James Tervo

Real Estate Investment in Japan

A.Status of Title; Leases; Significant Security Deposits

  1. Title Registration

In Japan, title to real property is registered for purposes of perfecting title and providing public notice. Registration does not guarantee good title to the registered interest in real property,although it is the best evidence to establish a seller has title. There is no title insurance in Japan.It is Japanese practice for a purchaser to rely on the representations and warrantiesof a seller as well as the registration. Japanese law treats land and buildings as separate and distinct for ownership and title purposes.

  1. Means of Taking Title

Generally, real estate in Japan is held either in fee simple or in trust (though the trust structure is mostly utilized by professional real estate investors). In the latter case, a licensed trust bank owns the property pursuant to a trust agreement for the benefit of the holder (“Beneficiary”) of the trust beneficiary interest (“TBI”). Real estate is entrusted in Japan to: (i) eliminate transfer taxes (4%); (ii) avoid the application of Real Estate Syndication Law when a tokumei kumiai investment structure is involved; and (iii) utilize the real estate expertise of the trust bank that acts as trustee. Trusts are governedand regulated by Trust law, Trust Business Law and Act on Concurrent Business of Trust Business by Financial Institution(“Concurrent Business Act”).Therefore, one needs to consider not only the impact of Trust law but alsothat of Trust Business Law and the Concurrent Business Act before utilizing a trust. In addition, the general supervision guidelines of the Trust Company, etc. and the Trust Inspection Manual made by the Japan Financial Services Agency (“FSA”) should also be considered.To conduct business as a trustee, a license to operate as a Trust Bank, or alternatively a license from the FSA to act as a Trust Company under Trust Business Law is required. Only a stock corporation (“Kabushiki Kaisha”) which satisfies certain requirements can obtain a Trust Company license.

  1. Lease

a.Two Types of leases

A lessee of real property in Japan is governed by a number of Japanese laws including, the Land Lease and Building Lease Law of Japan (the “Lease Law”).

There are two types of property leases used in Japan. The first, is the so-called standard or typical lease (futsuu chintaishaku)(“Standard Lease”). The second is the fixed term lease (teiki tatemono chintai shaku). The principal difference between these two types of leases relates to the renewal provisions.

(i)Standard Lease: Although a Standard Lease has a term of two years, it is automatically renewed for an unspecified term under the existing terms and conditions unless the lessee does not desire to continue the lease agreement or the lessor has a "reasonable basis" to terminate the leaseunder the Lease Law. The rental rate for the renewal term is the fair market rental rate for the leased premises.

(ii)Fixed-termLease:An amendment to the Lease Law in 2000 has mitigated, somewhat, the effects of the Lease Law, by permitting the tenant of a fixed-term lease to waive the right to renew its lease. Automatic renewal will not apply if the lease is in writing, provides for a definite term with no right of renewal, and the tenant has received a written explanation of the non-renewal provisions before entering into the lease. The lease comes to an end on notice of termination if given at least six months but no more than one year before the expiry date.

b. Rent revision under a Standard Lease

With a Standard Lease, at the end of the two year term the rental rate is adjusted to the then fair market rental rate, anda lessor is entitled to request a rent increase and a tenant is entitled to request a rent decrease, subject to certain conditions. The following should be considered when revising the rent:

(i)Any increase or decrease in taxes or charges levied on the leased property;

(ii)Any increase or decrease in the value of the leased property, or any other change in the surrounding economic environment; and

(iii)A comparison of the rent for similar buildings located in the vicinity of the leased property to ascertain whether the rent remains fair and appropriate.

A notice received (usually given in the form of certified mail where a copy of the request is deposited at the post office as proof it was sent) by one party from the other of an intent to increase or decrease the rent is sufficient to give effect to such increase or decrease with immediate effect from the day such request is received by the relevant party. If, in the case of a rent increase, the tenant does not consent to the increased amount, the tenant is only required to pay an amount the tenant believes to be fair. In those circumstances a depository office will most likely be used (as described below) until such time that a court judgment determining the rent increase becomes final.If a dispute over a rent increase cannot be settled through direct discussions, the parties will need to determine the rent by either of the following procedures:

(i)Conciliation: A person who wishes to file a lawsuit in connection with a rent dispute must first file a petition for conciliation pursuant to the Conciliation Law. Once a petition has been filed, any person who has been summoned either by the court or the Conciliation Committee must appear on the specified date, and if the person fails to do so without a "justifiable reason", the person is subject to a fine. Although the parties are not obligated to reach agreement, if at any time after the filing of the petition for conciliation, both parties agree in writing to be bound by the terms of a conciliation agreement set forth and deemed fair and appropriate by the Conciliation Committee, then the dispute may be resolved by entering into such conciliation agreement.

(ii)Lawsuit:If the parties fail to reach agreement pursuant to the conciliation procedures, the parties may bring an action in court.

In the case of a fixed-term lease, one can avoid the rent revision in accordance with the above procedure by inserting the provision relating to rent revision in the lease agreement.

