Property Based Tax Incentive Schemes in Ireland: A Critical Appraisal

Transcription

1 University of Limerick Property Based Tax Incentive Schemes in Ireland: A Critical Appraisal Author: Feargal Marren Student I.D.: MBA 2005

2 University of Limerick MBA 2005 Author: Feargal Marren Student I.D.: Property Based Tax Incentive Schemes in Ireland: A Critical Appraisal Supervisor: Dr Anthony Leddin Wordcount: 30,490 This project is solely the work of the author and is submitted to the College of Business University of Limerick in partial fulfillment of the Masters in Business Administration Programme October 2005

3 Dedication This project is dedicated to my wife Eleanor and our daughter Aoibhín for their patience, understanding and support over the past two years. I

4 Acknowledgements I would like to acknowledge the direction and supervision I received from Dr Anthony Leddin of the Economics Department in the University of Limerick. I would also like to thank those who participated in the qualitative research for the project, including Essie Golden, Dr Dan McLoughlin, Dermot O Leary, Michael O Dwyer, Kevin Flavin, Dermot O Reilly and Richard Tobin. Finally, I thank the members of my study group, Bernárd and Michael for their support and encouragement throughout the course. II

5 Table of Contents Dedication:..I Acknowledgements:...II Table of contents:.....iii 1.0 Introduction Tax Based Property Incentives; History and Background Introduction Tax Inequality Risk Associated with Tax Incentive Based Property Investments Tax Based Property Incentives Urban Renewal Scheme Town Renewal Scheme Rural Renewal Scheme Seaside Resort Scheme Park & Ride Scheme Multi-Storey Car Parks Living Over the Shop (LOTS) Scheme Student Accommodation Scheme Childcare Facilities Nursing Homes Other Tax Reliefs for Property Investment Evaluation of Tax Based Property Incentives Concluding Remarks Overview of the Irish Housing Market Introduction House Price Inflation Regional House Price Inflation III

6 3.3 The Determinants of Irish House Prices Empirical Model of the Irish Housing Sector Demand Side Factors Employment and GNP Growth Demography Income Levels Investor Involvement in the Residential Housing Sector Finance Tax Generosity Headship Rates Second, Vacant and Replacement Properties Supply Side Factors Affordability ConcludingRemarks Construction Sector s Contribution to the Economy Introduction Employment House Completions Tax Economic Growth Concluding Remarks Qualitative Responses from Market Participants Introduction Interview Questions Interview Responses Key points from Interview with Dr. Dan McLoughlin Key points from Interview with Michael O Dwyer Key points from Interview with Dermot O Leary Key points from Interview with Richard Tobin Key points from Interview with Dermot O Reilly Key points from Interview with Essie Golden Key points from Interview with Kevin Flavin..94 IV

7 5.4 Concluding Remarks Residential Property as an Investment Introduction Why do Private Investors Invest in Residential Property? Low Management Input Familiarity and Sense of Control Earnings Mostly Distributed Tax treatment of Interest on Related Borrowings Lower Volatility The Bacon Reports Tax Treatment of Residential Property Interest Relief Residential Property Investors Owner Occupiers Equity Investment Stamp Duty Capital Gains Tax Rental Yields Capital Appreciation Comparison with Other Investments Evaluation of a Making a Designated Investment Concluding Remarks Impact of the Cessation of Property based Tax Incentive Schemes Introduction Construction Sector Investors Tenants Government Environment Employment Finance Concluding Remarks V

8 8.0 Conclusion and Recommendations Appendices Appendix A: Cities & Towns Selected for the Urban Renewal Scheme Appendix B: Brochure for Section 50 Development VI

9 List of Figures: Page Figure 2.1 Headline from the Limerick Post 7 Figure 2.2 Harvey s Quay (left) and Howley s Quay (right) Limerick. A 10 Major Retail, Residential and Multi Storey Car Park Developments viewed from the Shannon River Figure 2.3 Cornmarket Row, Limerick. A Small Scale Residential 13 Development Figure 2.4 Completion of the Construction of Poppins Creche, Gerald 24 Griffin Street, Limerick. Figure 3.1 The Rise in New and Second-hand House Prices (Nominal) 32 Figure 3.2 Trend in Growth of House Prices 33 Figure 3.3 Plot of Actual House Prices (PA) and Fundamental House 39 Prices (PF) (in ) in real terms: Figure 3.4 Irish Quarterly Economic Growth 41 Figure 3.5 Irish Quarterly Employment Growth 41 Figure 3.6 Irish Population Levels: Natural Change and Migration 42 Figure 3.7 Demographic Profile 2004 and Projected Profile Figure 3.8 Average Earnings of Adult Industrial Worker, Private New 45 House Price, House Building Cost and Consumer Prices Indices Figure 3.9 Households classified by Occupancy Status of Dwelling 46 Figure 3.10 Rented Sector Accommodation Type 46 Figure 3.11 Household Types Classified by Occupancy Status 47 Figure 3.12 Interest Rates and Private New House Prices 48 Figure 3.13 The Impact of Competition in the Mortgage Market 49 Figure 3.14 Characteristics of Mortgage Stock 49 Figure 3.15 Average Earnings and Tax Bill 51 Figure 3.16 Average Household Size 52 Figure 3.17 Measure of Affordability 55 Figure 3.18 First-Time Buyers Classified by Perceived Affordability of 56 Mortgage Repayments, QNHS, June-August 2003 Figure 4.1 Employment in Construction Sector 60 VII

10 Figure 4.2 Expenditure on Gross National Product 62 Figure 4.3 Planning Permissions for Dwelling Units by Quarter 65 Figure 4.4 New House Build Contribution to real GDP Growth 67 Figure 5.1 The Site of the Former Savoy Cinema Complex 74 Figure 5.2 Arthur s Quay Development: One of the First Tax Incentive 83 Based Schemes in Limerick Figure 5.3 Riverpoint House: One of the Latest Tax Incentive Based 87 Developments in Limerick City Figure 6.1 Residential Investor s Survey, Reason for Investment 100 Figure 6.2 Privately Owned Rental Index 103 Figure 6.3 Fluctuations in Apartment Prices 104 Figure 6.4 Decline of Private Rents and Rental Yields 108 Figure 6.5 Actual and Fundamental House Prices (2 nd Hand Houses) 112 List of Tables: Page Table 2.1 Top 400 Earners Distribution in Ranges of Effective Tax 5 Rates: 2001 and 1999/00 Table 2.2 Property based Tax Incentive Schemes 9 Table Urban Renewal Scheme Incentives Applicable 12 Table 2.4 Investment in Designated Areas Table 2.5 Income Tax Position Before Investment 25 Table 2.6 Income Tax Position Before Investment 25 Table 2.7 Net Tax Savings After Investment 26 Table 2.8 Housing Completions Table 2.9 Tax Incentive Renewal Schemes Status, December Table 3.1 Increases in House Prices from 1996 to Table 3.2 Average House Prices for June Quarter Table 3.3 Long Run Housing Model Parameter Estimates 38 Table 3.4 Price, Earnings and Cost Indices 45 Table 3.5 Impact of a 2 per cent increase in ECB rates on a tracker 50 mortgage Table 3.6 Average Household Size 51 VIII

11 Table 4.1 Capital Formation in Housing (excluding site costs) 61 million Table 4.2 House Completions 63 Table 4.3 Estimated Tax Take from Private Housebuilding Industry 66 Table 5.1 Standard Interview Questions 69 Table 6.1 Stamp Duty Rates Implement in the 2002 Finance Act for 103 Investors Table 6.2 Example of rental account to illustrate impact of Mortgage 106 Interest Relief: Table 6.3 Ceiling for owner-occupier mortgage interest relief 106 Table 6.4 Stamp Duty Rates for Residential Property 107 Table 6.5 House Purchased in 1996 and Sold in Table 6.6 Cumulative Returns on Investment 111 Table 6.7 Investment in a 2-bedroom apartment in Clondalkin versus 114 AIB shares Table 6.8 Evaluation of a Section 50 Apartment Investment 18 Table 6.9 Evaluation of a Section 50 Apartment Investment 117 Table 7.1 Stakeholder Analysis Power Interest Matrix 120 IX

12 1 Introduction There has been phenomenal growth in Irish property values in residential, commercial and office property over the last decade. During this period, the supply of new residential properties has nearly quadrupled. In parallel, prices on aggregate rose significantly during the period, as demand outstripped supply. Major city centre areas have been rejuvenated while the borders, and midlands have seen a major uplift in construction activity. The reasons for these changes are numerous. Property based tax incentive schemes, both area-based and activitybased have contributed to increased levels of construction activity. Many of these tax incentive schemes are due to come to an end in July Will the impending cessation of many of these property based tax incentive schemes mark a watershed for the Irish construction sector, or are these tax incentive schemes a subsidy which are distorting the market place, in an economy where the construction sector at full employment? It is not possible to analyse the boom in residential housing demand and tax incentive schemes in isolation. There are many factors at play in the economy, primarily demand factors, which along with the subsidies offered by the tax incentive schemes have accounted for the phenomenal boom in the construction sector. This study will begin with an overview of the various tax incentive schemes, both activity and area based. Chapter 3 will look at the broader Irish residential property market, within which, tax-incentivised houses and apartments are constituent components. 1

13 Chapter 4 will examine the construction sectors contribution to the economy, at present and over the last ten years. Chapter 5 will capture the key points from interviews carried out with a range of market participants including economists, a tax consultant, a major property investor, and a resident within an area where tax based properties have been constructed. Chapter 6 will look at residential property investment. This chapter will explore the merits of investing in a tax-incentivised residential property prior to the cessation of most schemes in July In addition, the merits of investing in a regular residential property without capital allowances will also be explored. Chapter 7 will assess the impact of the cessation of many of the property based tax incentive schemes in July Finally, chapter 8 will provide the project s conclusions and recommendations. In the early 1990s I rented accommodation while studying in Galway. This ignited my interest in the rented residential property sector. I subsequently purchased residential dwellings for the purpose of letting, including a tax incentive based section 23 property. Since the early 1990s the Irish economy, employment levels, construction activity and property prices have all experienced strong growth. The cessation of many property based tax incentive schemes in July 2006 is an important milestone. At a micro level, investors need to explore the merits of acquiring a property with capital allowances before the schemes cease. 2

14 This study will explore the merits in such an investment. At a macro level, the construction sector constitutes a significant portion of GNP. In the twelve months to July 2006, the construction of tax incentive based properties, including residential, commercial and office type will account for a significant portion of total construction output. This study will explore the extent of tax incentive based construction activity within the overall construction sector, and the potential impact of the cessation of many of the schemes in July The project s research objectives are To outline the various tax incentive schemes, and where possible the level of investment in each scheme. To determine the contribution of the construction sector to the Irish economy. To investigate if residential property in Ireland is currently over valued. To investigate if residential property investment, including tax incentive based investments represent a viable investment. To explore the impact of the proposed cessation of the tax incentive schemes. 3

15 2 Tax Based Property Incentives; History and Background 2.1 Introduction This chapter highlights the tax inequality that currently exists within the Irish taxation system. An overview of many of the property based tax incentives, both area-based and activity-based is provided. In terms of the activity-based schemes such as crèches, private hospitals or nursing homes, the main focus is on passive investors, which essentially means investors purchasing the properties to lease to an operator. Workings examples are provided to illustrate how the tax savings actually work. Finally, an evaluation of the major schemes is provided in terms of the investment to date, and the projected investment to July Tax Inequality By spending a sufficient number of days out of Ireland each year, it is possible to be treated as a non-resident, and hence pay no tax in Ireland. JP McManus and Denis O Brien are two of Ireland s most famous citizens who avail of this non-resident status to avoid paying Irish taxes. Others involved in the horse breeding industry in Ireland can avail of the tax exemption status available on income derived from the cover fees of stallions, while artists such as U2 and Enya enjoy tax exemptions on their income. However, it is not necessary to be a superrich owner of a famous stallion, a world famous singer or to move abroad to a tax haven to avoid paying Irish taxes. As shown in table 2.1, in 2001, 41 people with income greater than 0.5 million paid no tax at all, while a further 35 people paid tax of less than 5 per cent. This is not illegal, but is actively encouraged by the government. By making approved investments, the costs can be deducted from the resident s tax bill. These investments can be in approved 4

16 residential dwellings, hotels, student accommodation, crèches, multi-storey car parks, nursing homes, private hospitals and sports facilities. Tax advisers who can structure a client s affairs in such a manner as to significantly reduce their tax bill have facilitated this tax avoidance. One of the most widely publicised property based tax driven investments to date has been the Four Seasons Hotel in Ballsbridge, Dublin. A group of high earners lead by Derek Quinlan purchased the hotel for 60 million, and then proceeded to offset the entire amount against their income tax bills over the next seven years. Table 2.1 Top 400 Earners Distribution in Ranges of Effective Tax Rates: 2001 and 1999/00 Range of Effective Tax Rates Numbers Percentage of Total % / /2000 Less than Total Source: TSG 04/22 1, Tax Incentives/Expenditures and Broadening of the Tax Base Other tax driven investments have been on a smaller scale. For example, business people in Ireland have established schemes whereby they rent their main business premises to an operating company that they themselves own, and through which they carry out their day-today business activities. This rental income from the business premises is sheltered from taxation using the tax relief from other tax incentivised section 23 properties that the businessperson owns. By setting the level of rent on the business premises at an appropriate 5

17 level, it is possible to limit the amount of profit and resultant tax being paid on the day-to-day business activity. The net result if that the businessperson does not pay any or else pays very little income tax on the day-to-day business activities. In addition, the rental income paid by the business to the property owner is sheltered from taxation using the section 23 relief. Businesses operating in this manner include amongst others veterinary practices, oil delivery companies and solicitors. While it may not have been the government s intention that property based tax incentive legislation should be applied in this manner, the reality is that structures already described are all perfectly legitimate. 2.3 Risk Associated with Tax Incentive Based Property Investments From the investor s perspective, the tax saving does not come risk free. Based on the 2005 marginal tax rate of 42 per cent, for every 100 invested by an investor, 42 is saved in tax. Investors have benefited in the last 10 years from capital appreciation on their investments and stable rental levels. However, the investors do face risks. As highlighted by Dan Boyle, TD, Green Party Finance Spokesman, property prices are inflated by the degree of the tax relief being given 1. Another risk associated with purchasing section 23 properties is that apartment schemes can become ghetto like, thus making it difficult to rent or sell on the properties. Consider the newspaper cutting shown in figure 2.1, which refers to a shooting incident that occurred in a section 23 rental property within Limerick city centre during It can t be stated that this shooting incident arose purely because the development was part of a tax incentive scheme. The development involved is located in what a poor part of Limerick city and it is debatable whether the development would have been undertaken without the tax incentives on offer. The development was completed over 6 years ago. At the 1 Interview on Prime Time, 23 May RTE 1. 6

18 outset, tenants were attracted from many social strata, but now approximately half of the tenants occupying the development are on social welfare assistance. In addition, it is suspected that there is a serious amount of drug dealing taking place within the development. Other section 23 apartments have been rented on short-term leases by third parties acting as a front for brothels. Figure 2.1 Headline from the Limerick Post Source: Limerick Post(2005) Woman could loose hand, 31 May 2005, p.1. However, on aggregate, investors have benefited from good capital appreciation on the tax incentive based properties, particularly those purchased prior to The fact that capital gains tax has been at 20 per cent for a number of years has enabled those investors to achieve good after tax return on their investment at the time of sale. The tax incentives have enabled investors to shelter income from taxation, and in many instances, social welfare assistance from the government is provided to tenants to assist them in paying rent. 2.4 Tax Based Property Incentives Property based tax incentive schemes commenced when the urban renewal schemes were first introduced in Ireland in October 1985 in response to the increasing problem of dereliction and 7

19 dilapidation that had affected large inner areas of our towns and cities. The core objectives of the schemes were to promote urban renewal and redevelopment by promoting investment by the private sector in the construction and reconstruction of buildings in designated inner city areas. These were areas where development was required but based on the dark economic conditions of the 1980s and in the absence of tax incentives developments would not otherwise have occurred. The tax-based incentives introduced targeted investors in and occupiers of properties in designated areas. According to the Irish Taxation Institute (2004, p.21), qualifying costs are offset against rental income from the let property in the first instance, and any loss arising may then be set against other rental income of the same year. Any remaining deficit will be carried forward for set off against all rental income for future years. 2 Currently, there are a number of tax relief schemes available throughout the country for investment in property. These reliefs are contained in several different incentive schemes as shown in table 2.2. Many of the schemes are due to expire on the 31st July The seaside resort scheme has already expired, but is included because it lead to many holiday homes being constructed, and is thus something with which people can relate. A number of other schemes, which have already expired such as the Temple Bar and Dublin Docks schemes, which ran from 1991 to 1999, have not been included. While each of the schemes has it s own particular set of rules, they are broadly similar. The student accommodation scheme deals solely with residential property for letting to students. The urban, town, rural and seaside renewal, along with park and ride, include reliefs for both residential and commercial property investment. 2 The Irish Taxation Institute. (2004). Income Tax 2004, p 21. 8

20 Table 2.2 Scheme First Urban Renewal Scheme (Note 1) Urban Renewal Scheme 1998 (Note 2) Town Renewal Scheme (Note 3) Rural Renewal Scheme (Note 4) Property based Tax Incentive Schemes Initial Introduction Date Expiry Date Is the Scheme Ring Fenced to Case V Income. If not, what is the limit of non case V income? No. No limit. All Income. 1 st August st July 2006 Yes for residential. No for commercial. Annual limit of 31, st July st July 2006 Yes for residential. No for commercial. Annual limit of 31, st June st July 2006 Yes for residential. No for commercial. Annual limit of 31, st July st December Not initially Seaside Resort Scheme (Note 5) Park & Ride Scheme 1 st July st July 2006 No. Annual limit of 31,750. Multi-storey car parks 1 st July st July 2006 No. Annual limit of 31,750. Living Over the Shop Scheme 6 th April st July 2006 No. Annual limit of 31,750. Type of Income (case) that can be offset against the Capital Allowance* Schedule D Case V Schedule E* Schedule D Case I* Schedule D Case II* Schedule D Case V Schedule E* Schedule D Case I* Schedule D Case II* Schedule D Case V Schedule E* Schedule D Case I* Schedule D Case II* Initially all income. Schedule D Case V Schedule E* Schedule D Case I* Schedule D Case II* Schedule D Case V Schedule E* Schedule D Case I* Schedule D Case II* Schedule D Case V Schedule E* Schedule D Case I* Schedule D Case II* Student Accommodation 1 st July st July 2006 Ring Fenced Schedule D Case V Scheme Child Care Facilities 1 st July 1999 There is no cut off date No. Annual limit of 31,750. Schedule D Case V Schedule E* Schedule D Case I* Schedule D Case II* Nursing Homes, Convalescent Facilities and Property for the Aged Hotels, Holiday Camps, Holiday Homes and Guest Houses Refurbished Residential Property for letting purposes Private Hospitals and Sports Injury Clinics NH: 3 rd Dec CF: 2 nd Dec PFA: 25 th Mar There is no cut off date No. Annual limit of 31, st July 2006 Now ring fenced except the Borders Midlands and Western region. N/A There is no cut off date 15 May 2002 There is no cut off date * Up to a limit of 31,750 per annum. Schedule D, Case 1 income is income from a profession. Schedule D, Case II income is income from a trade. Ring Fenced No. Annual limit of 31,750. Schedule D Case V Schedule E* Schedule D Case I* Schedule D Case II* Schedule D Case V except for Borders midlands & western region. Schedule D Case V Schedule D Case V Schedule E* Schedule D Case I* Schedule D Case II* 9

21 Schedule D, Case V is rental income from land and buildings in the state. Schedule E income is subject to deductions (i.e. tax, PRSI and the Health Contribution as appropriate) at source under the PAYE system. Note 1: Initially the five county boroughs Dublin, Cork, Limerick, Galway and Waterford and The Custom House Docks Area. In 1998, 10 new areas were added and a further 9 in In 1991, the tax incentive scheme for the Temple Bar Area was created. Ballymum was designated in Note 2: The scheme was originally scheduled to cease on the 31 st December There have been a number of extentions. Under this revised scheme local authorities were requested to draw up Integrated Area Plans in respect of each urban area they wished to have designated. A total of 78 Plans were submitted for assessment by a broad based expert advisory panel. The expert panel recommended designation in respect of 49 plans. Note 3: Confined to towns 500-6,000 population. Note 4: Aimed at the upper Shannon region counties Leitrim and Longford as well as certain areas in counties Cavan, Roscommon and Sligo. Note 5: 15 designated seaside resorts. Source: Tax Strategy Group Papers 99/32 and 04/22, Tax Find, The Irish Taxation Institute The other schemes which are listed in table 2.2 such as the provision of childcare facilities are activity based, rather than area based, meaning that in order to qualify for the tax relief the facilities such as nursing homes or crèches need not necessarily be located in tax designated areas. Figure 2.2 Harvey s Quay (left) and Howley s Quay (right) Limerick. A Major Retail, Residential and Multi Storey Car Park Developments viewed from the Shannon River Urban Renewal Scheme Since 1986, there have been three iterations of the urban renewal scheme, the first being the original scheme launched in 1986, with areas designated in each of the five cities - Cork, 10

