Some thoughts on the housing crisis

I was asked to make a submission to a Senate  Inquiry into Financial regulatory framework and home ownership, and appeared very briefly at a hearing Here’s what I wrote

I thank the committee for the invitation to attend a public hearing. I wish to confine my evidence to two points

(i) “Creative” financing options such as those in the ‘Help to Buy’ scheme are unlikely to make a fundamental difference to the availability of home ownership 

(ii) Australia’s current reliance on individual landlords to provide the great bulk of rental housing distorts both rental markets and markets for owner-occupied housing. Policy should be aimed at expanding the role of both social housing and commercial “Build to Rent” housing.

The irrelevance of creative financing

The central proposition of modern thinking on corporate capital structure is the Modigliani-Miller theorem, often called the “capital structure irrelevance principle”. Modigliani and Miller showed that in the absence of differential taxation, bankruptcy and other market distortions, the enterprise value of a firm is independent of the mix of debt and equity capital used to finance it. The most relevant form of the argument is to consider a firm which initially uses a mixture of equity and effectively riskless (AAA rated) debt. The expected rate of return demanded by equity investors is considerably higher than the rate of interest on AAA-rated corporate debt. 

It might therefore appear that the company can finance itself more cheaply by issuing more debt and repurchasing equity. However, this will result in downgrading the company’s debt, and raising the required interest rate. In the absence of market distortions, the two effects will cancel out. In practice, many corporations anticipate being able to avoid some obligations through bankruptcy and therefore prefer a more highly leveraged and risky capital structure.

Although this argument was developed for the case of corporate capital structure, the underlying principles are equally applicable to investments in housing. In an unregulated market, homebuyers with relatively low equity will pay higher interest rates to compensate lenders for the risk of default. Governments can subsidise homebuyers in various ways, all of which benefit individual buyers while driving up the price of housing. The implication of the Modigliani-Miller theorem is that the effects will be much the same whether the support is given as a cash grant, a concessional rate of interest or a “shared equity” scheme.  

The main issue here is that public finances should be transparent. “Creative” financing schemes that shift debt off-budget, or convert public expenditures into opaque contingent liabilities are best avoided.  It is also desirable that public programs of this kind should be general, in the sense that anyone who meets a pre-specified set of criteria should be eligible. By contrast, creative financing schemes, such as “Help to Buy” commonly involve a limited fund, which favors well-informed and financially liquid buyers. Those most likely to be in need of assistance will commonly be at the back of the queue with the result that by the time they apply, the funds will be exhausted.

A better model for rental housing

The dominant model for rental housing in Australia is based on contracts, typically of six to twelve months, between tenants and individual landlords. Around 15 per cent of Australians own investment properties, with the great majority owning either one or two properties. Social housing, the main alternative source of rental housing has declined steadily and now accounts for around 4 per cent of homes, and is mostly confined to welfare recipients and other low income households. Large-scale commercial providers of rental housing (the “build to rent” model) are virtually non-existent.

The dominance of individual landlords reflects the incentives associated with the combination of unlimited interest deductibility and concessional treatment of capital gains, commonly referred to as “negative gearing”.  The decline of social housing reflects the neoliberal ideology, dominant since the 1970s, which supported subsidies over direct public provision in a range of activities.

The private landlord model is unsatisfactory in multiple respects. The “negative gearing” model relies ultimately on the prospect of either selling the rental property and realising a capital gain, or else moving into the property following a decision to downsize or relocate. This limits any prospects of secure long-term tenancy. 

Individual landlords differ greatly in their willingness to treat tenants with appropriate respect , undertake necessary repairs and so on. Similarly, some tenants are careful of their homes, pay rent promptly and so on, while others do not.  The attempt to devise general rules that apply to this multitude of individual relationships is inherently problematic.

The development of a “build to rent” sector in Australia is highly desirable. However, under current circumstances, the focus will inevitably be on relatively expensive apartments, which will do little directly to resolve the rental housing crisis facing households on low and moderate incomes.  Private rent to buy must be accompanied by an expansion of social housing, ensuring that suitable rental opportunities are available for both high-income and low-income households

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