TOKYO -- Demand for office space in Japan, which has been strong for years, is showing signs of softness. And that's likely to weigh on shares of the country's biggest real-estate developers.

In late 2003, Japan's commercial-real-estate market began a prolonged upswing. As the economy recovered from a long slump and continued to expand, companies started to add staff and to need more space. Global financial firms, in particular, aggressively expanded their businesses and moved into bigger, pricier offices.

But in the past few months, demand has weakened. One reason is that the U.S. subprime-mortgage crisis, which has hurt many finance-sector firms, has led foreign companies to be more cautious about expansion plans.

There are other signs that the Japanese office market is softening. A survey by the Japan Real Estate Institute, a research group, in April showed the first increase in five years for an indicator the industry uses to value rent-producing properties. The rise in the indicator -- called the capitalization rate -- signals a decline in the prices that buyers of Tokyo commercial real estate are paying.

Vacancies for Tokyo office space, which had been falling for several years as companies competed for new space, rose at the end of May for the fourth month in a row to the highest level in about two years. Office rents are still increasing but at a slower pace than six months ago.

While the share prices of Japan's developers have been falling this year, recent developments and signals have made some analysts cut their targets.

In late May, Credit Suisse lowered its 12-month price target for Mitsubishi Estate, Japan's largest real-estate company by market capitalization, to 2,300 yen ($21.34) from 2,500 yen. The firm made a bigger cut in its target for Mitsui Fudosan, the second biggest, to 2,100 yen from 2,400 yen. Credit Suisse increased its target for Sumitomo Realty & Development by 100 yen, to 2,200 yen, but earlier this year it had chopped the target by 12%.

Those developers are known as the "big three" in Japan. All are trading close to the Credit Suisse targets. (Sumitomo Realty, which closed at 2,155 yen Thursday, is the only one currently below it. Among the three, its stock has had the biggest fall this year: 22%, compared with 6.3% for Mitsubishi Estate and 4.5% for Mitsui Fudosan.)

Commercial property played a key role in propelling Japan out of its decade-plus slump after the country's stock-and-real-estate bubble burst in the early 1990s. Some property prices wallowed for years at a fraction of their peak values.

In Tokyo commercial property now, "there's a softening of market conditions compared to 2007's tight market," says Takeshi Akagi, head of research in Japan for Jones Lang LaSalle, a real-estate-services firm. He says U.S. credit woes are unlikely to be resolved before the American presidential election in November.

Financial firms have been part of some sizable recent Tokyo property transactions this year. Shinsei Bank -- bought in 2000 by U.S. private-equity fund Ripplewood Holdings -- sold its Tokyo headquarters this year. And Citigroup sold its Japan headquarters to Morgan Stanley.

Masahiro Mochizuki, an analyst at Credit Suisse, says Tokyo's downtown commercial vacancy rate, now at 3%, could rise to 4% or 5% if demand is weak. He adds that while rents are still increasing in central Tokyo, those for properties outside Tokyo are generally falling.

One factor that could weigh on the property sector is the expectation that Japanese corporate earnings will decline in the current fiscal year, which for many companies ends in March 2009.

"If Japanese corporate earnings decline, even high-quality developers will be affected," says Junko Miyakawa, a real-estate analyst at Shinsei Securities. For developers, she notes, raising rents "will be more difficult."

There are some mitigating factors. Analysts expect that this year there will be only about 25% as much new office space added to the market as was added in 2007. That means the vacancy rate isn't likely to rise much, especially in the prime locations -- areas where the big three developers hold many assets.

"Demand is still strong for the trophy assets," says Simon Treacy, chief executive of MGPA Asia Investments, a real-estate investment firm.

Unlike the commercial market, Japan's residential market has been suffering for a few years, triggered by a scandal in 2005 when an architect was found to be fabricating earthquake-resistance data for dozens of condominiums. The episode temporarily cut housing starts and hit consumer confidence in the sector. The architect, Hidetsugu Aneha, was sentenced in 2007 to a combined five years in prison for faking the data and for perjury.

Now, there are new signs of a condominium glut as stagnant wages and growing economic uncertainty hurt sales.

While residential properties make up only about 20% of revenues of companies like Mitsui Fudosan and Mitsubishi Estate, the problems in this area are fueling concerns about their outlook, analysts say.

Unfavorable condominium-market conditions may "be a drag on real-estate stocks overall, including the big three," says Tomoyoshi Omuro, a real-estate analyst with Morgan Stanley.

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