As Japan moves from a "world without interest rates" to a "world with interest rates, " our asset management environment has reached a major turning point: In March 2024, the Bank of Japan decided to lift its negative interest rate policy, and has since taken steps toward normalizing monetary policy by gradually raising interest rates. This historic change has not only had a familiar impact on the immediate environment, such as higher interest rates on deposits, but has also had a significant impact on the valuation of assets such as stocks, bonds, and real estate.
In particular, the "yield gap," an important indicator for real estate investment, has been shrinking as interest rates rise. This means that the assumption of "low borrowing rates," which has supported the profitability of real estate investment in the past, is collapsing, suggesting that conventional investment strategies may no longer be applicable. However, while change is a risk, it also creates new opportunities.
In this article, we at INA&Associates, Inc. will reveal the essence of this "world with interest rates" and thoroughly explain how we should deal with assets in this era of shrinking yield gap, specifically "assets to buy" and"assets to sell," from our perspective as real estate experts. This presentation will explain how we should deal with our assets in this era of shrinking yield gap. Let's learn together how to protect our assets in order to survive in this era of change.
The "world with interest rates" and the true nature of the yield gap
To properly understand the transition to a "world with interest rates," it is essential to understand the underlying monetary policy shift and the nature of the yield gap, a core indicator in real estate investment.
The Bank's Monetary Policy Shift: Why "Interest Rates" Have Now Moved
The Bank of Japan has maintained a massive monetary easing program for an extended period of time in an effort to escape from prolonged deflation. However, in response to the global inflationary wave and signs of rising wages in Japan, the Bank finally decided to make a major shift in monetary policy in 2024. This decision is an important signal that the Japanese economy has entered a new phase.
| Year/Year | Major Decisions | Trend in Policy Rate |
|---|---|---|
| March 2024 | Removal of negative interest rate policy | -0.1% → 0.0% to 0.1 |
| July 2024 | Additional interest rate hike | 0.0%-0.1% → 0.25% approx. |
| January 2025 | Another additional rate hike | 0.25% → 0.5% approx. |
This series of interest rate hikes will not only have a direct impact on the interest rates on our mortgages and business loans, but will also shake the very foundation of their valuation, as they serve as the "discount rate" for all assets. This is why the "world with interest rates" is of critical importance to investors.
Understanding the "yield gap," the compass of real estate investing
In a nutshell, the yield gap is an indicator that shows the difference between the profitability and the cost of financing available from a real estate investment. The formula is very simple, but its meaning is profound, and many professional investors place the highest importance on it.
Yield Gap = Yield on the subject property (cap rate) - Borrowing interest rate (long-term prime rate, etc.)
The cap rate (cap rate) is the net operating income (NOI) of the property divided by the property price, and indicates the property's intrinsic earning power. On the other hand, the borrowing interest rate is the cost of obtaining a loan from a financial institution. In other words, the larger the yield gap is, the more efficiently the borrower is able to generate income (leverage).
One of the major reasons why the Japanese real estate market has attracted the attention of investors around the world is that this yield gap has been sufficiently secured compared to other countries. However, as mentioned above, the current situation is that this advantage is beginning to waver as borrowing rates rise.
Impact of the Shrinking Yield Gap on Real Estate Investment
Rising interest rates, in theory, directly compress the yield gap. So how does this affect the real estate market? We will reveal the mechanism based on data.
The Current State of the Yield Gap as Seen in the Data
The following table shows the recent trends in interest rates, real estate cap rates, and the yield gap. It can be seen that while interest rates have risen, cap rates have remained mostly flat or declined slightly, resulting in a steadily shrinking yield gap.
| Period | Long-term government bond yield (A) | Office cap rate (B) | Yield Gap (B-A) |
|---|---|---|---|
| End of 2022 | Approx. 0.4 | Approx. 2.8% Approx. 2.4 | Approx. 2.4 |
| End of 2023 | Approx. 0.7% Approx. 2.7% | Approx. 2.7% Approx. 2.0% | Approx. 2.0% Approx. 2.0% |
| End of 2024 | Approx. 1.0% Approx. 2.7% | Approx. 2.7% Approx. 1.7% | Approx. 1.7% Approx. |
| October 2025 | Approx. 1.5 | Approx. 2.7 | Approx. 1.2% Approx. 1.2% |
(Note) Figures are approximations for clarity. For actual figures, please refer to reports by various research institutions.
