Rights and Wrongs of Labor's Negative Gearing Policy

Last year I wrote a post on negative gearing (The Politics of Negative Gearing), finishing on this note:

"Despite housing affordability being a hot topic at the last federal election, neither of the major parties had any policy specifically directed at tackling it. Though quarantining negative gearing to new builds or removing it completely would only be one part of a solution to tackle the problem, Abbott has made it quite clear that he's not interested in a sensible debate on the matter. Last month Labor released a discussion paper aimed at informing Labor’s Housing Affordability Strategy (to be taken to the next election). I'd expect that with the right mix of policies directed to tackling housing affordability and the right attitude, Labor might just have an edge that could help them secure a win at the next federal election."

Recently Labor released their policy on negative gearing (along with reducing the capital gains tax discount) and it has been making plenty of headlines since.

For a long time negative gearing has been considered a sacred cow, but it was obvious with housing affordability concerns growing that something would need to change and we are nearing a point where even the 'untouchables' of our tax system may end up being manhandled (if not as a result of this election, then perhaps the next). Sentiment and polls have moved in Labor's favour following their policy announcement, but not yet decisively enough to win them an election.

Sadly some of those who have been campaigning for changes to negative gearing for as long as I have are blinded by the shiny coating of Labor's policy and are not interested in looking under the bonnet at the details.

The subject of negative gearing brings out a very black and white argument from most. Both those for and against negative gearing changes seem content spreading any research they can to support their particular side, without any consideration to the accuracy. For example the Liberal Party was quick to highlight the details from a BIS Shrapnel report and connect them to Labor's policy even though the details modeled were not all the same as Labor's policy. Similarly those in support of Labor's policy have suggested independent modeling from Ben Phillips is a 'slam dunk' in support of that policy despite the fact that it doesn't account for behaviour changes, doesn't consider the accounting impacts (such as carrying forward losses) and doesn't differentiate between the types of income investors negatively gear against (i.e. wage vs investment, so at face value it doesn't appear to model Labor's policy either).

I have tried to take a more objective approach even though I am in favour of changes to negative gearing in order to reduce investor demand in the housing market. We do need to take care when changing the rules which govern our $6 trillion housing market. Negative gearing should only be removed or changed with an objective in mind and it should only be changed if we are confident the legislative changes will achieve that objective. With that basis I present what I consider to be the rights and wrongs of Labor's negative gearing policy (because it's far from perfect).

Firstly, what Labor got right...

☑ Making the first move

Changes to negative gearing are something that have been raised regularly in political discourse, but not to the point where a major political party was ready to take a policy to an election (in recent history). Labor released a discussion paper on housing affordability in early 2015 and now have a policy to change negative gearing (and capital gains tax) to improve the same. Whether you agree or disagree with the policy (or parts of it), there is no question that it is a brave move and Labor deserves applause for taking the issue seriously and being the first to bring forward firm policy for consideration.

☑ Tackling housing affordability

Some may be surprised that I support changes to negative gearing, which essentially results in higher taxes for investors (at least in the short term). I come from a position that government controls essentially all levers affecting the housing market (see Who's to Blame for Australia's Expensive Property?), if that degree of control over the market is to continue (and I would be all for a change to that), then government needs to take responsibility for the outcomes of their policy, such as the reduction in housing affordability and home ownership rates (source).

Click Chart to Enlarge

Abolishing (or changes to) negative gearing isn't a one policy fix to housing affordability, but it will reduce investor demand by removing an incentive and reduce the level of debt they can carry/prices they are prepared to pay.

Click Chart to Enlarge

Secondly, what Labor got right/wrong depending on how you view it...

☒ / ☑ Grandfathering existing investors who are negatively geared

As Jordan Eliseo pointed out in a recent post, grandfathering existing investors is unfair:

..it hardly seems fair to say to 1.3 million Australians that they can keep a tax lurk that will be closed forever more to the remaining 20 million plus Australians, the great majority of whom are nowhere near as well off financially as a large portion of those who will get to keep the sweetheart deal in perpetuity.

If it is bad policy it should be junked outright.

