Brian Fallow: Room for professionals in rental market

COMMENT

What's wrong with this picture?

One of the biggest industries around, providing an essential and costly service to more than a quarter of all households, is a cottage industry.

Tens of billions of dollars are invested in it, but it operates like something from the pre-industrial, village smithy era.

It is, of course, the residential rental property market.

We are used to thinking of it not as a service industry or as a lot of small businesses, but as an investment option, an asset class, or as part of the real estate market.

But however you look at it, it represents a rapidly growing sector of the economy.

Inland Revenue says around 165,000 people declared income from rents last year, nearly twice as many as 10 years ago.

This is in the context of steadily declining rates of home ownership. The 2001 census found 68 per cent of households were owner-occupied, down from 74 per cent in 1991.

Part of the reason is demographic, a post-baby-boom thinning of the ranks of the mid-20s to mid-40s age group from which first-home buyers are largely drawn.

Housing New Zealand says that on current trends, the home ownership rate will fall to around 62 per cent by 2011.

That is equivalent to 80,000 fewer homeowners, it says in a discussion document entitled Building the Future: Towards a New Zealand Housing Strategy.

Households divide into three almost equal groups: those who own their homes free and clear, owner-occupiers with a mortgage, and those who rent. Among renting households, about 80 per cent are in the private sector rather than the social housing provided by the likes of Housing NZ.

In this context of a growing need or desire to rent on the one hand and a strong interest in rental property as an investment on the other, one would expect to see corporate intermediaries emerging.

Property companies, after all, are a longstanding feature of the commercial and industrial property markets and in the residential markets in other countries.

But they are few and far between.

Housing NZ is inclined to blame the tax system for the dearth of corporate residential landlords. "The benefits of investing in residential property enjoyed by individuals, such as untaxed capital gains and negative gearing, are generally not available to institutions, making it a less attractive proposition for that type of investor, especially when yields are low."

Negative gearing is the ability to claim losses on rental property against tax paid on another source of income.

It is not self-evident, however, that capital gains tax rules out the emergence of residential property companies. People do, after all, entrust retirement savings to fund managers, even though the latter face capital gains tax where people who occasionally invest in shares or government stock directly would escape it.

Fund managers are wont to complain that the tax system unduly favours investment in rental property.

But in effect, the tax laws treat someone who buys an investment property as having gone into business - the landlord business.

The general rule for taxing businesses applies. Expenses incurred in earning taxable income are deductible, including interest costs, maintenance and depreciation.

There is a message in this for the novice property investor. It is not a passive investment, it is a business. It may be a business on the side, but it is still a business - work, hassle, expense and risk.

This seems to come as a surprise to many buyers.

A survey of 818 landlords undertaken last year by the Centre for Research Evaluation and Social Assessments (Cresa) is richly illuminating.

Of the 818 respondents, 21.9 per cent had been a landlord for a year or less. Over half, 55.6 per cent, had been landlords for less than eight years and only one in six for more than 15 years.

This suggests there is considerable churn not only among tenants but among landlords, says Cresa director Kay Saville-Smith.

"Incoming owners of rental property appear to have a pattern of considerable exit after the first few years - although it is possible that this pattern represents an extraordinary influx of investors in rental property in the year before the survey."

But the latter explanation seems unlikely. The Inland Revenue data suggest the increase in the number of individual landlords over the past couple of years has been in line with the average of the past decade, about 7000 a year.

The result is a population of landlords who are in the main inexperienced apart from a minority who are very experienced.

This casts a different light on one of the more worrying features of the rental property industry, the high turnover of tenants.

Housing NZ says the average duration of all tenancies which ended during 2002 was less than 15 months. More than half of those lasted less than 10 months, a third less than six months and 13 per cent less than three months.

This, they noted in the demure language of bureaucrats, could have a negative impact on health, education and other social outcomes.

New Zealand is a highly mobile society.

But Andrew King, president of the Auckland Property Investors Association, says: "The main reason tenancies end is that people don't pay and skip off. There were 35,000 applications to the Tenancy Tribunal last year just over rent arrears."

This rate of churn suggests unhappiness on both sides of the relationship, however. Certainly there is plenty of anecdotal evidence that being a tenant is a lottery.

You might have a businesslike landlord who understands the need for asset maintenance and the desirability of keeping the tenant happy, or you might have one who just doesn't.

It works both ways. Of the landlords survey by Cresa, nearly a third cited problems with tenants as the main disadvantage of rental property ownership, followed by maintenance (27 per cent) and the non-payment of rent or the risk of that (18 per cent).

One way of avoiding the hassles, if not the costs, is to use the services of a property manager at a fee of around 8 per cent of the rental income.

But Housing NZ estimates the use of professional management services is only about half that of some Australian states.


The dissatisfaction suggested by these rates of churn of both tenants and landlords cries out for the emergence of corporate intermediaries, companies to own and manage residential rental property.

For the investor with his or her own life to lead and livelihood to win, it would provide a passive investment option which pooled the risks as well as the returns.

For the tenant, it offers the prospect of dealing with reputable and professional landlords with a brand to protect.

The prospect of capital gains tax when properties are sold should be less of an issue than it would be for a single-property investor.

In the context of rising demand and a well-maintained housing portfolio, sales could be relatively infrequent.

But it would require a shift in mind-set for many investors.

The prospect of capital gains topped the list of benefits of investment property ownership by the respondents to the Cresa landlord survey.

Don Brash, when Governor of the Reserve Bank and battling the inflationary effects of the mid-1990s property boom, once advocated a capital gains tax on residential investment properties during an appearance before Parliament's finance and expenditure committee. The MPs shrank back in their chairs as if confronted with something radioactive.

The reaction to the McLeod tax review's proposal of a wealth tax on home equity (in the interests of a broader tax base and lower rates all round) was equally negative.

But as the continuing prosperity of the fund managers attests, given the right structure and scale, a capital gains tax is not the end of the world.