The Real Estate Law Review: Japan
Introduction to the legal framework
i Ownership of real estate
The basic ways in which real estate can be held are either holding ownership title to real estate directly or holding a beneficial interest in a trust that holds title to real estate in connection with large-scale commercial investments.
Land and buildings are considered separate and independent real estate. Therefore, one person can hold the title to land while another person can hold the title to a building on the land. When different persons own a building and the parcel of land upon which the building is located, the two owners will typically enter into a contract such as a land-lease agreement where the building owner is permitted to use the land.
Joint title to real estate, which is governed by the rules under the Civil Code, is one form of title that can be held by multiple persons. Condominium title to a condominium that is part of a building, which is governed by both the rules under the Condominium Law and by the Civil Code, is another form of title that can be held by a single person separately from other condominium owners of the building.
Trust beneficial interests in real estate are typically issued when a real estate owner places the real estate in a trust. The trustee holds title to the real estate placed in the trust. The owner, on the other hand, holds a trust beneficial interest that represents a contractual relationship with the trustee under a trust agreement. Under this, the beneficiary may instruct the trustee to administer and manage the real estate in the trust and to distribute profits earned from the real estate (after deducting costs and expenses for administration and management of the real estate). Trust beneficial interests are used for various reasons, including delegating administrative duties from the beneficiary to the trustee and deferring taxes related to real estate transfers by transferring the trust beneficial interests instead.
ii System of registration
Ownership title and other property rights with respect to real estate are typically registered in the real estate registry maintained by local registration offices. Trustees are typically the registered owners of real estate that is placed in trust. The general rule is that transactions including the sale and purchase of real estate and creation of a mortgage on real estate take effect upon execution of agreements between the parties, and that no formalities are required; however, the holder of ownership title or other property rights with respect to real estate must have its interest registered in the appropriate real estate registry to assert its rights against a third party. This means that generally, to perfect a right over real property, there must be a valid agreement between the parties and the right must be registered in the name of the holder. The registration is governed by the Real Property Registration Act.
While registration of a real property right in the name of a certain person does not necessarily mean that the person actually holds the registered right, registration is usually considered strong evidence. Neither the local registration office nor the government guarantees the accuracy of the real estate registry. A registration in the real estate registry only reflects and records the transactional activities that private persons described in their applications for registration.
iii Choice of law
In the context of a cross-border transaction, choice of law rules are provided in the Act on General Rules for Application of Laws. Under the Act, if the subject matter is a property right or other registrable right in real estate, the law of the jurisdiction in which the real estate is located shall be the governing law; on the other hand, under the Act, the governing law of a contract can be chosen by the parties thereto. Despite the Act permitting the parties to choose the governing law of the contract, parties usually choose Japanese law as the governing law of a sale and purchase agreement with respect to real estate located in Japan because property right in real estate is governed by Japanese law.
Overview of real estate activity
Japan has developed various innovative real estate investment structures during the past few decades.
The GK-TK structure and the specified-purpose company (TMK) structure are frequently used in real estate investment transactions. Japanese real estate investment trusts (J-REITs) have made it possible for investors with smaller amounts of capital to invest in real estate through the purchase of listed J-REIT securities. The listed J-REITs have become major players in the Japanese real estate investment market through the use of the accumulated capital of investors, and the flow of capital through listed J-REITs into the real estate investment market has contributed to the overall growth of the real estate industry.
The increase in flexibility offered by such investment structures has resulted in a greater influx of domestic and foreign capital into Japanese real estate. The response to demands from an increasing number of participants has made the real estate investment market more sophisticated and attractive, and many investors consider the Japanese real estate market to be an important focus in their global investment strategy.
After the governmental pension fund's adoption of the Principles of Responsible Investment in 2015, and announcement to commence investments using ESG (environmental, social and governance) index as a benchmark in 2017, there has recently been a growing emphasis on the ESG factors in the Japanese market, including the real estate market. Growing number of investors into Japanese real estate market have started to realise that the value of real estate that considers ESG factors is increasing and will increase, and even listed J-REITs have started to publish their policy regarding ESG and obtain ratings from evaluating organisations.