22 Dublin, Galway, Limerick and Waterford. Cruises Street in Limerick is an example of an urban area that was renewed and enhanced as a result of the 1986 Urban Renewal Scheme. The second iteration of the urban renewal scheme was in This scheme was more focussed than the 1986 scheme, with greater emphasis being placed on residential development in inner urban areas. As captured in the interview in chapter 5 with Richard Tobin, Senior Planning Officer with Limerick City Council: since 1986 we have seen about 1 billion invested in property in the centre of Limerick, which is a pretty significant investment given that practically nothing was invested in the years prior to that. In terms of floor space we have only accurately quantified the floor space from 1998 onwards and I think we are looking at 2.5 million square feet of building floor area which includes 1,800 section 23 units...since 1998 there is about 300 to 400 million in straight building cost including site value. While the 1 billion invested includes a variety of different schemes, not limited to the Urban Renewal Scheme alone, this does not take away from the enormity of the investment in Limerick alone. The incentives available under the 1999 urban renewal scheme are captured in the table 2.3. Focusing on the residential developments, a comparison between owneroccupiers and investors shows that while an owner occupier can claim 50 per cent of the eligible construction cost against total income, at a rate of 5 per cent per annum over 10 years, the investor is can offset the entire 100 per cent of the construction costs against rental income, including income from other lettings. The investor has double the amount of allowances available, and the investor can claim all the allowances in a single year if that is appropriate for that particular investor. The fact that the investor can offset the rental income from other Irish rental property against the reliefs available on a section 23 property is a major incentive and encourages many business people to structure their affairs so that they rent their main business premises from themselves, offsetting this rental income against section 23 11

23 allowances, and thus avoiding paying tax on their business activities and on their rental income. Table Urban Renewal Scheme Incentives Applicable Owner-Occupier Capital Allowances COMMERCIAL/INDUSTRIAL DEVELOPMENT 50% initial allowance in Year 1 and a 4% annual allowance up to a maximum of 100% or free depreciation up to 50% in Year 1 and a 4% annual allowance up to a maximum of 100% Investor/Lessor Capital Allowances Owner-Occupier 50% initial allowance in Year 1 and a 4% annual allowance up to a maximum of 100% RESIDENTIAL DEVELOPMENT New Construction: 50% of eligible construction costs allowed at the rate of 5% per annum over 10 years against total income Refurbishment 100% of eligible construction costs allowed at the rate of 10% per annum over 10 years against total income Source: DOEHLG Investor/Lessor "Section 23" relief 100% of eligible construction, refurbishment or conversion costs may be set against Irish rental income (including income from other lettings) Qualifying residential property is limited to a maximum floor area of 125 m 2. Figures 2.2 and 2.3 provide examples of developments in Limerick city that have come under the Urban Renewal Scheme. Harvey s Quay and Howley s Quay are two of the more significant developments in Limerick City, while Cornmarket Row is an example of a small residential development. The impact of urban renewal in Limerick City is most obvious along the southern bank of the river Shannon, stretching from Arthur s Quay, to Steamboat Quay. This 12

24 area has been transformed from being run down with its back turned to the river, to being a modern retail and residential area, facing onto the river Shannon. Figure 2.3 Cornmarket Row, Limerick. A Small Scale Residential Development In the case of a new residential unit being constructed under the urban renewal schemes, the floor area must be in the range m 2. In addition, for an investor claiming relief, the property must be let for ten years. If the property is sold within ten years of the first letting, the relief is clawed back, and the new purchaser is entitled to the full relief, provided the property continues to be let. Consider the case of an investor purchasing a residential property qualifying for Section 23 type relief. In the first year the investor makes a claim, the Section 23 tax relief on the property is claimed in full. This creates a rental loss on that property. Rental profits from any other source in the Republic of Ireland can be set against this loss. Any unused balance of this rental loss rolls forward to future tax years until it is fully used up 13

25 by other rental profits. The full price paid for the property does not qualify for tax relief. A formula applies which eliminates the site cost from within the purchase price, as the site cost does not qualify for tax relief. Example 1 Property cost 300,000 Site cost 75,000 Development Costs 250,000 Special Formula: 300,000 x 250,000 (75, ,000) Qualifying tax cost 230,000 The 230,000 can be offset against all Irish source rental income until it has been fully utilised. This could take one year or twenty years depending on the amount of the investor s rental income. Consider the case of investor who has three properties one of which is a new Section 23 property, which cost 300,000 and has Section 23 allowances of 230,000. Example 2 illustrates the tax position for the first year. Example 2 New Section 23 Property Existing Property Existing Property Gross rents 10,000 15,000 12,500 Less Expenses (7,500) (5,000) (3,000) Rental Profit 2,500 10,000 9,500 Section 23 Relief (230,000) Rental Profit (Loss) (227,500) Offset other profit 19,500 (10,000) (9,500) Rental loss for year (208,000) Based on a tax rate of 42% and PRSI/Health Levies at 6%, the tax saved in year one is 10,560. The rental loss of 208,000 is carried forward against future years rental profit from all three properties until it is fully used up. The purchase of a Section 23 property is 14

26 particularly attractive to investors with an existing Irish property portfolio. However, an investor should not loose sight of the fact that section 23 property prices are inflated by the degree of the tax relief being given. Between the introduction of the schemes in 1986 and the end of 1995, over 1.75 billion was invested in the designated areas. Table 2.4 provides a breakdown of this investment by development category and geographical area. Interestingly, the investments in residential and commercial are similar, while the investment in office is slightly greater. Table 2.4 Investment in Designated Areas m Temple Bar CHDA Rest of Dublin Rest of Country Total IR m Residential Office Commercial Industrial Other Total , % > 100 Source: Department of the Environment Databases. CHDDA % Following an in-depth consultancy study on the operation of urban renewal schemes 3, the Government introduced a major new urban renewal scheme in Under the 1999 scheme, 5 cities and 38 towns were selected (see Appendix 1), based on Integrated Area Plans (IAPs) submitted by local authorities for these urban areas. 3 KPMG, Murray O Laoire Associates and the Northern Ireland Economic Research Centre. (1996) Study on the Urban Renewal Schemes. Dublin: Department of the Environment. 15

27 It is difficult to accurately calculate for the entire country the amount of investment which has taken place and tax foregone by the revenue commissioners under the 1999 urban renewal scheme, and these must be two of the reasons that the Minister for Finance, Brian Cowen has commissioned two independent reports on tax incentive schemes, one dealing with area based schemes and the other dealing with activity based schemes. As part of the research for this project, contact was made with the Revenue Commissioners to establish the amount of tax foregone as a result of the various schemes. Unlike grant aid which is very easy to track, it is difficult for the Revenue to accurately track the amount of tax foregone due to property based tax incentives, primarily due to the fact that the capital allowances associated with the tax based properties are only one of many different capital allowance. For instance, capital allowances also captures the allowances for business for such purposes as the depreciation of machines in factories and office equipment. To overcome this, the revenue has modified the annual tax return form to include different fields for the various capital allowances that can be claimed. This modification will take effect for the tax year 2004, which has a pay and file deadline of the 31 st October Hence, the tax year 2004 will be the first year for which it will be possible to accurately report the amount of capital allowances being claimed for that tax year. The estimated cost of all capital allowances in 2001 was 1,921 million 4. However, at a local authority level, it is possible to get estimates of the level of development that has taken place or is currently in the pipeline. For example, in Limerick City the scale of development captured by either the Urban Renewal Integrated Area Plans or in the Living 4 Department of Finance (2004) Tax Incentives/Expenditures and Broadening of the Tax Base TSG 04/22 [online], Available: [3 August 2005] 16

28 Over The Shop schemes amounts to 278,331 m2, with a project total investment under the Urban Renewal Scheme of million. 90% of projects are new builds Town Renewal Scheme In addition to the 43 major urban centres selected for the 1999 urban renewal scheme, 100 smaller towns were selected for the Town Renewal Scheme, which was launched by the government in The scheme is based on Town Renewal Plans (TRPs) prepared by the relevant local authorities. Similar to the urban renewal scheme, tax reliefs are available against capital expenditure on approved residential and commercial developments in the designated areas Rural Renewal Scheme The rural renewal scheme has followed on from the urban renewal scheme. The scheme is a pilot initiative of rural renewal aimed at invigorating the Upper Shannon region and covers all of the counties of Leitrim and Longford as well as certain areas in counties Cavan, Roscommon and Sligo defined by District Electoral Divisions. The tax incentives for the Irish rural renewal scheme were outlined in the 1998 Finance Act and the scheme was introduced from 1 June The reliefs available are broadly similar to those available to investors or owner-occupiers in commercial or residential property under the urban renewal scheme, with owner occupiers again being limited to claiming relief of 5 per cent per annum for 10 years against all income, while investors can claim 100 per of the qualifying cost against Irish rental income. Each letting of a residential property qualifying under the Rural Renwal Scheme must be for a minimum period of three months, to avoid holiday lets, and the house must be 5 Bradley, J. (2005), Senior Executive Planner Limerick Corporation Unpublished Letter: facts relating to the success of the IAP and LOTS incentive schemes as they have impacted on Limerick City 17

29 the main residence of the tenant throughout the period of the lease. In addition, the maximum floor area was increased in the 2001 Finance Act from 140 m 2 to 175 m 2 for rented properties, while owner occupied properties have a maximum floor area of 210 m Seaside Resort Scheme This scheme was launched on the 1 st July The tax reliefs provided were aimed at promoting and improving the qualifying resort areas of Achill, Arklow, Ballynunion, Bettystown, Laytown, Mosney, Bundoran, Clogherhead, Clonakilty, Courtown, Enniscrone, Kilkee, Lahinch, Salthill, Tramore, Westport and Youghal. The scheme ceased in December The scheme had the following incentives: Capital Allowances for investment in the construction or refurbishment of the buildings and facilities including hotels, holiday camps and holiday cottages registered by Bord Failte, registered or listed tourist accommodation (e.g. Bed and Breakfast accommodation) and other facilities approved by the Minister for Tourism. Double Rent Deduction for lessees of buildings and facilities which qualify for the above incentives and Relief for expenditure on construction, conversion and refurbishment of rented residential accommodation. The scheme ended on 31 st December As part of the project research, contact was made with various state bodies to gain information on the total investment in the seaside resort scheme and the amount tax revenue foregone. The only piece of information found was an estimated cost to the taxpayer of 106 million in The lack of information on the 6 Department of Finance (2004) Tax Incentives/Expenditures and Broadening of the Tax Base TSG 04/22 [online], Available: [3 August 2005] 18

30 amount of tax relief attained from this scheme is due to the fact that the relief was claimed by way of capital allowance, a general classification that does not distinguish between the wide variety of capital allowances. From a social perspective, the seaside resort schemes have provided a stock of reasonable quality holiday housing in the selected resorts. However, may of these holiday homes are vacant throughout the winter, effectively making ghost towns out of these seaside resorts Park & Ride Scheme Introduced in July 1999, the park and ride scheme provides tax reliefs for the construction or refurbishment of qualifying park and ride facilities and associated commercial and residential development. For commercial relief, the tax relief applies to the actual Park & Ride facilities and also commercial premises on the same site used for the retailing of goods or the provision of services within the State. The rates of tax relief which apply for construction or refurbishment are: Owner Occupier - 100% free depreciation or 50% initial allowance and 4% annual allowance. Lessor - 50% initial allowance and 4% annual allowance. Passive investors will be restricted to an annual claim of 31,750 against non-rental income, which is effectively PAYE income in the case of a PAYE employee. The amount of tax allowable expenditure on the commercial premises on the same site is restricted to 50% of the total expenditure at the Park & Ride Facility. The 50% test includes expenditure on residential property. In terms of residential property located at a Park & Ride 19

31 facility, Section 23 relief is available in respect of the construction of accommodation located on the site. In addition an owner-occupier relief is also available. Qualifying expenditure for residential units is limited to 25% of the total expenditure at the Park & Ride Facility. Of the schemes detailed so far, this is the first scheme, which includes a passive investor to claim 31,750 against regular non-rental or PAYE income Multi-Storey Car Parks Introduced in July 1995, this relief allows for accelerated capital allowances for multi-storey carparks outside the County Boroughs of Cork or Dublin. In Limerick city, an estimated 3,500 off street car parking spaces are available, to complement the 3,500 on street car parking spaces. The vast majority of these off-street parking spaces are in multi-storey car parks. The first such car park to be built in the city was Arthur s Quay, in which Limerick City Council invested. In its current format, the amount of tax relief available is Owner Occupiers : 100% free depreciation Lessor : 50% initial allowance and 4% annual allowance There are certain conditions that must be met, including a requirement not to dispose of the property within thirteen years to avoid the clawback of any reliefs granted and certification from the relevant local authority. Passive investors in multi storey car parks can claim tax relief of 31,750 per year against non-rental or PAYE income. Multi-storey car parks do not need to be located in a tax-designated area in order to qualify for tax relief. 20

32 2.4.7 Living Over the Shop (LOTS) Scheme This scheme was originally announced in September 2000 with the aim of tackling the problem of vacant space over commercial premises in the five cities of Dublin, Cork, Waterford, Limerick and Galway. The scheme commenced on 6th April 2001 and will end on 31st July Commercial property relates to the ground floor and basement of a qualifying building and must be used for retailing or supply of local goods and services. Relief on the residential portion of the property is identical to the 1999 urban renewal scheme. To qualify for tax relief on the commercial property, construction work must be carried out on residential units overhead. The amount of expenditure qualifying for tax relief on the commercial units will be the lower of: The amount of qualifying expenditure actually incurred or The amount of qualifying expenditure incurred on the overhead residential units. For the commercial property, the amount of tax allowance, is broadly similar to the urban renewal scheme: Owner Occupier Up to 50% of qualifying expenditure may be claimed by way of free depreciation or else as an initial allowance in year 1. Thereafter an annual allowance of 4% per annum is available. Lessor - An initial allowance of 50% in year 1 and thereafter an annual allowance of 4% per annum. As with the park and ride and multi-storey car park schemes, lessors can use 31,750 of allowances against non-rental or PAYE income. However, there is unrestricted relief for the tax allowances against all forms of rental income from within the State. 21

33 2.4.8 Student Accommodation Scheme The Section 50 tax incentive scheme was introduced in the Finance Act 1999 in an attempt to increase the supply of good quality student accommodation. The accommodation can only be let to students during term time but can be let out to tourists in the summer. While there are a number of specific rules governing the scheme, such as being linked to a third level institution and being within 8 km of the institution concerned, the provision of tax breaks, to investors in such schemes is similar to section 23 residential investments. The qualifying tax cost of the property is calculated by excluding the site cost: Example Property purchase price 250,000 Exclude site cost 50,000 Qualifying tax cost 200,000 The figure of 200,000 can be offset against all other sources of rental profit arising within the State. In addition to the schemes already discussed there is a scheme of relief in respect of buildings used for third level education purposes, which also expires on the 31st July Childcare Facilities Section 843A of the Taxes Consolidation Act 1997 (as introduced by Section 49(b) Finance Act 1999) provides tax breaks in the form of capital allowances on construction expenditure incurred on the provision of childcare facilities, e.g. crèche. In order to secure the tax status of the crèche, the childcare facility must be operated in compliance with the provisions of the 22

34 Childcare Act 1991 and the Childcare (Pre-School) Services Regulations The relief is given by way of capital allowances on capital expenditure incurred on the construction, of qualifying premises. Site costs are excluded. Any expenditure met by grants or other subsidies is also excluded. Relief for qualifying expenditure is given by way of an annual deduction over a period of seven years as follows: Years % Year 7 10% The relief is available to owner/occupiers and lessors. For lessors, the capital allowances are available for offset initially against the rental income from the Crèche. Excess allowances may be offset against the lessor s other sources of non-rental income, including PAYE income up to a limit of 31,750 per annum in years 1-7. In many instances, the scale of initial investment and resultant tax reliefs involved is such as to require a partnership structure consisting of several investors. In practice, thirteen investors form a partnership, which purchases the crèche facility and leases to an operator for a period of ten years. At the end of the ten-year period, there is a defined exit mechanism that often entails the operator purchasing the facility at a fixed price. This mechanism enables investors to benefit from substantial tax reliefs over a ten-year period. 23

35 Figure 2.4 Completion of the Construction of Poppins Creche, Gerald Griffin Street, Limerick. The following example illustrates the potential tax savings for a working couple investing in a childcare facility partnership, during years 1 to 6 of the investment: Assumptions Married Couple 2 Sources of Income, both Case I, which essentially means professional self employed individuals rather than PAYE tax payers Combined Income is 102,154 Before making the investment, the couple have an annual tax bill of 31,916. By making the investment, the couple is able to apportion some of the capital allowance available against rental income, in this case, 11,604, while 31,750 can be offset against total income. In addition, the PRSI bill is also reduced, as there is no PRSI associated with the rental income 24

36 which has been offset, and the total income upon which PRSI can be levied has been reduced to 58,000. Table 2.5 Income Tax Position Before Investment Income Case 1 Income 70,150 Case 1 Income Spouse 20,400 Net Rental Income 11,604 Total Income 102,154 Capital Allowances Against Rental Income 0 Against Total Income 0 Taxable Income 102,154 Tax Computation 58,800 x 20% 11,760 43,354 x 42% 18,208 Less: Annual Tax Credit (3,160) PRSI Computation 11,604 x 5% ,550 x 5% 4,528 Net Tax Liability 31,916 Table 2.6 Income Tax Position Before Investment Income Case 1 Income 70,150 Case 1 Income - Spouse 20,400 Net Rental Income 11,604 Total Income 102,154 Capital Allowances Against Rental Income (11,604) Against Total Income (31,750) Taxable Income 58,800 Tax Computation 58,800 x 20% 11,760 Less: Annual Tax Credit (3,160) PRSI Computation 11,604 x 0% 0 5% 2,940 Net Tax Liability 11,540 The net tax saving amounts to 20,376 for the tax year, as shown in table

37 Table 2.7 Net Tax Savings After Investment Net Tax Liability Before Investment 31,916 Net Tax Liability After Investment 11,540 Net Tax Savings 20,376 The above example illustrates the tax treatment of passive investors in a crèche. However, if the operator of the crèche were to purchase the facility, then that operator would be able to offset any of their income against the capital allowances associated with the crèche. In a similar fashion, a doctor purchasing a suite in a private hospital, and operating out of that suite would be able to offset their entire income against the capital allowances associated with the hospital suite purchased Nursing Homes Section 268(1)(g) of the Taxes Consolidation Act 1997 provides for tax relief on buildings which are used For the purposes of a trade which consists of the operation or management of a nursing home within the meaning of Section 2 of the Health (Nursing Homes) Act 1990, being a nursing home which is registered under Section 4 of the Act. The relief broadly applies to most private registered nursing homes. Similar to the other schemes discussed, relief is available in the form of capital allowances on expenditure incurred on the construction, conversion, extension or refurbishment of qualifying premises, but not on the site costs. Similar to childcare facilities, relief for qualifying expenditure is given by way of an annual deduction over a period of seven years as follows: Years % Year 7 10% 26

38 For lessors, the capital allowances are available for offset initially against the rental income from the nursing home. Excess allowances may be offset against the lessor s other sources of non-rental or PAYE income up to a limit of 31,750 per annum in years 1-7. Any remaining allowances can be offset against other Irish rental income Other Tax Reliefs for Property Investment Apart from the designated area or activity schemes already outlined, tax relief is also available in respect of the following types of property: (i) Hotels, holiday camps, holiday homes and guest houses. This scheme expires on the 31st July (ii) Refurbished residential property for letting purposes. There is no cut off date for this scheme. (iii) Private hospitals and sports injuries clinics. There is no cut off date for this scheme. 2.5 Evaluation of Tax Based Property Incentives The Minister for Finance, Mr Brian Cowen, T.D., announced in his Budget 2005 statement on the 1 st December 2004 that the Department of Finance and the Office of the Revenue Commissioners would undertake a detailed review of certain tax incentive schemes and tax exemptions in This review process is currently on going, with two consultant groups, Goodbody Economic Consultants on the area based schemes and Indecon on the sectoral based schemes, having been contracted by the Minister to produce reports on the sector. As indicated in table 2.2, many of the property-based tax reliefs, have a termination date of the 31 st July In the past, the cessation dates of certain scheme were extended to provide for an orderly wind-down for the reliefs. In his address to the Fianna Fail Ard Fheis, in Killarney 27

