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WSJ 9/10/03

Learning the Hard Way

Universities around the world are plagued by a host of intractable problems—except in America. What are they doing right?

By Barbara Kantrowitz
NEWSWEEK INTERNATIONAL

Sept. 15 issue — Rome’s La Sapienza university has endured seven centuries of war and political upheaval. But as school begins this fall, students at Europe’s largest university face a hardship of a different kind: nowhere to sit.
        MANY OF La Sapienza’s 180,000 students will attend classes under circus tents hastily erected to accommodate massive overcrowding. Others will study in movie theaters, some of which double as porn houses at night—and are only a slight improvement over—the unfortunate sociology class that met last year in a parking garage. At least they have a roof over their heads; at La Sapienza’s law school, with an enrollment of more than 40,000, students must call ahead to reserve a seat in the lecture halls. Those who don’t get in often stand outside and peer through the windows, even in the rain, hoping to overhear at least some of the lecture.
        That’s just in Rome. Elsewhere in Italy, educators must contend with a soaring dropout rate; at some universities, two out of three entering students never receive a degree. And universities in just about every other country in the world are struggling with their own assortment of intractable problems. In Japan and South Korea, the issue is too few students. Educators in both countries worry about a dwindling population of young people and a drastic decline in qualified applicants. Money problems loom large in many places. British students are fighting against a proposed tripling of tuition fees—an infusion of cash that university administrators believe is necessary for the survival of their institutions but that many students believe will mean graduating with a load of debt. Pakistani educators bemoan the lack of topflight faculty attracted to a low-paying profession. And in some parts of the developing world, war and political turmoil have completely stymied educational progress. Throughout much of Africa, for example, even basic literacy is still an elusive goal.
        No wonder so many of the world’s best and brightest are eager to earn their degrees in America, where campuses are thriving. Close to 600,000 international students are expected to arrive in the United States this month, the vast majority of them from India and China. “We could probably have a million international students here without ever missing a beat,” says Allan Goodman, president of the Institute for International Education in New York. “Other countries look at America as a role model... If you want the gold standard in higher education, —globally people will say, ‘Go to America’.” And that migration will only increase as the gap between America and the rest of the world keeps growing.
        Educators in many countries say their biggest single problem is relying almost exclusively on government funding—a long tradition just about everywhere except the United States. When that funding gets cut because of the budgetary pressures now endemic to most industrialized countries, educators have trouble finding other ways to pay the bills—the university’s as well as their own. One of the most troubling cases is Russia, where dwindling government support over the past decade forced many universities to put off even much-needed building repairs. “It’s dangerous even to go inside some universities,” says Christina Coshel, a 22-year-old student at the North West Academy of Public Administration in St. Petersburg. “From the horrific state of the buildings, you can imagine the quality of these educational institutions.” Budget cuts also mean less pay for professors and administrators; students say many have turned to bribery to “supplement” their salaries. “I paid $800 to get into the university,” says Andrei, a 21-year-old student at the Forestry Engineering Academy in St. Petersburg. “I’ve heard that now students are paying $1,500.” And it doesn’t end there. Every year, Andrei bribes his teachers about $50 to pass his term exams. The practice is so widespread that there is almost no risk of getting caught; students prefer guaranteed marks to exposing corrupt teachers.
        Even British universities—once widely regarded as the world’s finest—have been caught in the money mess. “Confused, bewildered, under funded and angry” is how Colin Matheson, head of Britain’s Coalition of Modern Universities, describes the current state of the system. In the past 15 years, the number of students has doubled while public subsidies have declined more than 36 percent. Britain now spends only 1.1 percent —of its GDP on postsecondary education, less than half of what the United States spends. At the same time, a bill currently before Parliament would raise fees to about $4,500 a year, a nearly threefold increase. While that may not seem high by the standards of American universities, which can cost more than $25,000 a year, many in Britain worry about able students being shut out.