It could also pull forward demand as is highlighted by Eliseo, if the policy is introduced at a future date investors may rush out to buy before the cutoff.

However not grandfathering investors is also unfair to those who've made significant decisions based on the current taxation settings.

Also, it's likely a policy change wouldn't get wide enough support without the grandfathering of existing investors.

☒ / ☑ Allowing negative gearing for new builds

There are well-intentioned reasons for allowing negative gearing (against salary/wages) to continue for new construction. It has the potential to encourage investors to provide and drive new supply. That means jobs and a boost to economic growth.

The downside to encouraging more new residential construction is that many say we already have an oversupply, particularly in the apartment market. Such a policy could broaden the oversupply to other types of housing and/or increase the oversupply of apartments, which I expect would lead to a collapse in prices. An oversupply of property has been one characteristic of other global housing bubbles which have collapsed.

Lastly (but not least), what Labor got wrong...

☒ It will help to repair the budget

Labor's policy document states that:

Two specific tax deductions – negative gearing and capital gains subsidies – are both significant calls on the budget and are growing at a rapid rate.

However, negative gearing shouldn't be seen as a budget boon for reasons I have highlighted in the past:

The reality is that an end to negative gearing for property wouldn't be a huge budgetary boon (as these commentators have suggested). Most advocating for it's removal suggest a 'grandfathered' approach, which means properties already owned by investors aren't affected (until the asset is sold). Even when investors make a purchase (following negative gearing's removal), any losses which would have previously been deducted in the same financial year against other income could be carried forward to claim against future income or profit from the same asset class (property). While it might delay when deductions are made (and some investors may not make a future profit in property meaning it never is), improving the government budget in the short term, it's long term impact would be negligible.

Furthermore, it's likely that over time investors would adjust their expectations and reasons for investing in property. Currently a large number of investors buy for the tax advantages that negative gearing (and other tax breaks) offers. 

It's removal would result in a lower number of investors prepared to speculatively purchase at higher prices knowing that (as it stands now) low yields (& resulting losses) are partially offset by a tax deduction against other income at the end of the financial year (or as they go for those investors using an Income Tax Withholding Variation). Over time this would likely result in a normalisation of rent to price ratios so that fewer investment property purchases would be loss making from the outset.

Other than the carried forward losses and behaviour changes, we also have to consider that Labor's policy doesn't necessarily stop an investor from negatively gearing an established property if they have other income (that doesn't fall under salary / wages) against which they can claim their property related losses (covered in more detail below).

☒ Only stops losses claimed against salary/wages 

Some have tried to claim that negative gearing (as it relates to property) is only those net losses which are claimed against salary / wages, but that is not the case. The ATO makes it quite clear:

A rental property is negatively geared if it is purchased with the assistance of borrowed funds and the net rental income, after deducting other expenses, is less than the interest on the borrowings.

The overall taxation result of a negatively geared property is that a net rental loss arises. In this case, you may be able to claim a deduction for the full amount of rental expenses against your rental and other income (such as salary, wages or business income) when you complete your tax return for the relevant income year. Where the other income is not sufficient to absorb the loss it is carried forward to the next tax year.

Labor's definition and policy appears to only affect those offsetting losses against salary / wage income:

The investor can deduct any losses associated with the investment from their salary and wage income.

&

This will mean that taxpayers will continue to be able to deduct net rental losses against their wage income, providing the losses come from newly constructed housing.

This suggests investors will be able to continue buying established homes and negatively gearing those losses against income other than wages. Granted salary and wages are the largest income item, but there is plenty of other income that property losses could be offset against. Look at this table from the ATO (showing 2013-2014), rental losses are minuscule compared to the other income they could be offset against:

Click Table to Enlarge

Based on the information we have available I am not convinced we can conclude (with certainty) that negative gearing of established houses will reduce with Labor's policy.

☒ It could increase rents in desirable (established) suburbs

Some have made the point that negative gearing won't increase rents because even if the pool of rental housing reduces due to fewer investors (in the established market), these houses have to be sold to someone, i.e. one less investor is one new home owner. They also highlight that increased investor participation in new builds will expand the rental supply.

