Money: Safe as houses or is it?

By Philip Macalister

Is the tide about to turn on residential property investment?

New Zealanders traditionally have had a strong love of buying homes as a form of investment. History shows that while there are many arguments against putting large amounts of money into residential property it has often delivered good returns.

WestpacTrust research shows that buying a second residential property has been a rational thing to do.

It created four portfolios, three with a strong emphasis on a particular type of investment, namely term deposits, residential property, managed funds and one which mirrored the WestpacTrust's Household Savings Indicator.

(This index shows how New Zealand households invest their money. Currently about 65 per cent of savings are tied up in residential property and the balance is split between managed funds and term deposits.)

WestpacTrust calculated how each portfolio would have performed over the past nine years.

It should be no surprise that the portfolio invested in bank deposits was the laggard and underperformed all others.

The other three portfolios were broadly similar, with the one invested in managed funds moving ahead of the others only in the past nine months on the back of strong international equity returns.

Perhaps the most surprising outcome was that investors with a housing emphasis have experienced less volatility in wealth than those with a managed fund emphasis, but not importantly, at the expense of significantly less wealth.

What really adds to the attractiveness of residential property is that it enjoys a tax-favoured status over most other investment options, and New Zealanders have been able to juice up their returns by heavily leveraging their properties.

That is by putting a small amount of capital into the investment and funding the balance with debt, the actual returns, or if things go wrong losses on the initial outlay are amplified.

Chief investment officer David Beattie: "By taking out mortgages on house purchases, housing investors are subjecting themselves to the powerful long-term phenomenon of leverage."

Changing economic conditions and a new Government may dampen the attractiveness of residential property.

The new Coalition Government has four key policies that will change the cityscape.

\EE Labour and the Alliance both want to build more state houses.

\EE State sector rents will be capped at 25 per cent of income.

\EE The private sector accommodation supplement will remain. However, of every dollar spent above the 25 per cent threshold, only 70 per cent will be refunded, compared with 100 per cent for state-sector tenants.

\EE A comprehensive review of the taxation system (which will be implemented if they win a second term).

ASB Bank economist Rozanna Wozniak says the three housing policies have negative implications for residential property investment.

Tenants renting from the private sector will have a financial incentive to switch to the state sector. This will tend to place downward pressure on private sector rents.

"Although this will impact most strongly on those properties which compete directly against state sector rentals, flow-on effects are likely across the rental market in general."

The other issue is supply and demand. The new Government's plan to increase numbers comes at a time when there is already ample supply. Adding to this problem is the rapid growth of apartments, especially in Auckland.

Mr Beattie says several years ago there were about 150 apartments in central Auckland. Now there are more than 5000.

The ballooning number of new dwellings means it is likely people will vacate houses in the suburbs for apartments.

Ms Wozniak says although such comments sound negative for owners of investment properties the outlook is not as bleak as it may appear.

She says the vacancy rate in the state sector is reported to be low so any shift from the private to the public sector will be gradual. Also, lower rents could result in increased demand for state-sector accommodation from current state-sector tenants.

There is evidence that the move to market rents created overcrowding and some of these people may seek their own state houses.

The key impact of these changes will be that some parts of the residential property market will become unattractive to investors.

Real Estate Institute national president Max Oliver: "The proposed policy may result in a move of investment to higher value, thus higher rental homes."

Tax is the other big issue. As mentioned earlier, residential property is the favoured asset class because its capital gains are tax-free.

To many people from Reserve Bank Governor Don Brash through to managed funds companies this treatment is an unfair advantage and they would like to see a more even competition between the various investment options.

Labour has promised a full review of the taxation system and that is likely to address this problem.

Already a number of reports have been produced which look at ways of fixing the tax system.

High-profile economist Gareth Morgan, of Wellington-based Infometrics, has written a discussion document for the Investments, Savings and Insurance Association titled Towards An Ideal Taxation Regime.

The report recommends the introduction of a capital gains tax and a tax on imputed rental income which owner-occupiers enjoy.

The thrust of the latter suggestion is to "improve the neutrality of the tax regime with respect to different forms of investment income."

A second report prepared for the Super 2000 Taskforce by accountants Arthur Andersen also highlights the issue.

Report authors Peter Goss and Alex Duncan say: "It would be highly desirable to reduce the extent to which investment in owner-occupied housing is tax favoured.

"But taxing owner-occupied housing on the same basis as other assets is probably not feasible."

The report also suggests that consideration should be given to extending the range of capital gains that can be taxable.

Mr Beattie says for investors, the best way to long term wealth creation is through a well-diversified portfolio.

There have been rational reasons why New Zealanders have embraced residential property over other forms of investment. These are entrenched behavioural patterns which will take a long time to change.

He says if there are changes it will be a slow creep rather than a sudden shock, unless there are legislative changes.

AMP Asset Management economist and investment strategist Anne-Marie Brook: "There will always be good returns to be made in some areas. It's a question of whether you can pick those areas or whether it is luck."

She notes that other savings vehicles, such as passive equity funds also offer investors options that are free of capital gains tax.

"It is certainly true that in the past New Zealanders have had quite a love affair with residential property. But times are changing. Because diversified tax-efficient products are new to the New Zealand market, many New Zealand households are probably still not aware of the alternatives."

She says any changes the Government makes are unlikely to enhance the benefits of property investment.

* Philip Macalister is the editor of online money management magazine Good Returns. It provides news on managed funds, mortgages, superannuation and financial planning (www.goodreturns.co.nz).