If the story were a straightforward issue of supply and demand, then what should we make of the fact that (according to recent Census data) in the five years to 2023, New Zealand’s population increased by 6% while dwellings increased by 9%, at a time when house prices were increasing dramatically?
Claims about supply and demand often cloud the actual issue here: supply and demand of what?
Housing serves two primary functions. We all need a place to live, and to provide shelter to our families. We can do so by renting off others. Or (as many New Zealanders aspire to do) we can become homeowners and effectively rent off ourselves, exchanging rental expenses for mortgage payments. In either case, what we are buying are effectively housing services - the ability to live somewhere.
Supply and demand are clearly important here. When there are too few houses and too many people, then the cost of somewhere to live will be higher. Someone’s decision to stop renting and buy a house instead doesn’t directly affect this a balance. In effect, there is one fewer property available to everyone else, but one fewer household requiring somewhere to rent. Rents therefore provide a fairly direct measure of the balance of supply and demand.
But the second function housing fulfils is investment. Some people want to own more properties than they need themselves because they expect an economic return. This is not a bad thing in itself, as many other people need to rent. But it also means the price of owning a house is conceptually different from the price of having somewhere to live. And unlike rents, the costs of homeownership can shift for reasons unrelated to the number of people and the number of houses.
One important driver of house prices is interest rates. If someone is considering investing in housing for an economic return, what they would pay for a house in part depends on what return they could get from other investment options.
A simple model called the “user cost of housing” suggests the rental yields on a property (annual rents in proportion to property prices) should roughly correspond with the costs of homeownership, factoring in mortgage payments, rates, maintenance, taxation, anticipated capital gains, as well as any intangible value that people place on homeownership.
If interest rates fall and there is no change to the level of rents, then there should be an upwards adjustment in property prices. In simplified terms, if interest rates fell from 10% to 5%, then what someone would be willing to pay for an investment property with a given level of rental returns should double. No shift in the supply of housing is necessary for this to happen.
The decades-long increase in house prices coincided with a prolonged fall in long-term interest rates, which has been reversing as of the last few years. In recent work Treasury, the Reserve Bank and the Ministry of Housing and Urban Development found house prices had increased significantly faster than rents and concluded “the main driver of house prices in New Zealand over the past 20 years has been a global decline in interest rates”.
If the supply of urban land was more flexible, we would expect building new housing would become a more attractive proposition, given the end value of rental properties would be high relative to building costs. Some of the recently announced policy changes, such as restricting councils from imposing urban boundaries, might therefore be beneficial to the longer-run supply response. But improving the responsiveness of supply likely depends on a range of factors, including addressing the lack of supporting infrastructure.
The suggestion here is not that we need to focus on interest rates themselves, which are largely beyond our control. But if the goal is more affordable housing and higher rates of homeownership, then policy changes that affect the attractiveness of housing as an asset, rather than a place to live, become very important.
The Government’s restoration of mortgage interest deductibility makes housing more appealing for investors. However, as new builds were still able to claim interest deductions under the prior rules, it is likely this measure will lead to higher house prices, without adding much to additional supply. Treasury’s advice on this issue also stated that “in the short and medium term, the bulk of the impact from restoring interest deductibility is likely to be reflected in house prices, with minimal impacts on rents”.
Second, the fact capital gains are not comprehensively taxed in New Zealand is reflected in our high house prices. Anticipated capital gains are another reason that the normal rules of supply and demand don’t work well for housing, as higher prices often lead to more investor demand rather than less.
Weakening the rights of tenants increases incentives for investors to buy up more of the existing stock of properties. At the same time, insecure tenants may feel even more desperate to get into a house of their own. Both of these factors put upward pressure on prices in the near-term, though any longer-term impact on supply may be negligible.
Supply and demand in the housing market matter, but we need to be clear about what aspect of the market we are talking about. The longer-term goal of more flexible urban land supply is important, especially for renters. But achieving better outcomes for prospective first-home buyers as well as renters requires us to think about how to move away from the zero-sum cycle of speculative investment which has characterised the New Zealand housing market over recent decades.