I agree with those comments and would think it unlikely rents in aggregate increase as a result of Labor's policy, however... while median rents may see downward pressure or a lack of growth, the ability for investors to negatively gear new properties could create a distortion where most of that downward pressure on rents is in the outer suburbs (where the number of rental properties will increase), while inner/sought after suburbs with mostly established housing stock see rents rise as natural attrition of existing established investors reduces the pool of available rental properties. Yes that means an increase in owner occupiers in those suburbs, but those who can’t afford to buy in those suburbs may be left to pay higher rents or be forced to move to less desirable suburbs.

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As you can see, while well intentioned Labor's policy is far from ideal, in fact we can't even be sure it will achieve what it sets out to. Sadly many of those who want negative gearing to go are defending Labor's policy without giving it the careful consideration it needs. Here's hoping that changes as we near the election or if Labor does get into office, then I hope they review their policy and make the changes required to meet an objective of improved housing affordability and a higher home ownership rate.

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Is Property More Affordable Today Than 30 Years Ago?

This is a continuation (that I have written) of a conversation written by fellow Adelaidean Peter Koulizos, see here for the prologue.

 

[Son enters room]

 

Son: Hey dad, I just heard you spinning a whole lot of nonsense to sis about housing affordability.

 

Dad: What do you mean son? I was just telling her how it was back in my day.

 

Son: Well you know finance and history aren’t her strong points…

 

Dad: Speak nicely of your sister please.

 

Son: Ok, as I was saying, you claimed that it took mum and you longer to save a deposit, because a 25 per cent deposit was required to buy, but isn’t it true that some building societies loaned up to 95 per cent, meaning similar loan to value ratios were available even 30 years ago?

 

Dad: Well, yes, but the interest rates were often higher than the major banks...

 

Son: But isn’t it also typical today for the lenders offering the easiest credit conditions to have higher interest rates?

 

Dad: You have me there son.

 

Son: And isn’t it true that in the early to mid-1980s that the First Home Owners Scheme was far more generous paying up to $7000 in benefits, equalling more than 10% of the purchase price you mentioned?

 

Dad: That is true. Your mum and I took full advantage of that and the First Home Owners Grant isn’t nearly as generous today.

 

Son: You did pay 17% interest rates for a short period of time, but isn’t it true that the higher level of inflation at the time reduced the real value of the loan rather quickly with wages rising faster than they are today?

 

Dad: Yes, but it was tough for the first few years…

 

Son: Didn’t you brag to me one time that you paid off your first home in less than 10 years because interest rates fell in the years after you purchased allowing you to pay off the mortgage much faster? Do you think that it will be made so easy for sis who would be borrowing at historically low interest rates with rate rises more likely in the future?

 

Dad: I hadn’t considered that.

 

Son: You mentioned her trip to Bali, but you know she got those tickets for only $300 return and the accommodation, food and entertainment over there is far cheaper than in Australia. In real terms wouldn’t her week in Bali be cheaper than the long weekend holiday you told us you took to the Gold Coast in the early 1980s while saving for your first home?

 

Dad: You are probably right.

 

Son: It’s also the case that a median house in Adelaide today will be on a far smaller block than you got in 1985. In fact if I recall correctly you said your first home was on a subdivisible block once the council changed the zoning, do you think sis will be able to do that with the typical 375sqm blocks of today?

 

Dad: No, I suppose not.

 

Son: Look, I know you think you had it tough with the mortgage and for the first couple of years that may have been the case, but if sis takes a larger mortgage today, to buy a smaller block, in a lower wage growth environment, with the possibility that interest rates may rise making it difficult to make the repayments in the future, isn’t she taking a greater amount of risk?

 

Dad: If you look at it that way...

 

Son: And shouldn't being able to afford something take into account the level of risk associated with doing so?

 

Dad: I’ve had enough of this, I am going to watch some TV in the lounge.

 

Son: Weren’t you going to have some dessert?

 

Dad: I’m going to put it aside until your sister returns from her friends place so we can sit down and eat it together while I explain that I wasn’t as right as I thought.