  1. Security Deposits/Key money

(i)Security Deposits (Shiki-Kin): Upon entering into a lease agreement, the tenant must deliver a security deposit to the lessor to serve as security for over-due rent and compensation for damages caused by the tenant. The residual amount must be refunded to the tenant upon surrender of the leased premises. The security deposit is likely to be equal to nine to twelve months rent and so responsibility for return of security deposits is a significant issue. The landlord is not obliged by law to segregate in a separate account or otherwise hold the security deposit, but may spend the money for any purpose.

(ii)Key money (Kenri-Kin): The lessor may also require atenant to pay “key money”as consideration forcertain benefits. In western Japan and some other regions the practice of requiring both security deposits and key money is not unusual. In principle, key money is not refundable even after surrender of the leased property, but rather is looked upon as consideration to obtain the lease.

(iii)Master Lease/Sublease:If property is entrusted with a trust bank, the trust bank does not ordinarily desire to enter into lease agreements with the end tenants or otherwise assume the role of a landlord. Similarly, the Beneficiary of the trust wants direct control of the property. Accordingly, in most instances the Beneficiary will cause the trust bank to enter into a master lease agreement with a master lessee. The master lessee then enters into the sublease agreements with the end tenants. The master lessee is often a special purpose entity and affiliate of the Beneficiary, with no net worth.

(iv)Consent Letter from End Tenants Waiving Responsibility to Return Security Deposits: At the time the master lease agreement is entered into, any existing lease agreements with end tenants may be transferred only upon consent by such end tenants. In the event the end tenants consent that only the master lessee will be responsible for returning security deposits, the Beneficiary and the trustee will be exempt from such responsibility and such tenants will only have rights against the special purpose master lessee which usually has no assets. It is common (although perhaps foolish) practice for tenants to sign these types of consent letters.

(v)Pass Through:Typically, where there is a master lease agreement, the master lessee fulfils its rent obligations by paying the trustee, in the form of a pass through, the amount of rent received from the end tenants.

  1. Lease Transfer

The owner can transfer the property to a third party without the tenant's consent unless otherwise agreed in the lease. The tenant, however, may not, without the owner’s consent, transfer its lease rights with respect to all or any part of the property to any third party unless otherwise agreed in the lease.

e. Limited Termination Rights of a Landlord

General contractual termination events that entitle the owner to terminate the lease include failure to pay rent, breach of contract and insolvency. Japanese courts, however, have restricted a lessor’s right to terminate the lease to cases where the tenant's breach is serious enough to destroy the trust relationship between the lessor and the tenant. Accordingly, a one-time failure to pay rent is unlikely to justify termination.

Tenants are typically given a right to cancel a lease by giving advance notice. In the case of a fixed-term building lease, however, the lease agreement typically prohibits a tenant from cancelingthe lease before the expiry of the lease term.Early termination by the tenant before the expiry of the lease term will usuallyresult in a penalty on the tenant in the amount equal to the rents corresponding to the remaining lease term as imposed by the terms of the lease.

B.Preferred Investment Structures for Foreign Investors

  1. TMK Structure and GK-TK Structure

The two most commonly used real estate ownership structures in Japan are: (1)the tokutei mokuteki kaisha(“TMK”) structure, and (2) the tokumei kumiai(“TK”) structure. An analysis and comparison of these two structures follows.

  1. TMK

A TMK is a special purpose corporate entity created by the Law Regarding the Liquidation of Assets enacted in 1998, as amended (“TMK Law”), for the purpose of providing a vehicle for securitization and liquidation of assets. However the use of the TMK Law has expanded beyond the original version of its drafters and today the TMK is the most attractive investment vehicle for large commercial projects. Investors in a TMK enjoy limited liability and the TMK can qualify for pass through tax treatment as described in detail below. Exhibits A and B show outlines of TMK structures.

  1. TMK Statutory Requirement

The TMK Law requires, among other things, that: (i) there be an Asset Liquidation Plan (approved by the local Finance Bureau of the Finance Ministry) prior to commencing business (including prior to such actions as signing a purchase agreement); (ii) there be a qualified asset manager, and (iii) all loans and bond financing must be from a Qualified Institutional Investor (“QII”).

