The loo-Year Japanese Residential Mortgage: An Examination

Chun-Hao Chang Krishnan Dandapani Rolf Auster

A recent innovation in the Japanese real estate industry to promote home ownership is the creation of a loo-year mortgage term. The home, encumbered by the mortgage, becomes an ancestral property and is passed on from grandparent to grandchild in a multigenerationalfashion. We analyze the implications of this innovative practice, contrast it with the conventional 30-year mortgage popular in Western nations, and explore its unique benefits and limitations within the Japanese economic and cultural framework. i%rough the use of simulation, the conclusion is reached that the MO-year mortgage has

failed to increase the affordability of homes. Instead, affluent homeowners are more likely to employ long-term mortgages as an estate-planning tool to reduce inheritance taxes.

The explosive growth of the Japanese economy has had some undesirable side-effects on its residents. Land and housing prices have increased rapidly, making Japanese real estate and housing markets among the most expensive in the world. While inflation is a major reason for these increases, other factors such as limited supply, high and continuing demand, speculation, and taxation have contributed to the pricing problem. Real property prices may also have been impacted by a nonneutral and progressive tax system prevalent in Japan.

While Japan grew into an affluent society comparable to Western nations in the postwar period (with per capita income over $25,000), increasing housing costs became a primary concern of its citizens. Since 1985, more than 80 percent

Journal of International Accounting Auditing & Taxation, 4(l): 13-26 ISSN: 1061-9518 Copyright @ 1995 by JAI Press, Inc. All rights of reproduction in any form reserved.

Chun-Hao Chang, Associate Professor, Krkhnan Dandapani, Associate Professor of Finance, and Rol Auster, Professor of Taxation l College of Business Administration, Florida International University, Miami, FL 33199.

14 INTERNATIONAL ACCOUNTING AUDITING 8c TAXATION, 4(l) 1995

of the general population have viewed themselves as middle class (Japanese Economic Journal, 1985b, p. 4). However, high land values and inheritance taxes have made it difficult to enjoy a life-style comparable to that enjoyed by residents of Western nations. Two cultural factors have played a dominant role in limiting Japanese home ownership. First, the average life expectancy of Japanese citizens has been steadily increasing. Today, their longevity is the highest in the world (Japanese Economic Journal, 1985a, p. 3). Second, the average Japanese family unit is larger than in Western nations since two and often three generations commonly share a dwelling unit because of an extended family concept.

Although inflation makes real estate expensive, it also makes mortgage payments less expensive since it converts the stream of fixed nominal payment commitments to a continuously declining stream of real payments. It is well documented that the unknown real payment stream makes it difficult to calculate the optimal mortgage amount (Lessard and Modigliani, 1975, p. 18). The high cost of housing, coupled with the mortgage financing decision, has prevented a majority of Japanese households from purchasing a home. In the late 198Os, it was estimated that the ratio of median home value to annual income exceeded seven to one in Japan, while the ratio was approximately four to one in most Western nations. Consequently, Japanese mortgage payments were often prohibitive.

Investors and governments in other countries have developed various innovative alternatives to address the high cost of residential and commercial real estate based on their unique real estate situations and applicable tax laws. In the United Kingdom and Germany, for example, the 99-year lease of land to commercial and residential builders has been one popular way of promoting property ownership to combat the effect of inflation (see Estates Times, 1994). By properly structuring the lease, the investor can defer paying for the high cost of land upfront, while the owner of the land is able to defer the capital gain.’ In other parts of Europe, especially in the erstwhile communist countries, the 99-year lease is used as a vehicle to overcome the regulatory problems of land ownership. In Belarus, Russia, for example, only citizens may own land privately (see fist European Business Law, 1993). All other land belongs to the State and foreign investors can only hold leases up to 99 years. In Poland, the local bureaucratic structure makes it very difficult for foreign investors to buy land even if the local residents are willing to sell (see Euromoney Central European, 1993). Thus, a popular strategy is for a foreign investor to enter into a 99-year lease, with the lessee paying 25 percent of the value of the land initially and up to 3 percent of the value of the land each year in rent to the lessor. For many international investors throughout the world, the 99-year lease of land seems to be an ideal way to avoid high land investment and property taxes.* One recent example is the Hilton International Division’s 99-year lease of land for the Hilton hotels in Australia (see, e.r., Euroopean Report, 1993).