 

Son: You don’t say.

 

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Adam Carr Wrong on Australia's Housing Affordability

Adam Carr had this to say on housing affordability in Australia (via Business Spectator)...

"...housing is still actually very affordable."

Carr was prepared to dive head first into showing how an $800,000 property is affordable on a $100,000 salary.

"A household on $150,000 could afford a $1 million-plus house -- no dramas. Someone on $100,000 could afford anything in the vicinity of $650,000 to $800,000. A lot depends on the loan-to-value ratio they’re taking -- I’ve used 70 per cent -- but it can be done."

Ok, let's break this down. $100,000 would be roughly $73,000 net, $1403/week. Carr is working from a position that they've saved a 30% (+ costs) deposit. Using $32,000 for stamp duty and fees (I went with NSW figures) and ignoring any other transaction costs (such as legals)... that's $272,000 required in savings (the deposit) before we can even start checking the affordability of the remaining mortgage. Based on a savings rate of 30% of net income ($21,900 per year, very generous if you ask me), it has potentially taken this buyer more than 12 years to save the deposit that Carr says they have on hand. That should already be raising alarm bells on this so called "very affordable" property market we have.

Now we could make any number of assumptions about this buyer, maybe he/she had property that appreciated in value before buying this one, maybe they have bank of mum and dad chipping in, maybe they're a gun investor who has turned a little savings into a lot of capital to fund the deposit... but these would be unfair presumptions to make. We could scale back the price and incomes at a comparable ratio and it would still look awful... e.g. someone on $50,000 buying a $400,000 property (for their first home) and using a $135,000 deposit will have to save for 10+ years using the same measure.

The mortgage repayments (on the remaining $560,000 loan) work out to $655 weekly (at 4.5% interest over 30 years). That's over 46% of net pay (34% of gross) and doesn't take into consideration the extra costs of ownership such as council rates, maintenance, insurance and more. It also doesn't take into consideration the possibility of interest rates rising, if they normalised to 7% the repayments would rise to $860 per week (61% of net income, 44% of gross).

Call me mad, but I don't consider Carr's examples to show affordable property any way you cut it (at least not in the way I think the word should be used)...

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Does Australia have a housing affordability problem?

There are a few key words that get thrown around time and time again when it comes to property in Australia. 

Take "shortage" for example. Someone bearish on Australian property as a whole might argue that with 10% of Australian homes empty (according to the latest Census statistics) we don't have a shortage of property in Australia (this level of empty homes has been relatively consistent for the last several decades). Another person who invests specifically in some Perth or Sydney suburbs where prices are rising sharply might argue that a shortage of homes in this specific area is driving rents and/or prices higher. Both of these individuals might be right (in the context of their own views), but they will probably squabble with each other for hours if you lock them both in the same room and tell them to discuss whether or not we have a shortage of property in Australia.

Another one of these key words is "affordability". It has been a very hot key word as prices rocketed to their peak on a national scale in early 2010 (using the RP Data/Rismark indices) and have slowly deflated since.

Some would go to the dictionary and grab the first definition of the word and throw that into the face of the property detractors who say Australian property isn't affordable:

"Afford: To have the financial means for; bear the cost of."

The "affordability problem" deniers will say things like "If Gen Y stopped spending all their money on iPods, LCD televisions, laptops, overseas holidays and widgets, then they would be able to afford a property" (and sadly this is almost a direct quote of the sort of rhetoric I see get thrown around). 

The "affordability problem" deniers will argue that younger generations are expecting too much for their first home. They will argue that living 40km out from the CBD is a reasonable expectation for First Home Buyers, when outer suburbs at the time they purchased meant 8km out from the CBD instead of 5km. They will argue that First Home Buyers should just buy whatever they can (even if it's a run down 2 bedroom hovel which the buyers will grow out of in a few years) to use it as a stepping stone in order to build equity and buy a larger home later down the track. 

The "affordability problem" deniers will argue black and blue that if a buyer can live off two minute noodles, take a cash handout from the government, leverage their savings (and handout) 20:1 (95% LVR) in an environment where interest rates are near historical lows, to buy the worst house on the worst street in the worst suburb of the city they live in then property is still affordable.

