House prices will fall: economists

In real terms house prices have already fallen 12 per cent from their peak in late 2007. Photo / Alan Gibson

Westpac economists expect house prices to fall about 2 per cent this year and another 2 per cent next year as a result of tax changes, rising interest rates and falling population growth.

Westpac economist Dominick Stephens said in real terms house prices had fallen 12 per cent from their peak in late 2007 and on today's fundamentals were only slightly overvalued.

But the tax changes due to take effect on October 1 would reduce the fundamental value of houses, creating a renewed reason to expect continued price weakness.

Much the most important change is the lowering of the top personal income tax rate from 39 to 33 per cent.

The tax laws allow landlords to use cash losses on property investments to offset other sources of taxable income, while capital gains are usually untaxed. Lowering tax rates reduces the value of that tax shelter.

Owner-occupiers also avoid tax in the sense that any other investment would incur income tax on the flow of benefits. "The tax cut will improve the return on alternative investments relative to buying a bigger or better house," Stephens said.

In comparison the removal of a depreciation allowance on buildings is much less significant.

It would seriously hurt the cash flow of a few highly leveraged property investors, Stephens said, but because landlords have to pay back depreciation claims upon sale (unless the property actually does fall in value) for most of them the tax change only meant the loss of an interest-free loan.

Westpac estimates house price inflation will be about 10 per cent less over the next few years than it would have been without the tax changes.

This rests on its view that property investors are the marginal buyers, who set the floor price for houses, particularly towards the market's lower end.

But not all of the adjustment will come through lower prices. "Our calculations suggest rents will end up about 7 per cent higher than they would have been had the tax system remained unchanged," Stephens said.

"But it will take years for these changes to work through the market."

The Treasury's estimates of the impact on house prices and on rents are lower. That is because it believes rental property demand is more elastic than Westpac does: that more young people, for example, will just stay at home if rents rise too fast.

But Stephens said that as the economic recovery strengthened, better job prospects should encourage more young people to fly the coop and enter the rental market.

Another effect of the tax changes is expected to be a widening of the gap between low- and high-end properties.

Landlords, more sensitive to tax, are more active towards the lower end of the market, while the potential buyers of upmarket properties get the biggest tax cuts.

Stephens expects the decade ahead to look more like the 1990s, when tax changes were unfavourable to landlords and favourable to those on high incomes, in contrast to the 2000s when the introduction of the 39 per cent top tax rate both hit those on higher pay and increased the incentive to buy rental properties.

The recovery in the housing market last year may have been partly caused by buyers rushing in while mortgage rates were low, Stephens said. "Now that floating rates are on a rising trend, buyers seem more reluctant."

Westpac expects floating mortgage rates to rise steadily, to a "new normal" level higher than that of the 2000s.

Global interest rates are expected to be higher, pushing up banks' funding costs, and higher average mortgage rates are tipped to reduce demand.