There are no direct restrictions on acquisitions of commercial or residential real estate in Japan by foreign investors, either directly or through a vehicle. Similarly, establishment of a corporation by foreign investors to invest in commercial or residential real estate is not restricted.
Under the Agricultural Land Act, an authorisation by the relevant authority is required to acquire certain agricultural land. This authorisation can only be granted if the purchaser is qualified as a farmer or a qualified corporation for owning agricultural land. It would not be easy for foreign investors to be granted such an authorisation.
After a foreign investor's acquisition of real estate, a post-transaction report to the government authority may be required pursuant to the Foreign Exchange and Foreign Trade Act (FEFTA). A post-transaction report of payment or receipt of payment may be required in the case of cross-border payments or payments between a foreign investor and a Japanese resident in accordance with the FEFTA.
Structuring the investment
When choosing an investment structure, the legal, accounting and tax implications must be considered, because each can be a driving factor for the choice. The most popular structures and investment vehicles used for real estate investments in Japan are the GK-TK structure, the TMK structure and the J-REIT.
i GK-TK structure
A limited liability company (GK) is one type of corporate entity under the Companies Act. In some respects, it is similar to an LLC in the United States; however, it is not itself a pass-through entity for tax purposes. When a GK is used as an asset investment vehicle, typically an investor leverages its investment by third-party loans and makes its own investment in the GK through a contractual anonymous partnership (TK) arrangement. The TK arrangement is a bilateral (not multilateral) contractual partnership relationship created for the investment purposes by the TK interest holder, called the TK investor. The other party to the contract is called the TK operator. Under the GK-TK structure, the TK operator is the GK. A TK arrangement qualifies for favourable tax treatment if the TK investor is a passive investor with minimal control over the management of the GK and the contributed funds under the arrangement. If the TK arrangement qualifies, the GK is permitted to deduct distributions to the TK investor from its taxable profits in addition to deducting debt payments. This tax-efficient combination of a GK and a TK arrangement is called a GK-TK structure.
Typically, a GK-TK structure has been used to make investments in trust beneficial interests in real estate, and loans backed by real estate. If a GK holds real estate directly, by raising funds from TK investors, it will generally be subject to a licensing requirement under the Act on Specified Joint Real Estate Ventures (ASJREV). Therefore, the GK-TK structure has usually been structured to invest in trust beneficial interests in real estate, not in real estate itself. An exemption from the licensing requirement under the ASJREV allows the GK-TK structure to invest in real estate itself if certain requirements are met.
A GK-TK structure that is used to invest in a trust beneficial interest in real estate will subject the GK to the strict registration requirement under the Financial Instruments and Exchange Act (FIEA), unless an exception applies. One of the exceptions available under the FIEA is the QII exemption, which essentially requires that:
- there is at least one qualified institutional investor (QII) under the FIEA among the TK investors;
- the number of non-QII TK investors (if any) is 49 or less (non-QIIs are limited to certain categories, which includes a foreign corporation);
- none of the TK investors is a disqualified investor as described in the FIEA; and
- the GK, as the operator of the TK arrangement, files with the relevant governmental authority a notification regarding the QII exemption.
Another exception available under the FIEA is the exemption by outsourcing to a registered discretionary investment manager. Under this exemption, the GK retains a registered discretionary investment manager (a 'registered financial instruments operator' under the FIEA) as its asset manager to manage its trust beneficial interest in real estate on a discretionary basis. This exemption requires, among others, that:
- the GK enter into a discretionary asset management agreement with the registered discretionary investment manager that authorises the manager to make a discretionary investment decision on behalf of the GK on its trust beneficial interest in real estate;
- the TK agreement provide that under the asset management agreement described above, the GK authorises the manager to make a discretionary investment decision on its behalf on its trust beneficial interest in real estate;
- the TK agreement provide an outline of the asset management agreement described above, including the fees (or the fee arrangement) to be paid to the asset manager from the assets managed under the GK-TK structure;
- both the TK agreement and the asset management agreement described above provide certain duties of the asset manager, such as the asset manager's duty of loyalty and duty of care of a prudent manager, both owed to the TK investor in carrying out the investment management of the trust beneficial interest in real estate held by the GK;
- the GK manage its assets of the GK-TK separately from its own assets (and its other investment assets managed for other investors, if any) and the asset manager supervises such separate management; and
- the asset manager file with the relevant authority a notification of the outsourcing by the GK prior to the GK entering into the TK agreement.
ii ASJREV structure
GK-TK structures may, provided certain requirements are met, directly invest into real estate without the GK (the TK operator) having to obtain a licence or registration.