The lOlLYear Japanese Reskkntid Mortgage 15

Beginning in 1983, the Japanese government attempted to increase the availability of homes by both relaxing the eligibility criteria for public housing and offering extremely long mortgages repayable over several generations. Subsequently, lending institutions offered the lOO-year home mortgage. These new loan arrangements take several forms. One option is to pay only the interest and defer all mortgage principal payments. Later, when the borrowers’ children reach adulthood, they may start making principal payments. Alternatively, up to three generations of borrowers may pay only the interest. No mortgage principal is repaid unless the property is sold. Other variations may be tailormade to borrowers’ and lenders’ needs.

The introduction of the lOO-year mortgage has received widespread attention in the Western media, with many analysts viewing this unique development with both surprise and skepticism. While cultural factors clearly play a role in the availability of long-term mortgages, the economic factors and financial implications of the loo-year mortgage need to be examined. If the Japanese initiative to promote home affordability is proven to be successful, other countries facing similar inflationary and growth problems should consider adopting this strategy.

The remainder of the paper is organized in three sections. A discussion of the home affordability aspect of the loo-year mortgage is presented in the next section. The cash flows of 30-year and lOO-year level-payment mortgages are compared. The second section covers tax deferral opportunities associated with a loo-year mortgage. We compare the net present values of payments required under a 30-year mortgage with the deferred-principal lOO-year mortgage. The third and final section consists of concluding remarks.

THEAFFORDABILITYARGUMENT OFTHE~OO-YEARMORTGAGE

In this section, we compare the casMow requirements of 30- and lOO- year conventional, level-payment mortgages to determine if the loo-year mortgage promotes home affordability. It is well established (Prakash, Karels, and Fernandez, 1987) that the monthly mortgage payment,3 denoted. by P, is given as:

I

i P=L

1 - (1 + z)-12n I (1)

where: P = Monthly mortgage payment L = Amount of original mortgage i = Monthly mortgage interest rate

n = Years to maturity.

16 INTERNATIONAL ACCOUNTING AUDITING & TAXATION, 4(l)

The mortgage balance remaining after t payments, is:

1995

MB, =

where:

I 1 - (1 + i)+w

L 1 - (1 + z)-12n I

MB1 = Mortgage balance after t payments.

(2)

The monthly interest expense in the tih month, I&, equals:

Z& = i - MBr4 (3)

From the above equations, we can derive the following proposition:

Pl: The monthly payment for a fixed-rate mortgage decreases as the term of the loan increases, and it decreases at a decreasing rate.

Proofi Differentiating P, as defined in Equation (l), with respect to n yields:

g= -12Li[ln(l + i)] [l - (1 + z)-12n]-2 (1 + z)-12n < O

The second derivative of P with respect to n is:

dP _ -- 144Li (1 + i)-lti [ln(l +z)12 [ 1 - (1 + i)-12n]-2 11 + (1 + z)-12*

dn2 [ 1 - (1 + i)-12n]-1} > 0

Therefore, P is decreasing and convex in n. Based on Proposition 1, as the mortgagor takes out a fixed-rate mortgage

with a longer term, the monthly mortgage payment is reduced. However, this reduction in the monthly payment is less significant as the mortgage duration is extended. Figures 1 and 2 illustrate the relationship between the monthly mortgage payment and the time to maturity of the mortgage.

