Untangling the complex housing nexus
Thu 1 Jul 2010 by Gareth Kiernan in Construction

The housing market and residential building sector are currently facing a range of conflicting forces influencing demand for housing, property prices, and construction activity.   Although we have discussed many of these factors in previous sets of forecasts, this article brings all the influences together and attempts to make sense of which ones will dominate trends in the building and property sector over the next five years.

A high starting point

Despite the downturn in the real estate market between late 2007 and early 2009, the significant overvaluation of house prices relative to long-term metrics remains.   During the financial crisis and recession, the New Zealand real estate market didn’t follow the lead of the US, where property prices plunged more than 30%, disappointing the most pessimistic predictions of a bursting housing bubble.

Relative to the long-term trend in real house prices, which rises at about 2%pa, housing in New Zealand became as much as 40% overvalued in mid-2007.   By March 2009, when house prices bottomed out, the correction had seen that gap with the trend line shut to 17%.   The rally in prices over the rest of last year means that we estimate that property is still about 20% above the long-run trend.

This measure of "fair value" for property is not perfect, but the extent of the gap with the trend line gives a pretty clear indication that housing in New Zealand is still relatively expensive.  The conclusion of overvaluation is backed up by other measures, such as the ratios of house prices to rents or house prices to incomes.

Given that property is still overvalued, it is a logical assumption that further house price rises of any magnitude will be difficult to achieve certainly more difficult than if we were starting from a point where housing appeared to be relatively cheap compared with fundamentals.

Effect on potential for house price growth (1-2 years): strongly negative
Effect on potential for house price growth (3-5 years): mildly negative
Effect on potential for residential building (1-2 years): mildly negative
Effect on potential for residential building (3-5 years): neutral

The finance conundrum

The global financial crisis saw banks tightening their lending criteria in a way that contrasted with the continuous deregulation and liberalisation of the financial system over the previous 25 years.   At the peak of the housing boom, mortgages to the value of 100% of property were easy to come by, but most banks scaled their loan-to-value ratios (LVRs) back to 80% as the clouds of recession, falling house prices, and bad debts loomed large in 2008.

The clampdown on lending meant that, particularly for first-home buyers, purchasing a property was significantly more difficult.   Whereas previously savings of $15,000 would have represented a 5% deposit on a $300,000 house, requirements for a 20% deposit would have meant that anyone with less than $60,000 was suddenly priced out of the market.   It’s not clear how big this segment of buyer demand was, but the tighter lending criteria will have been a factor in driving the median house price down $27,00 between November 2007 and January 2009.

Lending criteria are now less restrictive than they were in the immediate aftermath of the financial crisis, but we do not expect banks to be as free and easy in lending money as they were five years ago.   Over a five-year horizon, we may see conditions ease to the point where mortgages of 90-95% are reasonably widely available, but LVRs of over 95% seem unlikely.   Furthermore, some banks are better taking account of the greater risk presented by higher LVRs by charging an interest rate premium on borrowers with small deposits.

Farewell the finance companies

Even before the fall-out from America’s sub-prime crisis hit here, New Zealand had its own financial sector meltdown occurring.  From mid-2006, some finance companies started to fail, and by late 2007, then on-bank financial sector was coming under huge financial pressure as the property market turned down and companies struggled to maintain existing deposits or attract new funds.   The overexposure of many of the finance companies to the property sector, with their portfolios often dominated by a few large projects, meant that they were not well placed to weather a downturn in the market.

At the time of writing, the amount of deposits affected in failed finance companies and related organisations topped $6.2bn.   The loss of this funding channel, which had largely fed through into property development, has had a severe effect on the potential for new residential, commercial, and industrial developments.   Although residential consent numbers have shown signs of recovery since mid-2009, funding constraints are still clearly limiting construction activity.

Views from across the industry are generally pessimistic about the ability for funding conditions, for both residential and non-residential construction, to improve significantly in the near-term.   However, we note that, anecdotally, the focus of banks is shifting away from shoring up their balance sheets to once again boosting lending activity and generating profits for shareholders.   It is clear, however, that finance for property development in the future will be more expensive than it was over the last decade.

