Macro: A negative gearing bubble?

The ATO’s stats for the 2011-12 tax year reveal a nation of landlords under water. Is negative gearing a bubble, asks Macro’s Leith van Onselen?

Key Points

  • Two-thirds of property investors losing money
  • Real house prices growing at a far faster rate than real rents
  • Conditions ripe for a correction

If there is one thing that sets our housing market apart from most others, it’s the propensity for Australians to leverage into investment properties in the face of negative income returns.

Negative gearing occurs when an investor borrows money to buy an asset, but the income generated by that asset does not cover the interest on the loan. By definition, a negative gearing strategy can only make a profit if the asset rises in value by enough to cover the shortfall between the income received and the costs incurred from the asset. Alternatively, a negatively geared property may become neutrally or positively geared in a period of high rental increases.

Australia’s negative gearing rules are unusual in that they allow investors in both property and shares to write off their borrowing and other holding costs against all sources of income (including labour income), not just the income generated by the asset. There are also no limitations on the income of the taxpayer, on the size of losses, or the period over which losses can be deducted.

By contrast, in most other countries, rental property expenses cannot be deducted against unrelated labour income, which effectively limits negative gearing to professional investors and developers.

To date, negative gearing has been a successful investment strategy. When combined with the Government’s 1999 decision to change the nation’s capital gains tax (CGT) rules by halving the rate of tax payable on capital gains earned on assets held for more than 12 months, Australia's strong house price appreciation since the late 1990s has enabled investors to make good after-tax returns.

There is a dark side, however. Investors are increasingly crowding out first home buyers, consigning an increasing proportion of younger Australians to a lifetime of renting, or paying off jumbo-sized mortgages.

Insatiable appetite

The ability of investors to minimise tax via negative gearing, combined with easier access to credit and the halving of CGT in 1999, has seen the popularity of property investment in Australia surge, as highlighted by Chart 1.

As the Chart shows, Australia has morphed into a nation of landlords. In 1989-90, 7.4% of taxpayers reported net rental income to the Australian Taxation Office (ATO). In 2011-12, that figure was almost 15%.

Moreover, in 1998-99 the number of investors claiming net rental profits (ie positively geared) was roughly equal to those claiming net rental losses (ie negatively geared). The latest ATO data shows that two-thirds of all property investment is now negatively geared (see Chart 2), with aggregate losses totaling $7.9 billion in 2011-12, largely because real house prices have appreciated at a rate far faster than real rents over the past 14 years.

There are two logical explanations from the surge in negatively geared property investment (and property investment more generally) from the late-1990s.

First, financial deregulation led to a surge of new loan products in the mid-1990s, including those targeted at investors. These included interest only loans as well as the new-found ability to purchase an investment property through accessing equity in one's existing home, without a deposit.

Second, the Federal Government’s decision in 1999 to halve the rate of CGT payable on capital gains earned on assets held for more than 12 months encouraged investors to speculate on rising housing values, in full knowledge that any losses would reduce their overall tax liability and any capital gains would be taxed at only half the rate of labour income.

The net result of these developments is that Australian investors have increasingly become Ponzi borrowers – Hyman Minsky’s term for borrowers that rely heavily on capital gains to repay debt and interest – in the belief that housing is a sure-fire investment winner.

That said, aggregate rental losses in 2011-12 were lower than the 2007-08 peak when property investors claimed a record $9.1 billion of losses. They were also below the $8.3 billion of losses claimed in the prior financial year (2010-11). Given that average mortgage rates decreased further to 6.5% over 2012-13, next year’s ATO Taxation Statistics (covering FY13) will likely reveal a further reduction in aggregate rental losses.

However, for the 2013-14 year, it’s likely that investor losses will increase once more. While standard variable mortgage rates have fallen further this financial year – to an average of 6.0% over the first 10 months – investor buying has increased significantly while house price growth has decoupled from rents and rental yields have shrunk. This points to increasing negatively geared investment and rising overall rental losses, particularly in Sydney and Melbourne.