In Figure 1, a fixed-rate mortgage of $100,000 with an annual contract rate of 10 percent is amortized over terms to maturity ranging from five to 100 years. As we increase the term to maturity from live to ten years, the monthly payment is reduced by $803.19, or 37.8 percent, per month from $2,124.70 for the five-year term to $1,321.51 for the lo-year mortgage. However, the reduction in monthly payment is only $31.13 as we change from a 25- to a 30-year mortgage (from $908.70 to $877.57). In fact, the monthly payment rapidly

The lOO-Year Japanese Residential Mortgage 17

YEARS

Figure 1. Comparison of Monthly Payments: $100,000 Mortgage With 10% Contract Rate

converges to $833.33 as the maturity date is extended beyond 35 years. Figure 2 shows the percentage change4 in the monthly payment for different terms to maturity in comparison to the monthly payment of interest-only mortgages. The change is only 3.2 percent between a 35year and a loo-year mortgage, and the change decreases to 0.7 percent when comparing a loo-year and a 50- year mortgage. The percentage change converges to zero as the time to maturity extends beyond 65 years.

P2: The mortgage balance remaining for a fixed-rate mortgage at the end of the trh month increases as the time to maturity increases, and it increases at a decreasing rate.

Proa$- Differentiating the mortgage balance defined in Equation (2) with respect to n yields:

@$$ = 12 [ln(l + ;)I [l - (1 + z)-‘~]-~ (1 + z)-lti [L(l + z)’ - M&l > 0

18 INTERNATIONAL ACCOUNTING AUDITING & TAXATION, 4(l)

170

160

150

140

130

120

110

100

j 90

u 80

Ip 70

60

50

40

30

20

10

0

YEARS

Figure 2. Percentage Change in MontMy Payments: $100,000 Mortgage With 10% Contract Rate

The second derivative of MB1 with respect to II is:

!$!Z!= -12[ln(l + i)] [I - (1 + i)-lZn]-l (1 + i)-12n

!!!$! + [ln(l + z)] [L(l + z)’ - MB,] {12 + (1 + z)-12n [l - (1 + i)-‘*T’}

1995

<o

Thus, MB1 is increasing and concave in n. When comparing mortgage balances remaining at a specific point in time

for mortgages with different durations, a mortgage with a longer term has a higher remaining balance than mortgages with shorter durations due to differences in interest payments. Typically, the increment is smaller as the time to maturity is increased. Figure 3 demonstrates the relationship between the mortgage balance remaining at the end of the 60fh month and terms to maturity for the same mortgages described in Figure 1. The mortgage balance remaining converges to the loan amount fairly quickly as the time to maturity extends beyond 35 years.

The MO-Year Japanese Residential Mortgage

105

100 -

8 70 -

65 -

60. , 1 3’0

I , I IO 20 40 5kI 6’0 70 SO Sb Id0

1 25 3 45 5L

65 75 05 95 YEARS

Figure 3. Corrqmrison of Mortgage Balance Remaining for 60th Month: $100,000 Mortgage With 10% Contract Rate

19

As defined in Equation (3), the monthly interest expense I& is a function of the mortgage balance at the end of the previous month. Hence, the relationship between interest expense and time to maturity is a corollary of Proposition 2:

P3: For a fixed-rate mortgage, the monthly interest expense at the 8’ month increases as the time to maturity increases, and it increases at a decreasing rate.

The same mortgages presented in Figure 1 are examined in Figure 4. Here, the interest expense for the 61”’ month increases as the time to maturity is extended. It converges rapidly to $833.33, the amount of interest expense for an interest-only mortgage, when the mortgage duration exceeds 35 years.

