Friday, August 31, 2012

What Price Senkaku?

Governor Ishihara’s plan to buy four (three?)* of the five Senkaku Islands from a wealthy real estate developer in Omiya, Saitama Prefecture, with a war chest of 1.5 billion yen in private donations appears to have hit a road bump. The owner had second thoughts and refused to give explicit authorization to Ishihara to send in the Tokyo Metropolitan government to survey the islands before executing the purchase. This gave the Japanese government, the lessee of the four islands and owner of the fifth one, the right to properly refuse Governor Ishihara’s bid to make landfall. The developer appears to have been swayed by a more recent Japanese government offer of 2 billion yen. Whatever the absentee owner’s patriotic protestations, at the end of the day, it’s apparently about the money, honey. But how much is it really worth?

Note that the territorial waters and the ground beneath it belong to the state. Owners do not even have title to fishing rights, which the government dispenses to fishermen under the Fishery Act. The small, stark, collective landmass and its remoteness ensure that any legal economic activity is unfeasible. And woe be the lot of the members of the JSDF garrison there if it ever comes to that. So the annual rent that the Japanese government pays to keep everyone off the islands appears to be the only economic return on the property. So what’s it worth to the owner of those islands? Here’s the list of the islands in question, with surface and annual rent according to this Yahoo entry.
Uotsurishima : 3.82 km2 21.1 million yen
Kitakojima : 0.31 km2 1.5 million yen Minamikojima: 0.40 km2 1.9 million yen Kubashima : 0.91 km2 NA
Let’s assume that Kubashima, the island for US target practice, is priced similarly per unit of area at 4.5 million yen per year. That brings the total to 29 million yen per year. But there are costs. Most importantly, the owner must pay the fixed asset (real estate) tax to the local government. The standard fixed asset tax rate is 1.4% and is levied on 70% of the assessed value of the fixed asset. The current owner reportedly purchased the islands in 1976 for 46 million yen. Since then, the bubble economy came and went, and real estate prices, particularly in the boondocks, have been tanking ever since. Let’s be really, really generous and say that the islands are assessed at 100 million yen today. So the annual tax would come to 100 x 0.7 x 0.014 ≑ 0.9 million yen. So that makes the owners annual take 29 – 0.9 ≑ 28 million yen. That’s an extremely nice return on a property acquired for 46 million, a 28% annual return on the 100 million yen value that I posited. It’s an extortionary price being paid if you ask me. But it is wahat it is. What then, is the fair market value of these islands given their political value for which the government is willing to pay through its figurative nose?

I found this list of 35 REITs. Their expected annual rates of return range from 3.85% to 8.35%. Since the islands are a very safe investment, let’s put their expected annual rate of return at a near-JGB low of 2%. That would give the islands a market value of 28 ÷ 0.01 = 28 million. The islands, surprisingly, would still be undervalued at 1.5~2.0 billion yen. Even at a more generous 4% rate of return, or about the low end of REIT expectations, the islands would still be worth 14 million yen. But there’s a catch that would push the owner to ask for more in the event of a selloff. Remember that the owner bought it at 46 million in 1976, so he would have to pay a flat-rate income tax of 20% (15% national, 5% local) on the capital gains, so his next take from a gross 20 billion payment would be (20 billion – 46 million) x (1 – 0.2) = 15.6 billion yen. From a 15 billion yen payment, it would be 11.6 billion yen, at which point the 46 million yen per year would be a 3.96% return, which if more appropriate for the lower end of the riskier RIET spectrum. There may be other cost considerations, but you really can’t blame the owner for stiffing Ishihara since his bid is arguably below true market value (meaning, of course, the current value of the government rent payments). Ishihara only appears to have helped bump up the cost of keeping the islands in government hands from its already exorbitant level.

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