What’s driving capital gains in residential property?

What’s driving capital gains in residential property?


by Shahrukh Abdali, AFA, CFA

This article is the first of a series aimed to address some of the common topics our clients ask us to comment on. I hope the information provided will be useful to readers when making financial decisions. Note that the information provided is not intended to be financial advice and I would encourage you to take personalised advice from an Authorised Financial Adviser before making investment decisions.

Property is an evergreen topic of discussion in New Zealand. This has particularly been the case for the last five or so years given the rapid rise in property prices. Accordingly, I consider it appropriate to write about one of the most important aspects related to New Zealand Property – Capital Gains. To be clear, for the purposes of this article, New Zealand Property refers to residential housing in New Zealand. This article is primarily aimed at existing property investors or those that are considering making an investment in property. That said, first-home buyers and existing home owners may also find this article useful.

Capital gain is by far the biggest motivation for people looking to invest in residential property. It is also an important consideration for owner-occupiers in order to build equity for upgrading to a better property or perhaps using the equity created from capital gains in their own home to buy an investment property. There are also a growing number of homeowners downsizing their properties in later years to free up capital for personal use or homeowners moving to other parts of the country where property prices are lower enabling them to realise capital gains.

For the 5 years to March 2018, the median house price in New Zealand has risen from $398,500 to $560,000 (source: REINZ) representing an average growth of 7.0% per annum. Auckland has led the way with its median house price rising from $565,000 to $880,000 (source: REINZ) representing an average growth of 9.3% per annum. If you owned a property (or a few) over this time, you would likely have seen your capital grow significantly. That said, it is worth highlighting that the median house price in Auckland reached a peak of $900,000 as at March 2017 (source: REINZ) so it has come off its peak and has not been a source of capital gains since. I have quoted the median price (the middle of the range) rather than the mean price (the average) because the mean price can be biased particularly by the sales of high price houses.

There are numerous factors that have contributed to the rise in property prices over this period. A comprehensive discussion of all factors is beyond the scope of this article. However, three of the key factors are; i) record net migration combined with ii) easily obtainable and cheap credit (mortgages) fuelling high demand for houses and iii) lower supply of houses than required to meet the high demand. I review each of these factors below and consider how they might change going forward.

Strong Net Migration

Source: Statistics NZ

Calculated by subtracting permanent or long-term departures from permanent or long-term arrivals, net migration per annum increased in New Zealand from negative 4,068 in February 2012 to peak at positive 72,402 in July 2017 (source: Statistics NZ).

Migrants need somewhere to live so naturally the growth in net migration over this period has increased the demand for residential housing. It is worth noting that net migration has come off its peak to 68,943 in February 2018 (source: Statistics NZ). With a combination of the labour market in Australia tightening (i.e. a growing number of jobs vacancies across the ditch), a less “migrant friendly” new government in New Zealand and the increasing chorus of economists expecting the New Zealand economy to lose some of its steam in the short to medium term, it would be reasonable to assume that net migration will continue to trend lower from here. Since new migrants contribute to the demand for residential property, a decrease in net migration would be expected to ease the demand pressures on residential property.

Cheap Mortgages

Source: RBNZ

Over the last 5 years we have witnessed historically low mortgage rates in New Zealand on the back of historically low interest rates around the globe. This cheap funding has been readily available to property investors and homeowners alike. An environment of very low mortgage rates has enabled purchasers of property to borrow more than they would if rates were higher and increased their willingness to pay more for a property due to the lower loan servicing costs. However, interest rates are unlikely to remain at historically low levels forever and with rising interest rates comes rising mortgage rates. Globally, the US Federal Reserve (the US equivalent of the RBNZ) has already started to raise the federal funds rate albeit off a very low base with other central banks indicating their intentions to follow suit. The Reserve Bank of New Zealand (RBNZ) is expected to raise the Official Cash Rate (OCR) within the next 18 months. The RBNZ also implemented credit restricting measures in the form of loan-to-value ratios (LVRs) back in 2013 to constrain the growth in mortgage lending in an attempt to take the heat out of the housing market. Subsequent RBNZ tightening in lending requirements were recently eased slightly, allowing the banks to lend up to 15% of new mortgage lending to owner occupiers with a deposit of less than 20%. Furthermore, banks will be able to lend up to 5% of new mortgage lending to residential property investors with a deposit of less than 35%. So far, these changes have not and are unlikely to induce a house price resurgence as banks are expected to maintain tighter lending criteria due to the cost of raising deposits domestically in a low-interest rate environment and the risk of higher interest rates associated with raising funds offshore.

Low Supply

Ongoing construction of new properties is required to meet demand. As mentioned, demand for residential property has in part been fuelled by record-high net migration over the last few years. Building consents issued for new residential dwellings have increased substantially from 17,481 for the year ended February 2013 (source: Statistics NZ) to 31,245 for the year ended February 2018, but the time taken from the issue of a building consent to the actual completion of the dwelling means that supply is lagging demand. Furthermore, supply is not keeping up with demand due to capacity constraints around labour, materials and the availability of land. It is worth pointing out that tougher credit conditions are not helping property developers, some of whom are holding consents issued for new apartment blocks but struggling to secure finance to build. The lag in supply of new properties to the market due to capacity constraints in conjunction with high demand has created an ongoing shortage of residential housing in New Zealand (more pronounced in Auckland due to the city attracting the greatest share of net migrants). Initiatives taken by the new government are expected to increase the supply of new properties as well as subdue the demand in order to address the existing shortage. I will delve further into this and the implications in the next issue.

To sum it up, 3 of the key factors driving property prices are;

  • Strong net migration which is expected to trend lower,
  • Historically low and readily accessible mortgage rates but for how much longer, and
  • Supply of residential housing constrained by shortage of labour, materials and the availability of land, which the new government is looking to address.

Economics 101 would suggest the ongoing high demand and constrained supply of residential property should support current prices and further rises. I do not disagree with this in principle, however, I also believe that the above 3 drivers of property prices are starting to wane. In my opinion, current property prices broadly reflect a state of equilibrium for the present demand and supply dynamics. Put simply, New Zealand property prices are likely to remain flat or experience low growth for the foreseeable future. In the absence of material capital gains, what will this mean for property investors? I will address this in a subsequent issue.

In the next issue, I will discuss the new government’s policies with respect to housing and what that might mean for current and prospective property owners.