Budget depreciation change to slow the market: Louis Christopher

Budget depreciation change to slow the market: Louis Christopher
Budget depreciation change to slow the market: Louis Christopher


If you have been following my tweets and Facebook comments, you would have noticed that I have been very vocal about the new budgetary measures and, in particular, the new rules on plant and equipment depreciation.

Up until yesterday, it was obvious that large sections of the media were not aware of the full ramifications of what had been announced in last week's Budget.

Indeed, headlines last week claiming that “Negative gearing was left untouched” could not have been further from the truth. Ultimately, these headlines left me in a state of bemusement with sections of our media which is cause for a blog of its own.   

That all changed yesterday, where through the hard work of Australian Financial Review reporter, Su-Lin Tan, the full ramifications of what had been announced came to the fore via this front page story: Negative Gearing - Scalpel will cool apartment demand - experts

The new depreciation measures are significant as they massively reduce the ability of property investors to make deductions on their investment property, thereby reducing their ability to negatively gear. 

These were the very words used by the Treasurer:

“And from 1 July 2017, the Government will improve the integrity of negative gearing by disallowing deductions for travel expenses and, for properties bought after today, the Government will also limit plant and equipment depreciation deductions to only those expenses directly incurred by investors.

To give you an idea of the impact on investors, the mocked up depreciation schedules below clearly show what was normally claimed, with the columns circled in red showing what can no longer be claimed if these new measures are passed. Both schedules assume a circa $500,000 price tag on the properties.

This first property assumes a newly built situation where a Division 43 allowance (depreciation on buildings) can still be claimed.

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The second example is of an older style property where a new renovation has been completed.  Both these depreciation schedules have been provided with thanks to Mike Mortlock from MCG Quantity Surveyors.

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In both instances, plant and equipment depreciation are a significant component of the total deductible depreciation on a residential property. Literally, many thousands of dollars can no longer be claimed. Just keep in mind as well that these new changes only apply on residential property. Commercial property depreciation is still fully deductible.

The effective result is that tens of thousands of properties that were cash flow positive properties after the depreciation benefit will no longer be cash flow positive, keeping in mind these affect property purchases after May 9, so there is grandfathering.

In its simplest terms, also consider the following scenarios:

Property A

I own a new unit that was just built. I can claim the significant plant and equipment depreciation that comes with newly built dwellings. However, if I sell to you that unit tomorrow, you can not claim the plant and equipment depreciation.

At this stage, it is not clear regarding the plant and equipment depreciation  that If I own an off-the plan development that is not complete and I then flip it on to you (before completion) whether you can claim the depreciation or not. The Federal Government needs to clarify this situation.

Property B

I just bought a newly constructed unit after May 9, 2017. Normally, I would be able to claim the plant and equipment depreciation, however, at this point it is unclear under the new Budget measures whether I can going forward. A strict reading of the new measures suggests I cannot as it was the developer who originally purchased the plant and equipment.

This has been the view of some quantity surveyors while others believe the Government doesn’t intend to be so punitive. Once again, we are waiting for clarification.

Property C

I own an older style property on which I recently completed a renovation whereby I purchased $200,000 worth of plant and equipment. I then sell this property to you, today. You cannot depreciate any of the plant and equipment that I have spent money on during the renovation.  

No further clarification is required here. This is exactly how the Government wishes the new measures to apply.

In my view, this new measure, combined with recent APRA initiatives, plus the potential for the banks to pass on the new bank levy, will very likely result in a drop in property investor demand. When that drop happens is uncertain. But it could start at any time given once these changes are passed by the Senate, there will be a retrospective impact back to the May 9, 2017.

So those people who purchased an investment property last weekend will likely be impacted by these new measures.

As quantity surveyor Washington Brown stated in their blog earlier this week, these new measures might actually have some unintended negative consequences for affordability in that:

  1. Property investors may now feel the need to hang onto their existing properties to continue claiming depreciation because if they sell that property they won’t be able to get as many deductions on their next one.

  2. Developers rely on high depreciation figures in the early years to show investors how affordable an investment property can be. If these depreciation allowances are taken away, they will struggle to get pre-sales which are required by banks to fund the deal.

I am also concerned for investors in a new property as it is likely that any secondary buyer will demand a discount on a resale to take into account that lack of deductible depreciation, which is significantly large on new dwellings. It’s a similar issue we had with Labor’s policy on negative gearing during last year’s election. As it is, off-the-plan investors regularly experience price declines in new properties when selling in the first few years of the property's life.

These new measures may aggravate this reality which could then have a negative impact upon the supply of new housing stock in the long term. 

What the Liberals have announced is a light version of this policy in a way this will be a good test to see what would happen to dwelling prices and home affordability and rents under a no-negative gearing scenario.

Are these measures good for First Home Buyers? 
In addressing the affordability question one must ask do these measures, plus others announced such as the additional superannuation contribution scheme, the additional CGT discount on ‘affordable’ properties, the tax break for senior empty-nesters to sell their homes, the additional land supply, create the incentive for first home buyers to come back into the market?

Well maybe, maybe not. Regardless, developers will need more first home buyers to take up the slack that investors leave behind. Potentially, first home buyers could do just that, which is what we all want.

But they kind of need to. And if they don’t, the rent rises that may well follow could just force them to.

This brings us to the final unintended affect – the rental market.

Note the recent trend in falling building approvals.

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We are nearing the peak in housing completions in this cycle which we believe will be early 2018. Yet vacancy rates in Sydney and Melbourne are still tight.

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This is happening because our population growth rates have exploded in recent years. Melbourne is now expanding by 120,000 people each and every year. Sydney's population is rising by 90,000 people. The growth rates are above and beyond what was expected and is causing systemic strains on our two largest cities.  For more on this I strongly recommend you read the recent blog on population from Macro Business 

Remember, this time last year there was a real fear of a unit oversupply. Forget that now for Melbourne and Sydney. There is no oversupply. And, depending upon how first home buyers respond to the Budget, there could be significant under-supply later in 2018-2019 which may cause rents to skyrocket.

After all, rents in Melbourne are already well above expectations this year.

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Our 2017 Housing Boom and Bust Forecasts

It was reported yesterday that SQM Research may be revising down its 2017 forecasts as a result of the changes. After careful consideration, our base case forecasts stay un-revised for now. 
However, we believe that the probabilities have substantially increased that a peak in the price growth rates of the Sydney and Melbourne housing markets will happen this current June quarter and that the September and December quarters will record slower growth rates. The possibility of a modest price fall in either the September or December quarter has also increased.

Subsequently, we now believe the lower end of our base case forecast range is likely to be reality. And, depending upon how and when the banks respond, we may revise our price forecasts down. For now, they remain on track with no current slowdown occurring in the housing market.
Louis Christopher is a managing director of SQM Research. He can be contacted here.


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