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6. Demand factors

• Large increases in the size of the population, growth in the number of households, growth in real incomes, a period of low interest rates and increasing availability of credit have all contributed to rising demand for housing.
• Rising investor interest and expectations of capital gains have also played a part.
• Future demand will be underpinned by population growth and demographic changes, such as population aging, meaning that demand for housing is likely to grow at a faster rate than population growth.

6.1 Household formation trends

Household formation has increased at a faster rate than population growth, owing to changes in household size and composition. Between 2001 and 2006, the number of households in New Zealand increased 8.2%, compared with population growth of 7.7% and a 6.0% increase in the number of households between 1996 and 2001. Between 1986 and 2006, the proportion of households made up of couples with children has declined from around 37% of households to 27%. The share of one-person households has increased from 19% in 1986 to 22% in 2006. The share of couple-only households has also increased.

These recent trends are projected to continue in the future and the number of households, and therefore the number of houses needed for them to live in, is projected to continue to increase at a faster rate than the projected increase in population. Average household size is projected to decline from 2.7 people per dwelling in 2006 to 2.4 in 2021 (Statistics New Zealand, 2005). This is due to a projected increase in the older-age population and a decrease in the average size of family households as women have fewer children.

Impact on demand

Projected household and population growth suggests that New Zealand will need an additional 200,000 dwellings between 2006 and 2016.[8] This is in addition to any extra demand for holiday homes or other forms of second homes that are not available for permanent accommodation. Future growth in dwellings will therefore need to be around 20,000 per year to accommodate expected demand, plus any additional demand for second homes. This will underpin ongoing demand for housing. This rate of increase is only a little under the average growth achieved during a construction boom from 2001 to 2006, which averaged around an additional 22,000 occupied dwellings and 25,000 total dwellings per year, with the difference accounted for by unoccupied dwellings, including holiday homes. Generating this additional supply may pose some difficulties if some of the conditions that have boosted supply in recent years do not exist in the future, including the strong demand from investors and relatively low interest rates.

6.2 Population and migration

Changes in the size of the population and household numbers are important drivers of the demand for dwellings. Population growth occurs through natural changes in the population from births and deaths and through patterns of inward and outward migration. Between 2001 and 2006 the New Zealand population increased by 7.8%, well above the rate of population growth of 3.2% between 1996 and 2001.[9] Growth in Auckland accounted for 47% of the population growth of New Zealand as a whole. While the population of Auckland increased between 2001 and 2006, around 76,000 people moved out of Auckland to another region of New Zealand over the same period, and around 59,000 moved into Auckland from another New Zealand region, illustrating a net loss of population from internal migration.

Future population growth is not projected to be consistently as fast as during the period from 2001 to 2006, however, population growth is forecast to continue, with the population size expected to reach five million within the next 20 years, underpinning demand for housing in the future. In addition, major population surges, due to immigration and/or emigration, may reoccur in response to domestic and international developments.

Since the 1960s New Zealand has experienced a number of periods of sizable upswings and downswings in net migration. The numbers and ages of people entering and leaving New Zealand have important implications for the demand for housing. The sharp increase in permanent and long-term arrivals from late 2001 was driven by people aged 15–24 and 25–39. The 15–24 age group saw a particularly large increase, in part due to a surge in the number of students coming to New Zealand. The annual net arrivals of New Zealanders briefly increased from 20,000 to 25,000 following the terrorist attacks in the United States of September 2001.

Temporary arrivals of longer than one year are an increasingly significant feature of migration in New Zealand, with 87% of principal applicants approved for residence in 2005/06 previously holding a temporary visitor, student or work permit. Around 30% of temporary migrants became permanent residents over the same period. As a result, it is the temporary inflows that are the major driver of arrivals, not permanent residency approvals. Temporary inflows are largely demand driven, provided an applicant meets the relevant criteria. There is no cap on temporary arrivals, whereas permanent residency approvals are capped (currently set at 45,000–50,000 per year). In addition, returning New Zealanders are a major source of migration volatility. This is a demand-driven response that is not open to regulation.

Departures from New Zealand fell from around 80,000 in 2001 to 60,000 in 2003, further adding to the net migration inflow. The sharpest falls in departures were in the 25–39 age group, where departures fell by around one third. This is an important age group for household formation and demand for housing, so the decline in departures would have added to housing demand.