What this data shows is the stark fact that the "income from interest rate differentials" that investors used to enjoy is smaller than before. This means that even if one invests in a property with the same yield, one's residuals will decrease by the amount of the interest rate increase.
Two Reasons Why Real Estate Prices Do Not Fall Even When Interest Rates Rise
The conventional textbook explanation is that "when interest rates rise, real estate prices fall. However, this is not necessarily the case in the current market. Particularly in central Tokyo, prices have remained high or even continued to rise. There are two main reasons for this seemingly contradictory phenomenon.
The first reason is "rising rents. As the economy recovers and inflation rises, office rents and residential rents are on the rise. Recall the cap rate formula (net revenue ÷ property value). If rents (net revenue) rise, the cap rate will rise even if the property price remains the same. This rise in rents offsets the upward pressure on the cap rate (= downward pressure on prices) caused by rising interest rates, and as a result, real estate prices are maintained or even rise.
The second reason is the "attractiveness of Japanese real estate from the perspective of foreign investors. Major European and U.S. countries raised interest rates significantly ahead of Japan. As a result, the yield gap in many countries has shrunk to an extreme or even turned negative (reverse yield) in many cities. In comparison, Japan's yield gap, although it has narrowed, remains in positive territory and is seen as a relatively attractive investment destination. This strong foreign investment money is supporting Japanese real estate prices.
However, this benefit is increasingly limited to prime properties in central Tokyo, where rents are expected to rise and where foreign investors are likely to invest. We believe that the polarization of the real estate market will further increase in the future, as properties in rural and suburban areas are unlikely to see rent increases and may be directly affected by the negative impact of rising interest rates.
Assets to Buy" and "Assets to Sell" in a World with Interest Rates
In a "world with interest rates," where the yield gap is shrinking and the relative merits of different assets are changing, asset selection will become even more important than before. Rather than investing in the dark, it is necessary to optimize portfolios by assessing their resistance to the changing environment of rising interest rates.
Asset Strategy for the Entire Portfolio
First, it is important to understand how the major asset classes - real estate, equities, and fixed income - fare in the face of rising interest rates. The following table summarizes the general resilience of each asset class.
| Asset Class | Impact on Rising Interest Rates (Short-term) | Characteristics and Considerations |
|---|---|---|
| Real Estate | △ to 0 | Polarization is progressing. While rising rents can offset the effects of good properties in central Tokyo , it will be difficult for properties in rural areas. High borrowing ratio puts pressure on earnings. |
| Stocks | Decrease | Shading by sector is clear. Financial stocks will benefit from the tailwind. On the other hand, growth stocks with high P/E ratios are likely to sell off due to higher discount rates. |
| Bonds | ×x | Prices and interest rates have a seesaw relationship. When interest rates rise, existing bond prices fall. Long-term bonds are particularly affected. |
| Cash and deposits | x | Directly benefit from rising interest rates. However, their real value will diminish if they fall below the rate of inflation. |
Based on these characteristics, this section explains what specific assets should be included in the portfolio and what should be revised.
Assets to Buy
In a phase where interest rates are rising and inflation is rising simultaneously, the key words are "income" and"inflation resistance.
1. prime real estate in urban areas
Real estate that is least susceptible to the effects of rising interest rates is prime real estate in central Tokyo, where rents are expected to rise. In areas with strong economic activity, tenant demand is solid and rents can easily be raised. This enables them to absorb the increase in borrowing rates and maintain a stable yield gap. In addition, the asset value itself is resistant to inflation, making it effective as both a defensive and offensive asset.
2) High Dividend and Value Stocks
In the stock market, high-dividend stocks with a stable earnings base and high dividend yields and value stocks whose share prices are undervalued compared to their business value are more advantageous than growth stocks that are bought based on expectations of future growth. Rising interest rates increase a company's borrowing costs, but companies with sound finances and ample cash flow are strong enough to weather the effects and continue to pay stable dividends. Dividends are a valuable source of income during inflationary times. 3.
3. floating-rate and short-term bonds
Bonds are generally vulnerable to rising interest rates, but floating-rate andshort-term bonds offer relatively low risk. Floating-rate bonds improve profitability during periods of rising interest rates because their interest rates fluctuate with rising market interest rates. In addition, short-term bonds with short maturities have limited risk of price declines due to interest rate fluctuations. Incorporating these bonds is an effective strategy for increasing portfolio stability.
