Chapter 4. NZ’S UNFORTUNATE LOVE OF HOUSING

I have already given you a preview that I assess New Zealanders’ love affair with housing to be perhaps our most significant economic handicap. It has unbalanced our economy and diverted funding from productive commercial investment.

HOW BAD IS THE PROBLEM?

The Economist produces a series of interactive charts available on the internet. They compare house price movements since 1980 in a great many countries. In that period of nearly 40 years New Zealand house prices rose in nominal terms by around 15.6 times, and in real terms by around 4.5 times. Over the same period the ratio of New Zealand’s house prices to NZ average incomes, increased 56%. Cap rates on New Zealand rental property over the period more than halved (which means the value of an investment property with an unchanged rental income over the period, more than doubled. If the rent also increased, then the value increase was multiple). On virtually all of these measures, New Zealand house and property prices are among the most overvalued in the world. It is not often New Zealand leads world economic statistics, but we do on house prices, and for all the wrong reasons.

Whether Covid induced economic changes will have an impact on house prices has yet to be seen. There is no doubt incomes will decline. The post-Covid impact on the all-important ratio between house prices and incomes is as yet unclear.

WHY HAS HOUSE INFLATION BEEN SO PRONOUNCED IN NZ?

1. Supply and demand. The Reserve Bank in its publication DP 2018/02 examined ‘Residential Construction and Population Growth in NZ 1996 to 2016’. The Bank concluded that over this 20 year period there was a construction shortfall of between 40,000 and 55,000 dwellings. The Bank suggested the shortfall had occurred particularly in the second of these two decades (when coincidentally New Zealand had very high immigration). It appears a shortage of houses, especially in Auckland, has helped drive prices higher.

2. Building and development costs and constraints. There are a small number of building material suppliers in New Zealand. The cost of building materials here is very high by world standards. Then the cost of building is very high. Local Bodies have added to these costs in two different ways. First, having been burnt by liability for ‘leaky homes’, councils’ building consent process is expensive and detailed, intended to prevent them being sued. Secondly, councils influence the amount of new housing land available. Council planners – (no doubt influenced by planning approaches in large cities overseas, and by policies adopted in countries with high population densities)- have limited the availability of residential subdivisions. Overseas cities seek to preserve a green belt around them. They force their residents into apartments, which are perceived to be cheaper to service with infrastructure. Auckland City in particular has pursued these same policies. They have resulted in not enough subdivisions being available to meet the needs of a population which has particularly been swollen by high immigration into Auckland over the last six or seven years (see chapter 9 on Immigration below). The need for these planning policies is highly debatable in low density New Zealand. But they are being determinedly pursued by planners and local bodies, and thereby driving up the cost of residential land. The high costs of sections and the high cost of building on them significantly contribute to high house prices.

3. Banks. My first home, purchased in 1972, cost $18,500. My mortgage was $15,000. Back then the spread between bank lending rates and bank borrowing costs was in the vicinity of 3%. So each year my mortgagee bank made 3% of $15,000 = $450 on my loan. Fast forward to recently, with mortgages of $500,000 common. Bank margins have dropped, lets say to 2%. So now a mortgagee bank makes $10,000 per annum from such a loan.

Banks have been HUGE beneficiaries of house inflation. Walk past a bank branch and you usually see Property Press advertising books outside. Have a look at bank profits over the past 20 years. They went through the roof. How did banks help drive price inflation in the property market? By offering easy mortgage credit on low (or even nil) deposits with teaser low interest rates for the first year or two. In fact, so keen were banks to take on new housing mortgages they had to be restrained with Loan -to-Value Ratios, issued by the Reserve Bank.

As discussed in the previous chapter, all three of the Basel sets of rules for determining required bank capital, specify that domestic house lending requires less capital to back it than business lending does. The whole structure under which our banking industry is established favours banks making housing loans. No wonder 60% of bank lending in New Zealand goes into domestic mortgages.

There is a further significant negative aspect to bank activity in the New Zealand housing market. Banks source a significant part of the funds they lend into the property market from offshore. The most recent Reserve Bank figures indicate that around 23% of non-equity bank funding within New Zealand is sourced from overseas. Offshore bank funding accounts for almost two-thirds of New Zealand’s net external liabilities, which are high relative to most other developed economies, because of New Zealand’s weak savings rate.

That means New Zealand banks create a vulnerability for the country, by borrowing so much offshore. They pay big interest bills to the offshore lenders, who provide these funds to them. In addition, our banks are primarily Australian owned. They remit profits they earn back to Australia.

