I recently listened to a radio interview with a scientist who suggested that falling in love has more to do with our body odour than it has to do with candle-lit dinners.
Although disputed by my wife, it did start me thinking about the beliefs we hold that may be correct but that we believe for the wrong reasons. The risk with this is that when the environment changes we fail to notice the things that matter.
There is no disputing that New Zealanders have a love affair with property. It is estimated that 30% of our homes are owned by mum and dad investors. The foundational belief is that you can’t go wrong with property. And if one rental property is good, five must be better.
With domestic property values peaking in November of 2021 and, on average, falling 16.2% across most of the country since then, it does beg the question: is this decline entirely attributable to higher interest rates (and will stabilise when interest rate increases slow), or is something bigger going on?
Why has rental property ownership been so successful in the past?
Historically, the list of supporting factors is extensive. At its most basic level, it is driven by demand exceeding supply. This imbalance was amplified by high build and compliance costs, which means that the cost of adding new supply was very high by international standards.
Limited laws on housing standards and tenants’ rights provided landlords with great flexibility when it came to managing their property portfolios. If you add effectively no capital gains tax, deductions for interest and depreciation and being able to offset rental losses against personal income, then the tax treatment was also a significant driver.
Further underpinning these advantages are two technical factors: leverage and compounding growth. Leverage refers to our banking institutions’ willingness to lend money against properties. This feature amplifies the gain (or loss) that occurs in property investment.
Compounding growth is the underrated factor which is often forgotten when considering all investment returns. Property has several features that help enforce compounding growth. Compounding works best when three forces are aligned:
— Regular contributions. Property acts as a compulsory savings scheme. You won’t get a very good hearing from the bank if you decide to stop your mortgage just because the capital value has fallen. This ensures that you continue to build your equity over time.
— Holding through negative markets. The tangible nature of property means that investors seem to hold a higher level of confidence that property values will recover given enough time. In the interim they are comforted by the rental income stream.
— Time. The longer that an investment is held, the more time that compounding has to "work its magic". Anecdotally, most of the rental properties I see are purchased for the longer term, at least until something changes unexpectedly for the owner. So far, I have built a great case for rental property investment!
And I must say that I am not against rental property investments in general. But the environment has changed and most of these supporting factors have weakened or vanished. If you review each of the supporting factors I have identified, using a "pass" or "fail" mark, it looks something like this:
1. Supply and demand. Post Covid, immigration is still constrained but countering this is the cost of new builds, which remains very high. Recent climatic events will also create (at least in the short term) further pressure on supply — so this gets a pass mark, for now.
2. Housing standards and tenants’ rights. From a societal point of view the introduction of the Healthy Homes legislation and further legislation strengthening tenants’ rights have been a good thing. But from an investor’s perspective these changes have introduced new costs and reduced a landlord’s flexibility to manage their property. This a fail in investment terms.
3. Tax incentives. Over recent years there have been a raft of changes, including the removal of the deduction of interest costs for non-new builds, the introduction of "pseudo capital gains" tax via the bright-line test, changes to depreciation rules and the inability to claim rental property losses against personal income. Collectively these changes create a significant fail.
4. Leverage. The introduction of higher loan-to-value ratios (LVRs) for rental properties means that the benefits of leverage still exist, but are weakened. This, coupled with the removal of interest deductibility of the interest debt (for non-new builds), also scores a fail mark in this category.
5. Compounding. This is unchanged. Of course, with a little discipline, the value of compounding returns can be captured through other investments, such as shares — this is still a pass mark for rental property. Compounding remains the silent powerhouse of investors’ returns. I do often wonder if a rental property’s market value and investment returns were available daily to an investor, say via an app to a phone, whether they would be quite as resilient to the value changes.
So what does this all mean? Behavioural finance tells us that investors’ views of what is a good or bad investment tend to be driven by their immediate historical experience. If we look at the changes that have occurred in the environment for property, then we would have to conclude that the environment has changed for the worse. We are partway through a correction in property prices. The extent to which this correction is due to interest rate increases or environmental changes is yet to be seen.
My view is that property should be part of your long-term strategy but is dangerous if it is overly represented. Two of the key advantages offered by property, compounding returns and leverage, can also be accessed through other investment opportunities. All things in moderation still seems to be a good recipe for both building and protecting your wealth over time.
— Peter Ashworth is a principal of New Zealand Funds Management Ltd and is a Dunedin-based financial adviser.
The opinions expressed in this column are his own and not necessarily those of his employer.
His disclosure statements are available on request and free of charge.