        Faculty salaries are also considerably below the U.S. average, which has meant a drain of some of Britain’s best brains. Christopher Peacocke, a philosophy professor who left Oxford three years ago for New York University, says inadequate funding turns off academic stars in other ways as well. “The British salaries are much too low but I think that’s only one factor,” he says. “Much more important are research facilities. Most British universities will not give, for example, a regular research grant to the senior research faculty—something I never had even as a chair at Oxford.” In the sciences, that gap is crippling; only American universities can afford state-of-the-art research facilities.
        Government control can be a burden even when the money keeps flowing. China’s higher-education system is the largest in the world, with 16 million students. But analysts say the Chinese system does not allow enough flexibility in everything from paying tuition to choosing classes. Parents must pay for the entire year in September—a particular burden since tuition, nonexistent before China’s economic reforms, has risen fivefold in the past decade.
        Academic rigidity turns off some of China’s best students, who are forced to pick majors while they’re still in high school. There’s no room for intellectual experimentation. Linda Chen, 24, says her undergraduate experience at Nanjing University, one of the country’s most elite, was unimpressive. “I had a lot of classmates who just played computer games all day,” she recalls. As a result, she felt unprepared and overwhelmed when she enrolled as a doctoral student in sociology at the University of Washington in Seattle. “In China, teachers teach and you take notes,” she says. “Here there is more communication between students and professors. Students sit and brainstorm. You can even tell jokes.”
        That tantalizing freedom lures many of the brightest Chinese students to American campuses. Since China emerged from international isolation in the mid-1970s, more than 580,000 students have enrolled at U.S. universities. Her daughter Liu Yiting’s quest for an Ivy League degree inspired Liu —Weihua to write “Harvard Girl,” a best-selling how-to guide that has made her a superstar to ambitious Chinese parents, both on the mainland and in Hong Kong. “It is the dream of every middle-class Hong Kong parent to have a son or daughter in Harvard or Yale,” says Joseph Cheng, a political- science professor at the City University of Hong Kong.
        Students aren’t the only ones drawn to America’s tradition of academic freedom and its stellar research facilities. Pervez Hoodbhoy, a noted professor of nuclear physics at Quaid-I-Azam University in Islamabad, visits a top American university for several months every year—most recently Stanford and MIT—to do research. He’s even more outraged than before about the sorry state of his country’s universities, which he describes as “intellectual rubble.” That may sound harsh, but few Pakistani academics would disagree. The problems are many: a dearth of qualified faculty, students ill-prepared by a dismal public-education system, an often incompetent university bureaucracy and blatant government intervention. “On campuses, serious discussion of scientific, philosophic, social or political issues is virtually nonexistent,” he says. “It is difficult to imagine a system in the modern world which had a greater antipathy to intellectual inquiry than the one which presently exists in Pakistan.”
        It is ironic that at a time when so many are decrying U.S. imperialism, they are openly copying America’s educational system in order to keep their talent at home. A century ago, the great German universities occupied much the same place as Harvard, Yale and Stanford do today, attracting students and professors from all over the world. In fact, American schools began their own ascendancy when they copied the German system of integrating teaching with research. But by the early 1990s, German universities were a disaster. Selective admissions and tuition were abolished, turning once elite institutions into overcrowded behemoths. Professors turned into unmotivated civil servants, paid according to seniority rather than merit. The dropout rate was huge: up to 80 percent in many of the humanities and social services.
        Now, Germany is in the midst of a huge reform effort, much of which involves copying the United States. The first step is to give universities more autonomy, while avoiding outright privatization, so that each institution can do its own fund-raising and pick its own students, raising quality. More and more professors are being paid by merit. Almost all of Germany’s 68 universities have begun replacing the lengthy and internationally incompatible Diplom and Magister degrees with U.S.-style bachelor’s and master’s. Many have also introduced degree programs taught entirely in English. As a result, foreign-student enrollment is up 30 percent since 2000.
