Property investors can’t get past their own vested interest

Since late last year, uncertainty about possible tax changes has reduced the housing market’s momentum, and property investors have been increasingly vocal in their efforts to protect their favourable tax treatment.  John Key’s speech in February ruled out most of the Tax Working Group’s suggestions about property, leaving only the removal of the ability for landlords to depreciate their buildings, and a bright-line test to strengthen current provisions for taxing capital gains.

It’s worthwhile reminding readers that any depreciation claimed by property investors is clawed back by the IRD when the house is sold, if it has not gone down in value as implied by the depreciation. Assuming that the value of residential buildings does not fall over time, and all other things being equal, investors should be indifferent between depreciating or not depreciating their properties.  But by deducting depreciation in high-income years and having the claw-back occur in low income years, the marginal tax rate is often not equal between the two time periods. Furthermore, no-one is going to turn down what is effectively an interest-free loan from the government.

In my view, property investors are set to get off reasonably lightly, but that hasn’t stopped them from complaining that they’ve been unfairly singled out.  Some landlords seem to see themselves as providing a social service for people who can’t afford to buy their own house. With the proportion of state housing having fallen since the early 1990s, apparently property investment is a legitimate way of helping out the less well-off and stopping them from ending up on the street.

If you’re really serious about helping the needy, why would you do it through property investment with all its associated stress and hassle?  After all, the government offers you a 33% tax rebate on charitable donations, so if your income is below $48,000pa, this could be a better financial method of showing your philanthropic side… until you take capital gains into account, of course!

So I don’t buy into the whole "social service" argument.  I’ve also been exasperated by arguments put forward by other "experts" such as Dean Letfus saying that "people will literally have nowhere to live" and "the end result is a … chronic housing shortage and massive rental increases."

In response to these assertions, consider the following argument.  Let’s assume that the stock of housing is fixed in the short-term.  If landlords sell some of their properties because the tax changes make their investment position untenable, those houses and flats will still be available to live in.  The properties will be bought by someone else.  It could be another investor who can make the numbers stack up, possibly through a lower purchase price.  Even more alarmingly, the purchaser could be a first-homebuyer who has previously been priced out of the market because of the frenzy of investors that have driven property values out of reach over the last decade. So the idea that New Zealand will suddenly find itself desperately short of houses is ridiculous.

The other half of Dean Letfus’ statement –massive rental increases – deserves further examination.  If the income stream required by property investors has risen because they can no longer claim depreciation on buildings, it seems realistic to assume that rents will rise.  But landlords do not have unmitigated pricing power.  Their ability to put up rents is constrained by how much the tenant is able or willing to pay.  If a rent increase encourages the tenant to leave and makes the house less attractive to new tenants, the ensuing period of vacancy can easily undo the positive effect of any rent increases on income.

Rents have been flat over the last two years because the recession has meant that landlords have focused on keeping tenants rather than risking vacancies.  With the economy now recovering and household incomes set to improve, we see scope for rents to rise by 5-8%pa over the next couple of years, which is partly catch-up for the last couple of years, and partly a response to the likely tax changes.  This rate of increase hardly qualifies as "massive", however.  If landlords thought they could get away with significantly higher rents, as suggested by Mr Letfus, I’m sure many would have tried to increase them years ago.

In summary, the noises coming from property investors are the typical response you’d expect from an interest group that is about to lose some of its favoured status.  Rents may rise, but that needs to be balanced against the downward pressure on house prices, improved affordability for first-home buyers, and the potential for more productive investment decisions going forward.  If next month’s budget makes even small gains towards either of the latter two objectives, it must be viewed as a step in the right direction.

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