Dirty little housing crisis secrets hidden by the mainstream media

There are three reasons why the housing crisis is perpetuating in Australia, but you won't hear about them in the mainstream media. Tom Orren sets the record straight.

Dirty little secret number one: Variable interest loans and the ‘springboard effect’

Interest rates play a crucial role in the current housing problem. After an interest rate rise, we hear media reports about families suffering due to increased mortgage repayments and rents, and first-home buyers who find themselves locked out of the market.

But we also hear from struggling landlords who insist they’ll go broke unless they raise rents. Then, some months later, we hear reports about a bank making record profits. Strange isn’t it? One sector of society suffers while another benefits. Most of us assume this is an unavoidable feature of our free enterprise system but it’s not. There’s a glitch in the system.

The real estate and finance markets in Australia inadvertently create cycles of boom and bust, and interest rates are a key factor, especially the variable interest rates that banks charge for most home loans. They cause what I call the “springboard effect”.

The downward bend of the “springboard” occurs when interest rates are very low. During that phase, banks maximise their profits by lending out the largest sums possible (usually at variable interest rates) and access to those loans allows house buyers to bid up prices. That provides the upward movement of the springboard. As house prices continue to rise, property buyers need even bigger loans and the banks are only too happy to provide them — because they know that bigger loans will result in even higher property prices and even bigger loans.

But whatever goes up must come down and real estate prices are no different. Eventually, prices rise beyond any rational level and (just as happens in the share market) some buyers realise that it’s time to get out. When they do, prices fall or, as sometimes happens, stagnate for several years until the rest of the economy catches up. That’s the downward rebound of the springboard.

Interest rates are important because the most important factor when buying real estate is not the price of a property, but the size of the monthly mortgage repayment. When interest rates are low, repayments appear deceptively low and the human tendency to focus on the present and discount the future means that many buyers succumb to this deception.

But the banks know that they can always raise variable rates if conditions change and even their fixed loans are only fixed for a limited time, after which they can lock customers in to much higher rates. No matter which way interest rates go, banks will always find a way to benefit.

Avoiding the springboard effect requires greater stability of mortgage interest rates, so that temporarily low rates will no longer stimulate unsustainable price bubbles. Variable-rate mortgages put all the pressure on the borrower, whereas long-term fixed loans put that pressure on banks. When we ask the simple question, “Who is in the best position to accommodate long-term financial risk?” the answer is obvious: The banks.

It is perfectly possible for banks to set fixed, long-term rates to avoid the springboard effect because that’s what happens in the USA. Fixed rates may not fix every problem in the housing market but they would be a good first step. Steady interest rates would provide less incentive for buyers to borrow large sums when interest rates are low and, therefore, there would be less incentive to bid-up house prices.

But interest rate stability is the last thing that banks want. Australian banks have created the impression that variable interest rates are better for home buyers because they can save money when rates are low, but nobody tells them that those low-interest loans drive up prices that end up costing everyone more.

They also don’t tell us that rising house prices are a great way for banks to increase their profits because they can lend larger amounts for the same homes. Of course, the fine print says that the banks can raise interest rates on variable loans at any time, but who cares about that when the fear of missing out starts a bidding war for the house of your dreams?

In the end, the springboard effect provides banks with bigger loans at higher interest rates, which is why we keep hearing that one bank after another has made record profits. The current system allows them to do so regardless of what happens to interest rates — all off the backs of Aussie battlers.

Dirty little secret number two: Profiteering by greedy landlords, including religious institutions

Rents are connected to property prices via the interest that landlords have to pay for their loans. The bigger the loan, or the higher the interest rate, the more rent they have to charge — or so we are told.

But not all rents are tied to loan repayments. There is no public monitoring of, or legal limit to, the amount of profit a landlord can make from a rental property. Regardless of their actual expenses, they are free to charge the going market rate, which is determined by the demand for and the supply of rental accommodation.

