Goldman Sachs: The sustainability of this round of inflation in Japan depends crucially on rental prices.

Japan is shifting towards "ending deflation", can the real estate market support the inflation trend?

As the Japanese stock market has been performing well this year and is expected to "regain lost ground", the inflation level has been rising year after year: Japan's core CPI has been rising for 28 consecutive months, exceeding the 2% inflation target for 21 consecutive months, and annual inflation has been rising for three consecutive years.

Does this mean that Japan is about to bid farewell to the "lost thirty years"?

From the perspective of inflation, the key to sustainability lies in the growth prospects of rents.

Goldman Sachs released a report yesterday stating that the growth rates of almost all sub-items of Japan's CPI have reached the highest levels in the past 20 years, but only rents have not shown signs of accelerating growth. As a sub-item of CPI with a weight of up to 20%, Japanese rents will be the "last piece" affecting Japan's inflation and key interest rate levels.

Goldman Sachs analysis points out that rents will continue to drag down the overall inflation level in the short term, but in the long term, it is expected to slowly increase to the 2% inflation target, with the following key points:

• Even if a "wage - inflation" benign cycle is achieved and overall inflation stabilizes at the 2% target, the short-term weakness in rent growth may pull down the overall CPI to 1.7% or below;
• Basic wages are highly correlated with rents, if wage inflation remains stable at 2% annually, rent inflation is expected to slowly rise to above 2%;
• The unique nature of Japan's rental system, the existence of a long lag in asking rents, and the declining number of Japanese households all put pressure on rent inflation to rise.

Short-term: Leading indicators are rising, but the reflection on CPI is slow

As a leading indicator of rents, asking rents in Japan have been rising in recent years. Will this push up the rent CPI index?

Asking rents are the initial listing prices given by landlords, different from the actual rent paid by tenants. Generally, actual rents are influenced by property conditions and market factors, more accurately reflecting the price level of the rental market.

Before discussing the impact of asking rents on the rent CPI index, it is important to note that Japan's rental renewal process is unique.

The report points out that in Japan, tenant rights are protected by the Land and Building Lease Law, making it difficult for landlords to arbitrarily change rents even after the contract period ends, and landlords have little power to evict tenants as long as they want to renew the lease.

Past research data shows that only 10% of rental properties in Japan adjust rents annually, compared to 70% in the United States.

Therefore, the rent change frequency for most tenants in Japan is very low, lagging far behind the costs paid by tenants for new leases, i.e., asking rents. The rent CPI index includes both new leases and existing lease contracts, so it often lags behind asking rents, with a lag of up to five years in the Tokyo area, while in the United States, this lag does not exceed 1 year. In the context of rising asking rents, it is easy to observe a phenomenon where the increase in the rental CPI index lags behind the increase in asking rents. There may be two reasons for this: the actual rents for new leases are generally lower than the asking rents, and the range calculated for asking rents is narrower than that for the rental CPI index, with rental levels outside of asking rents dragging down the overall CPI increase.

In the report, Goldman Sachs estimated the responsiveness of the rental CPI index to the increase in asking rents for Tokyo apartments: in the long term (using the sample period from 2006 to 2023), a 10% increase in apartment asking rents would push up the rental CPI index by about 3%.

If we shift the sample period to 2023-2033, the impact of asking rents on the rental CPI index appears to be smaller:

When Tokyo apartment asking rents rise by 0%, the Tokyo rental CPI index slightly decreases;

When Tokyo apartment asking rents rise by 2.5%, the Tokyo rental CPI index increases by less than 1%;

When Tokyo apartment asking rents rise by 5%, the Tokyo rental CPI index increases by 1.5%.

In other words, in the next 10 years, even if the rental increase in Tokyo reaches 5% (higher than the average growth rate of the previous three years), the growth rate of the rental CPI index will be very modest - an increase of only 1.5%.

Goldman Sachs predicts that the annual growth rate of Tokyo apartment asking rents will reach 2.5%-5%, and by 2030, it will be 0.5%-1%; due to the difficulty in predicting the national trend of asking rents based on sample data, but it is expected that the growth rate of the national rental CPI index will be lower than that of Tokyo.

According to the report data, asking rents in other regions of Japan are lower than in Tokyo, and 56% of Tokyo's population resides in apartments with rapidly increasing rents, far exceeding the national average of 29%. Considering that the number of households in Japan is declining while Tokyo's remains stable, Goldman Sachs predicts that the annual inflation rate of the national rental CPI index will not exceed 0.5% in the next 5 years. This means that even if the growth rate of other sub-item prices reaches 2%, the CPI level will remain at 1.7% or below.

Long Term: With wage increases, the rental CPI index may slowly rise to 2%

Although Japan's rental housing system may temporarily suppress the rise in the rental CPI index, in the long term, the upward speed of the rental CPI index may be faster than the increase in asking rents.

The report found a long-term high correlation between Japan's basic wages and the rental CPI index, indicating that if wage inflation stabilizes at 2% annually, the annual increase in rents could reach 2%-3%. However, this may take a long time for tenants to accept. Goldman Sachs believes that it will take at least five years for wage inflation to fully reflect on rents, by which time the growth rate of the rental CPI index will reach 2%. However, the vacancy rate for rental housing in Japan may accelerate, putting pressure on rental prices. According to data from the Japan National Institute of Population and Social Security Research, the number of households in Japan will start to decrease in 2024, which means the number of family housing units will also decrease. Given the high costs of demolishing houses and taxes, the vacancy rate for rental properties will correspondingly increase.

Taking this factor into consideration, the growth of the rental CPI index will be slower than the growth of basic wages.

Therefore, Goldman Sachs concluded that rental inflation will drag down the CPI level in the short term, but in the long term, the CPI is expected to remain stable at 2%. As mentioned earlier, rental prices will slowly increase to 2% in the long term. Even if rental inflation remains subdued, monetary policy will accordingly be relaxed.