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Tony Alexander - Policy changes favour new build investment

Each month renowned economist, Tony Alexander will be writing a monthly update on the property market, trending patterns and economic insights. Sign up for our newsletter to follow his and Safari Groups articles on Property Development.

Policy changes favour new build investment

On March 23 the Government surprised everyone in the residential property sector with the announcement of a set of policies quite different from expectations. Most of us had expected that the brightline test for paying tax on a property’s sale would be extended from five years to at least seven years and probably ten. The extension to ten years therefore is no great surprise.

Some people thought that there might be a move toward removing 10% of interest expense as a deductible item, with that percentage perhaps increasing in future years if further restraint on the market was desired. But the government delivered a shock by announcing that from October 1 this year all existing investors in residential property will lose 25% of their interest deduction from rental income.

The proportion will then grow by 25% a year until early-2025 when no interest costs on a mortgage backed by an existing residential property will be able to be deducted.

Calculations by a number of analysts suggest that this change in a full year will cost the average investor who has one property about $6,000. For anyone with more the cost will be even greater.


Why has the government done this?

A year ago, the Reserve Bank responded to the shock of Covid-19 by cutting interest rates to record lows – having already cut rates in 2019 in response to a decline in business confidence. The cumulative reduction in interest rates of 1.5% over less than a 12-month period from May 2019 – March 2020 caused a surge of first home buyer demand for property which was quickly followed by a lift in buying by investors.

Around about August last year the demand from investors jumped quite strongly as FOMO (fear of missing out) kicked in and it was clear that average house prices would be rising in response to the Covid-19 shock rather than falling.

In September average house prices around the country rose by 2.5%. In October the gain was 3.3% then 3.9% in November. Come February there was a rise of 5.2% taking the extent of house price gains since the end of the lockdown in May to 25%.

There has been no change in underlying economic, social, demographic, or house supply fundamentals in New Zealand justifying such a massive rise during the biggest economic shock to hit New Zealand since the extended weakness of the 1970s.

For a government which has expressed a strong desire to improve housing affordability yet is facing rising prices, rising rents, and a waiting list for state housing which has grown in size four times since they were elected in 2017, this was a red rag to a bull.


No luck pressuring the Reserve Bank

The Finance Minister tried encouraging the Reserve Bank to rein in the interest rate sugar delivered to the housing market by requiring it to take into account the government’s housing goals when setting monetary policy. And he has observed like the rest of us the introduction of a 40% minimum deposit for investors from May 1 – something which probably caused the huge prices spike in February as investors sought to make a purchase before the rules kicked in.

But the Reserve Bank is not responsible for house price inflation. They are required only to make sure that inflation stays close to 2% and that banks do not engage in excessively risky lending. Any risky lending that was occurring – and not much was – will be taken care of by rule tightening banks themselves have already voluntarily brought in, plus the reinstated loan to value ratio regulations.

Backed into a corner with essentially no extra assistance to come from the prime driver of the house price surge – the Reserve Bank – the Finance Minister decided to label the legitimate deduction of interest expense as a “loophole” and remove its deductibility.


To what end?

What does the government hope to achieve? Essentially three things which were spelled out in the Finance Minister’s instruction to the Reserve Bank to take housing into account when setting its policies.

They want reduced investor buying of existing houses, better access to affordable housing for first home buyers, and more sustainable house prices. They do not seek a decline in prices, and they do not want the situation for renters to become a lot worse. But this is where things get interesting.

Because the cost of providing rental accommodation has gone up rents will rise more than would otherwise have been the case. In fact, a survey I ran recently attracting almost 4,000 responses from investors, showed 75% plan raising their rents by more than previously anticipated. Some 32% plan pulling back on their buying, while 25% plan selling.

In truth, we know from past instances of extra costs being imposed on landlords that very few ever follow through on their threats. But behaviour will change and one of them is this.

The government wishes to incentivise more rapid construction of housing. So, they have created a special $3.8bn fund which local councils can call on to fund infrastructure which will support new housing subdivisions. They have also given Kainga Ora (Homes and Communities) an extra $2bn in borrowing capacity to purchase land for social housing development.


The carrot

But most significantly, they have not applied the brightline or interest cost deductibility changes to investors in new dwellings. For investor purchasers of newly built units tax will not apply to capital gains on sales made after a five-year hold. And full deduction of interest costs against rental income will continue.

This is a substantial incentive for investors to shift their future purchases away from existing houses (which the government wants left available for first home buyers) towards new builds. Eventually, this incentive will drive greater construction of dwellings, most probably in Auckland to a greater extent than elsewhere.

The surge in housing demand this past year has led to a large scale buying up of sections around the country, to the point where in most local authority areas the pipeline of new section supply is near dry and it will take some time for bureaucratic processes to function and allow the rezoning of land from rural to residential, then development of infrastructure including upgrading of existing water and wastewater systems to allow development to proceed.

But in Auckland things are different. Courtesy of the Unitary Plan some 80% of land within the urban boundary is able to be developed or redeveloped. This is interesting because Auckland house prices on average are no longer above their long-term trend when compared with the rest of the country.

Over the past 4-5 years the regions have experienced strong price surges while up until the very end of 2019 Auckland house price inflation was near flat. The shortage of land outside Auckland is likely to encourage a refocussing of Auckland investors who have gone to the regions back to our biggest city.


The expat effect

On top of this effect there is the wave of returning expats expected to arrive on our shores once the international borders eventually reopen. While normally such people come back to New Zealand explicitly for lifestyle and usually want a house with a backyard, this flow of people will be different.


They will be seeking lifestyle for sure. But they will also be seeking simple distance from tough environments offshore and being used to living in locations of greater housing density than typical New Zealanders, are likely to be more willing to purchase a new unit in a multi-unit development that would normally be the case. They will also be wary of exposing their potentially new spouse and children to true small town New Zealand and will likely do what returning Kiwis have always tended to do – they will hedge their bets. They do this by targeting a return to one of the country’s big cities rather than seeking a piece of land big enough for two children and three sheep.

The outcome

The upshot of the rather large number of trends and changes in place now is likely to be this. There will be some refocussing of investors back to the main cities as densification rules allow greater construction of the new units which investors will now be wanting in greater numbers for their rental businesses. Some existing investors will look to sell their existing properties and switch to ownership of a new build. New investors will veer more toward new builds than has ever been the case before in New Zealand.

To achieve its housing goals the government needs extra house supply, especially in areas where population growth is projected to be the greatest. That means the likes of Auckland with population growth from 2018-48 projected at 39% versus 21% in the rest of New Zealand including 18% in Wellington City, 40% in Hamilton City and Tauranga.

Already these past few years, courtesy of strengthening requirements to provide high quality accommodation, investors have been shifting their ownership preference away from existing houses towards new builds and particularly apartments in low rise buildings and townhouses. That shift has now just received a substantial shot in the arm.

Tony Alexander is an economics commentator and former chief economist for BNZ. Additional commentary from him can be found at www.tonyalexander.nz