39 on the 22 nd October 2005, Minister Cowen reiterated his belief that it is unacceptable for high certain income individuals to be paying little or no tax, and signalled his intention to put a cap on the amount of tax relief individuals could claim. However, the Minister also stated that he wished to minimise the impact to employment in the construction sector. Looking at the period 1986 to 1995, approximately 20% of residential units constructed in Limerick and Dublin were in designated areas, as shown in table 2.8. Currently, there are no accurate figures available for the period from 1995 to today. As already outlined, this is due to the manner in which tax returns have been made in the past, with capital allowances for business activities as well as property based initiatives being captured together. Table 2.8 Housing Completions County Borough No. of Units Built in No. of Units Built in % of New Units in Designated Area Total in each City Designated Areas Dublin 5,350 24,018 22% Cork 839 6,422 13% Galway 553 5,653 10% Limerick 661 3,930 17% Waterford 200 2,484 8% Source: Local Authorities, DOEHLG Estimates are available on the level of investment in the urban renewal scheme, living over the shop scheme and town renewal. All three schemes combined account for an investment of 6,577.5 million as shown in table 2.9. Three key points can be taken from table 2.9: 28

40 Investment is heavily weighted towards the urban renewal schemes and hence the 14 urban centres to which the urban renewal scheme applies. The majority of the projected investment in all three schemes was either in the in planning phase or in the work in progress phase, as of December The value of the investment in the in planning phase and in the work in progress, amounts to 5,166 million. Expenditure on dwellings, improvements, other building and construction for 2004 amounted to 25,333 million. Hence, the value of in planning and work in progress associate with the tax investment schemes, is equivalent to 20% of total construction output in Table 2.9 Tax Incentive Renewal Schemes Status, December 2004 Status Urban Renewal Scheme 1999 million LOTS million Town Renewal Scheme million Total million In Planning 2, ,725 Work in Progress 2, ,441 Complete 1, ,412 Total 5, ,578 Source: Department of Environment, Heritage & Local Government Chapter 5 provides qualitative responses from market participants on property based tax incentive schemes. The Integrated Area Plans (IAPS) approach was introduced after the first urban renewal scheme based on the lessons learned from that scheme. These IAPS sought to introduce a holistic approach to developments, seeking to address community needs beyond purely residential needs. Certain participants in the interviews felt that the Urban Renewal 7 Expenditure on dwellings, improvements, other building and construction 2004 million based on constituent parts of Capital Formation Figures from CSO, with Machinery and Equipment Investment excluded from Capital Formation Figure. 29

41 developments were focused purely on the requirements of investors rather the needs of the community. 2.6 Concluding Remarks There has been significant activity in tax based property incentive schemes since Vast sums of money have been invested in residential accommodation, office spaces and commercial units. Employment has been created in the construction phase and the subsequent business activity. Inner city areas have been rejuvenated. Significant numbers of people now live in city areas that previously had no residential population. Dublin and Limerick have been transformed from a run down cities with their backs facing the river, to newly built cities facing the river. Tax reliefs are available to encourage investment in areas where the economy s infrastructure needs improvement such as child care, nursing homes, and private hospitals. For every 100 that an investor invests, 42 can be recouped in tax. With the assistance of tax advisers, many highly paid individuals have been able to structure their affairs in such a manner as to minimise the tax they pay. It can be infuriating for other tax payers, particularly those in the PAYE sector, who are not in a position to take advantage of such tax initiatives, seeing people with pay in excess of 0.5 million per annum, paying little or no tax. While families with both parents working in PAYE jobs struggle to meet the cost of childcare, against which no tax relief is currently available, investors can claim tax relief on the construction cost of the childcare facility. Many argue that the allowances are already factored into the price of the property. What is difficult to pin down is whether the seller is taking the lion s share of the tax benefit. The after tax cost of the property could be more than its real commercial value. In later chapters the merits of investing in either a standard residential property, or a tax incentive based property will be assessed. 30

42 3 Overview of the Irish Housing Market 3.1 Introduction Since the early 1990s there has been a significant increase in Irish house prices. According to NCB Stockbrokers (2004), Dublin property values have grown by nearly 400% in real terms over the period While the level of output of new houses has increased dramatically since 1991, demand has significantly outstripped supply. There are many positive factors, which when combined have driven price growth. Economic growth has been significant during the Celtic Tiger, with a resultant positive impact on employment levels and wage levels. According to Sutton, demand for housing, like demand for other goods, is positively related to real household income and wealth 2. Ireland s demographic profile means that a significant portion of the population is in the household formation stage. The reduction of interest rates in anticipation of joining the Euro zone, coupled with the subsequent reduction of Euro zone rates to their present level of 2% has provided historically low cost of finance. House prices have grown steadily. It is only in the latter half of 2004 and throughout 2005 that price increases have abated to levels that would be deemed reasonable. 3.2 House Price Inflation Figure 3.1 demonstrates the dramatic rise in new and second hand nominal house prices, in particular since 1996 onwards. 1 NCB Stockbrokers (2004) Residential Property V-other Equity Investments, Dublin. 2 Sutton, G.D. (2002) Explaining changes in house prices, BIS Quarterly Review, September 2002,

43 Euro '000 Figure 3.1 The Rise in New and Second-hand House Prices (Nominal) SECOND- HAND HOUSES NEW HOUSES Source: DOEHLG Period According to Duffy, adjusted for inflation, house prices have risen by 177 per cent between 1976 and Hence, house price inflation has significantly outstripped the consumer price index. A further boost to demand for second hand houses came in the November 2004 budget with the elimination of stamp duty on second hand house purchases for first time buyers, for house purchases costing less than Euro 317,501. Prior to the budget change, stamp duty was payable by first time buyers on second hand house purchases exceeding Euro 190,501 at a rate of 3%, which acted as a significant deterrent to first time buyers purchasing second hand property. 3 Duffy, D. (2004) A note in Measuring the Affordability of Homeownership, The Economic and Social Research Institute, Summer 2004, 70-78, Dublin. 32

44 3.2.1 Regional House Price Inflation Increases in house prices have been significantly greater in Dublin city than in any other part of the county, as demonstrated in table 3.1. Table 3.1 Increases in House Prices from 1996 to 2003 County/City Average House Price in 1996 Average House Price in 2003 Inflation Increase Dublin Dublin Cork Cork Galway Limerick County City County City County County 101,000 83,000 73,000 77,000 93,000 73, , , , , , , % 393% 299% 317% 259% 273% Source: Greehy G., The Determinants of House Prices in Ireland, University of Limerick 4 In addition, the Dublin market experiences much greater fluctuations in prices as shown in figure 3.2. Figure 3.2 Trend in Growth of House Prices 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% Mar-97 Sep-97 Source: Permanent TSB House Price Index Mar-98 Sep-98 Mar-99 Sep-99 Mar-00 Sep-00 Mar-01 Sep-01 Mar-02 Sep-02 Mar Outside Dublin Dublin 4 Greehy, G., The Determinants of House Prices in Ireland, University of Limerick. Sep-03 Mar-04 Sep-04 Mar-05

45 The sharp decline in the growth rate of house prices prior to 2002 is in part explained by the ending of the Celtic Tiger. As noted in the interview with Dan McLoughlin, which is detailed in chapter 5, there was a cyclical downturn around 2002 with unemployment rising from under 4 per cent to 5.5 per cent, with predictions of 6.5 to 7.5 per cent. Figure 3.4 illustrates that in first quarter of 2002 there was a two per cent reduction in GNP relative to twelve months prior. As illustrated in figure 3.13, from May 2001 onwards, ECB base rates were actually falling, so rising interest rates were not the cause of the declining growth rates. Another noteworthy factor during this period was the re-introduction of mortgage interest relief for investors at the beginning of The subsequent resurgence in investor activity lead to an acceleration in the rate of growth in house prices, from January The published data for the quarter ending June 2005 shows that new house prices have increased by 11.8 per cent nationally. While the pace of growth showed a slackening off in the first quarter of 2005, house price growth has rebounded in the second quarter. Relative to the previous quarter, new house prices increased by 0.8 per cent in the three months to March 2005 and by 4.1 per in the three months to June 2005, while second hand house prices fell by 1.3% in the quarter to March 2005, but increased by 9 per cent in the quarter to June Table 3.2 shows the average house prices for the quarter ended March Quarterly Housing Statistics, Department of Environment, Heritage and Local Government, 26 September

46 Table 3.2 Average House Prices for June Quarter 2005 New House Prices Second-hand House Prices Annual % Change Annual % Change National 275, , Dublin 346, , Source: DOEHLG 3.3 The Determinants of Irish House Prices Bacon et al (1998) reported the key drivers of the housing market to be economic growth, demography, the speed of supply response and the cost of finance 6. In interviews carried out as part of the qualitative research for this project, Dan McLoughlin identified the most significant risk facing the Irish housing market as a drop in income growth in the aggregate, while Dermot O Reilly and Michael O Dwyer identified the risk of a rise in interest rates from their current historically low levels, due to the increased level of indebtedness, as the most significant risk facing the market. In evaluating the determinants of Irish house prices, both demand and supply factors need to be taken into account Empirical Model of the Irish Housing Sector At the outset, consider an empirical model of the Irish housing sector that takes demand and supply factors into account. The Irish Financial Services Regulatory Authority (IFSRA) uses a model developed by Kieran McQuinn consisting of three simultaneous equations, similar in theory to the regime switching theory of Roche 7. McQuinn s model, takes account of the 6 Bacon, P. And Associates (1998) An Economic Assessment of Recent House Price Developments, Dublin: Stationery Office. 7 Roche, M.J. (1999) Irish House Prices: Will the Roof Cave In?, The Economic and Social Review, 30(4),

47 simultaneous interaction of supply and demand, and implicitly acknowledge the stickiness of housing supply to price signals 8. The three simultaneous equations are as follows: P t = f (+ U t, + YC t, + D t, + G t, - HC t, - R t ) (1) S t = f ( + P t, - B t /P t, - F t ) (2) H t = (1- t-1 + I t (3) where P = average house prices U = real rental price S = supply of housing I = housing Investment = PxS HC = housing stock (H) per capita (C) YC = income (Y) per capita D = demographic variable level of net migration B = index of builders costs F = land costs = depreciation rate of housing R = real interest rate G = average mortgage approved 8 McQuinn K. (2004), A Model of the Irish Housing Sector, Economic Analysis and Research Department, Central Bank and Financial Services Authority of Ireland. 36

48 The income per capita YC is net of taxation and thus takes account of tax generosity. Tax generosity is discussed further later in this chapter. The first equation is an inverted demand function. Most parameters are expressed as natural logarithms including the dependent variable, P t. In cases where the dependent variable and the specific variable being considered are expressed as natural logarithms, the parameter estimate shown is the elasticity. However, real interest rates and the demographic variable can be negative and hence can't be expressed as natural logarithms. To calculate the percentage change in average house prices as a result of a one per cent change in either of these variables, multiply the value shown in the table 3.3 by one hundred. Table 3.3 summarises the results attained using McQuinn s model. From this table, the factor having the greatest influence on house prices is the average mortgage approved. Effectively a one per cent increase in the average mortgage approved leads to a per cent increase in the average house price. A one per cent increase in real interest rates leads to a 0.5 per cent fall in the average house price, while a one per cent increase in housing stock per capita results in a per cent fall in the average house price. A one per cent change in net immigration results in an increase of 0.2 per cent in house prices. The fifth most significant factor is income per capita for which a one per cent increase results in a 0.11 per cent increase in the average house price. Given that a large number of Irish financial institutions have over the last two months commenced offering 100 per cent mortgages to first time buyers, it will be interesting to see what impact this will have on average house prices. Using equation 1, McQuinn calculated fundamental house prices. Figure 3.3 plots the resultant fundamental house prices and actual house prices. While there was a period from 1998 to 2001 when actual house prices were greater than fundamental house prices, in general actual house prices are accounted for by fundamental house prices over the period. This is 37

49 significant, as it indicates that actual house prices are not over-valued, and hence that a house price bubble does not exist. In chapter 6, which deals with residential property as an investment, other methods that treat residential property purely as an investment, neglecting the utility derived from a residence, are used to determine whether house prices are overvalued. McQuinn found that in the Irish market, a negative relationship exists between the real rental price and the average house price. While this is counter-intuitive, it can be explained by the dominance of capital gains. Hence, for the results shown in table 3.3, McQuinn focused on the real interest rate rather than the real rental price. Table 3.3 Long Run Housing Model Parameter Estimates Variables House Price Housing Supply INPT ln P t DN U t ln HC t D t ln YC t ln G t R t ln S t DN ln(p t /B t ) F t Note: ln denotes the natural logarithm of a variable. DN denotes dependent variable and INPT denotes intercept. Source: A Model of the Irish Housing Sector, Central Bank and Financial Services Authority of Ireland 38

50 Figure 3.3 Plot of Actual House Prices (PA) and Fundamental House Prices (PF) (in ) in real terms: Source: A Model of the Irish Housing Sector, Central Bank and Financial Services Authority of Ireland Demand Side Factors Employment and GNP Growth In the post Celtic Tiger era, Ireland continues to enjoy strong GNP and employment growth as illustrated in figures 3.4 and 3.5. The medium-term outlook for the Irish economy is positive. Hooke and MacDonald are forecasting an average economic growth of 6% per annum over the next five years 9, while Dermot O Leary in his interview expressed the view that economic growth would average between 4 and 4.5 per cent over a 10-year horizon. The release of Special Saving Incentive Accounts between May 2006 and April 2007 will provide a boost to 9 Hooke and MacDonald (2005). The Hooke & MacDonald Property Guide. Available: ReportIrishPropertyMarketHooke&MacDonald.pdf [3 August 2005] 39

51 the economy with an estimated 14 billion being released 10. Research undertaken by Irish Mortgage Corporation shows that 39% of homeowners with an SSIA intend to spend some or all of their savings on maturity and 53% plan to reinvest some or all of it. Property is by far the most popular intended destination for SSIA funds, with 27% intending to reduce their mortgage, 28% intending to carry out home improvements and 25% intending to purchase an investment property either at home or abroad. Assuming that the average SSIA account will yield 20,000, this would be insufficient to purchase a property, but it would be sufficient as a deposit on a property, and a bank would be well disposed to extending a mortgage to people who would be prepared to invest the full amount of their SSIA fund on an asset investment rather than on consumption. The resultant SSIA expenditure will further boost GNP and will also provide a boost to the property market. However, a future concern exists around the high level of economic activity and employment related to the construction of residential dwellings, which is explored in chapter 3. In terms of employment, approximately half of all employment growth is accounted for by the construction sector, while the number of people involved in manufacturing and agriculture is declining. A concern regarding the CSO s quarterly economic growth figures rests in the fact that there have been significant adjustments in recent published figures for 2003 and 2004, which complicates the decision as to how well the economy is really performing. 10 Financial Stability Report,

52 Total over 4 Quarters ('000s) GNP Year on Year Growth Rates (%) Figure 3.4 Irish Quarterly Economic Growth 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% -2.0% -4.0% Data Source: CSO 2002Q1 2002Q2 2002Q3 2002Q4 2003Q1 2003Q2 2003Q3 2003Q4 2004Q1 2004Q2 2004Q3 2004Q4 2005Q1 Figure 3.5 Irish Quarterly Employment Growth Q1 2002Q2 2002Q3 2002Q4 Data Source: CSO 2003Q1 2003Q2 2003Q3 2003Q4 2004Q1 2004Q2 2004Q3 2004Q Demography The CSO estimated the total population in April 2004 to be 4.04 million, the highest figure since 1871 (CSO 2004). A labour shortage in Ireland coupled with the free movement of citizens of the latest European Union accession states have resulted in net inward migration. Since 1995 onwards, there has been a significant increase in net migration into Ireland. This net migration coupled with the natural increase in Ireland s population is resulting in an annual population increase of 80,000 in 2005, as indicated in figure

53 Thousands Figure 3.6 Irish Population Levels: Natural Change and Migration Source: Census 2002, CSO Natural Increase Net Migration Population Change With labour force participation rates already high in Ireland and unemployment levels low, net inward migration will be required to sustain economic growth. The latest figures published by the CSO show that in the year to April 2005, the population grew by 87,000 to 4.13 million. In the second quarter of 2005, GNP grew by 3.1 per cent relative to the previous year, while the total number of people in employment grew by 5 per cent, inferring a greater number of jobs being created in the lower productivity sectors such as services and construction, rather than manufacturing. If this trend of falling productivity continues, it may contribute to a slowdown in house price growth, as the economy will be generating more low paid jobs, and these lower paid workers will not have the necessary income to purchase a residential property. An increase in population of 80,000 per annum over the next five years would increase the countries population by up to 400,000 by 2010, bringing the total population to 4.5 million. 42

54 Population '000 A further factor favouring demand for housing is the fact that immigrants to Ireland tend to be in the household formation age bracket, while those emigrating tend to be young adults, who are not yet at the stage of forming a household. The latest research by Hamilton Osborne King reveals that 30 per cent of new homes are being purchased by non-nationals, compared to 5 per cent two years ago 11. Furthermore, the demographic profile of the Irish population is such that the baby boom children born in the 1970s and early 1980s are at the house formation stage, leading to further demand for accommodation. Figure 3.7 illustrates this whereby significant proportions of the population are in the 20 to 29 and 30 to 39 brackets. Figure 3.7 Demographic Profile 2004 and Projected Profile to to to to 49 Source: CSO 2004, Goodbody Estimates Excluding Natural Migration Effects Age Bracket Income Levels House prices are very responsive to movements in disposable income 12. While income levels increased initially in line with the growth in property prices during the initial years of the current boom, in recent years, growth in house prices has outstripped the growth in disposable 11 Hamilton Osborne King (2005) Finfacts Business News Centre [online], 25 October 2005, Available: [26 October 2005] 12 Financial Stability Report, 2004, p

55 income 13. This is illustrated in figure 3.8 and table 3.4. Using 1991 as the base year, a base of 100 is applied to each of the indexes: house building cost, consumer price, private new house price and average earnings of an adult industrial worker. The house building cost index relates solely to labour and material costs and should normally not exceed 65% of the total price of a house 14. The results are shown in figure 3.8. As can be seen, building costs are in line with the average earnings of adult workers, while both are well ahead of the consumer prices. However, all three are eclipsed by the growth in private new house prices. Surprisingly, houses are more affordable in 2005 than in 2000, as is illustrated in figure 3.17, but affordability also takes into account the fall in interest rates as illustrated in figure Dan McLoughlin in his interview emphasised that the growth in income levels in the aggregate should be taken into account, including the growth in employment levels as well as the growth in the average earnings of a worker: if Irish annual employment growth is 5 per cent, coupled with a 5 per cent growth in the average income, this will lead to a double digit rise in the aggregate income. The large gap between the growth in the private new house price index and the other three indices can in part be explained by the increase in development land prices. However, much of the development land was already in the possession of developers. Builders and developers 13 Greehy, G., The Determinants of House Prices in Ireland, University of Limerick 14 Housing Statistics from the DOEHLG website. 44

56 Index have and are continuing to make significant profits, as is evidenced by Sean Dunne s involvement in the purchase of the Jurys Doyle Ballsbridge site. Figure 3.8 Average Earnings of Adult Industrial Worker, Private New House Price, House Building Cost and Consumer Prices Indices Base : 1 St Quarter 1991 = Source: DOEHLG House Building Cost Index Private New House Prices Consumer Price Index Average Earnings of Adult Industrial Worker Table 3.4 Price, Earnings and Cost Indices Year Private new house prices Average earnings of adult workers House Building Cost Consumer Prices Source: DOEHLG 45

