Strategy: Greg Hoffman
The Land of the Rising Sun and its archetypal “Mrs Watanabe” provide a cautionary tale for Australian investors
Aschool excursion took me to Japan in the early 1990s. I’ve been hooked ever since, returning many times to enjoy the wonderful people, scenery, food and powder snow. Yet for most of my career in finance and investing, Japan’s economy and financial markets have been curiosities, if not mysteries. An almighty property and sharemarket boom in the 1980s led to a nasty bust beginning at the end of that decade.
Japan’s famous sharemarket index, the Nikkei 225, rose from around 10,000 in 1984 to a staggering peak of almost 39,000 in December 1989. The Nikkei’s low for the following year was also made in December when it hit 21,902, a fall of some 43%. And it didn’t stop there. In 2003, the Nikkei fell well below 8000.
The direction of property prices was broadly similar, although their magnitude was less severe.
Commercial property prices spent the entire 1990s falling and continued the trend into the first seven years of the 21st century. Economic growth stagnated and the popular phrase “Japan’s lost decade” took on a sad irony as the whole chapter extended well past the 10-year mark.
Japanese interest rates were extraordinarily low for this entire period. The country even experimented with zero interest rates to try to help things along, with little success.
Eventually, a few foreign investors began working some numbers. In 2005, a portfolio of retail and office buildings could be acquired on an average yield of 5.6% a year. And banks would lend money against these properties at an average rate of less than 1.4%pa.
Using a 50% loan-to-value ratio, the table (right) shows a simplified “back-of-the-envelope” version of what the numbers looked like.
The ultra-low interest rates performed the transformation of turning a respectable 5.6% yield into almost a double-digit annual cash return with a conservative-looking loan-tovalue (LVR) ratio of 50%. To Aussie investors, such numbers proved hard to resist and the ASX saw no less than three investment vehicles listed with this strategy. Babcock & Brown Japan Trust was first, in 2005. Then came Galileo Japan Trust and Rubicon Japan Trust. Painful lessons eventually followed.
In a normal economy, you might count on a property portfolio’s rent rising slightly each year and its value following suit. And that may be what Aussie investors had in mind as they piled into these trusts that were taking advantage of the seeming disparity between Japan’s respectable rental returns and its low interest rates.
Yet each of these vehicles got into hot water and the reason why may prove salient to us as Australian investors in 2019.
The second table (above) shows the impact of 10 years of annual deflation (in rent and values) at 2%.
The LVR is key here. At the start of the period, each $100 (or yen) invested in the portfolio was financed by $50 worth of debt and $50 worth of equity, for an LVR of 50%. By the end of the period the portfolio’s value was just $83.37 and it was financed by the same $50 of debt, meaning the equity was worth only $33.37. This gives a LVR of 60% (and a 33% loss on the original $50 equity investment).
This dynamic sent the various Australianlisted vehicles that purchased Japanese property back to their investors several times seeking more equity to repair their LVRs. For investors enticed by initial forecasts of healthy cash returns, this was a complete turnabout. They expected to be receiving income each year, yet these vehicles were begging for the cash to flow in the opposite direction. It didn’t end well.
THE EVERYWOMAN
“Mrs Watanabe” is a fictional name used by people in the finance industry to describe the archetypal Japanese housewife: a matriarch seeking the best place to invest her family’s money. The term is used as a stand-in to refer to the typical Japanese small investor.
Over the past 25 years, professional investors have joked about how foolish Mrs Watanabe was to be accepting such low interest rates in safe government bonds. But she doesn’t look so foolish in hindsight given the losses suffered by Japanese property and sharemarket investors over most of that period. Mrs Watanabe has at least made a small positive return while many others suffered losses.
Our own Australian government 10-year bond is yielding less than 1%. In other words, for each $100 you lend to our government for a decade, you’ll receive an annual return of less than $1. A very “Japanese” rate, indeed.
The question is whether this rate signals a long period of future stagnation for the Australian economy or, worse, deflation. And, if it does, might we suffer some of the same challenges as Japan has already been through?
There are important differences between Japan and Australia (eg, demographics, immigration and natural resources). But Japan’s cautionary tale should not be dismissed out of hand.
In a recent speech, the governor of the Reserve Bank of Australia, Philip Lowe, noted that “for almost 4% of borrowers their current loan balance exceeds the value of their property. Over half of these borrowers are in Western Australia where there has been a large and persistent decline in house prices.” Perhaps our friends in WA are already going down the same path as the Japanese. We can only hope that the rest of us don’t follow but, if we do, forewarned might be forearmed.
‘ Investors expected to receive income each year, but the property trusts were begging for cash to flow in the opposite direction. It didn’t end well.