The calculations above clearly show that for conventional fixed-rate mortgages, there is a very limited cash flow benefit associated with extending the time to maturity from 30 to 100 years. For example, the monthly payment reduction for a $100,000 loan with a 10 percent contact rate is only $44.20 ($877.57 versus $833.37).’ Total interest paid amounts to $215,925.70 for a

20 INTERNATIONAL ACCOUNTING AUDITING & TAXATION, 4(l)

860 ,

840 -

620 -

800 -

E 760 -

H 760 -

kl 740 -

6 720 -

F 700 -

2 680 -

g 660 -

kf 640 -

tii 620 -

k-J Y 600 -

E 560 - -

560 -

540 -

520 -

1995

500 t , 10 2b 3b

I 40 5b do 1 1 I 70 60 90 160

15 2 3 4 5 6 75 85 35 YEARS

Figure 4. Comparison of Interest Expenses for-&t Month: $100,000 Mortgage With 10% Contract Rate

30-year loan and $299,925 for a loo-year loan during the first 30 years alone. However, after 30 years, in the case of the 30-year loan the principal has been reduced by the full $100,000, while the lOO-year loan has had its principal reduced by a mere $9.15! Clearly, the lOO-year mortgage has a much higher total cost than the 30-year mortgage, with an insignificant reduction in monthly payments.

THE lOO-YEAR MORTGAGE AS A TAX STRATEGY

A major motivation for the loo-year mortgage is often the perceived tax benefits to be derived by the borrower(s). In this section, we develop and evaluate the superiority of the loo-year mortgage within the Japanese institutional structure and tax laws. Japan has a tax structure that is different from that of the Western world. We note that at least three types of taxes play a part in determining the after-tax financial consequences of a loo-year mortgage. These are: (1) inheritance and gift taxes, (2) capital gains taxes, and (3) land taxes.6 A few other distinguishing features of the Japanese tax system

The 100-Year Japanese Residential Mortgage 21

relevant to this study are that a small tax credit, phased out as owner income and floor space per occupant increase, is allowable in lieu of a mortgage interest deduction; interest paid on other personal loans is not deductible; and capital gains on the sale of developed land are taxed at a higher rate. However, there are special tax benefits for capital gains on the sale of undeveloped land (Ishi, 1993, p. 112). In addition, earnings on savings deposits, bonds, and equity receive tax benefits.

While a comprehensive analysis of these taxes is beyond the scope of this study, we will examine the tax benefit of deferring inheritance taxes. A surviving spouse is exempt from the inheritance tax, a principle not unlike the “unlimited estate tax marital deduction”in the United States. However, an inheritance tax is due if the homeowner leaves the home to the surviving spouse and the children jointly, or just to the children. Using 1992 rates, the inheritance tax in Japan is higher and represents a greater source of tax revenue (3.4%) than the equivalent estate tax in the U.S. (1.80/o), France (1.70/,), United Kingdom (0.9%), or Germany (0.50/o) (Ishi, 1993, p. 224). The current (1992) effective inheritance tax rate (net of tax credits and exemptions) ranges from 3.9 percent for 50 million yen to 34.9 percent of the value of a taxable estate exceeding three billion yen. Based on current rates of exchange, three billion yen is equal to approximately $28 million. Minimizing inheritance taxes plays a major role in personal financial planning for affluent Japanese citizens, especially when inflation is significant.

To compare the benefits of a loo-year mortgage with a conventional 30- year mortgage, we use the standard time value of money approach of financial analysis. The net present value (NPV) models for both mortgages are developed below. Let NPV~O and NPVroo denote the NPVs of the 30-year mortgage and the lOO-year mortgage, respectively. Then the NPV models are:

NIV30 = PV (property value at year 30) -l- PV (cash flow in the next 70 years) - PV (inheritance tax at year 40) - PV (inheritance tax at year 80) - PV (total principal and interest payments for 30 years).

NPVIW = PV (property value at year 100) - PV (total interest payments for 100 years) - PV (principal payment at year 100).

?r = NPV30 - NPVm,.

We measure the net benefit of a 30-year mortgage over a lOO-year mortgage by using 7r. To simplify the analysis, the following assumptions are maintained:

1. The borrower is considering incurring a $500,000 mortgage to purchase an apartment house in Tokyo. The property is assumed to be held for 100 years and passed down two generations. Also assume that the

22 INTERNATIONAL ACCOUNTING AUDITING & TAXATION, 4(l) 1995

property value will appreciate at the market rate of interest, that is, the long-term treasury bond rate (the “risk-free rate”).