Figure 10: Annual migration and house prices	Figure 11: Annual departures and arrivals
Sources: Statistics New Zealand, QVNZ	Source: Statistics New Zealand
Figure 12: Share of annual PLT arrivals and departures that are New Zealand citizens	Figure 13: Annual net migration flows
Source: Statistics New Zealand	Source: Statistics New Zealand

Impact on demand

Around 120,000 people were added to the population from net migration between June 2001 and June 2007 (equivalent to around 3% of the population), increasing the demand for housing at a much faster rate than supply could easily respond to.

International studies suggest that the impact of population growth on house prices is relatively small, with a 1% increase in the population associated with a 1% increase in house prices (Saiz 2003, cited in Coleman and Landon-Lane 2007). Direct New Zealand evidence is limited; however, a recent paper by Coleman and Landon-Lane suggests that a net migration inflow of 1% of the population is associated with an 8%–12% increase in house prices after one year, and a slightly larger effect after three years. The authors note that the size of this impact seems implausible and suggest three possible explanations why it lasts for such a long period, even after supply has responded:

• If the construction sector is capacity constrained, house prices and construction costs would be high until the stock of housing caught up with increased demand.
• Migration flows could be correlated with other factors that are boosting house prices, for example, future income expectations.
• Migration could destabilise expectations about house prices.

The source of migration trends has important implications for the housing market. A new study on migration and house prices is currently underway, being conducted for the Department of Labour by economists at Motu. Preliminary results for 1986 to 2001 indicate that there is a relationship between the population in an area and the level of house prices; similarly there is a relationship between the change in the population and the change in house prices. The results suggest there is a relatively small effect on the prices of houses or rents from new immigrants to New Zealand. In contrast, there appears to be a significant relationship between returning New Zealanders and the changes in local house prices from 1986 to 2001. Non-New Zealand born migrants may have different patterns of housing tenure to other residents, temporary migrants in particular are more likely to rent if they do not expect to stay long in New Zealand.

Care is needed in interpreting these results as they do not establish a direction of causality. On the one hand, it could be that returning New Zealanders do add pressure on houses prices. Equally, it could be that New Zealand born individuals repatriate at the time there is strong economic growth and an active labour market. These factors may in themselves lead to upward pressure on prices rather than the flow of migrants per se. Migration might merely follow job growth and rising house prices rather than be an underlying cause of rising house prices.

6.3 Interest rates, inflation, financial deregulation and the availability of credit

Nominal and real interest rates have moved down sharply over the past 20 years. From 1985 to 1990, nominal 90-day interest rates fluctuated between 15% and 25%. A low inflation environment following the introduction of the Reserve Bank Act in 1989 saw nominal interest rates gradually trend down. A slowdown in world economic growth around 2000/01, together with expectations of weak growth following the terrorist attacks in the United States, saw expectations of growth in New Zealand downgraded. The RBNZ cut the Official Cash Rate (OCR) to 4.75% by the end of 2001.

During this period, central banks around the world also cut interest rates, which, in combination with large amounts of liquidity resulting from current account surpluses in Asia, saw long-term interest rates fall to historically low levels. The availability of foreign savings means that New Zealand’s investment does not have to be funded from domestic savings, resulting in a current account deficit and an inflow of foreign capital. There has also been an increase in banks’ willingness to lend to households through mortgages, with mortgages generally seen as a low-risk form of investment – mortgages are secured against houses, and the value of the loan is typically less than 100% of the value of the house, meaning the bank can generally recover the value of the loan in the case of default.

Real interest rates were also relatively low for a sustained period, although rates have increased in the past 12 months following a number of increases in the OCR.

Figure 14: Nominal interest rates	Figure 15: Real interest rates
Source: RBNZ	Source: RBNZ

These changes in interest rates have come during a period of financial deregulation. Financial deregulation has seen banks introduce new types of mortgages and relax the conditions they apply to borrowing. For example, Coleman (2007) notes that prior to deregulation, banks would generally not lend more than 75% of the value of a house, and imposed limits on the size of repayments relative to income, generally at 20–30%. Following deregulation and advances in technology, banks were prepared to lend 95% of the value of a house, mortgage repayment to income ratios were generally eased closer to 33% and the duration of mortgages was increased. In some cases, it is now possible to borrow 100% of the value of a new house.

