Grants distort lending in the housing market

Karl FitzgeraldCommentary2 Comments

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Creative Commons License photo credit: tanakawho

This article was so good we contacted Australia’s best e-news Crikey to re-print. A must read

Adam Schwab writes:

If the only property data you looked related to the lower end, first home buyers sector, you would be forgiven for thinking we are in the midst of an economic boom, rather than what appears the be the first worldwide depression in 70 years.

While prices in high-end property have weakened substantially as investment bankers and other professional types are laid off or receive dramatically lower bonuses, properties under $400,000 have remained firm. This has largely been due to the Howard-Rudd First Home Owners Grant (FHOG), lower interest rates and increasing rental costs.

As part of its first stimulus plan last October, the Federal government increased the FHOG from $7000 to $14,000 (or $21,000 for new properties purchased from developers). The effect has been dramatic, with Australian Financial Review noting that “the Australian Bureau of Statistics reported yesterday that first home-buyers were pouring into the market at record levels, lured by low interest rates, generous government handouts and increasingly affordable housing.”

Many first-home buyers are “taking the plunge” according to the AFR because it is ostensibly now cheaper to purchase a home than rent one. The only problem with that theory is it ignores many of the less obvious costs which come with owning a home. This principle was nicely outlined by Kate Lehay in The Age last Thursday, when she reported:

Teenagers Matthew Tregent and Sarah Zajac can see Melbourne’s skyline 18 kilometres to the east and a field of construction at their feet.

By October, the 19-year-olds plan to be living here, in their own three-bedroom home on 464 square metres of a Deer Park housing estate.

With $26,000 in government grants and the $5000 they saved after completing school last year, Mr Tregent and Ms Zajac, and thousands like them, appear to be keeping Melbourne’s outer suburbs growing amid the gloom …

It appears that the Federal Government has not headed the lessons of the US sub-prime debacle, which saw government intervention (specifically, through the Community Reinvestment Act or CRA, originally introduced by the Carter Administration) distort lending practices. According to Presidential candidate, Ron Paul, the CRA forced banks to lend to people who normally would be rejected as bad credit risks.

While the FHOG is clearly a very different beast to the CRA, in some ways their distortive effect is similar. Both the FHOG and the CRA act of convince people to pay more a property than they can really afford. Previously, Matthew Tregent and Sarah Zajac (from the above example) with their $5000 in savings, would be able to purchase a property worth around $100,000. However, due to the FHOG (and aided by cash payments from developers), suddenly, the young couple are able to purchase a property valued at upwards of $300,000.

Lehay continued:

Mr Tregent and Ms Zajac, who both work full-time at Foxtel in Moonee Ponds, say they would not have bought without the grants, including $6000 from developer Devine.

“I didn’t really expect it to happen so easily,” Mr Tregent said. Ms Zajac said she had always intended to buy, but not so soon.

“I didn’t want to rent,” she said. “I don’t want to waste my money going nowhere just to live somewhere.”

Despite Mr Tregent and Ms Zajac appearing overjoyed at not “wasting money” renting a property, that judgment appears to be an emotional, rather than a logical one. Most worrying is the fact that the FHOG will most likely not benefit the actual purchaser. That is because potential purchasers of ‘affordable property’ (all utilizing the grant) would simply ‘bid-up’ the price of a property by the value of a grant (or more, if the grant allows for additional debt to be assumed). Of course, the FHOG is however a boon for sellers of property (especially developers), who reap a windfall courtesy of taxpayers.

Assuming that the two teenagers above used their $26,000 in grants (and $5000 in savings) for the “equity” component of their purchase, they would be able to purchase a property with a ticket price of around $300,000 (assuming no stamp duty or other establishment costs). They would however need to assume debt of approximately $270,000. At an interest rate of 5.5 per cent (which will most likely reduce in the short-term, but is below the long-term average), their average monthly repayment is $1237 (on an “interest-only” basis). Add to that council rates, other bank fees, insurance and water rates and the monthly cash cost is likely to be closer to $1430.

Then there is the oft-forgotten depreciation effect. Unlike other assets (such as shares or cash) the value of a house reduces each year (a house will often need to be substantially renovated or rebuilt after around 30 years). The effect of depreciation for a property in an out-of-town development (where the house, rather than the land comprises most of the value) is substantial. In the above example, the Deer Park house would be worth at least $190,000 (compared to the land value of around $110,000) and would probably lose around $6000 in value each year. This adds a (non-cash) cost of around $500 per month. In reality, the teenagers are effectively paying around $440 per week for their first home. The only problem is to rent a similar property in Deer Park would cost them around $250 per week. (While the figures quoted are not exact, they are reasonably fair reflection of reality).

The increased costs are a direct result of the FHOG, which not only means the young couple pay more each year, but will almost certainly face capital losses when the FHOG is removed, or if unemployment continues to rise or when interest rates rise once more or if banks tighten lending criteria.

2 Comments on “Grants distort lending in the housing market”

  1. Mom Blogs – Blogs for Moms…


    Sorry… forgot to say great post – can’t wait to read your next one!

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