2007Jul Japan's Rally: Will It Last?

2007Jul Japan's Rally: Will It Last?

Evidence over the past year has indicated that Japan is finally breaking out of its grinding, slow-motion depression which started in 1990. Following a string of improvements in other areas of the economy, land prices have finally begun to rise again after a decade and a half of stagnation.

In the 1980’s, Japan experienced what was possibly the largest real estate bubble in world history, then watched it violently burst in the early 1990s as the Japanese Baby Boomers peaked in their Spending Wave and began to save for retirement. For the next decade and a half, residential land prices across Japan continued to drop, while cities such as Tokyo experienced declines of as much as a 60%. Recent data, however, suggest that this trend has finally reversed. The Wall Street Journal (March 28, 2007) reported in "Economic Change Propels Big-City Prices" that increased demand for commercial space has lead to the first general rise in property prices in Japan in sixteen years.

You read that correctly – the first general rise in property prices in sixteen years!

According to the article, last year commercial land prices rose 2.3%, while residential land prices rose 0.1% - an impressive turnaround from the previous year, when both commercial and residential property prices decreased an average of 2.7%. Morse, the author of the WSJ article, explains the increase in land prices is the effect of Japan "shifting from a manufacturing economy to a service economy. ... [This] means less demand for big plots of land outside major cities, where factories are usually located, and more demand for offices in city centers that are close to advertising agencies, accountancies and investment banks."

While Japan may indeed be shifting into a services dominated economy, we believe this assessment is incomplete. After all, the US has been dominated by services and information for decades, and many downtown city centers failed to improve as a result. For example, despite the massive investment in its renewal, downtown Dallas continues to have almost absurd vacancy levels, even while the surrounding metro area continues to grow and prosper. Many service businesses in the US – everything from credit card processing to Internet service providers - choose cheaper suburban campuses for their operations. These are the kinds of middle-income jobs that displaced industrial workers would take, not jobs in high-end urban sky scrapers. Furthermore, even some of the highest quality tech companies, such as Microsoft, have opted for the campus setting in most of their offices. Based on the US experience, we would expect Japan’s to be much the same.

The boom in higher-end services such as legal, accounting, and banking and the resulting boom in prime real estate is indicative of something bigger. The Japanese economy is slowly but surely awakening from its long slumber. The reason, naturally, is based on demographics.

Like Japan's Baby Boomers in the 1970s and 1980s, Japan's Echo Boomers are starting to march up their own spending wave. The consumer spending power of this rising generation, along with their increased productivity as they advance in their careers, has generated enough economic activity to get the economy rolling again. As a result, commercial real estate prices have improved. Residential prices should perform well too, as the Japanese Echo Boomers begin to “trade up.” In the coming years, expect real estate prices in general to follow a positive trend upward.

But…It Won’t Last Forever

As Japan's Echo Boomers grow older, we estimate that their spending power will be enough to largely compensate for the economic drag of the retiring Baby Boomers. Increases in consumer spending from Japan's echo boom will cause the economy to exhibit mild economic growth through the next decade until around 2020, when echo boomers reach their spending peak. After that point, Japan should enter a long-term economic cooling and loss of global influence from which the country is likely to never recover.

Government officials, however, are already thinking ahead and are attempting to “do something” about Japan's declining population and the long-term effects it will have on the economy.

At the urging of officials, Japanese firms have begun to offer incentives for having babies. The Financial Times (March 21 2007) reports in "Japan Pay Deals Offer Workers Baby Bonus" that "Japan's big companies have started offering special deals to workers with children in an effort to reverse a dramatic fall in the national birth rate. ... In the most startling development, Matsushita has struck a deal with its unions to put the bulk of pay increases this year into special allowances to encourage workers to have children. ... For its part, the government has legislated to allow one parent in Japanese families to take up to a year off work following the birth of a new child, at up to two-thirds pay."

Will making pay raises contingent on having children be enough to increase the population and save Japan's economic future as officials hope? Most likely not. A decline in birth rates in urbanized, industrialized nations is the effect of long-term changes in society, which cannot be undone by short-term monetary incentives. In a modern, individualistic society like Japan, it’s hard to imagine the incentive of two-thirds pay for a year off will be enough to compensate people for a lifetime of caring and responsibility. Thus far, similar programs have largely failed in other countries. There is no reason to believe that Japan will be an exception.

For the US, Japan is our canary in the mine. As an urbanized, developed economy, the lessons of changing demographic demands in Japan can be applied to the US. Both urban and rural real estate values declined by as much as 60% as demand ebbed in an aging population. In the US, that tidal change in age related demand is very few years away giving real estate speculators some time to unwind their bets. However, as Japan’s Echo Boomers reach peak spending; their capital markets will respond to rising domestic demand with improving profits offering US investors an attractive alternative for their portfolios.