An economic model illustrating
increases and decreases in a nation’s
real GDP over time.
As we have seen the fundamental economic problem is one of scarcity. There are insufficient resources, globally, nationally and personally to meet all our needs and wants.
Priorities need to be determined and choices made, nationally and individually.
Not making a choice also carries a cost, a lost opportunity.
In a highly specialised economy, your income determines your ability to consume, and income (and ‘wealth’ – a store of income in the form of assets) are unevenly distributed.
Australia is a modified, free enterprise economy.
Economies lie on a continuum from total laissez-faire, free market, unbridled self-interest to the other extreme of centralised planning and control.
While the profit motive and self-interest are driving forces in the decisions about what, how and for whom to produce in Australia, the government plays an active role in regulating, enforcing and incentivising economic decision making and alleviating the most severe excesses of the system.
The market is efficient; the interaction of supply and demand allocates goods and services highly effectively through the rationing device, we know as the price.
In a perfectly operating market, as demand for particular goods rises, supply expands to meet the demand. If supply cannot meet the rising demand, prices rise to distribute the available stock. The reverse is also true. If demand for a good or service falls, producers will run down their inventories and cut back on production, perhaps even cease production and prices may fall. Resources are then free to flow into the production of alternative goods and services.
That’s the theory!
It is, however, a simplistic, textbook version of the economy and relies on the assumption that a ‘laissez-faire’ (meaning to leave alone) strategy is best. It relies on ‘perfect competition’ – but perfect competition is conditional on ‘perfect knowledge’ (amongst other things) which empowers consumers to efficiently ‘shop around’.
In reality, many factors come into play that may inhibit the free operation of markets. Supply is not always perfectly ‘elastic’ or responsive to the heightened demand for a particular good – rather than increased supply; we may simply end up with higher prices for the same product or service. If this happens in a general and consistent way, we simply get inflation, and our buying power erodes.
Microeconomic reform is designed to address the inelasticity of the supply side of markets, making them more responsive to demand-side changes.
So, while the market system may be efficient in many ways, it is not necessarily equitable, nor is it always self-correcting!
Modern economies, like Australia’s, are subject to market failure.
The government in Australia manages the economy and its failings through a combination of macroeconomic policies designed to smooth out the worst extremes of the business cycle – the regular periods of instability accompanied by inflation at its peak and unemployment at its trough.
Fiscal Policy influences the economy through budgetary and taxation measures. When the economy is slowing, and unemployment is rising, the government can inject money into the economy by running a budget deficit = spending greater than revenue. (injections > leakages*)
When the economy is overheating, and inflation is rising, a surplus budget will dampen demand and put downward pressure on prices. (leakages>injections)
Remember that every policy decision has trade-offs and unintended side effects.
Running a surplus may reduce inflation, but it may also mean the loss of jobs. Running a deficit may employ more people but at the cost of higher prices.
Nothing is simple or straightforward!
Remember the circular flow of income model or the ‘above ground pool’ analogy? The size of the pool and therefore, the number of people who can get in and get wet depends on the balance between leakages and injections.
In the national income equation Y= C + I + G + (X-M)
The ‘G’ is Fiscal Policy which aims to maintain the level of the water in the pool but it is also deliberately formulated to incentivise participation and enterprise and encourage self-sufficiency.
Tax concessions, grants and exemptions are provided by the government to encourage property investment because of its significant contribution to incomes, output and employment directly and indirectly via the multiplier effect on the economy as demand for complementary goods and services rise in accord with housing construction. Property investment also provides a means of building wealth and reducing future welfare costs and so incentives are deliberately designed to encourage planning, entrepreneurship and self-reliance.
The government also depends on the Reserve Bank’s implementation of Monetary Policy to help even out the ups and downs in the business cycles.
