EC O N OM IC

PULSE

A REPORT ON THE asia pacific  ECONOMY AND

ITS IMPACT ON commercial REAL ESTATE

Inflation or deflation?
Which way is Asia headed?
Young populations and low debt levels enhance long-term
real estate investment opportunities in many asian countries

A logical strategy
The current debate raging is whether we are headed for inflation. And if so, what will be the effect on
commercial real estate prices? Recent Government and central bank actions have resulted in unusual
monetary and fiscal policies ranging from quantitative easing in the UK, ‘cash for clunkers’ in the USA and
very large bank loans in China. Some view these policies, put in place since the credit crunch hit a year ago
with the collapse of Lehmann, as being inflationary. Others argue that with output running at well below
capacity, inflation is impossible, and deflation is the more likely scenario. Here we separate out consumer
price inflation from asset-price inflation, and discuss that in the medium- to longer term, inflation is the more
likely scenario for Asia, not including Japan. This goes to show that investing in certain Asian real estate asset
markets remains a logical strategy in the present economy.

Figuring out where we stand

Consumer price indexes are currently low in most Asian countries, as demand and prices of things like
commodities have fallen along with global GDP output. Real estate asset prices are falling as the availability
of debt is curtailed, leading to a shifting of yields upwards. Governments across the globe are printing and
spending money in an effort to restart credit flows put a floor under falling asset prices and boost consumer
Choonbeng Ang
October 2009 demand. But what will happen next in Asia? Generally there are two schools of thought:

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1. Printing and spending money will prove to be inflationary and in high inflationary times one should not
hold cash, but rather real assets including real estate.
2. We are in a deflationary period and prices will continue to fall, as demand is far below the global
economy’s output capacity. In a deflationary period, it is better to hold cash, as you will be able to get a
better deal tomorrow.

In order to prop up weak economies and put cash back into the seized banking system, governments and
central banks have introduced regimes of increasing money supply with exceptionally low interest rates, for
example in the USA and UK. Usually, low interest rates:

1. Drive investors to put money into assets - and that includes real estate – compressing yields. The
opportunity cost of holding savings is reduced, pushing investors to buy assets.
2. Drive down the value of the currency against other currencies.
3. Are linked to increasing money supply, which can have an inflationary effect on goods and services.

An easy way to see the interconnection of these three points is to think about the prices of money1.

1. The price of money relative to time

g interest rates

2. The price of money relative to foreign currency

g exchange rates

3. The price of money relative to all goods and services

g inflation rates

Increasing the money supply usually leads to a fall in interest rates, depreciation in exchange rate and an
increase in the inflation rate. There have been arguments that we will not see any inflation whilst
economies are operating at well below output capacity. That may be true for goods and services
consumed today, but it is entirely possible that future uncertainty about government policy and currency
weakness or exchange rate risk, will push investors back into holding real assets.

The effects of these low interest rates get transferred to Asia via other policy rates, such as the Singapore
Interbank Offer Rate (SIBOR), and through currencies, whether formal pegs like the Hong Kong dollar or
informal pegs such as the Chinese Yuan. A weaker dollar may lead to stronger Asian currencies but, like it
or not, the effects of US loose monetary policy will be felt in Asia.

Consumer price inflation or asset price inflation?

In order to decide whether we are headed for inflation or deflation in Asia, we need to consider the
difference between asset price inflation and consumer price inflation. Consumer price inflation is a rise
in the value of things consumed today, whereas asset price inflation is the rise in the values of a future
stream of earnings. The connection between the two forms of inflation is the yield.

1. Moss, D.A. (2007) A concise guide to macro economics Harvard Business School Press, Boston.

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Real estate prices are subject to asset price inflation, and usually do not show up in consumer price indexes.
In some countries, a housing cost component is included in the consumer price index (CPI), usually the cost
of renting a small family home. Where house prices are rising because yields are compressing, from say 6% to
3%, that rise would not show up in the government’s inflation monitoring by the CPI. However, if asset prices
are rising because rents have risen from 100 dollars a month to 200 dollars a month, then that price rise
would show up in the CPI.

It is entirely possible to have asset price inflation in a period of low consumer price inflation, as we saw
during the ‘great moderation’ from 2003 to 2007 where, in the US, consumer price inflation was low but
asset prices rose steeply. Conversely, one can have asset price deflation during relatively high levels of
consumer price inflation. Generally, monetary policy focuses on consumer price inflation, but usually ignores
asset price inflation. Inflation in the values of goods and services consumed today is usually regarded as a bad
thing, but rises in the values of assets -- houses, commercial property, equity prices, the value of goods and
services consumed in the future -- is usually regarded by the public as a good thing, even though the effect is a
compression of yield and reduced returns to investors.