The 'special venture' GK-TK structure available under the ASJREV essentially requires that:
- the GK must be established for the sole purpose of distributing proceeds and profits from transactions related to the subject real estate;
- the GK as the TK operator must delegate the management of transactions related to the subject real estate to a licensed operator of 'specified joint real estate venture' or registered operator of 'small-scale specified joint real estate venture' to conduct the management activities pursuant to the ASJREV;
- the GK as the TK operator must delegate the solicitation of TK investments into the TK operator by the potential TK investors to a licensed operator of 'specified joint real estate venture' to conduct such solicitation activities pursuant to the ASJREV. The licensed or registered operator must also be a registered operator of 'type II financial instruments business' under the FIEA to conduct such solicitation of the TK investments, which are regulated as securities under the FIEA;
- the TK investors must be limited to 'special investors' (or professional investors), which includes licensed operators of 'specified joint real estate venture' under the ASJREV, real estate brokers approved to conduct transactions for the clients on a discretionary basis under the Real Estate Brokerage Business Act, real estate investment advisers registered under the Real Estate Investment Advisor Registration Regulations, professional investors under the FIEA, and stock companies with stated capital of ¥500 million or more, if the GK as the TK operator is to conduct development of land as a site for buildings, construction of a building, or repair or renovation of a building, the cost of which exceeds (1) 10 per cent of the value of the subject real estate, in the case that the asset manager retained by the GK is a licensed operator of 'specified joint real estate venture' or (2) ¥100 million, in the case that the asset manager is a registered operator of 'small-scale specified joint real estate venture';
- the agreement between the GK and the licensed operator of 'specified joint real estate venture' or registered operator of 'small-scale specified joint real estate venture' as described in (2) above must stipulate certain items specified under the ASJREV; and
- the GK must submit a notification to the relevant authority as the operator of a 'special venture' before commencing its business under the TK arrangement.
Another GK-TK structure available under the ASJREV (the 'venture only for qualified special investors') is a structure where the TK investors are limited to 'qualified special investors' (or 'super professional investors'), which includes licensed operators of 'specified joint real estate venture' under the ASJREV, real estate brokers approved to conduct transactions for clients on a discretionary basis under the Real Estate Brokerage Business Act, discretionary real estate investment advisers registered under the Real Estate Investment Advisor Registration Regulations and certain types of 'qualified institutional investors' under the FIEA. To use this structure, the GK as the TK operator is required to submit a notification to the relevant authority as the operator of a 'venture only for qualified special investors' before commencing its business under the TK arrangement, but it is not required for the GK to retain a licensed operator of 'specified joint real estate venture' or registered operator of 'small-scale specified joint real estate venture' as its asset manager or distributor.
The foregoing GK-TK structures under the ASJREV can enjoy certain preferential tax treatment such as reduction of registration and licence tax, and real estate acquisition tax.
iii TMK structure
A TMK incorporated under the Act on the Securitization of Assets (ASA) is another type of corporate entity often used as a real estate investment vehicle. This entity may only be used to liquidate or securitise certain assets. This investment platform is used to make investments in real estate, trust beneficial interests in real estate, and loans and TMK bonds that are backed by real estate. A TMK is typically funded by issuing TMK bonds and preferred shares that meet certain tax qualifications required for the preferential tax treatment of the TMK. If a TMK, its bonds and its preferred shares are properly structured, and the TMK meets certain other requirements under the Tax Code, it is permitted to deduct distributions to the preferred shareholders from its taxable profits in addition to deducting debt payments.