In summary, Australian banks making extensive New Zealand housing loans significantly increases New Zealand’s private external indebtedness, and significantly worsens our balance of payments. It bears repeating: overpriced housing is a major problem for our international position as an economy. It is not just some domestic problem where Kiwis pay other Kiwis too much for their houses.

4. Central bank low interest policies. There is no doubt low interest rate policies followed by central banks around the world since 2008 have encouraged a bull market in virtually everything, including housing. New Zealand has been no exception. And that is what you would expect – cheap loans and plentiful credit have encouraged everyone to pile into the housing market whether it is overvalued by world standards or not. Realising its low interest policies were inflating house prices to dangerous levels the Reserve Bank then tried to minimise the worst effects by placing Loan-to-Value restrictions on bank lending. These definitely slowed the housing market: but also effectively shut out of the market most first home buyers, except those with parental financial support.

5. Favourable tax treatment of housing gains. The law on when you pay income tax on profits made from a house transaction has always been a nonsense. You pay income tax if you bought the property with the intention of reselling it at a profit. EVERYONE buys with the thought in the back of their mind of reselling at a profit. Automatic income tax on gains made if a property is sold within two years (the recently introduced position) is a start to reversing the significantly favourable treatment the New Zealand tax system offers the property market; but much more could be done.

Recent proposals to consider a Capital Gains Tax were never going to be much help in slowing the property market because they were always going to exempt gains made on owner-occupied homes. That capital gains tax has in any event been ruled out, so favourable tax treatment of gains from house price inflation remains. There is no doubt this has helped exacerbate New Zealand’s house price inflation. It is notable that Australia (which has a capital gains tax), has also had excessive house price inflation so perhaps the impact of a capital gains tax in restraining the housing market can be overstated. But it is surely the case, that very limited income tax, and no CGT at all on housing, is helping and (unless changed), will continue to help skew investment into the New Zealand housing market.

6. Vested interests. Our print media are struggling in the electronic age. Advertising generated from properties for sale is an important revenue source. The print media is not above putting out stories designed to put some more wind behind the housing market. The real estate industry is relied upon by a great number of agents and employees – many of whom in a buoyant market earn high incomes. They also want to see the market higher. And who acts as a counterbalance to these groups talking up the market? Perhaps the Reserve Bank on occasion; but for the most part, no one.

7. Rating valuations. Local bodies engage firms of valuers every three years to value all the properties in their district. Councils want high property valuations so their rates appear low by comparison. The valuation firms naturally oblige their council clients who are paying them. Homeowners usually also like to get high rating valuations because that shows their properties are increasing in value. It is now common to see properties advertised for sale with the Rating Valuation quoted. Sellers know, the RV is at times above the market value and try to use it to get a better price. Our rating system, with its three yearly valuations definitely helps drive house price inflation.

8. It’s the Kiwi way. This is surely the most significant cause of New Zealand housing inflation – the ingrained and unshakeable belief by a majority of New Zealanders that you accumulate wealth through the value of your house. New Zealanders have traditionally bought a house when marrying, paid off the mortgage over their working life and when their family has grown up, they sell the house at a vastly higher price, downsize their property or move into a rest home and live off the balance of the sale proceeds as their retirement nest egg.

A number of factors encourage this long established behaviour. House prices have indeed risen and delivered generous nest eggs for retirees. Most New Zealanders understand the property market (houses only ever go up in value, as my wife tells me). They feel comfortable with owning houses and uncomfortable with financial markets. Retirees lost billions in collapsed finance companies after 2008, for example. So New Zealanders are united in their view that the best way to accumulate wealth, is to own houses.

Our forebears left Europe to build better lives in this country. Owning your own house on its own quarter acre was a central part of that better life. That same belief is still deeply engrained in us. Hence our general upset when new purchasers are now being priced out of the market. They are being denied their birth right as New Zealanders. That doesn’t mean NZers want property prices to come down (voters always want more Government spending, and lower taxes). Rather this birth right of home ownership helps keep people striving to get into the market even at high prices.

Would a major post-Covid economic slowdown , in which house values were declining significantly, change this? An extreme housing market drop would surely put a dent in the belief that housing is the best investment. But if nothing else changes there has to be a good chance that eventually the market will come back to its overpriced present levels. So the country needs to adopt some changes during any Covid-induced housing market decline, to make it more difficult for the worst housing price excesses to return.

THE DOWNSIDE OF LOVING HOUSES

On balance houses do little for the country. My wife and I ran a law firm on the North Shore. After 20 years the firm had approximately $1million in work in progress, book debts, equipment, fit out, furniture, etc, which is about the worth of a North Shore house. Our firm employed about a dozen people. They collectively earned say $750,000 per annum, from which they paid income tax, ACC, etc. The firm made profits from which it paid income tax, GST, ACC, etc, etc. I expect the firm and its employees in total paid several hundred thousand dollars to the Inland Revenue Department each year.

