Housing market on war footing

The Government is staking its political credibility on its war against soaring house prices, says BNZ chief economist Stephen Toplis.

Monday, March 29th 2021

He says it should come as no surprise the Government’s patience has been exhausted and a full attack on prices is underway.

“Whether the measures will have the desired impact or not is neither here nor there. If this set of policies fails then more will be introduced as the Government cannot be seen to fail.

“The Government has now fully exposed its intention to do what it takes in terms of moderating house price inflation. It will almost certainly win in the end.”

Unwarranted inflation

In the bank’s opinion, there is no doubt recent house price inflation is unwarranted and unsustainable. It has been boosted by a combination of ultra-low interest rates, relatively poor perceived returns on other asset classes, speculative fervour and first home buyers’ FOMO.

In contrast, the fundamentals of true demand and supply have actually been going the “wrong way”, says Toplis.

Thanks to Covid, population growth has plummeted alongside the slump in net migration. The increase in demand for housing is way less than expected.

Even when borders do reopen it is unlikely the shortfall in demand generated will be quickly reversed, he says.

“But while true demand has been much less than anticipated the pace of housing construction has accelerated beyond expectations.

“Right now, one new house is probably being built for every one person increase in population. This is clearly not sustainable.” This will be chewing into the housing shortage rapidly without last week’s housing policy announcements, says Toplis.  

He adds, investing in houses is not a one way bet as the Government will not be happy unless house price growth falls below income growth. So it is reasonable to assume house price inflation will fall to near zero, at best, in the not too distant future.

Asset fine tuning

The risk is that no government, or central bank for that matter, has ever been able to fine tune an asset market so the balance of risk is that a decent correction in prices occurs.

For all but new buyers this matters little as it will simply reverse some of the recent exceptional capital gains.

Independent economist Tony Alexander says from a new investor’s point of view before the new policies it meant if buying a property delivering $20,000 per annum in rent, financed with debt costing $15,000 in interest, then ignoring all other costs, taxable income would have been $5,000. The tax bill would be $1,650 at 33% and the investment would be cash flow positive.

Now, tax will be levied on the entire $20,000 of revenue delivering a tax bill of $6,600. The tax bill goes up $4,950 and the property is now cash flow negative.

“The returns to investing in residential property have altered – not just for the 24% of people purchasing investment property with a mortgage, but many of the 12% who pay cash.

“They would pay cash having raised debt on other properties they own in many instances. That debt will eventually be affected,” says Alexander.

“Therefore, the change in interest cost deductibility will lead to a reduction in investor demand for property. This will affect bidding at auctions.”

To put the coming price declines of uncertain magnitude in context – prices in February on average were ahead 25% from May and 21% from a year earlier. If prices on average now fall 10%, they will go back to where they were in October. If they fall 5%, they will be back to where they were in the first few days of February and 15% takes them back to August last year.

The possibility of a substantial correction is multiplied, says Toplis, if the potential oversupply diagnosis and new policies have a substantial negative impact on sentiment.

“House prices will come under significant pressure if everyone heads for the exit at the same time.”

Alexander says some investors will look to sell, even if the cash flow hit on them might not add up to much in the next 24 months.

“This effect will be spread over the next four-six or so years.”

Sure to rise

The jury is still out as to the longer-term impact on rents and supply, says Toplis.

Alexander believes rents will rise because investors will look for compensation for their inability to deduct interest costs.

“How much rents will rise is anyone’s guess, but a rise in average rents above 30% in the next four years could easily occur following rises of 22% since Labour came to power late in 2017 and since then has pushed landlord costs higher.”

Alexander says many landlords have refrained over the years from charging what the market will bear because they empathise with their tenants and have been able to say to themselves that sacrifice of rental return will mean little in the context of long-term capital gain.

“Now more people will have that capital gain taxed, and their properties will deliver far lower yields along the way. Many will feel, and have, no choice other than to potentially radically raise their rents when they come up for their annual review.”

The message from the Government is it no longer wants people to pursue rental property ownership as a business for which normal deductibility of expenses applies.

“It is actively disincentivising ownership of property for rental – hence the reduction to come in rental supply and rise in rents.”

Actively seek new builds

Alexander says investors will now be actively incentivised to buy new builds because of the probable continued ability to deduct interest costs.

“This new layer of demand for new builds will raise prices which developers are able to price their units at and make buying more difficult for first home buyers.”

However, Toplis says there has to be a question about where the capacity to build will come from.

“The construction sector is reporting significant labour shortages already. It is difficult to see how the sector can expand rapidly at this juncture.”

RBNZ’s response

It will now be interesting to see how the Reserve Bank responds to these developments, says Toplis.

Overlooked by many was a one-liner in the Government’s announcement that said: “The Reserve Bank will report back to the Government on the possible introduction of debt-to-income restrictions and restrictions on interest-only mortgages in May.”

Toplis is not sure where this will land but it will dovetail with the bank’s Financial Stability Review on May 5. He adds investors should not be surprised if there is more housing related policy announced in the May 20 budget.

Who loses?

According to Alexander it is almost all investors, all renters, real estate agents and mortgage advisers through reduced turnover. Also anyone who has bid against the odds recently to secure a property and now faces that property’s market value declining for some of the rest of this year.


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