Categories

Archives

Briefing Papers 8: “Real Estate Debt and the Balance of Trade”

AUT’s Briefing Papers initiative has kindly allowed us to syndicate their recent series on housing. The eighth paper is by investor and company director John Walley:

Auckland has a housing problem but this is not just a problem for Aucklanders, or new home buyers. Out of control asset inflation – as seen in the Auckland housing market – is toxic to the real economy, destroying our ability to deliver a long-run neutral balance of trade. High asset price inflation misdirects investment and lowers the competitiveness of the tradable sector resulting in lower average wages and falling returns to trade.

Under current conditions investment is largely focused on assets, not productive enterprise. In an effort to check rises in asset prices, interest rates in New Zealand are higher than other countries. Consistently higher comparative interest rates results in a stronger New Zealand dollar than would otherwise be the case, reducing export returns, competitiveness of manufacturers in our domestic market and lowering incentives to invest (key to future innovation, competitiveness and capability). Inequality is worsened, as house and land values contribute to higher living costs; this further damages our economic performance, as recent OECD research has shown higher inequality to be a drag on economic growth. As house prices rise, indebtedness rises in comparison to earnings, increasing vulnerability to economic shocks that can threaten financial stability.

Ever expanding debt, supported by banks and the large monetary stimulus programmes in the U.S, Europe, U.K and Japan, and even by the Reserve Bank of New Zealand (RBNZ rules favour land and buildings on bank balance sheets), fuel ever higher average house prices with respect to average earnings. This process is supported by the notion that prices will always rise and that debt will be paid by the (tax free) capital gain. The risk to stability is, of course, if prices fall. Research by the OECD estimated when household debt rises above trend by 10 percent of GDP there is a 40 percent chance of the economy entering recession in the following year, compared to 10 percent likelihood when household debt is rising at trend.

More generally, recent OECD research looking at the role of finance and growth suggested the following is the case in most OECD countries: more credit to the private sector slows growth; more stock market financing boosts growth; credit becomes a stronger drag on growth when it goes to households rather than businesses; and bank loans slow economic growth more than bonds.

Auckland house prices are high when compared to incomes. The graph below compares housing affordability (the ratio between median house prices and median annual household income) for each countries’ major markets – for New Zealand, this is the Auckland housing market. As of September 2014, the median house sale price in Auckland was 8.2 times median household income – the survey median was 3.8. The New Zealand national median house price-to-income ratio is also high, at 5.2. Demographia defines income multiples of 5.1 and over as ‘severely unaffordable’.

graph-12
Source: Demographia

Household debt reached a peak of 162.2 percent of disposable income in the first quarter of 2015, after previously peaking close to this at 161.2 percent in the second quarter of 2009. New Zealand’s household debt-to-GDP ratio is at 95 percent, down somewhat on the peak of just over 100 percent in 2009. Research by the Bank of International Settlements (BIS) suggest that household debt over 85% of GDP can damage an economy, though greater sensitivity to economic downturns, and by boosting debt for non-productive assets, pulling resources from the rest of the economy to service it, including skills and investment.

graph-13

This is the problem – for the whole New Zealand economy. Will building more houses in Auckland fix it?

Under-supply of housing naturally leads to higher prices, particularly with high net migration. Hence the solution to this part is to increase supply, open up new land for development, focus on increasing the number of houses built and responsibly reduce constraints and barriers to new builds. It is also important that such developments target high density development, particularly in larger cities such as Auckland, to reduce the cost of urban sprawl (some commentators have called for a debate on migration).

But supply side activity has a limited pace as the allocation of finite construction resources and labour has a limit, made worse when in catch-up mode, as seen in the large deficit in the cumulative net supply position in the graph below – this is a key area for the Government to do more, especially ensuring affordable housing is built. Low rent inflation suggests investors and speculators are contributing to house price inflation.

graph-14
Graph Source: MBIE

Supply side efforts take a while to take effect, and the threats to financial stability and the damage to the tradable sector are with us right now. More needs to be done. The supply response in the last two decades has favoured more expensive housing, rather than affordable homes, exasperating the inequality effect.

graph-15
Source: OECD Economic Survey – New Zealand

Intervention on the demand side, such as a register of foreign buyers, borrowing limits related to asset earnings and/or buyer earnings, higher deposits for landlords and capital gains enforcement can act quickly to reduce the growth in debt, slow price rises and thereby improve financial stability.

