Housing affordability... where to from here?

For generations, property has been the preferred investment of many New Zealanders.

Those of us fortunate enough to own our own homes take great pride in doing so. But, for many, the attraction runs deeper than simply having a roof over our own heads. We understand property. We trust property. We also know that over a long period of time, investors in residential real estate have mostly been able to generate a very good return from property.  

When we look at property markets overseas, residential property generally represents a solid if unspectacular investment. For example, in the chart below, we can see that the average price of residential property in the United States has increased by only 1.1% above the rate of inflation over the last 93 years. This price series excludes the effects of capital upgrades that occur when you spend additional money to maintain or make improvements to your property.

Long term growth of US residential property and inflation 1927 - 2020

This makes intuitive sense because if the price of property (excluding capital improvements) were to increase much faster than the rate of inflation, it would eventually outpace most people’s ability to purchase it!

But that’s not what seems to have happened in New Zealand.

The following chart shows data from the Demographia 2021 study on international housing affordability and compares housing affordability from about 30 years ago to today.

The measure of affordability is the national average home price as a multiple of the national average income. This measure helps us make an easier comparison between countries with different income levels.

International House Price to Income Ratios 1987/1992 to 2019

As can be seen quite clearly above, the red bar is twice the height for New Zealand as the green bar. That means it takes almost twice the income to purchase a house now compared to 30 years ago. This chart was based on 2019 data, so with the recent strength in the housing market, it’s very likely to be even worse today. We also observe that the red bar for New Zealand is higher than comparable English-speaking countries. The overall result is that New Zealand housing is much more unaffordable than it was 30 years ago, and it is much more unaffordable, on a relative basis, compared to other countries.

This probably helps explain why the New Zealand government felt compelled to introduce some changes to the tax regime faced by residential property investors.

The two main changes announced in March included:

  1. The extension of the ‘bright line test’ to 10 years for existing residential property (maintained at 5 years for new builds). This means an effective tax on any capital gains made on properties sold within 10 years since purchase.
  2. The removal of tax deductibility of interest expenses for homes purchased from 27 March 2021, with deductibility for existing homes to be phased out entirely over the next four years.

It seems these changes have been introduced with the intention of reducing the profitability, and therefore the incentive, of investing in existing residential property. And, if it removes the incentive for property investors to purchase the existing housing stock, then it might just make more room for the ubiquitous ‘first home buyer’ that the government spends lots of time trying to figure out how to help. 

It is far too early to tell whether these policy changes will have that desired effect, because at least part of what’s driving New Zealand’s relatively unaffordable housing market is a supply side issue. House prices are already high; but if these high prices aren’t inducing sufficient investment into new property developments, then there must be some constraint either on the supply of land, materials, or labour. Solving these issues isn’t anywhere near as simple as creating or extending a ‘bright line test’ for capital gains.

In the Demographia study, former Prime Minister Bill English is quoted as saying:

Housing affordability is complex in the detail — governments intervene in many ways — but is conceptually simple. It costs too much and takes too long to build a house in New Zealand. Land has been made artificially scarce by regulation that locks up land for development. This regulation has made land supply unresponsive to demand.

From an investment point of view, we’ve traditionally told clients that have wanted to pursue residential property investment that they needed to treat it like a business — their own property business.

They can hope for (but can’t guarantee) that house prices will rise. Therefore, they need to ensure they have a property that makes sense from a rent and cashflow perspective. They need to consider the time and cost of capital improvement and realise that they don’t own the “median house”. They own a physical property that will deteriorate over time, that renters use and inevitably damage, and their property will depreciate and will need maintenance to improve. Some who have undertaken residential property investment on this basis and approached it thoughtfully, like a business owner, have done very well.

But the government is now saying that investing in residential real estate is not a business, as interest expenses will not be an allowable deduction against what is tax-assable income, like it is for any other business. Additionally, turning over a property investment within 10 years might also have significant additional tax consequences. The end result is likely to be that the smaller and more leveraged investors might increasingly begin to look elsewhere to grow their wealth, like in the sharemarket.    

New Zealanders are unlikely to suddenly lose their love-affair with residential property. Those feelings have been nurtured by generations of New Zealanders being able to successfully gain leveraged exposure (with bank mortgages) to an investment sector that has, over time, steadily appreciated in value. Critically, those leveraged capital gains have, in the past, been ‘tax free’ and with interest rate deductibility!  

However, in light of the recent tax changes, it is possible the rate of future capital appreciation in this space might slow. That’s certainly what the government will be hoping for. Some investors may think twice before investing and some may change their strategy entirely. But it would be a brave person to suggest that this will mark the end of residential property investing.

The bricks and mortar appeal of investing in housing has, for a long time, resonated with Kiwis in a way that better performing investment sectors have never been able to match. While that might change, we wouldn’t bet the house on it.

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