What's on the Horizon for Property Markets
During the 1980’s the Japanese share market soared to heights of unimagined scale. My father can recall his personal experience as an investor during this time. His first personal taste of a boom was when the Australian Government abolished exchange controls in the early 1980’s and he diversified a proportion of his fledgling portfolio into Japan. The Japanese component of his investment portfolio increased in value by 300% in three years which certainly captured his attention. Every time he sought an explanation as to why it was overwhelmingly outperforming all other components of his balanced portfolio he was told that Western notions like valuations and Price/Earnings ratios were no longer valid in Japan. No westerners could understand Japan so the advice was, “don’t even try to explain it, just enjoy the ride”. The explanation at the time about the benefit of cross ownership between companies, competitors and banks, which supported the share price was flawed. He was told it was the Demmings Management Method that was benefiting Japan along with any other reason that could be concocted to explain the discrepancy. Fortunately, he wasn’t convinced and sold out to quit while he was ahead. On the last trading day of 1989, the Japanese Nikkei Index peaked at almost 40,000 and thirty-three years later at the end of 2022 it is valued at less than 30,000, still remaining over 25% below the bubble valuations of 1989.
Nikkei Index 1983 - 2022
It wasn’t just shares that suffered the spectacular boom and bust in Japan. Real Estate was supposed to be immune from price bubbles, as it was tangible. You could see and touch it and it wasn’t going to go away. They weren’t making any more of it in crowded Japan. By 1990, the value of Japanese property was equal to 20% of the total wealth in the world. It had increased by over 75 times since 1955. The total value of all golf courses in Japan was $500 billion, which was double the value of the entire Australian share market at the time. The Imperial Palace and its’ grounds in central Tokyo was valued at a greater amount than all the land in California.
Unfortunately, rental income was rising more slowly than property values and, as explained by Fishers Discounted Dividend Model this inevitably spelt disaster for Japanese Real Estate. As interest rates increased in the early 1990’s the ability to see and touch property didn’t stop it from falling over 70% in value and remain there decades hence. A few years later the very same thing happened in Hong Kong and Singapore. Property speculation can end in disaster just as easily as share market speculation, perhaps more so because of the strong mythology that people are prepared to believe about the safety of bricks and mortar.
In Australia at the end of 2022 we now have residential land worth more than all Japanese land was as a percentage of GPD in 1989. The ratio of residential land value to GDP is more than 330 per cent. Many commentators speculate that the RBA may increase rates to more than 4.8%, just 1.2% lower than Japan’s rate high in 1991 which is also akin to Australia's historic average. In reality, how high rates will go and how quickly is anyone’s guess, though the consensus is that they are not expected to go down anytime soon. With rising rates, mortgage repayments have increased more than 40% in a year, which is the fastest increase we have ever seen. This has drastically impacted serviceability, seeing mortgage costs double that compared to rent in Melbourne and Sydney. In Sydney, repayments are equivalent to the average full-time pre-tax salary. All the while rental yields are being squeezed. The impact of these changes have not been fully realized by homeowners given the delayed effect due to greater than usual concentration of fixed-rate mortgages and the fact that variable mortgages typically take 3 months to absorb rate changes. This comes as a particularly stark reality check for those who were recently swept up in the housing mania following covid. The question on everyone’s mind is “what are house prices going to do next?” The truth is nobody knows. What is reasonable though, is to expect fundamental values to prevail.
In looking down through the ages at the drivers of investment return it is refreshing to see that certain patterns emerge. Valuing assets comes down to understanding returns and where returns come from. Whether those assets be shares, bonds, property or cash the fundamental premise remains the same. The late Jack Bogle, legendary founder of Vanguard Investments, released some research, which he presented at the Australian Investors’ Association conference back in May 2002.[1] This research documented the returns from the US share market on a decade by decade basis over the last 100 years. He was able to break down the return; firstly to show what he termed the Investment Return. This was made up of both Dividends and Earnings Growth. Next he was able to determine what he called the Speculative Return which could be determined by subtracting the Investment Return (made up of dividends and earnings growth) from the Market return for that decade. The Speculative Return that remained was able to be attributed to the impact of the change in the multiple of earnings people were prepared to pay for the dividends and earnings growth of that decade.
In the first decade of the 1900’s the dividend for the US market averaged 3.6%p.a. and the earnings growth was 4.7%p.a. This meant that the Investment return should have been 8.3%p.a. The market achieved a return of 9.1%p.a. So therefore the extra 0.8%p.a. could be attributed to a growth in optimism or expansion of the P/E (Price/Earnings) multiple. The following decade was not so optimistic, beginning with the sinking of the Titanic and following that the devastation of the First World War, Bolshevik Revolution and ending with the Spanish Flu Epidemic. The earnings were actually higher at 5.3%p.a. during this decade but the earnings growth was only 2.0%p.a. This resulted in an investment return of 7.3%p.a for the second decade of the twentieth century. Despite combined earnings and earnings growth of 7.3% the market achieved only 3.9%p.a. over this decade. The Speculative Return or contraction of the P/E multiple was responsible for this. As people became more pessimistic over this decade they bid down the price of shares. This was responsible for the 3.4%p.a. lower return that the market achieved than the investment return dictated and this was purely the speculative impact of pessimism over that decade.
The results of each decade over the twentieth century showed a remarkable consistency in the dividend and earnings growth making up the investment return but enormous swings of optimism and pessimism in the speculative return. This accounted for the wide variation of returns over each decade but over the full period they canceled each other out so that by the end of the century the speculative return accounted for only 0.5%p.a. of the return. The dividend was 4.8%p.a. and the earnings growth was 4.8%p.a. creating an investment return of 9.6%p.a. compared to the market return of 10.1%p.a for the century. Despite this overwhelming evidence that earnings and the growth of those earnings are what matters most, enormous resources have been consumed and fortunes won and lost chasing the 0.5%p.a attributable to the speculative part of the market. This result is consistent with what Bachelier found when preparing his thesis in 1900 at the Sorbonne that “the mathematical expectation of the speculator is zero”, which he describes as a “fair game”[2]
The mood swings from pessimism to optimism and back have been in evidence for a very long time and is just as relevant to property markets as it is share markets. Investors that understand these principles will recognize when it is time to tighten the belt and times when opportunity abounds. Patience and the resolve to remove emotion from the decision-making framework are integral to investor success.
[1] Bogle, John C. 2002. “What’s Ahead for Stocks, Bonds and Managed Funds” Australian Investors Association Conference, May 2002.
[2] Bacheleir, Louis. 1900. Theory of Speculation. Paris Gautier-Villars