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AUG 15

Land, Buildings and the Balance of Trade

Housing has been a growing issue in many, but not all, economies around the world. In New Zealand, it has been a standout problem that seems to be getting worse, a problem characterised by the Auckland housing market. Housing and land values underpin an issue that directly affects everyone, through higher living costs, driving higher inequality; asset price inflation can be damaging on investment and competitiveness of the tradable sector and lower average wages. In current conditions, investment is largely focused on assets, not productive enterprise. Interest rates here are elevated in comparison, trying to check rises in asset prices and consequentially the exchange rate is higher than they otherwise would be, hurting export returns and competitiveness of manufacturers in the domestic market.

As asset prices rise, indebtedness rises in comparison to earnings, and generally the economy carries a higher vulnerability to economic shocks that can threaten financial stability. A downturn in the economy can see assets fire sales, prices fall, the economy worsens, more assets are forced up for sale and we see a price crash; this does happen, consider Ireland, Spain and even the U.S.

Source:  Demographia

The above graph compares the median multiple measure of housing affordability for each countries major markets – for New Zealand, this is the Auckland housing market. The median multiple is the ratio between median house prices and median annual household income – an important measure of housing affordability.

Ever expanding debt, supported by banks and the large monetary stimulus programmes in the U.S, Europe, U.K and Japan), and even by the RBNZ (in the way the RBNZ rules favour land and buildings on bank balance sheets), fuel ever higher average house prices with respect to average earnings, increases the risks around financial stability. A process supported by the notion that prices will always rise and that debt will be paid by the (tax free) capital gain. The risk to stability is, of course, is if prices fall. There are nonlinearities; research by the OECD estimated when household debt rises above trend by 10 percent of GDP there is a 40 percent chance of the economy entering recession in the following year, compared to 10 percent likelihood when household debt is rising at trend.

More generally, recent OECD research looking at the role of finance and growth suggested in most OECD countries: more credit to the private sector slows growth, more stock market financing boosts growth, credit becomes a stronger drag on growth when it goes to households rather than businesses and bank loans slow economic growth more than bonds. This report also proposed reforms to promote growth and financial stability, including: use of macro-prudential instruments to prevent credit over expansion, supervision of banks to maintain sufficient capital buffers, measures to reduce the threat of and subsidies to too-big-to-fail banks and reform to reduce tax bias against equity funding and to make value added tax neutral between lending to households and businesses.

House prices are high when compared to incomes. A recent Demographia affordability survey showed Auckland was the ninth least affordable city out of 86 major metropolitan areas, with populations over 1 million. As of September 2014, the median house sale price in Auckland was 8.2 times median household income – the survey median was 3.8. The New Zealand national median house price-to-income ratio is also high, at 5.2. Demographia defines income multiples of 5.1 and over as ‘severely unaffordable’.

Household debt reached a peak of 162.2 percent of disposable income in the first quarter of 2015, after previously peaking close to this at 161.2 percent in the second quarter of 2009. In reference to the build up of debt in the lead-up to the GFC the RBNZ said, “In New Zealand, house prices were a key factor driving the increase in debt to historically unprecedented levels.” On another measure, New Zealand’s household debt-to-GDP ratio is at 95 percent, down somewhat on the peak of just over 100 percent in 2009.

Research by the Bank of International Settlements (BIS) suggest that household debt over 85% of GDP can damage an economy, though greater sensitivity to economic downturns, and by boosting debt for non-productive assets, pulling resources from the rest of the economy to service it, including skills and investment. 

There are two sides to the housing issue – demand and supply. On the supply side, under supply of housing naturally leads to higher prices, particularly with high net migration. Hence the solution to this part is to increase supply, open up new land for development, focus on increasing the number of houses built and responsibly reduce constraints and barriers to new builds. It is also important that such developments target high density development, particularly in larger cities such as Auckland, to reduce the cost of urban sprawl. 

Supply side activity has a limited pace, allocation of finite construction resources and labour has a limit, and this is even worse when in catch up mode, as seen in the large deficit in the cumulative net supply position in the graph below – this is a key area for the Government to do more, especially ensuring affordable housing is built. Low rent inflation also suggests investors and speculators are also driving this house price inflation. The RBNZ estimate that over 40% of purchases of residential property are by investors and accounted for one third of new mortgage lending over the six months ended March 2015. 

Source: MBIE

Supply side efforts take a while to take effect, and the threats to financial stability and the damage to the tradable sector are with us right now. More needs to be done. Intervention on the demand side, such as a register of foreign buyers, borrowing limits related to asset earnings, and or buyer earnings, higher deposits for landlords and capital gains enforcement can act quickly to reduce the growth in debt, slow price rises and thereby improve financial stability.

The supply response in the last two decades has favoured more expensive housing, rather than affordable homes, exasperating the inequality effect – as seen below, this trend started in 1990 and has continued, which the percent of upper quartile value housing increasing rapidly, which middle and low quartile housing investment falling.

