Deflation
Like balloons, economies can deflate. It’s happened in Japan and the D-word is being uttered in the US and Germany. Could the UK head the same way?
Deflation means persistent price falls and, at its worst, shrinking economies (see box, right). Japan is struggling with this problem. As PruPIM’s Ben Sanderson describes (p56), Japan’s deflation kicked off after its stock market and real estate bubble collapsed in the early 1990s.
Worryingly, both the UK and the US have just seen the end of similar stock market bubbles. There are also fears that the house price bubble could burst, triggering more general deflation. The chairman of the Federal Reserve Bank, Alan Greenspan, warned last September, “Historically, it has been very rapid asset price declines – in equity and real estate, especially – that have held the potential to be a virulently negative force in the economy.”
However, leaving aside the uncertainty that an impending war with Iraq is creating, most economists do not think the UK is in for a bout of prolonged price falls. “We’re a long way from deflation,” says Dennis Turner, chief economist at HSBC.
While the prices of manufactured goods have been dropping, services are still seeing 4% inflation. “Since the UK economy is serviced-based, the average rate of inflation is 2%,” points out Turner. “Below a certain level, you squeeze inflation out of the system at the expense of jobs, output and economic activity.”
The Bank of England’s remit is to keep inflation within the 1.5-3.5% band. If it dips lower, the Bank can cut interest rates further to help stimulate the economy.
“The key to not suffering deflation is the policy response,” says financial writer John Plender. He points out that the Federal Reserve Bank acted quickly in 2001, when the US stock market bubble burst, by successively cutting interest rates. The US government has now loosened its fiscal policy, pumping money into the economy.
“The UK is not at serious risk of general price deflation unless something unforeseen happens to the economy. This is a cyclical fluctuation,” adds Plender. “Unless policy-makers are very stupid, they’ll find a way of addressing malign deflation before we’re in deep trouble.”
However, this does not mean that UK property is in for a painless ride. Even if prices do not start dropping generally, there is still asset price deflation to worry about. The stock market bubble has burst – will it be housing and commercial property next?
For now, most experts are predicting a semi-soft landing. The independent consultancy Capital Economics does not think that deflation will hit the UK, but predicts that house prices will peak this year, and then drop 20% over the next four.
Its predictions for commercial property performance are “relatively bearish”, according to economist Sabina Kalyan. “Our forecast returns of 9.6% for this year are at the bottom end of the range.”
Capital Economics is predicting that commercial rents will fall outright in 2003-2004. But it is not expecting a 1990s-style crash in property values.
The boom in rents and values has not been strong this time, so the adjustment will be much milder – capital value growth will flatten out to 0.5% this year and next, says Capital Economics.
“If asset prices fall significantly, everything depends on the nature of the property contract,” Plender points out.
“In Japan, it has been pretty catastrophic. There, it’s easy for the tenant to up sticks and move. In the UK, because of the way lease structures are financially engineered, they provide some protection to the landlord and asset prices for a period of five years.”
Andrew Jackson, investment director of property research at Standard Life, says: “Persistent deflation is not good for property. One would see occupiers getting uneasy paying static rents. They would demand flexible leases and upwards and downward rent reviews. The government would bring in controls to allow falling rents – yields and capital values would fall.”
Rather more worrying for the UK scene is the large volume of debt hanging over both the personal sector and the property market. With deflation, or even low inflation, that debt cannot be paid off as quickly as when prices and wages are rising rapidly.
“Debt is a huge problem,” says Turner. “In the residential sector, property looks broadly affordable – at 4% interest rates it is costing less than at 8%, that’s startlingly obvious. Clearly, if the base rate shoots up to 8%, the consumer sector will topple over. But I don’t think that’s likely.”
The commercial property sector also has a debt mountain, £94bn at last reckoning.
But here again, low interest and a positive yield gap mean the debt can be serviced. “The last collapse saw much higher interest rates, and much more development,” notes Peter Cummings, who heads the Bank of Scotland corporate banking arm.
“We’ve avoided areas we believed were going to be suspect and cyclical,” he says.
Turner says: “Commercial property rode a boom-and-bust cycle with double-digit inflation. People thought it was great fun – if they knew when to bale out.
“In a deflationary environment, they can’t do that. The priority is to manage the business more efficiently – inflation isn’t going to bale them out.”