        At Munich’s Technical University, president Wolfgang Herrmann is an outspoken advocate for reorganizing the country’s universities. He’s been lobbying the government to give universities more independence to compete and is vigorously restructuring his own school, which is Germany’s leading center for computer science, engineering and biotechnology. Herrmann, who has also taught in the United States, has introduced professional management and outside auditing, set up a branch of the university in Singapore and begun fund-raising among companies and alumni. He has even entered into partnerships with Stanford and Georgia Tech for student and professor exchanges, started headhunting for the best professors and has been actively recruiting students at home and overseas. As a result, foreign enrollment has tripled in the past six years to 18 percent. “American universities like Stanford, MIT and Caltech are benchmarks for us,” Herrmann says.
        The urgency of reform is palpable across the rest of the Continent. In 1998, education ministers throughout Europe met at the Sorbonne to mark the 800th anniversary of the venerable University of Paris. The need to compete globally was the top of the agenda. The next year, at a follow-up summit in Bologna, ministers from 29 countries set in motion a Europe wide evaluation of higher education with the Bologna Declaration. The goal is to create a more flexible system that is uniform across Europe. There is still resistance to the changes, which are supposed to be in place by 2010. The current French minister of Education, Luc Ferry, insists the goal is not to turn French universities into clones of Harvard or Stanford but to make France once again a prime destination for foreign students. The goal of EduFrance, created four years ago, is “to ‘sell’ French universities, just like we sell champagne, or perfume,” according to Francois Blamont, the director of the organization.
        In many countries, the pressing need for technological research has spurred reform. The Silicon Valley of Europe now centers around Cambridge, where, in the mid-’ 90s, university administrators began actively encouraging entrepreneurship and collaboration with industry—long considered a taboo. Last year alone, Cambridge spun out 25 new high-tech ventures, which could ultimately be profitable for the university. In —India, Bill Gates has called the seven elite Indian Institutes of Technology “an incredible institution that has changed the world” since their founding just over 50 years ago. Alumni have been major players in Silicon Valley as well as in India’s own burgeoning high-tech industry.
        In Japan, a once obscure regional technical institute has emerged as a role model. The Kanazawa Institute of Technology doesn’t yet have the prestige of Tokyo or Waseda Universities, but it does boast that 99 percent of its students have jobs before graduation—a remarkable statistic in a slow economy. The transformation began more than a decade ago, when KIT officials began sending groups of professors and staffers to major U.S. universities to study how things were done. By the mid-1990s KIT launched a reform plan that emphasized hands-on experiences. At the Factory for Dreams and Ideas, students build projects like a robot that shoots basketballs or a solar-powered car. There are also close ties with Japanese industry, an important source of additional funding. The school has launched its own company to commercialize its research and development.
         The influence of privatization is also changing the landscape of Brazil’s higher-education system. While many of the country’s public universities are languishing, private education is booming; nearly seven out of 10 university students are enrolled in private colleges. A few, such as the Catholic University of Rio, are now considered among the country’s best. Brazil is also experimenting with an exit exam, called the provo , to test the effectiveness of universities. “Before, evaluating higher education was all guesswork,” says Claudio de Moura Castro, an education analyst at the World Bank. “The provo is like flying with instruments after years of flying blind.”
        As higher education becomes more of a global commodity in the next few decades, it’s likely that new ideas like the provo or KIT’s Factory for Dreams and Ideas will inspire professors and students far from their original shores. And that would be the most important lesson that universities around the world could learn from the American example. Unlike most countries, the United States has always encouraged educational diversity, a sort of free-market approach. “We let folks decide for themselves,” says Barmak Nassirian of the American Association of Collegiate Registrars and Admissions Officers. In other words, let the best ideas win.