57 Investor Involvement in the Residential Housing Sector 16 per cent of residential dwellings within the country are rented as illustrated in figure 2.9. In 2004, investors purchased 22 per cent of all new homes purchased 15. These figures capture the importance of investors in the marketplace. A subsequent chapter evaluates the merits of residential property investment in the current environment. Figure 3.9 Households Classified by Occupancy Status of Dwelling Figure 3.10 demonstrates that within the rented sector, semi detached and terraced houses constitute 59 per cent of rented accommodation, with bedsits and apartments making up 29 per cent of the market. Figure 3.10 Rented Sector Accommodation Type Source: CSO, QNHS on Housing Q Irish Residential Market, Review 2004, Outlook 2005, Sherry Fitzgerald 46

58 An analysis of each accommodation type shows that the apartment/bedsit sector is the only sector dominated by rental as shown in figure Figure 3.11 Household Types Classified by Occupancy Status Finance Mortgage interest rates in Ireland are at historically low levels. Since adopting the Euro, Ireland relinquished control of interest rates. The average mortgage rate in Ireland has declined from about 15 per cent in the early 1980s to under 4 per cent by Figure 2.12 clearly demonstrates the inverse relationship between the mortgage interest rates and new private house prices, using a base of 100 in the first quarter of 1991 for both. 47

59 Indexed to 1991 Figure 3.12 Interest Rates and Private New House Prices Private New House Prices Interest Rates Source: DOEHLG The current ECB rate of 2% has fueled house price growth in recent years. When Irish inflation rates are taken into account, real interest rates have for the most part been negative over the last five years. Combined with lower ECB rates, margins for mortgage lenders have reduced subsequent to the arrival of Bank of Scotland, resulting in lower rates for customers. The acquisition of National Irish Bank by Danske bank has added further competition to the mortgage market. National Irish currently offer extremely competitive rates, including a 3.65% fixed five-year rate. Based on five-year money costing 2.7 per cent on the interbank market 16, this corresponds to a margin of 0.95 per cent. Figure 2.13 emphasises the impact of competition on the mortgage market while also tracking ECB base interest rates. The availability of finance has increased considerably over the last ten years. The size of mortgages available to a house buyer today, is far greater than in As shown in table 4.3, a 1% increase in the size of the average mortgage approved leads to a 1.048% increase in the average house price. 16 Five year inter-bank rate available for Euro funds on 16 th September

60 Figure 3.13 The Impact of Competition in the Mortgage Market % Jan-99 May-99 Source: Goodbody Stockbrokers Sep-99 Jan-00 May-00 Sep-00 Jan-01 May-01 Sep-01 Jan-02 May-02 ECB Base Rate Spread between average Irish Mortgage interest rate and ECB Rate Sep-02 Jan-03 May-03 Sep-03 Jan-04 May-04 Sep-04 Jan-05 May-05 Unlike our European counterparts, the Irish mortgage stock is dominated by variable interest rates as illustrated in figure Figure 3.14 Characteristics of Mortgage Stock 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Source: Central Bank of Ireland Over 5 yrs Between 3 & 5 yrs Between 1 & 3 yrs Variable rates (< 1yr fxd) It is a concern that 78 per cent of the country s mortgage stock is on variable rates. Continuous rises in the price of oil pose a danger for inflation that may put pressure on the ECB to increase interest rates. In August 2005, Euro zone inflation was 2.7 per cent, well above the target of 2 per cent set by the ECB. Given the predominance of variable rate mortgages, Irish mortgage holders are particularly susceptible to ECB interest rate changes. 49

61 Consider the case of a house owner with an interest only mortgage at tracker rate of 2.95 per cent. A 2 per cent rise in the ECB rate will result in a 68 per cent increase in the annual interest bill as illustrated in table 3.5. Table 3.5 Impact of a 2 per cent increase in ECB rates on a tracker mortgage Potential Current Tracker Future Tracker Loan Amount Interest Rate Interest Rate Change % Change 300, % 4.95% Annual Interest Repayment 8,850 14,850 6,000 68% This threat is more pronounced for recent first time buyers who have a larger repayment burden than the all mortgage holder. However, mortgage holders with interest and capital repayments can explore the options of lengthening the term of the mortgage or to change to an interest only mortgage repayment in order to lessen the monthly repayment burden. It is difficult to envisage many first time buyers being able to cope with their mortgage repayments if interest rates rose into double digits Tax Generosity Chapter 4 explores in detail the tax treatment of investors and owner-occupiers in residential property. In addition, throughout the 1990s and beyond 2000 there were reductions in the base and marginal rates of income tax. The combination of reduced taxes and increased incomes as illustrated in figure 3.15 have combined to increase net take home pay thus supporting affordability. 50

62 Figure 3.15 Average Earnings and Tax Bill When combined with lower interest rates, the net result is that monthly mortgage repayments when expressed as a percentage of net monthly income are more affordable in 2005 than in Headship Rates The average household size in Ireland is greater than the European average. The headship ratio for Ireland at an overall level was 32.9% at the last census count, up from 29.2% in 1991 and 31% in This increase reflects the decrease in the average number of people per household, as shown in table 3.6. Table 3.6 Average Household Size Year People Per Household Source: Census Data Figure 3.16 demonstrates the average Irish household size relative to other European countries. As the Irish economy has now surpassed many of it s European peers, it is 51

63 inevitable that the average household size will continue in its downward trend towards a European median. Figure 3.16 Average Household Size Second, Vacant and Replacement Properties 40 to 50 per cent of the current new house supply is for second (holiday) homes, the replacement of obsolete units or are unlet investment properties according to the 2004 report by Goodbody Stockbrokers on the Irish housing market 17. Demand for such second properties is dependent on continued high levels of disposable income and employment Supply Side Factors Chapter 4 deals in detail with the construction sector and details the annual output of housing units. Table 4.2 illustrates that the supply of new houses has more than doubled from 30,575 in 1995 to 76,954 in According to Dan McLoughlin, the output of new houses in Ireland today is equal to 40 per cent of the output of the United Kingdom. 17 The Irish Housing Market, Semi-detached from reality, p

64 In the short term, the supply of new houses is inelastic due to factors such as infrastructure and planning requirements, which impact upon supply. This inelasticity contributes to an exaggeration of the cyclical nature of the construction sector internationally, contributing to boom-bust scenarios 18. The fact that house prices continued to rise in the period from 1995 to 2004 indicates that supply was insufficient to meet demand, not withstanding the fact that over the last two years 50 per cent of demand was for second, vacant or replacement properties. In order to increase supply, several recommendations were made by Bacon et al in the first two reports in 1998 and 1999, including new planning guidelines, the utilization of zoned land for construction purposes and taxation changes regarding development land. The Sherry Fitzgerald Group estimates that in the period 2002 to 2016, approximately 670,000 new housing units will be required, equating to an average annual requirement of 48,000 units 19. Based on the current annual output of approximately 77,000 per annum, there is a risk of over supply. Another concern surrounds the profile of the new dwelling constructions. According to Goodbody Stockbrokers, apartments have accounted for over 20 per cent of total completions over the period. Figure 3.7 illustrates the aging of the Irish population that will take place by Apartments are often viewed as started homes for couples, but unsuitable for families, particularly those with children. This may well lead to a fall off in demand for apartments in the next decade, which may have a knock on effect on the 18 Foley, P.P., Are Irish House Prices Determined by Fundamentals? [online], Available: 19 Sherry Fitzgerald Group (2004) The Residential Market: Autumn

65 rest of the housing market, as apartment prices may be depressed for those seeking to trade up. In addition, as shown in figure 3.11, 85 per cent of apartments are rented, while 13 per cent are owner occupied. Figure 3.2 illustrates the volatile nature of apartment prices during the period of the Bacon reforms. Investors are particularly sensitive to changes in the market place. The dominance of investors in that sector of the market leaves it susceptible to a mass exodus by investors. Building companies in Ireland will continue to construct new dwellings while profits can be made. From an employment perspective, the construction of dwellings is more labour intensive than other construction activities such as road construction. This is borne out by the fact that in the three months to the end of June 2005 the economy grew by 4.1 per cent, while employment grew by 5.1 per cent 20. While jobs in the house-building sector represent lower productivity than the industrial sector, it is in the government s interest to have a vibrant house construction sector in order to maintain employment levels. 3.4 Affordability In spite of the fact that house prices have continued to rise since 2000, mortgage repayments are now more affordable than during 2000 and 2001, although affordability has deteriorated from the 23.8 per cent in the third quarter of 2003 to 25 percent in the second quarter of This is due to the fact that the cost of finance has decreased. While income levels have also increased, as illustrated in figure 3.8, this increase has not kept pace with the rate of increase 20 CSO National Accounts published 30 th September

66 Net Monthly Income % in private new houses. Figure 3.17 expresses affordability of mortgage repayments as the percentage of net monthly income required to meet monthly mortgage repayments for a dual income household purchasing a new home. Figure 3.17 Measure of Affordability 35% 30% 25% 20% Q1 00 Q2 00 Q3 00 Q4 00 Q1 01 Q2 01 Q3 01 Q4 01 Q1 02 Q2 02 Q3 02 Q4 02 Q1 03 Q2 03 Q3 03 Q4 03 Q1 Q Source: Goodbody Stockbrokers estimates based on a based on disposable income of a two income family each on average income The quarterly national household survey asked first-time buyers about their perception of the affordability of their mortgage repayments. Their findings shows that only small minorities less than 2 per cent in the state and less than 4 per cent in Dublin perceived their mortgage repayments as very difficult to manage 21. Figure 3.18 illustrates the results of the quarterly national household survey conducted by the CSO for the quarter June-August Fahey, T Housing affordability: is the real Problem in the Private Rented Sector? Quarterly Economic Quarterly, Summer. pp

67 Figure 3.18 First-Time Buyers Classified by Perceived Affordability of Mortgage Repayments, QNHS, June-August Per Cent Easy to manage Managable Difficult to manage Very difficult to manage Bought since 1996 Source: CSO (2004). Table 14 State Dublin 3.5 Concluding Remarks From the mid 1990s onwards, house price inflation, both new and second hand, has significantly outstripped the consumer price index. This increase has been greatest in Dublin city, with average house prices increasing 393 per cent in nominal terms between 1996 and House prices continue to increase, and based on the latest figures available, house prices increased by in excess of 10 per cent nationally in the twelve months to June The factors having the greatest influence on house prices are the size of the mortgage approved, real interest rates, the housing stock per capita, demographic change and income. Entry into the Euro zone accompanied by the record low interest rates in the Euro zone, the availability of 100 per cent mortgages, increased income in the aggregate, greater competition in the mortgage credit market, and the country s changing demographic profile have all contributed to increased demand for residential property. 56

68 Mortgage interest rates are at historically low levels. However, the fact that 78 per cent of the mortgage stock is at variable rate represents a risk. Debt per capita has increased significantly over the past ten years to current levels of 130 per cent debt to disposable income meaning that households sensitivity to interest rate increases has increased significantly in the last 10 years. The growth in new house prices has far surpassed the growth in building costs, average earnings of adult industrial workers and consumer prices, inferring that either landowners or builders or both are making a lot of profit. Investors play an important role in the market, with 16 per cent of residential property being rented. The average household size in Ireland is still greater than the median in either Europe or the United Kingdom. A significant portion of the new houses currently being constructed are second, vacant or replacement properties. Such demand is dependent on high levels of disposable income and strong employment. Supply now appears to be meeting demand. Over the next ten years the risk is that supply will exceed demand, if the current rate of construction is maintained combined with an economic shock impacting interest rates, the size of mortgage being granted or migration. Provided 57

69 mortgage holders can maintain their income levels and there is not an adverse interest rate shock, then mortgage repayments in the aggregate should remain affordable at or below 30 per cent of the net monthly household disposable income. 58

70 4 Construction Sector s Contribution to the Economy 4.1 Introduction The previous chapter has explored the many factors contributing to the increased demand for housing, the supply side response along with concerns regarding an over-supply in the future, and household affordability. The purpose of this chapter is to quantify the construction sector s contribution to the economy. As outlined in the interview with Dr Dan McLoughlin in chapter 5, Irish housing output is 40 per cent of the United Kingdom s. This is an extraordinary figure, in light of the fact that Ireland has a population just in excess of four million while the population of the United Kingdom is sixty million. While exports from US multinationals drove growth in the Irish economy during the Celtic Tiger, it is the growth in construction that is now one of the main drivers of growth. As an industry, the construction sector contributes to the Irish economy by providing employment, constructing and renovating the country s housing stock, constructing and renovating industrial and commercial buildings, and contributing tax to the exchequer. This chapter will explore each of these contributions. 4.2 Employment In many public statements, The Minister for Finance, Brian Cowen has expressed his disquiet at the fact that certain people on high incomes are using tax breaks to avoid paying tax. However, in each of those statements, Minister Cowen has qualified his intention to address tax breaks with an acknowledgement that construction sector employment is extremely 59

71 ('000 workers) important for the economy, stating that careful thought would have to be given to any changes that might impact on construction employment. Figure 4.1 illustrates that in 2004, in excess of 200,000 workers were employed in the construction sector. In comparison, the number of people employed in manufacturing in 2004 was 300,000. Essentially, the number employed in construction in 2004 was two thirds of the total manufacturing employment, and as employment in construction continues to grow in 2005, with manufacturing employment declining, a point may soon be reached where employment numbers in each sector will be similar. According to Kevin Flavin, executive member of the Irish Home Builders Federation, in 2005 the number of people employed by the house building industry is estimated to be in the region of 140,000, which is approximately 60 per cent of overall employment in construction industry 1. Figure 4.1 Employment in Construction Sector 260 % of Labour Force 13% '000 workers 12% 11% % % 8% 100 Mar - May 98 Mar - Mar - Mar - Mar - May 99 May 00 May 01 May 02 Mar - May 03 Mar - May 04 Mar - May 05 7% Source Data: CSO 1 Flavin, K., Member of Executive of Irish Homebuilders Federation (2005) Figures on Renewal Schemes, to F.Marren (Feargal_Marren@volex.ie), 9 August 2005 [9 August 2005] 60

72 Employment in the construction sector has increased by 95 per cent from 126,100 (7.8% of the labour force) in the quarter to May 1998 to 246,100 (12.1% of labour force) in the quarter to May During the period from May 1998 to May 2005, 29 per cent of the increase in total employment was accounted for by the construction sector. It should be a cause for concern for the government that the construction sector accounted for over three quarters of the overall growth in the number of males in employment in the year to May Considering the fact that 60% of construction industry employees are employed in house building, a halving in employment in the residential construction sector would result in 70,000 workers (3.4% of the labour force) exiting the sector. Table 4.1 Capital Formation in Housing (excluding site costs) million Source: DOEHLG Table 4.1 expresses expenditure in residential construction as a percentage of gross domestic fixed capital formation, and as a percentage of gross national product. In terms of gross domestic fixed capital formation, the contribution of residential construction has almost doubled from 21.7 per cent to 41.2 per cent. Expressed as a percentage of gross national product, the contribution of residential construction has more than trebled from 4 per cent to 2 Government of Ireland (2005) Quarterly National Household Survey, Quarter 2, CSO. 61

73 % of GNP 12.4 per cent. Residential construction now constitutes a far greater percentage of GNP than in Figure 4.2 Expenditure on Gross National Product 14% 13% 12% 11% 10% 9% 8% 7% 6% 5% 4% 1997Q1 1997Q4 1998Q3 1999Q2 2000Q1 2000Q4 2001Q3 2002Q2 2003Q1 2003Q4 2004Q3 Residential as % of GNP Non Residential Construction as a % of GNP Source Date: CSO Reviewing the contributing factors to gross domestic fixed capital formation, as shown in figure 4.2, it is clear that while residential construction continues to increase as a percentage of GNP, exceeding 13.1 per cent in the first quarter of 2005, the contribution of non residential construction as a percentage of GNP actually decreased, reflecting a tail off by government in major infra-structural projects. There is a belief among some commentators that a future reduction in residential construction activity will be compensated for in employment terms by an increase in the amount of non- 62

74 residential construction activity, such as motorway construction. However, it needs to be borne in mind that residential construction is far more labour intensive than motorway construction, where machine play a greater role, thus increasing productivity. In addition, as is shown in figure 4.2, expressed as a percentage of GNP, residential construction increased to 13.1 per cent, while non-residential construction actually decreased to 5.7 per cent, reflecting a tail off in investment in major infrastructural projects by the government. In conclusion, in order to maintain current employment numbers in the construction sector in the event of a slowdown in residential construction, there needs to be a significant improvement in other areas of construction. The reality is that this is very unlikely to happen. 4.3 House Completions As illustrated in table 4.2, in the ten years from 1995 to the 2004, house completions have more than doubled from 30,575 units in 1995 to in excess of 76,954 in Table 4.2 House Completions Year House Completions , , , , , , , , , , ,000-78,000 (Est.) Source: Irish Home Builders Association Convention Update

75 According to the Department of the Environment, completions for the first 6 months of 2005 amounted to units, down 1.8 per cent from the same period in Estimates are that the number of completions in 2005 will be in line with HomeBond registration figures for the first quarter of the year show housing starts at a similar level to that of the same period in According to the Irish Home Builders Association, Ireland is now producing houses at the rate of 20 units per 1,000 of population. This compares with a European and US average of 5 units per 1,000 of population. 1/3rd of Ireland s housing stock is now less than ten years old and we are adding to our housing stock at twice the rate of increase of the population. Logic dictates that the country can't indefinitely continue to build houses and apartments at twice the rate of population growth. The demand factors driving the growth in the supply of housing have already been explored in chapter 3. On aggregate, planning permission applications year in 2005 are slightly above the level of applications in 2004, as shown in figure 4.3. There was a noticeable increase in the number of houses being granted planning permission, up 17.6 per cent from 18,635 in the second quarter of 2004 to 21,938 in There was a reduction in the number of apartments granted planning permission, down from 7,313 in the second quarter of 2004 to 6,880 in This tail off in planning permissions for apartments in 2005 is in part be explained by the fact that the deadline for planning permission applications for the tax incentive schemes was the 31 st December 2004, and a large proportion of dwelling units being applied for as part of the schemes were apartments. 3 Govrnment of Ireland (2005) Quarterly Housing Statistics, 26 September 2005, DOEHLG 64

76 Figure 4.3 Planning Permissions for Dwelling Units by Quarter 35,000 30,000 25,000 20,000 15,000 Apartments Houses Total 10,000 5,000 0 Q103 Q203 Q303 Q403 Q104 Q204 Q304 Q404 Q105 Q205 Source: CSO Using planning permissions as a forward indicator, and based on the fact that planning applications have not shown a decline, it is reasonable to assume that in the absence of a major economic shock in the next two years, the output of residential dwellings will be maintained at the current level of approximately 77,000 units per annum. The fact that house prices have continued to rise throughout 2004 and 2005, all be it at a slower pace than in previous years indicates that demand for housing remains strong. Taking into account the demographic profile, and provided that employment levels remain strong and there is not an adverse rise in interest rates, then demand for 77,000 new housing units per annum should be maintained. 4.4 Tax Like all other industries, the construction sector contributes to the exchequer through a number of different taxes. These taxes include capital gains tax, stamp duty, PAYE, PRSI, local authority levies, corporation tax, and VAT. In terms of the contribution of the new 65

77 housing construction sector, the Irish Home Builders Association estimates that 40 per cent of output of the housing sector is taken in the form of taxes, equating to a tax take of 7.7 billion from new residential activity based on the average house price, corresponding to 23 per cent of the total expected Exchequer revenue in 2005 compared with only 3 per cent in 1995, as illustrated in table Table 4.3 Estimated Tax Take from Private Housebuilding Industry Completions (units) 26,604 77,000 Average House Price (euro) 77, ,000 Total Value of New Housing (million euro) 2,075 19,250 Tax Revenue (million euro) 498 7,700 Tax % 24% 40% % of Total Exchequer Revenue 3% 23% Source: IHBA The Minister for Finance, Brian Cowen has disputed the IHBA s 40 per cent figure, pointing out that the actual cost of a new home that accrues directly to the central Exchequer through taxation is in the order of 28%, based on both south Dublin and national prices 5. The Minister goes on to point out that this is broadly in line with the tax take on the overall economy. Whether the figure is 40 per cent or 28 per cent will not be debated here. The fact remains that the new house-building sector is a major contributor of funds to the exchequer. Any reduction in the output of new houses would have a serious impact on exchequer revenue. 4 Fitzpatrick, H. (2005) Irish Home Builders Association Convention Update 2005, presented at the Irish Home Builders Convention, 4 May Dail Debates, (2005) Parliamentary Question 7205/05 [online], Available [25 August 2005]. 66

