As we all know, house prices have gone up massively over the last couple of decades, and much faster than inflation. On the other hand, rents haven’t gone up so quickly – lucky for the 35% of Kiwis (or 38% of Aucklanders) who don’t own the home they live in.

As someone with more than a passing interest in inflation, rents, yields and prices, I’ve thought for a long time that the growing gap between rents and house prices must have a lot to do with the switch from a high inflation environment to a low inflation one. It’s exactly what economic theory would predict. And luckily, another economist, Rodney Dickens, has come along and taken a look at it (hat tip to Bob Dey for the link).

First, some background. Up until the 80s, New Zealand often had very high inflation, as per the chart below:


Inflation was particularly high through the 1970s (oil prices sustained at much higher levels than ever before, plus the switch to a floating exchange rate, and various other factors besides) and the 1980s, except for a brief period in the 1980s where Muldoon thought price freezes were a good idea. The 1989 Reserve Bank of New Zealand Act put a new focus on inflation targeting, and it wasn’t long before inflation rates dropped to well below 5% a year, where we’ve been more or less ever since.

Unsurprisingly, mortgage rates tended to follow a similar pattern to inflation, although they didn’t fluctuate as much:

Inflation and mortgage rates

Floating mortgage rates topped out at more than 20% in the late 80s, and fell dramatically through the early 90s. They’ve stayed below 10% for most of the time since.

So, if you’re an investor in the 1970s, and inflation is at 15%, and you can borrow money at around 15% (or put it in the bank and earn at least 10%), what kind of return do you expect on your rental property? You might expect a yield, or return, of 20%, say. Flipping that around, the property value is five times the net rent you receive.

OK, so now it’s the 2000s. Let’s put aside thoughts of capital gain for now – assume you just want a fair return on your money. You can borrow it at 8%, and put it in the bank at maybe 5% or so. Property seems like a fairly safe investment, so perhaps you’d be happy with 6% return. That means your property value is now nearly 17 times the net rent.

Of course, we wouldn’t expect the runup in asset values to happen just for property. We’d expect it for all types of income-producing asset – shares, capital goods, human capital. You’ll see it as a drop in yields for these assets, as for Rodney’s graph below, which shows yields both for residential property and for government bonds:

Rodney graph 1

As Rodney says:

“CPI inflation has been consistently lower since the early-1990s. In the first house price boom after 1990 – between 1994 and 1996 – rental price inflation increased much as had been the case earlier. But it would seem that by the time of the 2002 pickup in house price inflation the low inflation environment had taken over. It would appear that landlords began to struggle to justify or achieve higher rental inflation in an environment of sustained low general inflation.

This new, inflation-constrained behaviour is reflected in CPI and rental inflation living in similar ballparks since after the government interventions resulted in rental inflation turning temporarily negative in 2001. The result was that the relationship between house price and rental inflation largely broke down”.

He goes one step further, and looks at an issue closely related to housing affordability, as Stu has written before. Here’s Rodney on the issue:

This can also be viewed from the perspective of rents compared to incomes. This is another means by which lower general inflation, including lower income growth, will put a ceiling on rental inflation. The [chart below] compares the ratio of the national average house price to the average annual gross income (black line) with the ratio of the average national annual gross rent to the average annual gross income (blue line).
Prior to 2000 the two ratios largely moved in synchrony while since then the rent/income ratio has fallen and the house price/income ratio has skyrocketed.

Rodney graph 2

I quite like the way Stu puts it: housing is a commodity like anything else, and “you don’t measure the  affordability of cookies based on the cost of buying the cookie factory”.

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  1. I read a lot about this also on interest, but the most obvious thing is that rents are paid from real money, out of real people income, sweat, work and productivity, that is finite. Houses are paid with fake bank money that don’t exist, so they can be as expensive as many zero you can put on a computer screen. Banks want houses to be more expensive, so they give you more fake money and so on, while we all get poorer. If we started listening a bit less to the Economists (with capital E) and a bit more on our brain cells, we would all be better off.

  2. I also read Rodney’s piece and was left wondering what his point was. Do we want high inflation back…?! It may explain why rents and purchase price were more closely linked, but does not offer an answer for the future IMHO.

