Is our economic future at risk as a result of the huge debts we’ve accumulated to indulge our love affair with housing?
According to a recent report by Goldman Sachs chief economist, Tim Toohey, household debt levels in Australia now stand at an elevated level, both in relation to historic norms, and compared to other countries. For instance, Australia’s debt to household income ratio is higher than in the United States and Spain, and stands at a similar level to the United Kingdom. Only the Netherlands and the Nordic countries have higher ratios.
And, the huge amounts of money we’ve borrowed have largely been spent on housing. According to the report, 62 per cent of debt is in owner-occupied home loans, and a further 27 per cent is in residential investment loans. As the report notes, “that is, 89 per cent of all household debt is directly related to domestic housing. By way of comparison, in 2007, 85 per cent of US household debt was secured against housing.”
As I wrote on the weekend, Toohey has written a perceptive report on the Australian housing market, in which he argues that housing prices are between 25-35 per cent overvalued. As a result, he says, we run the risk that Australia’s house prices could drop sharply if a sharp decline in Chinese growth prompted a steep drop in our export earnings.
Toohey points out there are good reasons for our obsession with housing. Australia offers one of the most advantageous tax regimes for investing in housing in the developed world. Only the Netherlands is more generous.
For instance, we have no capital gains tax on owner-occupied housing in Australia, while property investors pay capital gains tax at half their marginal tax rate if they hold the investment property for more than a year.
Further, the tax system also offers generous deductions for those who buy rental properties, through measures such as negative gearing (which allows investors to offset losses on the investment property against other income), and depreciation deductions. These tax provisions greatly reduce the cash flow burden of investing in low-yielding rental properties.
The report calculates that an investor who buys a $500,000 investment property using a standard 7.5 per cent housing loan is likely to face a negative cash flow of around $28,500 a year. But the property is likely to incur tax losses of more than $22,000 a year as a result of negative gearing and depreciation. This means that for an investor on the top marginal tax rate, the out-of-pocket expense of owning the investment property plummets from $548 a week to $126 a week (or approximately $6500 a year).
Toohey notes that interest rate moves have a major impact on the economics of investing in rental properties.
For instance, back in April 2009, when the mortgage rate was at a low 5.75 per cent, our investor would have faced an after-tax expense on their investment property of $36 a week, or $1872 a year. Since then, the weekly expense has risen by $90 a week, or around $4700 a year.
The report predicts that the Reserve Bank will increase interest rates by 100 basis points in the next year, which would push the after-tax expense of the property up to $177 a week, or $9204 a year. “As such, it is likely that investor demand will soon begin to ebb”, the report notes.
Still, despite the generous tax treatment, many investors are left with negative after-tax cash flows from their rental property investments. The report notes that one reason that investors continue to invest in rental properties is that they’re hoping to profit from rising property prices.
For instance, in the example given above, the investor faces a negative cash flow of $6500 a year from buying the $500,000 investment property.
But if property prices jump by 20 per cent, they’ll achieve a $100,000 capital gain, which means their total return will be $94,500. And, as the report notes, “the annual returns are much higher when leverage is introduced into the analysis; hence it is not hard to see why during periods of trend growth in house prices highly geared investor housing has been attractive.”
What’s more, housing has been an outstanding investment over the past 20 years. Residential property has been the top-performing asset class over the past two decades, delivering the highest returns along with the lowest volatility.
According to data from the Australian Tax Office, only 13 per cent of taxpayers are claiming rental income, which represents a slight increase from 1997-8, when the figure was 12 per cent. The report estimates that only about 19 per cent of non-renting households own an investment property.
So who are the people most likely to snap up investment properties?
Interestingly, it appears that Reserve Bank officials are the keenest investors in rental properties. “We are not sure whether to be relieved or concerned that of the five central bankers who were brave enough to note their occupation on their tax form, all five had an investment property!”, the report says. “Of the 200 occupations classified by the Australian Tax Office, the employees at the Reserve Bank topped the list with respect to their investment property exposure.”
But people working in the medical and banking industries, along with people employed in the property sector also figured prominently as owners of investment properties.
On the other hand, people working in the funeral services industries, and in the hunting and trapping industries, were least likely to own an investment property.
High income earners derive the greatest tax benefits from investing in rental properties. As a result, we see that the proportion of taxpayers who own a rental property rises strongly as income levels increases. The report says, “this is particularly evident for those using negative gearing strategies with negative rent claims rising proportionately with income right up to incomes of $1,000,000 per annum.”
But our infatuation with housing has pushed up the gearing levels of Australian households. The report notes that household leverage in Australia is higher than both the US and the UK, and has been since the mid 1990s.
According to the report, in order to get household gearing to the average level that prevailed in the 2003-7 period, either Australian household debt could have to decline by 8 per cent, or household asset prices would have to rise by 9 per cent.
“With the economy already operating at full capacity, lowering gearing ratios via asset inflation is not a sensible policy option”, the report warns. “Tighter fiscal policy, higher interest rates and ‘jaw boning’ may be the only way from preventing households from becoming more exposed to an adverse and sustained shift in the terms of trade.”