One of the requirements for the preferential tax treatment is that its TMK bonds be purchased by an institutional investor or other similar person or entity (a Tax II or equivalent investor) as defined in the Tax Code. Certain QIIs under the FIEA and certain other QIIs meeting additional requirements fall under the definition of a Tax II or equivalent investor. One of the important steps in setting up a TMK structure is to find a TMK bondholder that is a QII and is a Tax II or equivalent investor.
When using a TMK structure, it is also important for the TMK to comply with strict regulations under the ASA. These regulations include a requirement to file an asset liquidation plan with the relevant governmental authority. The asset liquidation plan of a TMK outlines how its assets are to be liquidated or securitised. A TMK structure requires close attention to be paid to the regulations regarding the asset liquidation plan.
A J-REIT is a type of investment fund formed under the Act on Investment Trusts and Investment Corporations (AITIC). A J-REIT established to invest in and manage real estate assets uses investors' funds to purchase real estate assets, in return for which investors receive investment units. The investment units of a J-REIT can be listed and traded on the stock exchange. If a J-REIT's investment units are listed, the J-REIT must comply with the rules of the stock exchange in addition to the AITEC. Under the AITEC, a J-REIT must retain an asset management company (a registered financial instruments operator under the FIEA) to manage its investment. In practice, all investment decisions for a J-REIT are designed to be made by its asset management company.
Unlike an ordinary corporation, which is subject to corporation tax on its profits, a J-REIT is exempt from taxation if certain requirements are satisfied, including:
- the J-REIT is not engaged in any business other than that permitted for J-REITs;
- the J-REIT would not be classified as a family corporation as defined in the Tax Code at the end of its fiscal period;
- the J-REIT distributes more than 90 per cent of its profits as dividends to the holders of its investment units for each fiscal period; and
- more than 50 per cent of the investment units on an aggregate issued amount basis have been offered in Japan.
The basic concept underlying the J-REIT legislation is that unlike a GK-TK structure or a TMK structure, a J-REIT's investments are not limited to certain assets specified at the time of its start-up. By raising long-term funds through a combination of debt and equity financing, a J-REIT can continue to accumulate and replace its investment portfolio for a longer term. At the same time, however, it would distribute most of its profits (more than 90 per cent) to the holders of its investment units for each fiscal period as described above, and, therefore, may not have sufficient internal reserve funds. When structuring a J-REIT, it is important to mitigate the potential risks of not having sufficient funds to deleverage its debt during an economic downturn. Because a J-REIT would practically be restricted regarding the amount of reserves it may retain, it should adopt another financial strategy to mitigate the potential risks, such as keeping its debt-to-asset ratio at a conservative level.
Real estate ownership
City Planning Act
The City Planning Act is the primary national law that governs real estate development and zoning.
Under the City Planning Act, land development is strictly controlled in urbanisation control areas. Developers are required to obtain approval from local government authorities for developments in areas designated for urbanisation. Approval is given if the proposed development meets certain requirements under the City Planning Act.
There are various local laws established under the framework of the City Planning Act. Local government authorities are granted the power to control land use in accordance with the City Planning Act and the local laws.
Building Standards Act
The Building Standards Act provides regulations with respect to construction of a building, including regulations with respect to its use and the ratio of its total floor area to its site area.
Under the Building Standards Act, the appropriate local government authority must approve construction work for a building before the work commences. Furthermore, a completion inspection of the building by the appropriate local government authority is required upon completion of work.
Under the Soil Contamination Countermeasures Act, if a manufacturing factory that uses certain hazardous materials ceases its operations, the owner, manager or occupant of the land (the landowner) must examine the land and test for contaminants. In addition, in the case of the development of a large area of land (at least 3,000 m²), the developer must notify the appropriate local government authority at least 30 days before any change is made to the land. After receiving this notice, if the authority determines that the land may be contaminated in the manner designated by the Soil Contamination Countermeasures Act, it may order the landowner to investigate. The local government authority may also order a landowner to examine land and conduct testing for contaminants if it determines that the land may harm the health of inhabitants in the neighbourhood through underground water or otherwise in the manner designated by the Soil Contamination Countermeasures Act. If the result of an examination of the land reveals that the relevant regulations have not been met, local government authorities will designate the land as a contaminated area and require appropriate measures, including cleaning up the land, to prevent public health from being impaired.