The Big Board's Barrel (editorial)

By Susan Lee
942 words
10 September 2003
The Wall Street Journal
A24
English
(Copyright (c) 2003, Dow Jones & Company, Inc.)

Ordinarily, the operations of the New York Stock Exchange go unremarked. But disclosure of Richard Grasso's hulking compensation has caused eyebrows to shoot up. Critics are shocked! shocked! shocked! that the head of a not-for-profit, quasi-regulatory concern could amass about $140 million in deferred compensation without putting a penny at risk. Meanwhile, supporters are smug and righteous that the person who manages the world's leading stock exchange deserves every million.

Standards of opprobrium aside, making judgments about Mr. Grasso's compensation is a mug's game. The Big Board is not a public company where additions or subtractions to shareholder value can be measured. Rather, it is owned and run by its members (though not all members knew, or approved, of Mr. Grasso's compensation). As the head of a company enjoying an unusually dominant position in its industry -- or, as some say, enjoying a monopoly lock -- Mr. Grasso's compensation is part of the monopoly profits extracted. Not to put too fine a point on it, but this great symbol of American capitalism is not a capitalist institution and its operations, including salaries, are not subject to any usual kinds of market discipline.

Here are two quick examples of how competition is limited. On the trading side, consider the so-called trade-through rule. The original notion was to make sure that stocks were bought and sold at the best price available, no matter the trading venue. If the NYSE has the best price for IBM shares, then the order should be directed to the NYSE. Sounds great, right? Except in practice. Because it takes longer to complete a trade on the NYSE than in some other markets, by the time the order comes up, the price may have vanished. In fact, "best" price is often just a "maybe" price. Beyond being irritating in the extreme, this slowness creates a big problem for traders. If a trader sees that the price has slipped away while she is waiting for the NYSE to respond, she cannot cancel her order instantaneously. If her bid is hit in another market, and then hit 15 seconds later on the NYSE, she finds that she has bought double the amount of IBM.

Thus, those who value speed and certainty of execution and would rather trade on speedier, more certain markets, don't. That's why about 80% of trading in listed stock is done on the NYSE.

And consider company listings. The Big Board operates with a rule that makes it almost impossible for companies to delist once they sign on. Under the aptly called "roach motel rule," a company wishing to shift its listing to another market has to jump through expensive and time-consuming hoops. Most decided not to check out. Under pressure, the exchange recently suggested repealing this rule.

Simply put, Mr. Grasso's out-sized compensation cannot be judged by the usual canons of executive compensation. It's hard to make the case that he is the leader of a company that must fight, day by day, for profitability in a competitive market.

As damning, Mr. Grasso's compensation cannot be considered in light of his record. No doubt the late 1990s were good for the NYSE -- volume soared, listings multiplied and stock prices roared. But times were also good for other trading venues, here and abroad. However talented Mr. Grasso may be, he didn't make investors all over the world want to trade. As Benn Steil, economist at the Council on Foreign Relations remarks, "Crediting Richard Grasso for a bull market is like crediting the groundskeeper at Yankee Stadium for the Yankees."

Nor can he be credited with making the Big Board the world's leading stock exchange. Many, many decades ago, rules and regulations, most of them sanctified by the Securities and Exchange Commission, gave the NYSE the bulk of trading. The result was, as the exchange reminds us day and night, the most liquid market. But the existence of a "most liquid market" creates a Catch-22. Everybody wants to trade where the liquidity is and liquidity is where everybody trades. Since no trader wants to be the first to move to another market -- no matter how much better that other market might be -- the incumbent market always has the advantage.

As the incumbent, then, the NYSE is bound to log good performance. No matter who sits in the chief executive's chair. Indeed, it's only a tiny stretch to suggest that any one of the exchange's janitorial staff could have done as good a job as Mr. Grasso. All of which makes Mr. Grasso's salary and compensation a prime example of what economists call economic rent. Payment is well above the minimum required to make available his executive services. Of course there is a bigger issue with Mr. Grasso's compensation. While the compensation committee was busy shovelling millions of dollars of economic rent to him, were they scrimping on resources necessary to perform the exchange's regulatory function? This is in fact the question raised by the SEC in a recent letter to the exchange.

