The abolition of negative gearing and the inevitable housing downturn

Over recent decades housing has evolved into one of the central pillars of the Australian economy, underpinning household wealth, consumer confidence, bank profitability and a substantial share of national economic activity.

Australian residential property is estimated to be worth around $12.8 trillion[1], making it by far the largest asset class owned by households. The value of the nation's housing stock now rivals the annual economic output of some of the world's largest developed economies.

When a nation becomes increasingly dependent upon ever-rising property values, even modest price falls can have consequences well beyond the housing market itself.

For many Australians, rising house prices have been synonymous with prosperity. Housing appreciation has supported wealth creation, strengthened household balance sheets and underpinned consumption for decades. Yet this success comes with a hidden vulnerability. When a nation becomes increasingly dependent upon ever-rising property values, even modest price falls can have consequences well beyond the housing market itself.

That vulnerability is now being tested.

Until early May, housing markets in Brisbane and Perth were setting records. Pent up demand, a supply deficit, immigration, and tax incentives had all contributed to an environment fuelling price growth. The May Federal Budget altered the incentives underpinning residential property investment. The abolition of negative gearing for existing dwellings and the reduction in capital gains tax concessions materially changed the economics of property ownership for many investors.

Market responses were rapid. Reports from lenders, brokers and estate agents pointed to a sharp reduction in investor participation. In August, the Commonwealth and Westpac Bank reported large and unprecedented falls in investor mortgage applications since the 12 May Federal Budget, down by 28%[2] and 26%[3]

The abolition of negative gearing for existing dwellings and the reduction in capital gains tax concessions materially changed the economics of property ownership for many investors.

Investors currently account for around 40%[4] of housing-finance-backed residential property purchases in Australia, up significantly from around 24%[5] five years ago. With investor participation contracting sharply, a significant source of housing demand has weakened, increasing downward pressure on prices.

Without negative gearing, investor borrowing capacity is reduced. The capital gain required to breakeven after costs becomes higher. All of these factors significantly reduce the attractiveness of buying an established property for an investor, limiting demand for these properties to traditional upsizers, downsizers or first home buyers. Of course, the abolition of negative gearing abolition did not extend to new builds. Policymakers were hoping that investors would flock to this end of the market to counter the downturn in the established dwelling market. But this has not yet happened, and is unlikely anytime soon.

All of these factors significantly reduce the attractiveness of buying an established property for an investor, limiting demand for these properties to traditional upsizers, downsizers or first home buyers.

Investor appetite for new dwellings has also been constrained by concerns over construction quality, project delays, builder insolvencies and remediation costs. Many investors further recognise that long-term property appreciation is typically driven by land scarcity rather than the dwelling itself, which depreciates over time. The other problem for an investor buying a new build today is that it becomes an established property (limiting the pool of potential buyers) when it is later sold.

Given these circumstances, house price falls were inevitable. Leading economists cannot agree on the magnitude of the downturn but forecasts have been consistently revised down since the May Budget. Major bank and economist forecasts for Sydney and Melbourne generally imply peak-to-trough declines of around 8-13%, with some analysts warning of larger downside risks.

Leading economists cannot agree on the magnitude of the downturn but forecasts have been consistently revised down since the May Budget.

When the first signs of housing weakness began to show up, the Labor government quickly blamed interest rates and global uncertainty. While it is true that these are incidental factors, the timing and sequence of events does little to support this claim.

The Government has consistently maintained that these reforms would have only a modest impact on housing prices. Housing Minister Clare O'Neil has pointed to Treasury modelling suggesting only mild affordability effects from the changes[6]. If property prices ultimately fall materially more than anticipated, difficult questions will inevitably be asked. The divergence between forecast and outcome would represent a significant public policy failure.

Supporters of the reforms argue that reducing investor demand may improve affordability for owner-occupiers and redirect capital towards more productive parts of the economy. Few would dispute the merit of that argument. While these benefits may emerge over time, the transition risks associated with a sharp decline in housing activity could prove far more significant in the short to medium term.

The stakes are high. Australia enters this housing downturn in a vulnerable position. Not only is household debt among the highest in the developed world, but almost one quarter of annual economic activity is linked to the sector. Housing construction, real estate services, mortgage lending, conveyancing, legal services, insurance, and property management collectively represent a significant share of economic activity (10-11% of GDP[7]) and employment (12% of jobs[8]). When the host of downstream suppliers are included, including furniture, whitegoods, carpet, window furnishings and other related retailers, the combined contribution to GDP is in the order of 24%[9]^.

Australia enters this housing downturn in a vulnerable position. Not only is household debt among the highest in the developed world, but almost one quarter of annual economic activity is linked to the sector. 

It follows that when housing weakens, almost one quarter of the economy is likely to slow too. The second order impacts though are more significant. The effects ripple through consumption, employment, credit growth and business confidence simultaneously.

The biggest risk may ultimately lie in the banking sector. Bank lending is likely to slow as housing activity weakens, reducing loan growth and intensifying competition for existing borrowers. More importantly, the Australian banking system remains heavily exposed to residential mortgages. Housing market conditions have an outsized influence on consumer confidence, financial stability and economic growth.

The biggest risk may ultimately lie in the banking sector.

Falling house prices can create a negative feedback loop. As household wealth declines, discretionary spending often slows, reducing demand across the broader economy. If a housing slowdown were to coincide with an external shock, such as where the war in Iran becomes intractable and oil shipments remain heavily restricted, recession risks could increase materially.

A sharp rise in unemployment would place additional pressure on borrowers. Banks lend on the assumption that households can service their debts and that the underlying collateral retains value. If employment conditions deteriorate while property values fall, arrears and bad debts could rise.

Fortunately, the Australian banking sector enters this period from a position of relative strength. Most homeowners have accumulated substantial equity over many years of house-price appreciation, and banks remain well capitalised. As a result, the probability of a housing correction developing into a broader financial crisis appears low.

The probability of a housing correction developing into a broader financial crisis appears low.

That will offer little comfort to households that purchased property shortly before the policy changes. For some, falling prices may already have pushed them into negative equity, where the value of their home has fallen below the amount owed on their mortgage. For those forced to sell because of unemployment, illness or other life events, the consequences can be severe. For this cohort, the Australian dream could turn into a nightmare.

When an asset class worth more than $12 trillion sits at the centre of household wealth, banking stability and consumer confidence, policymakers should approach structural reform with considerable caution.

The coming years will determine whether the benefits of the controversial tax changes ultimately outweigh the economic and political costs of the transition. When an asset class worth more than $12 trillion sits at the centre of household wealth, banking stability and consumer confidence, policymakers should approach structural reform with considerable caution. The greater the economy's dependence on housing, the greater the risk that unintended consequences extend far beyond the property market itself.