Stamp taxes, registration and licence taxes, and real estate acquisition taxes apply when the ownership title of real estate is transferred.
Stamp taxes are paid by affixing a revenue stamp on a taxable document. An agreement to transfer the ownership title to real estate requires a stamp tax of progressive amounts generally ranging from ¥200 to ¥600,000, based on the purchase price provided in the agreement. A range from ¥200 to ¥480,000 will apply to an agreement entered into between 1 April 2014 and 31 March 2022.
Registration and licence taxes are imposed when registering certain matters with respect to real estate with the appropriate local registry. The tax rate to register a transfer of ownership title to buildings is generally 2 per cent. A rate of 1.5 per cent will apply to a registration regarding a transfer of land occurring between 1 April 2013 and 31 March 2021, and a rate of 0.3 per cent will apply to a transfer of ownership title to certain qualified residential buildings that are acquired by an individual by 31 March 2022, to be used for residential purposes.
Real estate acquisition taxes are imposed on a purchaser of real estate at a rate of 3 per cent (for land and for residential buildings), or 4 per cent (for non-residential buildings); provided that the reduced tax rate of 1.5 per cent will apply to residential lands that are acquired by 31 March 2021.
Transfer to a TMK
If a TMK acquires real estate and meets certain requirements, it may qualify for the following tax benefits:
- the registration and licence taxes to register the acquisition until 31 March 2021 will be reduced to 1.3 per cent; and
- the real estate acquisition tax rate is currently two-fifths of the original rate, and this reduced rate will apply until 31 March 2021.
Transfer of trust beneficial interest
Using a trust structure where the trustee holds ownership title to real estate provides certain tax benefits. Stamp taxes for real estate trust agreements and for sale and purchase agreements for a trust beneficial interest in real estate is ¥200, which is substantially less than stamp taxes for a sale and purchase agreement of the real estate itself. While registration and licence taxes and real estate acquisition taxes will be imposed on the purchaser of real estate, the following reduced registration and licence taxes will be imposed on real estate being placed in trust, and on a trust beneficial interest in real estate being transferred from the initial holder to the purchaser:
- on placing the real estate in trust: 0.3 per cent (for land, until 31 March 2021), or 0.4 per cent (for buildings); and
- on the transfer of the trust beneficial interest: ¥1,000 for each building and piece of land.
Real estate acquisition taxes are not imposed on real estate when it is placed in trust or on the transfer of the trust beneficial interest.
However, when the holder of a trust beneficial interest in real estate (other than the initial holder) terminates the trust agreement and receives delivery of the real estate from the trustee, registration and licence taxes at a rate of 2 per cent will be imposed upon registration of the real estate transfer. Upon such a transfer, real estate acquisition taxes will also be imposed on the beneficiary at a rate of 3 per cent (for land and for residential buildings), or 4 per cent (for non-residential buildings).
By applying the tax benefits of a trust structure as described above, a substantial amount of taxes related to the real estate acquisition can be deferred until the trust agreement is terminated and the real estate is delivered to the beneficiary.
Transfer of real estate to a GK-TK structure under the ASJREV
Preferential tax treatment applies to certain GK-TK structures under the ASJREV.
If the GK as the operator of a 'special venture' under the ASJREV (except where the GK delegates management of transactions related to the subject real estate to a registered operator of a 'small-scale specified joint real estate venture') or as the operator of a 'venture only for qualified special investors' under the ASJREV (where the GK delegates the management of transactions related to the subject real estate entirely to a real estate broker licensed under the Real Estate Brokerage Business Act) acquires one or more of the following: (1) land satisfying certain requirements to be used as a site for a building with certain scale and quality, provided that such building will be newly constructed or reconstructed by rebuilding a building older than 10 years or seriously damaged by natural disasters, newly constructed on vacant land or created by extension, repair or remodelling of a building older than 10 years or seriously damaged by natural disasters; and (2) a building older than 10 years or seriously damaged by natural disasters to be rebuilt, extended, repaired or remodelled on land satisfying certain requirements, by meeting certain requirements, it may qualify for the following tax benefits until 31 March 2021:
- the registration and licence taxes to register the acquisition is reduced to 1.3 per cent; and
- the value of the real estate for the purpose of real estate acquisition tax is deemed to be half of the applicable value with respect the subject real estate.
