Interest Rates Archives - Balance Transfers

NZ real estate investor interest deductibility and the future

There’s a reason why I’ve stayed out of the residential real estate investment sector, other than not having the money for a deposit. I’ve long since thought that runaway capital gains would result in a bright red target being painted on investors’ backs, which would eventually translate into policy and specifically what has resulted in NZ is the elimination of the ability to claim an interest expense as a deduction for real estate investment.

While they failed to implement the capital gains tax, the government has put into law a cancellation of deductions on interest for residential investment property purchased after 27 March 2021, excluding the family home and new builds, which came into effect on 1 October 2021.

My main concern for this is that in an environment of rising inflation, and hence, eventually, rising interest rates, eliminating the right for investors to claim interest deductibility may have a compound effect which is hard for the markets to price.

As significant as it is to remove interest deductibility in the current low interest rate environment, it will be significantly more punishing once interest rates start to go up. To have a growing, non-deductible expense attached to marginally profitable asset could easily add velocity to an asset price downturn. And if a downturn does occur on the back of this, it could dampen the chances of a swift recovery for so long as interest rates remain high.

This is particularly a problem when we have no way of knowing where interest rates will sit in five years’ time.

As it stands, I just can’t see how investment properties can be valued.

How Friedrich Hayek predicted Evergrande

‘Prediction’ may be a strong word, but I need a catchy title to catch clickbaits. What I really mean by the above is that the dire state of the Chinese residential real estate market was totally foreseeable using textbook Austrian Business Cycle Theory.

ABCT holds that there are consequences to having a central bank fool around with interest rates, and that artificially lowered interest rates would give rise to ‘mispricings’ from seasoned and professional capital investors, which in turn will accelerate the boom-bust cycles in the economy.

For many decades Hayek was essentially written off – this was because early studies into the decision-making surrounding the purchase of capital assets contra-indicated his economic theories. Studies that followed the investment decisions and investment consequences of seasoned financial officers purchasing capital machinery for their businesses indicated that there was no significant consequence to fluctuating interest rates.

Anyone who has ever worked with capital assets in a business context can explain why this was. Some of these machines could improve the productivity of a factory by 120%. If a baker procured an oven on finance that led to a round of baking producing 88 units instead of 40, it was a no-brainer for the business and didn’t matter substantially whether the lease came in at 8% or 9%.

But the people who studied Hayek hadn’t seen anything yet. There is simply no comparison between the sagacity of industry-specific financial officers who know their trade and the dumbness of residential real estate buyers. The reason early studies reviewing Hayek overlooked this was because the advent of households themselves becoming the key asset of households gave rise to a new class of professional asset mispricer, driven more by a glut of emotions including greed and fear of missing out rather than even the most rudimentary back of napkin math.

And I am not for one second knocking the Chinese. This is a worldwide phenomenon. The extent of the behaviour across cultures shows how valid the theory is. In particular, the fact that 20% of Evergrande’s residential real estate portfolio now sits dormant and unoccupied points to another conclusion of Hayek’s found in the closing pages of ‘Prices and Production’ – that prolonged lowering of interest rates would lead to the oversupply of capital assets, resulting in a glut in the market, with the eventual outcome given being deflation, not inflation.

How the property price jump is easily explainable using back of napkin maths

One of the first things I learned about when learning the stock market was the discounted cash flow method. For those too lazy to look it up, I’m not going to explain what this is. For the purposes of this article, the only thing that interests me is the relationship between the discount rate and net present value.

I have the dubious advantage of having built various spreadsheet calculators to help me calculate NPV. I’ve applied these spreadsheets to everything from individual stocks to specific properties to solar panels to get a picture on the net present value of different assets within different asset classes. Yes, I do this for a hobby.

It’s only once you’ve built and fooled around with these sorts of calculators that you can see the dangers of certain types of macroeconomic policy.

The interesting thing is that the discount rate is never really consistently defined. Certain people will use a risk-adjusted rate, whereas Warren Buffett will simply use the long term government bond rate.

