Housing requires a demand AND supply-side fix

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By Leith van Onselen

Stephen Kirchner, a research fellow at the Centre for Independent Studies, has written an article in The Australian defending negative gearing and arguing that housing reform should instead focus on the supply-side. Let’s take a look:

DEBATES about housing affordability continue to point to negative gearing as a factor putting upward pressure on house prices. However, negative gearing has been in place for decades and through many up and downs in house prices. The fact that people want to invest in housing should not be a problem for housing affordability.

The real problem is the increasing inability of the supply-side of housing markets to accommodate the demand for both owner-occupied and investment property without upward pressure on prices. Public policy needs to focus on boosting supply rather than suppressing or diverting demand…

The concessional tax treatment of saving via owner-occupied and investment property adds to demand by making both a more attractive vehicle for saving relative to other asset classes, but is also positive for housing supply…

It is sometimes noted that demand from property investors is largely met through existing rather than newly built dwellings… It is only supply-side constraints that prevent demand for existing dwellings from inducing new construction…

The short- to medium-term impact on the rental market from less generous tax treatment of investment property highlighted by the Henry review could be mitigated to the extent that any fall in prices induces more renters to become owner-occupiers.

However, substitution between investors and owner-occupiers is unlikely to offer much relief in terms of overall housing affordability, especially if there is also a negative supply response.

Public policy should aim to improve incentives for increasing housing supply.

Let me say from the outset that I have some sympathy for Kirchner’s view. If Australia’s land-use, planning and taxation systems were more liberal towards housing, and housing supply was as responsive as, say, Houston or Atlanta, then negative gearing would not be an issue. Any increase in demand from negative gearing (or any other policy) would quickly lead to the building of additional low priced housing (either on the fringe or in-fill), keeping house prices in check. Further, speculators would be less likely to pile into such a market, since there would be little prospect of achieving strong capital gains. Investing would instead be more about yield.

So in one sense, Kirchner is correct that the first best policy is to free-up constraints on Australian housing supply, which are preventing affordable homes from being built.

That said, Kirchner is wrong to suggest that negative gearing is not adversely affecting housing affordability. Given Australia’s constipated housing supply system, it makes absolutely no sense to add fuel to demand via tax incentives. Such deductions are not allowed in most other countries and they are costing the Budget billions in foregone revenue.

Contrary to Kirchner’s claim, negative gearing also does absolutely nothing to improve housing supply. As explained yesterday, Reserve Bank of Australia (RBA) data clearly shows that the overwhelming majority of investors – almost 95% – buy pre-existing dwellings, not newly built dwellings, and that the proportion of investors buying new dwellings has fallen spectacularly since negative gearing was re-introduced in September 1987 (see next chart).

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Moreover, the amount of investor funds going into new housing has barely shifted in 25 years, whereas investment in pre-existing dwellings has skyrocketed:

ScreenHunter_947 Jan. 21 16.44

Kirchner’s claim that negative gearing would not improve affordability is also spurious. Less demand from investors would lower prices (other things equal), making it easier for first home buyers to enter the market. It is plain logic.

Nor would the rental market be adversely affected by negative gearing’s removal.

Since investors primarily purchase pre-existing dwellings, negative gearing merely simply substitutes homes for sale into homes for let. In the event that negative gearing was once again quarantined and a proportion of investment properties were sold, these homes would be sold to renters, turning them into owner-occupiers. So while the supply of rental properties would likely be reduced if negative gearing was abolished, so would rental demand, leaving the rental supply-demand balance unchanged.

Rents would also likely be unaffected under the above scenario. As shown yesterday, the below chart plots the Australian Bureau of Statistics (ABS) rental series from 1972, with the period where negative gearing losses were last quarantined (i.e between June 1985 and September 1987) shown in red. As you can see, there was nothing spectacular about this period, with much higher rental growth recorded in earlier periods when negative gearing was in place:

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Similarly, if we deflate the above series by CPI, in order to remove the effects of inflation, we again see that rental growth over the period when negative gearing was last quarantined was nothing special, with periods of higher rental growth recorded both prior to and subsequently:

ScreenHunter_33 Oct. 22 07.42

The fact remains that negative gearing is costing the government billions in lost tax revenue – funds that could instead be used to fund schools, hospitals, housing-related infrastructure, or any number of other worthwhile initiatives. At the same time, negative gearing does nothing to boost supply, and also creates additional demand from tax subsidised investors, placing upward pressure on home prices and locking-out would-be first time buyers.

