House prices pushed up by tax and interest rates

House prices have doubled in five years, but they are not materially overvalued, say Westpac economists.

Monday, March 19th 2007, 12:21PM

by The Landlord

Rather, house prices have risen for good reason says Westpac chief economist Brendan O’Donovan.

The two key drivers in the recent house price boom are higher tax rates and lower interest rates, he says.

The increase in the top tax rate to 39% increased the attractiveness of property for investors, pushing up prices by about 17%.

O’Donovan explains that most landlords make a loss on their rental properties, since the rent does not cover the mortgage interest and expenses. This loss can be offset against other income, effectively reducing the landlord’s taxable income. The landlord receives a tax rebate on rental losses at their marginal tax rate. If the marginal tax rate goes up, the tax rebate goes up.

The fall in long-term interest rates made it cheaper to take out a mortgage, meaning people could bid more for property to the tune of 20%.

With lower long-term interest rates now than in the 1990s, it is cheaper to borrow money for purchasing property. From an investor perspective, lower interest rates spell lower costs and greater profits. Since mortgage interest is often an investor’s main expense, small movements in long-run interest rates can have big effects. Between 1999 and 2007, five-year mortgage rates fell from 9% to 8%. O’Donovan estimates that this increased the investor value of property by almost 20%.

Together, tax rates and interest rates explain more than a third of the house price increase this decade, says O’Donovan, and claims property is now more-or-less fairly valued.

Capital gains are the last piece in the puzzle behind the investor value of housing, O’Donovan says. To justify current house prices, investors must realise a long-run capital gain of 6% per annum. The historical average increase in house prices is inflation plus 3.3% per annum. Inflation expectations are currently around 2.7%. Current house prices are not based on unrealistic expectations of capital gain, he says.

The main risks O’Donovan sees for property investors are a fall in the top tax rate, or an increase in long-term interest rates, because either could reduce the investor value of housing. And a reduction in the investor value of housing could lead to a downturn in the housing market as a whole.

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