No doubt lots of delicious stuff will be revealed in the coming months. And it might turn out that Mr. Grasso's compensation was reasonable given his contributions. But the fact remains that his achievement would seem more solid, and his compensation more just, if the conditions under which he labored were truly competitive. Anybody can shoot fish in a barrel.

Letters to the Editor: Specialists Control NYSE? That Floors Us

351 words
10 September 2003
The Wall Street Journal
A25
English
(Copyright (c) 2003, Dow Jones & Company, Inc.)

In regard to your Sept. 4 editorial "Grasso's Giant Payday" about the controversy surrounding the compensation of Dick Grasso, New York Stock Exchange chief:

You state, "Mr. Grasso works for the board of the exchange, controlled in turn by the `specialist' firms that essentially own the exchange." Really? The Board of the New York Stock Exchange has 27 members of which four come from the floor community; three of these are specialists (though only two currently sit on the board). Members include such luminaries as Madeleine Albright, Juergen Schrempp and E. Stanley O'Neal. They would be interested to know that three specialists control them and their fellow members. Not even the exchange's harshest critics or fiercest competitors believe that.

Valid arguments exist as to the merits of various trading systems but your referral to "the floor-screaming model of stock trading versus the quietly humming room of computers model" displays a clear bias. Apparently you haven't been on the floor of the NYSE -- 99% of our orders are delivered electronically. One of the first impressions of most new visitors to the floor is how quiet and organized trading is compared with their expectations. Our open outcry auction trading system is the most fair, efficient and transparent pricing mechanism in the world. The "many" that you refer to that consider ours an "obsolete business model" tend to be our competitors. They prefer to treat order flow as a commodity, allowing them to buy it, sell it and trade against it to maximize their profits at the expense of investors. We believe in matching investor orders directly so they trade with each other to the investors' benefit.

Your assertion that specialists own the exchange and so reward Mr. Grasso for keeping a system that benefits them rather than investors is absurd. We invite any member of the Journal's editorial board to visit our floor and see for themselves how human interaction combined with advanced technology best serves the investing public.

David Humphreville
President
The Specialist Association
New York

House Acts to Derail Pension Rules

Amendment May Prevent Cash-Balance Regulations Proposed by the Treasury

By Ellen E. Schultz and Theo Francis
947 words
10 September 2003
The Wall Street Journal
A3
English
(Copyright (c) 2003, Dow Jones & Company, Inc.)

In an unexpected move that involved possibly doctored Treasury documents, an expensive full-page advertisement in the New York Times and a lot of heat over cash-balance pension plans, the House passed an amendment that could prevent the Treasury from issuing controversial pension regulations.

Rep. Bernie Sanders, a Vermont independent, offered the amendment, which was tacked on to an appropriations bill, to stop the Treasury from issuing final regulations on cash-balance pension plans -- regulations that have been on the drawing board for more than 15 years. The vote passed 258 to 160, with 65 Republicans and 192 Democrats in favor.

Cash-balance plans are controversial because they usually cut pensions for older workers. In late July, a federal district court in Illinois concluded that International Business Machines Corp.'s cash-balance plans had discriminated against older workers.

Mr. Sanders and his co-sponsors, who include Reps. Gil Gutknecht (R., Minn), George Miller (D., Calif.) and Maurice Hinchey (D., N.Y.), say the Treasury regulations would have reversed the court's decision in the IBM case. "The court found that IBM knew that older workers would lose up to 47% of their pensions under the cash-balance conversion," Mr. Sanders said. "Now the Treasury is about to help employers make an end run around the courts and illegally cut pensions."

Although the final regulations haven't been issued, the Treasury is widely viewed as sympathetic to employers in pension matters, and in December issued proposed regulations that said cash-balance plans wouldn't be subject to age-discrimination rules.

Hundreds of large employers have adopted cash-balance plans, which usually save companies money by cutting pensions for older workers, and indirectly boost earnings by cutting pension liabilities.

