The country's post-war boom and subsequent stagnation has been well documented. However, the listed property sector's ability to continue improving shareholder value has not been. Matthew Hodgkins reports
Japan has had to learn how to deal with a lower level of aggregate demand the hard way. There was no textbook response 20 years ago. The only option was to learn from mistakes and try again.
Without the government's repeated stimulus efforts and drastic easing of monetary policy, Japan's recession, which began with a real estate bust, would have been a lot deeper. Against this backdrop, listed property still managed to significantly outperform the broader market, posting the second-best Japanese equity sector return since 1992.
Japan's boom and subsequent bust was not dissimilar to what happened in many other industrial economies after World War II. However, it is clear there were powerful forces preventing growth.
There was a huge accumulation of capital relative to expected future output through to 1990 that proved to be excessive once the economy slowed. Household and corporate balance sheets collapsed as equity markets and housing prices dived. The weaker stock markets discouraged firms from issuing new equity, limiting the creation of new capital and altering the nature of Japan's economic cycle.
The deterioration in balance sheet quality undermined the quality of banking loan books. Non-performing loans exacerbated the economic problems, partly because the banking industry failed to recognise that it should recapitalise, causing the economic recovery to remain fragile because of the absence of a decent credit multiplier.
The consequence was wealth destruction equivalent to three years' worth of GDP. Furthermore, with many Japanese ‘levering-up' in the late-1980s to take part in the bubble, financing understandably shut down.
In our view, it was natural for the salary man or corporate executive to decide that earnings would not to be used for consumer products or new machinery, but to pay down debt and rebuild savings that had been decimated by the economic turmoil.
Japan had to adjust down its growth expectations and seek new export markets. The fear of bankruptcy led to an entire economy adopting a ‘don't ask, don't tell' mantra that was sustained largely thanks to the ability of Japanese companies to keep servicing debts and a reluctance of Japanese banks to admit that they were effectively bankrupt.
All this sounds alarmingly familiar when analysing the current developed-market experience.
Political heavyweights, academic commentators and market participants indulged in an irrational belief that ‘this time it's different' and globalisation would benefit all. An explosion in debt issuance fuelled by the proliferation of financial innovation gave stock markets globally a sense of invincibility. Importantly, in the US and Europe, we also saw banking sectors that are still effectively bankrupt.
Like Japan, we find ourselves with highly supportive governments wary of the fragility of their banking sectors and its broader impact on the economy. This modern day ‘don't ask, don't tell' has been exacerbated by accommodative changes to accounting standards that have allowed a culture of ‘extend and pretend' to become accepted industry practice.
Ultimately, we believe the global economic growth of the past 20 years was not real economic growth: it was driven by a massive debt binge in the West that should now moderate, if not collapse.
In Japan, the response by all three was rational: consumers saved to restore wealth, businesses serviced debt to avoid bankruptcy and the government made up the shortfall.
Figure 1 shows changes to real GDP in the 1990s in Japan, highlighting the replacement of private spending with public expenditures. The actions of the government were unprecedented, yet it was not until 1995 that the world realised that the problems facing Japan were far larger than assumed. As late as January 1995, long bonds, for example, continued to yield more than 4.5%; 1995 was also the year that the yen peaked and the first year of deflation.
The government's response became increasingly experimental. It cut the overnight interest rate from 8.2% in March 1991 to 2% four years later, taking it to down further to 0.5% where it remained until the end of the decade. It took fiscal measures to stimulate demand, which helped Japan maintain nominal GDP above its 1990 level through to the present day.
However, with the financial system broken, there was no tool to transmit these policies, keeping Japan in a rut. Lenders were unwilling to lend and borrowers unwilling to borrow. The private sector was in no rush to take advantage of low rates and ‘lever up' again to fuel growth.
Today, we find ourselves in a similar situation. Consumers have looked at their balance sheets, including negative equity in their home values and the impact of a decade of lost stock market investing, and face a likely lower-income future with government bond yields below 3%. They have reacted by spending less and starting to save.
Businesses are believed to be in better shape financially today, yet this was also the case for Japanese businesses in the 1990s. They were operationally sound, found new export markets for their products and maintained market share through technological innovation. Global leaders such as Toyota helped Japan to run large current account surpluses, offsetting weakness in the domestic economy.
