.  A lot of 8975 JP’s success since 2012 is due to its western style capital management driven by its sponsor, Ichigo Inc. (“2337 JP”). 

2337 JP is a publicly traded asset management company that places great emphasis on shareholder returns and best practices in corporate governance, as it strives to be among the top 200 of the JPX-Nikkei 400 Index (a Japanese “elite” index developed by the exchange to only include Japan’s most profitable and shareholder-friendly companies).  2337 JP is a rare breed in Japan in that its CEO Scott Callon is an American investor who has a clear understanding of ways to maximize shareholder returns. In addition, Ichigo Asset Management, a private investment fund managed by Callon, is the largest shareholder of 8975 JP with 22.5% ownership.  Callon made his name back in 2007, when he launched the first successful proxy solicitation in Japan and blocked the merger of Osaka Steel and Tokyo Kohtetsu as the deal massively undervalued Tokyo Kohtetsu.  He has since been a proponent for improving corporate governance and greater focus on shareholder value among the Japanese companies he invests in, as well as incorporating these philosophies in his own companies, including 8975 JP.

As 8975 JP represents significant strategic importance to both 2337 JP and Ichigo Asset Management, all Ichigo entities involved are strongly incentivized to protect the value of this REIT platform.  Based on our conversations with 8975 JP, getting their stock back to peer valuations is the main focus and they’re even considering options such as a stock buyback to help close the valuation gap. 

Tokyo Office Supply/Demand:

Japanese office REITs in general have had stagnant stock performance in the last 12 months, despite steadily improving occupancies and increasing rents.  Investors main concern has been an increase in new office supply in Tokyo’s central business district that is projected to come online in the next four years – Savills estimates an 11% increase in gross office supply (before demolitions) between 2017 and 2020 (http://pdf.savills.asia/asia-pacific-research/japan-research/japan-office/tokyo-office-supply-through-2020.pdf).  Historically, a new wave of office supply hits the Tokyo market every four to five years, and each wave typically drives down occupancy a few percentage points for a period of time, but has very little impact on market rents (see Graph 1 on page 2 of the Savills PDF mentioned above).  

We believe 8975 JP is relatively well positioned against the next supply increase given its small and medium sized office building focus.  We’ve individually analyzed each new development in the pipeline and, by our calculation, 93% of new offices (in terms of leasable area) in the next four years are Grade A and Grade S offices, compared to just 7% that are grade B.  This means that most of the occupancy pressure from new supply will be felt by existing Grade A and Grade S office buildings, as there will be very little migration from Grade B to Grade A or Grade S.  In the case of 8975 JP, the average leasable area of their central Tokyo office buildings is ~2,700 square meters, compared to an average ~103,000 square meters per building for the new Grade A and Grade S buildings.  More importantly, rent for these large offices are more than double the rent on 8975 JP’s properties on a per square meter basis.  Given 8975 JP’s tenants profile consists of mostly small and medium sized businesses (96% have 50 employees or less), most of which likely can’t afford to move into Grade A or Grade S buildings, 8975 JP’s portfolio should be well insulated from the increases in Tokyo Grade A and Grade S office supply.

Summary:

Trading at a substantial discount to peer valuations as a result of forced selling that ended in May 2017 and paying a 5.6% dividend yield with an incentivized management team to improve valuation, 8975 JP is a timely investment with a great risk-reward.    

Helpful Links:

Slide 66 of 8975 JP’s investor deck to see how stable Grade B office rents have been historically:  https://www.ichigo-office.co.jp/module/_newsPdfReit/501/IchigoOffice_20170614_Corporate_Presentation_ENG%20.pdf

Slide 48 of a peer investor deck also shows rents by asset class going back further: http://www.kdo-reit.com/file/en-term-14593990f34ec0cb5148131f805a63977983d446.pdf

Slide 42 of a peer investor deck confirms limited amount of Grade B office supply: http://www.nippon-reit.com/file/en-top-5e04fe7cfdb5935fad9ee575c7903055deb5c0f5.pdf

Catalyst

- forced selling ends

- potential buyback

- continued improved results