The adverse decision in the IBM case alarmed employers, which are seeking favorable regulations from the Treasury, which they hope will aid them in their cases in the courts.

On Monday, an IBM lobbyist, Susan M. Siemietkowski, sent a document she called the "Treasury's statement of opposition" to various lawmakers' staffs, including Mr. Gutknecht. The Treasury document, on official Treasury letterhead, noted "Treasury Strongly Opposes the Sanders Amendment" and advised lawmakers to oppose the amendment, which it said "will weaken the defined benefit system."

Tara Bradshaw, a spokeswoman for the Treasury, said the agency didn't issue the document. "It is a Treasury generated fact sheet stating our position on a set of [past] amendments that were never offered. However, they were not sent in the format you provided and, therefore, appear to have been doctored."

She said the Treasury had prepared an earlier document pertaining to an amendment offered by Mr. Sanders last year, but that the original document was "designed for informational purposes and was not formally released," she said. "We were not aware the document had been circulated beyond a very limited number of select staff."

IBM spokesman Bill Hughes says, "We received the document from the Erisa Industry Committee, and we understand it was prepared by Treasury and distributed to members of the House last week. We believe that the document was not changed from what the Treasury distributed." He added, "We're doing everything we can to get to the bottom of this."

The IBM lobbyist also sent lawmakers a document titled "IBM-Wash Post.doc," which included text that appeared yesterday, in full-page ads in the New York Times and the Hill, a daily newspaper for members of Congress and their staffers.

The Microsoft Word document labeled its creator as Richard C. Shea, a lawyer at Covington and Burling, which is defending IBM's case.

When asked if he wrote the advertisement, Mr. Shea said no. When told that his name was attached to the document, he said he was aware of "various versions" of the ad "floating around," and said he didn't write it. He declined to say whether he was involved in the ad campaign, saying one of its sponsors was a client and hadn't authorized him to discuss it. "It's possible someone took a document I had originally drafted and prepared a new one on top of it," he said.

The ad carried the headline "Don't Destroy America's Pension System," and said the Sanders amendment would "outlaw vast numbers of pension plans." It was signed by a handful of lobbying groups, including the Erisa Industry Committee and the American Benefits Council, lobbying groups to which IBM belongs, and paid for by Erisa Industry Committee. Also listed was the Coalition to Preserve the Defined Benefit System, an employer lobbying group. The Web site for the coalition doesn't identify its members. However, the site's address is registered to Watson Wyatt, a consulting firm that is IBM's actuary, and which helped it implement its cash-balance plan.

When asked about Watson Wyatt's relationship to the coalition, Eric Lofgren, global director of the firm's benefits-consulting group, says Watson Wyatt was "in at the birth" of the coalition "with a bunch of employers," and functions as an adviser to the group.

Last year, Mr. Sanders offered a similar amendment, which passed the House 308-121, with most Democrats and 47% of Republicans voting in favor; it ultimately was stripped from the final bill.

Sen. Thomas Harkin (D., Iowa) also is expected to introduce a limitation amendment aimed at preventing the Treasury from issuing cash-balance regulations. If the reconciled amendments ultimately pass, the final regulations on cash-balance plans won't come out for another year.

Japan Gets a Pulse (editorial)

738 words
10 September 2003
The Wall Street Journal
A24
English
(Copyright (c) 2003, Dow Jones & Company, Inc.)

It's too early to shout banzai! but the Japanese economy is actually improving for the first time in years. We'll now see if Prime Minister Junichiro Koizumi can use this momentum politically to follow through with his long-promised structural reforms.

Japan recently announced the sixth successive quarter of growth, and economists are predicting GDP growth of around 2% for calendar year 2003. This may not sound like much, but for an economy that has poked along at little more than 1% a year over the past decade, this is nothing to sneeze at.

It's particularly encouraging that the current recovery is led by domestic demand, unlike last year's export-driven growth. In the April-June period, Japanese companies' capital spending rose 6.4% from a year earlier. Even consumer spending is up, accompanied by a drop in Japan's famously high savings rate.

