Same old same old… new Reserve Bank rules change nothing

The Reserve Bank (RBNZ) recently proposed a 70% LVR restriction for investors in the Auckland property market.

While it was tempting to jump straight out of the gates with a comment, we thought it would be more useful to wait for the RBNZ’s discussion document and provide a deeper analysis of their announcement.

In this article we look at their argument for the need for a LVR restriction and the potential impact this might have on Auckland house prices.

The 30 second summary

From Oct 1 the RBNZ has stated that it will implement a new prudential measure that will require investors in the Auckland property market to have a 30% deposit.

The Reserve Bank have now released a consultation paper that lays out their argument for the assertion that the Auckland housing market poses a risk to the New Zealand economy. Their argument is based primarily on its analysis of what drove the collapse of the Irish and US house markets during the GFC. However we would argue that New Zealand’s property and banking fundamentals are significantly different from these markets and therefore the rationale is flawed.

In the end, even the Reserve Bank admit marco-prudential measures will only have a moderate effect on house price growth and the impact of such measures tend to wane over time. They also think house price growth will persist in the near term.

So what impact do we think this prudential measure will have? The same as the RBNZ – rather limited.

The Detail

What has actually been announced?

• On 15 May RBNZ announced it was looking to enforce a requirement that banks lend a maximum of 70% on new property investment purchases in Auckland in order to control what it perceives is dangerous price inflation, with effect from 1 October 2015.
• They have now released a consultation paper which they are looking for feedback on by 15 July.
• Once they have announced the feedback they will release the final format of the policy by early August.
• Any new policy will take effect from 1 October.

Why the RBNZ’s argument for LVR restrictions may be flawed

The RBNZ thinks the Auckland housing market is over heated primarily because the income to house price multiple is too high and because there are too many speculative investors in the market. Because of this they think there could be a house price correction in an economic down turn resulting in investors that can’t afford to service their loans or in a negative equity situation, to walk away from their loans. This in turn puts the balance sheet of banks in jeopardy and the economy in general at risk.

So is this a sound argument?

House price median as a multiple of income. This is an old measure, often favoured by economists, but not necessarily reflective of risk. Yes Auckland’s multiple is higher than London and Melbourne but not by much. When you step back and think globally, you realise that urbanisation means Auckland is becoming an increasingly popular place to live on a global scale. It’s no longer mowing the lawns, washing the falcon, and Mum at home with the kids, the world has changed and Auckland is a place many around the globe want and can live in. Minister for Building and Housing, Nick Smith, told a recent Property Council audience that Auckland has a housing supply problem and its New Zealand’s housing problem.

The RBNZ points to the US and Ireland housing markets pre and post the GFC as examples of what can happen when speculative investors drive market prices up. We contend that Auckland is nothing like these examples. In pre-GFC USA, many banks or lending institutions would approve loans based on self-declared income – i.e. the borrower didn’t have to verify their income (the so called “liar loans”). This resulted in many loans approved to people that couldn’t really afford them. In some states in the US residential loans are non-recourse, meaning that in the case of default the bank can take back the house, but they can’t take any of the borrower’s other assets. Combine these with a “bankruptcy” culture in the US – so even in states where loans are not single recourse, there is a greater cultural acceptance of walking away from a debt. NZ banks on the other hand are very good at multi recourse loans. Generally any loan you take out with a bank will be secured by every property you have already offered as security to that bank. And banks will certainly come after your other equity if you owe them money. Finally, over the last year or so banks have already had to tighten up their lending practices with a restriction on loans to people with less than a 20% deposit.

In the case of Ireland the collapse was driven by two main things – a massive over supply of new houses…700,000 homes built during the last recession resulting in one house for every 6 people. There were a lot of vacant properties during the GFC leaving a lot of investors without rental income. Furthermore, a weak financial regulatory environment resulted in loose lending practises. In Auckland we don’t have enough housing to meet the demands of the population as evidenced by plenty of publicity around the extremely competitive environment for rental housing.

What’s the real risk?

The RBNZ thinks the risk is that the higher prices climb, the more severe the correction will be with spill over effects on the banks and the wider economy. Essentially they see the risk of borrower default increasing. But again, they are relying on the US and Ireland as their examples. The people who defaulted in the US and Ireland largely did so because loose lending policy meant some borrowers were never able to afford their loan in the first place, and in the case of Ireland, there was not enough rental demand for new housing supply.

Auckland’s price growth in contrast has been driven by very solid economic principles, demand for housing is greater than supply. If there was an economic crisis we would still have a deficit of supply in Auckland and it is very hard to imagine that interest rates will rise during a recession.

Analysing the RBNZ’s assumptions.

