RBA: Productivity Commission Inquiry on First Home Ownership

The Reserve Bank welcomes the Productivity Commission Inquiry on First Home Ownership. The terms of reference cover a wide range of subjects. This submission will not attempt to cover all of them, as we would not consider ourselves to be experts in a number of these areas. It will confine itself to addressing the questions of whether housing is becoming less affordable for first-home buyers and, if so, why. The answer to the second question will provide a focus on areas for further examination or possible action.

In preparing this submission, special attention was paid to identifying those developments that were unusual by Australia's past standards, or unusual by the standards of other comparable countries. In order to accomplish the latter task, we held discussions with the relevant authorities in the United States, Canada, the United Kingdom and the Netherlands.

The central fact from which any discussion of affordability must start is that there has been a more than doubling in house prices over the past decade, and that strong price rises are still occurring. This is shown by all the indices of house prices, which also confirm that, unlike some earlier booms in house prices that were specific to certain areas, this one is Australia-wide. The ratio of the price of the average home to average income has risen sharply, as has the cost of servicing the mortgage if the home is acquired, making it increasingly difficult over recent years for first-home buyers to achieve home ownership.

The major reason that house prices have risen so much relative to incomes over the past decade or so is that interest rates on mortgages have approximately halved (comparing the second half of the 1990s with the second half of the 1980s). This structural reduction in nominal interest rates has been principally a result of the transition to low inflation. The housing market is an unusual market in that most purchases are made using debt. Because of the fall in interest rates, households have been able to afford to service much more debt, and this has greatly increased their purchasing power. This, in turn, has enabled them to compete with other households for more expensive houses. But this additional purchasing power is not confined to first-home buyers; indeed, existing home owners, with accumulated equity in their houses, have been in a much stronger position to compete than first-time buyers.

Mortgage interest rates have been relatively stable at a low rate now for the past half-dozen years. If the decline in mortgage rates for owner-occupiers was the only thing at work in pushing up borrowing and prices, then that trend should be tapering off by now, so that house prices would be rising by no more than could be explained by the underlying growth in incomes. Instead, house prices have continued to rise rapidly and credit to finance house purchases has been accelerating. So we must look for additional factors at work. The three main possibilities are:

there is a structural problem which means the supply of new dwellings is not keeping up with underlying demand;
various state and federal government taxes or grants have pushed up house prices;
demand to own dwellings as assets is being boosted to an unusual extent by considerations of expected returns, with households seeking an increased exposure to property through their own home and/or through purchase of one or more investment properties.

We have not examined supply influences in detail, but at the macro level there is not much evidence to suggest that the growth in house prices has been due to a persistent shortage of supply of houses relative to underlying demand for new housing. The two main determinants of underlying demand – population growth and the rate of household formation – have not been high by historical standards. Even though underlying demand does seem to have risen in the past couple of years, declining rental yields and rising vacancy rates suggest overall supply has at least kept up with demand. There may be mismatches between supply and underlying demand at the micro level, for particular types of housing (e.g. detached houses versus apartments) or for particular locations, and these factors may be important in explaining differences in price movements across the major cities. However, at an aggregate level these factors do not appear to be the main reason for the rapid increase in dwelling prices over the most recent couple of years.

The second possibility is that government activity in raising revenue or in assisting home buyers may have pushed up house prices. It has, for example, been asserted that state government stamp duty on property transfer has been a major cause. The pattern of stamp duty varies from state to state, and it is difficult to discern any economically logical basis to the system. In our view, however, stamp duty has not pushed up house prices, for reasons elaborated in the body of the submission. There can be little doubt, on the other hand, that when stamp duty is applied to first-home buyers, it increases the 'deposit gap' they face, and thus makes home purchase more difficult.

It has also been suggested that the Federal Government's First Home Owner Grant (FHOG) and Commonwealth Additional Grant (CAG) contributed to the rise in house prices by adding to the purchasing power of first-home buyers. In our view, the net effect of these schemes has been clearly beneficial for first-home buyers through reducing the 'deposit gap', and the effect on house prices has been minor. The FHOG was compensation for the effects of the GST, and the CAG was a temporary and effective means of shifting housing demand to a period of low activity from a period of high activity.

It is our view that the main impetus to the continued increase in house prices at present is from the third of the three possibilities noted in paragraph 5: an unusually strong desire by existing property owners for further exposure to residential property, either in their own home, or in an investment property.

The role of investors is particularly noteworthy in the current episode. For every new dollar lent for housing purposes, around 40 cents now goes to investors – a figure much higher than we have ever experienced before. The stock of credit outstanding is rising at nearly 20 per cent per year for owner-occupiers – an exceptionally rapid pace – but for investors the growth rate is closer to 30 per cent per year.

As a result, prices of residential property have been lifted to the point where the rental yield has reached an extremely low rate. At present, the gross yields are reported to be around 3½ per cent which means that, after payment of municipal rates, water rates, management fees, strata levies, maintenance, etc., the cash yield is around 2½ per cent or a little lower. The gross yield on residential property in other comparable countries is typically between 7 and 10 per cent. In Australia, the typical yields on industrial, commercial and retail property are 8–9 per cent. These are the sorts of yields required to get professional property investors to invest in property, yet households are investing at less than half these yields.

Thus, we find support for the view that investors have been contributing disproportionately to the increase in housing demand over recent years, with the effect that affordability, especially by first-home buyers, has been reduced. We accept that owner-occupiers moving to more expensive and better houses is also an important influence on prices, but it is the investor demand that is growing most rapidly.

The dominant role played by investors in Australia in the current cycle is the result of interaction between:

the desire of investors to earn capital gains from investing in rental property;
the ease of obtaining finance to enter this activity; and
the taxation treatment of investments in residential property.