Effect on potential for house price growth (1-2 years): mildly negative
Effect on potential for house price growth (3-5 years): neutral
Effect on potential for residential building (1-2 years): strongly negative
Effect on potential for residential building (3-5 years): mildly negative

Not building fast enough

There has been considerable debate over the last year about whether New Zealand is facing a shortage of housing.   Some analysts point to a lack of rental inflation, a low rate of household formation, and the overbuilding of previous years as factors that make them feel relaxed about the build rate getting down as low as 13,600pa last year.

The undersupply issue is also one we have covered off in some detail in previous forecasts.   In our view, the very low rate of household formation over the last 1-2 years has been driven by the economy’s downturn and its effect on incomes.   The lack of new house building has also been a constraint on household formation it’s pretty hard to form a new household if there’s no house to live in!   Both these factors are cyclical ones, and will reverse out as the economy recovers and the build rate increases.   In other words, they do not give a clear indication of underlying demand for housing.

By March 2013, our forecasts see a shortage of housing equivalent to 0.23% of the dwelling stock developing just over 4,000 houses nationwide.   The forecast undersupply is nowhere near as critical as estimates in previous cycles, as Graph 7.2 shows.   But it is an important component of our medium-term outlook that the build rate has failed to keep up with underlying demand.   This assessment does not guarantee a significant future recovery in construction activity, but it certainly provides scope for such an upturn.

Until residential consent numbers start to meet underlying demand, this undersupply should help put a floor under house prices.

Effect on potential for house price growth (1-2 years): mildly positive
Effect on potential for house price growth (3-5 years): strongly positive
Effect on potential for residential building (1-2 years): mildly positive
Effect on potential for residential building (3-5 years): strongly positive

A new tax approach

The tax changes announced at this year’s government budget have altered the playing field for property investors.   The removal of the ability to use depreciation on buildings as a tax write-off has meant that investors effectively require more of their cash flow to come through their properties’ rental incomes.   In the first instance, landlords will look to improve their cash flow through higher rents, but their ability to increase rents is not unlimited.   The change in the tax system will mean that some landlords will find that some of their property investments no longer stack up given the rents they can charge and their costs (which will be most heavily influenced by their interest bills and degree of leverage on the property).   As a result, some investors will look to reduce their property holdings, increasing the supply of properties available for purchase.

The reduction in the top tax rate from 38% to 33% also removes some of the rationale for investing heavily in property.   Labour’s introduction of the 39% tax rate in 2000 was widely viewed as unnecessary, unfair, and ideologically driven, given that the government’s books were balanced, and the government surplus became increasingly large over subsequent years.   Throughout the last decade, many people viewed property investment losses as a useful way of reducing their overall tax liability, with the expectation that capital gains would more than make up for the losses overtime.   With the top income tax rate now lower, the incentive to invest in property for tax purposes has been reduced.

KiwiSaver’s helping hand

Offsetting the negative effects of the government’s tax changes on the housing market is the maturity of KiwiSaver tithe point where the first members will be able to withdraw funds for a deposition their first house from the middle of this year.   For low-income households (below $100,000pa), there is also the possibility of a government subsidy, although this is subject to some fairly tight conditions on the value of the house that is being purchased.   Given these restrictions, we believe that any “KiwiSaver effect" for the housing market is likely to be relatively small, despite the scheme effectively acting as a subsidy on the eventual movement of funds into residential property.   Furthermore, people thinking of buying their first house would have been saving pretty hard anyway, even if KiwiSaver hadn’t been introduced.

Effect on potential for house price growth (1-2 years): strongly negative
Effect on potential for house price growth (3-5 years): neutral
Effect on potential for residential building (1-2 years): mildly negative
Effect on potential for residential building (3-5 years): neutral

Planning less urban planning

Last year, the government introduced its first reforms to the Resource Management Act.   These changes were focused on addressing excessive bureaucracy, costs, and delays imposed by the RMA, and their effect on the residential construction sector was negligible.   However, the second phase of reforms potentially has more significant implications for housing and construction.

