The recent capital gains measures have helped to release inherited property onto the market, as this tax, at 12%, has axed two-thirds off it's previous value of 35%.
For the vast amount of vacant property existing, that has been hoarded for a large number of years, this budgetary measure is again good news; as for old hoarded property to be released onto the market, this will involve a large realised gain between the original purchase price and today's selling price. This again signifies an approximate two-thirds saving on the original capital gains tax value.
As a bureaucratic measure applying a withholding tax of 12%, this again is good news. This measure has to be compared to the successful measure of the 15% withholding tax applied to bank saving interest moneys and secured dividends.
An instantaneous payment settlement calls for less stress and risk on the investor, which can be transmitted into a lower return requirement. This condition has, however, to be matched with an acceptable amount of return derived from development or investment undertaken.
The following two examples outline the inadequacy of the proposed 12% withholding tax on property contracts undertaken.
Property developments
Nowadays a developer buys a large tract of land, in the form of a large house with gardens, or a 40-year-old outdated terraced house to be developed into a number of maisonettes/flats with underlying basement to be sold off probably as first-time residences.
It is to be noted that, most probably, by the time this developable site is in the hands of the developer, this would come at an inflated price. The reason for this inflated price is that a number of promise of sales (konvenji) would have occurred from when the original owner sold off, up to being acquired by the developer.
These middlemen in turn would have taken a profit slice without forking out any money, although there is a risk that they could even lose out. The developer, who is the person taking the greater slice of the risk, forks out the cash flow for the price of the land together with the costs of development, probably with the bank's injection of debt into the project.
The fallacy arises as it is being assumed that real estate development projects yield profits far in excess of 30%. This is completely unfounded as a reasonable return for the risks involved in property development hovers around 17% of the market value.
In the late Nineties when these brownfield developments of demolishing old properties started taking off, due to market information inefficiencies for this new type of property development, profits were higher than the accepted norm of 17% - hovering above 30%.
This may be compared to the initial share prices of Bank of Valletta and Mid-Med Bank in the early years of the Malta Stock Exchange, which with hindsight may be considered to have been sold for a song. Nowadays due, to the middlemen referred to above, together with the original owner's better perception of his property's development potential, profits have even narrowed down to within a 12% range.
A high percentage of developers nowadays are builders as, due to their reduced overheads, a profit margin of 12% is enough reward for their undertaking. Possibly their knowledge/skill limits them to undertaking another venture outside the building industry. With a withholding tax of 12%, their profit margin is being eroded. Can they go for a higher asking price? MEPA approved 2,974 permits for flats and maisonettes in 1995, increasing to 6,231 permits in 2004. The number of annual marriages is known to hover around 2,500 p.a., so at present there is a surplus number of units for sale.
A median affordable three-bedroomed flat is at present priced at Lm55,000, while a two-bedroomed flat is priced at Lm40,000. With a 90% mortgage, this works out at monthly payments of Lm220 and Lm160, respectively. Can the average earning household go for higher mortgage payments?
It is at present considered on a global level that, with the worldwide rise in house prices having created the biggest bubble in history, which actually had shouldered the stock market collapse during the early years of this century, house prices will decline from their present historic levels.
These unsustainable house increases had also been fuelled by low interest rates, which now considering the US Fed's rise in interest rates from 1% to 3.75% in just under 18 months, is a further indication that mortgage rates will be steeper in future and that the past three years' double figure property price increases should be considered a thing of the past.
In fact, over the past four months, the affordable property increase has been only 1.5% when compared with the previous 12-month period of a 25% increase. For each 1% increase in the lending mortgage rate, monthly repayments will increase by approximately 15%. How can the Maltese first time buyer be expected to pay out more mortgage monthly payments when the average Maltese pay increases are known to be the lowest globally, possibly not even catering for the inflationary increases?
Labour Force Survey data show that while the average gross annual salary rose by nearly 6% in 2002 and by 1.1% in 2003, it rose by just 0.3% in 2004 around Lm5,068 p.a. (Lm97.50 weekly).
So if the builder developer cannot secure a fair profit from higher property values, he will have to procure more illegal labourers, skive off VAT payments and go for lower building specifications. This in turn will lead to less safe construction practices on site while producing hazards in the built environment due to less safe buildings.
Our health and safety building practices are already dubious, together with the black economy already rampant in this market sector. This proposed measure is not creating incentives for workers to shift into the formal economy, thus making it less efficient.
It was further mentioned that this measure was to address the underdeclaration of property contracts. It is being questioned whether this is at present so rampant, considering that a contract value as per 1995 stood at Lm7,407, increasing to Lm38,668 in 2004.