The GK as the operator of a 'small-scale specified joint real estate venture' under the ASJREV or as the operator of a 'special venture' under the ASJREV (where the GK as the operator of a 'special venture' delegates the management of transactions related to the subject real estate to a registered operator of a 'small-scale specified joint real estate venture') may qualify for the following tax benefits until 31 March 2021, if the GK meets certain requirements:
- the registration and licence taxes to register the acquisition of a building for the purpose of new construction or reconstruction by rebuilding, or extension, repair or remodelling will be reduced to 1.3 per cent; and
- the value of real estate for the purpose of acquisition tax is deemed to be half of the applicable value with respect to the subject real estate, if the real estate is (1) a building constructed before 1 January 1982 and acquired for the purpose of extension, reconstruction, repair or remodelling, or (2) land acquired as a site for the building.
iv Finance and security
Mortgages on real estate are the most frequently used form of security interest in real estate.
In general, once the mortgage is registered, it is granted priority over unsecured creditors; however, even a registered mortgage is subordinate to tax claims against the mortgagor that became due prior to the registration of the mortgage. The registered mortgage will also be subordinate to any previously registered mortgages or other previously registered security interests on the same real estate.
Another form of security interest in real estate that is frequently used is a pledge over a trust beneficial interest in real estate. If real estate is held in the form of a trust beneficial interest in real estate, the lender would create a pledge over the trust beneficial interest and not a mortgage on the real estate itself. Perfection of the pledge is made by obtaining the consent of the trustee with a date certified by a notary public.
TMK bondholders are granted a security interest by operation of law, which is a statutory general security interest on all the current and future assets of the TMK granted in their favour under the ASA. The statutory general security interest will also secure (by operation of law under the ASA) all the TMK bonds subsequently issued. In many cases, therefore, holders of TMK bonds do not create a mortgage or pledge on the real estate or trust beneficial interest in real estate held by the TMK. This is mainly because the mortgage and pledge securing the bonds need to be held by a trustee in accordance with the Secured Bond Trust Act, and additional costs to establish such a trust arrangement are not considered economically justified in many cases.
Leases of business premises
The Act on Land and Building Leases (ALBL) and the Civil Code regulate real estate leases. The general rule is that the ALBL is applicable to land leases that are made for the purpose of the lessee owning a building on the land, and to building leases. The ALBL takes precedence over the Civil Code when their provisions overlap.
i Types of lease
The ALBL provides for various types of lease, including the following.
Land lease for the purpose of a lessee owning a building on the land
Ordinary land lease
Under the ALBL, a land lease made for the purpose of the lessee owning a building on the land (other than a fixed-term land lease as discussed below) has a 30-year term, unless the parties agree to a longer term. These land leases are automatically renewed for a term of 20 years for the first renewal and 10 years for subsequent renewals unless otherwise agreed by the parties. The lessor cannot object to renewal without a justifiable reason. Generally, a justifiable reason is not easy to establish, and the lessor's refusal to renew the lease is strictly restricted.
Fixed-term land lease
A fixed-term land lease made for the purpose of the lessee owning a building on the land is not renewable under the ALBL; however, the parties are not prohibited from entering into a new lease agreement at the expiry of the lease. Fixed-term land leases were introduced because concerns of landowners about the strict restrictions on the ability of the owners of land to refuse to renew a land lease were considered to inhibit effective use of real estate. There are three types of fixed-term land leases:
- a general fixed-term land lease available for either residential purposes or business purposes (the fixed term is 50 years or longer);
- a land lease with a special agreement by which the lessee assigns the building on the land to the lessor (the lease agreement can provide for the lessor's right to obtain the building on the land from the lessee at a reasonable price to terminate the lease after 30 or more years following the commencement of the lease); and
- a fixed-term land lease for business purposes (the fixed term is 10 years or more but must be shorter than 50 years).