In the discussion document the RBNZ’s first heading is “Problem Definition”. Clearly they perceive there is a problem with housing market values in Auckland. Let’s look at some of their assumptions

• Investor share of transactions in Auckland are 40%, having risen from 36% before the 10% LVR restriction – mainly because the 10% restriction pushed home buyers out of the market. True, but this is nothing new. CHRANZ reported back in 2006 that home ownership rates have been falling and they will continue to fall. It’s what happens as more people move to the city.
• Acknowledges supply constraints will not be fixed in the near term. That’s correct, and supply is one of the main reasons we have rising prices – demand far exceeds supply. Auckland needs 13,000 homes per annum based on population growth forecasts and we have a 20,000 deficit. Prices accurately reflect normal demand supply economic conditions. Keep this in mind as you read the following RBNZ suggested drivers for the house price inflation.
• The Auckland housing market is now one of the least affordable housing markets in the world, with a house price to household income ratio of around eight. By some estimates, this surpasses ratios seen in London and Melbourne, and approaches Sydney multiples. Yes the ratio is more than London and Melbourne, but only slightly. But does high multiple mean house prices are too high? NZ is a desirable place to live. A recent McKinsey paper states that trends in urbanisation in developing and advanced economies are driving a worsening housing affordability gap. Also, urbanisation experts like Richard Florida argue that the “creative class” will be attracted to cities like Auckland – with good infrastructure, safe, attractive and a great place to bring up children. Why wouldn’t people want to live here?
• Auckland is NZ’s largest city, but small compared to other large cities that have sustained house price growth. So what? That in itself doesn’t mean a weakness – especially not if people want to live here and demand exceeds supply.
• “The Reserve Bank’s concern is that the risk of a substantial correction in the Auckland property market is rising, and will continue to rise the more that prices do”. What’s the definition of fundamental values? If it’s based on income to house price values, then as mentioned above, it’s debateable.
• A significant correction in house price values could be triggered by:
     – Economic down turn
     – Down turn in migration in flows
     – Material increase in mortgage rates
  The RBNZ believe loans to investors are more risky – e.g. Ireland and US experience. As highlighted above, in the US it was much easier to get debt through “liar loans” and Ireland’s massive build of supply swamped demand. Their experience has little relevance in NZ’s stronger regulatory environment.
• Investors with own home and several properties – their gearing will be significantly higher and a substantial fall in values will leave their income more heavily under water relative their labour income – this diminishes their incentive to continue to service the mortgage relative to an alternative such as bankruptcy. This seems erroneous – isn’t the ability to service the mortgage more of a determinant of whether someone will walk? No one wants to be in a negative equity situation, but most individuals are largely informed and know that property is a long term investment and that over the long term property is very forgiving. Further to this, the implications of bankruptcy in NZ are far more serious than in the US, making their experience less relevant.
• Investors may have their own home in a trust and therefore more likely to default on investment property loans. There would not be many investors who have not offered up their own home as security. If they have, then they are unlikely to be the type of investor to default.

The RBNZ’s solution to “the problem”

Firstly, they state the objective of any policy is to reduce the rate of growth in Auckland house prices, thereby reducing the probability and magnitude of a subsequent correction. BUT, interestingly they note that given the size of the imbalances in the Auckland market, price growth is likely to persist in the short term.

Secondly, they want to protect banks’ balance sheets in the face of a housing market correction. Their assessment of the likely impact of LVR restrictions on growth rates is that it will reduce the growth rate by about 4 percentage points over 12 months following implementation of the measure, but most of the impact in the first 6 months.

Thirdly, they think the lending to investors with an LVR of greater than 70% is about 17% of lending or about 13% of Auckland property transactions. It also assumes that some of these > 70% LVR investors will restructure to avoid the restriction. In summary they think the rule will reduce transactions by about 8%.

They also note that this move will, over time, improve the balance sheets of households.

They also note the easing of the 20% LVR rule out side of Auckland could result in more Auckland investors buying in Hamilton and Tauranga.

Why LVR restrictions won’t change anything

Prudential measures in other cities haven’t always had the intended impact. In the UK banks have to charge investors higher interest rates, but that hasn’t stopped the London house prices accelerating at break neck speed. In Singapore a stamp duty imposed on foreign buyers didn’t stop price growth… in the end it was immigration restrictions and the government intentionally flooding supply with new government housing that slowed price growth.

Our analysis suggests that house sales volumes are most closely linked to population growth. As long as people can borrow, have confidence and have a job, then they will borrow to buy. The LVR restrictions will have some impact, but only temporarily.

So overall we don’t think these measures will have much impact because the real drivers – strong population growth and a shortage of supply are ongoing fundamental influencers.

What should happen?

By now you probably think that we believe the market should be left alone and let the natural forces of demand and supply take effect.

Whilst we don’t agree with the RBNZ’s case for an overheated market, nor its assessment of what would happen if there was an economic down turn or such, we are actually quite benign about the restriction. In itself it won’t stop price growth. As a professional buyer of properties we don’t like a panicky market. Far better a market that has steady, more predictable growth. So in fact – it could well extend this growth phase and bring some sensibility back. We just don’t agree with the RBNZ’s analysis of the Auckland market.

What we think should really happen, if we wanted to control price growth, is to slow down immigration. And in our opinion the RBNZ probably knows this – they know what Singapore has done, and the results, but they don’t have the jurisdiction to do so. Or, alternatively, if they really want to protect against borrowers being unable to meet loan payments, they could mandate serviceability criteria loan applicants must meet.

What would I do?

So if I was thinking of investing, I would. The RBNZ thinks prices will continue to rise until the supply problem is fixed and all their 70% measure will do is slow down growth a bit. So I say “thanks RBNZ”.

A speculative thought

The RBNZ knows the measure itself won’t stop many people buying – is it that they are relying more on the discussion and publicity around this topic to make people get nervous and back off?