Underdeclaration in 1995 could have stood at 50%, but it has possibly slid down to 15% in 2004. Further refining of the system by the Inland Revenue Department could fine-tune this system to more acceptable levels, without disrupting the market.
Is this 12% withholding tax by reducing profit margins too finely going to act as a deterrent for the developer to again increase underdeclaration?
Investment properties
Financial institutions have always sought to diversify their portfolio by including a proportion of their investment in properties. The properties most favoured include office buildings, retails outlets and industrial premises.
These notably have upward rising lease agreements attached. Possibly some upmarket residential units may also be included in the portfolio.
Notable absences include leisure industries, and properties such as hotels, gaming rooms and sporting facilities as these are considered to be more volatile due to the nature of business.
It is known that hotel developments do not even create values that recoup the construction costs of the development, let alone the land value. No wonder that hotels are currently being demolished to be converted into upmarket apartments.
The investment properties under new lease agreements could have rent increments attached in the region of 10% for every three-year period. So truly the annual increment in investment properties can hardly be in excess of 3% p.a.
The commercial property market has been relatively flat in Malta since 2000, due to a large amount of vacant commercial properties around, together with the banks having also secured a number due to foreclosures. Thus the local commercial property market cannot be compared to the double figure annual growth in recent years experienced in the residential property market.
An investment property revalued with the newly imposed 12% withholding tax has been subjected to a 9% decrease in its market value, as compared to last year's value. Thus, this new tax imposition is to affect negatively on the companies' audited annual accounts, which include investment properties in their portfolios due to the above measure.
The new International Accounting Standards (IAS) now in force globally require the inclusion of present fair value in the accounts. This gives no option to the companies but to address a reduction in value to their investment property portfolio.
Real estate in relation to Malta's economy
Malta's economy has been taken for a rollercoaster ride in past years. Global economic growth for 2004 stood at 3.9%.
Thus, it appears that Malta's economy is shifting away from a period of stagflation experienced in 2001 and 2003, with predicted growth rates, however, not sufficient for Malta's quality of life to average out the EU's average over a reasonable 15-year period, where growth in excess of 4% p.a. should be striven towards.
Considering the property market's contribution to the economy over the past 10 years, the value of contracts undertaken over this period has been of the order of 7.2% of GDP in 1995, increasing to 22.2% in 2004.
Sales to foreign buyers have increased from 267 in 1995 at an average price of Lm30,210 per unit to 705 in 2004 at an average Lm62,675. In the same period Malta's annual net mortgage lending as a percentage of the national income increased from 14% in 1995 to 295% in 2004.
The share of the construction sector in the GDP hovered around 5%. This figure compares to the EU-25 for the first quarter of 2005, which stands at 4.7%. This low figure may surprise many, given the general understanding that this sector is a boost to the economy in general.
It is, however, in the multiplier effect created, whereby this percentage is said then to exceed 10%, where the contribution to the national economy has a substantial bearing. Construction statistics issued by Eurostat in their Euro Indicators noted that a construction upturn occurred during the first quarter of 2005 at 7% increase for Malta, the highest rate recorded in the EU-25, with a negative average 1.6% drop in the EU-25. This 7% quarterly increase is to be compared with the average 1.2% quarterly increases for 2004.
Tourism is a pillar of Malta's economy. However, it has been striving for growth, with possibly minimal inroads created over the above past 10 years. This demonstrates the importance of keeping a healthy real estate market to stimulate the necessary growth.
Mixed messages
This is the scenario when choosing between the 12% withholding tax and the 35% capital gains tax.
However, the imposition of a five-year period is to disturb the proper functioning of the property market, although an advantage may be drawn in that a property that would probably be hoarded for a number of years would now probably be released earlier onto the market.
Could this help reduce the existing high amount of vacant properties?
This five-year period implies that to obtain a break even between the two schemes an average property growth rate of 9% p.a. has to be achieved. Although the residential sector over the past years has easily surpassed this growth rate, there is no guarantee for future heavy growth, as noted above. On the other hand, over the immediate past five-year period, the commercial sector has at most only achieved a total 20% growth; losses have also been recorded.
Taxing growth is the only fair measure. This five-year period will disturb the property market, causing duress to sell before the five-year period is up. Property should remain an option for long-term investment as a hedge against inflation.
Dennis H. Camilleri, Eur.Ing, A&CE, B.Sc., (Eng)., BA (Arch.)., C.Eng., ACIArb, F.I.Struct.E., FICE, is a structural and property investments consultant.