Month: December 2021

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.

‘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.