If negative gearing is quarantined cities like Sydney will be facing chronic undersupply

If negative gearing is quarantined cities like Sydney will be facing chronic undersupply
Pete WargentDecember 7, 2020

Cameron Kusher of RP Data drew the ire of a few pundits recently as he highlighted a number of points as to why negative gearing won't be abolished.

There are four main points which advocates put forward in favour of abolishing negative gearing:

  1. Rents wouldn't rise

    Nobody knows for certain whether this is actually true.

    But let's face it, the inevitable hand of self-interest means that if negative gearing rules were quarantined landlords would probably take the opportunity to at least try it on by jacking up their rental charges (cf. the colossal 57% increase in rents in Sydney last time the rules were tweaked, 1985-1987).

    Let's suppose for the sake of argument that rents stayed flat....

  2. Government would save billions

    This was one of Kusher's main points: 

    "The government only owns and rents out 4.1% of the housing stock. Conversely dwelling approvals data shows that a very small proportion of new housing approvals are granted to the public sector."

    Common sense dictates that if the government scraps the prevailing negative gearing legislation it would have to step up its public housing expenditure.

    "If negative gearing was to be removed the government would likely have to play more of a role in constructing new homes and managing a portfolio of properties. On balance, they probably play see that foregoing almost $8 billion in taxation revenue is more cost effective than developing and managing a greater proportion of housing stock."



    So much for all the billions in tax savings: the biggest furphy of the lot.

    Indeed, according to contemporary commentary the principal reason that negative gearing rules were reintroduced in the first place in 1987 was the spiralling waiting list for public housing, particularly in New South Wales where numbers increased alarmingly by nearly 40% to 140,000.

    Again, let's suppose that the government recovered in full the foregone funds from its negative gearing subsidies and a grandfathering or quarantining of the prevailing rules proved to be fiscally neutral.

  3. Renters would buy up the properties sold

    Kusher again:



    T
    his is obviously true.

    If property investors sell their properties, are renters who have not been able to buy previously really going to be in a position to suddenly step in and buy them? That seems unlikely, unless renters already had pre-existing deposits and closing costs ready to roll.

    But again, let's suppose that investors sold their properties and renters somehow did find the deposits and the appropriate financing to buy up the surplus stock with no associated decline in lending standards (also unlikely).
     

    This is where the housing affordability arguments become circular and contradictory...

    Higher home ownership rates?

    On the one hand, people say "we should be like Germany with its stable housing market where most people rent" and on the other they argue "renters should be able to buy into the property market".

    One or the other argument might make sense, but I can't see how they both can.

    Certain economists believe that artificially pumping up home ownership rates beyond their natural levels promotes boom/bust cycles. 

    Look at countries where home ownership rates are artificially high, such as Singapore, where dwelling prices are up by 60% since 2009.

    Hardly a model for affordable housing, and rents are preposterously high in the city too (at least, they have certainly seemed to me to be when I've visited friends in the city - I'm happy to stand corrected on this point if it's incorrect on a city-wide basis).

    Britain too experimented with making home ownership a part of the very fabric of society through Maggie Thatcher's selling off of council houses, pushing UK home ownership rates to exceptionally high levels of around 70% by the end of the century.

    This all seemed to be a tremendous success when house prices were booming in the 1980s (and again in the 1990s and first half of the 2000s) with the stakeholder economy benefiting from an unprecedented boom in credit and wildly exaggerated wealth effect.

    However, it's commonly acknowledged that the UK housing market has also been one of the most manic-depressive boom/bust markets in the world ever since ownership rates increased.

    Meanwhile, ownership rates until recently appeared to be in the process of heading all the way back down to from whence they came...until, that is, the government stepped in with its Help to Buy and Funding for Lending wheezes - the cycle repeats...

  4. Negative gearing doesn't increase supply

This point is logical enough, since negatively geared properties are mostly comprised of existing housing stock.

Let's disregard all of the above factors which are precluding the negative gearing rules from being quarantined.

Suppose for a moment that:

(a) the negative gearing rules are quarantined or grandfathered out;

(b) a large number of property investors sell their properties;

(c) renters buy up the surplus stock increasing home ownership rates to 70%+;

(d) rents don't rise;

(e) a decline in lending standards doesn't lead to a mass of defaults when interest rates rise;

(f) no boom/bust market ensues; and

(g) dwelling prices fall by, say, 20% (which presumably is the main underlying point of this entire debate after all).

