Prime Minister has claimed that reducing or abolishing negative gearing will reduce the price of family homes all over Australia which, by implication is a bad thing. He’s oversimplifying the situation.
The first thing that will happen is that if the benefits of negative gearing go down then the number of investors will go down and the price of houses will go down as well.
And that will probably be the end of civilisation as we know it.
This initial dynamic is shown in the Causal Loop Diagram below. (The S at the end of the red arrow indicates that these two variables in the Same direction as shown in the graph).
However, is a little bit more complicated than Turnbull suggests.
When the number of investors goes down the price of houses also goes down.
However, while the price of houses may go down, rents will probably stay the same, which means that the returns on rentals on investment property will go up (shown by the O at the end of the connecting arrow meaning that these two variables move in the opposite direction) and this will draw some investors back into the market.
This will trigger another dynamic. As the price of houses comes down the number of first-time buyers will go up as housing has become affordable.
But the arrival of new buyers in the market will also drive prices up. So the impact of the fall of investor interest in housing will probably be balanced (to a greater or lesser extent) by new homebuyers coming into the market. So Malcolm Turnbull’s prediction that house prices will fall disastrously will probably not be fulfilled.
The other element of this dynamic is that the increased numbers of first-time buyers will lead to a decrease in the number of people renting, as people move out of the rental market and into the home buyers’ market. As a number of people renting houses goes down, returns on rentals will also decline.
So there are two pressures on rental returns. The first is the declining number of renters, who have become first-time buyers, driving prices down and the second is the falling price of houses which will improve rental returns.
The final element of this dynamic is that as the number of investors in the housing market goes down, the number of houses available for first-time buyers will go up.
These will be the houses that investors are either not buying (if negative gearing is restricted to houses purchased before 2016) or are selling (if negative gearing benefits are reduced for existing investors.)
As the number of houses available for people who want to rent declines because first-time buyers are purchasing them, rents and the investment returns for rental properties will increase.
So as not as simple as Malcolm Turnbull would lead us to believe.
What happens to the prices of homes will depend on the rate at which investors move out of the rental market and first home buyers move in. The activities of first-time buyers may offset the impact of investors leaving the rental market. The dynamics of the rental market will affect investor decisions and some investors may find the housing market still constitutes a reasonable return even without the benefits of negative gearing.