My point should be obvious. A house creates jobs and income for the building industry when it is first built but after that it contributes little to the country each year. Indirectly the contribution of housing is negative because the house mortgages which underpin the housing market significantly originate from offshore, resulting in high levels of private overseas debt for the country and a negative contribution to our balance of payments.

On the other hand, a sum of money equating to the worth of an average New Zealand house, invested in a business, provides employment, tax revenue for the Government and far greater national benefit than putting that same sum into housing.

Before the NZ Super Fund and then KiwiSaver appeared (i.e., until the last 15 years) New Zealand did not have any funded public superannuation. The vast majority of our wealth has been tied up in housing. New Zealand banks have had to borrow from overseas to fund their domestic lending because there has been an inadequate fund of domestic savings within the country. This all leads to further adverse impacts on the balance of payments as bank interest costs and profits are remitted overseas.

Secondly, with most of the average New Zealander’s wealth tied up in housing, and with many citizens paying interest on their now very large mortgages, there is little money left in the economy for investment in productive investments. It is no accident New Zealand’s productivity growth is low; our investment in industrial research and development is below other countries; that ownership of our corporate sector has significantly passed into overseas hands. As a country, we spend too much of our funds on housing and don’t have enough left over to fund growth in the real economy.

Compare this with arguably the most successful economy in the world – Switzerland. There, house prices have been stable for the last 40 years, people are indifferent whether they rent or own their home; and the country has a fabulously wealthy commercial sector with a stable of many world leading companies, which the Swiss happily invest in and gain from.

If somehow we could prick the housing bubble and puncture New Zealanders’ belief that housing capital gains are how you accumulate wealth, the benefit in productivity growth and the jump in New Zealand’s economic progress would surely be dramatic. Introducing most New Zealanders to Kiwisaver and the advent of the NZ Super Fund, have both started to rebalance the economy towards the commercial sector – but both schemes are still in their relative infancy. Less emphasis on housing (if it could be achieved) would allow more savings and more locally sourced productive investment.

Our house prices are dangerous at their present levels. As we face life after the Covid lockdown with house prices relative to incomes at some of the highest levels in the world, there is a significant risk to both New Zealand’s economic wellbeing and the wellbeing of its highly mortgaged citizens. It was a US housing meltdown, for example, which led to the 2008 Global Financial Crisis. A housing meltdown in New Zealand would significantly damage the economy, potentially threatening some of our banks and badly hurt many over-mortgaged homeowners. If incomes drop after Covid and people cannot pay their large mortgages such an outcome is a definite risk.

High house prices hurt the young most. Even if prices never fall, young people are paying massive mortgages. At one stage there was even talk of a 50 year table mortgage being available. Who wants to spend 50 years paying off their home? If a young couple have $200,000 as a deposit, and have to pay $1m for a house, their mortgage is $800,000. If instead they were able to buy a house for $500,000, their mortgage would be $300,000. A reduction in house prices leads to a proportionally greater reduction in the amount of mortgages.

Not good for banks, but great for home owners. I haven’t done the calculation but with the same monthly payment you can probably pay off a $300,000 mortgage in 25% of the time it takes to pay off a $800,000 mortgage. Or the young family could pay less off their smaller mortgage and have more to live on. The Government’s ‘Working for Families’ income top-up for the lower paid could be reduced or scrapped.

The benefits of lower house prices are obvious in so many ways – except to existing traditional New Zealand homeowners using their home as an investment and the basis of their future retirement. Those homeowners want house prices to keep going up. They make up a very big number of the electorate and are a very powerful political force.

High house prices are resulting in declining housing standards. New Zealand has one of the lowest population densities in the world. There is plenty of room for us all to live with some space around us. We grow timber as a major industry. And yet the contortions in the housing market drive young New Zealanders into low quality, cramped apartments and houses on small plots of land. I looked at a hillside of new houses at Albany on the northern edge of Auckland recently and shuddered. There are apartments being built in Auckland which would be considered small even in Hong Kong. The quality of those new houses and apartments is poor – cheap materials and poor workmanship. In an attempt to try and achieve affordable housing we are significantly short-changing those of the next generation who can just afford to get their foot on the lowest level of the property ladder. It should make New Zealanders angry that our housing standards are going backwards so quickly.

WHAT COULD BE DONE TO REDUCE HOUSE PRICES?

1. Make the Commerce Commission more effective in increasing competition in the building materials sector and in trying to reduce building costs. It is not just petrol reselling, where the New Zealand economy is uncompetitive.