In other words, being the words of Admiral Akbar, ‘It’s a Trap!’ If it stands to reason that a drop in the discount rate leads to assets with a fairly minimal cashflow adding half a million dollars to their valuations, then it also stands to reason that even a slight, slight increase in the discount rate will lead to the price collapse of many of those assets.

Having said that, I’ve always been a cynic on the housing market, being a Hayekian, and this is perhaps the continuation of a long-held and fairly-wrongheaded (according to recent data anyway) set of postulations.

Why I think quantitative easing will make things very, very hard

A few years ago as a result of the global financial crisis, central banks used quantitative easing to purchase securities from the market in order to lower interest rates and increase the money supply. The money was then distributed to lenders as a way of stabilising their balance sheets and then promoting lending.

The point is that despite everything feeling normal, we are actually in uncharted territory as far as economics is concerned. Following a major economic event that threatened to devastate the international economy and usher in a new great depression, central banks responded by dramatically increasing the money supply. This in turn resulted in a period of artificially low interest rates, more capital circulating in the economy, and the resumption of economic growth. It also led to (frankly), the return to old bad habits of investing in assets that have been shown so recently to be bubble-prone.

This, despite the fact that the downsides of quantitative easing have not been figured out. We are very inexperienced with quantitative easing: this is, after all, a new maneouvre. There are two main drawbacks to quantitative easing that people regularly draw attention to, namely, that QE may cause inflation, and that it may devalue domestic currencies. But I believe that there is another, unscoped, potential risk to QE that will rear its ugly head in years to come.

The loan hierarchy

To understand this third risk, we need to look at the loan hierarchy. The lenders to whom central banks have distributed the proceeds of QE have a hierarchy in terms of how they look at investment propositions. To radically simplify everything, let’s look at a hospital and the people who work within it and the way that banks may proceed in terms of funding certain investment propositions.

A doctor comes to a bank to get a loan to buy a house. The bank looks at the doctor’s income, assets, and credit score, and notes that the doctor has a stable professional job and a good chance of repaying the loan over time. The lender therefore approves the loan.

A nurse comes to a bank to get a loan to buy a house. The bank looks at the nurse’s income, assets, and credit score, and notes that the nurse has a stable professional job, albeit at a lower level of salary, and a good chance of repaying the loan over time. The lender therefore approves the loan.

A part-time hospital orderly comes to a bank to get a loan to buy a house. The bank looks at the orderly’s income, assets, and credit score, and notes that while the orderly only works part time for the hospital, and that there is less of a margin on being able to service the loan due to an increase in asset valuations as a result of all the doctors and nurses having recently purchased houses, that the income nevertheless appears stable, and since the bank has relaxed their lending criteria due to having a surplus of capital to lend, there are some doubts, but if they don’t approve the loan, the orderly will go to the bank down the street and get it approved there.

On and on it goes, during times of surplus capital and relaxed lending restrictions, until every man, woman and dog in the hospital has a loan. Eventually, the lenders are providing interest free loans to people to buy chainsaws to cut butter. Which leads to…

The mass creation of bad debt

A consequence of having so much capital circulating the economy is that irresponsible lending practices will likely result (again, as they did ten years ago). Lenders will reach further and further down the hierarchy in order to find ‘deals’. Even under normal circumstances, this could cause problems, but in the long run it also causes a major unforeseen event, which is that…

Loan defaults will be more responsive to interest rate rises

In the old days, when central banks increased interest rates in order to reduce inflation, they did so with at least some level of awareness of what sort of impact the interest rate might have on reductions in consumer spending.

With QE, however, this has all changed. With dramatically more money in the economy, and that capital circulating around and around again due to the credit multiplier, the responsiveness of any nation to an increase in the central bank’s interest rate movements will be unpredictable and potentially more severe.

To illustrate this, shifting interest rates upwards by 25 basis points would have dramatically more impact on consumer spending if it applied to one hundred million loans rather than 25 million loans. Particularly if the bottom 75 million loans are at the bottom of the loan hierarchy: loan defaults will skyrocket.

My concern is not just that lenders may not have realised this, my concern is that people on the street (who under times of lax lending restrictions themselves become professional capital mispricers) may not have realised this. This is one of those things that is going to be so simple in hindsight – and yet, few, if anyone, will have seen it coming.