Accelerated demand is essential for putting an end to one of Japan's primary economic woes: deflation. Yet in the past decade Japan has seen several brief pickups in demand that ultimately led nowhere. The real challenge is restoring a virtuous cycle of rising domestic investment, production and consumption.

That won't happen until Japan cleans up its banking system. Banks are still overwhelmed with bad loans and continue lending to companies that would provide great benefits to the economy if they were allowed to fail. Deflation, which increases the real burden on debtors, is both a symptom and a contributing factor to the bad-loan mess.

Unfortunately, Japan's official reactions to previous economic spurts do not give grounds for optimism. In 1997, for example, the government responded to a brief upturn in the economy by raising taxes. This time around one immediate danger is not a policy blunder, but is complacency. There is still quite a lot to be done, and the biggest mistake Japan could make would be to see recovery as a sign that further reform is unnecessary.

Treasury Secretary John Snow lavished Mr. Koizumi's government with praise during his recent visit, going so far as to say that he was "heartened" by the efforts of Japan's companies to clean up their balance sheets. It is true that the prime minister has made some promising efforts in this regard, but there is still much further to go than Mr. Snow's remarks would suggest. Last year, Mr. Koizumi and his financial-services minister put together a plan aimed at stopping lending to deadbeat companies but the reform measure was watered down in the legislature.

The Japanese government estimates that the country's banks hold about $370 billion in bad loans, although some economists estimate that the real figure is three times as high. The recent nationalization of Resona, the nation's fifth-largest bank, marked some progress in Mr. Koizumi's initiative to stop banks from cooking the books. But still worrying is the vague loan-classification system that allows banks to portray dubious loans as "healthy."

The pickup in economic growth offers Mr. Koizumi what is probably his last chance to push through structural reforms. The Liberal Democratic Party holds leadership elections next week -- he's expected to win -- and he's been out on the stump this week sounding his old themes of fighting deflation and restraining the growing public debt.

In all this, Mr. Koizumi has one powerful weapon: public approval, which remains above 50%. After he came to office in April 2001, his sky-high opinion poll ratings let him overpower his opponents and introduce a 30-trillion-yen ($257 billion) cap on bond issuance as well as postal privatization measures. Last year, Mr. Koizumi's temporary drop in popularity allowed the LDP old guard to eviscerate his tax reforms.

And while many in the LDP despise Mr. Koizumi's proposed reforms, they also realize his popularity may be the only thing keeping the party in power. With a general election looming, Mr. Koizumi has a chance to use his approval ratings to subdue critics in the LDP who would love to undo his initiatives and try to put Japan Inc. back in business.

Mr. Koizumi likes to think of himself as a reformer. For the sake of global growth, let's hope he takes advantage of the current upswing to push through the reforms needed to make this Japanese recovery last.

Forget Fixing Leaky Toilets: There's A Better Way to Invest in Rental Property

By Jonathan Clements
994 words
10 September 2003
The Wall Street Journal
D1
English
(Copyright (c) 2003, Dow Jones & Company, Inc.)

LOCATION, LOCATION, location.

Looking to invest in rental real estate? Here's my advice on location: Try the stock pages.

I get a steady stream of e-mails from readers, asking about the virtues of investing in apartments and vacation homes. My response: If you really want to invest in rental real estate, buy equity real-estate investment trusts, or REITs, which make their money by purchasing and then renting out offices, shopping centers, apartments and other properties.

To be sure, if you invest in rental property, you could increase your returns with leverage and your rental income may dwarf the dividends you receive from REITs. Even so, I would still lean toward REITs, because there are fewer hassles, less risk and far lower costs.

-- Weighing Returns: Equity REITs have lately been on a tear, with share prices up a cumulative 31% over the 3 1/2 years through June 30, according to Washington's National Association of Real Estate Investment Trusts.

