It is inexcusable for banks to lend on ‘businesses’ incapable of outperforming a risk-free return without speculative capital gains
Opinion: Although Kiwis are arguably the most extreme property fanatics in the Anglosphere – at least those who have and can afford property – there are common threads that we share with other countries.
Though housing supply is often promoted as the chronic cause of the lack of housing affordability and building more homes the utopian solution for it, building more homes in our existing economic framework is unlikely to address housing affordability and more likely to reward and encourage property speculation.
In New Zealand homebuilders have produced record numbers of new homes in the past year, and housing shortage estimates are no longer being regularly reported in the media. However, eerily familiar headlines are commonplace overseas and call for 106,000 additional homes in Australia, 250,000 in Ireland, 3.5 million in Canada, 4 million in the UK and 6.5 million extra homes in the US to resolve their respective housing shortages and achieve affordability.
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Supply-side solutions are championed by politicians of all stripes because homebuilding generates jobs and economic activity. In a rare show of bipartisanship, the Labour and National parties recently enabled housing supply via intensification by jointly supporting the RMA Amendment Act.
However, it’s extremely unlikely that by building more homes, we are going to build our way to housing affordability and a healthy balance between household incomes, rents and house prices. Boosting housing supply is absolutely key to relieve overcrowding but mass production of million-dollar townhouses on postage stamp lots will not bring down house prices.
Despite alligator tears shed by landlords, about being unfairly treated and overly regulated in comparison with other businesses, debt-funded rental property acquisitions in the vast majority of cases are not genuine ‘businesses’
Moreover, if a rush of new supply is added to a hot, buoyant housing market, as was the case in Ireland before the global financial crisis, then this simply feeds housing speculators and causes prices to race further ahead of incomes and rents.
My recent research article on rental property purchases in Auckland found that nearly all are speculative and amount to bets placed on future capital gains. A further paper I co-authored found that investors’ speculative activity pushes up house prices. That said, it is critical to recognise that investors are enabled by a well-heeled accomplice: the bank.
Residential property investors are a core client of banks throughout the Anglosphere. Investors’ largest presence is in Australia where a fifth of all taxpayers own a rental property and over a third of new mortgage debt is used to fund investment purchases. Over the past decade roughly a quarter of new home loan debt in New Zealand was channelled to investors.
In America a quarter of homes are sold to investors with an increasing presence of institutional buyers. Canadian cities have seen a steady increase in investor activity, which currently nets a fifth of home purchases. In the UK, ‘Buy-to-let’ loans account for 14 percent of new mortgage debt, but in Ireland it is only two percent of new lending.
Despite alligator tears shed by landlords, about being unfairly treated and overly regulated in comparison with other businesses, debt-funded rental property acquisitions in the vast majority of cases are not genuine ‘businesses’. Based on current Auckland house prices and market rents, investors are buying dwellings with gross yields below 4 percent. This is simply the ratio between annual gross rent and the purchase price.
Of course, a landlord will never realise a gross yield because they must pay outgoings including insurance, rates, property management, maintenance, etc from their rental income. Even if you disregard interest payments, which tends to consume much, if not all, of the rental income, investors’ cash-on-cash returns will be considerably less than 4 percent. Put into context, current term deposit rates are over 5.5 percent.
Unsophisticated 'Ma and Pa investors' can potentially be excused for failing to appreciate the concept of risk and return, but it is inexcusable for commercial banks to lend on such ‘businesses’ incapable of outperforming a risk-free return in the absence of speculative capital gains. This same fundamental issue is facing all countries in the Anglosphere.
How can New Zealand be an exemplar on addressing debt-fuelled housing speculation?
Over the 12 months to February 2023, roughly $11 billion of new mortgage debt was created by banks to enable more than 21,000 Kiwi investors to purchase a rental property. The average loan was just over $500,000. Without specifics, it’s not possible to determine if all of these transactions were speculative but based on my previous research and the current high interest rates it is likely the vast majority were just that.
The Labour government has systematically sought to undermine investors and tilt the table in favour of first home buyers by extending the brightline test and gradually removing investors’ ability to deduct interest expenses when determining their tax liability on rental income. Both of these policies are on the chopping block if there is a change of government later this year.
What is missing are policies that address the banking sector and its direct role in housing speculation. Debt-to-income limits are now officially in the RBNZ’s toolkit but despite being initially considered as a demand-side solution a decade ago, this has moved at a glacial pace and will not be available until next March at the earliest. I believe a more radical approach is warranted.
To ensure residential property investment is genuinely about rental income and not capital gains then such acquisitions should be treated like their commercial property counterparts. When underwriting a commercial property loan an interest cover ratio is often applied. This is the ratio between the net operating income and the loan interest. They tend to range from as low as 1.2 to 3.0 but in all instances, there must be a positive rental income buffer.
Subjected to such underwriting standards, rental property loans would either be declined outright or investors would need to contribute far more cash towards their next purchase to satisfy an RBNZ-mandated interest cover ratio. Either way the flow of new credit into the housing market will reduce as will investors’ ability to outbid first-home buyers. Such a policy will move New Zealand’s housing market in the right direction – towards affordability.
