When changes to interest deductibility bite, interest rates rise (and the higher 40% deposit required by investors) click in unison, investors will feel the pressure. This confluence of external factors comes at the end of a period of unprecedented price growth, a dark cloud on the horizon. But what are the real implications for investors? And will these changes lead to a levelling off of the market?

The Government and Reserve Bank have been trying, through tax change policies and loan-to-value ratios (LVRs), to cool the housing market for the best part of a year. So far it has had little effect – apart from putting a dampener on investors holding one or two residential properties, who have taken a back seat, while the more substantial property portfolio holders have continued buying.

And now, the broad rule preventing most property investors from offsetting interest charges against their taxable income is being touted by Finance Minister Grant Robertson as the centrepiece of a package intended to rein back surging house prices. Over the first four years the Government is expecting tax deductions to drop by between $1 billion and about $1.8 billion.

ANZ senior economist Sharon Zollner says the tax changes, in particular, are “massive” for the Government, because it risks upsetting a large voting base. “It’s brave. It’s a pretty significant levelling of the playing field.”And the fact they are retrospective means large numbers of people will experience an increase in their tax bills. But at a macroeconomic level, she says it’s difficult to engineer a soft landing from vertical take-off: so there are unlikely to be house price falls.

Just look at the figures. While house price growth has shown signs of cooling recently, with monthly growth in some regions falling to 1-2%, the market is remarkably resilient. QV figures show the value of houses rose 3.6% nationally over the three months to the end of September, up from 3.3% in August.

The national average value of a house now sits at $977,456. This represents an increase of 26.3% year-on-year, down a fraction from 26.6% in August.

Advice Dismissed

Interestingly, Inland Revenue did not want the Government to go ahead with the tax changes. The Government ignored IRD’s advice which warned the tax changes will risk rents rising and increase opportunities for tax avoidance. “Affordability for renters will not be promoted by taxing the provision of rental properties by landlords more heavily.”

It also warned the changes will increase compliance costs for 250,000 taxpayers likely to be hit by the new tax rules. It will also increase Inland Revenue’s costs, as it chases people for compliance.

Independent economist Tony Alexander says he is not surprised the Government ignored the IRD’s advice. “It is consistent with the Beehive’s behaviour in other areas. It didn’t take any advice or consult before banning gas and oil exploration nor on its proposal to insert a clause in commercial landlords’ leases forcing them to offer rent relief to all tenants during alert levels four and three whether they need it or not. It was dropped on commercial landlords without any warning.”

He says some investors, particularly with only one or two properties are struggling to get their heads around the tax changes, but investors with bigger portfolios are reducing debt and for some that means selling property.

“There has definitely been an impact on the willingness of investors to buy,” Alexander says. His surveys of real estate agents, spending and property management show a slow pull-back in buying.

“The bigger impact will be when investors with smaller portfolios look at their capital gains and then realise their income is not what they expected after mortgage tax deductibility starts to be phased out and sell,” says Alexander. “It will be different for the bigger portfolio holders as they primarily consider yields when buying and will keep purchasing.”

The tax changes, he says, will not be as painful as interest rate rises now the Reserve Bank has started raising the OCR and subsequently the major trading banks are increasing mortgage interest rates. The extreme pain won’t kick in for a couple of years.

The Reserve Bank lifted the OCR on October 5 by 0.25% to 0.50%. It is the first in a series of hikes towards 1.5% and possibly higher. Economists expect further 0.25% increases in November, February and May with the OCR reaching 1.5% by the middle of next year. The Reserve Bank is signalling a continuation to 2% in 2023.

Alexander believes the lift to 2% will not be the end and the Reserve Bank will lift the OCR higher. “While interest rates will not go back to where they were in the past, there will be a substantial rise because we are living in a higher inflationary environment. “Even with elevated inflation and interest rates people still look favourably on housing as an investment asset.

“Over time as yields diminish, investors may look at a more diversified portfolio to include more money deposited into KiwiSaver, shares, commercial property, cash and bonds.” Of the 1,900 responses to his latest survey, 69% of investors are looking at buying shares but still a high 36% favoured residential property.

Bigger Effects

CoreLogic’s latest research shows property investment activity – particularly from new investors as opposed to those adding to existing portfolios – has been elevated over the past 18 months as they took advantage of looser credit conditions, low mortgage interest rates and the search for investment yield.

“Increased regulation for this section of the market will now impact profitability for recent investors and reduce the attractiveness for other investors to replace those who may sell out,” says Nick Goodall, CoreLogic’s research head.

Using its Buyer Classification data CoreLogic has identified areas which have had heightened investor activity and/or now offer low investment yield for new entrants. These areas have high vulnerability scores under CoreLogic’s just released new Property Vulnerability Index. They include Otorohanga, Mackenzie, Ruapehu, Kaipara, Kawerau and Opotiki.

The bigger cooling effect, says Goodall, is the LVR requirements of 40% deposits from investors. It cooled the market quite quickly when it was first introduced in 2016 as investors fell away when deposit requirements were lifted. “Proposed debt-to-income ratios (DTIs) will also have a significant cooling effect as investors might not be able to borrow as much, unless they have portfolios with little or no debt.” The Reserve Bank is expected to introduce DTIs next year.

“Inevitably market cooling comes down to the tax changes, deposits, interest rates and banks’ willingness to lend on residential property,” says Goodall. “It is a perfect storm for investors.”

Exemption Anger

A surprise exemption in the tax changes is for landlords who lease properties to Kainga Ora and registered housing providers. They can still claim the tax deductions if they lease their properties for social housing.

It has angered many investors. IfindProperty owner and operations manager Nick Gentle says it looks like a “giant bribe” to skew the housing market so that private landlords shift their rentals to social housing.

He says by allowing deductions for properties in social housing, the Government appeared to be saying investors could keep one third of their annual interest payment per property.

Hundreds of thousands of people rent but aren’t on a social housing list. The financial incentive to not rent to them is now thousands of dollars a year and the social implications are enormous.

Gentle says it is an attempt by the Government to get people out of emergency housing in motels at $200 per night per room. If investors go down this track it will be unfair on young working families in the already stretched private rental market.

“It will be tempting for smaller investors to lease their properties to social housing providers, particularly those who will struggle with the additional tax costs from the loss of interest deductibility. That will hit sitting tenants, particularly if investors have to contemplate selling and find the only way they can keep their property is to lease it to social housing providers.”

Gentle says the exemption for new builds should have also been broadened. He bought a derelict block of flats in Invercargill for basically the land price and not much more, stripped them back to the framing, rebuilt them and rented them to two pensioners and a single mother, who get housing support from the Government.

He cannot claim the 20-year exemption allowed for new builds, although Gentle reckons his complex is basically new. “Only a few parts of the framing could be saved.

“If I gave the keys to Kainga Ora I would be $6,000-$7,000 a year better off under the tax changes. Because he rented them on the open market Gentle says he is $100 a week worse off on each unit.

“It is harrowing that it is only investors who take on these types of projects, yet we are being pummelled with increasing taxes, interest rate rises and increasingly restrictive lending practices by banks. It’s a no-win situation.”