Rental losses big proportion of income

As Chart 3 shows, rental losses across all investment properties nationally averaged $4,146 per investor in 2011-12, or 7.9% of average taxable income. However, losses for negatively geared investors were much higher, totaling $10,895 per investor in 2011-12, or 21% of average taxable income.

According to the ATO statistics, property investment is most popular amongst higher income earners, presumably due to the increased tax benefits on offer as one moves up the marginal tax scale.

In 2011-12, 35% of taxpayers earning over $180,000 held an investment property, with 24% negatively geared. By comparison, 15% of taxpayers earning between $50,000 and $60,000 held an investment property in 2011-12, with 11% negatively geared.

However, while property investment is more prevalent amongst higher income earners, the majority of rental properties are held by middle-to-lower income earners, with 72% of all property investors (62% of negatively geared investors) earning less than $80,000 per annum in 2011-12.

The average reported losses on investment properties are also a significant percentage of taxable income. In 2011-12, average net rental losses are mostly between 4% and 8% of income, with relative losses higher at lower tax brackets, despite higher income earners suffering significantly higher dollar losses.

For negatively geared investors only, average net rental losses were much higher in 2011-12, mostly comprising between 10% and 20% of taxable income. Again, percentage losses were heavily skewed towards the lower income brackets, with higher income brackets incurring higher dollar losses.

Boomer threat

What kind of threat, if any, does this pose? It’s possible that as the baby boomers, who own the lion's share of investment properties, retire en masse and sell down their assets to fund their lifestyles, the property market could be in for a very tough time.

Negative gearing is only attractive as a tax minimisation strategy when there is labour income to offset rental losses against. Once the baby boomers enter retirement, they lose the ability to offset tax and negatively geared property investment loses its attractiveness.

And the incentive to sell off property will be greatest among the lower-to-middle income earners that hold the bulk of Australia’s negatively geared investment properties, many of whom are likely also to be baby boomers. Still, the retirement of the baby boomer generation has only just begun. With the oldest members having turned 65 in 2011, this process could take a decade to play out.

In the meantime, the financial repression from Australia's record low mortgage rates has recently driven frenzied buying of investment properties, and that spells more problems.

According to ABS housing finance data, the proportion of housing loans (excluding refinancings) going to investors has hit a near record 46% (see chart 4).

The recent surge in investor demand nationally has been driven by Australia's two biggest states – New South Wales and Victoria – where investor mortgage demand has reached record highs of 53% and 45% respectively, with both states also leading the nation's price growth in the year to April, according to RP Data.

Fragile footing

Arguably, the current make-up of Australian mortgage demand is not conducive to sustainable house price growth. Investors are more likely to cut and run as soon as conditions change. This places Australian housing on a more fragile footing than if demand was driven primarily by owner-occupiers, who tend to buy into housing for the longer term.

Indeed, the strong run-up in prices, combined with soft rental growth, has caused rental yields to contract, particularly in Sydney and Melbourne. In the year to April, dwelling values across the five major capitals rose by 11.7% compared to rental growth of just 2.3%, with Melbourne and Sydney gross house yields plummeting to well below 4%.

Expecting ongoing solid capital growth in the face of declining yield suggests a strong belief in the ‘greater fool theory’, and is ultimately unsustainable.

Added to this view that investor demand will likely soon evaporate is the fact that Australian housing valuations are likely to hit their highest level on record later this year, just as the economy embarks on its biggest adjustment since the early-1990s recession. Meanwhile, income growth is likely to remain anaemic as the unwinding of the biggest commodity price boom in the nation's history continues to drag on national incomes.

These factors combined should keep unemployment elevated and ultimately reduce the scope for sustainable house price and rental growth, in turn diminishing the potential returns from housing speculation.

In summary, Macro Business believes that now is definitely not the time to be gearing up into property speculation, with the risk of a correction some time in the near future arguably greater now than at any other time in living memory.

 

Leith is an economist previously of the Australian Treasury, Victorian Treasury and Goldman Sachs. He writes as the Unconventional Economist at Macro Business.

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