    Or, like Nonsense says, is the last graph not the giveaway – the issue is not correlation with inflation, but disconnection of incomes from lending. In terms of timelines, the early 2000’s also corresponded with a worldwide loosening of lending behaviours I understand, certainly in the European economies and I think in the US as well, and this seems to have a lot to answer for in subsequent global financial behaviour, surprise surprise.

    Rodney is right however to point the role of finance and financial policy above all else. Urban planning policy that constraints supply [intensification and greenfield in Auckland’s case] is hardly the primary root of all this as postured by many commentators – most likely just a colluding element. Fix financial models and we will get a far more effective long term fix.

    1. To clarify – planning needs fixing in some big ways, but it’s not the source of all evils compared to finance. And growing outwards is hardly the panacea, just a part of the solution… etc etc.

  3. We are not unique. One variable in the logic defying increases is the global view is that Auckland, along with Vancouver and large Australian cities are seen as stable and attractive ‘Hedge Cities’ for overseas money.

    While not an issue for those who own our houses, in fact a potential benefit when they sell, it’s an almost insurmountable problem for New Zealanders wanting their own home and the significant long term benefits that go with it.

    If the political outcome we want is for residents to own houses, there are two simple steps that need to be taken:

    – Remove mortgage interest payment tax deductions for landlords or provide equivalent relief to homeowners*
    – Non residents must buy or build a new property, not an existing one.

    * Noting gross rental yields in the graphs above and net yield less, many investment properties do not make a profit, other than untaxed capital gains on sale. Removing interest deduction would fix the problem faster, though more painfully than a CGT. Interest deductions are being used as a subsidy in property investment, but not so much other productive business sectors, which we wish to encourage. Banks are of course happy to lend when they have security over property.

    1. Genuine question Jeff: why do you consider that interest on loans for property investment should be treated differently from interest on loans for any other business activity? How would you treat a business that borrows to purchase both a building and machinery etc? To their credit, the present government closed both the LAQC loophole and the depreciation rort (where IRD had consistently failed to pursue sellers who had not declared depreciation recovered). Disclosure: I carry no loans so am a disinterested party.

      1. I tend to agree with Jonno on this one; interest costs are an expense, and there’s no real reason to treat them differently than other expenses. On the other hand, we should get a CGT in place – not because it might slow house price increases, but because it’s a “gaping hole” in our tax system, as Brian Fallow puts it. Ideally, this should be applied across all property and other assets, so a bit broader than the Labour proposals which exempt “the family home”.
        The LAQC and depreciation were changes that had to happen, although I think that the depreciation changes could have been done a bit better – they create a bit of an issue for leasehold property.

        1. This always sounds like the wrong way to frame the question to me: surely it’s not about treating business equitably (landlords don’t compete with machinery suppliers etc) but about treating participants in the property market equitably? I don’t see any shortage of people queuing up to be landlords in this country, but there are a lot less queuing up to be machinery suppliers.

          I agree that properly enforcing CGT is the real fix, but it’s clear that property investment is not a business like every other one. Few businesses acquire value for so little OPEX expenditure by comparison. The worst aspect is that it sucks investment from more investment in businesses that truly create new value to a much higher degree.

      2. Jonno – suggestion qualified by “If the political outcome we want is for residents to own houses”.

        Interest could be treated differently to level the playing field between geared investors who leverage off other assets and the asset poor first home buyers, assuming we want to lift declining home ownership levels.

        Borrowings for commercial buildings and machinery create a productive sector in the economy, whereas there seems to be plenty of evidence to show the incredible sums borrowed on housing are doing the opposite for an entire generation (not mine by the way).

        CGT would probably be a more palatable solution, but in my view messy to administer.

  4. Rents have not been stable in proportion to income in Christchurch. . The below facts shows how disaster economics works in NZ. Who benefits who doesn’t.

    3. This chart shows median rents have increased $130 from $320 per week to $450 in Christchurch, a 41% increase in three and half years. This is much more in absolute and percentage terms than any other urban area in New Zealand, the Wellington, Auckland and National increases being between 13% and 17%.

    For Christchurch this translates to a $6,500 annual rental gain to the typical landlord and corresponding loss to the tenanted household. Median household incomes are only $65,000 to $70,000, so this is the equivalent of the tax rate going up 10 cents in the dollar, i.e. tax payments increasing from say 20% to 30% of household income. Future tax cuts will not be this big so for tenants housing reform is more important than tax cuts.

