Japan: Housing Investment: Not V-shaped but L-shaped

Summary

The market as well as the Ministry of Land, Infrastructure and Transport appear to think that the housing market slump, owing to the revised Building Standards Law, will be temporary, but it may unexpectedly last longer. We think that the trend in housing investment is more likely to resemble an L-shaped pattern than a V-shaped recovery. The housing market slump is likely to be a protracted one because of problems in clearing up bottlenecks in the proliferation of approved software and the diminished affordability of homes.

What’s new

On January 8, the ministry announced it would provisionally approve by January 21 some of the software for structural calculations based on the revised Building Standards Law. The ministry plans to ask review entities to review applications within 35 days because approved software streamlines the construction permit review process. As a result, some of the bottlenecks in the review process are widely expected to be cleared up. However, we doubt that housing starts will normalize soon because of supply bottlenecks in the construction permit process and the diminished affordability of homes, an unexpectedly major issue.

On the supply side, we believe that it is unclear whether provisional approvals using ministry-approved software will dramatically improve the construction permit review process because of several factors. First, there are still only a limited number of qualified people for peer checks of the structural calculations. Second, the ministry’s approved software can be used for offices, plants, warehouses and other buildings with simple structures, but may not be useful for condominium buildings with fairly complex structures and atypical designs. Third, reviews using newly approved software may not save much effort because the structural calculation software is not limited to software newly approved with anti-fraud features, and can be existing software. Accordingly, we doubt that construction permits and construction starts will rebound sharply in 2008.

On the demand side, households are unable to afford as much as they used to. Home prices in urban areas have risen quite substantially in the past two years because of increases in land prices. In addition, nominal wage growth at the macro level remains sluggish because of a decline in the average wage owing to the retirement of many seniors and margin deterioration at smaller companies. Finally, mortgage rates have risen by more than household incomes have, following two BoJ rate hikes since 2006. The number of Tokyo-area condos sold in November 2007 (based on Real Estate Economic Institute figures) declined 43.6%Y to less than 4,000, the weakest November figure in 16 years. The contract ratio was notably weak, at only 64%. The recent sharp decline in housing starts might thus be attributed to a combination of weak demand and shocks from policy problems rather than entirely to a poorly prepared ministry. Regardless of whether the supply bottlenecks are cleared up, the prospects for a sharp recovery in housing investment are likely to weaken further.

Where we differ

In our revised economic forecast as of December 11, 2007, we estimated that GDP-based real housing investment would decline by 14.5% in F3/08, not much different from the Toyo Keizai consensus expectation of a 12.5% decline, but we expected it to shrink 3% in F3/09, versus the consensus expectations of a V-shaped recovery of 6% (likewise, the government looks for a similar drop of 12.7% for F3/08 and sharper rebound of 9.0% for F3/09). The difference stems mainly from our cautious assumption for construction starts. Based on our housing analyst Hiroko Kubota’s latest estimates, we assume that housing starts will slump to 1.04 million units in F3/08 from 1.28 million in F3/07, and then recover, but only to 1.14 million in F3/09 at most. Based on the above assumptions, we currently look for GDP-based housing investment to drop 12.1% in F3/08 and rise 1.5% in F3/09, which is a little better than our original forecast due to the stronger rebound of the October and November housing starts numbers. That said, there is not a significant difference for the upcoming L-shaped trajectory of housing investment.

Our expectation that housing starts will remain weak in F3/09 may seem inconsistent with the recent MoM rebound, but we are not needlessly pessimistic. To be sure, November starts of detached housing, for which structural calculations are fairly simple, again declined, by 14.9%Y, to 1.01 million (not annualized). However, November starts of condominiums, which require somewhat complex structural calculations, declined 63.9%Y to 8,300, with no indications of a rebound.

Under such circumstances, the proliferation of ministry-approved software is widely expected to ease some of the construction permit requirements and lead to a rebound in housing starts sometime soon, but we doubt that condo starts will recover quickly because of the existing supply and demand problems we noted earlier. A decline in the amount of property that households can afford is also likely to hold back any rebound in housing starts in F3/09. Housing starts peaked in F3/07 and are unlikely to recover that much because of a likely decline in the number of households and increases in construction costs. Demand may surge ahead of a consumption tax increase, but probably not until F3/12. The slump in housing starts may also reflect a reduction in the housing stock following an excess of supply through mid-2006, when the BoJ’s zero interest rate policy (ZIRP) was in place. Condo developers competed to develop new buildings in those years because the carrying costs for land were relatively inexpensive and land prices were expected to rise. We think that we are now seeing a reversal of the trend.

What’s next

GDP-based real housing investment, which slumped 7.8% (27.9% annualized) in July-September, probably weakened further in October-December (the figure comes out around February 14; we estimate a decline of 8.6%, or 20.4% annualized based on the housing starts figures up to November) because the figure is based on construction progress rather than starts. However, as construction starts by floor area recovered in October-December, real housing investment might achieve positive growth in January-March for the first time in five quarters. Even so, we expect a base effect to hurt real housing investment in F3/09, as explained later. We thus think that the January-March figure will be technically important for gauging real housing investment in F3/09. The January-March GDP data are scheduled to come out in mid-May.

We think that a more fundamental factor for whether our caution is warranted will be the trend in condominium starts in the first half of 2008. Given the reports of a bottoming out of construction permits among some developers, we intend to closely follow monthly housing starts and micro-level data.

Risks

Our cautious view could prove mistaken if conditions seriously worsen, the ministry implements measures to safeguard against radical change, or the revised Building Standards Law is watered down. However, we believe that the construction permit process will become irreversibly tougher because the ministry wants to expand the market for existing homes by ensuring that they are more durable. We also think that the process needs to become more stringent to improve Japan’s housing stock.

A second risk factor for our cautious view is the base effect. In our forecast dated as of December 11, 2007, we expected GDP-based real housing investment to grow in every quarter in F3/09 but still be down slightly on a year-on-year basis because of a low launch pad (i.e., negative base effect), stemming largely from the figures for October-December 2007 and January-March 2008. As stated above, however, these figures might be stronger than we expect, given that November housing starts, which were announced on December 28, grew by slightly more than we expected, and we cannot exclude the upside risk that housing investment in the October-December and January-March quarters prove to be stronger than our original outlook. Even in this case, however, we doubt that real housing investment will grow in F3/09 by as much as the government expects (+9.0%Y). Rather, we think that the trend in housing investment will resemble an L-shaped pattern after all.

By Takehiro Sato & Takeshi Yamaguchi New York
Morgan Stanley
January 16, 2008