In particular, the government is investigating "the potential of an aligning process for … building consents under the Building Act and resource consents under the RMA particularly for small-scale projects.   This work will run in close coordination with work being done to review the Building Act being undertaken as part of the Regulatory Review."   This accompanying review of the Building Act aims, among other things, to "reduce the cost and complexity of consenting" for building work.

Perhaps even more important in the government’s RMA reforms is the issue of urban planning.   The Ministry for the Environment provides the following statement regarding work in this area.

The work will look at the effectiveness and efficiency of options and tools, including national policy statement and metropolitan urban limits, to manage urban growth and achieve better urban planning and design outcomes.   It will examine ways of achieving better co-ordination between local authorities, government agencies and the private sector in the planning and design of our cities.

It will also examine the relationship between land supply and housing affordability.   It will align with other departmental work streams and will pay attention to the issues raised in the Report of the Royal Commission on Auckland.

It is unclear how far-reaching any changes by the government to zoning and RMA restrictions will be.   However, the effect of the constrained supply of land has been one of the factors driving up house prices over an extended period of time.   The government has recognised the link between land supply and housing affordability, and there is definite potential for land to become more freely available over the medium-term as a result.

Effect on potential for house price growth (1-2 years): neutral
Effect on potential for house price growth (3-5 years): mildly negative
Effect on potential for residential building (1-2 years): neutral
Effect on potential for residential building (3-5 years): mildly positive

The role of demographics

Back in 2006 we examined the role that baby boomers were playing in the housing boom 1.The article examined demand for various types of housing, as determined by people’s age and stage of life.   One of the key points from this article was that, as the baby boomers reached retirement, the number of people wanting to be landlords would start to ease we estimate from 2015/16 onwards.   By around 2017/18, the number of people wanting to rent could be falling as well, as the baby boomers’ children settle down and start to have families of their own.

These trends contrast with the experience of the last eight years.   The numbers of renters and potential landlords have grown strongly as a result of the age profile of the population.   At the same time, the number of people wanting to live in a "starter" or first home has probably been declining over most of the last ten years as there have been fewer people aged in their thirties.   However, the age profile of the population suggests that potential first-home buyer numbers will start increasing again from 2012/13.

We note that other demographic factors, such as the choice of people not to have children, can also have an influence on home-ownership decisions.   However, over a medium-term horizon of 5-10 years, the influence of the changing age profile of the population is likely to outweigh these lifestyle choices, as the latter tend to change more gradually when compared with the sizable humps and hollows in the age profile of the population.

The likely pick-up in first-home buyer numbers in 2-3 years’ time may contribute to some upward pressure on house prices towards the bottom end of the market, particularly as renter and potential landlord numbers will still be increasing as well.   Nevertheless, growth in the total number of households comprised of renters and first-homebuyers will still be slower than it was between 1992 and 1996, and again between 2002 and 2004 both periods that were notable for substantial acceleration in house price inflation.

Effect on potential for house price growth (1-2 years): neutral
Effect on potential for house price growth (3-5 years): mildly positive
Effect on potential for residential building (1-2 years): neutral
Effect on potential for residential building (3-5 years): neutral


We have summarised each of the six influences discussed above in Table 7.1, assigning scores between -2 and +2 for each factor depending on our assessment of what effect the factor will have on house prices and residential construction activity (-2 is strongly negative, +2 is strongly positive).

It is clear that the combination of economic, market-specific, demographic, and government policy factors will be a constraint on both house prices and building activity over the next couple of years.   From about 2012 onwards, the negative factors for both these indicators will fade, although the relative overvaluation of housing could still be a constraint on the potential for house price growth.   However, the positive influences are likely to be clearly dominant in residential construction 3-5years from now.

1 Baby boomers dominate housing market trends.

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