Ordinary building lease
A building lease usually has an agreed term. Under the ALBL, a building lease with an agreed term (other than a fixed-term building lease as discussed below) is automatically renewed and the lessor cannot object to the renewal of the building lease without a justifiable reason. Generally, a justifiable reason is not easy to establish and the lessor's refusal to renew the lease is strictly restricted.
Fixed-term building lease
A fixed-term building lease is not renewed under the ALBL; however, the parties are not prohibited from entering into a new lease agreement at the expiry of the lease term. The parties can agree on the fixed term without restriction on its duration.
ii Typical provisions
There are typical provisions for leases of business premises in Japan regarding increase or reduction of rent, termination and assignment of lease or sublease.
Rent increase or reduction
Under the ALBL, if the amount of rent payable becomes inappropriate (e.g., if it differs significantly from the market rent), the lessor or the lessee may request that it be increased or reduced. This applies both to land leases made for the purpose of the lessee owning a building on the land and to building leases. The parties to the lease agreement, however, can eliminate the right to request an increase in rent by agreeing not to increase the amount of rent for a certain period. The right to request a reduction cannot be eliminated from a lease that is not a fixed-term building lease.
Under the Civil Code, if one party breaches an agreement, the other party can terminate it; however, under Supreme Court precedents, a lessor cannot terminate a real estate lease agreement if the lessee can establish the existence of a special circumstance where a relationship of mutual trust remains between the lessor and the lessee even after the breach. Failure to pay rent for several months would usually entitle the lessor to terminate the lease, because this non-payment would usually be regarded as destroying the relationship of mutual trust.
Assignment of lease or sublease
Lease agreements usually prohibit the lessee from assigning the lease or subletting without the consent of the lessor.
Developments in practice
i Rent reduction owing to covid-19
The real estate lease industry has historically been affected by downturns in the economy. One such economic downturn has been notably apparent owing to the global spread of covid-19 – recent economic indicators showed a drastic drop of GDP in Japan by 27.8 per cent in the third quarter of 2020, indicating the greatest fall since the post-war period. In such circumstances, there is a strong incentive for many lessees to negotiate rent reduction with lessors to alleviate financial difficulties resulting from the recession. The legal questions are as follows: 'What legal tools are available to such lessees and how are the lessors protected by the existing lease contracts or the law?'
One of the unique features of covid-19 is that national and local governments generally restrict the movement and gathering of people. The hotel industry has been severely affected by this restriction, as can be already seen by affected hotel operators going bankrupt. In this respect, hotel operators as lessees have a stronger incentive to not be bound by existing lease contracts. The same legal questions as described above apply in a more severe way to hotel properties.
Article 32 of the Act on Land and Building Leases
Article 32 of the Act on Land and Building Leases gives a lessee the legal right to break a contract, namely the right to request rent reduction notwithstanding the lease contract. Pursuant to Article 32, a lessee may request a rent reduction, but only when rent becomes unreasonable as a result of a change in, among other things, economic circumstances. Covid-19 should be a strong factor affecting, among other things, the economic circumstances as described above (similar examples would be the burst of bubble economy in Japan in the 1990s and the Lehman shock around 2008). Lessors can avoid this request for rent reduction and be protected by the lease contracts if the lease is fixed-term and the lease contract contains a provision prohibiting rent reduction. Article 38.7 of the Act on Land and Building Leases provides such limitation to the lessee's right to request rent reduction. On the other hand, if the lease is a regular one or a fixed-term lease without a provision prohibiting rent revisions, the lessor is not protected by this limitation, and can only be protected from lessee's right to request rent reduction by arguing that the requirement of showing that the rent has become unreasonable under Article 32 is not met.
Statement by the Minister of Land, Infrastructure, Transport and Tourism
Even where Article 32 is not applicable, parties to lease contracts can voluntarily discuss rent. On 31 March 2020, the Minister of Land, Infrastructure, Transport and Tourism issued a statement requesting property owners or lessors to be considerate of the difficulties faced by lessees to pay rent due to covid-19, and to consider taking lenient measures such as accepting deferred payment of rent from troubled lessees. Even though this statement does not have a legally binding effect, it should have had a significant influence on the rent discussions between parties to lease contracts separately from or in addition to the Article 32 framework.
ii Act concerning Proper Management of Rental Housing
The Act concerning Proper Management of Rental Housing (the Rental Housing Management Act) became effective on 15 December 2020. The newly introduced regulations on rental housing business under the Rental Housing Management Act may have an adverse effect on investment into residential real estate. A major issue for investors looking to invest in residential real estate would be whether the master lease agreement between the owner of the real estate and the master lessee in the investment structure will be subject to newly introduced regulations such as those on the specified lease agreement under the Rental Housing Management Act.