Personally I would use this definition for affordability of housing:

"Afford: To manage or bear without disadvantage or risk to oneself."

Both of the above definitions were from the same dictionary, yet both put a fairly different spin on what affordability means in the context of buying a home.

The first definition suggests that if it is financially possible then it is affordable, the second if you can manage it without putting yourself at risk then it's affordable.

Affordability of Australian property cannot be calculated on a mathematical equation alone. 

Some historical measures of affordability have attempted to formulate an affordability measurement based on the percentage of your income which is taken by housing costs. Typically 30% has been a level to gauge affordability (e.g. if you're having to spend more than 30% of your income on housing then it's not affordable), but the problem with this is spending 30%+ on housing could have a much larger detrimental effect on someone with a low income.

Another issue I see with this type of measurement is that the calculations today are being made in an environment where interest rates are near historical lows and pose a pretty big risk if/when they start to increase again.

Take a mortgage holder in the mid 1990s for example who may have had a mortgage rate of 12%. A 1% increase in rates for this borrower is an 8.3% increase on interest costs for the loan. With current low rates a 1% move higher where the borrower is on 6% is a 16.6% increase in cost of interest. For a new borrower this will increase the repayment by a significant amount and poses a significant risk, especially where they have borrowed with a high LVR.

One of the arguments made by housing commentators such as Chris Joye is that the low interest rate environment has allowed for appreciation of house prices and that the price rise can be justified almost completely by the fall in interest rates. Take for example this quote from an article he posted on Property Observer yesterday:

There is a sound explanation for this innovation: the long-term cost of mortgage debt in Australia declined by north of 40% between 1980 and 1995, and 1995 and today. This was largely a function of the long-term reduction in realised inflation and measured inflation expectations, which in turn allowed Australia’s central bank, the RBA, to permanently lower its cash rate.

The radical reduction in the day-to-day cost of mortgage debt permitted Australian households to significantly increase the amount of debt they were servicing without a noticeable rise in underlying mortgage default rates.

Although this argument holds water on a serviceability level, if we look at the effects that a doubling price and halving interest rates have on a mortgage holder over the term of their loan it's a real eye opener (use this mortgage calculator to run your own scenario):

$300,000 borrowed @ 6%

Repayments of $2000 per month

23 years, 2 months to payoff loan

Total repayments = $555,903

$150,000 borrowed @ 12%

Repayments of $2000 per month

11 years, 7 months to payoff

Total repayments = $278,643

The initial interest costs on a $300k loan at 6% is the same as a $150k loan at 12%, however the smaller loan is repaid at a much faster rate if the borrower has the capacity to repay either loan at the same rate.

So are lower interest rates making property more affordable? Not if prices rise to fill the serviceability gap.

By taking on a larger amount of debt, even if the interest rate is half of some historical levels, borrowers are taking on significantly larger amounts of risk and hence by the second definition perhaps can't be considered as affordable as some would make them out to be.

Many bullish housing commentators have been talking about falling interest rates bringing back buyers to the market, but I think that buyers are starting to smarten up on the whole "lower interest rates makes property affordable" lie. Even following two cuts in late 2011 and two more this year (including a 50 point cut in May) we have buyers sitting on the sidelines waiting for lower prices. As Leith points out on MacroBusiness today:

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What is most worrying about this result is that it follows the RBA’s -0.5% cut in official interest rates in early-May. While it is only one-month’s data, these figures imply that this rate cut had absolutely no impact on mortgage demand which, in fact, took another leg down over the month.

Housing credit growth continues to remain at very subdued levels, which ties in with the very low volumes of sale (from RP Data):

CLICK CHART TO ENLARGE

It seems that even if buyers could continue to buy prices at current levels, they are choosing not to afford property (given the risks). A wise choice in my opinion as the short term downside is a much greater risk than missing out on upside.

In my opinion the best thing that Government could do to help any perceived affordability problem is to step back and stop meddling with the markets, let them deflate.

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