Collateral apartments will have lower vacancy rates and slower declines in rent than other properties.
Still, rent levels for properties underlying residential mortgage-backed securities (RMBS) backed by apartment loans will decline.
The performance of apartments could deteriorate because of inflated loan repayments amid higher interest rates. Over the longer term, a worsening supply-demand balance and lower rental income due to demographic shifts could further dent performance.
In recent years, we have seen pure investment transactions where both land and buildings are purchased. Initial loan-to-value (LTV) ratios for such transactions are relatively high. This is because there is no in-kind initial investment in land. Under a stressed environment, performance of apartment loans in these transactions is likely to deteriorate faster than that of traditional apartment loans, where borrowers own the land before the transactions start.
Apartment Loan Market: Healthy For Now
Japan's apartment loan market is growing. However, the supply-demand balance is likely to deteriorate and weaken the profitability of properties. Apartment loans are mainly used to construct rental apartments for investment or inheritance tax purposes. They are mostly nonrecourse loans, unlike owner-occupied residential loans.
The total number of rental housing units is trending upward. New rental housing starts have provided a steady supply of 300,000 units to 400,000 units per year. The overall market reached about 24 million units in 2023 (see charts 1 and 2).
Chart 1
Chart 2
The outstanding balance of rental housing loans is also increasing steadily. It totaled about ¥37 trillion in fiscal 2022 (ended March 31, 2023; see chart 3). In terms of lender categories, regional and shinkin banks are actively engaged in providing apartment loans and condominium investment loans. This is seen in their lending balances for rental housing, which have been increasing in recent years. Their new lending balances totaled about ¥1 trillion at regional banks and about ¥800 billion at shinkin banks. These figures are significantly higher than the about ¥500 billion for city banks and trust banks.
Chart 3
Demand for rental apartments is likely to decline. In our view, this should in turn lead to higher vacancy rates and lower property prices. The total number of households has increased consistently in Japan, and the supply of rental housing has been strong. However, Japan's population started to decline in 2011 as it rapidly ages with a declining birth rate. The National Institute of Population and Social Security Research expects the number of households to peak in 2030 and decline thereafter (see chart 4).
Chart 4
Performance Of Assets Underlying Apartment Loan RMBS And Credit Analysis Methodology
Underlying loans: Rising interest rates without higher rents could lead to stress
Performance of the underlying apartment loans remains favorable thanks to stable income under long-term master-lease contracts. Both delinquencies and defaults have been low for the loans underlying apartment loan RMBS we rate. This is despite the average seasoning of about 20 years (see charts 5 and 6). Apartment loan borrowers typically enter into long-term master lease contracts with apartment builders or other parties. This allows borrowers to receive stable master lease rents regardless of actual vacancy rates or apartment rents.
Chart 5
Chart 6
The primary source of repayment for underlying apartment loans remains rental income from properties. Borrowers tend not to pay back the loans with salaried income. Stable cash flow provided by master leases supports the performance of underlying loans, in our view.
We do not expect prepayments to rise significantly while underlying loans are primarily based on floating rates, even in the current environment of rising interest rates. Prepayment rates have been low at less than 5% (see chart 7). The rate temporarily increased when the Bank of Japan introduced negative interest rates in 2016 . Only a small number of financial institutions offer funds for refinancing apartment loans. In addition, there is limited benefit for borrowers to refinance apartment loans given short remaining terms to maturity.
Chart 7
We forecast Japan's policy rate will rise to 1.0% toward 2027. This pace of increase is moderate relative to other countries'. However, a heavier repayment burden could weigh on the performance of apartment loans if rent levels do not rise in line with interest rate hikes.
Underlying assets: Accounting for risk
In analyzing the credit quality of underlying assets, we consider borrowers' real repayment ability assuming that long-term master lease contracts are terminated. The source of repayment for apartment loan borrowers is typically rent income under the long-term master lease contracts they enter with apartment builders or other parties. These contracts allow borrowers to receive stable income regardless of actual vacancies and apartment rents, although certain fees are deducted from the rents ultimate tenants pay.