Of course, the most highly-geared landlords are the most vulnerable so, if interest rates rise, they have no option but to raise rents. However, it’s a different story for landlords whose expenses are less than the rent they receive. They are in what I call the “profit zone”, so they do not need to keep raising rents. As long as the rent they charge is 10% or more above their expenses, a landlord will make a decent return, but there is nothing stopping them from making more until their profit becomes “super profit”.

I have not been able to find figures that show the proportion of rental properties that are in the “profit” or “super profit” zones, but most rental properties that have been owned for ten years or more would qualify (and I suspect that the vast majority fall into that category).

That is based on some inside information I received many years ago about the Church of England from a friend whose father was the Church’s accountant. He told me that the Church of England was one of Sydney’s biggest landlords and that it owned hundreds (by now, possibly thousands) of properties, most of which were acquired via bequests. And I suspect that many other churches are in the same boat.

If a property is owned outright, a modest rent of $500 a week will generate a gross profit of $26,000 per annum. If we assume management fees of 10% ($2,600), $2,000 p.a. in rates and about $4,000 in maintenance costs, that will yield a net profit of $17,400, which produces a net profit ratio (NPR) of nearly 70% (when an NPR of 20% is considered high).

And because property management fees are a percentage of rent, property managers keep pressuring landlords to increase rents. This is a system that cannot help but spiral rents upwards.

These churches, and any landlord who owns multiple, low-expense properties, are likely to be in the “profit zone” and, therefore, will be more or less immune from the pain of interest rate increases. They do not need to increase rents, but they do so that they can maximise their incomes (which, in the case of religious institutions, is tax-free).

However, many smaller-scale landlords are in the same boat and are encouraged to keep raising rents by property managers who are paid a proportion of the rents they collect. And because nobody but the landlord and the Australian Tax Office (ATO) will ever know exactly how much profit they are making, they can never be accused of ruthless profiteering — even though they are.

That’s why sob stories about struggling landlords are so misleading — and why we should question the charitable nature of many religious institutions.

Dirty little secret number three: The negative gearing feedback mechanism

While many property investors only own one rental property, others end up owning many. However, most only keep their properties as long as they can provide them with the opportunity to negative gear — while their incomes attract a high, marginal tax rate. This tax advantage usually diminishes as they enter retirement, so they are often sold off to provide a nest egg.

Buying a first rental property is straightforward. The investor simply takes out an interest-only loan, which means that the loan’s principal does not get paid off. However, the entire amount of the repayment is tax deductible, which provides them with the maximum tax relief. This relief means that the cost of their monthly repayments is split between them, their tenants and the ATO — which is a very cheap way to acquire real estate.

While the interest-only loan is in place, the investor only has to pay a few hundred dollars a month (perhaps less than $100 or $200 a week) and, after five years or so, they can expect their rent and the property’s value to have increased (enough to give them significant equity).

For example, a property that was bought for $500,000 ten years ago may be worth $1,000,000 today. It could be sold and the loan paid off, with any remaining money going to the investor. Of course, they would have to pay capital gains tax on their profit, but their windfall would only be taxed at 50% of their marginal income tax rate.

However, interest-only loans are usually only temporary and the loan will eventually become a “principal and interest” loan, which means that part of every monthly payment goes towards paying off the principal. And, because that part is not eligible for negative gearing, the landlord cannot save as much tax. Also, because the property is slowly being paid off and the rent has risen, the investor’s “loss” will eventually become a profit, so the property will be positively geared and will no longer qualify for a tax deduction.

But there’s a simple way for an investor to keep claiming a negative gearing deduction, which is to take out another loan to buy another rental property. In other words, as each mortgage gets paid off, the tax system “forces” negative gearers to buy more properties, which is why so many property investors end up owning multiple properties. The tax system creates a self-perpetuating cycle of property buying and, as more tax-payers embark on that treadmill, more houses are demanded and prices are forced to rise.

Try and read about those secrets anywhere else.