Comprehensive reform of Australian housing requires both measures to free-up supply-side bottlenecks, as well as efforts to remove speculative demand induced by spurious tax incentives.

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Comments

  1. I think that Kirchner has a point. Anti negative gearing arguments are a bit like killing a horse to save a cat.

    It’s supply of the lack thereof that has pushed prices in Sydney (but not only Sydney) higher than they should be.

    To a large degree I also blame the RBA for hiking interest rates in the past far too early, before a proper supply response came from the market.

    They have constantly put lids on prices to the detriment of supply. I don’t think they have that luxury this time, and although prices will overshoot, supply should come in sufficient volume to stabilise prices in Sydney for a long time.

    Time will tell.

    • “To a large degree I also blame the RBA for hiking interest rates in the past far too early, before a proper supply response came from the market.

      They have constantly put lids on prices to the detriment of supply.”

      In a well functioning housing market, you shouldn’t need a big increase in prices to induce supply – this only happens in constipated systems like Australia, the UK, New Zealand, parts of the US, etc.

      In a well functioning market, changes in demand manifest more in movements in construction volumes, rather than prices.

      • When developer contributions were added to the cost of land, and then later GST was added to the cost of both land and construction, that meant production costs increased to a point above what the market could tolerate.

        An increase in price was needed to make it worthwhile to bring supply to the market. Each time the RBA hiked rates too early to contain prices, they ensured that supply fell further behind demand, which later again increased prices. Like a cat chasing it’s tail.

      • “In a well functioning housing market, you shouldn’t need a big increase in prices to induce supply”

        “In a well functioning market, changes in demand manifest more in movements in construction volumes, rather than prices”

        Especially seeing as it is fundamentally something that we will perish without access to.

      • Peter I think I broadly agree that other supply side issues are a greater issue than negative gearing, but nonetheless the onus is on the ‘pro-negative gearing’ side to demonstrate the public benefit that warrants billions of dollars of taxpayer dollars as subsidy.

        UE has demonstrated a well known fact that investors are barely contributing to new builds at all. Therefore if negative gearing is not accomplishing its sole policy objective of stimulating supply in a cost-efficient manner why do we continue to pay it?

      • JohnsonM – I don’t think that investors have ever built houses, they buy existing homes because they are cheaper and they can receive a tenant on the day of settlement.

        Some investors buy units OTP but most of those investors are either kidding themsleves that they are getting value, or they have been sucked into a rental guarantee agreement that is bound to end in tears. It’s easy to guarantee a high rental for a couple of years when the cost of that is loaded into the price – I know how it works. Charge an extra $50K and give them back $20K in higher rental – Simple. The returns look great on paper but they don’t last.

        Smart IP buyers buy existing homes.

    • @ PF: “Anti negative gearing arguments are a bit like killing a horse to save a cat.”
      I think the ‘horse’ is more of a ‘pig with an agenda’ dining at the Treasury trough of consolidated revenue being doled out in deductions for decades long loss-making businesses called ‘investment properties’. We do not need to ‘kill’ the ‘horse’, rather simply give the ‘pig with an agenda’ lap-band surgery by removing some tax incentive.
      I am over the fact that a portion of my taxes pays for this speculative activity. Negative gearing should only be for new build. Give the next generation of FHB ‘cats’ some breathing space linked to sane tax rules rather than extreme mortgages result of tax favouritism.
      Re the RBA, it is unrealistic for us to believe RBA can directly do much in relation to land zoning, land-banking or ATO rules that favour “investors”.

  2. Thanks UE. Man, you are on fire!

    Readers, defeating NG wont be achieved with a handful of articles, no matter how accurate, devastating and accessible they are.

    The spruikers are still out there claiming NG keeps rents down (nonsense!); add to supply (piffle!) and that ‘Gearers are taller, more handsome and therefore more deserving of the government support they receive than the average taxpayer.

    Australia is in the grip of economic apartheid. It is that serious. The resolution will be political and involves tax reform, debt restructuring, a land price correction and a zoning revolution. We seem rigidly determined to go about this the hard way. Be careful out there!

    Don’t Buy Now!

  3. TheRedEconomistMEMBER

    Whilst I do not dispute the large amount of investors crowding out first home buyers and upgraders in the last 12 months.