78 4.5 Economic Growth Section 4.2 has already outlined the contribution made by the construction sector in general and the new house construction sector to employment. Figure 4.4 captures the contribution of new house building to real GDP growth. In 2003, 20 per cent of the overall growth in GDP was accounted for by the construction sector. This in part reflects the slowdown in the growth of US multinationals in Ireland, which played a key role in GDP growth during the Celtic Tiger, and the continued growth in the output of new houses. Figure 4.4 New House Build Contribution to real GDP Growth Source: CSO, Goodbody Estimates 4.6 Concluding Remarks The construction sector is a major contributor to Ireland s economy, providing employment, constructing new housing and renovating the country s existing housing stock, and contributing significant revenue to the exchequer. The rate of house completions has now leveled off, with the output of new houses in 2005 being on a par with Using planning permissions as a forward indicator indicates that the current level of output will be maintained for a number of years. The house construction sector is now a key driver of economic growth 67

79 in the Irish economy, particularly since the tail off in growth of the US multinationals. However, the fact that housing output in a small country like Ireland is running at 40 per cent of the output of the United Kingdom, begs the question as to how long the current rate of output and the associated demand can be sustained. The house construction sector has become a major contributor to the exchequer and the overall economy. Any cooling off in the house construction sector will have serious consequences for both the economy and the exchequer. 68

80 5 Qualitative Responses from Market Participants 5.1 Introduction Much of the information used to research this topic has been quantitative. There was merit in including qualitative research in the form of interviews with a number of different stakeholders, either with an interest in, or affected by the tax incentive schemes in the property market. Interviews were conducted with leading economists, a tax consultant, a resident in an area where many section 23 developments have been constructed, a senior planner from Limerick Corporation, a representative from the Construction Industry Federation and a major investor in residential accommodation. 5.2 Interview Questions Each interview consisted of four set questions listed below. In addition, where points of merit were raised, these were explored further. Table 5.1 Standard Interview Questions Question 1: Do you think that the tax incentive based property schemes have been a success? Please give reasons for your answer. What are the main benefits and disadvantages? Question 2: Do you believe that the government should bring an end to these schemes in July 2006, or is there merit in extending the schemes beyond July 2006? Is there merit in introducing new schemes? Are there any particular areas that should be considered? Question 3: What will be the impact (short, medium and long term) of the termination of many of the schemes in July 2006? Question 4: What is the biggest risk facing the residential property market in Ireland today? 69

81 5.3 Interview Responses As each interview lasted approximately thirty minutes, it would be impractical to include the entire content of each. In this chapter, the key points made by each of the interview candidates are captured Key points from Interview with Dr. Dan McLoughlin Dr. Dan McLoughlin is the Chief Economist with Bank of Ireland Global Markets, and is one of Ireland s leading economists. The following are the key points made by him. Question 1: Do you think that the tax incentive based property schemes have been a success? Please give reasons for your answer. What are the main benefits and disadvantages? Answer 1: It is difficult to understand the rationale for tax incentives for property when the construction sector is fully employed. Underlying demand for property has driven supply. In the aggregate, there is little point in having the schemes. Incentives have boosted the income of the property sector, effectively transferring income from the taxpayer in the aggregate to the builders. Question 2: Do you believe that the government should bring an end to these schemes in July 2006, or is there merit in extending the schemes beyond July 2006? Is there merit in introducing new schemes? Are there any particular areas that should be considered? Answer 2: There is merit in extending the schemes only in particular contexts where there is a pronounced market failure. In the aggregate, there is no failure within the construction sector. 70

82 In the 1980s when these schemes were first introduced, tax levels in Ireland were above optimal levels, resulting in much tax evasion. When these schemes were introduced, they offered a means for people to lower their effective tax rates. That is not an efficient way to do things. Now when we have a low tax rate system, there is not a compelling reason to have a load of allowances. Tax breaks transfer income from the taxpayer in the aggregate to specific taxpayers. The compelling social or economic argument was never that strong in housing. Question 3: What will be the impact (short, medium and long term) of the termination of many of the schemes in July 2006? Answer 3: The impact will not be dramatic. If these allowances were disappearing in a static economy, the impact would be more pronounced. The fact is that Irish housing output is forty per cent of the UK s output. The fact that you build that amount of houses and prices are not falling suggests that the demand is there. Tax breaks are going in an extraordinary buoyant market. If they were being removed in a stagnant market, the story may be very different. Question 4: What is the biggest risk facing the residential property market in Ireland today? Answer 4: Employment is the biggest risk. The key driver of the growth in house prices is income growth, which on aggregate is made up of the earnings of each worker and the change in employment. In the second half of the 1990s annual employment growth was 5 per cent annually. In the year to June it was 5.1 per cent, which is extraordinary relative to the rest of Europe. If employment grows by 5 percent, and pay increases by 5 per cent, that results in a 71

83 double-digit increase in household income. It is not the fact that people are borrowing more, but that far more people are borrowing. The people borrowing are those getting jobs, and their income is going up and they are forming households. If employment growth stagnates or falls below the level required to absorb the rising population, in other words we get unemployment rising significantly, then that is the risk. Around 2002 we had a cyclical downturn. Unemployment went up from under 4 per cent to 5.5 per cent, and people at the time were predicting 6.5 to 7.5 per cent. That didn t materialize, but if it did, then I think that the housing market would look a lot different. The fact that unemployment went back to 4.1 per cent is the important point. In terms of interest rates, they are at a 50-year low. People don t believe that they will go up, which is mistaken. It is likely that interest rates will go up over the next year. That will affect the market simply because the more debt that you have, the greater the impact of a given increase in interest rates. However, it is difficult to see interest rates rising to levels that will seriously hammer the market. It is likely that interest rates will rise to 3 or 3.5 per cent, which will affect the market but will not kill it. If rates were to rise to 5 or 6 per cent, then there may be problems, but that is unlikely in the current Euro zone backdrop Key points from Interview with Michael O Dwyer Michael O Dwyer is a property investor based in Limerick with property interests in Limerick, Dublin and London. He heads up a group of property investors. Question 1: Do you think that the tax incentive based property schemes have been a success? Please give reasons for your answer. What are the main benefits and disadvantages? 72

84 Answer 1: The schemes have been an unqualified success. Look at the Quays in Dublin, whatever about the rest of the country. The main benefits have been the revival of dormant areas. Some areas did not need tax incentives. They were already fantastic locations but what the schemes did was to accelerate development in these areas. Consider the borders and midlands regions. They have benefited enormously. In terms of disadvantages, Ireland did not have the pool of labour to match the demand, so the quality of some of the development left a lot to be desired. Economic growth has overtaken some of those poorer developments now and some of those sites that were tax-designated are being re-developed once the ten-year period has run out. For a building to be productive economically speaking it should have a lifespan of fifty years at a minimum. Consider the student village in Castletroy, which only lasted ten years, or the Savoy, which lasted fifteen years. What worries me is that when the eventual downturn does come in the economy there will be a lot of poor quality buildings that can t be occupied. In Limerick there have been some very poor quality section 23 apartments in the city centre. However, nothing is difficult to rent at the moment. There is a huge shortage of rental accommodation. Question 2: Do you believe that the government should bring an end to these schemes in July 2006, or is there merit in extending the schemes beyond July 2006? Is there merit in introducing new schemes? Are there any particular areas that should be considered? 73

85 Figure 5.1 The Site of the Former Savoy Cinema Complex Answer 2: There should be tax breaks there to alleviate other problems in the economy. The original tax breaks for residential accommodation were introduced to alleviate the problem of the lack of quality rental accommodation. That problem is alleviated now. Tax breaks in the health sector and education sector would make an awful lot of difference. There may be merit in having tax breaks in the tourism sector. We need to make Ireland a very attractive tourist destination. In the education sector the quality of primary schools is atrocious. If you had public private partnerships, investors could invest in schools, get a rent from the government along with tax-free capital allowances and a buy back facility for the government after a certain period. 74

86 Question 3: What will be the impact (short, medium and long term) of the termination of many of the schemes in July 2006? Answer 3: Already we are seeing a drop off in the planning applications. It is quite spectacular. The number of residential units being built will drop off significantly. It could lead to a slowdown in the construction sector that in turn could lead to unemployment. Fortunately, this looks like being alleviated by demand from the UK in the run up to the Olympics. Going back to the period when the recommendations of the Bacon reports were implemented, there was a reduction of investor activity in the market and also a significant increase in rents. If the same numbers of migrants continue to pour into the country, there will be a rapid rise in rents from mid 2006 onwards, but there are a lot of assumptions there. A decline in construction activity will lead to a reduction in employment in the construction sector. In the long term, if interest rates stay low, it will automatically lead to a vibrant construction sector, but if interest rates were to rise at the same time that the tax breaks were running out, the construction sector could get a double hit. 100,000 workers could become unemployed in the construction sector if both interest rates rose significantly and tax breaks came to an end. Question 4: What is the biggest risk facing the residential property market in Ireland today? 75

87 Answer 4: A change in interest rates without a shadow of doubt. It will reduce peoples buying power and it will have an impact on the general economy. So where families have double incomes, the possibility is that one of those earners will be on zero income or possibly short time, which in turn may result in people not being able to hold onto their houses. There will be a double hit in that their monthly outgoings will be increased and their monthly incomes will be decreased. We need to create a situation where a portion of the huge growth in disposable incomes is absorbed into investments. At the moment, for a large portion of the population, more than 80 per cent, a large portion of their income is going consumption, with little or none of it being invested. So when the tide does turn, there could be some very serious problems. People have not thought through the impact of a change in interest rates. At the moment, people have the opportunity to fix their rates for five years. The people that will be exposed will be those buying into the market in 8 to 12 months time. But because of the expansion of Europe, and because of the problems in France, Germany and Italy, it is unlikely that we will see a rise in variable rates until late 2006 or early 2007, but the long-term rate will probably increase before year-end. 5 year fixed rates today are around 2.7 per cent with 3 year fixed rates are 2.5 per cent. Both of those will be a percentage higher by the first of March Key points from Interview with Dermot O Leary Dermot O Leary is the Chief Economist with Goodbody Stockbrokers, and is one of Ireland s leading economists. The following are the key points made by Dermot in response to the four questions. 76

88 Question 1: Do you think that the tax incentive based property schemes have been a success? Please give reasons for your answer. What are the main benefits and disadvantages? Answer 1: First of all we should point out that there is a lot of in depth econometric analysis and a lot of in depth research into these property based incentives ongoing at the moment in terms of economic consultant and the like. Just based on my own views it is difficult to assess the success of such schemes in light of the sort of buoyancy of the property market in Ireland over the past decade. You have to look at the success of the property market because of the economic conditions and the success of the property based incentive schemes. On my own views if the question were has it achieved the goals in encouraging construction in certain areas, you would say yes, it has been a success. But you have to look at it in light of the success of the overall economy. The main shortfalls were that the reliefs were not accompanied with a set of guidelines on the provision of services and funding for other services within communities. Now is an opportune time to review the schemes. If you look back at when the schemes were introduced in 1985/86 there was an entirely different economic environment then. We needed investment in certain areas because we had a declining population. We had very weak employment statistics, and weak wages earnings gross. We needed those incentives offered to investors to invest in certain urban areas and certain rural areas. But the situation is different now and perhaps the review should have been conducted back at the start of the construction boom in 1994/95. But overall it s difficult to accept the success of the scheme in light of the overall success of the construction industry in particular. 77

89 A disadvantage of tax incentives is that they can distort the market, either by encouraging investment in areas where there could have been an investment opportunity already in place or otherwise that encouraging investment in areas where there is no investment opportunity available. You might have a situation whereby investors are going into the market just to take advantage of those tax advantages. You might see investors coming out of the market after the expiration of the scheme, and it may be difficult to lock investors into projects for a longer period. Question 2: Do you believe that the government should bring an end to these schemes in July 2006, or is there merit in extending the schemes beyond July 2006? Is there merit in introducing new schemes? Are there any particular areas that should be considered? Answer 2: At a minimum the schemes should be looked at. They should be looked at in terms of maybe spreading the money elsewhere. Is it causing distortions in the market? Is it encouraging investment in areas whereby that incentive is not needed anymore? You know there is ongoing in depth research by many economical bodies into this so I will leave the socalled nitty gritty conclusion to them but in my own view they have to be looked at. After 10 years of rapid expansion in a large number of areas in the country it is debatable that some of the schemes are needed to promote development in these areas any more. For example a lot of urban renewal schemes in large cities would have significant investment potential without the tax breaks. It may be better to phase in the proposed July 2006 changes to reduce the potential volatility resulting from them. 78

90 What is missing in many of the current schemes are community based activities and the likes. That is probably an area that needs to be incentivised going forward. Builders don t need an incentive to build at the moment. There is a need for funneling of these tax breaks to areas most in need and I know from listening to people in government and private institutions that the social side of things has been lacking. I think there is an argument to have a look at that in depth and see what conclusions might come out of it. For example public private partnerships could be used to funnel investments towards schools. Over the last two years the government has been very slow in getting public private partnerships off the ground. The danger is if capital allowances do end Irish people will invest in property in Eastern Europe or other foreign places hence it would be beneficial to have capital allowances available in such needy areas as Education so as to retain wealth within the country. Question 3: What will be the impact (short, medium and long term) of the termination of many of the schemes in July 2006? Answer 3: The impact will be different in different areas. If projects have been instigated in areas that have little more to offer other than the tax break then the future for these areas may be bleak. Short-term reaction could be pretty marked in those areas. If projects were located in areas that offered significant opportunity even without the tax breaks then that investment proposition should remain unaltered and there should not be a short-term impact. But there is concern as to what will happen to investment demand. So change in the investment outlook could cause investors to come out of the market en mass. We saw back in 2001 with the Bacon Report changes that uncertainty did cause a certain amount of volatility in the market 79

91 in particular the apartment market where prices fell by up to 15 per cent. Hence the phasing in approach would be more appropriate to avoid short-term uncertainty, which has a huge impact on mobile investment demand. I m not sure if it will have a marked effect in the medium or long-term. Really the long-term prospects come down to the demographics and the outlook in the wider economy. The demographics are pretty sound. The economy is pretty solid. We did some research earlier on in the year as to what economic growth Ireland could achieve in the coming 10 years and we found that over a 10 year horizon we found that the Irish economy could grow roughly 4% to 4.5% per annum so that is a pretty buoyant outlook. Factors like this will affect the property market over the long-term and not short-term aberrations, such as tax breaks that might be offered to investors. Question 4: What is the biggest risk facing the residential property market in Ireland today? Answer 4: I m going to look at one short-term risk and one long term-risk. First the shortterm risk, which is the rapidly rising household debt levels in the Irish economy over the past decade. Debt to disposable-income ratios, which is the most appropriate gauge of debt levels, will be at 130% at the end of this year. In an international context the UK, Holland and certain Scandinavian countries would be higher than us. But it is the growth in debt levels that would be the concern in Ireland. Back 10 years ago debt levels were less than 50% of disposable income. This is quite a significant jump in the space of a few years. What that means is that households sensitivity to interest rate increases has increased markedly in the 80

92 last 10 years. For example in the UK at the moment where household debt levels are so high there is great sensitivity to any increase in Bank of England interest rates. I would be concerned that this might be the case in Ireland as well. We have had record low level of interest rates in Ireland over the last couple of years. People are now getting used to that. So when interest rates do rise, as they inevitably will, the impact on Irish households will be far greater. In terms of the medium to long-term risk the evolving demographics of the Irish population and the type of household mix that we currently have may not be compatible with each other. For example 20 per cent of the residential completions over the last number of years have been apartments. Some of this may be as a result of the tax incentive schemes that have been on offer. That s fine for the population in Ireland today because we have so much young people. I would classify apartments as entry-level housing. But as the population gets older they will want to be trading up. That may cause some stress in the apartment sector in particular. The apartment market is not a market on its own but is part of the wider residential property market so it may have knock on effects on the rest of the market. That will lead to a gradual drain on demand in the apartment market Key points from Interview with Richard Tobin Richard Tobin is a Senior Planning Officer with Limerick City Council. In his role, Richard has been involved in the planning process of many of the tax incentivised property developments in Limerick city, from the outset of the schemes in the 1980s including the Arthur s Quay development right through to today. The following are the key points made by Richard in response to the four questions. 81

93 Question 1: Do you think that the tax incentive based property schemes have been a success? Please give reasons for your answer. What are the main benefits and disadvantages? Answer 1: If you define success as planners do in terms of getting things built yes they have been a great success. On our calculations here since 1986 we have seen about 1 billion invested in property in the centre of Limerick, which is a pretty significant investment given that practically nothing was invested in the years prior to that. In terms of floor space we have only accurately quantified the floor space from 1998 onwards and I think we are looking at 2.5 million square feet of building floor area which includes 1,800 section 23 units. That does not account for the section 50 s student accommodation of which there is a very large number built in Limerick and it does not include the non-section 23 because there is also quite a lot of non-section 23 building still going on. Since 1998 there is about 300 to 400 million in straight building cost including site value. In terms of disadvantages, there is a danger that a number of these developments will simply become social housing by another name and that would not be good. The standard of certain section 23 developments is not the highest, and investors find it difficult to let them to tenants who had an expectation of spending a lot of time in them and want a degree of comfort. I have been quoted in the papers as saying that we have just built the slums of the future and the future might not be that far down the road. Some early tax incentive investments have already come to the end of their tenure. e. They have come to the end of their tax benefit and are now derelict. In Castletroy, there is one 82

94 particular block that is half burned down totally boarded up. It was built as student housing in the early part of the section 50 days and we are now considering knocking it and having someone rebuilding. It can t compete with the newer section 50 s. There is no demand for them. The same as the Savoy in the centre of town. That was built with a section 23 benefit. This has also been demolished. What was built years ago with the tax incentive attached is deemed insufficient today. Figure 5.2 Arthur s Quay Development: One of the First Tax Incentive Based Schemes in Limerick Certain predicted negative results have not materialised such as the shadow effect, where any available money would go into the designated areas and no development money would go into areas just alongside. We have seen the majority of investments certainly in the areas designated for tax relief but we have also seen significant investment in areas just outside. 83

95 There was also a fear that there would be a mass exodus from the traditional office areas of the city into the newer offices that were being provided. That didn t happen either. The exodus was pretty gradual and it didn t leave a great deal of vacancy behind it. Question 2: Do you believe that the government should bring an end to these schemes in July 2006, or is there merit in extending the schemes beyond July 2006? Is there merit in introducing new schemes? Are there any particular areas that should be considered? Answer 2: The EU ultimately will have the decision and will drive the policy. EU policy does not favour such tax incentive schemes and therefore the government won t have much of an option but to bring an end to the schemes in their present form. I think the government will introduce new schemes in a form that the EU will find acceptable. The direction that the EU is heading is very much in the cultural line so for example the various papers that are being produced by the commission is saying that even going as far as giving direct grants let alone tax relief for maintenance for cultural buildings, protected structures, etc. We would be lobbying the government to move to that so that if you were the owner of a protected building that you could get a tax write-off if you maintain or improve or conserve that particular building. Culture is only one area that the European Union may look kindly upon. Transportation and energy are other areas. I believe the Minister for Finance will make announcements in relation to the Shannon basin on a new form of rural tax relief for developments in his next budget. 84

96 The Docklands area of Limerick could potentially benefit from tax incentives going forward. We proposed to government that if new tax exemptions were being considered we would prefer to localise them in the docks area. A plan has been done up by the corporation and we have sent the proposal to the Minister. The fourth crossing of the river Shannon would be ideal for a tax incentivised public private partnership. Question 3: What will be the impact (short, medium and long term) of the termination of many of the schemes in July 2006? Answer 3: Designated schemes would account for 15% of all construction at the moment. We are seeing it already in a turndown in the number of applications for developments in the centre of Limerick and I expect that that turndown will last for a year or so. Applications would have been excessive in the last year or two anyway, with a huge surge before the December deadline, and a lot of activity until June of this year to get every application cleared. There will be a fall off in construction in 18 months time. There could be an extension of the deadline beyond July to enable the orderly completion of projects. The minister will find a formula whereby if development is up to roof level they will qualify for an extension. 85

97 In the medium term the level of background building going on is still significant. It may plateau out rather than tailing down. There is a considerable amount of building going on that has nothing to do with tax exemptions. There are 3 shopping centres planned just outside the boundary of Limerick City. Each one being 0.5 million square feet or more. If you are looking at 1,000 per square metre to build each of these projects will cost in excess of 50 million euro. There does appear to be a very large investment pool around Limerick. For instance the developer involved in the Riverpoint tax incentive scheme are rumoured to have 250 million euro available to them to purchase land. After the termination of the tax incentive schemes there is still an awful amount of money out there to be invested. The question is will that money be invested in Ireland or abroad. Question 4: What is the biggest risk facing the residential property market in Ireland today? Answer 4: For section 23 s in Limerick the letting profile is the biggest risk. If section 23 residential accommodation is for the most part rented to people on social welfare assistance slums will be created which will depress property values. In-migrants are major occupiers and purchasers of city centre residential property. If we put a cap on in-migration that would be a problem because they are major occupiers and major purchasers. For the most part these section 23 properties do not repay the monthly mortgage. That means that the section 23 s have to be part of a portfolio. They are not in themselves economic but landlords definitely have to have them rented all of the time. So a lack of tenants would be a problem. 86

