Housing Hunger Games: negative gearing catching fire

by Harry Chemay | Mar 25, 2024 | Finance & Tax, Latest Posts

The Budget will soon disclose the booming transfer of more wealth via negative gearing to the already wealthy. Harry Chemay reports on negative gearing and the political reality of politicians mollycoddling investors and leaving renters in the cold.

Australia’s residential housing supply stood at 10,852,208 private dwellings during the 2021 Census, of which 30.6%, or some 3.3 million, were rented.

The vast majority of residential rental properties in Australia are owned by private landlords, those rented via state or housing authorities having halved since 1999 to around 3%. These landlords now hold residential property wealth valued at over $2.5 trillion.

According to Tax Office data, some 2,245,000 individuals had an interest in a rental property during the 2020-21 income year.

Rental-related deductions are now the second-largest item of tax revenue forgone.

Collectively, Treasury estimates that these individuals will punch a $27 billion dollar hole in this year’s Budget. So who exactly are these property investors?

Far from the myth of ‘mum and dad investors’ perpetuated in the wider media, residential property investing is a game disproportionately played by those higher up the income scales. Treasury analysis below shows that more than a third of benefits go to about 500,000 landlords who happen to be amongst the top 10% of income earners.

Chart 1 - Treasury Share of Rental Deductions by Income

Source: Australian Treasury 2023-24 Tax Expenditures and Insights Statement

Or, in Treasury’s own words:

Rental deductions are most commonly claimed by those with higher taxable incomes, with individuals in the top 30 per cent of taxable income accruing 65 per cent of the total benefit.

But why would presumably intelligent taxpayers be so enthusiastic about an investment that likely makes a cashflow loss each year, dipping into their own pockets for the difference between the rent collected and the expenses (loan interest, council rates, agent fees, property taxes and maintenance) incurred?

Surely it can’t just be for negative gearing’s ability to deduct rental income losses against other assessable income, can it?

Rental Crisis – The West Report

Residential property – a ‘sure bet’ investment?

Somewhat ironically, the Australian Securities Exchange (ASX), that bastion of Australian capitalism, has inadvertently provided the key insight.

In a series of ‘Long-Term Investing Reports,’ the ASX (together with global asset firm Russell Investments) calculated the 10 and 20-year returns for some of the most popular investing strategies, including cash, Australian shares, managed funds, and, yes, residential investment property.

The endeavour was, presumably, to highlight the superiority of Australian shares (its own ‘product’) as a creator of long-term investment wealth.

Rather than functioning as a content marketing campaign for shares, the reports backfired spectacularly by consistently pointing to the same outcome: the final report (to the best of the author’s knowledge) somewhat exasperatedly concluded,

The top line results from the 2018 Russell Investments/ASX Long-term Investing report are: Australian residential property outperformed all asset classes for the 10 and 20 years to 31 December 2017.

The below chart, taken from the 2018 report, shows how much better: residential investment property first, daylight second.

Chart 2 ASX Russell Long Term Investing Report 2018

Source: 2018 Russell Investments/ASX Long Term Investing Report.

And that’s before accounting for taxes. When they are, property investment extended its historic advantage for high-income earners over Aussie shares, despite our dividend imputation system.

For a top marginal taxpayer, property’s pre-tax return of 10.2% per year for the 20 years to 2017 reduced to 7.6% per year after tax, markedly higher than the net 6.7% per year achieved by the same taxpayer holding Australian shares.

Residential property also generated returns 3% per year higher over the period than Australian listed property trusts, which generally invest in commercial property such as office buildings, shopping centres and industrial warehouses.

Same asset (land and a building on it that can be leased), yet vastly superior investment returns for residential property investing.

Residential property bending the rules of investing

On any rudimentary understanding of investing risk and return, these outcomes should not occur so consistently over such extended time periods.

Shares are far riskier than residential housing, and in a well-functioning capital market, this should result in higher long-term returns for share market investing.

For example, in the depths of the global financial crisis downturn, the report found that as Australian shares crashed 40.4% during 2008, residential property declined a gentle 3.7% by comparison. Only during three other years did property investments deliver a return less than 6%.

In residential property, Australia has clearly found a way to break with established investing norms.

We’ve managed to create an investment strategy where the returns bear little relationship with, and are nonsensically above, the risks borne in attaining them, particularly after tax.

In one sense that’s a stunning feat of political and taxation engineering, somewhat unique amongst developed economies, where the long-term appreciation in the value of housing has been found to be entirely attributed to the rental yield, with real capital gains close to zero.

In another, it means that renters engage in the housing market with a proverbial peashooter, up against property investors carrying the financial equivalent of a bazooka.

Australia’s renters versus rent seekers

Australia’s renters (and prospective first homebuyers) now find themselves trapped in a game they can’t remotely win unless one of two things happens: either real income growth must accelerate while house prices stay constant, in real terms, for an extended (multi-year) period of time, or housing prices would have to fall to rebalance the historical multiple of prices to income. Neither is likely to eventuate any time soon.

With the wage price index rate for 2023 at 4.2%, the highest annual wage growth since 2008, wage growth is an unlikely route out of the housing Hunger Games. Falling house prices would upset the nation’s property owners and investors. In the numbers game that is politics, neither side wishes to see this scenario occur.

Chart 3 - Wage Price Index Chart

Source: Australian Bureau of Statistics, Wage Price Index, Australia December 2023

Very simply, absent decent and sustained long-term wage growth, the only way to make the majority of the population feel like they’re progressing in life now is with ever-escalating property prices.

This ‘wealth effect’ is not a particularly sophisticated way to manage an economy, but it is remarkably efficient.

Former Prime Minister John Howard’s political antennae were well calibrated when he noted that no voter had ever approached him to complain about the value of their property rising too much.

The flip side, however, is that no government now wants to see house prices fall on their watch.

Wealth effect ‘Catch-22’

The wealth effect working in reverse would damage consumer confidence and, if severe enough without offsetting changes (interest rate cuts), might induce a recession.

That would be a fast way for an incumbent government to find themselves on the opposition benches.

So here we are, in 2024, in Australian housing’s Hunger Games. Fabulous for the 7-odd million households who own the roof over their heads, particularly where mortgage-free.

And fantastical for those investors who also own the roof over someone else’s head; thanks in large part to the twin boosters of negative gearing and the post-1999 capital gains tax rules.

For those wanting to rent by choice or forced to rent while the dream of home ownership becomes ever more distant? Not so much.

The Hunger Games of renting. Most liveable cities in the world or dystopian nightmare?

Editors note: This article is the second in a series on the housing crisis.

Harry Chemay has more than two decades of experience across both wealth management and institutional asset consulting. An active participant within the wealth and superannuation space, Harry is a regular contributor to investment websites in Australia and overseas, writing on investing and financial planning.

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