Money illusion in asset prices

In accordance with Milton Friedman’s famous quote, “Inflation is always and everywhere a monetary
phenomenon”, if money supply is too strong, too much money will be chasing a relatively fixed amount of
goods and services, which leads to consumer price inflation.

For asset prices, too much capital (including available debt) chasing too few assets for any specific geography
can lead to asset price inflation through yield compression. For example, Hong Kong has limited land and
limited physical assets available to purchase. We recently saw an uplift in residential prices as money from
China’s stimulus package is leaking in to the city. But asset price inflation through yield compression cannot
go on indefinitely. When it becomes apparent that the current vendor bought a 2.5% yield and now cannot
sell at a 2%, eventually the bubble must burst. Alan Greenspan once famously said it was too difficult to try to
spot asset price bubbles and do anything about them. In Asia, are we starting another asset bubble through
excessive yield compression, or will real estate prices turn out to be a good investment based on a sensible
rental income stream? And why is it so hard to spot an asset bubble forming?

The answer probably lies in fundamental difference between consumer prices and asset prices -- assets are
consumed over a long period of time. Where there are long time periods, there is uncertainty about the
future. Uncertainty makes people susceptible to market psychology forces, or irrational exuberance, but
the exuberance may not be all that irrational. Robert J. Shiller, who wrote Irrational Exuberance2 recently
co-authored with George A. Akerlof Animal Spirits: how human psychology drives the economy and why it matters
for global capitalism.3 Shiller and Akerlof list the following five factors to demonstrate that people are not the
rational actors that standard economics assumes:

2. Shiller RJ (2000) Irrational Exuberance Princeton University Press NJ

3. Akerloff GA & Shiller RJ (2009) Animal Spirits Princeton University Press NJ

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• Confidence
• Fairness
• Corruption
• Money illusion – inflation/deflation
• Stories

Of these, ‘money illusion’ is the most important in considering whether we are headed into a real estate asset
bubble. Money illusion means people have considerable difficulty taking inflation into account when working
out how to invest their money.

Over long periods of time in advanced economies, house prices do not rise in real terms at the same rate as
GDP, and other investments such as equity markets, might produce better returns. However, that ignores
the fact that people find it easier to get debt to buy a house or apartment, than to get debt to invest in the
equity markets.

Consumer price inflation erodes the real cost of debt over 25 years, a common mortgage length in advanced
economies. Even with low levels of consumer price inflation, for example 2%, the cost of debt in that time
period would have fallen 40%. At a 7% inflation rate, the real value of debt halves in just 10 years.

Part of the reason for asset price inflation is that people are well aware of the effect of consumer price
inflation on the cost of debt. Therefore, it becomes entirely logical on an individual basis to borrow as much
as one can (leaving aside the tax benefits that certain countries have where interest payments on mortgages
are tax deductable). To reap the benefits of any inflation, the logical course of action is to load up on debt in
an inflationary environment.

The problem comes at a society level, where individuals are free to borrow as much as they can in a
regulatory environment that supports free markets and the assumption that people will only take on as much
debt as they can afford to repay. The folly of such thinking has of course been more than demonstrated by
the sub-prime mortgage crisis in the US.

Not surprisingly, recent studies have started to focus on asset price inflation in residential real estate and its
links to the workings of the wider economy. Asset price inflation through house prices has clearly had a
greater effect on the wider economy than has been previously recognised4. This in turn feeds into commercial
property prices.

4. Reinhart, CM & Rogoff, KS (2008) The Aftermath of Financial Crises American Economic Association Meeting San Francisco 3 January 2009
Goodhart, C & Hoffman B (2008) House prices money credit and the macro economy European Central Bank Working paper 888 April 2008

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Figure 1 | inflation rate, % Inflation in Asia

Figures 1 and 2 show inflation rates – as measured
by CPI - across Asia plotted against real GDP from
1991 and forecast out to 2015. The average for
China is four percent, comparable with the last
thirty years in the UK and USA when the inflation
rates averaged close to five percent and four
percent respectively. Measuring from 1991, the US
inflation rate has been much lower, reflecting the
action taken in the 1980s to contain inflationary
expectations.