Regarding the first of these factors, there is a common belief that house prices cannot fall, or if they did, the fall would be small and short-lived. It is not surprising that this view – essentially an extrapolation of the past three decades' experience – is so widely held. The fact that house prices have fallen noticeably in some other developed countries, or that at times they have fallen in real terms in Australia, does not seem to have shaken this belief. In addition, falls in equity prices and recent revelations of governance weaknesses in corporations and investment banks around the world have increased the perceived attractiveness of property relative to other forms of investment.

The second factor is the ease of obtaining finance. In earlier decades, investment in rental property was an option only for the well-off and well-connected because of the difficulty in obtaining finance. Over the past decade or so, finance for this activity has become much more widely available. Banks and other providers of finance are now eager to lend to households for investment purposes based on the collateral in their own homes. There is no longer an interest-rate penalty, low-equity and interest only loans are readily available, as are split-purpose loans and innovations such as the deposit bond. The property investment seminar industry has expanded in a way not seen in other countries. The up-front cash cost of buying an established investment property is virtually nil for a household which has a reasonable amount of equity in its own home. For an 'off-the-plan' purchase, the up-front cash cost is not much higher – about 1 per cent of the total purchase price if using a deposit bond. In examining these trends in the availability of finance for investor housing, we do not find evidence of a widespread deterioration in lending practices by financial institutions. Rather, these developments are the inevitable result of ongoing innovation and competitive pressures within the finance sector.

The third factor is the tax system and the desire for tax minimisation. In Australia, where the top marginal tax rate on income cuts in at a relatively low income ($62,501), there is a large proportion of taxpayers who are attracted to investments which will lighten their tax burden. This has long been the case, and has recently been accentuated by the success which the property investment seminar industry has had in emphasising the tax effectiveness of property as an investment choice. A big attraction of property is the relatively modest after-tax holding cost of even a low-yielding property, due to the way that investments in rental property are taxed. In the body of the submission, we give some arithmetic examples of the low after-tax holding cost of rental property.

We wish to make it clear that we are not challenging the validity of the concept of negative gearing, whereby losses on one economic activity – in this case, being a landlord – can be offset against a person's principal source of income. Negative gearing per se does not necessarily mean that the tax system is overly investor friendly to rental property; negative gearing also applies to losses incurred on other assets. Negative gearing systems can be designed and administered with varying degrees of investor-friendliness, as the experience of other countries shows.

In fact, there are no specific aspects of current tax arrangements designed to encourage investment in property relative to other investments in the Australian tax system. Nor is there any recent tax policy initiative we can point to that accounts for the rapid growth in geared property investment. But the fact is that when we observe the results, resources and finance are being disproportionately channelled into this area, and property promoters use tax effectiveness as an important selling point.

To summarise the above, the key structural characteristics of the Australian housing market which distinguish it from markets in other countries studied in preparing this submission are:

a high proportion of individuals own rental properties;
a high and rising proportion of lending for housing directed to households for investment purposes;
very low rental rates of return on residential property;
plentiful availability and variety of credit available to investors;
an active property investment seminar industry; and
a tax system which is viewed by investors as assisting property investment.

Any policy response to the current difficulties faced by first-home buyers needs to take into account all of these factors. We set out some possibilities in paragraphs 21 to 25 below.

First, we have no specific suggestions for assisting first-home owners by adding to their purchasing power. However, if this path were to be chosen, it is important to remember that simply adding another source of purchasing power to the existing demand would lead to some further rise in prices. For this not to occur, any measures that add to purchasing power need to be carefully targeted to limit their effect on overall demand, and balanced by a reduction in demand elsewhere.

Second, the most sensible area to look for moderation of demand is among investors. While it is not for the Bank to make specific recommendations for changes to the tax system, the work undertaken in preparing this submission has highlighted a number of areas in which the taxation treatment in Australia is more favourable to investors than is the case in other countries. In particular, the following areas appear worthy of further study by the Productivity Commission:

the ability to negatively gear an investment property when there is little prospect of the property being cash-flow positive for many years;
the benefit that investors receive by virtue of the fact that when property depreciation allowances are 'clawed back' through the capital gains tax, the rate of tax is lower than the rate that applied when depreciation was allowed in the first place.
the general treatment of property depreciation, including the ability to claim depreciation on loss-making investments.

Any changes in these arrangements probably cannot be divorced from the general tax structure, including the level of marginal income tax rates faced by investors and the point in the income distribution at which they cut in. Any changes would also need to take into account how they would affect other asset classes.

As an additional point, we welcome initiatives by the Australian Tax Office to tighten enforcement of the existing tax law with respect to property investment, and would encourage a continuation of these initiatives.

Third, while a number of steps have been taken recently to bring the property investment seminar industry under closer regulation, a more consistent and unified regulatory framework is needed in this area.

Fourth, there should be some consideration given to evaluating how state stamp duty raises the barrier to home ownership by first-home buyers who, as a class, are most restricted by their capacity to overcome the 'deposit gap'.

Fifth, while we do not believe supply deficiencies at a macro level are the main reason for the reduction in affordability for first-home buyers, there may well be possibilities for increasing the responsiveness of supply and speeding up the approval process. Importantly, we do know the direction of the influence of increased supply – it will put downward pressure on prices in at least some areas of the housing market.

The body of this submission is set out in three parts. The first part presents the main facts concerning the trends in house prices, borrowing for housing, and affordability. The second part evaluates the possible explanations for the increases in house prices observed over recent years. The third part suggests areas that could be examined further as possible means of alleviating the current pressures on affordability for first-home buyers.

PRODUCTIVITY COMMISSION INQUIRY ON FIRST HOME OWNERSHIP

Executive Summary