House Price Inflation – is it fair?

The recent Auckland City Council property valuations indicate that there has been an average 33% increase in residential values over the last three years (about 10% pa). The Reserve Bank Housing Price Index (ie. house price inflation) indicates that the Auckland rate is reducing, with the year ending September 2014 rate being 8.4%. Nationally, house price inflation rate is now 5%.

House guests 3As Aucklanders have clamoured to the Council website to see what their new property value is, the general public response there has been positive and that people feel better off. But what is the reality of house price inflation?

How House Price Inflation Works

Consider this scenario. Say that a speculator bought a house in Auckland three years ago for $500,000 using full finance from a bank. Three years later the speculator sells the house to a new home buyer at a 33% price increase, that is $665,000, the average rise in house prices in the last three years. A bank agreed to fully finance all transactions (let’s assume the Reserve Bank’s 20% equity contribution doesn’t apply).

The profit, or capital gain, to the speculator is $165,000, assuming that the three years rental income covers loan interest payments, rates and insurance.
What is relevant to the three ‘players’ in this scenario?

The Bank
On sale/purchase day:

  • The bank credits the account of the first home buyer with $665,000. This money doesn’t come from depositor’s accounts, from cash held in the bank’s vaults, etc. It is just created by a bank clerk entering that number in the buyer’s bank account by way of a computer entry.
  • The buyer’s account is debited with $665,000 and the speculator’s account is credited with the same amount. This is essentially what happens, even though the money usually flows through lawyer’s trust accounts and different banks may be involved.
  • The speculator repays the original $500,000 loan to the bank, once again merely by computer entry.

Over time the new home buyer will pay to the bank the $665,000 borrowed plus interest. If the term of the loan is 20 years and the interest rate over that time 6%, then the total interest paid will be $478,424. If the term of the loan is 30 years and the rate of interest 8% then the total interest paid will be $1,091,632.

In respect of the inflationary portion ie. $165,000, the bank will receive interest of $118,707 for a 20 year/6% interest arrangement or $270,856 for a 30 year/8% interest arrangement. This additional interest paid by the new home buyer, and received as income by the bank, is directly as a result of the house price inflation over the three year period.

If the speculator leaves the $165,000 gain with the bank, then out of the interest received from the first home buyer, the bank will have to pay a portion to the speculator.

The Speculator
The speculator has four options, or any combination of these options:

  • Continue on with the $500,000 loan and purchase another house for $500,000, or $665,000.
  • Repay the $500,000 loan and leave the $165,000 gain on deposit with the bank.
  • Repay the loan and invest the $165,000 in shares or other financial investments.
  • Spend the $165,000 in the goods and services economy ie. on consumer items such as a car, TV, computer, furniture, food and drink, travel, clothes, entertainment, etc.

The First Home Buyer
These are the effects of the house price inflation on the first home buyer:

  • If the speculator spends the $165,000 gain on goods and services consumption, then the buyer in reality pays for the whole of that consumption. The speculator has provided no benefit to the buyer and in effect the buyer is supporting the income of the speculator in addition to their own.
  • The buyer pays to the bank additional interest of $118,707 – $270,856 as a result of the $165,000 increase in house price.
  • Also, the 33% increase in house price means that the first home buyer’s income would needed to have increased by $273 – $279 per week (ie. depending on the interest rate and loan term) to service the additional $165,000 of borrowings.
  • The buyer may be subject to minimum deposit requirements, imposed either by the bank or by the Reserve Bank. If the buyer was subject to a 20% deposit three years ago, then they would have needed $100,000 in savings in 2011 to buy the house the speculator bought. To buy the same house now subject to a 20% deposit, they would need $133,000. So if the buyer was just under the 20% threshold three years ago, they would have to have saved another $33,000 to buy the house which hasn’t changed it’s physical nature at all in three years – it’s still the same 3 bedroom house on the same section. To put it another way, the house purchasing power of the buyer’s $100,000 has decreased by about $25,000 to $75,000. In respect of the purchasing power of $100,000 for goods and services over the same three year period, there has only been a decrease of about $3,000, to $97,000.
  • Both the speculator and the bank provide no benefit to the buyer in respect of these amounts and in reality the buyer is paying these extra amounts to support the incomes of the speculator and bank employees and shareholders.

Who Benefits?

First Home Buyers
The objection to inflation is that it decreases the purchasing power of a currency. Strict Government control over goods and services inflation means that the purchasing power of our money remains. But there are very few controls over house price inflation, especially on a regional basis. So for a first home buyer in Auckland, the purchasing power of their savings is eroding at an average of about 10% per year. For those who are relying on their Kiwisaver investment as the cash contribution to their first house, the investment must return at least 10% per year, just for the house purchasing power of their investment to remain the same.

