10 May 2009

Interest Rates, Koushin, and Japanese Place Names

While the bursting of the real estate bubble is helping Americans rethink attitudes to real estate, I've wanted to write for awhile about the weird approach to real estate in Japan, how it's enabled by interest rates, and how it influences place names here (honest).

The image of many famous cities is associated with their traditional housing stock. Whether the sturdy brick buildings of Dublin, the mansard roofs of Paris, or the Victorians of San Francisco, traditional housing has a big influence on the ambience of a city.

Except here in Tokyo. When you first come to Tokyo you're impressed with the skyscrapers, subways, and the occasional truly idiosyncratic building, but if you actually go out looking for apartments here, like I did two years ago, you'll find the strangest thing: there is no such thing as housing more than about 25 years old. This is really not an exaggeration: my building was built in 1988 and is thus considered "old".

This isn't limited to housing: hotels, office buildings, factories, and so on are all torn down and rebuilt about every 20-25 years. The word they use for this is koushin 更新, which means 'renewal'. Interestingly, that same word is also used for updating software or for replacing the display in a department store.

Of course, I find this kind of sad: I like classic old housing, that's why I own a San Francisco Victorian. But after looking around awhile, I realized that sort of thing just isn't an option in Tokyo: either you get recent high-rise precast-concrete construction, or recent poorly insulated, noisy low-rise wooden construction. As much as I had visions of a wonderful Japanese-style apartment, I opted for the high-rise.

But apart from my emotional reaction, it seemed frighteningly inefficient to me: why in the world would you tear down a perfectly good 25-year-old building, and replace it with essentially the same thing? Right now the former Motorola office building down the street from our office is in the midst of being koushin-ed. They tore down the old 7-story office building, cleared the site, and are now building a new 7-story office building. This is quite normal for koushin: whereas in America we might think of tearing something down and building a bigger, taller building on the site, it's quite normal in Japan to tear down a building and build a new building of about the same size. It's just newer.

The builders will say this is because Japanese prefer new construction. Of course, most people in most countries prefer new construction: the question to me was, why is it pervasive here? The key answer lay in interest rates, combined with demographics.

Japan, as everyone has heard, is a very savings-intensive nation. Because of that, interest rates here have been lower than America for many decades, but it became even more true after the bursting of the Japanese bubble economy in around 1990. Since then, the BOJ interest rates (the equivalent of Federal Reserve rates) have been around 0%. Even at the retail level, a normal home mortgage goes for 2-2.5%. In other words, if you can manage to qualify for a mortgage loan here, you won't pay much on it.

Secondly, the population of Japan is actually shrinking. Although the Japanese are very long-lived, the birthrate here is very low (second-lowest after Italy). The birthrate has finally caught up to the longevity, and each year there are fewer Japanese than the year before. Combine this with the fact that Japan does not permit large-scale permanent immigration, and you realize that the aggregate demand for real estate is also falling. This weak demand is most pronounced in rural areas, where real estate is becoming almost valueless, but it's true everywhere.

As you would expect given declining demand for something, that means long-term prices are weakening. Even in Greater Tokyo, the long-term expectation for the growth in value of a piece of real estate is zero. That is, if you've done well, 20 years from now your house or apartment will be worth the same as what you paid for it. If you're unlucky, it'll go down -- my boss lost 30% of his equity on the first apartment he ever owned.

What does this combination of low interest rates and long-term declining real estate prices mean? Well, first of all, it means you have no incentive to view real estate as in investment. You buy real estate to lower your rent (if an individual) or for the sake of the rental cash flow (if an investor). Either way, you look at real estate purely from a cash-flow point of view.

Secondly, Tokyo is famous for real estate being expensive. But mostly what's expensive here is land. The underlying land parcel for a building is expensive, but the building on it isn't considered to be worth much. Why? Well, it's a depreciating asset since everyone wants new construction.

So here's how that all connects to the koushin phenomenon. Let's say you're the owner of a 25-year-old apartment building. It's considered kind of drab, so you're not getting the highest rents in the neighborhood. Let's say the land is assessed at about $10M US, and the building at U$5M. If you've done a good job of marketing, our building is covered its expenses, meaning your getting about U$1M per year in total rent. Here's what the breakdown looks like for koushin vs. not koushin:

Don't rebuild: Your rents continue to slowly decline. You have no new capital expenditure to put in, though.

Rebuild: You have to borrow U$5M to build a new building, but at 2%, that only costs you U$100,000 per year. However, because your building will then be brand new, you can charge among the highest rents in the neighborhood.

So in other words, if spending U$5M to renew the building means you can increase your rents by 10%, it's a good economic deal for you. Given the prediliction of Japanese for new construction, I think 10% is way conservative: new construction easily commands a 20-30% premium here, I think.

But isn't there a third alternative? In America, the owner often choose to remodel: give the building a new lobby, replace all the elevators, repaint the walls. Why isn't that a good option? Well, let's say we could remodel for $1M. That would only then increase interest costs by U$20,000 per year, meaning you only need to justify a 2% rent increase. That's also economically compelling, but the question is, why do that when you could just rebuild? They're both a lot of trouble, and the rebuilding option can get you much higher rents.

For single-family houses, the only thing different from the above analysis is the timing. Most people don't tear down and rebuild their house while they're living in it. However, when the original family moves out, the same tradeoffs apply: a builder can buy the old house, raze it, build a new one, and get a higher price than simply reselling the existing house. Because most of the cost of buying a piece of property is tied up in the value of the land, not the structure, so rebuilding the house just isn't that big a deal economically.

So the unholy combination of declining real estate prices, low interest rates, and a market that prefers new construction (combined with the utter lack of historical preservation or zoning laws -- neither of which exist here) results in the total teardown and rebuilding of everything on the surface of Tokyo every 20-30 years. It's really shocking given how admirably efficient the rest of the society generally is.

And finally, how does this relate to Japanese place names? I noticed when I got here that a huge preponderance of the place names are temples and shrines (and a second major category are the names of elementary, junior high, and high schools). Eventually I realized why: those are the only buildings that aren't torn down regularly. Thus, it makes perfect sense to name a bridge, subway station, or intersection after a shrine, template or occasionally a school: those are the only things you can be sure will still be here in 30 years.

1 comment:

Chris said...

Leo,
What a well written, informative and delightfull piece. Much better than most of my Econ profs, for sure.

I also wonder if the political power of the construction industry is involved at all in this phenomenon.

There may be incentives, like the drastic car inspection that drives the export of used cars.

chris