Other countries have acted:

  • Last year the Bank of England reintroduced Loan to Income Ratios, where no more than 15% of mortgages issued can exceed a Loan to Income Ratio of 4.5.  If you earn £100,000 a year, your loan would be capped at £450,000.
  • The Central Bank of Ireland introduced Loan to Income Ratios, of 3.5 times of gross income and Loan to Value Ratios set at 80% (a 20% deposit is needed) with a lower ratio of 70% for those buying rental properties. For first home buyers this is set at 90% for properties up to €220,000, with 80% on any value exceeding this. This tougher requirement on rental investors reflects their higher default risk as compared with owner-occupied homes.

Research by the BIS suggests that such macro-prudential tools can be effective in slowing house price inflation and mortgage credit growth if they are introduced at a time when these are both high. In other words, they can be most effective in slowing a boom, and are less invasive at other times, keeping the lid on gently.

Another issue often cited as a factor increasing prices is demand from foreign investors. Unfortunately with no register of such ownership in New Zealand it is hard to judge the extent of this.

  • Singapore introduced stamp duty taxes on non-resident buyers of property. This tax now sits at 15%, increasing from 10% when it was introduced in 2012. They also introduced a cap on debt repayment costs at 60% of the borrowers’ monthly income. These measures have seen prices fall 4% in 2014, and sales volumes falling.
  • Australia: there are proposals to introduce such a register as well as fees on foreign investors: A$5000 fee for property up to A$1m, and investments over A$1m would incur an A$10,000 fee for each additional A$1m purchased. These measures are probably too small to make much difference but are a start. Foreign investors are limited to purchasing new build, and not existing property, and these rules may be strengthened. The state of Victoria is now also planning a 3% tax on foreign buyers of property.
  • England, Ireland and Australia also have some form of Capital Gains Tax.

In a recent speech, the Deputy Governor of the RBNZ suggested New Zealand needs fresh consideration around tax settings for housing, particularly for investors, sayinghousing is the most tax-preferred form of investment, particularly when it is highly leveraged. Indicators point to an increasing presence of investors in the Auckland market and this is no doubt being reinforced by the expectation of high rates of return based on untaxed capital gains.”

While we have seen positive steps forward by both the RBNZ and Government in addressing these issues, wider reform is needed. Limiting the expansion of private debt to both earnings and equity is important not only for those trying to buy a home, but to reduce the impact on competitiveness of the tradable sector through the exchange rate channel and cost of borrowing. More generally, the Government and RBNZ need to stop shying away from strong demand side changes, being sufficiently bold to tackle hard issues around the treatment of asset debt by the RBNZ, and fiscal policy changes by Government around the capital gains incentives.

23 comments to Briefing Papers 8: “Real Estate Debt and the Balance of Trade”

  • RB

    The first graph really says it all. To the Chinese most Western countries are seen as having cheap real estate. Until immigration fro China is addressed we will continue to witness the great sellout of major western cities, including Auckland. No surprises there. The only real surprise has been a government in constant denial.

    • Nick R

      That graph shows Hong Kong, not China proper.

      • Bruce

        And China proper also has had a massive housing bubble. That has turned now with prices falling there. The Auckland market is starting to turn with many auctions now failing (9/10 failed at an auction house I went to recently and it is happening all over the place).

  • JimboJones

    This country has had a pretty good result from adopting a free market approach to almost everything other than housing which for some reason we highly regulate. We don’t need more regulation to fix it; instead get rid of all restrictions other than those that are absolutely necessary. Let the market decide what types of residences are wanted, where they are wanted, what they are made out of, how much parking they have, how well they are built, who can buy them, etc.

    • harrymc

      ” how well they are built”. Now I disagree with your general thrust but this in particular?
      Have you heard of leaky homes? Do you know how much that has cost the productive economy? What a ridiculous statement.
      The free market works well in most areas (not all) but only when it is tightly regulated.
      Otherwise why not get rid of regulations on banks, finance companies (oh wait we tried that – how did that work out?), the labour market (zero hours contracts).

      • JimboJones

        But all our regulations and building inspections didn’t stop the leaky buildings!! Maybe if it was buyer beware the buyers would have done better due diligence and the builders wouldn’t have got away with poor quality. Or maybe the buyers would have insured against faulty building work. And even if they did leak, if they had paid half as much for them even a leaky house might not have cost as much all up as our overly regulated houses do.