Banks tend to express mortgage repayment to income ratios in nominal terms. As a result, for the same real interest rate, borrowers can borrow more in a low inflation environment because the nominal interest rate is lower and the mortgage repayment smaller. A combination of a higher mortgage repayment to income ratio, low nominal interest rates, and a lengthening of the repayment period, resulted in a large expansion in the amount households could borrow. Coleman shows how a household with an income of $50,000 could increase the amount they could borrow from $79,000 in 1989 to $191,000 in 2005.

Impact on demand

Financial deregulation helped put in place the conditions that have allowed households to borrow more through a gradual change in lending practices. Financial deregulation in isolation is likely to have had a relatively small impact on the demand for housing, however, the combination of deregulation, lower nominal and real interest rates and an increase in the global availability of credit has seen a large increase in borrowing capacity. This has encouraged people to ‘trade up’ their dwelling by buying a bigger and better house, adding to demand for housing and lifting prices. Interest rates began to increase from 2004 onwards, progressively reducing the importance of interest rates as a driver of increased demand for housing. Many of these factors have also played a part in driving house prices up in a number of other countries.

6.4 Economic growth, income growth and unemployment

The current upswing in economic activity that began in 1998 is the longest period of economic growth in the past 30 years. During the house price boom, real Gross Domestic Product (GDP) increased 19.4% between December 2001 and June 2007.

The period of strong economic growth has been associated with rising employment and labour force participation, falling unemployment and increased income. At the start of the housing boom in December 2001, the unemployment rate was 5.4%. By September 2007, this had fallen to 3.5%. Over the same time period, total nominal income earned by wage and salary earners increased by around 40%, or around 25% in real terms.

The growth in income has been unevenly distributed, with the largest increases coming at the upper end of the income distribution and much smaller changes in real income occurring at the lower end of the income distribution. This topic is discussed in more detail in section 11.

Impact on demand

A lower unemployment rate is likely to have increased people’s confidence about future income and therefore their willingness to take on higher levels of debt. Rising real income, particularly towards the upper end of the income distribution, has increased the amount of money that people have for spending on houses and for servicing mortgage debt. In the future, rising incomes are likely to be associated with increased demand for housing, with more people likely to seek holiday homes or other second homes as they become wealthier. In the past, this trend has meant that increases in the stock of dwellings have exceeded household formation, with some of the dwellings not available for permanent accommodation. These factors have also played a part in driving house prices up in a number of other countries.

6.5 Expectations

Rising house prices attracted people into the housing market, with an expectation that prices would continue to increase and a desire to enter the market before prices increased further. Coleman (2007) describes how expectations may not be formed rationally in circumstances where there are difficulties in making a well-informed prediction about prices.

Coleman suggests that when expectations are formed adaptively, prices and the number of transaction volumes in the market can diverge from fundamental or equilibrium values for an extended period of time. Willingness to purchase a house will depend on households’ financial circumstances, their expectations about average house prices and the suitability of the house. A demand shock may destabilise equilibrium patterns of prices and volumes, with the shock generating a change in reservation prices for sellers and expectations of future prices for buyers, leading to a long-lasting increase in prices.

Impact on demand

The demand shocks discussed elsewhere in section 6 may have induced a change in expectations of the future path of house prices. This is likely to have been one of the drivers of price increases, as well as a factor drawing investors into the market. Establishing the magnitudes of these influences compared with more fundamental drivers of activity is complicated. Econometric analysis by O’Donovan and Stephens of Westpac bank (2007) suggests that the fundamental drivers can account for most of the rise in house prices; however, a more recent update from Westpac suggests that prices may now be overvalued following recent interest rate increases.

6.6 Preference for property as a form of investment

New Zealanders have a strong preference for houses as a form of investment due to the strong recent returns to housing and previous volatility in equity markets, such as the sharemarket crash of 1987. Estimates suggest that debt on rental properties has increased from around 21% of total mortgage debt in 1991 to around 33% in 2006, with debt on rental properties accounting for around 38% of the net increase in total mortgage debt.

Burns and Dwyer (2007) examined New Zealand households’ attitudes to various forms of saving and investment. They concluded that investment decisions and preferences are influenced by a number of factors, including:

• complexity, transparency and perceived past and future performance of different kinds of investment options
• a general lack of independent financial advice
• recent superior performance of property investment
• perceptions and personal tolerance of risk
• an often low level of financial literacy about products other than property
• personal or family experience of investment, a general wish to have control over the investment and trust in the advice of friends and family over unknown professional advisors.