    But I know of some owner occupiers and wannabe land lords are building new homes in Sydney northwest to become their PPOR, and renting out the existing residence.

    So the supply of rental properties available is increasing, leading to a dip in the Real Rental Price Growth.

    Once the wannabe landlord new house is finished, the new loan on the older home is switched to investment.

    So this strategy would explain why investment loans on existing property are strong.

    But unfortunately…. the drip feeding of new blocks by our biggest developers and red tape from local councils is not satisfying the pent up demand out there.

    From memory D Collyer had a table of all the block held by our large developers.

    if anyone has a link to that or the current estimates, it would highlight the manufactured bottleneck to supply.

    • It is not as simple as a bottleneck of sections held back by developers trying to maximise their profits.

      The problem goes back upstream to them, to what they had to pay in the first place for the raw land.

      Even Joe Hockey recently admitted that rising prices were good, because it would enable more developers to bring sections to market on which their profit margins are currently slender or non-existent.

  4. Spot on, Leith. I think the point to emphasise, however, is that, as you say, if the supply side was properly fixed, negative gearing would not be an issue.

    If we had a properly functioning housing market, houses would be getting cheaper (for equivalent quality), not more expensive.

  5. “If Australia’s land-use, planning and taxation systems were more liberal towards housing, and housing supply was as responsive as, say, Houston or Atlanta, then negative gearing would not be an issue”

    Leith, can I make one point without being yelled at? As discussed many times here the planning system in both Germany and Houston/Atlanta have resulted in much more sensible house prices than the UK, Australia etc. However the German system has created more compact, walkable, sustainable cities whilst Houston and Atlanta are known as the poster children for sprawl. Why then your emphasis on promoting the Houston model over the German model?

    Surely the German model is worthy of more consideration?

    • Well, I think you have a fair point, TL. Although at the moment it seems Australians are quite enamoured of sprawl.

    • German models are always worth considering. Audi BMW Merc or Porsche? Although I reckon you might be a VWGolf kinda dude.

    • I have written many times on the German system. It, too, is a worthy model. The key benefit is that Germany has “right to build” embedded in its constitution, which provides a presumption in favour of development, rather than the negative approach employed here. Germany is also very decentralised, with loads of small cities built around its various manufacturing companies. It is a real economy.

      • Germany is also very decentralised, with loads of small cities built around its various manufacturing companies. It is a real economy.

        Spot-on…and how I wish that was what we had here in Australia.

      • Can you can please post a link here to one of your posts on the German system?

        Even with a right to build entrenched in the constitution surely German citizens must comply with local planning regulations. What’s to stop a homeowner concreting every square inch of their block and erecting a 20 storey apartment tower?

      • Thanks for the link.

        I note there are only one or two paragraphs on how the German planning regulations work and it doesn’t expand much beyond making the “right to build” point and asserting that it is more liberal. Most of the article is about what’s wrong with the UK planning system not what’s right about the German system.

        I’d love to know more about how planning works in Germany.

        • “I’d love to know more about how planning works in Germany.”

          Definitely read the paper linked in the post. It’s a ripper and goes into great detail (about a dozen or so pages). The RICS European Housing reviews have also written a bit on it, noting how Germany’s is one of the most “elastic” housing markets in Europe.

          “…what’s right about the German system”

          As outlined in my post: 1) liberal supply (planning); 2) good fiscal incentives that makes local authorities pro-development; 3) security of tenure for renters (reduces “panic buying” by FHBs); and 4) tighter credit controls. It’s a good system.

      • Yes UE, i remember back in 1998 (before the total Made In China plague) The company I worked for needed a lot of tooling in a hurry..long story short, the contract for about 3-5 mill worth was awarded to a Tooling workshop situated in a town about the size of Lithgow(nsw). As a tooling engineer I was sent over a few times and I couldn’t believe the fact that in villages all around there were Heat Treatment factories, machine shops, tool designers who worked in little offices next to their homes…one high tech Heat Treatment place was right next to a farm…and not far away were truck and auto factories etc….I even visited a young guys new home that was being built..the quality of the home was just so much better than the Australian gyprock castles.
        But as I’ve said before…Germany has had its Stalingrad moment and they’ve learnt from it.