      • JimboJones

        You can easily spend 100k on a car and no government do gooder checks it was built well. They may check for safety (I’ve got nothing against that), but that’s about it. Why is housing any different?

        • > Why is housing any different?

          Housing isn’t different! Most of the things you use every day from the “free market” are in fact heavily regulated for all sorts of reasons. Cars are an excellent example – is there anybody who wants a non-truthful odometer? Luckily for the 100% of people who want a working one, it’s required by law.

          Most of those things that are regulated aren’t necessarily inspected by the government, but it’s still a crime to violate or avoid them, as Volkswagen have recently found out.

          For the most part, our building industry isn’t that heavily regulated compared to other industries. Most aspects of building are not inspected by the government, but are self-certified by the professionals doing them. Once you’ve got a ticket to do a certain type of work, you’re trusted to do it properly. Water-tightness is an excellent example, since it’s mostly impossible to inspect the quality of the work after the fact. How is a house-buyer supposed to inspect the sealant applied to the rear of a retaining wall once it’s filled in, for example?

          And lastly, the housing market doesn’t allow for after-the-fact solutions. Building companies come and go like the wind – generally, there’s simply nobody left to sue if something goes wrong years later. Violating the Building Code, on the other hand, can potentially have criminal consequences.

          Regulation does add cost to building, but mostly that comes from A. supply, coverage and height restrictions that drive up the price of sections, and B. regulations requiring people have visible obvious things they may not want, such as balconies, yards, setbacks, extra bedrooms, excess parking, etc. These almost entirely are regulations of local government district plans, rather than the (central government) building code.

          • Frank McRae

            There are two different sets of regulations that need to be distinguished: building regulations, and planning regulations. The justification for regulating something to protect the consumer, and the level of regulation we accept on consumer goods like cars usually rates to things that the user cannot easily observe or understand. So safety standards are regulated on cars but there are no regulations forcing you to buy a bigger or higher spec’d car.

            Our building code regulations rightly relate to things that the consumer cannot easily observe. It’s not easy for a non-expert to tell if a house is watertight, structurally sound, or well insulated so those things are regulated. But when it comes to planning there are many rules which regulate things the non-expert consumer can easily observe themselves – like dwelling size, or ceiling height. The consumer is denied the chance to buy a sound but lower spec’d house the way one can buy a Honda Civic instead of a Lexus. Our planning rules mean everyone has to buy a Lexus when it comes to housing. It would be better if we let building regulations protect people from the things they can’t observe, and left planning regulations to deal with genuine externalities.

          • JimboJones

            I don’t agree that ‘the building code regulations rightly relate to things that the consumer cannot easily observe’. The building code covers the likes of garages, carports, etc – is this really necessary? And when you build a house there are a multitude of inspections to ensure the house is built right – are they all necessary? And even with all these checks, we still get leaky, poor quality houses!

            In these modern days a builder could easily take photos at certain times during the building work and pass them on to the first owners (or the council I guess but I don’t see any need for them to be involved at all). If the builder was to give false photos it would be a criminal offence. And if you buy a new house where the photos weren’t taken, you do so at your own risk. As a buyer you would want to make sure that your new home was built well – but the government doesn’t need to be involved in this.

            The building code also forces approved materials to be used which adds a significant cost to the build. Apparently it is perfectly safe to eat food produced in China, but very dangerous to use plaster board made in China in your house. Because of this fletcher can charge pretty much whatever they want for GIB board – which is why we pay something like four times the price they pay in the US.

            But yes the main gripe I have is more around planning than the building code.

          • JimboJones

            I had a look at Bunnings Australia website, a 1200×2400 sheet of ‘Gyprock’ costs $12.70. Unfortunately Bunnings NZ site doesn’t have the price of GIB board, but I think it is around $25. We are pretty much regulated to use GIB as it is too costly for other suppliers to get BRANZ / building code approval.
            Are you sure our stupid regulations don’t add to house prices?

          • Peter Nunns

            Well said, Stephen. There is a good case to regulate invisible aspects of buildings, and a weaker case to regulate things that are highly visible. Due diligence is much easier on the latter than the former.