98 Figure 5.3 Riverpoint House: One of the Latest Tax Incentive Based Developments in Limerick City Key points from Interview with Dermot O Reilly Dermot O Reilly is a Senior Partner in Grant Thornton Tax Consultants. In his role, Dermot has been involved in putting together packages for investors based around the various tax incentive schemes. The following are the key points made by Dermot in response to the four questions. Within the interview with Dermot, he raised many interesting points, into which I posed further questions. Question 1: Do you think that the tax incentive based property schemes have been a success? Please give reasons for your answer. What are the main benefits and disadvantages? 87

99 Answer 1: Absolutely. Everyone that jumped on board has benefited. The construction sector has benefited in the form of employment for construction workers and profits for builders. Tenants have benefited from better quality accommodation in a greater range of locations. We now have a greater stock of accommodation to accommodate the transient nature of our economy, be it section 50s to house students, or rental accommodation to house the many transient workers involved in road building projects. The government has foregone tax due to the capital allowances associated with the construction costs of the buildings, but through PAYE/PRSI, VAT etc. gains between 33 per cent and 35 per cent of the selling price of each property. There are vastly increased rent rolls compared to when the schemes were introduced, which will result in significantly greater tax revenue when the capital allowances expire. Because the private sector has invested so much in accommodation, the requirement for government to invest significant sums of money in the provision of housing is no longer necessary. Urban areas dilapidated at the beginning of the 1980s have improved significantly. City councils benefit from the rates on the commercial properties constructed under the schemes. Investors have benefited through the significant capital appreciation of many of the properties associated with the schemes. For example, there is a bank in Patrick Street which was leased to AIB and it was funded by 20 reasonably well off individuals who took 5% stake in the property and put up a sum of say 25, The rent out of that property is 135,000 per year. The banks leant the money and the rent covered the bank repayments of say over a period of 15 years so in reality the investors got tax relief on the total purchase of the property 88

100 excluding the site cost and the builders profit. They could utilize that tax relief against their total rental income at the same time they were generating a serious rental income which was going to repay their bank loan and therefore as time went on the value of the property was appreciating as the loan was diminishing and now that property having been bought say 12 years ago for 1.5 million is currently at a value of in excess of 6 million so to each investor the current value of that property is now 300,000 plus each and they only invested 25,000. So in reality with the tax reliefs and the creation of this wealth everyone has benefited. Question 2: Do you believe that the government should bring an end to these schemes in July 2006, or is there merit in extending the schemes beyond July 2006? Is there merit in introducing new schemes? Are there any particular areas that should be considered? Answer 2: If you look at the politics of it look at Fianna Fail government their strategy always has been that when they close one door they will always open another door that s their political life and how they are in government. They never close a door completely. The question that you address is what are the future needs in this country beyond Identify the need and create the enthusiasm for that need and I think the government will then provide an opportunity for wealth to be invested in Ireland rather to be invested abroad. For example you could have private investment say coming on board and instead of the government giving all these bridges to private individuals or companies who support the party create a business expansion scheme program and let it be owned by the public and reward them in that way and create a tax incentive so there is the world of opportunity if they put their heads together. The road structure in Ireland requires a lot of investment. If you build toll roads throughout Ireland 89

101 with private investment and lets say its like a business expansion scheme program that put 25,000 or 50,000 in and they get their tax relief. The roads are constructed the money goes into a fund and the toll money comes back and rewards those investors and down the road say in 20 years time all the roads are then handed over to the government free of charge. Now its funded by private investors they get the reward and in certain time the government get their full return and have the roads free of tolls. Question 3: What will be the impact (short, medium and long term) of the termination of many of the schemes in July 2006? Answer 3: Well the immediate impact is that people with wealth or money are going to rush to buy before the close out date. I mean rush and that means that builders are going to increase their prices significantly before close out date. Bank interests are relatively low, funds are available, at the moment banks are offering 100% mortgages so why not take the risk and borrow and buy the property because the likelihood is with the increase in population you are going to have the tenants available and with the tax relief it seems like the right thing to invest in. However my own personal view is I would be extremely cautious because builders will go and create the buildings they will sell for the tax relief and it will take some time to catch up on the residential side of it so you may have a period of lulls in properties. Now for example in Limerick alone the commercial property area in my opinion is overdone and as a result you have many very good quality commercial properties idle and not fully rented out. 90

102 After 2006 there is likely to be a reduction in construction activity and a fall off in employment in the construction sector, workers in the construction sector will emigrate to get employment. If the balance between supply and demand in the construction sector is got right its likely that the employment in the construction sector will revert to an equilibrium level below what its currently at. Don t be surprised if a number of building companies go into liquidation because they won t anticipate the slow down on time. The economy as a whole should be able to withstand the downturn in construction because if you look at where we were 10 years ago there was roughly 1 million people in the PAYE system. At the moment its double that figure. So in the 10 years you literally have doubled employment. That level of growth will be difficult to sustain but the likelihood is that labour rates will increase. We may loose a number of traditional manufacturing industries and they will go to cheaper labour cost countries. The whole situation will change dramatically in the next 10 years and we will end up with a high value added country and low manufacturing output. Question 4: What is the biggest risk facing the residential property market in Ireland today? Answer 4: Greed - people buying and borrowing thinking that there will never be a recession, never be an increase in interest rates and there will always be tenants to rent. The reality of life is if we look at the last 5 to 10 years interest rates have never been lower in the country or in the EU. We have had plenty of people available to rent properties and with students to rent section 50 s there was no problem in renting out properties. Now looking to the future if 91

103 interest rates increase which I believe they will have to, it s going to increase the cost of funding of all of these properties. Billions of Euros borrowed is going to put pressure on owners to increase their repayments to banks to meet the increase in interest rates and that again is going to put pressure on certain people. As a result some of them may have to sell their properties because they won t be able to fund their bank repayments particularly people with 100% mortgages unless they are using additional incomes to supplement the bank repayments they are going to have difficulty. So once they start to put properties on the market and if it escalates with interest rates increasing further and more people putting their properties on the market you could have a serious depression on property markets. My advice to people is not to borrow more than 50% of the property. Sadly a lot of the people involved in residential property renting at the moment are not experienced in the markets of the world: recession, boom and bust and things like that. I think they will be the main casualties once we have a recession Key points from Interview with Essie Golden Essie Golden is a resident in Little Gerald Griffin Street in Limerick. She was brought up on the street. Limerick City Council subjected her original home dwelling to compulsory acquisition for the purpose of facilitating a new section 23 residential scheme. Essie still lives on the same street, but in another house located across the road from the section 23 residential scheme, which occupies the plot where Essie s original home was located. The following are the key points made by Essie in response to the four questions. Question 1: Do you think that the tax incentive based property schemes have been a success? Please give reasons for your answer. What are the main benefits and disadvantages? 92

104 Answer 1: Yes in the short term. Most of the development takes place in areas that were once derelict. However the quality of architectural appearance is dismal, along with the choice of materials. Limerick is a badly designed red brick Lego land. Most developers/investors have a 10 year plan in mind: put the bare minimum investment in over 10 years and then sell up before the tax benefits are just over. Question 2: Do you believe that the government should bring an end to these schemes in July 2006, or is there merit in extending the schemes beyond July 2006? Is there merit in introducing new schemes? Are there any particular areas that should be considered? Answer 2: No, the government should target the incentives better, prioritizing the areas of the city and activities that most need it. More quality standards in the red tape for developers and social provision should be prioritized. Question 3: What will be the impact (short, medium and long term) of the termination of many of the schemes in July 2006? Answer 3: There should be a decrease in the amount of development in the city. There will be more long-term goals for development as the quick buck mindset will not be incentivised. Hopefully better amenities will be provided when the quick buck investors/developers are gone. The current social plan for residential development provides no amenities for children. 93

105 Maybe, socially mismanaged areas will not get any development, as the incentive is not there. Developers don t have any social issues in mind. Airgead at the end of the day rules the roost. Question 4: What is the biggest risk facing the residential property market in Ireland today? Answer 4: People over extending themselves to own their own property. The notion abounds that property is a gravy train. Property is not the best performing asset class and having too many eggs in the one basket is a major risk Key points from Interview with Kevin Flavin Kevin Flavin is a member of the Executive of the Irish Home Builders Association and the Construction Industry Federation. The following are the key points made by Kevin in response to the four questions. Question 1: Do you think that the tax incentive based property schemes have been a success? Please give reasons for your answer. What are the main benefits and disadvantages? Answer 1: The CIF is of the opinion that they have been very successful. Consider the IFSC, and key schemes around the country where the residential portion has been very successful. Consider the 1980s; Temple Bar was a derelict area; now it a thriving cultural and residential area. The only disadvantage is the shortage of time to complete certain schemes given the July 2006 deadline. Limerick has many schemes that are still in the planning process and have not moved on at all. 94

106 Income tax and stamp duties certainly compensate the government for the tax reliefs provided. The income tax from the IFSC alone is estimated at 620 million last year by the department of finance, which is sizeable where compared with the reliefs granted at the outset. Question 2: Do you believe that the government should bring an end to these schemes in July 2006, or is there merit in extending the schemes beyond July 2006? Is there merit in introducing new schemes? Are there any particular areas that should be considered? Answer 2: The schemes have received an extension in the past and we believe that there is merit in further extending the schemes. All the projects in the pipeline should be afforded the opportunity to see out their lifespan. Hence, an extension to at least January 2007 would be our initial aim. There is merit in adopting new schemes, as there is lots of remaining urban and rural areas that would benefit from a more holistic approach in line with sustainable development. For example, moving away from schemes that would be targeted just at residential or hotels to schemes that are more community based and more in line with sustainable development. Question 3: What will be the impact (short, medium and long term) of the termination of many of the schemes in July 2006? 95

107 Answer 3: Short term there will be a phenomenal rush and huge pressure on the construction industry to meet the deadlines, and the deadline may endanger some of the projects that are there at the moment, putting them in jeopardy. Massive amounts of people would need to be taken into the industry to meet these deadlines, and the question is what would happen after the deadline expires. Currently, the industry is performing at a phenomenal level, and the residential sector is at equilibrium with the rate of inflation of house prices half of what is was last year. Medium term is difficult to assess. It might be another six months before we can have a clear picture. There has been no tail off in planning permissions over the last few months. The CSO recently released a report showing Q1 of this year 60 units down on Q1 of last year in terms of planning permissions, which is negligible. Per the data from the CSO, the total number of dwelling units for planning permission was: Jan-Mar 2004: 25,401 Oct-Dec 2004: 16,000 Jan-Mar ,351 Based on these figures, the construction sector is in a sustainable mode. July 2006 will not bring down the whole construction industry, but this is not to underestimate its impact. The household size in Ireland is 2.91 compared to a EU average of 2.6, with the UK being Long term, demand for housing will remain strong. Household size, housing stock levels, net immigration, the natural increase in population and demographic indicators point to continued demand at the current level. Recent CSO figures show that there are an additional 54,000 net immigrants working in the country over the last 12 months. 96

108 Question 4: What is the biggest risk facing the residential property market in Ireland today? Answer 4: At the moment, there is nothing that we can say will seriously impact on the construction industry, the residential market in particular. Registrations and completions are staying at last year s levels. Interest rates are still favourable. I can t find a huge risk. 5.4 Concluding Remarks The majority of interviewees agreed that the property based tax incentive schemes have been a success, with the primary benefit being the encouragement of construction in dormant areas. Interestingly, both of the economists interviewed felt that it was difficult to assess whether the schemes had been a success, in light of the success of the economy from the mid 1990s onwards. While there was merit in the schemes when first introduced in the mid 1980s, it was difficult to justify them from 1995 onwards. A common criticism of the schemes was the poor quality of the buildings, either in terms of architecture or workmanship. Other disadvantages cited included the failure to provide services for the communities, and the potential distortion of the market due to the tax incentives. The majority of those interviewed agreed that there was no merit in extending the schemes in their current format. There certainly is not a pronounced market failure in the residential construction sector, and hence there is no longer a justification to provide tax incentives for residential construction. Kevin Flavin of the CIF did make the point that there was merit in extending the deadline beyond July 2006 to facilitate an orderly completion of those schemes in the pipeline. All interviewees agreed that there was merit in using tax incentive schemes to 97

109 tackle other areas of weakness within the economy. Areas identified included educational facilities, road building, and energy. The promotion of cultural activities and community activities were also identified. A criticism of the property tax incentive schemes to date is that they failed to take a holistic approach and that they placed too much emphasis on residential construction. In the short term up until the deadline in July 2006, the widely held view is that there will be a surge in activity. Demand from investors wishing to stock up on capital allowances prior to the ending of the schemes will lead to a surge in prices. Two of the interviewees cited the current tail off in planning applications as an indicator of a reduction in construction activity post July Associated with this, there will be a reduction in construction employment. However, in the medium term, the outlook for the economy is good. The construction sector is in a sustainable mode. Provided that there is not an adverse economic shock, such as a large increase in interest rates, construction activity should plateau, rather than declining sharply. In terms of risks, the most frequently cited risk is that of an increase in interest rates. The rapid growth in household debt means that going forward Irish borrowers will be far more sensitive to changes in interest rates. Interestingly, as shown in chapter 3 in table 3.3, McQuinn demonstrated that the two greatest influences on house prices were the size of the average mortgage approved and real interest rates. Other factors identified as posing a risk were the level of in-migration and the risk that the government may place on cap on it, together with the level of employment and income growth in the aggregate. 98

110 6 Residential Property as an Investment 6.1 Introduction In Ireland, it has been predominantly private investors who have invested in residential property in Ireland while institutional investors have tended to focus on equities, bonds, and commercial property. Chapter 2 has outlined the level of investor involvement in the residential property sector and the profile of rented sector accommodation. It is important to distinguish between property speculators, those who purchase new properties off the plan with a view to selling them on prior to completion in the hope of short term gains, and property investors, those who invest in property long term with a view to renting the property to achieve an income which will pay the interest and potentially capital on loans taken out to purchase a property over the medium term, with a view to selling in the medium to long term to achieve a capital gain. Essentially, investors take a more long-term approach. 6.2 Why do Private Investors Invest in Residential Property? In 2004, a survey was carried out on behalf of EBS/Gunne to determine why residential investors chose to acquire property. The findings are shown in figure % of those surveyed indicated that they invested in property to provide a pension, while 58% invested in their children s future. 99

111 Figure 6.1 Residential Investor s Survey, Reason for Investment 80% 70% 60% 50% 40% 30% 20% 10% 0% Pension for self/partner Nest egg for children Accomodation for Children Regular Income Holiday Home Source: EBS/Gunne, Feb 2004 Many people favour residential property investment over other forms of investment including equities, retail investment property, commercial investment property and manufacturing or service enterprises. There are quite a number of reasons for this preference, including low management input, familiarity and sense of control, most of the earnings go to the landlord, interest relief, and lower volatility Low Management Input The day-to-day management involved in managing a residential property portfolio is far less than that required in managing a manufacturing or services operation. A low demand on time and resources mean that residential property investment can be pursued as a part time activity Familiarity and Sense of Control People are familiar with residential property from their own homes. The step from being a homeowner to a residential property investor is more readily comprehendible and palatable than investing in equities. Bricks and mortar are more tangible than a share certificate, and investors feel a greater level of security and control is attached to physical property than to 100

112 equities. For example, when Eircom was taken private and de-listed from the stock exchange, small shareholders were powerless to stop the process Earnings Mostly Distributed In the case of investment property, the majority of earnings in the form of rent go to the investor, after the deduction of costs for maintenance, property management, insurance and interest repayments. In the case of equity investment, companies retain earnings for reinvestment in the business, with only a portion of the earnings being distributed to shareholders Tax treatment of Interest on Related Borrowings As already outlined, interest on related borrowings is a tax-deductible expense in the case of property investment, but not in the case of equity investment. As a result, investors can use financial gearing to increase the size of the investment being made. In addition, banks are more willing to lend money for property investment Lower Volatility The price of residential property is not as volatile as equities, giving investors peace of mind. 6.3 The Bacon Reports Residential property investors play an important role in the housing market, providing rental accommodation. The reports of Peter Bacon and Associates on the Irish property market published in 1998, 1999 and 2000, commissioned by the Government had a significant impact on property investment and the rental sector. The reports sought to ease price increases in the residential property market by increasing the supply of residential property and decreasing 101

113 demand on the part of investors and speculators. After the publication of the first Bacon report 1, the government sought in the 1998 Finance Act to deter investor involvement in the market by: 1. The introduction of stamp duty for non-owner occupiers purchasing new houses and 2. The removal of the deductibility of interest on any new investment residential mortgage as a discountable expense for tax purposes. The revenue gained from the removal of interest deductibility was put at 26m in Subsequent to the third Bacon report 3, the government introduced a flat rate of stamp duty of 9 per cent for all categories of investors buying new or second-hand residential property. The implementation of these changes resulted in a significant reduction in investor activity in the residential property market. This reduction resulted in a reduced supply of rental property coming on the market. In the period from 1998, there was a sharp increase in rental levels, reflecting the reduced supply, as illustrated in figure 6.2. The importance of investors in the residential property sector was recognised in the 2002 Finance Act, where the government reintroduced interest relief as a tax-deductible expense for investors, and aligned stamp duty rates for investors in new and second hand property with the rates applicable to owner-occupiers purchasing a second hand property. Both of these changes were an effort on the part of the government to actively encourage investors back to 1 An Economic Assessment of recent House Price Developments, Peter Bacon & Associates, April TSG 01/33, Infrastructure 3 The Housing Market in Ireland, An Economic Evaluation of Trends & Prospects, Peter Bacon & Associates, June

114 the property market in order to increase the stock of rented residential property and thus to stem the rise in rents. Figure 6.2 Privately Owned Rental Index Source: CSO Table 6.1: Stamp Duty Rates Implement in the 2002 Finance Act for Investors Consideration value Investors Up to Euro 127,000 Nil 127, ,500 3% 190, ,000 4% 254, ,500 5% 317, ,000 6% 381, , % 635,001 upwards 9% Source: PWC Global. Finance Act These changes resulted in revived investor interest in the residential sector, and stemmed the rise in private rents, subsequent to January 2002 as shown in figure 6.2. The decline in the privately owned rental index reflects the increased supply of rental property on the market and the continuing increased rate of residential property construction. 103

115 1998Q4 1999Q2 1999Q4 2000Q2 2000Q4 2001Q2 2001Q4 2002Q2 2002Q4 2003Q2 2003Q4 2004Q2 2004Q4 YoY (4QMA) Another impact of the implementation of the Bacon report recommendations was a sharp decline in the price of apartments, in particular in 2001 after the implementation of the 9 per cent stamp duty rate for investors, as illustrated in figure 6.3 below. Subsequent to the reintroduction of mortgage interest relief and the harmonization of stamp duty rates with rates paid by owner-occupiers purchasing second hand property in the January 2002 Finance Act, there was a resurgence in the value of apartments. As illustrated in chapter 2, the apartment sector is the sole accommodation type dominated by investors, with owner-occupiers dominating all other accommodation types. Figure 6.3 Fluctuations in Apartment Prices 60% 50% 40% 30% 20% 10% 0% -10% -20% -30% Whole Country Cork Dublin Galw ay Limerick Waterford Source: DOEHLG 6.4 Tax Treatment of Residential Property At the point of purchase of a residential investment property, stamp duty is payable by investors. Table 6.1 summarises the stamp duty rates applicable for first-time-buyer owneroccupiers, other owner-occupiers, and non-owner occupiers of residential property. The gains 104