2. Two mortgages are available: a 30-year monthly payment conventional mortgage and a lOO-year mortgage. The latter requires a monthly payment of interest only for the full lOO-year term and the principal is due at maturity.

3. An inheritance tax will be paid twice if a 30-year mortgage is chosen: at the end of the 40th year and at the end of the 80th year. The lOO- year mortgage is treated as an offsetting liability. Therefore, the inheritance tax may be avoided or at least reduced at these times7

4. If a 30-year mortgage is chosen, the inheritance tax savings are invested in long-term treasury bonds paying the risk-free rate for the next 70 years.

5. The discount rate used is the risk-free rate which is assumed to be constant over the 100 year investment horizon. (A rate of 4 percent is used in the simulation below).

6. Land taxes and capital gain taxes are not explicitly considered. The tax rate used in the model is the effective inheritance tax rate and is assumed to reflect the applicable capital gain and land taxes, which should provide a reasonably close approximation to reality.

7. For simplicity, the mortgage contract rate and origination expenses on both the mortgages are assumed to be identical. (A rate of 6 percent is used in the simulation below).

Based on our assumptions, NPV 100 is necessarily converging to zero since there is no extraordinary property appreciation in the model.* However, the value of NPVJO depends on the effective inheritance tax rate. Figure 5 illustrates the NPV of both mortgages under different effective tax rates, assuming the contract rate, K, equals 6 percent and the risk-free rate, &, equals 4 percent.

In Figure 5, NPV~O is a continuously decreasing function of the inheritance tax rate. When the inheritance tax rate is low, 7r is always positive and a 30- year mortgage is therefore superior to a lOO-year mortgage. The net benefit rr declines as the inheritance tax rate increases. The two mortgages break even when the effective inheritance tax rate is approximately 21.3 percent. If the borrower’s tax rate is above the break-even point, the lOO-year mortgage is most likely the optimal choice. This result implies that the superiority of the lOO- year mortgage primarily depends on the expected inheritance tax burden of the borrower’s heirs. If the borrower’s heirs expect to pay a high inheritance tax rate, the loo-year mortgage becomes the better choice to the family. Otherwise, the conventional 30-year mortgage continues to be the more attractive alternative.

The NO-Year Japanese ResidenW Mortgage 23

lOO-YEAR M)ATWGE VS. 30-YEAFI U)RTGAGE

2ooI

ul > !G -100

l-? gg -200

i!

I-” - 9 300

-400

- 500

-600’ ’ ’ ’ ’ ’ ’ ’ ’ ’ ’ ’ ’ ’ ’ o., 0 15 0.2 0.25 0.3 0.35 0.4 0.45 0.5 0 55 0 6 0.65 0 7 0 75

EFFECTIVE TAX RATE

Key: (SET BOX) NPV of MO-year mortgage. +: NPV of 30-year mortgage.

Figure 5. NPV Analysik for Loan Amount of $500,000: IOO-year Mortgage Versus 30-Year Mortgage

Table 1 presents simulation results under different sets of parameters (loan amount, contract rate, and risk-free rate combinations). The simulation results show that the break-even estate tax rate is invariant to the amount of the loan. Other factors being equal, an increase in the contract rate increases the breakeven inheritance tax rate. For example, as shown in the first two columns of Table 1, as K increases from 6 to 7 percent, the breakeven tax rate increases from 13.0 to 15.2 percent. Similarly, an increase in the risk-free rate alone reduces the break-even estate tax rate. This relationship is evident from the second and third columns of Table 1, which show that an increase of & from 5 to 6 percent decreases the break-even tax rate from 15.2 to 9.5 percent.

CONCLUSION

Fluctuations in real estate prices and nonaffordability of homes have the potential to destabilize the economy and affect the welfare of all inhabitants of a nation. During these times, it is imperative that the government and

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The lObYear Japanese Residentid Mortgage 25

financial institutions take the lead in formulating stable policies to promote social welfare. In this paper, we examined an instrument offered by Japanese lending institutions and identified its merits and limitations to help assess the possibility of developing such an instrument in Western countries.