Monetary policy involves setting the interest rate on overnight loans in the money market (‘the cash rate’). The cash rate influences other interest rates in the economy, affecting the behaviour of borrowers and lenders, economic activity and ultimately the rate of inflation. In determining monetary policy, the RBA has a duty to maintain price stability, full employment, and the economic prosperity and welfare of the Australian people. To achieve these statutory objectives, the Bank has an ‘inflation target’ and seeks to keep consumer price inflation in the economy to 2–3 per cent, on average, over the medium term. Controlling inflation preserves the value of money and encourages strong and sustainable growth in the economy over the longer term. https://www.rba.gov.au
Interest rates are eased to encourage spending and growth and therefore, employment and tightened to control inflation.
Through a combination of Monetary and Fiscal Policy,
governments aim to even out the extremes of the business cycle.
We are living through an unprecedented crisis and are almost certainly headed for a recession – defined as two consecutive periods of negative growth, something Australia hasn’t experienced for nearly three decades:
The latest release of the Australian National Accounts reported the 110th consecutive quarter since the Australian economy last faced a recession. This achievement represents the most prolonged period of growth without a recession for a developed country since the System of National Accounts was introduced internationally following World War II.
27 years and counting since Australia’s last recession
What is different about the current situation is that the downturn in activity and confidence is not a result of an economic or financial shock but a viral pandemic. The risk of a recession is real, and there are no precedents to call on to to be able to accurately predict how long it may last or how deep it may be. Unemployment lines are the first sign that we are in a precarious situation, economically and socially.
HOWEVER, THERE ARE SOME DIFFERENTIATING FACTORS TO KEEP IN MIND:
- The Reserve Bank of Australia has reduced the overnight cash rate to a historic low of 0.25% and has stated that they are prepared to engage in quantitative easing – a first for Australian Monetary Policy. It involves buying back government bonds and semi-government securities to inject cash into the economy.
- The Federal Government has approved expansionary Fiscal Policy of an unprecedented scale to ‘pump prime’ the economy through various measures to support businesses large and small and to help soften the landing of the impact of the sudden exit of thousands from the job market. The size of the stimulus is also unprecedented in magnitude and reach, with the government stating they will ‘do whatever it takes’ to keep the economy from imploding.
- While several industries and their workforces have been decimated, others are thriving, and some employees can transition to new sectors where job creation is happening rapidly( retail workers being redeployed to Centrelink offices, hospitality workers employed by supermarkets and logistics)
- Australia’s economic fundamentals before the crisis were strong, and we should bounce back strongly once an end is in sight for the COVID 19 pandemic.
- Scientists are working on developing treatments and a vaccine, and once they are viable, the confidence of consumers will be boosted significantly.
The property cycle is divided into 4 phases
The property cycle is a recurring pattern of upturns and downturns in the market for housing influenced by economic, political, social and psychological factors.
Periods of growth are inevitably followed by periods of reduced growth and market ‘corrections’.
While property cycles can vary in length, pace and the height of the peaks and the depths of the troughs, they follow the same long term positive trajectory. Variations around the trend line are to be expected, but it is the overall direction of the trend that is important.
This is why a property is not considered a short term investment or a ‘get rich quick scheme.’
It is worthwhile noting too that while recovery periods typically match the length of time, it takes to go from peak to trough, it is not always the case.
Investors need to commit to sustainable levels of debt that will allow them to ride out the downturns.
Investment in real estate like any other asset class is subject to market sentiment and the performance and management of the economy as a whole. Returns may fluctuate depending on factors such as supply and demand for housing, population growth, interest rate changes by the RBA and government incentives and exogenous shocks to the economy.
Influences on the demand side include:
The business cycle – if the economy is growing, unemployment is low, and consumer confidence is high, as incomes rise more people buy their own homes and more people are in a position to invest. If the economy is slowing and unemployment or underemployment is growing, and consumers are pessimistic about the future they will hold off and wait for conditions to improve, leading to a decline in demand.
Government incentives through fiscal measures encourage owner-occupiers and investors via grants and stamp duty concessions, negative gearing allowances and capital gains tax discounts. Removal of the same inducements will have a reverse effect. Political uncertainty and imminent elections also inhibit consumer confidence.
The RBA’s manipulation of the cash rate influences the cost and availability of credit in the economy, and more people are likely to borrow and purchase property either for owner occupier or investment purposes when rates are eased and less so when the policy is tightened.