But property prices have also been rising smartly. If you had bought a rental property in late 1999 and it appreciated at the same rate as other homes, you would have made 28% over the same 3 1/2-year stretch, according to home-finance corporation Freddie Mac.

That 28% gain, however, isn't really comparable to the 31% return from equity REITs. One reason: REIT returns benefited from leverage. Currently, REITs have debt equal to a little under 50% of their total capitalization. That's like owning a $200,000 property with $100,000 left on the mortgage.

When folks buy rental properties, they often also use leverage. Suppose that, 3 1/2 years ago, you put down $100,000 on a $200,000 house and the home's value climbed 28%, to $256,000. Thanks to the leverage involved, your gain would be 56%, with your $100,000 down payment growing to $156,000.

Unfortunately, however, you wouldn't have pocketed nearly that much. Why not? First, there would be the often-exorbitant cost of first buying and later selling the property. Second, that leverage would come at a cost, in the form of hefty monthly mortgage payments.

People sometimes argue that rental properties are a better investment than REITs, because you can employ more leverage. But this argument doesn't impress Chris Mayer, a finance professor at New York's Columbia Business School. He points out that, if you really want a leveraged play on real estate, you could open a margin account at your favorite brokerage firm and buy REITs with borrowed money.

"To which people say, that's really risky," Prof. Mayer recounts. "To which I say, it isn't any more risky than taking out an 80% loan on a piece of rental property."

-- Comparing Yields: While price appreciation gets all the attention, the biggest gain from both REITs and rental property is likely to be the yield. That yield is the dividends you receive from your REITs and the rent you get from your tenants.

Currently, equity REITs yield an average 6%. It doesn't cost much to collect that yield. If you invest through a no-load REIT mutual fund, there's no expense when buying and selling. Your only costs are the fund's annual expenses and trading costs, plus taxes if you held your fund outside of a retirement account.

What about rental property? The yield will vary from city to city. If you rent out a single-family home in Los Angeles, you might collect annual income equal to 6% of the property's value, figures James Joseph, owner of Century 21 Grisham-Joseph in Whittier, Calif. Meanwhile, Sean Conlon, co-founder of Century 21 Sussex & Reilly in Chicago, figures the yield in his city might be closer to 7%.

But once again, both leverage and costs come into play. If you took out a mortgage to buy your rental property, the yield as a percentage of your down payment would be higher than this 6% or 7%. But unfortunately, you would also face a truckload of ongoing expenses, including maintenance costs, homeowner's insurance and taxes. Add it up, and I suspect a lot of rental-property owners will find they could fare just as well with REITs.

Still, if you buy rental properties in depressed real-estate markets, the yields could be much higher than the 6% and 7% cited above. But high rents don't necessarily translate into high total returns. Indeed, a hefty yield may indicate that home prices won't rise a whole lot.

-- Considering Risk: While you can't be sure whether REITs or rental properties will perform better, REITs do have one undeniable advantage: They are a lot less risky.

If you invest in a rental property, you are banking a ton of money on a single piece of real estate, rather than getting the diversification of REITs. Moreover, there is the problem of collecting those rent checks. "If it takes you three months to evict a tenant, you're out a quarter of that year's return," Prof. Mayer notes.

The bottom line: Owning REITs is not only less risky, but it also involves far fewer hassles. "It's easy to describe the difference" between REITs and rental properties, says William Bernstein, an investment adviser in North Bend, Ore. "One is an investment and the other is a job. It all depends on your tolerance for broken toilet bowls and psychopathic tenants."

                   Housing Your Dollars
  Here are five no-load, low-cost real-estate funds to consider.
                                 ANNUAL     MINIMUM
FUND                            EXPENSES   INVESTMENT
Fidelity Real Estate             0.87%      $2,500
T. Rowe Price Real Estate        1.00       $2,500
SSgA Tuckerman REIT              1.00       $1,000
TIAA-CREF Real Estate            0.45       $2,500
Vanguard REIT Index              0.27       $3,000
  Source: Morningstar Inc.