116 from investing in property are obtained in two different ways: the first from letting out the property and the second through capital growth. The former is earned on an ongoing basis throughout the period of ownership and dealt with under special income tax rules. The latter is liable for capital gains tax whenever the property is disposed of. The tax treatment of property investment is significantly different from investment in equities and from the tax treatment of a person principle private residence. The key areas of difference are mortgage interest relief, stamp duty and capital gains Interest Relief Residential Property Investors The Finance Act 2002 allowed for interest accruing on and from 1 January 2002 on borrowed monies employed in the purchase, improvement or repair of rented residential properties to be allowed as a deduction in calculating rental income 4, essentially reversing one of the major changes introduced after the first Bacon report. To illustrate how mortgage interest relief can be used to reduce a property investors tax liability, consider table 6.2. The re-introduction of interest relief has made a significant difference for investors. Essentially, the investor can move from a negative to a positive annual cash flow position, as a result of the re-introduction of mortgage interest relief. 4 Department of Finance (2002)[online] Available: [28 August 2005] 105

117 Table 6.2: Example of rental account to illustrate impact of Mortgage Interest Relief: Euro Euro Gross Rent: 7,000 7,000 Less Expenses Mortgage Interest 5,000 Insurance Letting Fees Repairs Total Expenses 6,350 1,350 Profit\(Loss) 650 5,650 Tax\PRSI at Top Rate , Owner Occupiers In the case of owner-occupiers, a ceiling applies on the amount of mortgage relief permitted as shown in table 6.3: Table 6.3: Ceiling for owner-occupier mortgage interest relief First Time Buyers* All Other owner occupiers Single Persons 4,000 2,540 Married/Widowed 8,000 5,080 *The higher limits for first-time buyers, apply for the tax year in which the mortgage is taken out plus six subsequent tax years. Source: Revenue Commissioners TRS1 Since January 2002, tax relief on mortgage interest payments for homeowners has been granted at source. However, this relief is granted at the base rate of tax, which is currently 20%, and there is a ceiling on the amount of interest upon which relief is permitted. The maximum potential relief for a married couple who are first time buyers is 20% of 8,000, amounting to 1,600 net relief. In the case of a property investor with an interest bill of 106

118 8,000, relief would apply at the upper rate of tax, currently 42%, along with relief at the rate of PRSI and health levies, amounting to a potential 3,760 net relief Equity Investment Unlike investment property, in the case of equities, it is not possible to get interest relief on borrowings used in their acquisition. This is a significant deterrent to leveraging (borrowing funds) for the purpose of equity investment Stamp Duty Table 6.4 shows the stamp duty rates applicable on residential property for first time buyers (F.T.B.), other owner-occupiers and investors. Table 6.4 Stamp Duty Rates for Residential Property Consideration value *F.T.B. *Other Owner Occupiers Investors Up to Euro 127,000 Nil Nil Nil 127, ,500 Nil 3% 3% 190, ,000 Nil 4% 4% 254, ,500 Nil 5% 5% 317, ,000 3% 6% 6% 381, ,000 6% 7.5% 7.5% 635,001 9% 9% 9% *First Time Buyers/Owner Occupiers are exempt from Stamp Duty for new properties up to 125sq.m. provided a floor area certificate is issued and they occupy the property as their principal private residence for 5 years. Source: Revenue Commissioners In the case of equities, stamp duty payable on the purchase of companies registered on the Irish stock exchange is 1%, a ½% rate applies for equities registered on the London stock exchange, while no stamp duty applies to equities registered in the American stock exchanges. 107

119 6.4.3 Capital Gains Tax An individual s principal private residence is exempt from capital gains tax provided the sale proceeds do not reflect development value 5. In the case of investment property and equities, capital gains tax is charged at a rate of 20 per cent. 6.5 Rental Yields Since the end of 2001, private rents have been declining. Data from the CSO shows that rents have been falling 4.1% year on year, and have fallen 10% since their April 2002 peak. This decline is captured in figure 6.4. A significant proportion of the dwellings constructed during the last ten years were for rental. The 2002 census showed that in the period from 1996 to 2002, 33,000 (21 per cent) of the 157,500 houses constructed were rented. This trend has continued beyond 2002, leading to a healthy supply in the rental sector pushing rent down. Figure 6.4 Decline of Private Rents and Rental Yields *Note: Yield calculation based on national average house price (PTSB/ESRI) Source: Goodbody Stockbrokers 5 Hooke & MacDonald (2005) The Hooke & McDonald Property Guide, [online], Available: [25 August 2005] p

120 For existing investors in the market, declines in rents have been offset by continued capital appreciation on their properties. For new investors, rented residential property only makes sense on the anticipation of significant capital gains. Despite these low rental yields, investors have continued to purchase residential property. Research carried out by the Educational Building Society and Gunne Residential in 2004 indicated that between 15% and 20% of residential property was being purchased by investors, while similar research by Sherry Fitzgerald revealed that 21 per cent of second hand homes traded in Dublin during 2003 was acquired by investors 6. However, Bank of Ireland predict that incremental investor demand will fall to 10% when the realization of declining rental yield accompanied by declining capital appreciation finally begins to dawn Capital Appreciation Many investors are content to accept low single digit rental yields in the current favourable interest rate environment, provided capital appreciation continues. In chapter 3, figure 3.1 illustrated the rise in new and second hand house prices in nominal terms while figure 3.3 showed the real growth in house prices. Both graphs confirm that since 1996, capital appreciation on houses has been significant. By virtue of the fact that in most cases investors leverage their equity using borrowing, the gains on the original equity investment are significantly magnified. Consider the example shown in table 6.5, where an investor purchased a house in May 1996 for 80,000, using 20% equity and 80% borrowings, on interest only monthly repayments. The same house was sold in November 2004 for 210, The Sunday Business Post (2004), Investors still in residential market, says new research, The Sunday Business Post, 18 January Bank of Ireland (2005) The Irish Property Review; A Quarterly Analysis, March [online] Available: [20 July 2005] 109

121 Table 6.5 House Purchased in 1996 and Sold in 2004 * An indexation factor of is used from tax year to ** The personal allowance exemption of 1,270 is not factored into the calculation. Hence, for an original equity investment of 16,000, the investor makes a net capital gain 88,000. For a 262% increase in the value of the property in nominal terms, there is a 650% increase in the investor s equity in nominal terms. Thus leveraging the investor s equity by the use of borrowings has amplified the gain on the equity invested. This is the major advantage that differentiates property investment from investment in shares. Shares are viewed as more volatile and hence, in the normal course of events, banks will not lend money for the purpose of purchasing shares, but are willing to lend up to 100% of the purchase price of an investment property. Furthermore, interest on borrowings to purchase an investment property is tax deductible, while interest on borrowings for the purpose of share purchase is not. However, it is worth cautioning that this leveraging effect due to borrowing can have a negative impact when property prices are decreasing. For instance, a 20% decline in the value 110

122 of a property where an investor has 20% equity and 80% borrowings will result in the investor s equity being wiped out. 6.7 Comparison with Other Investments Looked upon purely as an investment rather than for the services which housing provides such as shelter and comfort, housing has turned out to be a very good investment over the last fourteen years, outperforming equities and bonds. Table 6.6 illustrates the returns achieved in 2003, where an equal amount was invested in the ISEQ, property and government bonds in 1988, and the subsequent earnings reinvested in the asset. The property investment produced a return 1.3 times as large as that from investing in the stock market, and 2.7 times the return from government bonds 8. Table 6.6 Cumulative Returns on Investment Asset Type Investment in 1988 Value in 2003 * Property ISEQ % Year Government Bond * Earnings subsequent to 1988 re-invested in the asset. Source: CBFSAI Calculations The Economist believes the Irish housing market is one of a number that appear seriously overvalued, based on comparing house prices to rents, effectively a price/earnings measure for housing 9. As illustrated in figure 6.5, house prices have appreciated since 1985, with a significant acceleration in property values from 1995 onwards, while rental values have remained comparatively flat. One method used in the Financial Stability Report to establish 8 Central Bank and Financial Services Authority (2004), Financial Stability Report 2004, page 67. Dublin: Cahill Printers 9 The Economist (2005) Still Want To Buy, The Economist 3 March

123 fundamental house prices is to multiply rental levels by the long run average price/earnings (P/E) ratio, which was 8.1 taken over the period 1980 to 1995, by the rental income, to yield an estimate of sustainable house prices. The resultant evolution of fundamental to actual house prices is shown in figure It is clear that based on a P/E evaluation, actual house prices are far greater than fundamentally sustainable prices. As can be seen, actual house price and fundamental house prices calculated based on the P/E method began to diverge in Figure 6.5 Actual and Fundamental House Prices (2 nd Hand Houses) Source: DOEHLG and CBFSAI calculations As of Quarter , average fundamental houses prices based on rental values amounted to slightly in excess of 100,000, while the actual average house price was in excess of 270, Financial Stability Report, p

124 Another model used with the Financial Stability Report to evaluate Irish house prices is the discounted present value model. The report concluded that using this model, by 2003, Irish house prices had become significantly over-valued 11. However, the Financial Stability Report also demonstrated that using a model that incorporates the demand for housing based on the services it provides as well as the demand for housing as an investment provided no evidence of overvaluation. This holistic model, which takes account of the services and utility derived from housing is broadly similar to the model which was developed by Kieran McQuinn of the Central Bank of Ireland and is discussed in chapter 3, with an illustration in figure 3.3. Looking to the future, in order to make a comparison between investing in equities, or investing in residential property, consider for example a comparison between investing 300,000 in a 2-bedroom apartment in Clondalkin, and investing 300,000 in AIB shares listed on the Dublin stock exchange. Table 6.6 illustrates the scenario. At the outset, neither investment is offering particularly high yield. The initial earnings yield before tax on the individual for the AIB share investment at 3.38% surpasses that available from the investment in the apartment at 2.87%. However, if the investor borrows the funds required for the property investment, the interest expense is tax deductible. In this example, if the investor borrowed 300,000 at a rate of 3.5%, then the annual interest bill amounts to 10,500, thus offsetting any potential tax liability, due to the fact that the investment property 11 Central Bank and Financial Services Authority (2004), Financial Stability Report 2004, page 59. Dublin: Cahill Printers 113

125 is actually loss making. In the case of the investment in AIB shares, the earnings yield would be liable to tax at the marginal rate of the individual plus PRSI and health levies, irrespective of whether funds were borrowed to invest in the shares. However, in order to make a fair comparison, it must be pointed out that the dividend yielded by AIB is approximately 50% of the organizations earnings, and the earnings withheld by the organization are used to grow the organization, whereas the earnings received by the property investor represent the full earnings of the property, with no earnings withheld. Table 6.7 Investment in a 2-bedroom apartment in Clondalkin versus AIB shares Investment in 2 bedroom apartment Effective Investment 300,000 Monthly Rent* 950 Gross Annual Rental Yield 11,400 Less Vacancy (9%) (1,026) Less Management & Maintenance Costs (11%) (1,254) Net Earnings Yield before tax on individual 9,120 Stamp Duty (5% rate) 15,000 Solicitor & Surveyor Fees 3,000 Gross Investment Outlay 318,000 Initial P/E ratio (E = Net Earnings Yield before tax on individual) Initial Earnings Yield before tax on individual 2.87% Investment in AIB shares Effective Investment 300,000 Price of AIB share** Dividend Yield ** 3.44% Net Earnings Yield before tax on individual 10,320 Stamp Duty (1%) 3,000 Brokerage Fees (0.75%) 2,250 Gross Investment Outlay 305,250 Initial P/E ratio (E = Net Earnings Yield before tax on individual) Initial Earnings Yield before tax on individual 3.38% * An Estate Agent in the area put a monthly rental value of 1,100 on the property. Monthly rental figure is reduced to 950 monthly to simulate a less than optimal monthly rent. **Dublin closing price on 9 th September 2005 and dividend yield is based on historic yield. 114

126 The merit in either investment resides in the potential for capital appreciation. As pointed out by NCB stockbrokers, capital appreciation is the reason why returns from Irish property investment are higher than the return from investing in equity or government bonds. Favourable demand drivers, including demographics, economic growth and low interest rates, are driving this capital appreciation. Investors need to judge how long and to what extent these demand drivers will be favourable. NCB stockbrokers argue that Property is ultimately no different to any other equity investment in that sustained and consistent capital appreciation in excess of the rate of inflation can only be expected if it goes hand in hand with sustained and consistent growth in net rental earnings in excess of the rate of inflation Evaluation of a Making a Designated Investment Table 6.6 provided an example of a non-tax incentivised residential property investment. There is merit in considering a tax incentive based residential investment. Consider for instance a section 50 student accommodation type investment. The Gateway located at Ballymun Avenue Dublin, is a section 50 development being promoted by Ely Properties. Appendix B provides a section of the brochure for this development, detailing the price, capital allowances, total estimated tax saving based on the top rate of tax of 42% and 5% for PRSI and health insurance levies. Table 6.7 evaluates the yield available on such an investment on its own initially, while table 6.8 evaluates the investment as part of a broader property portfolio, where the available allowances can be utilized. 12 NCB Stockbrokers (2004) Residential Property -V- other Equity Investments, [online], Available: p. 11. [10 August 2005] 115

127 In both cases, it assumed that the investor borrows 100% of the gross investment outlay. What is clear from the figures in table 6.8 is that as a stand-alone investment, annual interest is greater than the net rent. Hence, there is no tax liability, and thus no outlet to avail of the capital allowance. However, if the investor has a portfolio of other rental properties, upon which an annual profit is being made, then the total available capital allowance of 240,000 can be offset against those other properties, over one single year or over a number of years, depending on the level of annual profit being made by the investor from rental activities. Table 6.8 Evaluation of a Section 50 Apartment Investment Investment in a 3 bedroom section 50 apartment as an individual standalone investment. Unit 11, Block B. Effective Investment* 300,000 Capital Allowances (80%)* 240,000 Gross Annual Rental Yield* 11,340 Less Letting Charge* (1,247) Less Management Charge (1,500) Net Rent 8,593 Stamp Duty (5% rate) 15,000 Solicitor & Surveyor Fees 3,000 Gross Investment Outlay 318,000 Initial P/E ratio (E = Net Rent) Initial Earnings Yield before tax on individual 2.70% Gross Borrowings 318,000 Rate of Interest (10 year fixed from Bank of Ireland)** 4.4% Annual Repayment interest only based on 10 year fixed rate 13,992 * Based on brochure advertising the development ** A 10 year fixed interest rate is chosen because the apartment would have to be retained and let to students for a minimum of 10 years Assuming that the capital allowance is used up to 24,000 each year for 10 years, that the investor is on a top PAYE tax rate combined with PRSI and health levies of 47%, and 116

128 applying a discount rate of 4.4%, then the net present value of the capital allowances is 89,696. If the net present value of the capital allowances is credited against the gross investment outlay, the resultant investment outlay is 228,304, and the price earnings ratio can be revised to 26.57, with an equivalent earnings yield of 3.76%. Table 6.9 details the figures involved. Another way to view the situation is to look at the annual cash flow. Essentially, on an annual basis, a positive cash flow of 5,851 can be achieved, provided there is sufficient rental profit on other properties to utilise the capital allowance. Table 6.9 Evaluation of a Section 50 Apartment Investment Investment in 3 bedroom section 50 apartment as part of a portfolio. Unit 11, Block B. Effective Investment* 300,000 Capital Allowances (80%)* 240,000 Gross Annual Rental Yield* 11,340 Less Letting Charge* (1,247) Less Management Charge* (1,500) Net Rent 8,593 Stamp Duty (5% rate) 15,000 Solicitor & Surveyor Fees 3,000 Gross Investment Outlay 318,000 Net Present Value of Capital Allowances 89,696 Investment outlay net of NPV of allowances 228,304 Initial P/E ratio (E = Net Rent) Initial Earnings Yield before tax on individual 3.76% Gross Borrowings 318,000 Rate of Interest (10 year fixed from Bank of Ireland)** 4.4% Annual Repayment interest only based on 10 year fixed rate (13,992) Annual Cash Flow Analysis including Capital Allowances Net Rent 8,563 Annual Tax Saved 11,280 Interest Charge (13,992) Net Positive Cash flow 5,851 In conclusion, the acquisition of a section 50 property would only make sense to an investor with a portfolio of Irish properties upon which there are sufficient rental profits. The question 117

129 an investor needs to ask is whether the investment property will be worth more than 228,304 at the end of the ten year holding period, and if so, by how much. The investor must then decide whether the premium value at the end of the ten-year period is sufficient to reward the investor for the risk involved and the opportunities foregone. 6.9 Concluding Remarks Investors play an important role within the Irish economy. The flight of investors from new residential developments as a result of the implementation of the Bacon report recommendations resulted in a sharp increase in rents. The subsequent removal of the Bacon reforms lead to a return to the market by investors, and a reduction in rental levels due to increased supply. Investors involved in the market prior to the year 2000 are in a comfortable position, having enjoyed the benefit of strong capital appreciation. However, even with historically low interest rates, it is very difficult to justify making a residential property investment in Ireland today. Similarly, an investment in a designated scheme is of interest only to those with an existing portfolio of Irish rented properties generating a rental profit. Interest rates are at historically low levels. In a working paper, the ECB defined the Euro area s long-run natural real rate as 3%, combined with a rate of inflation of 2% and a risk premium of 1% (includes bank s margin) 13. Investors need to be comfortable with interest rates in the order of 5%, and should strongly consider fixing rates at the current time. In evaluating new investment opportunities, investors should thread very carefully, as rental levels are continuing to decline, and interest rates will not remain at such low levels 13 Glammarioli N. and Valla G., (2003), The Natural Real Rate of Interest in the Euro Area, ECB Working Paper No [online]. Available: 118

130 indefinitely. Throughout the world, there have been significant rises in property values. As captured in a recent article in The Economist: Indeed, a drop in nominal prices is today more likely than after previous booms for three reasons: homes are more overvalued; inflation is much lower; and many more people have been buying houses as an investment The Economist (2004) In Come the Waves, The Economist, 16 June

131 7 Impact of the Cessation of Property Based Tax Incentive Schemes 7.1 Introduction The cessation of the various schemes on the 31 st July 2006 will impact in two distinct time periods: The immediate period up to the cessation date and The subsequent period after the cessation of the schemes. There are a number of stakeholders to consider, which are illustrated in table 7.1. Table 7.1 Stakeholder Analysis Power Interest Matrix POWER Low High LEVEL OF INTEREST Low Minimal Effort 1. Tenants Keep Satisfied High Keep Informed 1. Investors 2. Developers 3. Urban Councils 4. Dept. of Health 5. Construction workers 6. Tax Consultants 7. Architects 8. Engineering Consultants Key Players 1. Dept. of Environment 2. Dept of Finance These stakeholders can be captured under four headings: Construction sector 120

132 Investors Tenants and Government 7.2 Construction Sector In chapter 2, section 2.5 outlined the amount of investment in the in planning and work in progress phase of tax incentive renewal schemes, as of December 2004, which amounted to 5,166 million, and is equivalent to 20% of total construction output in A serious concern has been expressed by the construction Industry Federation about the amount of tax incentive based property developments being held up in the planning system and as a result might not be completed in time for the July 2006 deadline. In order to achieve the July 2006 deadline, the construction industry will be under significant pressure. This will have a positive impact on employment numbers within the construction industry, on demand for construction materials and ultimately on exchequer tax receipts from the sector in the period up to July The positive impact on employment numbers is being reflected in the continued growth in employment in the construction sector. In the period after July 2006, there is a risk is of a tail off in construction activity, with a resultant decline in employment numbers, demand for materials and associated exchequer tax receipts. However, as indicated in figure 4.3, planning permissions for dwelling units have increased in the first and second quarters of 2005 relative to 2004, indicating that there is not likely to be a slowdown in construction activity. Rather than causing a slowdown in 121

133 construction activity, the cessation of the schemes will act to prevent overheating in the construction sector. 7.3 Investors A residential property investor with a number of rental properties in his portfolio will seek to have a section 23 type property in the portfolio along with its associated tax reliefs, in order to avoid tax and PRSI being levied on rental profits from Irish rental activities. In other instances, as described in section 2.2, self-employed business people in Ireland have established schemes whereby they rent their main business premises to an operating company which themselves own. This rental income is sheltered from taxation using the tax relief from other section 23 properties which the businessperson owns. By setting the level of rent on the business premises at an appropriate level, it is possible to limit the amount of profit and resultant tax being paid on the day-to-day business activity. Self-employed people with their affairs structured in this manner will seek to prolong their shelter from paying tax by acquiring additional section 23 properties with their associated capital allowances. Chapter 2 details investor activity in the residential property market. Chapter 5 explores in detail the merits of residential property investment in the current environment. As illustrated, the business case for making a residential property investment is marginal. In the period prior to the July 2006 deadline, investors will need to carefully assess the merits of including additional tax based properties in their portfolios. In particular, those investors with rental 122