    The situation is predicted to get worse with rents forecasted to hit Auckland levels by next year.

    The housing supplement is much less in Christchurch compared to the North Island cities, the supplement works on zones and in the Christchurch zone the maximum supplement is $51 per week, it is $45 more in the North Island cities at $96 per week.

    These zones have not changed since 2005, so tenants are burdened with the full cost of post earthquake rent increases without any protection from government agencies.

    1. I suspect the Christchurch situation indicates a genuine housing shortage, as opposed to the one Demographia keeps telling us we have everywhere in the country.

      1. Greater Christchurch had nearly 8,000 homes red zoned, and many thousands more which have been uninhabitable or close to it, needed demolition etc… by comparison, there are around 160,000 households in the area, so the city lost around 5-10% of its housing stock. It’s a natural disaster which has had serious consequences for household budgets, as Brendon points out.

        But let’s not get into the Demographia/ planning etc thing here please, this post isn’t really the place for it. It’s a post about the shift from high inflation to low inflation, and the flow-on effect that has on housing prices.

  5. I will not get into the whole Demographia argument but what if NZ had European style rental conditions that were more like long term rentals. Then tenants could safelyremain as tenants until housing prices calmed down.

    1. already it’s a shame that you do a contract for a year but the landlord can increase the rent earlier. It is surely skewed towards the lanlord I guess not many MPs rent…

      1. > already it’s a shame that you do a contract for a year but the landlord can increase the rent earlier.

        No they can’t. The Residential Tenancies Act 1986 s.24 (g) prohibits any rent increase above the amount agreed in the tenancy agreement, for a fixed-term tenancy.

    2. > what if NZ had European style rental conditions that were more like long term rentals

      You can legally do things like long-term rental agreements in New Zealand, and when you’re talking about a five-figure-a-year business deal like renting a house, there’s room to negotiate things like that. I’ve had a one-year fixed term tenancy with an option to renew for another year at the same price, for example. But that was in “dying” Wellington, with a more predictable property market.

      But fundamentally there’s the same problem with renting as with buying a house – too much competition for too few houses, leading to poor quality and high prices. It’s not something you can fix with legal shenanigans. It’s something you fix by building more and better houses for people, whether they come from the government or the private sector.

  6. A lot financial experts would tell you that the 10 year government bond is the risk free rate, but that ignores the simple truth that the government controls the inflation rate. For now it is low and reasonably stable but that hasn’t been the case for much of history. I think most New Zealand view the return on property closer to risk free as you can remove monetary risk and policy risk. It is part of why we pour money in, we dont trust the government or the financial sector. So I am not sure that lower nominal returns leads to higher house prices like a bond model but rather the opposite, we bid up properties in order to preserve out money and that leads to lower gross returns. We dont really invest in property as much as hoard it.

  7. Another interesting contribution from the Reserve Bank of Australia, via Bob Dey:

    The RBA researchers argue that the best way to tell if houses are overvalued is to compare the costs of home ownership to the costs of renting. They’re dismissive of price:income ratios (e.g. Demographia), and comparing price:rent ratios to their long-term averages (e.g. OECD, The Economist). Instead, the relevant factors are thing like the day-to-day expenses (which presumably don’t change too much over time), interest rates (which do), and – as a bit of a wild card – how much house prices are expected to increase in the future.

    In brief, the researchers find that houses in Australia aren’t overvalued at the moment, although there are times when they have been. They also note that “home ownership is more attractive the longer a house is owned… consistent with conventional wisdom, households expecting to move again in a few years’ time are better off renting, unless they believe they can sell the property for an unusually large capital gain.” This “conventional wisdom” has often been forgotten in NZ in recent years!

    It’d be interesting to see the same approach applied here. The Australians don’t seem to have experienced the same degree of house price growth as we had here in the early 2000s, and that could easily have fed into higher expectations for future growth. I wouldn’t be surprised if homes were found to be a bit overvalued in Auckland and Christchurch currently, due to genuine supply shortages for those cities. But I’d also expect that these issues would moderate over time – the next 3-5 years, say. There’s also the bite that will start to come from interest rate rises in the near future. Overall, it’s pretty hard to see there being significant capital gains in NZ housing in the future, certainly nothing like we had in the early 2000s.

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