Economic overview by Tony Alexander

New rules in the housing market

On Tuesday, 23 March at 9.00am the government announced a range of measures aimed at tilting the field against investors and in favour of first home buyers, in favour of growing supply, and towards more sustainable prices. Let’s start with the small stuff, then look at the main change attracting attention. 

Brightline test

The brightline test has been extended from five years to ten years. Some people may be dissuaded from investing in residential property because they will have to pay tax on their nominal capital gain if they sell less than ten years after purchasing.

The effect of the change will be to encourage some people to hold onto their properties for a longer period of time than would otherwise be the case. It will reduce investor demand only marginally.

Housing Acceleration Fund

The government has created a $3.8bn contestable fund which councils can call on for grants to help fund infrastructure needed to allow growth in the number and speed of subdivision development around the country. This is a very positive development.

It addresses a key issue discussed recently which is that the government can greatly influence housing demand, but their ability to address supply is severely limited by the fact that councils control supply. Ratepayers as a rule don’t want to pay higher rates for infrastructure development to let more people live nearby, clogging up their roads, taking away green space, and filling up schools. 

Those latter concerns will remain, so we should not be thinking that the $3.8bn fund will radically increase house supply. But it will help facilitate greater growth in supply over the long-term.

Homes & Communities land fund

$2bn has been allocated for Homes and Communities (the old Housing Corp.) to purchase land for social housing. This is a very positive development given the sharp rise in demand for social housing likely to arise as a result of the announced reforms. 

The $2bn fund will tend to place upward pressure on land prices.

First Home Products

There will also be a tiny bit of upward pressure on prices from the raising of the income and house price limits for first home buyers to access the First Home Grants and Loans.

Apprenticeship funding

More money has been provided for more apprenticeships in the construction sector. This is a very positive development because a key constraint on the speed with which new housing can be made available is the lack of staff. That constraint is likely to become fairly binding in the next few years not just in terms of putting houses up but developing the subdivision infrastructure in the first place.

There is already hefty demand for people in the infrastructure space as councils contemplate many years of replacing aged infrastructure under the ground. 

Removal of interest cost deductibility

And so, to the big and unexpected change. I had expected that the government might change the ability of existing investors to deduct interest rates to the extent of maybe 10% of those costs. Then, I figured that they would raise that 10% to 20% and so on over the years.

Instead, from October 1 this year, existing investors will lose 25% of their ability to deduct interest cost. That is, they can only claim 75% of their interest costs against their rent revenue when calculating income to be taxed from their rental property. 

This 75% will continue through to April 1 2023 after which 50% of interest cost will no longer be able to be deducted. This falls to 25% from April 1 2024, then a year later no interest expense will be able to be offset against rental income.

I have emphasised this four-year time period for fully removing interest cost deductibility because it means not all of the coming adjustment in prices as a result of the change will happen at once. The impact will be spread over time.

However, for all new purchases by investors the loss of all interest cost deductibility will happen right now. It looks like investors purchasing new builds will not only still retain a five-year brightline test but may also retain the ability to deduct interest costs. There is consultation to be done on this and the wording in the press release from the Beehive read like this 

“The full removal of interest deductibility from 1 October 2021 will apply to all investment properties other than potentially new builds - purchased on or after 27 March.”

What will be the impact of the interest deductibility change?

Looking at this from the new investor’s point of view it means if one anticipated 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 to $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 an 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.

Therefore, the change in interest cost deductibility will lead to a reduction in investor demand for an existing property.

At the same time, 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 to six or so years. 

Overall, investors in residential property will be worse off, but some will gain. These are the people investing without any debt, so for whom interest cost deductibility is irrelevant. They will see the value of their portfolios give up some of the 25% price gains on average nationwide since June last year.

But they will enjoy higher rents. 

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 the boost above normal rises will probably be spread over the next four years. 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 have pushed landlord costs higher.

There has already been a blowout in the number of people on the state house waiting list. A lot more people may now join the queue. A lot more people will find themselves homeless, and a lot more people will need to be housed in motels around the country. 

Ultimately, who wins? First home buyers (maybe), people in the infrastructure, land development, and construction sectors. The construction sector benefit arises because the government is leaving the brightline test at five years for investors in new builds. They are also consulting on the idea of still allowing interest cost deductions for investors in new builds. The measures will incentivise new construction which is good from an economic growth point of view.