Today, businesses have a lot of cash and have kept profit margins high as a consequence of reacting to the Great Recession swiftly and cutting employees. However, they face an uncertain future given the lower level of aggregate demand in their domestic economies. This will likely feed through to lower operating margins and thereafter lower returns.
Finally, governments globally have acted to try to safeguard their economic futures. We have seen globally coordinated bank bailouts, the socialisation of private debt, the evolution of monetary policy, massive fiscal expansion and the creation of the world's largest special-purpose vehicles that are keeping developed real estate markets on life support.
With the Japanese experience in mind, we expect a similar fate for the global economy.
The total effect of the government measures is unclear, other than to see them as an attempt to normalise global liquidity. The intention is to reduce the role of the derivatives and securitised products that propelled economic growth higher.
Growth expectations globally will need to be adjusted down, just as in Japan, and possibly more aggressively so, given that Japan was an exporting powerhouse. The developed market does not have this growth lever at its disposal, thanks in large part to globalisation and the existence of cheap labour and low manufacturing costs in Asia. It is mathematically impossible for everyone to export more than they import and to run current account surpluses!
Against such a difficult investment and macroeconomic backdrop, we expect investors to change their preferences as it becomes clearer that a ‘normal' cyclical recovery is highly unlikely. This is because the key driver of economic growth over the past 20 years, principally debt, will not be available in such abundant quantities.
Investors will likely follow the Japanese experience and adopt a more defensive bias to their portfolios, putting greater emphasis on ‘value' investing as opposed to ‘growth' investing. This means investors will pay attention to the size of dividends that businesses are willing to pay and will scrutinise the actual value of businesses with the intention of not overpaying for speculative endeavours.
This was certainly the case for Japanese equity investing, with ‘value' investments making money since 1992 and massively outperforming ‘growth' investments, which lost more than 50% of their value.
The simple answer is: superbly. Since 1992, listed property in Japan has posted the second highest equity sector return. Total returns have been just below 2% a year. Over the same period, the TOPIX has lost some 20% of its value (-1.4% annually, dividends reinvested).
We believe this outperformance results from investors seeing listed property as the classic ‘value' investment. Real estate assets are typically easier to value than other equity sector assets, as their valuations can be verified by independent appraisers and they have visible cash flows.
Crucially, a greater proportion of an investor's total return is in the form of dividends exceeding the wider equity market dividends. This is especially true when other sectors are compared with the evolving REIT industry.
Furthermore, listed property companies are able to find alpha "among the ashes". It is marginal players taking less than marginal roles that usually cause speculative bubbles in the sector. These are generally the first to cut their losses and run when the going gets tough.
This short-term volatility creates a survivorship bias (also a value investing characteristic) and generous investment opportunities for high-quality listed property businesses that are well capitalised, can buy from distressed sellers and earn normal returns through all economic cycles.
How has global listed property performed since the market bottom?
Like Japan since 1992, the answer is simple: tremendously.
Since the market bottom in March 2009, global listed property has outperformed global equity by more than 50%. Equity and debt capital markets globally opened their arms to the sector, giving market participants the ability to grow portfolios and earnings yields at a time when many competing sectors faced an unprecedented decline in end-market demand.
We expect this outperformance to continue for the next decade as investors begin to understand that growth expectations will be adjusted down because of large-scale deleveraging.
We believe consumers, businesses and governments will behave in the same manner as the Japanese did and likely switch their portfolios to a higher-quality bias. This is where the listed property sector's defensive investment characteristics become highly attractive.
In conclusion, we see many similarities between the Japanese real estate crash 20 years ago and the economic turmoil of today. The most important lessons learned from Japan are that in balance sheet recessions, nominal GDP can remain in positive territory even when the private sector is deleveraging, as long as the authorities take supportive monetary and fiscal measures. Furthermore, listed property can rise from the ashes and return alpha to investors.
More broadly, listed property offers an excellent value investing opportunity given its resilience to economic cycles, transparent valuations and ability to deliver superior dividend yields to long-term investors.
And ultimately, with asset values closer to the bottom of the asset pricing cycle than to the top, with global property dividend yields exceeding 4% and against the backdrop of an uncertain global economy, we expect the listed property sector's defensive characteristics to lead to long-term outperformance.
Matthew Hodgkins is an investment analyst at BNP Paribas Investment Partners