(Corrects date, fixes typo in paragraph 21)
By Mariko Katsumura
TOKYO, Dec 11 (Reuters) - Tokyo's office market, the last stronghold for investors in the country's faltering property sector, is showing signs of weakening as the economy wilts, heaping more pressure on developers and real estate trusts already suffering from the global credit crunch.
Hit by worldwide financial turmoil, Japan slipped into recession in the third quarter for the first time in seven years, with thousands of companies cutting staff and scaling down the size of their businesses.
That helped to push up the average vacancy rate in Tokyo's core business district to a three-year high of 4.3 percent in October, up 0.23 percentage points from September, data by real estate broker Miki Shoji showed.
Among Tokyo's S class buildings, the swankiest and most prestigious ones in terms of location, the vacancy rate jumped 2.1 percentage points from October to 5.8 percent in November, according to real estate brokerage CB Richard Ellis.
Japan's biggest developers, Mitsui Fudosan Co and Mitsubishi Estate Co, cut their full-year profit outlooks by 5 percent and 7 percent, respectively, in October on the weakening property outlook, citing slower apartment sales.
So far, rising office vacancies have not had a major impact on Mitsui or Mitsubishi because few leases have come up for renegotiation, but it will catch up with earnings eventually. Both firms are highly exposed to a downturn in the prime segment, relying heavily on office leasing and commercial development.
Mitsubishi has said some tenants at its Marunouchi Park Building in central Tokyo, which will open next near, had agreed to pay monthly rent of 80,000 yen ($840) per 1 tsubo or 3.3 square metres -- nearly triple average rents for class A space in midtown Manhattan.
But such bullish deals might soon become legend.
"We aren't seeing negative news about those top-class buildings yet ... but that could happen from the year after next. They (big developers) might need to reduce rents by up to 5 percent," said Goldman Sachs analyst Sachiko Okada, adding that times would be tough in Japan's property market for at least the next few years.
In the last big property downturn in the 1990s, many Japanese landlords were insulated from big falls in rents because of cosy agreements with tenants, many of whom were parts of the same corporation. But in the last few years as the market rose, Japanese landlords have tried to become more "Western" and hike their rents in line with those usually set by new buildings.
Now that the property market is turning again, tenants may push back by demanding lower rents in coming years as their multi-year leases expire, or threaten to move.
Rising office vacancy rates may pose a more immediate threat to real estate investment trusts (REITs) such Creed Office Investment Corp which have bigger exposure to Class B or C office buildings and smaller cities, said independent REIT analyst Shigeo Yamazaki.
Nearly 500 real estate firms have already folded in Japan this year with total debt of 1.7 trillion yen, and investors fear more cash-strapped developers will collapse as lenders reject their refinancing pleas. More collapses could feed a vicious cycle where failed firms are forced to dump cheap assets onto the market, further depressing property values and rents.
The Tokyo Stock Exchange's real estate index has lost close to 60 percent of its value so far this year compared with a 46 percent fall in the benchmark TOPIX index.
YEAR AFTER NEXT?
Despite sliding property prices, investors in prime Tokyo offices will likely be able to squeeze out attractive returns for some months yet until existing leases are renewed. But any rental deals done now will probably lock landlords into lower rents for a few years, which could see them lagging any industry recovery.
The rental yield for top-class Tokyo offices is still around 3 percent, little changed from last year, and 1.5 percentage points over 10-year Japanese government bonds.
In Singapore, a drop in capital values for class A buildings has pushed yields up to 5.6 percent from 4.3 percent last year, while in Hong Kong, yields have inched up to 4.7 percent from 4.5 percent. Both of those economies have also fallen into recession.
In Tokyo, the vacancy rate for class B and C offices could reach nearly 10 percent, said Daisuke Seki, chief executive of REITs consultancy IB Research & Consulting.
The vacancy rate for top-class buildings was also likely to reach 5 to 6 percent in 12 months, three analysts said.
"Normally, there's a one-year time gap between the office vacancy rate and macroeconomic movements," said SMBC Friend Research Centre analyst Masato Banba. "The office market could further deteriorate and if so Mitsui and Mitsubishi can be hit."
Mitsubishi sees almost zero vacancy at its Marunouchi area offices, while Mitsui said the vacancy rate at its buildings in metropolitan Tokyo was 1.6 percent in September.
But Nikko Citigroup analyst Yoshizumi Kimura said strong rents for top buildings are likely to be partly offset by higher vacancy rates and longer vacancy periods after tenants leave.
"For companies without new projects, the current demand and supply balance is such that March 2011 leasing business profits will be either flat or down slightly on the yearly basis," Kimura wrote in a recent research note. (Additional reporting by Dominic Whiting in Hong Kong; Editing by Kim Coghill)