Ongoing supply? 

As I looked at here, our major residential developers in Australia are not generating strong margins. Far from it in fact.

So if dwelling prices are to fall, who is going to build the new housing stock? 

If you think developers are going to do anything other than maximise shareholder returns, as indeed they are compelled to do, then you likely also believe in tooth fairies.

The Reserve Bank itself highlighted the reason why margins on multistorey apartment block residential developments are so slender: construction costs on infill sites are too high for it to be otherwise.

This chart shows why a long drawn out fall in apartment prices in Sydney was never feasible since it would have quickly taken the price per dwelling below its equivalent replacement cost.

Land developer Stockland's (SGP) underlying profit in FY13 was hampered by weak housing conditions, with that financial period encompassing the period from 1 July 2012 when sentiment was 
still in the process of picking up. 

Stockland's (SGP) residentiual division recorded an EBIT margin of 19.9% in FY2013.



The Mirvac Group (MGR) managed to improve group gross margins on its residential developments to just 22% from a desperately poor 18% in the prior year.

 

Lend Lease might yet prove to be the biggest basket case of the lot, the group reportedly struggling to turn a decent worthwhile ROI on some of its resi developments even at today's higher dwelling prices.
 
Lend Lease's (LLC) entire Australian geographical segment is recording EBITDA of only $500-$600 million and NPAT of around only $400-$500 million from colossal annual revenue streams of  $7.5 billion plus.
 
 
 
I'm sure that $7.734 billion top line figure is keeping a few execs living in the manner to which they have become accustomed, but those kind of net margins are hardly likely to see shareholders sending the champagne corks flying.

Even back up at a PE of above 14, the share price is still at only at around half of its former glory.

Lend Lease's FY14 H1 results for its Australian geographical segment have disappointed as development and construction profits have once again slipped back.

 
 
Implications

If you're not familiar with accounting convention, what this means simply is that if dwelling prices fall, developers ain't barely going to be making a profit even before financing charges, and it will almost immediately be a case of 'see you later new dwelling supply'.

Say, for the sake of argument dwelling prices fall by 20%.

You can be more or less certain that absent new subsidies, major developers would instantly put any new planned projects on ice until upwards price pressure returned.

In case it's still not clear why, this table explains the basic maths:

 
FY13 
FY??
Turnover
100
80
COS
(80)
(80)
EBIT margin
20
-

In our cities with booming population growth this would be disastrous for renters. 

Even in the event of interest rates remaining at their lowest levels in a generation, developers would soon have zero incentive to build since if dwelling prices are sliding, since they'd only be breaking even before financing charges were booked. 

There would be no corp tax to pay since there wouldn't even be a net profit upon which to raise tax, so the government would be getting zinged on its own revenues there too...and zinged again would they be on stamp duty foregone as the supply of new dwellings evaporated.

So much for all the billions in tax savings.

As for the capital gains tax take, which forms a part of the individual income tax assessment: when prices are falling...oops there goes another revenue stream

So when Stockland discussed in 2013 "the prolonged downturn in the Australian residential land market" as adversely impacting results, they aren't being facetious.

They are simply noting what is plainly the case for developers in their resi divisions - there ain't barely no money in it, which is why it has taken a significant upturn in Sydney's prices to see dwelling approvals at last begin to flow through, after a woeful lull across the past decade.

Conclusion

If dwelling prices fall over any meaningful period of time in a city such as Sydney, we would quickly see supply dry up and with a population growing at 80,000 plus per annum we'll be back into chronic undersupply territory in just a few short years.

This is why negative gearing rules probably won't be quarantined or grandfathered out.

And this also why, if affordable housing is considered to be a genuine target, the government would probably need to look at tackling supply through subsidies as I posted about here, while at the same time easing demand through considering other property tax reform and not the NG rules.

As I've noted before though, I'm sceptical as to whether there is any real desire to make housing more affordable from those in power.

You can visit AllenWargent property buyers (London, Sydney) or Pete's blog.

His new book 'Four Green Houses and a Red Hotel' is out now.

Pete Wargent

Pete Wargent is the co-founder of BuyersBuyers.com.au, offering affordable homebuying assistance to all Australians, and a best-selling author and blogger.

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