  1. TMK Can Be a Tax Qualified Entity

In addition to compliance with the TMK Law, if certain tax requirements are followed, the TMK can deduct all dividends in determining net taxable income. These requirements include without limitation:

  1. One of the following financing conditions must have been satisfied: (i) the TMK has issued specified bonds that have an issue price of one hundred million yen (¥100,000,000) or more through a public offering, (ii) the specified bonds issued by the TMK have been subscribed by QIIs only, (iii) the preferred shares issued by the TMK have been subscribed by at least fifty (50) persons, or (iv) the preferred shares issued by the TMK have been subscribed by QIIs only;
  1. The placement of a majority of the TMK bonds and preferred shares issued by the TMK must be made within the territory of Japan within the definition of the applicable cabinet order (i.e., more than fifty percent (50%) of the TMK bonds and preferred shares must have been solicited in Japan);
  1. The TMK must conduct its business related to the liquidation of assets in accordance with its asset liquidation plan (“ALP”), and must not conduct any other business;
  1. The assets of the TMK must be entrusted to a trustee or management of the assets must be entrusted to a third party; and
  1. The amount distributed as dividends by the TMK for each fiscal year must exceed ninety percent (90%) of the income that is distributable as dividends, as interpreted under the applicable cabinet order, for such fiscal year.
  1. Domestic QIIs

Not only must the initial bondholder be a QII, but all subsequent holders of TMK bonds must also be QIIs. Although there is some ambiguity in the tax regulations, if the bondholder acquired the TMK bonds with the possibility to later securitize or otherwise transfer, then the almost unanimous view is that all holders of any securitization notes or beneficial interests (including participation interests) in the TMK bonds must also be QIIs. When the TMK Law was first enacted the list of institutions that qualified as QIIs was for all practical purposes limited to Japanese regulated domestic institutions,such as security brokers, banks, and insurance companies, that generally possess knowledge and experience in investing in securities, and are not considered to require the protection provided by the disclosure of public offerings.

  1. Qualifying a Foreign Investor asa QII

Over the past few years, the types of institutions that may qualify as a QII for tax purposes has been expanded on several occasions. Most significantly, aQII may be a foreign financial institution if it submitswritten notice to the Commissioner of the FSA,operatesone of the following businesses (individuals excluded) in foreign countries (such as the United States),is regulated under foreign law (such as being a regulated financial institution in the United States) and its total capital investment or funds, respectively, is the same or more as set forth as follows:

a.Financial instrument business (underwriting and other securities related business): Fifty million yen (US$500,000).

b.Investment management business: Fiftymillion yen (US$500,000).

c.Banking acceptance of deposits and loan or negotiation of promissory notes or drafts, or currency trades as defined in Banking Law: Two billion yen(US$20,000,000).

d.Insurance business including but not limited to life insurance and property insurance as defined in the Insurance Business Law: One billion yen(US$10,000,000).

e.Trust business as defined in the Trust Business Law (limited to those other than management type trust business as defined in the same): One hundred million yen(US$1,000,000).

The notice can be given in January, April, July or October and QII status becomes effective from March 1, June 1, September 1 or December 1, as applicable.

  1. Further Expansion of QIIs: the LPS and Other Asset-Based QIIs

An Investment Business Limited Liability Partnership ("LPS"),as defined in the law on Investment Business Limited Liability Partnership Agreement ("LPS Law"), can be a QII for TMK tax purposes. An LPS partnership must have a general partner, with unlimited liability, and must have a limited partner that owns approved securities of at least one billion yen (¥1,000,000,000) and meets certain other statutory requirements.

There is also a new category of asset-based QIIs. To qualify the entity must be publicly traded, make annualsecurities filings with the FSA, and hold approved securities with a value of at least ten billion yen (¥10,000,000,000) before applying for QII status for tax qualification purposes.

  1. TMK May Hold Real Estate in Fee Simple or Through TBI

A TMK can hold real estate in fee simple or through TBI under the TMK Law (Please see Exhibits A and B). The decision of whether to hold real estate in fee simple or through TBI is primarily based on financial considerations. There will be lower transfer taxes if the TMK holds the real estate through TBI, which savings will exceed the additional fees payable to the trust bank acting as trustee if the real estate is held through TBI. The Real Estate Syndication Law does not apply to a TMK structure, whether owning a TBI or owning real estate in fee simple.

  1. Collateral for TMK Bonds

TMK bonds are unsecured, except for a statutory lien (“ippan tanpo”). The bondholder may also enter into negative pledge agreements with equityholders, property trustee, asset manager, property manager, etc., which, upon an event of default, give the bondholder certain contract remedies to get title to the TMK’s assets and to take other remedial actions.

  1. The Alternative Ownership Structure: GK-TK

A TK is not a separate entity, but rather a contractual relationship between a TK Investor (tokumei kumiai-in) and a TK Operator (eigyosha) pursuant to which the TK Investor invests in the business of the TK Operator pursuant to a TK agreement between the TK Operator and the TK Investor. Althoughoften called a “silent partnership”, it is simply a contractual relationship. For real estate investments, the TK Operator, which owns the real estate, is usually not a stock company (kabushiki kaisha) (“KK”) but insteada Japanese limited liability company (goudou kaisha) (“GK”). The TK Operator exercises complete control over the business of owning and operating the real estate. The TK Investor is not permitted to engage in management of the business and is required to be a passive investor. All profits distributed to the TK Investor can be deducted for Japanese tax purposes as expenses of the TK Operator. In essence, the TK Operator serves as a pass through vehicle from the point of view of the TK Investor. The TK Investor’s liability is limited to the extent of its TK investment. Exhibit C shows an outline of a GK-TK structure.