SQM Research contradicts itself on ALP’s negative gearing policy

By Dr Gavin r Putland, cross-posted from the Land Values Research Group:

The formerly respected SQM Research, in its report called “Labor’s Negative Gearing Policy — A Market Viewpoint” (22 June 2016), has joined the conga line claiming that requiring future negative-gearers to invest in new homes would somehow raise rents.

That claim is first made in the Summary (p.2):

Rental changes are initially likely to be negligible with rental growth remaining at current levels of between 1–2%, nationally. However there may be an acceleration from year three (2020) due to the possible cancellation of dwelling projects (ref page ten).

So the argument is that rents would rise because supply would fall because projects (meaning construction projects) would be cancelled. But why would a policy directing negative-gearers towards new homes lead to less construction?

When we “ref page ten” in search of an answer, we find some analysis of what happened when negative gearing was quarantined from 1985 to 1987. SQM at first seems to steer clear of the old canard that the quarantining pushed up rents:

As it has been well reported… the rental market was mixed during the brief repeal of negative gearing during the 1980s.

But then it addresses construction:

It should be noted however that there was a 24% decline in dwelling completions over the period thereby reducing the supply of new dwellings. Post September 1987, there was a surge in completions.

SQM doesn’t acknowledge that the stock-market bubble must have attracted funds away from property, or that the ensuing “crash of ’87”, must have caused a flight back to property. Nor does it acknowledge that the decline in construction, which bottomed out in 1986-7, was one of six such declines over the last three decades, and that all six closely followed, or were simultaneous with, rises in interest rates. Only the first was correlated with the quarantining of negative gearing, and it was not noticeably worse than the others. The following graph tells the story on construction and interest rates.*

ScreenHunter_13676 Jun. 23 09.56

Most seriously, SQM’s discussion of 1985–87 fails to acknowledge that Labor’s current proposal would allow negative gearing for newly constructed homes, whereas the 1985–87 policy did not. But that doesn’t stop SQM from concluding (still on p.10):

The risk is that if building approvals (and subsequent completions) fall and stay below underlying demand as a result of a two-three year market downturn, there may be shortage pressures over the medium term, resulting in an acceleration in rents above and beyond the CPI rate.

On page 11, we get the money quote:

SQM Research believes there is a very high risk that, based on Labor’s policy, investors purchasing new property may experience losses on a resale in the first three years of the property’s life.

The issue is that any secondary buyer will demand some type of discount given that buyer would not be entitled to receive negative gearing tax concessions on the property. And subsequently, such a buyer may demand a discount to offset the lack of concession.

In addition is the fact that developers may put an additional premium (over and above what is already there) on such properties given they will be in higher demand than existing properties (due to the concession).

But if the initial buyers can’t re-sell for a capital gain, what can they do but seek tenants, thereby putting downward pressure on rents?

But let’s try to be kind. Maybe the claim that construction would fall (pp.2,10) is not based on the experience of 1985–87 (notwithstanding the juxtaposition on p.10). Maybe it’s based on the “issue” raised in the second paragraph on p.11, namely that investors in new homes won’t be able to re-sell the right to claim negative gearing.

Of course, investors in new homes back in 1985–87 had a far worse problem: not only could they not re-sell the right to claim negative gearing; they didn’t even have that right themselves. Nevertheless, the above graph offers no evidence that the suspension of negative gearing caused any slump in construction beyond what was caused by other factors. Compared with 1985–87, the current proposal is more favourable to construction in that investors in new homes would still be able to claim negative gearing. Moreover, some of the existing investment in established homes (we don’t know how much of it, but certainly some of it, and certainly not a negative fraction!) would be redirected to new homes. Hence I am forced to conclude that the current proposal would increase construction rather than reduce it. But I am also forced to conclude that the inability to resell the negative-gearing right is the reason why SQM claims that construction would fall — because, although it’s a lousy explanation, it’s the only one they have!

But if investors are scared away from new properties because they won’t be able to re-sell them to negative-gearers, why would there be any “additional premium” on new properties, as claimed in the third paragraph on p.11? Speaking of which, on page 6 we find this:

SQM expects rising dwelling prices in FY17 in the run up to the 1 July 2017 cross over date as buyers will be active in the secondary (existing) housing market in order to receive the ‘grandfathered’ tax concessions.