Housing bubbles always burst, as will the present Auckland bubble. For the first home buyer who buys towards the top of the market they may lose a substantial part of their equity contribution, as well as have suffered from the erosion of their purchasing power while they saved for their house.

When one considers that many first home buyers in the 25-35 age group have student loans to repay and young children to raise and pay for, you will appreciate their objection to funding as well the incomes of speculators and bankers.

Existing Houseowners
For existing houseowners, they don’t receive any benefit from house price inflation. If their house value has increased, it is likely that the values for other similar houses have also increased. So there is no benefit in selling and buying another similar house.

Existing houseowners can only benefit if they sell and trade down, or move to another region. Retired people often do this to fund their retirement. The monies released are reasonably protected by the low rate of goods and services price inflation.

People who use their house price inflation to borrow from the bank to buy a car, boat or overseas trip still have to pay the loan back from income. As consumer items, they are quite literally consumed, and have no lasting value.

Speculators
Speculators invariably benefit. Tenant income services their bank loans and other outgoings. If they have borrowed most of the money required for purchase, they are in a no profit situation and therefore pay no tax. Their capital gain is invariably tax free. There is a risk that their gain can be minimised by a housing bubble bursting.

Banks
Banks benefit from house price inflation as over time the total lending to housing increases from house price inflation. Over the last 30 years, the equity share of houseowners in their houses has decreased from 81.5% to 71%, with the share of bank household lending correspondingly increasing from 18.5% to 29% (from the Reserve Bank of New Zealand statistics ‘C18 Household Financial Assets & Liabilities’). In the USA and UK on average people have a 50% equity in their house with 50% being owed to the bank.

This increase in lending of course results in an increase in the total interest banks receive. The greater the disparity between people’s incomes and the price of housing, the longer the term people require to repay their loan. Again this increases the amount of interest banks receive.

Property Developers
Genuine property developers add value to land via roading, water and sewerage services and the houses built on the land. They are the people who actually provide housing for people. And as they are in business, they pay taxes on the profits they make. Further, bank lending to property development businesses requires considerable more ability than homeowner lending for speculation lending. So in speculative markets, property developers often have difficulty borrowing money from banks.

Speculators add no value to houses, invariably pay no taxes and bank borrowing is easily obtainable. Genuine property developers add real value, pay taxes and find bank borrowing difficult.

The Solutions

The following could be used to considerably reduce house price inflation:

  • A capital gains tax could be introduced by Government. While most proposals have excluded the family home, they contribute to the problem as much as speculators and banks. The tax rate could be at least the personal rate, or more. Obviously money actually spent on capital improvements should be excluded. This ensures that improvements aren’t in effect being double taxed.
  • Tax can be payable on sale, or annually. If paid on sale, people have the available money to pay. However rates is essentially a tax, and houseowners mostly appear to pay their rates.
  • As a condition of maintaining a banking licence, the Reserve Bank can prohibit bank lending for speculation on housing. This would not only address house price inflation, but also free banks to concentrate on business lending (an essential banking function) including genuine property developers. The Reserve Bank considers that the lending restrictions, such as the 20% minimum deposit condition, can control house price inflation. They also consider that the house price inflation in Auckland over the last three years isn’t a housing bubble.
  • Housing Corporation of NZ could be revamped by Government as a bank to provide first home buyers with mortgage loans, including full financing for first house purchases. The loan could be carried forward to replacement house purchases, provided speculative activity was not being engaged in. Interest rates could be in the range of 1%-2% to cover the cost of administration and the risk of default. This would result in homeowners being able to repay their loans in 10-15 years, rather than 20-30 years. Following repayment, homeowners would have a good number of years to save/invest for retirement, rather than relying on cashing up the inflation portion of their house value.
  • Government could decide that houses may only be purchased by New Zealand citizens or permanent residents, or businesses owned by such people, from funds sourced from within New Zealand (ie. not funded by overseas speculators).

Successive governments have been able to control goods and services price inflation. There is no reason why the same cannot be done with house price inflation. A price stable housing market would make New Zealand a fairer society rather than rewarding speculators who make money from no effort.

Banks have an important role in contributing to decisions about how economic resources are allocated, including housing. Their involvement in housing speculation doesn’t contribute to this role and they are simply engaging in exploitation for personal gain.

A price stable housing market would minimise boom and bust cycles in the building industry. And finally it would enable councils to increase housing according to long term demographic data and the positive objectives under the Resource Management Act.

Tony Banks
November 2014

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