Australia’s fatal flaw: Negative Gearing

“You only find out who is swimming naked when the tide goes out.”

– Warren Buffett, Chairman’s letter 2001.

Negatively geared property investors are exposing themselves, the banks and every Australian citizen to capital destruction, a highly infectious disease that leaves permanent scars.

Negative geared property is the glaring weakness in Australia’s deflating housing market. Even modest falls in house prices will force tax-driven ‘gearers to dump rental properties. Only those who sell now for whatever they can get have any chance of keeping their capital intact.

Australia is just now starting to hear the muffled warnings that it has blown a property bubble of immense proportions.

The ATO says about 1.7 million taxpayers have rental income. Of these, around 1.25 million are negatively geared, generating a net rental loss of $6.5 billion in 2009 to claim against other taxes. 1.19 million own just one investment property, 294,000 have two, while 88,300 have three. 14,100 Australians have six or more investment properties.

The vast majority are middle income earners trying to escape Australia’s punitive PAYE tax system.

Relying on heavy borrowings and deliberate thin equity means their financial position can turn around with surprising speed and force. Negative gearing accelerates gains in a rising market; it erases equity in a falling one. Worse, the assets they bought with borrowed money are both illiquid and lumpy.

Middle income earners typically do not have the asset base or liquidity to promptly top up their equity if prices fall – as their mortgage contract provides.

For twenty years property spruikers have worked to sell the residential real estate dream. And access to easy credit – you should see how much the lender’s mortgage calculators allow negative gearers to borrow! – has created an entire class of landlords that are one pay-packet or half a month’s rental from insolvency.

Further, much of the housing stock sold to this poor rentier class is sub standard, poorly located or in SE Queensland.

The wholesale lenders are already starting to see investor arrears overtake owner occupier arrears.

Unravelling this mess – selling up the properties at a discount, lenders clawing back the capital losses from ’gearers and the widespread wealth destruction resonating through the economy – will drive Australia into a credit-driven recession. This will be an ugly end to the extraordinary twenty years of unbridled growth we have just experienced.

The ‘gearers will have been warned by their accountants of the serious risks they face. But many were seduced by innovative property sales techniques and the siren song of owning a ‘rent roll’.

Skilled investors do not indulge in negative gearing or residential property portfolios. They would never willingly expose themselves to these terrible risks. The maximum borrowing they would tolerate would be where rents are 120 per cent of interest costs. Skilled investors regard residential property as a highly unattractive asset class with poor returns, high maintenance charges and significant vacancy risk.
The ‘gearers were reacting to the serious flaws in our tax system by minimizing their PAYE obligations and maximizing concessionally taxed capital gains.

Australia’s tax base relies very heavily on wage and business imposts. The Henry Review recommended removing 125 stupid, behavior-altering, hard to administer and easily evaded taxes and relying on a few, including Land Value Tax and the Resources Super Profits Tax.

Blame-merchants pointing the finger at ‘gearers for the unfolding economic damage need to put responsibility where it belongs. I say, the tax system made them do it.

10 Comments

  1. Steven Shaw25-05-2011

    The tax system is simply a catalyst. Housing booms were had in other countries that do not have negative gearing. The root cause appears to be the credit/lending/banking/monetary system.

    Curious if you can think of an alternative way out of Australia’s current predicament other than discounted/forced sales etc?

  2. Bryan Kavanagh25-05-2011

    Nice article, David!

    Yes, I agree negative gearing only worsens the situation in Australia, Steven. Whilst other countries don’t have negative gearing, few if any of their tax systems capture back a significant enough part of the community-generated uplift in land values through municipal rates, land tax, &c. This weights all tax systems to favour property ‘investment’ (as against productive activity).

    The question of an alternative to forced sales is a good one, and I’d be interested to learn how to keep people in their homes, especially those first home buyers conned by the FHOB. Down the track, as all banks contract the wobbles, I know the last thing we should be doing is bailing them out.

    I see people are already discounting Australian bank shares, and it seems GE is looking to offsell its Oz mortgage portfolio. Gee! That’d really be a bundle worth owning, he said, lying through his teeth. What will GE pay the Australian banks to take it off their hands?

  3. David Collyer25-05-2011

    @ Steven: We dont have NINJA borrowers or land shortages as the base of our land bubble, but the thin equity of ‘gearers is a significant risk not present in other countries. We definitely have a credit bubble.

    The government will consider every tool available to ease the coming slump. Gen X & Y won’t tolerate a FHOS – they understand clearly this simply lifts prices.

    I predict: lower but not zero interest rates with the government picking up the funding burden from departing o/s lenders to our banks; higher inflation than usual to dilute the loan burden (a cost to depositors); challengingly high immigration to soak up the housing oversupply; determined buying by government for welfare housing, road construction or even parkland; big ‘nation-building’ infrastructure projects to soak up the unemployed construction workers; a breathtaking increase in government debt (from a very, very low base) due to its spending and the automatic stabilizers of higher welfare payments and lower tax take.

    The discounted sales will go ahead by the banks who will suddenly find themselves owning great swathes of property. The banks will capture every available buyer and undersell private vendors at every turn, so dont plan to sell property for the next six plus years.

    Cheery, aren’t I.

  4. Steven Shaw25-05-2011

    @Byran, I’m sceptical about the extent to which our economic woes are due to not capturing land price increases due to tax-payer funded infrastructure/parks etc. Is there a way to quantify what price increase is due to increased public services and what is simply due to a speculative credit bubble?

    @Bryan, on the issue of what to do. Certainly not bailing out the banks. I don’t have answers but I’d be willing to consider some or other of the following: prosecuting bankers, lenders, mortgage brokers etc; reversing mortgages for folks duped into this boom without having them go bankrupt; some kind of debt jubilee? (could try printing up $100,000 for every Australian to make it fair for savers like myself :); retire the bank lending system; do something with the monetary system (but what would fly?).

    @David I certainly hope that our government doesn’t do everything you imagine they will but you list many of my greatest fears. It’s sure that the RBA will finally have to reduce the cash rate. As a saver who’s currently living off his savings, this is a bad outcome for me. Inflation is already out of control… I’m even considering heading back to the UK (I’m a dual citizen). Amazing to think that the UK could be better off than Australia but I could rent a decent detached house (somewhat unusual in the UK) for about $300AUD/week.

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  8. David W30-04-2012

    Crash baby crash…. I’m totally sick of the “lucky country” bullshit, bogan mentality, speculations, spruiking and incompetence I have been exposed in this God forsaken place for the last 20 years. Thankfully there is a very small percentage of people and places one can listen to or visit without experiencing an instant rise in blood presure.
    Thanks David for your effort…

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