Figure 3 plots inflation against real GDP growth. In

essence there is not much correlation between real
GDP growth and inflation. India has averaged an
inflation rate of close to 7%. If you buy a house
there, you would expect the real value of your
mortgage debt to halve in ten years. Given that India
Source: IMA Asia
is currently developing a middle-class housing
market, the inflation rate may boost the market
Figure 2 | inflation rate, % psychology of buyers, required to start a mortgage
and housing market.

The idea that a relatively high rate of inflation might

encourage economic development is unorthodox in
western economies where consumer price inflation
is held low at 2%. Higher inflation is seen to reduce
the buying power of savings, and redistribute wealth
from those who diligently save to those who take
on debt. Nonetheless, an argument can be made
that a moderate inflation rate encourages the
investment of savings, preventing a build up of global
imbalances with ever-larger piles of savings in
cash-like instruments.
What would appear significant for real estate
market development and stability is not necessarily
a low inflation rate, but a stable yield relationship
Source: IMA Asia
between current rental streams and future rental
streams. Embedded in the argument for maintaining stable yields is an assumption that it keeps debt relatively
fixed in the equation at a loan-to-value ratio of say 70% to 80%. For example, whilst unusual mortgages of
125% were available in parts of advanced economies, in Singapore the rules remained that loan-to-value could

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Figure 3 | Real GDP Growth, %, 25-yr average

not exceed 80% throughout the boom in residential
mortgages elsewhere. That degree of stabilisation
through debt regulation will help prevent asset price
inflation from yield compression.

What about commercial real estate

prices?
In the longer term, we will find inflationary
pressures in Asia, emanating from a range of
different governments policies from both inside and
outside. Governments worldwide are being forced
to run loose monetary policy with low interest
rates, a scenario that will continue for some time
due to the high levels of debt held by consumers,
companies and governments in advanced
economies. Those effects will find their way to Asia
via linked policy rates and exchange rates.

Low interest rates and loose monetary policies may

Source: IMA Asia
initially help Asia recover from the global recession,
but bring the potential of rising inflation. Consumer
price inflation by itself does not preclude real GDP growth. If we are in for consumer price inflation then
holding real estate assets is sensible. Of the more worrying asset price inflation, which can turn into asset
bubbles, Asian governments are structured in such a way that they are generally able to stop asset price
bubbles from excess yield compression through the regulation of capital and debt.

We remain optimistic about commercial real estate prices in most of Asia based on solid growth potential
from two factors:
• good demographics – large populations of relatively young workforces
• low levels of debt and plenty of savings

The demographics support a long-term demand for property, reflected in the rental stream. The low levels
of debt and extensive savings will allow investments to be made without the problems of high levels of debt
servicing payments that governments, companies and consumers will have to make elsewhere. The one
country in Asia that does not share these characteristics is Japan, which has high levels of public debt and
a shrinking work force due to its aging demographics. On that basis, further long-term weakness can be
expected in the Japan real estate markets.

There is a solid story to the rest of Asia, with stable government regulation that can and has reacted quickly
to the credit crisis. Asia is well on its way to recovery with all the major Asian countries on expansion paths.
In all real estate markets, there will be points where supply will temporarily exceed demand, and grade A
office space in Singapore would be one area to highlight. But on the upside, the rate of demand in Asia is
expected to pick up given it has money to spend and is not labouring under debt.

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Figure 4 | Asian Prime Rents and Yields as at 2Q09

Country City Offices High Street Shopping Centres

Rent Yield Rent Yield Rent Yield

US$/sqft/yr % US$/sqft/yr % US$/sqft/yr %
China Beijing 1 46 7.50% 198 8.00%

Chengdu 1 21 12.00%

Hong Kong 2 132 4.00% 1211 5.00%

Shanghai1 44 5.00% 288 6.00%

India NCR 2
64 8.30% 237 12% 119 12.00%

Mumbai 2 75 11.00% 126 12% 120 12.00%

Indonesia Jakarta 3 21 10.00% 66 12.00%

Malaysia Kuala Lumpur 1 21 7.00%

Singapore Singapore 1 63 5.00% 320

South Korea Seoul 1 44 8.10% 451

Taiwan Taipei 1 36

Thailand Bangkok 2 20 8.00%

Vietnam HCMC 2
48 11-13%

Source: Cushman & Wakefield

Note: 1) Net Rent, 2) Gross Rent, 3) Semi-gross Rent

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A C U S H M A N & WA K E F I E L D R E S E A R C H R E P O RT

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