First home buyers will face reduced competition at auctions and get marginally improved access to government subsidies to help them achieve home ownership. But the trend toward rent-vesting will likely stop. This involves first home buyers purchasing a property as an investment then taking the capital gain when they sell as a deposit towards the first house they will own and live in. 

That route excludes accessing first home buyer grants when making that second purchase, and they can’t access their Kiwisaver money for that purchase either. So probably not a great number of people have gone down that route.

But now, the extension of the brightline test means it is highly unlikely many would contemplate ten extra years renting before living in an owned house. Plus, removal of the ability to deduct interest cost as an expense means their expected returns from a rental will fall sharply. 

Note that 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 may raise prices which developers are able to price their units at and make purchasing more difficult for first home buyers. Given that more and more new builds have been towards the affordable end of the market, the pushing away of first home buyers into an older housing market which they possibly can’t afford (land, larger dwelling), could see many of these buyers now worse off. 

Exporters win because there is now a reduced chance of interest rates being pushed up by the Reserve Bank next year (though fixed rates still face upward pressure from developments overseas). The NZD has already shed about 2 cents in response to this change in the NZ monetary policy outlook.

Owners of sections and developable land win because extra construction which will eventually occur will require more land. 

Who loses? Most investors, all renters, and perhaps some people who have bought investment properties recently with high debt levels. 

Will average property prices fall? Probably. But we need to put any changes 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 those dim, dark, days of October. If they fall 5%, we will be back where we were in the first few days of February. 15% takes us back to August last year.

In Summary : 

The government has announced changes aimed at dissuading investors from purchasing existing properties and increasing the supply of new dwellings. Both goals are likely to be achieved as a result of the new policies, but it is not at all clear that they will achieve their desires of improving home ownership opportunities for first home buyers, lowering the ratio of house prices to incomes, and improving conditions for renters.

For renters in particular things look like they will in fact become worse. Faced with higher costs for owning an investment property it is only reasonable to expect that landlords will raise rents more than they were otherwise planning at their annual reviews. 

But not only will renters face higher costs, they are also likely to face reduced availability of properties. This will arise because some investors will sell their existing properties and purchasers are now more likely to be owner occupiers than other investors.

The data tell us that on average there are more occupants per tenanted property than in each owned and occupied property. Therefore, this simple change in ownership and type of occupier will produce a greater fall in rental property supply than rental property demand.

For first home buyers, there is the problem now that investors have been highly incentivised to purchase new builds rather than existing dwellings. This will provide good growth opportunities for property developers, builders, etc. But it will also apply new upward pressure to land prices, and this along with the new source of demand facing developers, will lead to higher prices being charged for new dwellings.

In Auckland, this will have an impact somewhat different from the rest of the country. In our biggest city, around 60% of dwellings being built are townhouses and apartments compared with around 40% elsewhere. These properties tend to be more toward the affordable end of the price spectrum than houses. 

New demand from investors will see many first home buyers unable to purchase as easily off the plan as they had been otherwise thinking before the rule changes. 

First home buyers will increasingly be pushed towards purchasing existing houses and the problem there is that these houses tend to be less affordable than the new, smaller units, and they have upgrade expenses and maintenance requirements which could prove daunting for many young people. 

Young people have also just seen their ability to grow a deposit by investing in their own right become less attractive. They will, like all other investors, have their returns after-tax affected by the extension of the brightline test and removal of the ability to count interest costs as an expense. 

With regard to the long-term outlook for prices, things have not really altered from what I have been delivering as a key message in recent years.

On average in Auckland, since 1992 house prices have risen by 7.7% a year. My expectation has been that this pace will slow toward 5.5% or so and the government’s moves largely bring that transition closer in time rather than necessarily radically altering the long-term track for prices.

My view of price growth slowing down has been based on expectations of higher house supply following: 

• introduction of the Unitary Plan, 
• new rules regarding where six-storey buildings can be erected with councils unable to prevent such construction, and 
• an expectation of additional measures to boost supply such as we have just seen via special funding for infrastructure installation,
• transport infrastructure improvements.

In addition, my view is and remains based on a belief that a 3–4-decade period of falling interest rates has now come to an end. This means the upward pressure on house prices from falling debt servicing costs has now ended. 

Interest rates will not soar from current levels, but they are unlikely to fall further.

Also, I have expressed a view that the upward trend in net migration flows will flatten out and this will remove one source of prices pressure which has been continuing population growth surprises.