Contract terminations can tie rent income to vacancy rates and rent levels. A contract could be terminated, for example, because of the apartment builder defaulting. In assessing the repayment ability of borrowers, we exclude the effect of stable master lease rent and estimate rent income based solely on the actual vacancy and rent levels of the underlying properties, together with market conditions.
The performance of the pure investment loans for both land and buildings is likely to deteriorate and underperform traditional apartment loans in times of stress. A typical borrower of an apartment loan had been a landowner who builds a rental apartment building for inheritance tax purposes. The initial LTV on such a loan is kept relatively low because land effectively acts as equity. However, we have seen in recent years transactions where both land and buildings are purchased. These are riskier because there is no in-kind investment of land, and their initial LTVs are relatively high. Furthermore, loan amounts tend to be large because transactions must fund the land purchase.
Table 1
| Key factors in the credit analysis of apartment loan RMBS and owner-occupied residential loan RMBS | ||||||
|---|---|---|---|---|---|---|
| Owner-occupied residential loan RMBS | Apartment loan RMBS | |||||
| LTV | Yes | Yes | ||||
| DTI | Yes | No | ||||
| DSCR | No | Yes | ||||
| Employment type | Yes | No | ||||
| Seasoning | Yes | No | ||||
| LTV--Loan-to-value. DTI--Debt-to-income. DSCR--Debt service coverage ratio. Source: S&P Global Ratings. | ||||||
In owner-occupied residential loan RMBS, we assume that loans will be repaid with borrowers' salaried income (see table 1). Therefore, we consider factors that are likely to affect the stability of this income, including employment type (full-time, part-time, and self-employment), and debt-to-income (DTI) ratio as measures of borrowers' ability to repay. For seasoned loans, we apply a positive adjustment to reflect the tendency for continued performance over time to reduce the likelihood of default.
In contrast, the ability of repayment for a borrower of apartment loan RMBS would depend on the rental income generated by the underlying apartment properties, rather than their salaried income. Thus, we add the debt-service coverage ratio (DSCR, obtained by dividing net operating income from property by interest and principal repayments) in place of DTI, employment type and seasoning.
Vacancy and rent declines: Continued containment
Rent levels for 20-year-old collateral properties have declined on average by about 10% from initial levels. This is slower than the average pace for the market. We have calculated the current vacancy rates as well as rent declines from inception to date of underlying properties backing apartment loan RMBS we rate (see note 1).
Rent declines for properties underlying apartment loan RMBS we rate are lower than the market average. Properties included in our calculation are aging, with an average age of about 20 years. However, about 70% of these properties have vacancy rates of 10% or less (see chart 8). Vacancies at these properties are contained to a certain extent, as evidenced by the average vacancy rate of 8.6%. In addition, about 50% of these properties had rent declines of 10% or less since inception (see chart 9). Overall, the average rent decline was 9.9%. According to Japan's Ministry of Internal Affairs and Communication, rent levels for 20-year-old private rental properties in 21 major cities have declined about 20% since inception (see note 2).
Chart 8
Chart 9
Despite their age, apartment properties can retain a degree of competitiveness, in our view. Most of the collateral properties are under long-term master lease agreements, with major apartment builders or their affiliates providing maintenance and tenant leasing services.
Notes
1. Vacancy rates are calculated as the simple average of the number of vacant units divided by total units per property. Rents are based on asking rents, not master lease rents.
2. According to the Statistics Bureau of Japan's Housing and Land Survey: Basic Tabulation on Dwellings and Households, the average monthly rent for properties less than two years old is ¥5,439 per tatami unit (about 1.6 square meters), and for properties about 20 years old is ¥4,331, a decline of about 20%.
Related Criteria
- Global Methodology And Assumptions: Assessing Pools Of Residential Loans--Asia-Pacific Supplement, April 4, 2024
- Global Methodology And Assumptions: Assessing Pools Of Residential Loans, Jan. 25, 2019
Related Research
- Japan Structured Finance Outlook: Inflation Entrenches? Jan. 11, 2024
This report does not constitute a rating action.
| Primary Credit Analyst: | Shota Tatewaki, Tokyo + 81 3 4550 8276; shota.tatewaki@spglobal.com |
| Secondary Contact: | Hiroshi Sonoda, Tokyo (81) 3-4550-8474; hiroshi.sonoda@spglobal.com |
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