Real estate, the new mafia: How can we fix Pakistan’s housing market?

Land takes the lion’s share in property prices. Hence the key to solving the real estate problem is property tax.

The new Pakistan Tehreek-e-Insaf (PTI) government’s priority is housing. Providing five million houses would certainly pick up the economy since around 40 industries would be throttled up to meet the demands of around five million houses. This is indeed commendable. Even though the target of five million houses seems a bit far-fetched, one could argue that setting up a lofty goal would actually keep the government on its toes. Even achieving a small percentage of the mighty five million would be a relief for the homeless and relevant industries.

For the purpose of land for this scheme, government is eyeing state-owned land. That is a band-aid measure which would not address the endemic problem of exorbitant rates of real estate. Speculative investors are using real estate to park their capital and get massive returns on it. It has driven up prices for buyers who want to use the land to actually live in the houses they construct. As this write-up points out, existing housing prices far exceed median household income – according to the State Bank of Pakistan, the house price-to-income ratio in Pakistan is 20:1 compared to a global average of 5:1. And the lion’s share in property prices are of land prices that have risen by over 152% since 2012.

What should be done then?

Recently, during an interview to Bloomberg, Finance Minister Asad Umar hinted reviving the defunct wealth tax. Though wealth tax is considered regressive, we can pick and choose from the wealth basket and tax real estate to correct the market. The key to solving the real estate problem is property tax. We can fine-tune property tax laws to drive out speculative investors from the market. Under the legislation that I suggest, except for one house where he or she resides, a person would have to pay a high percentage of tax on all other residential property he/she holds. Let’s say 25% of the property value.

A person who is using the property for commercial activities, including rental income, would be exempt from paying the property tax on those assets. The point of this tax is not to hurt land holdings for commercial activity but only to discourage the non-productive and speculative trading in real estate. This measure would discourage speculators from holding the much needed land and they would put those properties up for sale. Hence, increased supply of residential plots would result in a dip in prices that average households would be able to afford.

The state has shown considerable spine when it initiated the drive for anti-encroachment. This should be replicated in enforcing the property tax as well. It is a tax levied on the value of property but the problem with valuation is that we are still stuck with abysmally low deputy commissioner-approved (DC) rates. For the purpose of federal and local taxes, DC rates are used to assess the value of the property which is much lower than the actual market value of the asset.

The former government tried to solve the issue by determining property rates through the Federal Board of Revenue (FBR). They abolished the scheme and introduced a buy-back option in which the FBR would be able to buy a property at double the rate at which it is declared. For example, a property’s market value is Rs50 million but it is declared at Rs5 million. FBR would be able to acquire that property by paying Rs10 million. The point of this legislation is to discourage under declaration.

However, this scheme is bound to fail since the government is already cash strapped. How would it engage in a spending spree on property acquisition when almost all of the property is declared at DC rates which are much lower than the actual market rates? For the calculation of property tax, a value closer to the market rate should be assessed and that could be done by reviving FBR determined rates which were closer to market rates. This whole exercise should make holding of extra property costlier for speculators and this would not be possible without charging heavy tax on value close to the market value. That would make the cost of holding greater than the expected return.

The suggested policy would have two advantages. First, it would result in tempering prices of the real estate in urban areas making it easier for middle income households to use their savings to construct houses. Second, it would free up the trapped capital in the real estate and increase domestic investments, which would pick up the economy. In the last five years, our gross domestic product (GDP) growth was bolstered by government spending. If we want our economy to grow, we would have to increase investments, that is spending by businesses. We could couple it by creating an ideal environment for businesses to flourish. Presently, we rank 136^th on the Ease of Doing Business Index, and thus incentives for investments and disincentive for parking cash in the real estate would pump up the economy.

The real estate mafia is quite strong and it would resist any measures that go against their vested interests, hence this policy will face a lot of backlash. However, this government has shown tough resolve through its anti-encroachment drive and anti-money laundering initiatives and it has shown that it means business. This policy would also prevent money laundering in the real estate sector which is home to a huge amount of laundered capital. Market correction is long overdue and if we want to solve our housing crisis and jumps-start economic growth through domestic investments, the government needs to concentrate on this measure.