Prudential regulators such as the Australian Prudential Regulation Authority (APRA) can encourage or discourage borrowing by relaxing or toughening the guidelines for financial institution’s lending criteria.
Demographic trends such as population growth and the divorce rate will increase or decrease the demand for housing (and the type of housing)
Media coverage intensifies consumer perceptions and ‘fear of missing out’, and it can also drive ‘doom and gloom’. Consumer confidence and emotion govern many decisions.
Influences on the supply side include:
The availability and cost of development sites and materials: vendors will assess the profitability of entering the market as a supplier and calculate the risk and return potential. If they expect costs to increase, they will seek a higher margin as insurance against future erosion of profits.
Bureaucratic red tape and compliance costs influence the profitability of ventures, including the approval process and mandatory infrastructure co-contributions
The cost and availability of finance for developers. If credit is limited and difficult to obtain, a smaller number of projects will get off the ground, typically by more substantial, corporate developers.
Builder expectations, confidence and perceptions of buyer demand influence their willingness to take risks and enter the market.
The property cycle is divided into 4 phases:
Profit is the return to risk
but ‘bricks & mortar’
is relatively predictable,
safe and reliable
“Australian residential property outperformed all asset classes for the 10 and 20 years to 31 December 2017”
Source: ASX/Russell Investments
1. Inflation favours tangible assets – inflation is a sustained general increase in the prices of goods and services over time. Unlike real assets such as property, the value of bank deposits can diminish over time due to inflation. Not only do the dollars in the bank potentially buy less than when you put them in, but the interest earned may not compensate for the higher prices over time.
The ‘real interest rate’ = interest minus inflation.
Think of something you bought from your childhood, perhaps at the school canteen, what did it cost? What would it cost now?
(I provided my classes with much amusement when I’d tell them what their favourite canteen items cost in ‘my day’)
An example of the ‘time value of money’ effect is demonstrated when lottery winners are persuaded to accept regular monthly payments’ for life’ (read 20 years) rather than a lump sum now, which is customarily a bit smaller.
For example, what would you rather have? $25K per month for 20 years which equals $4.8M or $4.25M now???
Take the money NOW! The $25,000 will buy you less in 10 or 20 years than it does now.
2. Low volatility over time – records have been kept in Australia since the 1890s. During that time, the overall trend for house prices has been positive, despite variations around the trend.
Aussie 25 Years of housing trends
3. Real estate ranks between fixed income and equities on the risk-return scale – housing doesn’t provide the lowest risk, but it also doesn’t carry the highest.
4. The ‘power of leverage’– Being able to borrow a large proportion of the funds required to invest means that lenders are comfortable with the property as an investment, and you use other people’s money!
A property makes your money work harder.
$30,000 invested in the bank at 5% pa = $1500 capital gain (which is then added to your gross income and taxed)
$30,000 deposit on a $300,000 house at 5% pa = $15,000 capital gain (and costs of ownership reduce your taxable income and CGT can be deferred until exit and at a more tax suitable time)
5. Government Legislation that allows limited recourse borrowing within a Self Managed Super Fund for a property is an endorsement of the strategy as a defence against the unexpected and sudden erosion of retirement funds.
6. Favourable tax treatment. Back in the first Lesson, ‘market failure’ was introduced as an essential concept to understand. In a free-market economy such as Australia, goods and services are produced according to demand and the ability of supply to respond to that demand, in other words, via market forces. While the market is generally efficient, it is not always equitable.
Government modifies the free market by compensating for its ‘failures’ (remember the business cycle)
It provides some goods and services that the market can’t or won’t and restricts the supply of some that it would if it could, such as illicit drugs.
Rather than ‘crowd out’ (entering the market and increasing competition for funds and resources that the private sector may be competing for) more productive private sector activity, the government provides tax incentives for individuals to invest, thereby encouraging the supply of housing.
New builds, in particular, are promoted because of the multiplier effect on the economy and employment specifically. Building new properties has a ripple effect on consumption that is hard to replicate.
