Negative Gearing: Be Patient, Don’t Muck With It

What will the impact be on the property market if the proposed changes by Labour go ahead to abolish negative gearing on old properties? What will life be like for investors? How will it affect first home buyers? Jeremy Sheppard from DSR Data walks us through the winners and losers.

Supply and demand

In a free market, prices rise when demand exceeds supply. But if the government tampers with the market, like seen in communist regimes, the natural law of supply and demand may be distorted.

What caused demand to exceed supply?

Some would argue that investors are responsible for the increased demand for property. And that might be true for Sydney and Melbourne for the most recent boom.

However, there have been booms in the past without such significant involvement from investors. This time was just a magic combination for investors. We shouldn’t apply a permanent measure for a temporary situation. Time will balance things out anyway as I’ll explain soon.

Australia is a truly great place to live, that’s the real reason why prices are so high here. We have a great economy and freedom from a lot of problems making hell-holes elsewhere in the world.

It makes sense that people want to live here which pushes up prices. If the government considers high prices to be a problem, they should look at modelling how other countries have maintained low prices with some of this:

• Civil war
• Famine
• Corruption
• Restricted education
• Poor health care
• Low technology
• No infrastructure
• Dictatorships

Implementing any of these strategies in Australia will quickly solve the demand problem.

Supply

To solve the “problem” with supply, government could reduce taxes charged on developers to build new properties. They could also look at relaxing development constraints.

However, without those taxes, vital infrastructure like water supply, electricity and sewerage would not be available. And without building constraints, developers could prop up any cardboard box like shack.

In other words, government should make it as easy as possible for shanty towns with no sewerage to spring up overnight everywhere.

In every boom, the response from developers has been: build, build, build. They make a buck by supplying to the demand. Eventually they balance out the supply and demand equation and normality is restored.

The same will happen to ease the current boom. It’s not something that needs fixing. Supply and demand in Sydney and Melbourne will probably balance out before Labour get into power anyway.

Impact on existing investors

Because the proposed change wouldn’t be retrospective, existing property investors would be largely unaffected. However, if they owned property in well-established areas where old properties dominate the landscape, there may be reduced capital growth.

Although such areas may still be in demand by owner-occupiers, the demand to buy old houses by investors would diminish. So the short term capital growth prospects for such areas might diminish too.

Impact on future investors

After the plan is introduced it would be tax-inefficient for investors to buy old properties. However, new properties are unattractive to many investors given:

• High margins applied by developers

• Lack of opportunity to add value through renovations

• Established areas have limited land available so new properties in established area are invariably units with little uniqueness

• New housing estates on the other hand are typically in poor capital growth locations distant from the CBD

• There is also a risk of the developer failing to complete the project or problems with quality of finish – all the usual risks with off-the-plan purchases that investors prefer to avoid

So the proposed change may knock a significant portion of investors out of the market. They may instead choose shares to be a better option.

Initially, this reduced demand from a segment of the buyers in the market is what would improve affordability. Investors roughly represent about a third of all buyers. Negatively geared investors represent a smaller proportion than that.

In the short-term it would be ugly for some. But eventually, the law of supply and demand would rebalance and either rent would rise or property would become scarce again pushing up prices.

Impact on developers

It’s not known if investors will switch to less effective new investments, or simply exit the market. In the 1st case, there would be an increased demand for new property. So developers would be licking their lips.

In the 2nd case, with decreased demand from investors and lower prices, more developers would find some deals simply unfeasible. Some might even go belly-up. Most would simply cancel less profitable projects.

Note that with less development projects, supply will quickly dry up and prices will start booming again. Supply and demand will have its way.

Impact on 1st home buyers

FHBs have been complaining recently that it is not possible to compete with investors. If investors target new developments, FHBs will be in an even worse position buying anything new.

But established areas with old properties are usually in better locations and therefore command a price tag well outside the reach of FHBs. So with no way of affording existing properties and more investors than ever to compete with over new properties, FHBs might be between a bigger rock and a harder place than they are now.

Impact on renters

If renters are still unable to convert to FHBs, I don’t think they’ll be stung by rising rents as much as some would suggest. Most landlords are already charging the top dollar possible. In fact, there may be a temporary drop in rents by landlords to secure their tenants rather than lose them as budding FHBs.

However, if investors are knocked out of the market and prices drop as planned, development will dry up. Developers won’t want their clientele diminished nor their profit margins cut. With less development supply is reduced which will eventually lead back to higher prices and higher rents again.

Suburbs most heavily impacted

Those suburbs most likely to feel the pain of the change would have the following characteristics assuming investors decide to pursue new developments:

• Suburbs with very little development currently or planned – means there is less interest from new buyers who might be investors

• Suburbs traditionally of interest to investor owners rather than owner occupiers – means a greater percentage of future buyers are affected by the change

• Unaffordable suburbs for FHBs – means buying activity from FHBs is unlikely to prop up the reduced demand from lack of investor interest

• Suburbs with a lot of old stock on the market at the time the plan is implemented – sellers will lose interest from investors and may be forced to drop prices further

Supply and demand feedback loop

Knocking investors out of the market to reduce demand has an effect on developers. With reduced clientele and reduced prices, there are reduced profit margins for developers. So they reduce their construction which reduces supply which eventually leads to price rises again. This brings investors back in and developers too.

That’s how supply and demand works. There’s an in-built feedback loop in a free market that ensures that eventually everything returns to normal. Don’t be spooked by markets that are out of balance for a couple of years.

It’s beautiful how it all works together. It sorts itself out – no need for the government to meddle in it.

Once property becomes cash-flow neutral under the new regime, investors will return to the market. Developers will follow that increased demand with increased supply and balance will once again be restored to the cosmos. Prices will continue to climb as they always have.

In a nutshell

You have two options to affect prices:

1. Decrease demand by making our country a hell-hole; or

2. Increase supply by encouraging shanty towns

A sudden tax change will merely create overnight winners and losers. But the same “problem” will reappear. Supply and demand will sort it all out naturally in time.

Australia is a great place to live – don’t muck with it.