Our markets are behaving as one would expect in a situation where:

• The cost of a home has risen to a level where the number of first home buyers capable of being part of the current growth cycle is limited.
• The RBA is letting all who want to listen know that there will probably be no further interest rate cuts and that all should expect rates to rise in the next 12 months.
• Consumer sentiment is not unexpectedly strong given the various warnings about a rising unemployment level.
• Very significant “jawboning” by our Treasurer that we all have to take pain to allow our Federal Budget to return to surplus and government debt levels to be returned to more acceptable levels.

The Australia-wide dwelling growth position is provided in Graph 1.

Graph 1

The graph points to a market that is reaching the peak of its growth for this cycle. This is further evidenced by the lower auction clearance rates recently, which are now in the low 70% region.

The Sydney market has continued to power ahead. The median value of all house in Sydney is just $5,000 away from passing the $800,000 mark. As property prices have increased, the investor has suffered because although rental dollar costs have risen by about 6%, it is still someway off the increase seen in house prices. The consequence is that Sydney now is providing relatively unattractive rental yields for houses. The yield for units is a little better, but is now below 5%.

Table 1 – March Update

Our Federal Budget is due to be delivered on Tuesday, 13 May 2014 and we are being repeatedly told that there has to be significant cuts to expenditure. State Budgets will be delivered soon after the Federal Budget. Given this, I thought I may offer some suggestions to both levels of government. Yes, it probably won’t do us any good but perhaps they need something positive to make us all more accepting of the pain we are about to suffer. In essence, it is time to deliver something that is new and helpful to maintain and increase housing stock, but at the same time ensure it does not simply drive housing prices higher. This definitely rules out changes to negative gearing as its removal would simply reduce investor activity and available housing stock.

There are two outcomes in our housing markets that are needed:

1. Ensure there is an increase in Australian citizen investment in new housing stock.
2. Increase the number of first home owners in the market.

The first point, in my view, is a state issue.

Most of us will have family or friends who have been trying to buy a home and have failed because they have been out bid by a cashed-up foreign buyer. One has to ask whether foreign buyers should have equal rights as Australian citizens. I suspect not. That is not to say that foreign buyers are not necessary in our markets, but rather that they are simply investing in a low risk, very attractive country and for that benefit they should have to pay some type of premium. Furthermore, we are subjecting our housing market to an increased level of risk by allowing significant foreign investment in our market. For taking this risk we should receive some form of compensation.

One might question what those risks are. They are many, but the most obvious is around what would happen if, for example, these foreign investors needed to sell en masse because of a change in their country’s legislation, or simply because the economy in that country necessitated the sale.

Equally, it is possible that at some time in the future, there might be an anticipated or predicted significant drop in the value of the Australian dollar that will drive foreign investors to decide to exit our market en masse. Our property values would adjust accordingly and the outcome could be very prejudicial to our economy.

So, how do we gain that premium from foreign investors in our markets and potentially decrease their activity without necessarily decreasing supply of new stock. The answer:

Alter our land tax regime. That is, increase the land tax payable by non-Australian citizens who own property in our country and, at the same time, decrease the rate of land tax charged on property owned by Australian citizens, with all properties purchased in the future and currently held being subjected to these changes. Obviously, the amount of these alterations will need to be modelled and the changes would need to be phased in.

The consequence is clear. Foreign investment activity would be marginally reduced (depending on the altered tax rate applicable to them), and the lower tax rates for Australian citizens should cause increased investment activity by this group. It should also mean that first home buyers have a better chance of competing when buying.

The second point, in my view, is a Federal Government matter.

First home buyers have been forced out of the market simply as a consequence of rising house prices and the consequent level of income needed to support a home loan.

In essence, we need to organise things so this group has adequate cash flow to meet high home loan repayments. This will particularly be the case when interest rates increase in the medium term. We could look at just helping first home buyers, but perhaps it would be better to expand this help to everyone buying a property to live in.

So, how could the Federal Government help without significantly and adversely impacting on revenues in the medium term?

A relatively simple change to the Capital Gains Tax legislation is required.

This change would allow home owners to claim interest deductions on their home loan repayments where they elect to be subject to normal capital gains tax on the profit they make on any future sale of the property. In essence, they exchange the right to have their home exempt from capital gains tax in exchange for the right to immediately reduce their taxable income by the interest they are paying on their home loan.

Being brutally honest, given the government’s current budget problems, the government should simply phase in the removal of the Capital Gains Tax exemption on the family home all together and automatically provide first home owners who buy a new home with the right to claim interest deductions. Politically, this might be better for the government than altering pension rights and health benefits etc.

This removal would not have an immediate impact on that many people in the population, and the government could, for example, go about implementing the change in the same manner as they did when introducing our current Capital Gains Tax legislation. That is, simply exempt houses purchased before, say, 2003. There are many alternatives and “bells and whistles” that could be added to this process to make it more palatable. The potential revenue from this measure would be very significant.

To demonstrate, let’s assume that 20% of all homes sold last year were purchased in 2003 and are now subjected to CGT. On my calculations, this would mean that, based on the growth in the Australia-wide median dwelling price over this period, the taxable profit per home would be in the order of $290,000. In the case of a unit, it would be $140,000. The tax collected on this across Australia in the first year would probably be in the order of about $1.2 billion.

Getting back to the first home owner, allowing them to elect to claim interest as a deduction would mean an improved annual cash flow that will help to make housing more affordable. What is the cash benefit? Well assume someone has a loan of $400,000 and a tax rate of 22%, then the annual benefit at current interest rates would be in the order of $5,000 per annum, or roughly about $100 per week.

The impact of this proposal on borrowers as interest rates increase should also not be overlooked. That is, deductibility means that interest rate increases will not have as large of a negative impact on first home owners as they would have otherwise. As interest rates increase, their deductions increase and their tax liability is reduced. Hence, as interest rates rise, defaults on home loans are also likely to be lower.

On the basis that the Capital Gains Tax election was only available where a home owner was purchasing a new home valued at less than say $400,000, then, assuming a 90% borrowing by around 100,000 first home owners in the first year, then it would have a cost of something less than $500 million on my calculations in the first year of operation. It would then increase from this point until about the fifth year, when a reasonable number of properties would start to be sold and revenue would then start to be generated from Capital Gains Tax receipts from property sales.

Clearly, there needs to be some detailed modelling to work out a progressive phasing-in, and potentially define a percentage of the interest cost on the home loan that would be allowed to be deductible. Once this is done, then a reasonably solid estimate of the cost to the Federal Budget could be identified.

However, given the potential benefit in stimulating the building industry, providing new housing stock, the flow-on effects in the area of increased retail sales of furnishings and white goods etc., the resulting increased job prospects and consequential improved PAYE tax revenue for government, the net cost could be potentially minimal. In fact, given a situation where a borrower is paying down a loan, and home values increase by more than interest rates (which is the norm), it is more likely that the government would, over time, win in all respects.

From any logical perspective, a combination of subjecting all of our owner occupied housing to a form of Capital Gains Tax and allowing first home owners to access interest tax deductions, it does have merit. And, provided it is structured in a manner that does not drive housing prices higher, it will also make housing affordable for the next generation.

The negative that could be seen as a benefit by some, is that it would encourage home owners to limit their trading activity in their own home. That is, a home owner would potentially be less inclined to use their home as trading stock and instead use it as a mechanism for wealth generation by buying with the intent of selling following renovation.

In the short term, we are going to be asked to accept some difficult decisions and perhaps the above, if implemented carefully by the government, could potentially soften the perceived blow.

Some food for thought. Until next month, happy investment searching.

John Edwards.