134 profits, with limited or no capital allowances remaining for 2005 or 2006 need to seriously consider acquiring a tax based property. As described in the interview with Dermot O Reilly, this demand for additional capital allowances to shelter rental income will lead to a further rise in the asking price of tax based properties as the deadline approaches. In the medium term, there are three potential routes investors may take: 1. Invest in those designated schemes not due to expire in July 2006, including child care facilities, private hospitals, sports injury clinics, and nursing homes, in order to acquire additional capital allowances to offset future rental profits. 2. Pay tax and PRSI on rental profits or 3. Certain investors may decide to sell their residential and/or commercial investment properties rather than pay tax and PRSI on rental profits. In reality, the first option outlined above is limited as on aggregate, the opportunities for investment will be small relative to the amount of investment which has taken place and will take place up until July 2006 in urban renewal scheme residential, commercial and office buildings. Hence, the amount of capital allowances available going into the future will be limited, and will be insufficient to meet the needs of investors in the aggregate. As a result, it is likely that investors will be faced with paying more tax on rental profits, and certain investors may decide to sell their properties taking advantage of the capital gains achieved, rather than paying income tax. The investors that do choose to sell may then re-invest their wealth in offshore property or in equities. 123

135 7.4 Tenants Marginal rental yields, combined with tax liability on rental profits may result in investors selling their investment properties. The resultant reduction in the number of rental properties available to tenants may result in an increase in rents as happened after the implementation of the recommendations of the first Bacon report, when investors were deterred from entering the market, resulting in a curtailment of supply. However, as shown in table 4.2, the current annual output of new houses is nearly double the level of output in 1998, when the Bacon recommendations were implemented. This increased supply will reduce the likelihood of a reoccurrence of the increase in rents. In the short-term, there will be a surge in the number of new properties coming onto the market prior to July 2006, which will lead to greater choice for tenants. During the interviews, a failing of many section 23 developments highlighted was the quality of the build. For example, Michael O Dwyer emphasised the fact that Ireland did not have sufficient skilled workers to meet the level of demand, which resulted in poor quality construction. In addition, developers and investors paid more attention to the tax reliefs available than to the quality of the buildings being constructed. The cessation of tax incentives will re-focus investors minds on the quality of the built product, as ultimately the value of the property will depend on its resale value. The end result will be a higher quality of construction, and a better standard of rented residential accommodation available for tenants. 124

136 7.5 Government Unlike the other stakeholders, the government is where power resides in terms of taxdesignated schemes. While the Minister for Finance has announced the cessation of many schemes, he has also commissioned two consultant groups, Goodbody Economic Consultants and Indecon Economic Consultants to review property tax incentives as part of a detailed review of the various tax incentives in the context of the 2006 Budget. Goodbody Economic Consultants have been commissioned to report on the area-based Urban Renewal, Town Renewal, Rural Renewal and the Living-over-the-shop schemes and Indecon Economic Consultants have been commissioned to report on the sectoral property tax incentive schemes namely multi-story car parks, park and ride facilities, student accommodation, third-level buildings, hotels, holiday cottages, nursing homes, private hospitals, sports injuries clinics, childcare facilities and refurbishment of rented residential accommodation 1. Government interest can be captured under a number of headings including environment, finance and employment Environment The various designated schemes have enabled the government to target investment in certain activities and geographical areas that would not otherwise have been favoured by private investors. The cessation of the designated schemes will remove the tax-based incentives for future developments and may limit the amount of private investment in certain activities and geographical areas. 1 Department of Finance (2005) Award of the Consultancy Contracts for the Review of Certain Property Tax Incentives [online], Available: [29 June 2005]. 125

137 7.5.2 Employment A study carried out on the employment effects of the rural renewal tax scheme suggests that the tax scheme has had positive effects on the numbers of people unemployed in the tax area 2. As outlined in chapter 4, 12.1 per cent of the labour force is employed in the construction sector as of May Table 2.9 illustrated that there was a significant amount of investment in renewal schemes at the In Planning and Work in Progress stages, as of December The surge in employment in quarter , associated with the construction sector is in part due to the impending deadline associated with designated schemes in July Due to the significant investment to be completed prior to July 2006, employment in construction will remain buoyant in the short term. A question remains over employment prospects after July 2006, although commentators such as Kevin Flavin, Dr Dan McLoughlin and Richard Tobin expressed the opinion that there will be sufficient activity after July 2006, due to the fact that there is a lot of wealth in the country and demand for new housing continues to be strong. In addition, as illustrated in figure 4.3, planning permissions in 2005 to date are slightly higher than If a slowdown in general construction activity occurs, combined with the ending of construction activity on designated schemes, employment in the construction sector will be impacted. Figure 4.2 illustrated the decline in first quarter of 2005 in non-residential construction as a percentage of GNP, and also illustrated the cyclical nature of the contribution of non-residential construction to GNP. An uplift in this area through investment in new major government sponsored capital programs such as roadway construction, would 2 Keane M. and Garvey E. (2003) Measuring the Employment Effects of the Rural Renewal Tax Scheme, NUIG. 126

138 benefit employment levels in construction. However, productivity per worker is much higher in such roadway construction, where machines do most of the work. Hence, it will not be possible for non-residential construction to match the employment levels of residential construction Finance Tax reliefs narrow the tax base. However, the availability of tax reliefs may lead to economic activity that otherwise would not have occurred. This was emphasised in the interview with Dermot O Reilly, whereby the initial property based tax incentive schemes acted as a catalyst generating employment and wealth across a number of sectors in the economy. Thus, while eliminating a particular relief would lead to direct revenue gains, it also could indirectly lead to revenue losses stemming from reduced revenue from investments, employment, VAT receipts etc. and this could serve to partially or wholly offset the direct revenue gains from eliminating the particular relief. A constraint acknowledged by the department of finance in assessing tax expenditures and incentives is the lack of availability in many cases of sufficiently detailed and timely information on costs and take-up 3. In an effort to overcome this lack of information, the tax return forms for 2004, including Form 11, Form 11e and Form 12 now include a section at the end of the form seeking information on capital allowances being claimed, the precise scheme involved and the amount of relief being claimed in that particular year. In the short term, there will be a surge in taxes related to the actual construction of the residential, commercial and office building under the designated schemes due for cessation in 3 Department of Finance (2004) Tax Incentives/Expenditures and Broadening of the Tax Base TSG 04/22 [online], Available: [3 August 2005] 127

139 July Based on a value of 5,166 million in the work in progress or in planning phase, and assuming that 28 per cent of the actual cost accrues to the exchequer, the tax take would amount to 1,446 million. In the medium term, the completion of the existing designated projects will lead to a reservoir of capital allowances being available to investors to offset against rental profits derived from Irish investment property. Taking the combined investment value for completed, work in progress and in planning developments, at 6,578 million, a marginal tax rate of forty two per cent, PRSI at four per cent and a health contribution levy of two per cent, the maximum potential revenue foregone by the exchequer is 3,157 million (forty eight per cent). In the long term, increased tax revenues will accrue from profits on property rental when the capital allowances associated with the designated schemes have run out. It is difficult to estimate what this will amount to. However, if a rental yield of 3% is applied to the combined investment value of 6,578 million, it amounts to 197 million. Assuming that there are no major expenses to offset against the rent, and applying a forty eight per cent tax rate (top rate of tax, plus PRSI at 4 per cent and health levy at 2 per cent), the annual tax take on rental profits from the designated properties amounts to 95 million. After July 2006, tax revenue on the construction activity will be foregone due to the ending of construction activity associated with tax incentives. However, the latest projections from AIB 128

140 Capital markets are that new house completions will remain at 77,000 in 2005, and through 2006 to 2007, due to continuing strong demand, particularly in the first time buyers market 4. As Richard Tobin pointed out in his interview, there is an enormous amount of wealth in the country looking for a home. Much of this wealth is now being channeled into the construction of new shopping centres. Similarly, Dr Dan McLoughlin emphasised that the construction sector is operating at full capacity, while Kevin Flavin of the Construction Industry Federation expressed the view that the level of house completions would remain at their current buoyant levels until In light of these forecasts, it is unlikely that there will be a significant drop in revenue from the construction sector after July Concluding Remarks In the short term, up until July 2006, there will be a lot of activity, with developer rushing to complete the schemes, and investors rushing to top up their reservoir of capital allowances. Looking beyond July 2006, the construction sector in Ireland is operating at full capacity. The market does not need an incentive to encourage the construction of residential, commercial or office buildings. The level of planning permissions in 2005 to date, and the latest research carried out by AIB Global Treasury indicate that demand for housing will be maintained at 77,000 units per annum through to The reality is that today, there is a shortage of construction workers in the country. Hence, the cessation of the property based tax incentive schemes in July 2006 will not have a negative impact either on the level of housing output, or 4 Beggs, J. et al, (2005) The Irish Housing Market and Personal Sector Finances [online], Available: [27 October 2005]. 129

141 on construction employment. The impact of the cessation will actually be positive as it will prevent an overheating in the market. Property investors will be faced with paying tax at a point in the future. However, in reality, the asking price of all tax incentivised properties has been marked up to take account of the tax incentive being offered. The cessation of incentives will lead to property valuations reverting to market fundamentals rather than being distorted by tax incentives. In the longterm, this is in the best interest of investors. In the medium term, tenants will not be impacted by the cessation. Government will not be adversely impacted by the cessation. The construction industry will remain buoyant to 2008, leading to strong tax receipts and employment from new construction activity. The one potential negative is the fact that there will be certain areas or activities in need of investment, which without the stimulus of a tax incentive will not attract investors. 130

142 8 Conclusion and Recommendations At the outset of the project, the following research objectives were set: To outline the various tax incentive schemes, and where possible the level of investment in each scheme. To determine the contribution of the construction sector to the Irish economy. To investigate if residential property in Ireland is currently over valued. To investigate if residential property investment, including tax incentive based investments represent a viable investment. To explore the impact of the proposed cessation of the tax incentive schemes. In this project, chapter 2 provided an overview of the various property based tax-incentive schemes currently available with working examples illustrating how investors can utilize capital allowances associated with tax incentive properties to limit their tax bill. As outlined in chapter 2, tax incentive based property schemes have accounted for significant investment since they originated in 1986, while the potential investment value of tax incentive schemes in the in planning or work in progress stages, is 5,166 million, which amounts to 20 percent of the total construction industry output in Chapter 3 provided an overview of the housing market. Factors influencing house prices include the average size of mortgages approved, real interest rates and the housing stock per capita. As demonstrated in this chapter, when a house is evaluated as a home, based on the utility provided as opposed to purely a property investment, then current house prices are not 131

143 over valued. Important statistics presented in chapter 3 include the growth in the house prices relative to the growth in industrial wages, house building costs and consumer prices. Landowners and developers are making supernormal profits while young people starting on the housing ladder are borrowing vast sums of money, and this money is being transferred to a small number of wealthy individuals. The Irish government needs to pay attention to this potential time bomb. Government needs to explore what steps could be taken in order to avoid a price bubble developing in the residential housing market and the subsequent burst in this bubble. Increased debt levels combined with historically low interest rates and the fact that 80 percent of the Irish mortgage stock are at variable rates mean that Irish mortgage holders are more sensitive to an interest rate hike than any time in the past. Chapter 3 also highlighted the important role played by investors with 16 percent of the country s housing stock being investor owned. The construction sector plays an increasingly important role in the Irish economy. Employment in the overall construction sector has doubled since 1998 to over 240,000 workers, which represents 12 percent of the labour force. New house construction accounts for 140,000 jobs. The annual output of new houses is now 77,000, and this rate is set to continue until at least 2008 according to research carried out by AIB Capital Markets. The rate of planning permissions granted in 2005 as presented in chapter 4 supports this rate of output. However, as shown in chapter 3, the natural rate of population growth is below 40,000 per annum, so we currently have situation where we are constructing new houses at twice the rate of growth in population, a fact that was highlighted by Dr Dan McLoughlin in his interview. 132

144 A concern raised by a number of interviewees in chapter 5 was the poor build quality of some of the tax incentive properties. Buildings such as the Savoy in Limerick city constructed at the beginning of the urban renewal scheme has now been knocked, while a particular student accommodation scheme in Castletroy has become derelict. While there was merit in having the tax incentive schemes in the 1980s and early 1990s when the Irish economy was in a poor state, most respondents felt that there was little merit in extending the schemes, particularly as the construction sector is operating at full capacity. As discussed in chapter 7, there may be merit in extending the end date out to December 2006 for developments already commenced, in order to facilitate an orderly completion of projects. The assessment of a rented residential property investment carried out in chapter 6 showed that the only justification for such an investment was expected capital appreciation, while there is only merit in purchasing a tax incentive based property as part of a broader Irish property portfolio with rental profits. In conclusion, the cessation of the schemes will not have a negative impact on the construction sector, given that the new house-building sector is experiencing an unprecedented boom. The continuation of the schemes would be an unnecessary stimulus that would distort the market. The very fact that the purchase of many of these tax incentive properties can t be justified as a stand alone investments in their own right, as illustrated by the example of a section 50 apartment given in chapter 6, supports the view that the price of tax incentive based properties is distorted by an amount approximately equal to the relief 133

145 available on the properties. In the short term, there will be a surge in the value of the remaining tax incentive based properties as the 31 st July 2006 deadline approaches. 134

146 9.0 Appendices 9.1 Appendix A: Cities & Towns Selected for the Urban Renewal Scheme. Cork Corp Blackpool/Shandon City Docks Area Dublin Corp Ballymun HARP Inchicore/Kilmainham Liberties/Coombe North East Inner City Millennium/O'Connell St Galway Corp 3 suburban LA estates Limerick Corp 1 large central area Waterford Corp Periphery of commercial centre Carlow Carlow Louth Drogheda Dundalk Clare Shannon Mayo Ballina Cork Bandon Cobh Mallow (N) Passage West(S)/Glenbrook Meath Navan Donegal Buncrana Monaghan Monaghan DunLaoghaire/Rathdown Dun Laoghaire Offaly Birr Tullamore/Clara Fingal Balbriggan Nth. West Blanchardstown Sligo Sligo Galway Kerry Kildare Tuam Tralee Athy Kildare South Dublin North Clondalkin Tallaght Tipperary NR Roscrea Thurles Tipperary SR Carrick-on-Suir Tipperary Kilkenny Kilkenny Waterford Dungarvan Laois Portlaoise Westmeath Athlone Mullingar Limerick Newcastle West Wexford New Ross Longford Longford Wicklow Arklow Wicklow 135

147 9.2 Appendix B: Brochure for Section 50 Development 136

148 An opportunity to invest in Dublin's most, spectacular city regeneration _"

149

150 Mr F ergal Marren, Springfield Clonlara Co Clare ELY PROPERTY 22 Ely Place, Dublin 2, Ireland. Tel: (01) Fax: (01) info@elyproperty.ie 16th June 2005 Launch of, The Gateway, Ballymun Avenue, Dublin 9 Section 50 Sale & Leaseback Scheme Dear Mr Marren, We are pleased to offer to the market, The Gateway, Ballymun Avenue, Dublin 9. The Gateway consists of 109, 3 bed fully fitted apartments built to a high specification and are part of a fully gated private community with a full time on site caretaker. All units are available with the benefit of a ten year lease back from Ely Property. This exceptional Section 50 package is unique to the market and offers a fully de-risked Section 50 investment for the tax life of the property. In addition to this investors can also avail of: Capital allowance of circa 80% +. Expected gross yield of circa 4% Part of the biggest regeneration project Dublin has ever seen. Prices for 3 bedroom units range from 300,000 Euro - 325,000 Euro. Please find attached a spreadsheet outlining all financials, to reserve units please call (01) Kind Regards, ~.~ ~~~, Yours Sincerely, ~ ~ ~~~~ ~~- " Cathal Bre~n EL Y PROPERTY LTD Registered in Ireland. No Directors: Mr P.E.]. Marley & Ms C. Bartley

151 ELY PROPERTY 22 Ely Place/ Dublin 2/ Ireland. Tel: (OJ) Fax: (01) THE GATEWAY, BALLYMUN AVENUE, DUBLIN 9, SALE & LEASE BACK, EXPLANATORY NOTE Investors in the Gateway will enjoy the benefit of a long lease with a 10 year break clause with Student Accommodation Services Ltd., Ireland's largest operator of student accommodation. Rents are distributed through the operation of a pooled rent system. Rent is calculated per bed space per unit and all rents collected are divided by the nunlber of bed spaces and distributed pro rata. For example: If your unit contains three bed spaces you will be paid three times the average rent per bed space. For our projection, rents have been calculated at 90 Euro per bed over a 42 week period. The advantage of such a system is that in the event of any potential vacancies the loss of income is spread among all investors. Therefore reducing any individuals exposure to loss of rent. Ely Property has exercised all the relevant due diligence and research to be comfortable that investors net rent from the Gateway under their lease agreement with us, will cover their mortgage on an 80% Interest Only basis, under current market conditions. Student Accommodation Services Ltd levy an 11 % rental charge only on rents collected and not on rents projected. This is a direct incentive to our letting division to maintain the highest yields and occupancy levels. Rents are paid quarterly in arrears directly to into investors bank accounts or by cheque as stipulated by individual investors. i.,:,) ':.~.:,.:.~ '. ",,:',;':: ~~...":.~ Regi5iered'in.lrel,llld.. No J '..: Dil:e~rors: 'Mr~RILJ MarleY' &' Ms C. B:m ley..,.:, '. I,: ' -:,'

152 - - r _ I,,...,.,,--. r...,..-...,...., ""1L.r~... cry...,.- - BLOCK B 80% CAPITAL TAX GROSS LETTING MGT NET INT. ONLY UNIT NO BEDS sa M APSECT FLOOR PRICE ALLOWANCES SAVED RENT Charge Charge RENT MORTGAGE NthlWest Ground 305,000 80% 114,680 11,340 1,247 1,500 8,593 8, South Ground 300,000 80% 112,800 11,340 1,247 1,500 8,593 7, South Ground 300,000 80% 112,800 11,340 1,247 1,500 8,593 7, Nth/Sth Ground 307,000 80% 115,432 11,340 1,247 1,500 8,593 8, NthlWest First 310,000 80% 116,560 11,340 1,247 1,500 8,593 8, South First 315,000 80% 118,440 11,340 1,247 1,500 8,593 8, South First 315,000 80% 118,440 11,340 1,247 1,500 8,593 8, Nth/Sth First 310,000 80% 116,560 11,340 1,247 1,500 8,593 8, NthlWest Second 322,000 ~ 80% 121,072 11,340 1,247 1,500 8,593 8, South Second 320,000, 80% 120,320 11,340 1,247 1,500 8,593 8, South Second 320,000 80% 120,320 11,340 1,247 1,500 8,593 8, Nth/Sth Second 315,000 80% 118,440 11,340 1,247 1,500 8,593 8, NthlWest Third 327,000 80% 122,952 11,340 1,247 1,500 8,593 8, South Third 320,000 80% 120,320 11,340 1,247 1,500 8,593 8, South Third 320,000 80% 120,320 11,340 1,247 1,500 8,593 8, Nth/Sth Third 320,000 80% 120,320 11,340 1,247 1,500 8,593 8,448 BLOCKC 80% CAPITAL TAX GROSS LETTING MGT NET. INT. ONLY UNIT NO BEDS sa M APSECT FLOOR PRICE ALLOWANCES SAVED RENT Charge Charge RENT MORTGAGE Nth/Sth Ground 305,000 80% 114,680 11,340 1,247 1,500 8,593 8, South Ground 300,000 80% 112,800 11,340 1,247 1,500 8,593 7, South Ground 300,000 80% 112,800 11,340 1,247 1,500 8,593 7, Nth/Sth First 310,000 80% 116,560 11,340 1,247 1,500 8,593 8, South First 315,000 80% 118,440 11,340 1,247 1,500 8,593 8, South First 315,000 80% 118,440 11,~40 1,247 1,500 8,593 8, Nth/Sth Second 315,000 80% 118,440 11,340 1,247 1,500 8,593 8, South Second 320,000 80% 120,320 11,340 1,247 1,500 8,593 8, ' South Second 320,000 80% 120,320 11,340 1,247 1,500 8,593 8, North Second 322,000 80% 121,072 11,340 1,247 1,500 8,593 8, Nth/Sth Third 317,500 80% 119, ,340 1,247 1,500 8,593 8, South Third 320,000 80% 120,320 11,340 1,247 1,500 8,593 8, South Third 325,000 80% 122,200 11,340 1,247 1,500 8,593 8, North Third 325,000 80% 122,200 11,340 1,247 1,500 8,593 8,580 UNITS IN BOLD ARE RESERVED