Source:  OECD Economic Survey - New Zealand

International experience
Last year the Bank of England reintroduced Loan to Income Ratios, where no more than 15% of mortgages issued can exceed a Loan to Income Ratio of 4.5. To explain, if you earn £100,000 a year, your loan would be capped at £450,000 – you can only borrow up to 4.5 times income.
The Central Bank of Ireland has taken similar measures, learning from the damaging experience of a housing bubble and resulting crash. First they introduced similar Loan to Income Ratios, though set at a lower 3.5 times of gross income. This is in line with “affordability” ratios reported by Demopgraphia.

Ireland supplemented Loan to Income limits with Loan to Value Ratios similar to those introduced by our own RBNZ, set at 80% (same as New Zealand and means 20% deposit is needed), with a lower ratio of 70% for those buying rental properties. For first home buyers this is set at 90% for properties up to €220,000, with 80% on any value exceeding this. This tougher requirement on rental investors reflects their higher default risk as compared with owner-occupied homes.

Research by the BIS suggests that macro-prudential tools, (Loan to Income and Loan to Value Ratios) as those described above, can be effective in slowing house price inflation and mortgage credit growth if they are introduced at a time when these are both high. In other words, they can be most effective in slowing a boom, and are less invasive at other times, keeping the lid on gently.

Another issue often cited as a factor increasing prices is demand from foreign investors. Unfortunately with no register of such ownership in New Zealand it is hard to judge the extent of this, but other countries have introduced additional surveillance to deal with this problem. Recently, the RBNZ put their best estimate at foreign purchasers of residential property making up around 10% of sales.

Singapore saw record high prices, increasing 40% in the five years to 2013, and in response introduced stamp duty taxes on non-resident buyers of property. This tax now sits at 15%, increasing from 10% when it was introduced in 2012. They also introduced a cap on debt repayment costs at 60% of the borrowers’ monthly income. These measures have seen prices fall 4% in 2014, and sales volumes falling. Action of this sort can see prices, in relation to earnings, fall over time avoiding a demand side shock.

Australia has had similar problems, and like New Zealand, they have not have a foreign ownership register to measure the real extent. There are proposals to introduce such a register as well as fees on foreign investors: A$5000 fee for property up to A$1m, and investments over A$1m would incur an A$10,000 fee for each additional A$1m purchased – these measures are probably too small to make much difference but are a start. Foreign investors are limited to purchasing new build, and not existing property, and these rules may be strengthened. The state of Victoria is now also planning a 3% tax on foreign buyers of property.

England, Ireland and Australia also have some form of Capital Gains Tax. In a recent speech, the Deputy Governor of the RBNZ suggested New Zealand needs fresh consideration around tax settings for housing, particularly for investors, saying “The tax treatment of housing is a major factor with potential to influence the demand/supply imbalance in the housing market.” Also saying “housing is the most tax-preferred form of investment, particularly when it is highly leveraged. Indicators point to an increasing presence of investors in the Auckland market and this is no doubt being reinforced by the expectation of high rates of return based on untaxed capital gains.”

The RBNZ has recently specifically called for the Government to readdress the tax-preferred status of housing. It both incentivises unproductive investment in property and overvalues such assets (fuelling risk of bust), while pulling investment away from the real economy, where it could be most productive in terms of job creation and growth. Other solutions aside from CCT are also available, such as a Land Tax or Comprehensive Capital Income Tax. Regardless of the specific solution, it is clear this tax-preferred status needs to be corrected.

The Government recently announced changes to the existing tax regime, creating a new “bright line” test – this deems any residential property sold within 2 years to be liable for tax at the individual’s income tax rate. However this change does not take effect until later this year, giving some scope for investors to sell now and avoid taxation. After 2 years, the existing “intention” regime for determining if tax is liable remains. While this is a positive step forward, and may have some slowing effect on house prices, it does not correct the tax preferred status currently felt by property, and is unlikely to significantly stem excess build up of debt.

The RBNZ also recently moved to address financial stability risk stemming from the Auckland housing market by introducing a new LVR of 70% for residential property investors in Auckland. Coming into effect 1st October, this will require all purchasers of a property which is not owner occupied, to have a 30% deposit. The RBNZ also expect banks of observe the spirit of these restrictions from the date of announcement. This change was facilitated by creating a new asset class for residential property investors, requiring higher risk weights to better reflect the higher default risk of investors as compared to owner-occupied properties. Bill English was quoted as saying the RBNZ had the tools to limit interest only mortgages, which are often cited as a way investors are negatively gearing properties to chase capital gains and reduce current tax paid.

It is clear that there are other tools that could be used to tackle our housing issues, of which many are already being used around the world - we should learn from their experience. And while we have seen positive steps forward by both the RBNZ and Government in addressing these issues, wider reform is needed. Limiting the expansion of private debt to both earnings and equity is important not only for those trying to buy a home, but to reduce the impact on competitiveness of the tradable sector through the exchange rate channel and cost of borrowing.

More generally, the Government and RBNZ need to stop shying away from strong demand side changes, being sufficiently bold to tackle hard issues, around the treatment of asset debt by the RBNZ and fiscal policy changes by Government around the capital gains incentives.
Out of control asset inflation is toxic to the real economy, destroying our ability to deliver a long run neutral balance of trade, as well as driving inequality, which further damages our economic performance. Reform in this area can boost growth for the whole economy in a more sustainable and equitable way.

tags: housing, tax, taxation, land, property, ireland, investment, investors, speculation, land tax
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