2. Reform local bodies to speed up consenting of new dwellings and the approval of more new subdivisional land. Pass a law, saying local bodies cannot be sued if they are negligent in granting any consent or in approving any building work. Then councils could stop watching their back and the consenting process could be streamlined. Cut out some of the costs involved. If local bodies did not have to fund their infrastructure from land development and reserve contributions they could afford to reduce their subdivisional levies. Create circumstances where local bodies approve more sections in their areas.

3. Allow immigrants to purchase a business at any time after arrival but not residential property in Auckland City or Queenstown (or in other areas where values are high) for say three years after arrival. Try to take some demand out of higher priced areas.

4. Replace our system of three-yearly rating revaluations with a local body property grading system. This would assign council tax grades to each property, not a value. The grade of your house would determine the amount of rates you pay. It is the system used in the UK. Not only does it reduce significantly the cost of the three yearly valuation process, it avoids issuing valuation figures which can be used by homeowners to try and support higher prices on their property. Put this system under the control of a nationwide independent Rates Grading Body so the opportunity local bodies have to encourage high valuations or grades within their own districts, is removed. (Note: this may not be appropriate if New Zealand moved to a wealth tax- see chapter 5 on tax).

5. Cut immigration numbers and temporary visa numbers much further. We haven’t got either the housing or the infrastructure for the immigrants who are here already – so why bring in more and compound the problems?

6. Tell banks that in calculating the tax they pay on their New Zealand profits they cannot deduct interest paid on any borrowing overseas. Raising funds internally would then become more attractive for banks and they would have to pay retirees a better return. New Zealand’s total private overseas debt would hopefully drop and our balance of payments improve, with less interest paid overseas by the banks. If banks responded by increasing their interest margins these increases would likely be offset by a low and falling Official Cash Rate, meaning mortgagors may not even notice the change.

7 Change the tax laws. Apply income tax to property gains where the property is sold say within three years of purchase. There would obviously need to be exemptions, for marital splits for example. Rather than thereafter an or all or nothing cut-off, attach tax to a reducing part of the profit. Say 100% of the profit is taxable in year 1-3; then 80% in year 4, 60% in year 5, etc. Also, bring in a capital gains or wealth tax, where a property sale falls outside these income tax periods.

8. Reintroduce stamp duty on property transactions. It is a big source of revenue for many overseas governments. New Zealand is a rare exception having no stamp duty at all. First-home buyers could be exempt. Overseas residents (to the extent they can still buy property) could pay perhaps double rates. Put the stamp duty on both vendors and purchasers – say, at 2% of the sale price each. Then give local bodies, say, 50% of the stamp duty revenue as an extra income source for them to make up for the subdivisional fees they lose if their consenting role is streamlined, much as Australia uses GST to fund the States. Local bodies have long complained that rates are their sole source of income. With the infrastructure demands they now face, stamp duty proceeds would be a useful extra income source for them.

9. To put a dent in the New Zealand love affair with housing, have super funds, business and political leaders constantly sell the message that a dollar saved (and thereby invested in commerce) is far better for the country than a dollar invested in housing.

If Covid does lead to a significant meltdown in house prices it would be painful in the short term but should be positive in the long term for the country. Householders would be horrified but would blame the economy not politicians for the decrease in their values. House prices would have already come down, so the key then would be for the country to adopt as many steps as possible, to try to minimise any bounce back in prices when the housing market finally stabilises.

SUMMARY

New Zealand’s overpriced housing is ultimately the result of this country’s capital being significantly misallocated, with far too much in property and far too little in businesses and in our sharemarket (investment in those sectors will automatically increase if Kiwisaver and NZ Super Fund both grow).

Misallocations in any economy always create risks that they will revert spontaneously in a market correction, dropping house prices significantly. The chance of that occurring in New Zealand after Covid is real. Even if we avoid such a significant correction, the misallocation will continue to provide a significant drag on the optimum performance of the economy in the future – low productivity growth surely being an example of the steady damage our distorted housing market is causing.

Bringing house prices down will lower average mortgages so people have more money in hand. Housing (without mum and dad’s help) will become less unaffordable, something a lot of people want to see happen for young people. Social disparity will thereby be reduced for the future.

Changing the investment mix of the country away from housing is a herculean task. But if the mix can be changed, first home buyers should be able to afford their first homes and the country’s economy should definitely receive an impetus to improve and grow. This change, weaning New Zealand off its housing addiction, is vital to our long term success as a country and as an economy. A post-Covid induced economic contraction, would potentially be a time for this to start to occur.

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