TOKYO, Mar 26, 2008 (AsiaPulse via COMTEX) -- -- The transformation of real estate into a financial product helped to draw investments from abroad and underpin higher land prices, but the same forces are poised to deflate the market.

While real estate investment trusts have played a key role in the surge in property values, their holdings, purchased for 6.9 trillion yen (US$68.9 billion), carry a market value of roughly 4 trillion yen. The nearly 3 trillion yen in unrealized losses underscore the sector's potential weakness.

The value of investment property is predicated largely on future earnings streams. Tokyo's official land prices climbed for a second straight year amid favorable financial conditions and strong income prospects. However, the subprime mortgage fallout has weakened the investment capabilities of hedge funds and other purchasers of Japanese property.

At the same time, financial institutions are growing more cautious about funding such transactions. Foreign lenders have tightened screening of nonrecourse loans, a major financing conduit in real estate investments. Lending by foreign banks has plunged more than 1 trillion yen compared with 18 months ago.

The fundamental characteristics of REITs and other real-estate-related investment products have also changed. Although their risk should be lower than that of stocks, the price volatility of these instruments has exceeded that of stocks in the past year. Retail investors unloaded holdings out of concerns about sharp losses, with financial institutions also selling more than they purchase in light of risk management issues.

Major redevelopment projects in central Tokyo continue to tap underlying revenue potential, helping to keep prospective income streams from deteriorating sharply. Demand to buy prime properties held by corporations remains strong as well.

Asian and Middle Eastern investors less reliant on financing are actively snapping up Japanese properties. For example, the Government of Singapore Investment Corp. has purchased the Westin Tokyo luxury hotel. At a time when the American and British real estate bubbles are bursting, Japan is still seen as an attractive market.

Yet Japan's macroeconomic outlook is increasingly clouded. Sentiment among large companies turned negative in the January-March quarter, according to a Ministry of Finance business survey. Office vacancy rates are showing signs of rising, and condominium sales have slowed.

Furthermore, appraisals for the government's land price survey were conducted around November. The repercussions of the subprime turmoil were still limited at that time.

Inflows into real estate investment products enabled Japan to escape asset deflation. But when conditions change, such investments just as quickly flow out of Japan. In light of the looming outflow, the financial and real estate industries are bracing for a correction in land prices.

(Nikkei)