If the Land Bubble Pops, Will Whole World Feel It? : Japan: Overvalued real estate has become the top domestic problem. But a freeze may not be the answer.
The Japanese stock market has fallen 25% in the first three months of this year. The astounding loss of nearly $1 trillion has been felt not just in Japan but also by investors around the world. Inevitably, financial markets everywhere are nervous about spillover effects on other stock markets.
But the cause for worry doesn’t stop with the stock market. Financial markets now fear a similar collapse in the Japanese real estate market, which could cause widespread damage to the entire Japanese financial system.
Since the real estate assets of Japanese corporations help to justify high Japanese stock prices, a collapse of the real estate market could cause a new round of declines in share prices. To the extent that inflated real estate values serve as security for bank loans, the Japanese banking system is also vulnerable to a real estate collapse.
While the overvaluation of Japanese land prices is legendary, the present situation has become a major political problem. The vast fortunes created by the surge in real estate values has disturbed the traditional income distribution and Japanese social values. At present levels, prices are so high that very few Japanese can ever expect to purchase a home.
Land prices have risen throughout the past decade at rates that are much greater than the increases in the consumer price level. Just in the last year, the average price of residential land has jumped 17% while overall consumer price inflation has been only about 3%.
Prime Minister Toshiki Kaifu, concerned about the increasing discontent among the voters, recently declared the high price of land to be Japan’s most serious domestic problem. He endorsed a proposal to freeze the price of land in certain urban areas.
But preventing land prices from rising could actually trigger a real estate collapse.
The key problem is that today’s prices cannot be justified by current rental levels. A Japanese real estate owner is lucky if the rent that he receives equals 2% of the market price of his property. Compare that with the 7% interest that he could receive on perfectly safe investments in Japanese government bonds.
An investment in real estate makes sense only if its value is expected to keep increasing by at least enough to compensate the investor for the loss of interest income and the greater risk of investing in property rather than government bonds. Just to keep pace with a 7% return on government bonds, the real estate investor must expect his property to appreciate by at least 5%. With a 2% rental return, the investor can then just match the 7% return on government bonds. More realistically, the investor must expect a further price rise to compensate for the extra risk associated with real estate investment.
What happens if the government freezes real estate prices? The entire return to the investor must then come from rental income. Think about a property that now has a value of 100 million yen and an annual rental income of 2 million yen. If the rental income alone must yield a return of at least 7% to compete with the return on government bonds, then the price must fall from 100 million yen to less than 30 million yen.
In actual practice, such a drastic fall is unlikely. Investors might gamble that the freeze would only be temporary and that the government would step in to offset such a severe decline in property values. That kind of speculation would encourage property investors to accept a temporary lower rate of return.
But there can be no doubt that the rapid rise of Japanese land prices in recent years has created a financially dangerous situation. Even without government intervention, real estate prices cannot continue to rise at the rates of the recent past. And when the price increase slows, the investor’s need to maintain the required return on property will force a fall in land prices.
Thus, the financial shock waves from Tokyo may just be beginning.
