Tuesday, 16 May 2017

Negative gearing on rental properties, and the effect on rents

Negative gearing occurs when an investor borrows money to purchase a rental property, and the rental income from that property is less than the costs of operating the rental property (including costs like property rates, insurance, maintenance, and interest on the loan). In many countries, these losses cannot be offset against other income to reduce the investor's taxable income, but in New Zealand they can. This provides a greater incentive to own rental property in New Zealand relative to other countries, especially given that capital gains on the value of the property are not taxable (unless you sell within two years - the so-called 'bright line' test that was recently introduced).

Negative gearing has been in the news this week because of Labour's proposal to ring-fence losses on rental property, so that they would not be able to be used to offset other income and reduce the investor's overall tax liability. The Property Investors Federation immediately squealed (as you would expect - their members will be made worse off if this proposal goes ahead), and claimed that this would raise rents. In contrast, we have this today:
Tenants Protection Association Christchurch manager Di Harwood said tenants shouldn't be worried about the policy backfiring on them...
Harwood said it was difficult to see how cutting the negative gearing tax break would make things harder for the average landlord, as it was a perk at the end of the tax year, rather than a week-by-week cost.
Renters United spokeswoman Kayla Healey said the idea was "fantastic", and getting rid of negative gearing would be good for renters...
She said it was a common argument that such changes would push up rents.
"But at the moment, I think rents now are as high as they possibly could be.
"Demand is so high landlords are charging as much as they possibly can already.
"I don't think this would have any impact overall on rents."
So, who's right in this debate? It actually depends. But before I get to that, let's think carefully about the statement by Kayla Healey: "Demand is so high landlords are charging as much as they possibly can already." I can assure you, rents could go higher. If she thinks rents are already "as high as they possibly could be", she clearly hasn't looked at the cost of renting in San Francisco or New York (yes, that's US$3500 per month for a one-bedroom apartment in San Francisco. And that's the average).

Removing the tax deduction for negative gearing won't affect all landlords, but it will affect at least some of them (91,000 according to this Herald editorial, which does a good job of laying out the debate). That equates to a higher cost for those landlords of owning a property. If we think of a really simple supply-and-demand analysis, higher costs shift the supply curve up and to the left, and raise prices. And that's exactly what the Property Investors Federation is claiming will happen - fewer rental properties available, and higher rents.

But that's not the end of the story. Removing the tax deduction for negative gearing makes owning rental properties less attractive for investors (relative to other investments they could put their money into). Some of them will sell their properties, and on top of that fewer investors will want to buy properties. That leads to both an increase in supply of homes for sale, and a decrease in demand for those homes. This will put some downward pressure on house prices. But lower house prices make it less costly for new landlords to own property (or less costly for existing landlords to add to their property portfolio) - for example, they'll now need a smaller mortgage for any new properties they buy. Over time, this will reduce landlords' costs (shifting the supply curve down and to the right), decreasing rents. On top of that, some previous renters might be able to buy the now-cheaper homes instead, reducing demand for rental properties (which again, lowers rents).

So, who is right? Both sides probably are. Rents will likely rise in the short term if this policy is implemented, but as house prices decrease, rents will fall (or rather, they will be lower relative to what they would have been without the policy - it's unlikely that rents will actually decrease).

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