Are we blowing bubbles?

Over the last six months the New Zealand Government has announced several housing and property policies, including an extension to the bright-line test, removing interest deductibility, the reintroduction of depreciation for commercial buildings, and more.

The impact these policies will have on the investment sentiment of New Zealanders is yet to be seen. Will they achieve the desired effect of cooling the housing market and help struggling businesses, or create unintended long-term consequences?

Todd Lauchlan, Managing Director of JLL, Infometrics Senior Economist and Director Brad Olsen, and Kiri Barfoot, Director at Barfoot & Thompson, provide MEttle with their views as to what this means for our country’s economy and the impacts they believe will emerge as the policies settle.

Residential properties acquired on or after 27 March 2021 (excluding “new builds”)
Bright-line test extendedCapital gains taxed if sell within 10 years, up from 5 yearsExcludes main home, but test tightened
Interest deductibility deniedNo deductions for new borrowing from 1 October 2021Deductions on existing borrowing phased out by 2024/25 year

Commercial and industrial buildings
Depreciation deductions reinstatedDepreciable from 2020/2021 yearExcludes residential buildings

Todd Lauchlan surmises that the bright-line test extension was something that most market participants saw coming. Despite seeing the bright-line test extension as quite onerous by international standards, he describes it as an understandable policy reaction to people moving en masse to invest in housing as an investment class.

“Fundamentally, if you’re exiting the residential housing market for capital gain you have to pay tax, so that’s not today’s problem. It may change the investment horizon for some investors, but many entering the housing market are longterm focused. If you are in that shorter-term trading market, then you’ve already been caught in the old tax regime.”

Kiri Barfoot agrees: “It will potentially have the adverse effect of people holding on to their property longer and actually reducing supply, which goes against what this policy is trying to achieve. If you look overseas, it hasn’t made a difference as people are still buying and selling, but when they sell, they either they take longer or try to get more money for the house to pay for the tax.”

“In the short-term people are adopting a ‘wait and see’ approach. Apart from the UK, which has a much watered down version of removal of interest expense deductibility, nobody seems to think this has happened overseas.

“Ultimately, it’s too early to say if this policy will achieve the Government’s desired effect straight away. What you can see is that new builds are now more attractive to people because they can still deduct interest and the bright-line test only applies for five years, not 10 years.”

However, Barfoot believes the cost of building a house in New Zealand is prohibitive compared to other countries.

“If the Government wants to tackle the supply issue it should consider the cost of building. Penalising landlords is not going to solve the problem.”

If the Government wants to tackle the supply issue it should consider the cost of building. Penalising landlords is not going to solve the problem.

Interest deductibility removal a slap for investors

Brad Olsen believes the surprise announcement of the removal of interest deductibility will change the mathematics of residential property investment for many people.

Before there was no downside. People are still looking for capital gains, but they also must be able to service their mortgage. The cashflow element was important because you needed to have a good enough rental income, but it was offset against your costs. Now you can’t do that, so your cashflow becomes much more important.”

Barfoot agrees: “Most property investors are quite conservative people. Many only own one rental and could have inherited it, becoming ‘accidental landlords’. They are not sitting at home, or out on their boat having a holiday because they’ve earned so much money from property. Most have big mortgages they need to service, and many didn’t mind subsidising the tenant or the rent because in the long term there’s an expectation of capital gain. Now they can’t deduct expenses, so where is the benefit?

“The wider implications are that maybe they don’t paint the house like they were planning, or the primary caregiver needs to go back to work to pay tax on the income no longer sheltered by interest deductions. Even though mortgage interest rates are going down, rates, insurance, meeting Healthy Home expectations are all going up, so there’s a lot of pressure on landlords.”

Olsen’s expectation is that there won’t be as many people jumping into the market from the investor point of view.

“I wouldn’t expect house prices to fall as there are still more people looking for properties than there are properties available, and even with more properties coming online as new builds, all of that takes time to work through.”

Are we blowing bigger bubbles?

So, what might the Government’s actions lead to? Lauchlan says that the depreciation change that came in last year reinstated the ability to depreciate commercial buildings, which is a very strong positive for that sector.

“From a macro level, it is a net positive. In the long-term this should mean more money delivered into the economy through new investment, new housing, Build to Rent and more.

“All things being equal, you will make less money buying an existing house, but for any other form of commercial property or residential new builds they are not affected by the changes.”

Olsen believes there is a potential risk that the Government’s latest policies may create a wider bubble but adds that stock market investment is less prone to a bubble, at least in the short-term.

“The stock market is much freer to operate. There are more options, if someone wants to put their money into a certain business, they are going to look at that business with a fair amount of regard to its future outlook. In property there are not as many options.”