  6. Great Leith.
    Negative gearing for claims in connection with existing property must end.
    NG only for new build.
    That will feed into employment, defuse debt loads that “investors” and new buyers get themselves into and in the process assist home ownership for FHB. At the end of the day we need a functional community, not some business model based on the financialisation of shelter.

    As noted in the The Australian article by SK:
    “Public policy should aim to improve incentives for increasing housing supply.”
    The incendinary of poorly targeted negative gearing has caused a mini conflaguration of housing costs.
    As noted in the article above, “negative gearing has been in place for decades and through many up and downs in house prices”. The logic is then that its removal will have not significant effect on the market.
    SK and the NG brigade cannot have their cake and eat too.

  7. If you work somewhere that you’re privy to hearing the madcap schemes and justifications for buying investment properties, you quickly understand what a lure it is and how it probably does push first home buyers out.

    I’m sure Voldemort will disagree because he only sees well reasoned, intelligent buyers, but like always he’s talking his book.

  8. The great attraction of focusing on the supply side is simply politics.

    It is very very easy to characterise action on the demand side as a direct attack on ‘wealth’ and the value of something that millions of people own.

    If the ALP at its best could not do it, it is wishful thinking in the extreme to expect more from the current government.

    Expanding supply is politically much easier – especially for a party not weighed down by environmental ideology about the human foot print, hipster snobbery about the suburbs and union concerns about labour competition from migration.

    While logically expanding supply will impact on prices across the market, it is not direct.

    It is much much harder to whine that the government should stop people building themselves houses simply because it may reduce upward pressure on the value of your existing house.

    Can you imagine someone arguing that the government should limit the sale of new cars because they want the value of their second hand Commodore to be increased?

    The strongest point of attack is

    1. Get the FIRE sector working of MUD style financing models for hew developments to remove the cost of infrastructure lump sum in new housing costs.

    2. Get the pollies on board with the economic benefits of first driving new construction and ultimately how an efficient lower cost housing market will improve the competitiveness of the economy.

    Throw the idea of a land value tax on new developments into the mix as pollies love auto-pilot growth taxes.

    SUPPLY SUPPLY SUPPLY

    By all means talk about the demand issues but remember supply is the lay down misere.

  9. surely a simpler solution to supply side constraints would be to legislate that developers need to build on their land within say 10 years… would stop land banking. if the government increased supply it would just be bought by developers and land banked anyway and they would continue to drip feed land supply and supply would increase at their desired rate.

    • Land banking is a natural result of supply side constraints.

      Once there are controls that restrict what undeveloped land can be developed there is a natural tendency to buy and hold.

      A simple solution that once worked quite well was to have government organisations acquire agricultural land at market prices and then sell individual blocks to home buyers to build on.

      Unfortunately, that approach broke down when governments realised they could make millions by becoming a landbanker and work with the existing land bankers to drip feed blocks and gouge higher prices.

      Government has all the power that is needed to get new blocks of land into the hands of home buyers at low cost.

      It just needs more people to complain about the practice.

      Sadly, there are a lot of people (many who consider themselves progressive) who are snobs when it comes to suburbia and actually support the government gouging people who cannot afford to (or prefer not to) live in well established existing suburbs.

  10. I think the original article is a bit back to front, easily to to blame supply instead of dealing with the issues of demand being deliberately juiced, through negative gearing, CGT discount and targeted extra demand from foreign investors.

    Sure there are supply issues but they wouldn’t be nearly as bad if every Australian didn’t want to be property barons and own 2 or more properties each. 28% of property investors own 2 or more investment properties and account for 49% of investment properties. How many property investors also own a PPOR?

    Based on 2011 Tax statistics, 1.76m property investors own ~2.5m properties at a minimum between them. Say every property investor also has a PPOR, that is 5 million homes owned by by 1.7million people. Quite a chunk right there owned by few. This doesn’t even take into consideration IPs held through other entities (SMSF, trusts etc).

    This kind of appetite needs to be curbed if we ever want a healthy functioning housing environment or else the 28% will continue to expand and gobble up what ever supply is created.

  11. I agree with Kirchner that negative gearing is the demand side fix when we should be concentrating efforts on the real problem which is the supply side.

    I don’t think Leith has countered the two main points Kirchner raises which are, the low supply of new dwellings relative to existing dwellings and that negative gearing boosts rental supply at the expense of renters wanting to become owner-occupiers.

