Gavonomics
Economics as if production matters
Sunday, July 29, 2007:
Getting sustainably high returns on real estate
In terms of public policy, there are three basic methods of increasing both pre-tax and after-tax returns for property investors:
(1) Increase spending power of renters and buyers so that, for the same quality of accommodation and the same intensity of competition for accommodation, they will be willing and able to pay higher rents and prices;
(2) Improve and extend infrastructure that adds utility to the serviced locations, so that renters and buyers will pay more for those locations;
(3) Create a shortage of accommodation in order to intensify competition among renters and buyers and thereby force up rents and prices.
Method (1), on balance, does not harm renters and buyers, although the ensuing increases in rents and prices obviously reduce the benefit to them from their higher spending power.
Method (2) has some overlap with method (1), as greater "utility" may lead to greater spending power. While method (2) raises rents and prices by improving the utility of given locations, it does not raise rents or prices of locations of given utility, and is therefore of little consequence to renters and buyers; at worst, it may force renters in particular locations to move, and only if their higher utility is not expressed in higher spending power.
In contrast, method (3) is a zero-sum game in which the gains of current property owners are the losses of renters and buyers, and is to be avoided not only because it is inequitable, but also because it is unsustainable. When the cost of accommodation becomes more onerous, other spending must be reduced. This in turn reduces the income of other parties and hence their capacity to pay for accommodation. At best, this mechanism cancels the gains of property owners; at worst, it causes a cascade of insolvencies, hence economic contraction, hence lower overall spending power and lower returns to property owners.
Accordingly, property investors who wish to influence public policy for their own benefit should concentrate their efforts on methods (1) and (2).
Pursuant to method (1), maximum spending power requires full employment. But jobs cannot be created unless:
(a) the employer can pay the rent or mortgage on the business premises out of the proceeds of the business; and
(b) the workers can pay the rent or mortgage on housing within commuting distance of the jobs, out of wages that the employer can pay out of the proceeds of the business.
Both of these conditions require that the competition for accommodation is not too intense; in other words, they further contra-indicate any pursuit of method (3).
To ensure that the supply of accommodation does not become too tight, any subsidies or tax concessions given as "incentives" to property investors must act as incentives for construction of accommodation, and not merely for acquisition of existing accommodation (or vacant land). To this end:
(i) All property taxes should be on sites (unimproved land and airspace and attached building rights) rather than buildings, because taxes on buildings can deter construction (but taxes on sites cannot obliterate sites). Note that it is possible to shift recurrent property taxes off buildings and onto sites in such a way that no property owner is left worse off.
(ii) All subsidies for property owners should be for buildings rather than sites, because the production of buildings can be increased by incentives (but sites do not need to be produced).
(iii) All taxes on sites should be holding taxes rather than transaction taxes, because holding taxes encourage income-earning activities (including construction where necessary) to cover the taxes, whereas transaction taxes inhibit turnover (which may be a prerequisite for construction). Note that a site tax may have the form of a transfer tax but the substance of a holding tax, in which case it combines ease of payment with desirable incentives.
Pursuant to method (2), if the government responsible for infrastructure receives a percentage of all uplifts in site values, it has an incentive to provide infrastructure in order to raise site values. Hence the government provides infrastructure that would not otherwise be provided, and property owners get capital gains which they would not otherwise get, and which are only partly taken back in taxation. It can be shown that any piece of infrastructure that passes a cost-benefit test can be funded in this manner. Moreover, holding taxes on sites — consistent with method (1) — are eminently suitable for this purpose.
In summary, if property investors wish to maximize their returns in the long term, they must think not in terms of increasing their fraction of the pie, but rather in terms of making a bigger pie. To that end, they need to think of tenants and buyers not only as present customers, but as future returning customers whose spending power must be maintained, not exhausted. And they need to consider the tax system not simply as a cost, but as a medium through which they may invest in infrastructure which in turn increases their asset values.