The big challenge is investors are looking for returns says Olsen: “Previously you had a continuum where some people put their money into a term deposit that was low yield but very safe, through to housing and stocks that were riskier but generally delivered higher return. Now, term deposit returns are minimal, so everyone is shifting to the riskier angle. In a sense you could pump up a stock market bubble, but you could also see households start to take on much more risk than they thought they were.”

Will the policies achieve their goals?

Through a wholly political lens, Lauchlan observes that New Zealand’s housing market has underwritten the wealth of mum and dad Kiwis for a long time, so whatever the Government can do to try and get that investment into a more productive state probably means a net positive for the overall commercial real estate sector.

“It’s more of a momentum and sentiment driven policy, because in reality I don’t believe supply and demand has changed enough to drive prices up by 20+ per cent in one year.

“Ultimately, if you remove the tail wind and get the market to stabilise, then you allow the supply side to react, which is obviously part of that solution. It leaves a more stable long-term market and is a sensible response to a market getting out of kilter. I don’t think it will mean less money into real estate – I think it will mean less money going into residential housing.”

If you remove the tail wind and get the market to stabilise then you allow the supply to react which is obviously part of that solution. It leaves a more stable long-term market and is a sensible response to a market getting out of kilter.

Olsen believes that house prices will still go up, but at a slower clip.

“We’re likely to see an even faster deceleration of the housing market because of the pile-on of policy ideas and similar. We had already seen the loan to value ratio restrictions reimposed by the Reserve Bank, which knocked some wind out of investors sails, especially with the Reserve Bank going to a 40% LVR from May.”

Broadly speaking though, he says that he believes the Government’s policies will achieve the desired effect.

“However, I think it is important to step back and see how we got here. Over the last decade New Zealand hasn’t built enough houses to meet the growing population, and we saw a massive decline in construction activity, as well as a commensurate reduction in the supply of construction ability with builders heading to Australia. When building activity began again in New Zealand there was plenty of intention, but not enough resources to get going.”

What followed, he says, was a period of population growth running far faster than we could build to keep up, which created the current undersupply situation.

“Due to the undersupply, prices have continued to go up as there was an incentive relative to other forms of investment, particularly as investors weren’t getting taxed as much from the eventual sale of the property as they were from other forms of income.”

Olsen believes the latest policy changes are designed to do two things, which will in turn have at least two flow-on impacts.

“Firstly, in the short-term the Government wants to reduce the level of investment activity and speculation. Therefore, property may not guarantee as a good a return as investors previously thought, and investors need to do their financial sums and understand if they’ll actually make a profit.

“Secondly, over the medium-term they’ll build more houses. This extra building can’t happen in the short-term as we simply don’t have enough resources. The Government’s aim is to cool the current level of activity while also expanding the stock that is available and try and reduce the gap between supply and demand.”

Changing investor behaviour

Olsen believes the Government has provided a direct signal to investors that they are on notice, and that returns from property investment are no longer golden, locked-in opportunities.

“There is an element of risk that there’s not the perpetual rocketing gains coming through in the housing market.

“That’s quite a flip as it has shifted from mindless investing due to an ‘assured’ return, to something that’s just a little bit more ambivalent about the outcome – now you’ve got to do your homework. What we’ve seen over the last year with investment changes will need to prompt a greater conversation in New Zealand around financial risk and assessing. We need to be aware of what is happening because I worry too many people jump in feet first.”

What we’ve seen over the last year with investment changes will need to prompt a greater conversation in New Zealand about financial risk and assessing.

Is real estate still worth it?

From a commercial point of view, Lauchlan believes it is still a good investment in a risk-adjusted basis, particularly in locations like Auckland where there’s considerable economic activity and overseas investor interest.

“In the last year there has been significant changes in how people live, work and play, changes in lifestyles and more people entering the market. We still need to have net new investment, otherwise we’ll get gridlocked. New Zealand needs large organisations and new foreign investment to build new infrastructure, housing, and commercial property to cater for the strong demand and lessen the gap between supply and demand.”

Barfoot agrees: “If you look at investments over the longer term, property – whether it’s commercial or residential – is still a good long-term investment.”

Expectations are changing

To conclude, Olsen urges people to recognise that the risk environment is changing, and not only in property.

“It’s about what is motivating people to make money, where the money is coming from, and importantly what people want to do with their returns.

“There is going to be an underlying shift in the New Zealand market that property is not the be-all and end-all of investment. People have some strong views on what they expect from an investment option, and what they expect to do with their returns in terms of the social and cultural aspects as well as the economic underpinnings.

“If you’re someone who is creaming it in the housing space, from an economic point of view that’s great. But from an environmental, social, and cultural point of view there’s an emerging feeling that pure economic returns, at the detriment of peoples’ personal livelihoods, might not be an enduring way to run a business.”

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