Is our economic future at risk as a result of the huge debts we’ve accumulated to indulge our love affair with housing?
According to a recent report by Goldman Sachs chief economist, Tim Toohey, household debt levels in Australia now stand at an elevated level, both in relation to historic norms, and compared to other countries. For instance, Australia’s debt to household income ratio is higher than in the United States and Spain, and stands at a similar level to the United Kingdom. Only the Netherlands and the Nordic countries have higher ratios.
And, the huge amounts of money we’ve borrowed have largely been spent on housing. According to the report, 62 per cent of debt is in owner-occupied home loans, and a further 27 per cent is in residential investment loans. As the report notes, “that is, 89 per cent of all household debt is directly related to domestic housing. By way of comparison, in 2007, 85 per cent of US household debt was secured against housing.”
As I wrote on the weekend, Toohey has written a perceptive report on the Australian housing market, in which he argues that housing prices are between 25-35 per cent overvalued. As a result, he says, we run the risk that Australia’s house prices could drop sharply if a sharp decline in Chinese growth prompted a steep drop in our export earnings.
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Toohey points out there are good reasons for our obsession with housing. Australia offers one of the most advantageous tax regimes for investing in housing in the developed world. Only the Netherlands is more generous.
For instance, we have no capital gains tax on owner-occupied housing in Australia, while property investors pay capital gains tax at half their marginal tax rate if they hold the investment property for more than a year.
Further, the tax system also offers generous deductions for those who buy rental properties, through measures such as negative gearing (which allows investors to offset losses on the investment property against other income), and depreciation deductions. These tax provisions greatly reduce the cash flow burden of investing in low-yielding rental properties.
The report calculates that an investor who buys a $500,000 investment property using a standard 7.5 per cent housing loan is likely to face a negative cash flow of around $28,500 a year. But the property is likely to incur tax losses of more than $22,000 a year as a result of negative gearing and depreciation. This means that for an investor on the top marginal tax rate, the out-of-pocket expense of owning the investment property plummets from $548 a week to $126 a week (or approximately $6500 a year).
Toohey notes that interest rate moves have a major impact on the economics of investing in rental properties.
For instance, back in April 2009, when the mortgage rate was at a low 5.75 per cent, our investor would have faced an after-tax expense on their investment property of $36 a week, or $1872 a year. Since then, the weekly expense has risen by $90 a week, or around $4700 a year.
The report predicts that the Reserve Bank will increase interest rates by 100 basis points in the next year, which would push the after-tax expense of the property up to $177 a week, or $9204 a year. “As such, it is likely that investor demand will soon begin to ebb”, the report notes.
Still, despite the generous tax treatment, many investors are left with negative after-tax cash flows from their rental property investments. The report notes that one reason that investors continue to invest in rental properties is that they’re hoping to profit from rising property prices.
For instance, in the example given above, the investor faces a negative cash flow of $6500 a year from buying the $500,000 investment property.
But if property prices jump by 20 per cent, they’ll achieve a $100,000 capital gain, which means their total return will be $94,500. And, as the report notes, “the annual returns are much higher when leverage is introduced into the analysis; hence it is not hard to see why during periods of trend growth in house prices highly geared investor housing has been attractive.”
What’s more, housing has been an outstanding investment over the past 20 years. Residential property has been the top-performing asset class over the past two decades, delivering the highest returns along with the lowest volatility.
According to data from the Australian Tax Office, only 13 per cent of taxpayers are claiming rental income, which represents a slight increase from 1997-8, when the figure was 12 per cent. The report estimates that only about 19 per cent of non-renting households own an investment property.
So who are the people most likely to snap up investment properties?
Interestingly, it appears that Reserve Bank officials are the keenest investors in rental properties. “We are not sure whether to be relieved or concerned that of the five central bankers who were brave enough to note their occupation on their tax form, all five had an investment property!”, the report says. “Of the 200 occupations classified by the Australian Tax Office, the employees at the Reserve Bank topped the list with respect to their investment property exposure.”
But people working in the medical and banking industries, along with people employed in the property sector also figured prominently as owners of investment properties.
On the other hand, people working in the funeral services industries, and in the hunting and trapping industries, were least likely to own an investment property.
High income earners derive the greatest tax benefits from investing in rental properties. As a result, we see that the proportion of taxpayers who own a rental property rises strongly as income levels increases. The report says, “this is particularly evident for those using negative gearing strategies with negative rent claims rising proportionately with income right up to incomes of $1,000,000 per annum.”
But our infatuation with housing has pushed up the gearing levels of Australian households. The report notes that household leverage in Australia is higher than both the US and the UK, and has been since the mid 1990s.
According to the report, in order to get household gearing to the average level that prevailed in the 2003-7 period, either Australian household debt could have to decline by 8 per cent, or household asset prices would have to rise by 9 per cent.
“With the economy already operating at full capacity, lowering gearing ratios via asset inflation is not a sensible policy option”, the report warns. “Tighter fiscal policy, higher interest rates and ‘jaw boning’ may be the only way from preventing households from becoming more exposed to an adverse and sustained shift in the terms of trade.”
*This story originally appeared on Business Spectator