Opinion: Why a depreciation change would boost rents; send economy into downward spiral

By Olly Newland NZ Prime Minister John Key made a fundamental blunder when he recently delivered to Parliament his views - the government's views - of the proposals from the Tax Working Group. Quite rightly he booted out the looney leftist ideas of land tax and capital gains tax (typical notions that arise from those whose lives are filled with envy whenever they see people other than themselves doing well). However he caved in on one recommendation and gave a clear signal that the treatment of depreciation on investment property would be attacked in the Ministers of Finance's Budget due out in May. What the new measures would be was not made clear. No details were given, so the public has been left guessing about the imminent new measures. Neither, it seems, has anyone considered what the flow-on effects may be and what unintended consequences may eventuate. Even more disappointingly, by innuendo the Prime Minister appeared to go along with the suggestion that property investors act as some kind of free-loading extortionists ripping of the system while swimming up to their armpits in ill-gotten gains. It appears that he chose to be 'the populist' - swayed by the ignorant masses who bay for blood, revel in public hangings, while cutting everyone down to size at the first opportunity. The government as a whole has stumbled badly this time, which is hard to understand given that the Prime Minister and the Minister of Finance, Bill English, both have a good background in finance. Surely their collective wisdom would have taught them one thing: Uncertainty creates unease and unease creates distortions. Initially I believed that the proposed changes to depreciation would do little harm. On further research and discussions with others, the ramifications and problems became clear and I am now of the opinion that any major changes would indeed be harmful. I would not be surprised in the least if the suggested depreciation changes will be watered down (or even abandoned all together) when reality finally gets through the six inch thick skulls of those poor unfortunates whose task it will be to write up the proposed legislation. Across the Ditch The Australian Government (which often acts more decisively than our politicians here on NZ) has had a similar recommendation as our report but it hasn't been released as yet - much to the frustration of the property owning class. This report is called the 'Henry Report' and the fact that no one knows what it contains is causing a huge surge in property prices as home owners and investors buy up big in the belief that any tax changes will not be retrospective. The Australian government's dithering about releasing the report (let alone implementing it!) seems to confirm this belief. Kevin Rudd too busy to release tax review This is indeed food for thought. Will our proposed tax changes be retrospective? I doubt it. It seems logical to me that they cannot be retrospective as this would create an accounting nightmare. Imagine what would happen if somebody who has owned a property for 20 years, and claimed depreciation for all that time. Would they now be forced to pay it all back? The notion is ridiculous. So those who own now or buy before the tax changes are in place may have a huge advantage over future investors. Look at the Australian example and draw your own conclusions. Don't say I didn't warn you! The NZ Prime Minister's statement to Parliament on Feb 2010 included this: The Australian Government's response to a parallel tax review is expected to be made public in March, and is likely to include cuts to the company tax rate. But he said a decision on tax reform could be made in New Zealand without waiting to see what happened across the Tasman. As the Australian response to their tax report has been so glacial to date (indeed it may never appear) it would be surprising if NZ tax law with regard to depreciation, deviated much from our cousins across the ditch - capital gains tax differences notwithstanding. Alas, common sense and politics make unhappy bed-fellows so anything is possible. Practical reality Let's consider what we are dealing with: Property investment is a $213 billion dollar business with 180,000 landlords controlling 452,000 houses or around 2.5 houses on average per landlord. You can probably add as much again if you include commercial properties such as shops, offices and factories. The grizzle is that depreciation allowances have generated $500 million worth of losses and the tax forgone on those losses. Assuming an average 30% tax rate, the logic goes, there has been a loss of tax of around $150 million. If that was all there was to it, the exercise it would be easy - but of course, things are more complicated that that. What has been left out of the equation is that the tax losses are in effect a subsidy on rents as well as a huge source of employment for the working classes. Without this subsidy, the damage inflicted on the rental