Negative news for property

We know that prices move due to an imbalance in supply and demand. If supply is unchanged but demand increases, prices will rise.

Back in 2000, John Howard and the federal government introduced the GST. At the same time, he also introduced the $7,000 First Home Owners Grant (FHOG) with the aim of offsetting the effect of housing price rises due to GST being added to contruction costs. Understandably, the FHOG was rather popular.

State governments took note, and added in their own grants. For example, in 2004, The Victorian government began offering a $5,000 First Home Bonus. Then in October 2008, Kevin Rudd and his federal government sweeteed the pot further with a $7,000 First Home Owner Boost ($14,000 for new homes). Everyone’s been seen to offer first home owners a hand-out.

But it isn’t clear that it was actually helping first home owners. As these grants didn’t directly affect supply, but they did affect demand, the prices of housing for first home owners would naturally rise. It’s not immediately clear how much prices actually rose, but we might be able to take a guess.

There are two basic ratios that banks look at when deciding whether to grant a home loan: the LVR (loan to valuation ratio) and DSR (debt to service ratio). The LVR (amount of loan divided by value of property) is typically limited to between 90-95%. The DSR (periodic interest payments divided by periodic income) is typically limited to 30-40%. So, the more deposit you have, or the more income you have, the more you can borrow for a particular property.

According to this Fairfax article by Jessica Irvine, banks will require as much as 5% of your deposit to be real savings, but the rest can be government grant. So, for a Victorian first home owner, eligible for $26,000 in grants to build a new home, if the DSR is not limiting them, and they are taking out a 90% LVR loan, then the grants allow them to borrow an extra $260,000 than they would otherwise be able to receive.

In practice, the DSR would limit our hypothetical first home owner, even with the historically low interest rates on offer at the moment. But the above exercise does go to show how significantly the FHOG and its successors can move house prices.

This might all seem pretty good: the government subsidises new home owners, and existing home owners and developers get more money for their properties. However, here’s the rub – the rumour is out that Kevin Rudd is going to rein in these grants, and perhaps even end them after this financial year. I didn’t think it would ever happen – it’s very hard to unwind these things once you’ve put them in. Anyway, he’s going to tell us in the budget announcement this month.

However much the FHOG has stimulated demand, removing the FHOG will undo it. If supply is unchanged but demand decreases, prices will fall.