Tax Changes & Market Update From Matthew Gilligan

No doubt you have been reading in the newspapers and listening to the media various reports reviewing what is going on in the property markets; highlights of the reports are both positive and negative, and you hear various opinions around the marketplace about what  2010 is going to hold for us. So is it boom or doom?


Positives

On the positive side:

1. We have low floating interest rates, the 5-year rates have firmed up and are now declining, signalling that the cost of funds for the long-term rates will fall. (Don't fix for 5 years at present, just float your interest rates….your blended cost of capital will be lower if you float at present than fix for 5.)
2. We have positive net inflows from immigration annualising out at the time of writing at around +19,000 as a net inflow annually, indicating more housing demand in the wings.
3. Rents are rising with a shortfall in housing supply with a backdrop of historic lows in building consents versus positive net immigration, i.e. pent-up demand for housing is getting worse/better depending on your perspective. From a landlord's perspective, this is great news. 
4. Business confidence has rebounded, in the face of general public confidence being very low.  However, there is a historic link between business confidence rebounding before the public's confidence returns, generally linked to employment and the employers in the marketplace signalling a return to buoyancy eventually flowing through to the rest of the public once they see employment statistics improving.
5. The exchange rate appears to be falling. Great news for exporters - bring on the now well-overdue export-led recovery. Though it is up and down like a yo-yo and the flip side of a low exchange is imported inflation on cost of goods imported - petrol, financing costs, etc.

Negatives

On the negative side:

We have a global backdrop of many nations signalling insolvency.

There is the prospect of sovereign default, not only in Greece currently restructuring its debt. The main areas of concern are the so-labelled PIIGS. (Portugal, Ireland, Iceland Greece and Spain). With many nations indebted up to their eyeballs, even some of the traditionally stable nations in Europe have question marks hanging over their heads. Obviously the USA is in dire straights, but so is the UK. You may have noticed the British pound weakening with the Kiwi now at 46 pence to the dollar at time of writing, a clear signal that the British economy's budget deficits are a huge problem.  The signal from the market by that slide is that even the Kiwi is ranking better than the UK currency, in relative terms.  With concern over a domino effect in Europe, with the last domino leading perhaps to the USA, or maybe the whole thing in reverse starting with the USA.

Tax changes are a bucket of ice over property markets. The unanticipated effect (but totally foreseeable) is that SMEs rely on their housing portfolios to gain access to capital. I can't believe that the government does not realise that when you threaten house prices, you threaten SME lines of credit and businesses lose access to capital. Clearly there are no accountants in public practice dealing with SMEs advising government, or if there are they are simply out of touch, because they missed this link. My co-director John Rowe was talking about this on TV3 news two months ago. Why is it so obvious to everyone in business but not the government?

In my mind, a question mark hangs over the stock market. In my view in a W, not a V-shaped decline and recovery. Assets were over valued in 2007 when the stock markets were supported by thriving markets with huge consumption and activity levels. In 2010, we have nearly recovered all of the losses of the market crash, but the markets are no longer thriving. I think the asset bubble has returned and we may see a crash again. This comment also applies to property assets, though not to the same degree. I am advising clients to sell their equities and return to cash for this reason. With little upside prospect and plenty of downside, the risk/return analysis must surely point to holding cash and not shares in this environment? Once inflation rears its head, hold physical assets (property, select shares), but until we see governments inflating their way out of their indebted position, we have a hard road to travel and I think cash will be king again before we know it.

Tax Changes

 In the writer's view, the tax changes in New Zealand signalled by John Key, while intended to promote investment in business and ultimately generate a recovery, in fact have the opposite effect.  A bucket of ice thrown over the property market will lead to reduced consumption, reduced public confidence, and ultimately an erosion of the ability of small business in New Zealand to function.  The sooner the government come out and clarify the tax position that they are taking with property, and the softer they make such position, the sooner the markets will recover from the current icicles hanging off most For Sale signs around the country. 

You might have heard that there was an increase of over 50% in listings between January and February year on year, an additional 5,000 properties listed over a base of 10,000 on realestate.co.nz between January and February alone. This statistic holds nationwide with listings across the board up around 47%. It seems Kiwis are panicking that the tax changes signalled may devalue property, and are running to their local real estate agent to sell in advance of the upcoming Budget announcements. 

As mentioned in previous articles, the government have been responsible and ruled out many of the tax working group's recommendations to give some clarity as to what they intend.  In short, they have ruled out most of the recommendations made, but left the prospect of depreciation being denied on property investments and raised the question of ring-fencing of losses.  While building depreciation being denied will definitely have an impact on property values and increase the number of mortgagee sales around the country with the impaired cash flow that this will create, the ring-fencing of losses will be catastrophic.

In Sweden when the government ring-fenced tax losses from property investment, the market fell some 35%.  Other experiences around the globe where governments make drastic intervention into property markets with changes to tax rules have been the same, with significant reductions of property values when the government makes such changes.  While the government ruled out the risk free rate of return method for taxing equity in property and denying tax losses, they have left the door open to ring-fencing of losses as a stand-alone policy. 

In the writer's view, they will not do it (ring-fence losses) because they will quickly find out that the Sweden experience will become a New Zealand experience with massive devaluation of property assets.  Westpac also predicted this in their analysis on the same.  Westpac talked of a reduction of house prices of up to 34% if the risk free rate of return method of taxing property was brought in.  For this reason I do not believe the government will bring in ring-fencing, because they are fundamentally pro-business and while it might be observed they are anti-property based on their current tax tendencies, the government will know that devaluing house prices in any significant manner will have the opposite effect to that which they want.  Such a move would destabilise banking and kill consumption (with nobody consuming in an environment with massive asset devaluation) and generally small to medium sized businesses which rely on their houses for working capital and financing will become destabilised by such measures.

Doom & Gloom or Opportunity for the Shrewd?

In my opinion, 2010 will not be a good year for property, and neither equities.  We will see devaluation of financial assets in New Zealand and tax changes signalled by this government will have a big part to play in that.  But the backdrop of the global environment will make this worse.

The counterpoint is that what comes down ultimately goes up again in financial markets, and astute buyers looking for bargains in such a down market may well be rewarded in the medium term if they swim against the tide and look for the bargains in mortgagee sales or in the stock market. 2009 was a dramatic recovery, demonstrating this point. 

While property assets may be devalued by the cashflow taken away with tax changes, the cycle ultimately restarts at the new values established no matter how low property values may go (depending on what the government does). Accordingly, even if assets are devalued, they will grow again from a new, lower base.  In this regard, it is the writer's view that if we see devaluation of assets, look at it as an opportunity and get out and see if you can pick up a bargain. 

One thing is for sure - we must see more mortgagee sales from changes to the depreciation regime, and such disposal of assets always results in great buying opportunities.

Anybody wondering what the impact of the changes to depreciation might do to their investment portfolio is welcome to contact us for help at [email protected], via our website or by phoning +64 9 522 7955. 

We further note that we will keep a close eye on the government's changes and report to you as things unfold, and we will most certainly have our eye firmly on this Budget and be quick to give you a report when we know what is happening.