April 14, 2002

Gimme land, lots of land - and no crash

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In his autobiography Jack Welch devotes a chapter of his life to golf, and goes on to imply that without golf it is very hard to network in business. He almost goes so far as to say that without golf, nobody can succeed in business.

His view of the world was certainly embraced by the average Japanese salaryman in the 1980s, most of whom took to golf like new cult members. In fact, one of the most interesting aspects of the Japanese bubble economy of the late 1980s was the central role played by golf and speculation on golf club memberships. Like many things in Japan, the game acquired an odd internal hierarchy of its own. The social pecking order so apparent in Japanese society became equally well defined by certain golf clubs.

Since the members owned the clubs, when land prices began to increase, so too did the price of membership as the property rights associated with membership became increasingly attractive. In 1982 one of the big Japanese dailies decided to construct a golf club membership index. This index tracked the changes in the membership prices of the top 500 golf clubs in Japan.

The index was 100 in 1982 and had reached 160 by 1985. By 1987, the index stood at an astronomical 1,000 and over 20 clubs in Tokyo cost more than $1 million to join.

When any asset becomes that valuable, the market usually responds by trading the asset. In Japan a secondary market in golf club membership sprung up. Brokers typically took a commission to buy and sell memberships. Banks lent up to 90 per cent margin against the collateral value of the golf club memberships.

Very soon the Japanese were building golf courses in Hawaii, on the basis that it was cheaper to fly golfers to Hawaii to play golf than to play at home. Not satisfied with Hawaii, Japanese golf companies, backed by the ‘collateral’ of golf club memberships at home, started buying in the US. This process culminated with a medium-sized Japanese golf development company buying the Pebble Beach Resort Club in California for $850 million.

In 1990, with the Nikkei Stock Index at 34,000, Nomura Securities forecast that it would be at 100,000 by 1995. Anything seemed possible as long as money was cheap. And money certainly was cheap. Real interest rates in Japan were being kept low by the central bank in an effort to keep the value of the yen down.

With the system awash with liquidity, a new form of creating money became apparent. Most people who have watched economics, even from a distance, will have heard of the gold standard.

This system, prevalent in the world up until the early 1970s, allowed central banks to print a certain amount of money as long as it was backed by gold in the vaults.

In Japan a land standard emerged: land took the place of gold in the banking system. From 1953 to 1989 land prices had risen by 5,000 per cent, yet inflation had only doubled in the same period. As a result, most Japanese banks naturally thought that land was as safe as houses. Japanese banks started lending against land prices rather than cashflow, and regarded illiquid land with notional values as a decent substitute for cashflow when assessing a company’s ability to repay.

So long as land prices rose, this approach was fine. Suffice to say massive distress became evident in Japan by 1992, and the golf club index in 1994 stood at half its 1992 level.

Let’s leave Japan and look at Ireland today. There are some disturbing similarities to the Japanese situation of the late 1980s, yet there are some differences that can’t be overlooked.

The primary similarities are the land standards in operation in both countries. Irish banks are lending against land values as if it were going out of fashion. If you believe that land prices are inflated beyond all reasonable levels, then there is a serious problem, because the banks are lending against already inflated values and therefore their prudential ratios are based on non-prudential values.

In Ireland, the effect of a 10 per cent increase in land prices is amplified by the amount of money that is lent against this notional value, and in turn, the more money in circulation, the more land prices are going to go up. Higher land prices beget more borrowings, which in turn beget higher land prices, and so on.

As long as interest rates remain low, the only issue discussed is whether houses are affordable relative to income at these levels. With interest rates at a 30-year low, it is not surprising that most indices of affordability suggest that everything is hunky dory. That’s that, until we ask ourselves why interest rates are so low, and whether they are likely to remain low for some time to come.

European interest rates are low because the economy is in a bind. Many argue that this is structural and the combination of a high savings ratio and an ageing population. This combination suggests that Europe is in a long-term slow growth phase.

This implies that although there will be peaks and troughs in the business cycle, these will be moderate and interest rates will only go to, let’s say, 6 per cent, barring some class of shock. One such shock was German reunification — that sent interest rates to 12 per cent. But this can’t happen again.

What about an oil shock? Is this likely?

An article in last Friday’s Wall Street Journal pointed out that the best possible outcome for oil over the coming year was predicated on no American invasion of Iraq. This political scenario allowed the oil price to drop modestly from today’s $27 a barrel to $24. It pointed out that there was a significant chance of oil moving up to an average of $35 a barrel and possibly spiking and staying at around $50 a barrel, depending on the outcome of events in the Middle East. This type of scenario could disturb some of the more sanguine forecasts for the Irish property market.

Yet there’s another highly significant difference between bubble Japan and present day Ireland that might just prevent value and price moving back into line here.

A recent United Nations report of demographics reveals that of the industrialised nations, only Ireland and the US will experience population growth over the next 50 years.

Both countries are likely to see a 30 per cent rise in population by 2050. This suggests that both will certainly be more dynamic, because, put simply, young countries grow faster.

This doesn’t mean that Irish house and land prices will go up forever, but it does imply that there is a stronger probability that when they fall (as they did last year) they might recover quicker. This would be plain sailing if it weren’t for the unfortunate fact that a state such as California, which has seen its population rise every year since 1900, experienced a 30 per cent fall in land prices in the early 1990s.

So although Ireland’s bubble may not be quite like Japan’s of the 1980s, the multiples at which houses are trading vis-a -vis average income, together with the operation of a ‘land standard’ and inappropriately low interest rates, indicate some similarities.

These factors suggest the fact that house prices rose by close to 5 per cent in the first quarter of 2002 should be a cause for concern, not celebration.

Where do we go from here? Check your golf club membership fees. If there was a big jump last year, be warned. If the fees were flat, stay chilled. If they plummeted, then offload.


  1. adollard

    Gimme land, lots of land – and no crash 14/04/2004

    I liked your article.
    History shows deflationery depressions occur every 50 to
    100 years on average.
    90 percent declines in the housing market at extremes are
    common. If its going to happen watch 7500 on the Dow Jones
    industrial average. Germany should enter it first in Europe
    or dare I say its already started.
    Interesting theory with the golf.

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