The public sector is typically not as efficient as the private sector. Resources are wasted by big bureaucracy that has social welfare as its agenda rather than self-interest. Consequently, there are some goods and services that the government outsources to the private sector to provide. It also offers incentives to others to do what they cannot do in sufficient numbers or with optimal efficiency – a prime example is housing!
7. Tax breaks in the form of Negative Gearing and Capital Gains Tax Discounts are strong incentives for investors to enter the housing market. Negative Gearing allows investors to claim all the costs of property ownership against their taxable income and provided the property is held for at least 12 months, the CGT payable is discounted by 50%. (dependent on the legal structure)
Depending on rent yields, prevailing interest rates, personal tax brackets and government concessions, it is possible for a property investor to own a property predominately paid for by the tenant and the tax office:
Conditions like these promote entrepreneurial spirit, the building block of the market system, and are an incentive for individuals to create wealth for their retirement, thereby reducing the burden on future generations of taxpayers.
(Remember the ideas about building a business for the future)
8. Tax on any capital gain is deferred until the asset is sold. This is when ‘timing’ becomes more relevant.
9. Rental income is reliable, it isn’t subject to individual’ management performance’, the returns are contracted in a tenancy agreement and are protected by Landlord Insurance, AND they are
NOT a DIRECT TARGET OF MONETARY POLICY
As we approach retirement, we are encouraged to take less risk, and cash is typically favoured as the least risky asset class of all, but is it really?
Given the RBA’s recent lowering of the official cash rate to a historic low of 0.25%, the returns on fixed-term deposits have fallen to levels that make it impossible to survive on. Self-funded retirees depending on interest on safe, secure bank deposits often disproportionately bear the impact of Monetary Policy adjustments to the cash rate.
Could you survive on current returns to cash?
The relatively inelastic demand for housing and the rapidly
growing population coupled with the sensitivity
of cash to lower returns due to macroeconomic management
is a powerful recommendation
for having rental income in any investor’s asset mix.
10. Interest rate rises usually mean fewer people buy their own homes and therefore demand for rental properties rises. All things being equal this should translate into higher rents.
Monetary Policy is the Reserve Bank action designed to influence both the availability and cost of finance in the economy. Interest rates are pushed up to slow the economy and curb inflation, and they are eased to boost spending and activity and therefore, employment. So, as economic circumstances change so will the prevailing cost of credit.
The upside of a rate increase is that your tax deductions increase and more people may delay buying their own home and continue to rent and put upward pressure on rents. Remember, ‘profit is the return to risk’ so you do have to take some risks if you are to build wealth for the future but make it a calculated risk.
In really low-interest-rate environments, retirees with assets dependent on bank earnings are adversely affected. When interest rates (and particularly real interest rates, taking inflation into account) are almost negligible, as they are currently, earning your retirement income from rent, even in part, is a very appealing and sensible alternative.
It is relevant here to examine the role of exogenous factors currently influencing the global and Australian economies.
Globalization means there is no escaping the effects of the COVID19 epidemic, both physically and economically.
The following excerpt from the RBA’s media release illustrates the role of government in managing the economy to moderate the effects of an exogenous ‘shock’ such as a health pandemic.
The RBA has reduced the official cash rate to a record low in the hope of stimulating consumer spending and investment borrowing. (C, I) and the government is prepared to provide stimulus through fiscal policy (G) to maintain employment. It is classic macroeconomic management.
Monetary Policy Decision Number2020-28 Date3 November 2020
Media Release Statement by Philip Lowe, Governor:
At its meeting today, the Board decided on a package of further measures to support job creation and the recovery of the Australian economy from the pandemic.
With Australia facing a period of high unemployment, the Reserve Bank is committed to doing what it can to support the creation of jobs. Encouragingly, the recent economic data have been a bit better than expected and the near-term outlook is better than it was three months ago. Even so, the recovery is still expected to be bumpy and drawn out and the outlook remains dependent on successful containment of the virus.
The elements of today’s package are as follows: a reduction in the cash rate target to 0.1 per cent a reduction in the target for the yield on the 3-year Australian Government bond to around 0.1 per cent a reduction in the interest rate on new drawings under the Term Funding Facility to 0.1 per cent a reduction in the interest rate on Exchange Settlement balances to zero the purchase of $100 billion of government bonds of maturities of around 5 to 10 years over the next six months.