*This story originally appeared on Business Spectator
Yes, negative gearing facilitates wealthier Australians growing their wealth at the expense of less well off Australians, who not only pay hugely inflated costs of housing as a result of negative gearing – but also take on a greater proportion of the nation’s tax burden as wealthy Australian’s avoid paying taxes as part of the process of increasing their personal wealth. Great for the yuppies are probably not so great for the country as a whole
It’s hardly surprising that the Business Spectator advocates continually raising interest rates as its favoured course of action. Most wealthy Australians get to claim a large portion of their interest payments as a tax deduction via negative gearing because most of their interest payments are on investments, not their primary residence. Those who feel the most pain from rising interest rates other working Australians who are struggling to pay off their first home , and therefore don’t get to participate in the wealth creation game readers of the Spectator play with such gusto.
Why is it I wonder, none of this country’s wealth in the feudal landlords are advocating diminishing the benefits of negative gearing to remove some of the inflationary pressure in our housing market. Oh, that’s right – this would make purchasing a first home more attainable for many of those people who are currently paying exorbitant rents to grow the wealth of their landlords
It’s also not surprising the Business Spectator avoids mentioning the single biggest contributor to rising household debt levels in Australia – the deregulation that has allowed banks to encourag their mortgage customers to keep drawing against the equity in their homes to buy lovely new cards, widescreen TVs and holidays in exotic destinations. The degree to which many Australians now use the equity in their home as a credit card or ATM is one of the primary reasons the financial wizards who created this new paradigms fear the heat being taken out of the housing market. THIS is the primary reason the beginning of town now has a perennial interest in perpetuating Australia’s housing price bubble – any major downward correction could hundreds of thousands of Australians are homeowners suddenly underwater – owing far more to the bank on their mortgage than their house is actually worth.
I hadn’t noticed just how far to the right of the Financial Review Crikey’s financial coverage was capable of straying until I read this article, but will definitely be watching this with interest in future
One correction:
[For instance, we have no capital gains tax on owner-occupied housing in Australia, while property investors pay capital gains tax at half their marginal tax rate if they hold the investment property for more than a year.]
Hands up any serious housing investors who pay Capital Gains Tax? Anyone?
A few do, but only if their investment model collapses, forcing them to sell. If you open up any of the property investment books in your local Dymocks, or go to any property investment seminars, you will learn that selling your property is for losers.
These days property investors realize their capital gain by reborrowing against a property once the market valuation has gone up. The borrowed money may be used to put a deposit on another property, to cover the cashflow shortfall of negative gearing, or even for living expenses.
Capital gain with no Capital Gains Tax – and an increasing number of properties which will not be sold until those investors die or their trusts are wound up.
That puts the squeeze on the remaing properties that still change hands from time to time. As these APM and RP Data-Rismark figures show, the proportion of houses being turned over has been trending downwards for the last 8 years. In 2002 about 7.5 per cent of properties changed hands. In 2009, it was about 5.5 per cent.
Forget about owner-occupiers; it’s this distortion in the Capital Gains Tax that is squeezing supply and driving up prices. Residential property speculators (those not actually building any homes) are the most tax-free sector in the entire economy – and the least productive.
Just another “green belt effect” brought to you by the Australian government. And it’s a total black hole for the economy. House prices squeezed upwards by their unavailability represent a zero sum game, each asset being bid up simply because the others are not for sale. The excess mortgage payments are a bigger drain on many incomes than tax – but at least tax can be spent on something useful.
Analysis of our housing situation against historic trends indicates that it will all end in tears. The “soft landing” option of zero price growth for the next 15 years is possible, but more likely we will see an abrupt drop in prices brought on by rising unemployment. It is likely that the only things to have prevented this fall already are the extremely high net migration rate over the past few years, the big government stimulus spend and persistent high prices for our mining exports.
Lower house prices would be a good thing for almost everyone (construction industry and property developers excluded of course). Imagine first home buyers being able to buy a place for only 3 times an average wage! You could buy a place and have kids at the same time, and still be able to eat more than just rice and gruel.
Yes, that’s a good point raised by ACIDIC MUSE about owner-occupiers taking out “reverse mortgages” to use their homes as ATMs. A number of federal and state tax distortions make this temporarily lucrative, such as –
* the Capital Gains loophole I described above
* the ability to offset negative gearing against unrelated income
* the daylight robbery of taxation on bank deposit interest (Kevin Rudd was very careful to excuse only the first $1000 when pretending to follow Ken Henry’s recommendation) which cannot compete with property as a suitable place to park capital
* the GST on building new homes, and several years of first home owners boosts which conspicuously did not address their stated purpose of “compensating for the effects of GST”
* the dependence of the states on stamp duty revenue (which was to be abolished in a federal-state tax agreement, but the federal government reneged on its side of the deal)
* infrastructure levies on new homes needing to be paid up front rather than being deferred into ongoing land tax
Generally, there is a political climate of going to any length to pork barrel property investors, which even tainted much of the stimulus during the financial crisis, because anyone in government when the bubble pops can forget about being reelected.
It’s the great Australian black hole, because so much wage income drains into this zero sum game, instead of flowing through the economy to make more jobs.
Its not just the huge amount of debt we have on housing, its the investment we don’t have in everything else. The banking industry in this country have failed to perform any useful purpose – measure risk, mobilise savings, invest productively – to justify their existance. They have purely acted to put themselves in a parasitic position of skimming off a large percentage of earnings in the form of servicing debt. The question is why we carry these ticks on the collective hide of productive enterprise. A decent national investment bank with some clear investment objectives would have purchased a lot fewer tellies, and a lot more rail, hospitals, university places, power stations etc. And those would be bonds I would actually like to buy, rather than the equally debt financed options on the ASX. But there you have it; we are not as smart as the Norwegians. Maybe whale meat is good for the brain.