housing market (and the economy in general) could be very great indeed. Take a simple example: Mr and Mrs Smith own a 3 bedroom investment house worth $350,000. The land is is worth $150,000 and the house $200,000. The typical set-up would be a mortgage of $250,000 costing 7% plus rates, insurance etc off set by a rent of $350.00 per week for 50 weeks a year. The sums work out as follows: Income $350 per weeks 50 weeks = $17,500 p.a. Less interest ($17,500 pa.) Less rates, insurance, expenses [est.] ($2,000 pa.) Income (loss) ($2,000 pa.) Plus depreciation relief $200,000 x 4% = $8000 x tax 30% $ $2,400 p.a. Surplus p.a. $400 Well you might ask, why do Mr & Mrs Smith bother? They bother because (1) The house is at least 'washing its face' in money terms. (2) They hope/expect that over time it will increase in value. If the deprecation rebate was abolished three things would immediately occur: (1) The Smiths would have a real cash shortfall of $2,000 per annum (2) The Smiths would cut back severely on any improvements, upgrading work, and repairs (other than the most essential) (3) The pressure would go on to the tenants to pay MORE RENT. Multiply this basic scenario 452,000 times (never mind the commercial market) and the country could swiftly fall into a downward economic spiral. Walking in their sleep What is overlooked by all the bleaters and complainers is that the 452,000 residential homes will likely contain over one million Kiwi workers. Many of them them reliant on wages and salaries derived directly or indirectly from the 182,000 investors who pay the wages for painters, carpet, appliances, plumbing, architects, builders, concrete workers and suppliers of all kinds. If Mr & Mrs Smiths of the country all cut back on spending and upgrading because they just don't have the money you can imagine what the net result will be. Add to this the pressure on rents to recoup losses and we have a nightmare in the making as the politicians sleep walk their way the next election. Rents - sure to rise Residential rents are at a record low as compared to the asset they are using. Over the last decade the yields from residential properties has dropped from 6% to 4%. This data from Infometrics shows that in the past decade yields on residential investment property (returns by way of rents) have dropped 33% -- a situation which is only tolerated because of the current depreciation rebates which soften the wait for eventual capital gain (of which there is precious little at present -- in some markets, just the opposite!) It seem therefore blindingly obvious that rents will have to rise to compensate for losses, a fact totally lost on the pointy heads on the Tax Working Group and sadly forgotten on John Key as well it seems. From whence cometh the pressure? There will soon be massive pressure on rents in any event for several other reasons. (1) We have a current shortage of houses, the building industry is woefully behind in supply, as new build starter houses are notoriously unprofitable, (2) Raw materials are rising at an alarming rate (10% for timber alone by some reckoning), (3) An increase in GST to 15% as mooted will go straight into the end costs and hurt job creation as well, (4) Immigration and natural population growth is increasing by leaps and bounds, (5) The leaky homes disaster has virtually wiped out a decade of house supply. Thousands of houses with an estimated value of up to $11.3 Billion are now almost unsaleable because of this mess. The result is a further tightening up the market which exacerbates the shortage and pushes up prices even more. The year to come -- revised version Earlier this year I wrote an article where I forecast that the property market is most likely to stay flat with a small chance of hyper inflation or major recession as alternatives. Should the new depreciation rules be implemented as suggested then a new forecast will be necessary. We will either have to endure a Zombie market where everything stagnates ... or even possibly another huge spike in property prices to compensate for losses and increased costs. Can this be possible? Yes anything is possible: 'What the mind can conceive can always become true.' The Australians are 'enjoying' that right now. Frustrated Aussie investors (and Asian too) could see NZ as a soft target with cheap real estate. As has happened many times before they will come here by the bus load to pick up the bargains. First home buyers Increases in rents and prices hurt first home buyers- that's true enough but they only make up a very small part of the market. It's the rest of the market that makes the rules. It should be carefully noted that the large increase in February property listings only came after a record decrease in listings in January. As a result, the REINZ spokesman quoted on the front-page of the latest Sunday Star Times House prices set to slide may have missed the point and in reality the market is only in catch up mode. Used with permission. www.ollynewland.co.nz © 2010 Olly Newland. All rights reserved.