Our analysis showed that the loo-year mortgage provides no substantial advantage to the individual homeowner in terms of reduced monthly mortgage payments or increased home affordability. Our analysis revealed that the benefits of the loo-year mortgage are a function of the applicable inheritance tax rate and the difference between the mortgage interest rate and the return on investment. We also analyzed the sensitivity of the different variables. Our analysis showed that entering into a lOO-year mortgage is often motivated by a desire to defer income and/or inheritance taxes. We conclude that the multigenerational mortgage is primarily being used as an estate planning tool by the affluent. This is contrary to the Japanese government’s goal of increasing the affordability of homes for the middle class.

This paper does not address the legal ramifications of the mortgage contract as it spans the lives of more than one individual when structured as a multigenerational mortgage. The challenge of structuring mortgage payments and the impact on tax policy and national savings might be an interesting area for future research.

1.

2.

3.

4.

5.

6.

7.

NOTES

The capital gains tax, also called a speculative tax in Germany has been a major source of revenue for the government. However since reunification, the capital gains taxes have been abolished in the former East German region in 1991, and is expected to be phased out by 1993 in other regions. The property taxes are significant in many other countries and their relative importance as a source of revenue varies from a high of 13 percent in U.K. to a less than 2 percent in Germany. See Ishi (1993, pp. 263) for details. We assume the mortgage payment is made at the end of the month, which is standard practice. The percentage change is calculated using the equation:

$%J Change = (Monthly Payment - 833.33) / 833.33

In this numerical example, the net reduction in annual cash flow, when capitalized, amounts to less than 2 percent of the property value. It is hardly sufficient to justify promoting home affordability. The land taxes are different from real property taxes, and in Japan land tax is levied in addition to the property taxes. The land tax is unique to Japan, Korea, and Taiwan (Ishi, 1993, p. 345). The primary motivation behind the taxation of landholding is to reduce the advantages of land as an asset and to encourage the efficient use of land by increasing the cost of holding land (Ishi, 1993, p. 357). Since properties in Japan are appraised once every three years, it is noted here that most properties on the average are valued at approximately 60 to 70 percent of their market value for estate tax purposes (Ishi, 1989, p. 360).

26 INTERNATIONAL ACCOUNTING AUDITING & TAXATION, 4(l) 1995

8. We make this assumption to keep the analysis simple. However, we note that even if there is substantial appreciation of the property, the value of rr will be reduced since there will be positive impacts on estate taxes in NPV30.

REFERENCES

East European Business Law. 1993. Finance/Business Section. December [ABI/Inform]. Estate Times. 1994. U.K. housing associations tempt institutions. (January 14) [ABI/Inform]. Euromoney Central European. 1993. Eastern Europe real estate: How to win the space race.

(November 1) [ABI/Inform]. European Report. 1993. Ladbroke buys Hilton leasehold in Australia. (October 6) [ABI/Inform]. Ishi, H. 1989 The Japanese Tax System. 1st edition. Oxford, UK: Clarendon Press. Ishi, H. 1993. The Jupanese Tax System. 2nd edition. Oxford, UK: Clarendon Press. Japanese Economic Journal. 1985a. Panel urges retirement age be extended to 65 by year 2000.

(June 25): 3 [Reuter Textline]. Japanese Economic Journal. 1985b. 82% of Japanese think they belong to middle class.

(November 16): 4 [Reuter Textline]. Lessard, D., and F. Modigliani. 1975. Inflation and the housing market: Problems and potential

solutions. Pp. 13-45 in New Mortgage Designs for an Inflationary Environment. Cambridge, MA: Federal Reserve Bank of Boston.

Prakash, A.J., G. Karels, and R. Fernandez. 1987. Financial, Commercial, and Mortgage Mathematics and Their Applications. New York: Praeger.