A specified lease agreement is a contract executed by the owner of the real estate and the master lessee for the purpose of operating a business where the master lessee subleases the rental housing to a third party. If the master lease agreement in the investment structure is considered as the specified lease agreement, the master lessee is subject to various restrictions such as restrictions on advertisement and solicitation, and requirement for explanation, which would result in less flexibility in the investment structure.
Exemption from these restrictions applies where:
- a J-REIT master-leases to an affiliate of its asset manager;
- a TMK master-leases to an affiliate of its asset manager;
- the operator of a 'special venture' under the ASJREV master-leases to an affiliate of an operator of a 'specified joint real estate venture'; or
- the trustee of a trust holding real estate master-leases to:
- an affiliate of its settlor or beneficial interest holder;
- an affiliate of the asset manager of the J-REIT as the beneficial interest holder; or
- an affiliate of the asset manager of the TMK as the beneficial interest holder.
In addition, where (1) rent payment is structured as pass-through rent and the master lessee does not retain any fees as a middleman; or (2) the beneficial interest holder of a trust itself enters into a master lease agreement as the master lessee, such master lease agreement would not be considered to have been executed for the 'purpose of operating a business', and therefore does not fall under a specified lease agreement under the Rental Housing Management Act.
If a structure to invest into residential real estate using a master lease structure falls under any of these exemptions, the investor can avoid being subject to the newly introduced regulations on rental housing business.
iii Real estate security token offering
Recent developments in distributed ledger technology have attracted attention to security token offering (STO), including those involving real estate tokenisation (real estate STO). Tokenised securities in real estate context are typically TK investments into real estate assets.
A series of new regulations on tokenised securities were introduced in May 2020 under the FIEA, the Japanese securities law. The government also started to discuss amendment to the ASJREV to introduce regulations on tokenised TK investments into real estate under the amended ASJREV.
The introduction of the foregoing regulations on tokenised securities under the FIEA have drawn the attention of traditional real estate market players to real estate STOs; however, the market has not yet succeeded in implementing any real estate STO to offer any instruments that are regulated as tokenised securities under the FIEA. In this regard, real estate STO remains an evolving area. Even though there may be a long road ahead, it is hoped that the market will eventually see an established real estate STO practice compliant with the FIEA (and the ASJREV, if the Act is amended as is currently being considered by the government).
Outlook and conclusions
The global outbreak of covid-19 in 2020 brought forth unprecedented challenges and difficulties, severely affecting commercial activities in Japan. The real estate sector was invariably affected, the hotel real estate sector having the most notable impact due to various restrictions on leisure activities and movement of people. Despite such implications, data shows that Japan's real estate market as a whole has been able to maintain stability in 2020, with a relatively moderate decline in specific sectors such as the office leasing market. According to a Nikkei Business article (22 October 2020), Tokyo ranked as the number one destination for real estate investments in the first half of 2020, surpassing other attractions such as New York, Paris and Seoul, showing the strength of Japan's real estate market, particularly in times of crisis. Current events also indicate that major foreign investment funds are venturing to expand real estate investment in Japan (e.g., a Hong Kong-based fund to invest up to US$8.4 billion in Japanese real estate over the next four years; a Canada-based fund to invest up to US$10 billion in Japanese real estate for the coming two to three years). We hope that even during the current difficult time, established and stable real estate investment platforms as discussed above will continue to provide the market with confidence in the Japanese real estate market and, more importantly, the basis of sustainable growth.
1 Norio Maeda, Takuya Shimizu and Akihiro Shiba are partners, and Yujin Gen, Yuto Tokoro and Masato Morizuka are associates at Nishimura & Asahi.