6.7 Preference for home ownership

Home ownership is an important aspiration for many New Zealanders because of the ability to personalise a property, the security of tenure and wealth accumulation benefits. Under existing commonly-used tenancy arrangements, tenants have limited tenure security and little capacity to personalise the property and treat it as their home. As a result, those households that want secure tenure need to buy a house. This does not increase the demand for the number of houses in New Zealand, but it does affect the demand for owner-occupied housing.

6.8 The tax system

A number of elements of the New Zealand tax system directly affect the housing sector. This section discusses each of these factors.

Absence of taxation of imputed rent for owner-occupiers

If a household invests in, for example, a term deposit and rents a house to live in, the interest earnings on the term deposit are taxable. If the household uses their money to buy a house to live in, they receive an untaxed flow of housing services that is equivalent to the money that they would have paid to rent a similar property. This flow of services is often called imputed rent. Because imputed rents are not taxed, the tax system tends to favour more investment in owner-occupied housing and less in other types of assets.

The extent of this benefit to owner-occupiers depends on the level of equity held in the property. For owners who have debt, the payment of interest on the debt diminishes part of the benefit from imputed rents. The full benefit is captured by owners with 100% equity. The system therefore encourages the early repayment of mortgages and leads to a bias in the portfolio of households towards housing.

Non-deductibility of mortgage interest payments
A dollar paid off a household’s mortgage generates a return equal to the pre-tax mortgage interest rate. The same dollar invested in another asset with comparable earnings, which is subject to tax, would generate a return of the mortgage interest rate less whatever tax is payable. Any move towards making mortgage interest deductible without making imputed rents taxable would result in a substantial subsidy to highly-geared households (OECD, 2000).

Concessionary treatment of capital gains

New Zealand does not have a general capital gains tax. Consequently, no capital gains tax is applied to owner-occupied housing and, typically, no capital gains tax applies to rental property, unless the property was bought and sold with the intention of making a capital gain.[10] New Zealand makes a distinction between revenue receipts that are taxable and capital receipts that are not. The OECD (2000 and 2006) highlighted a number of adverse consequences arising from a failure to impose a comprehensive tax on capital gains, including a narrowing of the tax base and distortion of the allocation of savings and investment. The McLeod Review (2001) recommended against a capital gains tax because of the practical difficulties and the risks of high compliance costs.

Ability to deduct losses on investor rental housing

Like other businesses, a rental property investor can combine their net rental income with income from other sources. An investor’s total deductions for interest, rates, repairs and insurance may exceed the gross income from rent, creating a loss that can be applied to reduce the taxpayer’s liability on other sources of income. The value of this aspect of the tax system is directly related to marginal tax rates. Therefore, the increase in 2000 to a top marginal tax rate of 39% may have encouraged some additional investment in rental housing.

No GST on imputed or actual rents

Landlords do not charge Goods and Services Tax (GST) on rents but indirectly pay GST on the inputs used in providing the service, such as maintenance. Instead, New Zealand like other jurisdictions has opted, in the case of new dwellings, to apply GST at the time of the initial purchase of a property. This treatment should, at least in theory, have the same result in present value terms as applying GST to the rental flow from the property, with fewer serious practical issues. Applying GST to rents would also (in the absence of taxing imputed rents) drive a tax wedge between tenants of rental properties and owner-occupiers.

Depreciation allowances for investment properties
Depreciation is one of the expenses that a rental property investor can offset against other forms of income. The tax saving on depreciation is only a time-value-of-money saving as the tax on the depreciation component must be paid when the property is sold.

Local government rates

Rates are a form of taxes. Local government has discretion in setting the rates they charge in order to cover operating expenses. Grimes (2003) found that New Zealand has relatively light property taxes compared with many other developed countries. The OECD (2000) notes that the share of taxation revenue raised from property taxes (rates) in New Zealand is broadly in line with other countries and concluded that “property taxation is not acting as a significant barrier to the efficient use of land”.

Impact on demand for housing

The absence of tax on imputed rents favours home ownership over other investment options. In addition, the capacity for investors to deduct losses from rental properties against other sources of taxable income puts investors at a relative advantage to first home buyers (assuming they fund the property mainly through debt). Estimates prepared by the Unit, described in box 1, suggest that the ability to deduct losses from rental properties increases the value of a median-priced house to the investor by $25,000, relative to a potential home owner who needs a large mortgage to buy the same house.