    Property investors like most investors are looking for high returns and minimal risk. Both are satisfied when buying existing dwellings away from the city fringe. This is not caused by NG but by restrictive planning laws in the inner city/suburbs that enhance investment returns and consumer preference to be located near work and amenities.

    Kirchner mentions this here while debunking the “investors tend to buy existing stock and not new stock” argument: “It is sometimes noted that demand from property investors is largely met through existing rather than newly built dwellings. This reflects the fact that the flow of new houses is small relative to the existing dwelling stock. But it is about as relevant as noting that investors in the stockmarket mostly buy already held rather than newly issued shares. It is only supply-side constraints that prevent demand for existing dwellings from inducing new construction.”

    I found this conclusion by Leith to be flawed: “Since investors primarily purchase pre-existing dwellings, negative gearing merely simply substitutes homes for sale into homes for let… these homes would be sold to renters, turning them into owner-occupiers.” It’s flawed because it assumes that renters can easily become owner-occupiers. Almost all renters will NOT be able to take on a mortgage and buy a property even if NG is scrapped and property prices fall by 10%. More likely is that other investors would purchase property at these lower prices.

    My own conclusion is the same as Kirchner’s view that we should focus on the supply side and not the demand side.

    • “I found this conclusion by Leith to be flawed: “Since investors primarily purchase pre-existing dwellings, negative gearing merely simply substitutes homes for sale into homes for let… these homes would be sold to renters, turning them into owner-occupiers.” It’s flawed because it assumes that renters can easily become owner-occupiers. Almost all renters will NOT be able to take on a mortgage and buy a property even if NG is scrapped and property prices fall by 10%. More likely is that other investors would purchase property at these lower prices.”

      So if other investors buy these properties at lower prices, how is this an issue for renters? The rental supply-demand equation will still be unchanged following negative gearing’s withdrawal, which is entirely my point. But the taxpayer will have saved a bundle of cash and those renters that would like (and are able) to own at lower prices will be able to do so.

      “My own conclusion is the same as Kirchner’s view that we should focus on the supply side and not the demand side.”

      No, we should do both.

      • You were claiming that if NG was removed then any investors that sell will be fully absorbed by renters wanting to become owner-occupiers. My point is that only a fraction of post-NG abolition buyers will be previous renters while the rest will be investors marginally affected by NG.

        It was just a minor critique of your argument. Buy you are right in that getting rid of NG will lower prices. I was just pointing out that we won’t see a huge influx of renters becoming owner-occupiers as you implied.

        Let’s be honest here, the taxpayers don’t SAVE any money. Saving implies reduced expenditure and what abolishing NG amounts to is a tax increase. Sorry for being pedantic about this but it needs to be clarified and established that increasing taxation revenue does not save the taxpayers money.

        • NG is a tax expenditure, so yes it does “save” the taxpayer money. Regardless of pedantry, the taxpayers win, as would first-home buyers. And importantly, renters would not lose. We also wouldn’t see as much capital diverted into pre-existing housing, so the economy would likely win as well.

  12. “Any increase in demand from negative gearing (or any other policy) would quickly lead to the building of additional low priced housing (either on the fringe or in-fill), keeping house prices in check.”

    I strongly disagree here. What this would do is lower prices slightly but mostly allow me the choice of paying my higher house price in time (living further from work/everything) or quality (no pets, smaller space, less rights over your own property.) instead of just money. And the price quality tradeoff is probably going to be unbalanced with investors getting a nice share of the difference.

    We should improve supply constraints (you convinced me on that) but it is allowing Rent that is the problem. Eliminating rent, would drive out speculators and push prices down towards actual utility values. Scrap all investor subsidies and a land tax as broad and high as possible.

  13. Another small factor at play here is that an owner-occupier requires 1 house per household where a renter requires around 1.03-1.04 houses per household to maintain rental vacancy rates. The original reports of a housing shortage in Australia all drew on the number of additional houses required to bring rental vacancy rates up to the ‘norm’. Thus when a house is sold to an investor rather than an owner-occupier the number of renters and houses for rent both go up by one, thus pushing rental vacancy rates down and increasing the perceived housing shortage.

    At this stage of the cycle where many FHBers are being locked out that would otherwise be willing to purchase, when an investor buys an existing house they actually increase the housing shortage. Yes, in other terms, negative gearing is actually increasing the housing shortage. Aren’t you glad to pay tax all you renters? XD