Rents to rise under Labor, negative gearing/CGT policy risky to economy: SQM's Louis Christopher

SQM Research believes there is a "very high risk" based on Labor’s proposed negative gearing policy, that investors purchasing new property may experience losses on a resale in the first three years of the property’s life.

"Investors seeking to benefit from the new concession by buying new properties are exposed to a substantial risk of their property being valued below purchase price, especially if the buyer is seeking to sell their investment within the first three years," SQM director Louis Christopher said.

While the SQM director Louis Christopher says there is no solid data to prove this point, it was in SQM'S experience that over the course of a cycle:

• Off-the-plan developments will be sold between a 15-30% premium to the existing market.
• 30% of off-the-plan developments will sell at a loss to the initial purchase price if sold within the first three years if the dwelling’s life.

A premium paid over and above the existing market is often justified as one is effectively buying ‘new’ and the best quality fixtures and fittings compared to the existing market. 

Christopher predicts dwelling prices to fall.

"Given the forecast of initial negligible rental growth, SQM Research forecasts an additional correction in the housing market of between 4% to 8% over a three year period (2020 to 2022) with most of the falls occurring in years one and two."

This assumes an interest rate cut of 50 basis points by early January 2020.

He sees yields as rising.

International comparisons as well as historical precedents indicate that acquisition rental yields are likely to rise between 0.85% and 1.2% (85-120 basis points) over a two to three year period post the implementation of the new policy.

"If interest rates are cut by 50 basis points, the rise in yields will be smaller at between 60 and 95 basis points."

He tips rents to rise 7-12% over 2020 to 2022.

"Rental changes are initially likely to be negligible due in part to a current oversupply in Sydney and some other cities.

"However, there may be an acceleration from year 2021 due to an expected sharp fall in dwelling completions.

"Brisbane and Perth are forecasted to record the largest rises."

The report envisages housing construction and completions will fall further.

SQM Research forecasts the total fall in housing construction activity will amount to a 25% to 30% decline from 2019 levels.

"Given the existing falls in construction and the anticipated peak in infrastructure spend in 2021 this could have a large impact on GDP and employment in the economy," Christopher said.

"The total adjustment in the market housing market is forecasted to last for approximately three years, with most of the adjustment phase occurring within two years.

"Thereafter the market would likely return to equilibrium, having ‘priced-in’ the loss of the tax concessions."

He forsees sales turnover to fall by another 12% to 15% with most of the declines in sales to occur in the first year (FY2021).

This would result in a fall in state stamp duty revenue of approximately $2.3 billion.

The report represents an update on his 2016 research to cover the potential price, rent and turnover impact of the Labor Party’s negative gearing policy initially released February 2016.

Labor will limit negative gearing to new housing from a yet-to-be-determined date after the next election.

All investments made before this date will not be affected by this change and will be grandfathered which means that taxpayers will continue to be able to deduct net rental losses against their wage income, providing the losses come from newly constructed housing.

From a yet-to-be-determined date after the next election losses from new investments in shares and existing properties can still be used to offset investment income tax liabilities. These losses can also continue to be carried forward to offset the final capital gain on the investment.

The report presents several scenarios.

• Scenario 1 - Negative Gearing cut 1 July 2020 and interest rates cut by 50 basis point

In the first scenario, The Reserve Bank of Australia cuts interest rates starting from late 2019 by half a percent (50bp). Negative Gearing is changed and CGT increases are passed and enacted on 1 July 2020.

SQM take the view there would be an overall gross yield increase of some 65 basis points after taking into account the rate cut; 25 basis points of which is passed on. Prices would still considerably fall in Sydney and Melbourne but other cities would be less affected.

There is a likelihood the housing market could rally post the interest rate cuts and leading into 1 July 2020 as investors take advantage of grandfathering. The earlier the rate cuts, the greater the likelihood of a rally. Most of the price falls would happen over later 2020 and 2021 with a potential market bottom in 2022.

Rents in Sydney and Melbourne do not lift initially on the back of some existing oversupply of rental stock. But that stock is quickly absorbed in 2021/2022 leading to an acceleration in rents.

• Scenario 2 – No Interest Rate cut

In this scenario, the market takes the full brunt of the Negative Gearing change and CGT lift. Prices fall sharply with a minimal pick up in demand prior to passing of the bill (assumed 1 July 2020).

Average capital city gross rental yields lift by 85 to 120 basis points with the yield increase being shared between price falls and rent increases.

With prices falling sharply over 2020/21, housing commencements fall greater than scenario one therefore creating a larger shortage of housing relative to underlying demand in 2021/2022.

• Scenario 2 assumes no recession but there would have to be serious questions on the state of the economy.
• Scenario 3 – No Negative Gearing change and 50 basis point rate cut

This scenario assumes either the Labor Party defers the tax changes or the Liberal Government wins the 2019 Federal Election. This assumes therefore, a likely recovery in the housing market as confidence returns due to a rate cut, no Negative Gearing change and no Capital Gains Tax increases. Bank lending is less restrictive.