Assets to Sell (or Assets to Be Cautious About)
On the other hand, we should consider selling or reducing the ratio of assets that are directly exposed to the headwind of rising interest rates.
1. income-producing real estate in rural and suburban areas
The flip side of assets to buy, properties in rural and suburban areas, where rent increases are unlikely and vacancy risk is high, are directly affected by rising interest rates. If rents cannot be raised while borrowing rates rise, the yield gap will narrow, and at worst, the risk of falling into "reverse mortgages (taking out)" will increase. Since exit strategies (selling) may also become more difficult, it is wise to review your portfolio before market conditions deteriorate. 2.
2) High PER Growth Stocks
Growth stocks with high growth potential and high price-to-earnings ratios (P/E ratios) are particularly vulnerable during periods of rising interest rates. This is because the discount rate (interest rate), which is the denominator in evaluating a company's stock price by discounting future profits to present value, rises. High-tech companies with losses and no current profits need to be especially careful.
3. long-term fixed-rate bonds
Long-term fixed-income bonds issued when interest rates were low are among the assets most at risk of price declines when interest rates rise. For example, if you are holding a 10-year bond with a 1% interest rate and market interest rates rise to 3%, you will be forced to significantly reduce the price of your existing bond if you attempt to sell it because it is less attractive than newly issued bonds. Although the principal will be returned if the bond is held to maturity, the opportunity cost and price volatility risk until then are very high.
Summary: Asset Protection Techniques for a New Era that Sees Change as Opportunity
In this article, we have focused on the impact of the transition to a "world with interest rates" on our asset management, particularly the phenomenon of a narrowing yield gap. In closing, I would like to reiterate today's main points.
- The Bank of Japan's monetary policy shift has brought an end to the era of low interest rates, and the assumptions on which assets are valued have changed dramatically.
- Shrinking yield gap: As interest rates rise, the yield gap, which indicates the profitability of real estate investments, is shrinking. As a result, it has become difficult to secure income with conventional investment strategies.
- Polarization of the real estate market: Even with rising interest rates, prices of prime urban properties are likely to remain stable as rents rise, while regional properties face a difficult situation, further polarizing the market.
- Importance of asset selection: In a rising interest rate environment, it is essential to assess the resilience of each asset. It is necessary to restructure portfolios by identifying "assets to buy" (e.g., urban real estate, high-dividend stocks) and "assets to sell" (e.g., regional real estate, growth stocks).
The advent of a "world with interest rates" is uncharted territory for many investors and may seem risky. However, from a different perspective, this is also an opportunity to correct market distortions and identify quality assets at the right price. Speculative methods that rely on excessive leverage are no longer acceptable, and the time has come for the intrinsic value of assets to be questioned.
At this turning point, it is more important than ever before to construct an optimal portfolio that matches your asset situation and risk tolerance by utilizing the knowledge of trusted professionals. As real estate professionals, we at INA & Associates, Inc. are committed to helping each and every one of our clients protect their assets and create value. If you have any concerns or questions about your asset strategy, please feel free to contact us.
Frequently Asked Questions
Q1: Is it dangerous to start investing in real estate?
It is not generally dangerous. What is important is "property selection. As explained in this article, prime properties in central Tokyo that are less susceptible to rising interest rates and where rents are expected to rise remain attractive investment targets. On the other hand, investment in regional properties relying on easy leverage is more risky than before. The key to success is to carefully examine properties after consulting with an expert.
Q2: What should I do with the properties I already own?
First, we recommend that you accurately simulate the income/expense situation of your property holdings and the impact of future interest rate hikes. If the property has little room for rent increases and the cash flow is likely to deteriorate due to rising interest rates, one strategy is to consider selling the property while market conditions are buoyant. On the other hand, if the property is in good condition, there is no need to sell it in a hurry. Take it as a good opportunity to review your entire portfolio.
Q3: What will happen to variable mortgage rates in the future?
It is highly likely that variable mortgage rates will gradually increase in line with the Bank of Japan's policy interest rate hike. However, competition among financial institutions is fierce, so a sharp increase is unlikely. It is important to check your household cash flow and make sure that you will be able to repay your loan even if interest rates rise by a certain degree. If you are uncertain, consider refinancing to a fixed rate as an option.