Under the program to purchase longer-dated bonds, the Bank will buy bonds issued by the Australian Government and by the states and territories, with an expected 80/20 split. These bonds will be bought in the secondary market through regular auctions, with the first auction to be held this Thursday for Australian Government securities. Further details of the auctions are provided in the accompanying market notice.
The Bank remains prepared to purchase bonds in whatever quantity is required to achieve the 3-year yield target. Any bonds purchased to support this target would be in addition to the $100 billion bond purchase program.
At today’s meeting, the Board also considered an updated set of economic forecasts. The global economy has been recovering from the initial virus outbreaks, with the recovery most advanced in China. Even so, output in most countries remains well short of pre-pandemic levels and recent virus outbreaks pose a downside risk to the outlook, particularly in Europe. In Australia, the economic recovery is under way and positive GDP growth is now expected in the September quarter, despite the restrictions in Victoria.
It will, however, take some time to reach the pre-pandemic level of output. In the central scenario, GDP growth is expected to be around 6 per cent over the year to June 2021 and 4 per cent in 2022. The unemployment rate is expected to remain high, but to peak at a little below 8 per cent, rather than the 10 per cent expected previously. At the end of 2022, the unemployment rate is forecast to be around 6 per cent. This extended period of high unemployment and excess capacity is expected to result in subdued increases in wages and prices over coming years.
In underlying terms, inflation is forecast to be 1 per cent in 2021 and 1½ per cent in 2022. In the most recent quarter, year-ended CPI inflation was 0.7 per cent and, in underlying terms, inflation was 1¼ per cent. The Board views addressing the high rate of unemployment as an important national priority. Today’s policy package, together with the earlier measures by the RBA, will help in this effort.
The RBA’s response is complementary to the significant steps taken by the Australian Government, including in the recent budget, to support jobs and economic growth.
The combination of the RBA’s bond purchases and lower interest rates across the yield curve will assist the recovery by: lowering financing costs for borrowers; contributing to a lower exchange rate than otherwise; and supporting asset prices and balance sheets. At the same time, the RBA’s Term Funding Facility is contributing to low funding costs and supporting the supply of credit to the economy. To date, authorised deposit-taking institutions have drawn $83 billion under this facility and have access to a further $104 billion.
Given the outlook for both employment and inflation, monetary and fiscal support will be required for some time. For its part, the Board will not increase the cash rate until actual inflation is sustainably within the 2 to 3 per cent target range. For this to occur, wages growth will have to be materially higher than it is currently. This will require significant gains in employment and a return to a tight labour market.
Given the outlook, the Board is not expecting to increase the cash rate for at least three years. The Board will keep the size of the bond purchase program under review, particularly in light of the evolving outlook for jobs and inflation. The Board is prepared to do more if necessary.
11. Investment in property is socially beneficial. Private sector activity is supported through negative gearing and results in a more efficient allocation of resources and the creation of jobs.
12. Risks can be mitigated through insurances
There are always trade-offs, and with property as an investment vehicle they are:
- It’s a long term strategy – property investment is not a strategy that you should come in and out of on a short term basis. That approach amounts to speculation and relies on investors being able to second guess what is going to happen or implementing a ‘crystal ball’ approach which is very risky. Property investment requires a long term commitment.
- It is a relatively illiquid asset. Liquidity refers to the ease at which an asset can be transferred into cash at will. (But this also helps to reduce volatility)
- It is an asset that you cannot divest from in part! Property is largely an indivisible asset. You can’t sell half a house (assuming it’s not a strata-titled duplex in which case you might be able to or as you will see later in the course, you have individual shares in a property).
- Costs such as land tax (a state-based tax levied on land ownership that applies beyond a threshold value which is different in each state) is another reason to diversify.
- Capital gains tax is levied on any profits on exit. (can be minimized through expert advice and timing your exit in a lower marginal tax rate period).
- Management of a real estate asset also requires ongoing involvement to a greater degree by the investor than it would in other cases.