Excuse me, but those who rush to buy established properties before the policy change won’t be able to re-sell the right to claim negative gearing after the change. So we are supposed to believe that, on the one hand, investors will be so spooked by the non-transferability of negative gearing that investment in new homes will fall, in spite of the continued allowance of negative gearing for new homes but not established homes; and on the other hand, investors will be so un-spooked by the non-transferability of negative gearing that they will not only pay an increased premium for new homes relative to established homes, but will scramble to buy negatively-geared established homes while they still can!

What if a “new” home is defined as one that has not yet been lived in, even if it has been previously sold? Then off-the-plan buyers will still be able to sell their homes as new, so that the “issue” raised on p.11 will not exist for them. And no definition of “new” can resolve the contradiction between the alleged fall in construction and the alleged scramble to beat the policy change. Wherever you draw the line between new and established homes, the homes that negative-gearers will allegedly rush to buy before the change will be those that already count as established homes, and the new homes that investors allegedly won’t want will be those that will count as established on the next sale. As neither category will come with a transferable negative-gearing right, there is no reason to suppose that one will be snapped up while the other will be avoided.

I now turn to the issue of rental yields versus rents. The summary (p.2) begins by saying that

acquisition rental yields are likely to rise between 0.90% and 1.1% over a two to three year period post the implementation of the new policy…

That much is uncontroversial, as long as we understand that rental yield is the ratio of rent to price, so that the yield may rise through an upward effect on rent or a downward effect on price, or, for that matter, a downward effect on rent and a bigger downward effect on price — all effects being relative to a continuation of current policy and the associated trajectories of rents and prices! But yes, if negative gearing is restricted for future investors, the effective after-tax interest rate faced by those investors will rise, so that it will take higher yields (ratios) to persuade future investors to invest. As new homes will be exempt from the changes, they will not become subject to the higher effective interest rate until they are re-sold. This will dilute the effect of the policy on yields, so I can’t vouch for SQM’s numbers; but yes, there will be some effect, and SQM didn’t really need to take any pains to prove it.

But it did. On pp.3–4, we get a heavy dose of statistics showing that rental yields tend to be higher in countries that restrict or disallow negative gearing. That’s unsurprising, provided (again) that we remember that yield is a ratio. Then on p.4, out of the blue, we read:

In reality what is more likely to actually happen is an impact in terms of rental income and property prices both adjusting, with a rise in rental income likely to offset some of the dwelling price falls and being stretched over a period of time.

Again that does not explain why the increase in the rent/price ratio should be due, even in part, to an increase in the numerator — especially if future investors, in order to claim negative gearing, need to invest in new homes, stimulating construction and exerting downward pressure on rents.

On p.6 we find a graph of rental yield, including the 1985–87 quarantining period, which looks exceptional in the graph. But the graph is of yield, not rent, and the page is curiously silent on the distinction between the two. As has been repeatedly explained at MacroBusiness, if you plot the real year-on-year change in rent for the combined capital cities over the last four decades, there is nothing special about the period during which negative gearing was quarantined; real rents rose faster at other times before and after that period.

Another curious silence occurs on pp.7–8, where we find much discussion of sales and finance approvals for the 1985–87 period, but no acknowledgment that sales in the housing market can be turnover of existing stock rather than first sales of newly built stock, and no acknowledgment that the latter will be exempt from Labor’s proposed changes but were not exempt from 1985 to 1987.

In short, the middle pages achieve little but to distract attention from the crucial difference between yields and rents, and the crucial difference between what was done 30 years ago and what is proposed now.

SQM is not the first “independent” consultant to claim that directing negative-gearers towards new supply would somehow reduce supply and raise rents. Others include BIS Shrapnel and ACIL Allen. But all of them, in their treatment of the present issue, have flouted the same golden rule: If you want to bamboozle your opponents with dodgy modelling, you have to produce a big fat report that nobody has time to read. If your report is too short — and SQM’s is the shortest of the three — your faulty reasoning will be laid bare.

________

* “Dwelling commencements” are private-sector, quarterly, and seasonally adjusted (ABS 8752.0, Table 33). The “mortgage rate” is the “indicator” standard variable mortgage rate (RBA Series ID FILRHLBVS, for the middle month of each quarter). The green and orange bars show periods during which the respective policies were in force, with accuracy limited by the time resolution of the spreadsheet on which the graph is based.

Comments

  1. Someone at SQM had a ‘Road to Damascus’ moment. Faced with an impeding LNP win, decided to throw the hat in for the winning lot hoping to get a few commissions for ‘ research ‘ from the incoming gov.

  2. “The risk is that if building approvals (and subsequent completions) fall and stay below underlying demand as a result of a two-three year market downturn, there may be shortage pressures over the medium term, resulting in an acceleration in rents above and beyond the CPI rate.”