            On Jimbo’s point, I wonder whether we have a case in which unnecessary rules are “crowding out” necessary ones. I.E. if it’s difficult to comply with one rule, people may have less resources/time to spend on other aspects.

            I could see this applying both to builders, who may have less money to spend on important but invisible building features after complying with other rules, and consenting authorities, who may spend too much time checking for compliance on stuff that buyers could decide.

            It’s hard to say for sure without having done an analysis of all the rules we’ve got and some we haven’t, though…

        • Bruce

          Not a single car manufacturer designs or builds cars in NZ anymore so we get cars of international standard. The same can’t be said of houses.

      • JimboJones

        And with finance companies, people assumed they were safe because they were ‘regulated’ by the reserve bank. Had they not been I think more people would have done their due diligence.

        • Realist

          What is not covered in your analysis is the need to protect people from unscrupulous developers. The lack of regulation in the CBD resulted in developments like “Zest”, which are not only an eyesore but resulted in chicken coop sized apartments. Why shouldnt poor people be able to buy an apartment that has rooms big enough to fit a bed and which have access to sunlight?

          The cost of aparments has more to do with:

          – developers not actually having any capital themselves (eg buy off plans, high interest costs)
          – non existent immigration control
          – lack of competition in building market

          Sure planning controls add to the cost, but they are not the key determinant

  • Realist

    Jimbo Jones – you obviously havent observed that most of the ills in society can be traced back to the “hands off” free market ideology introduced in the 1980s. Why on earth would “more of the same medicine” be a sensible approach?

    As the article explains, the key issue has been the derugulation of finance and surprise, surprise we get a bubble as a result. Wake up and smell the coffee!

    • JimboJones

      If the government hadn’t deregulated our car market do you think we would be driving better cars today? And do you think they would be cheaper? I doubt it.

      • Realist

        Well the car market is an interesting one. Total deregulation has meant a glut of cars and the serious congestion you see on our motorways every morning. Before deregulation we have far higher usage of buses and active modes. The problem is everyone wants the “free market” or “freedom of choice”, they just don’t like/ don’t think about the consequences!

  • James

    The only comment that makes sense in this post is the high NZ dollar is a negative to our export industry. Rather than trying to control that by intervention in the housing market (introducing cgt), the Govt could fix the NZD at a rate to the US that supports our export industry.
    Of course the Govt would be voted out at the next election because the public would be pissed off that a lower NZ dollar means they have to pay more for all the crap they buy (anything with an imported component), will no longer be able to afford cheap holidays overseas and the cost of petrol would go through the roof.
    Interestingly the building industry would suffer as new builds would become more expensive and the majority of NZ industry, that do not export, would bitch and moan about costs going up.
    John Walley is CEO of the NZ Manufacturers and EXPORTERS institute. of course he is going to push agenda that lowers the dollar value.

    • Peter Nunns

      We had a fixed exchange rate prior to 1984. It ended in tears.

      That being said, I think you’re making a valuable point, which is that the interests of consumers and producers do tend to diverge in a small, open economy. Some people argue that long-run living standards depend largely on our ability to produce and export more. I think there’s some truth to that, but how much I’m not sure.

      • JeffT

        I tend to find myself in two minds over this on-going government policy of being an export-led economy also. Yes greater net exports will improve the current account and balance of payments, ‘earning more than we spend’ as an economy, and a lower exchange rate will help achieve this. But as consumers we spend on many imported goods we do not produce here. If we can no longer afford to buy these imported goods due to a lower exchange rate how does that improve our standard of living? Impoverishing the nation to balance the books. There is some benefit in consumption-led growth.

  • JeffT

    Why has an affordability index been used for Hong Kong in Graph one instead of mainland China? Is it because mainland data was not available? Kong Kong housing prices, and I would think, incomes, are likely to be very different for the ratio than the mainland.

    NZ affordability and prices higher than Australia. Contrary to the argument our government have been using against demand-side policies (some of which are finally being implemented).

    Also, where is the debt being sourced? If it is from off-shore sources for off-shore buyers maybe not as big an impact.

  • Ted F

    It seems to me that the material costs here are far higher than they are in Australia.
    The cost design and compliance is also higher.
    The ability to buy a section and build a garage and live in it while you build your own house has been taken from the young folk of today.
    How can we get those things back to normal? or at least reasonable costs and opportunities.