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UK property prices |
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Rents and capital values have been rising against low inflation |
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Source: Investment Property Databank |
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UK bank lending, interest rates and yields |
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Bank lending to property has rocketed with low interest rates |
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Source: DTZ, Investment Property Databank |
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Spiral of falling prices leads to a depression |
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Deflation occurs when there is a persistent fall in the prices of goods and services. It’s not necessarily a bad thing. If prices fall because productivity increases allow businesses to produce things more cheaply, and the economy is robust, deflation is benign. Take computers and telecoms. For a decade, the prices of these goods and services have fallen. We’re all better off as a result – producers and consumers. But there is also a malign form of deflation. This occurs when there are too few customers chasing too many goods and services. Businesses have excess capacity, their revenue falls and profits are squeezed. Competitive price cutting leads to cost cutting, jobs and wages are slashed, business investment falls and so does consumer spending. The economy then starts to shrink. When deflation really takes hold, consumers and businesses postpone spending and hang on to cash, knowing that prices are likely to be lower in future. This intensifies the recessionary pressures, and wages and prices spiral further downwards. This is what happened in the Great Depression of the 1930s, and this is what Japan has been experiencing for the past four years. Under deflation, income – cash today and tomorrow – becomes paramount. For commercial property the impact will vary depending on the security of the rental stream. Buildings and portfolios leased long-term to strong tenants, with traditional upwards-only rent reviews, are likely to see their values increase. These are the bond-like investments, providing a fixed income stream while prices elsewhere are generally dropping. Meanwhile, the traditional valuation methods, say, using an all-risks yield in perpetuity, are inappropriate. Discounted cash flow becomes the name of the game. Moreover, the covenant of the tenant becomes crucial. And deflation does not affect all sectors equally – retailers tend to feel the profit squeeze more than financial or business services, while public sector occupiers are least likely to be affected. Properties that have more of an equity element – where there is more uncertainty about future rents (and thus capital values) because of a short lease or break clause – are more vulnerable. The value of this less secure income stream depends on the likely path of market rents, and how they are affected by falling prices generally. If rental values deflate at the same rate as prices, and yields are also adjusted fully downwards, the capital values would, theoretically, remain stable. This, however, assumes that tenants’ profits are not squeezed to the point of them going out of business. But deflation squeezes businesses’ profits, and, moreover, occupancy costs may be easier to cut than jobs or salaries. The institutional lease, with upwards-only rent reviews, would come under intense pressure. |
Japan
To understand the impact of deflation, it is important to appreciate the Japanese context. In the late 1980s, Japan’s economic boom reached its peak with soaring stock market and real estate values and a roaring economy. Capital values rose sharply, particularly in Tokyo.
At its most extreme, the notional capital value of the Imperial Palace gardens in the centre of Tokyo was said to be greater than that of the whole of California. A correction came during the early 1990s when equities, land prices and real estate capital values all fell sharply (see graph below).
At the time, many economists dismissed this as an “over-shoot” – the markets had moved too far above “fair value” during the bubble years and then over-corrected to an “unfair” lower point. Immediately afterwards and up until the mid-1990s, optimists suggested that Japanese equities and real estate offered good value because asset markets were set to recover.
However, asset markets did not recover their former values but instead kept on falling. By 1999, asset price deflation was compounded by more general price falls as consumers reacted to uncertain economic times by paying off debt, reducing spending and building up savings. Interest rates were reduced to zero and prices reduced to encourage spending – with little positive effect. As a result, prices for some consumer items, such as furniture, are now 15% cheaper than they were in the mid-1990s.
The Japanese experience is now looking increasingly relevant to the rest of the world. Just like Japan, the US and European economies have experienced a bubble of equity and asset price growth that is now deflating. And, just as with Japan, many leading economists are suggesting that US and European assets look good value and that growth will recover strongly once these markets have returned to some sort of “fair value”.
But a key message from Japan’s experience is that the market imbalances resulting from asset price “bubbles” do not necessarily work themselves out as quickly as hoped. Recovery will come eventually – although Japan has now been waiting over 10 years – but after an asset price bubble, the recovery is likely to be more sluggish and arrive later than was initially predicted.
Also, during a period of uncertainty and falling asset prices, consumers’ and businesses’ behaviour alters fundamentally as they adapt to changed circumstances. The “working out” of the bubble and subsequent deflation has seen consumer confidence and spending stagnate, while business confidence and investment has remained depressed.
For Japanese real estate, deflation has had significant effects. In the past 10 years, investors have seen capital values drop by80% and rents by 60%. Jones Lang LaSalle estimates that average annual returns on central business properties have been negative since 1993.
Despite low interest rates, debt financing in a period of deflation can prove burdensome as the real value of debt increases. For highly leveraged investors in Japan, year-on-year falls in capital values have often only increased losses. Although there are some signs that capital values are at last starting to recover – and opportunities still exist for well-informed investors – many remain wary and the market is struggling to attract international institutional capital.
For occupiers, deflation has placed extra pressure on costs. Businesses cannot pass on price rises to their customers and so Japanese tenants commonly ask for regular downward rent reviews to maintain profit margins. Landlords often oblige – even when these reviews are not written into lease terms – for fear that, with a six-month notice period standard in most Japanese leases, occupiers can easily move to a cheaper building.
It is improbable that the Japanese experience will replicate itself completely in Europe and the US. Their economies and real estate markets are more diverse, and their banking sectors more independent and market-focused than those in Japan.
However, it has to be acknowledged that Europe’s economies and real estate markets have experienced some “bubble characteristics”, which distorted asset markets and led to financial imbalances that are only now beginning to be corrected. The Japanese experience tells us that when markets begin to adjust downwards they can sometimes keep on adjusting.
Ben Sanderson is a director in the property research team at Prudential Property Investment Managers. In 2002, he was based in Tokyo as part of Jones Lang LaSalle’s Asia Pacific Research team. The views expressed here are those of the author and do not necessarily reflect the views of PruPIM.
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Office property and inflation over the past decade |
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Capital values have not recovered as rapidly as predicted |
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Source: Jones Lang LaSalle. Statistics: Statistics Bureau and Statistic Center |
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