    When, if ever, have rents stayed in line with CPI? A colleague at TUNSW has recently charted this – keep an eye out for it…

    • SQM’s report was never partisan. Just poorly worded and plain wrong on rents. It also contradicted SQM’s previous strong support for Labor’s policy (and NG reform more generally).

      The report was a lost opportunity. It should have been a force for reform and not left itself open for use by the property lobby (see my post yesterday).

  3. I haven’t read the SQM report and if I’m honest, I probably wouldn’t understand most of it. I could barely stay awake reading the article above.

    But I can see a way in which new construction will not increase as a result of the ALP policy:

    1. As MB keeps reminding us, investors generally prefer existing dwellings to new despite new constructions already being preferably taxed due to stamp duty exemptions and capital works deductions.

    2. This is probably because new dwellings carry a larger risk around unidentified construction faults and because there is historical market price data in which to benchmark the “value”.

    3. The ALP policy in theory makes new dwellings even more attractive by giving them preferential tax treatment over every other asset class in the country. Developers will not be able to resist spruiking this charging a premium for this gift to unsophisticated investors (and in fact if they don’t there is no reason for them to actually build more than they currently build).

    4. Hence the economics on new dwellings will become even worse in absolute terms for an investor class that doesn’t really like them in the first place.

    5. As has been pointed out many times (well by me mostly 🙂 ), the ALP policy will actually not discourage wealthy investors away from buying existing properties because they will have sufficient non S&W income to offset any NG losses (and actually under the ALPs CGT policy, will have MORE non-S&W income). Indeed, those investors will also have been given a gift by the ALP as they no longer need to compete with middle income investors who only earn non-S&W from their investment property. And as MB and Grattan and Elsake and others keep telling us, the wealthy are already the dominant investor class when it comes to property.

    6. So your only buyers of new constructions which are going to go up in price are OOs who are apparently already the dominant buyers, and middle income earners who currently don’t buy this stuff and face worse economics for doing so under the ALP regime.

    7. So where is all this extra demand going to come from?

    And all this is without the fall off in overseas buyers who get no benefit from negative gearing.

    No doubt someone who has managed to make it this far through my post will point out any obvious flaws in my logic in a respectful manner.

      • Maybe they just aren’t very bright. More likely, they don’t want to risk the status quo.

      • UE
        Because their constituents wanted it (demanded a reply more likely) – having been heavily involved in the UDIA, PCA etc. in the past – they want to retain paying members and attract more. That’s all – they are a business. 1st rule of business is to keep your customer satisfied.
        Below is what I wrote about such matters earlier this week.
        Thanks for allowing the hyperlink.
        Michael
        http://us8.campaign-archive1.com/?u=1c5572de85655446f0c283f04&id=e76621f557

      • 100% and great

        We are about to return to blog posting not power point reports with new website in coming months – if you cannot beat them, join them

        in the mean time – I suggest MB end articles with this footnote please:

        Michael is director of independent property advisory Matusik Property Insights. His firm has helped over 550 new residential developments come to fruition. He writes a regular post called the Matusik Missive. To subscribe (its free) go here : http://matusik.com.au/subscribe/

        Feel free to cross promote

        Our current missives come out via a mail chimp email each Tuesday at 8pm

        Thanks again

  4. You guys are hilarious! If something comes out that doesn’t fit your filter on the world you spend all your time picking it to bits. Does it make you feel better about the size of your equipment? Hahahhaa

  5. Neville Gearless

    Well, with the amount of $$ the spruikers are spending on their (convoluted and often contradictory) propaganda, the only conclusion is that Labor’s policy is spot on.

    • Yes – that is about the sum of it.

      There is an entire industry – real estate, mortgage broking, lending etc – living off the credit creation being sprayed at the residential housing asset class.

      Their true fear – is that the ALP policy will result in some of that credit creation being sprayed at some other class of assets or purposes.

      Possibly even a productive purpose. That would be an eye opening but dont get too excited.

      The bees that sting hardest are those closest to the honey.

      The idea that the ALP want to drive down house prices is absurd – even more absurd than the idea that the ALP NG/CGT reforms will wreck the joint.

      The real risk to the property industry rent seekers is that the economy benefits from a bit less malinvestment in existing residential assets and a bit more investment in stuff that is actually productive.

      If that happens they might need to get a real job.

  6. Terrific logic and clear thinking from Gavin Putland. There is so much disinformation abut rents and behavior out there it is surprising anyone can see straight.

    Lisa from Ray White will cry herself to sleep tonight, bonus denied.