Don’t ditch depreciation

Kiwi buildings never wear out. No scientist can explain how this miracle transpires. Is it some magical elixir, or an undiscovered fountain of building youth effervescing from a Rotoruan hot spring that wards off obsolescence?

At any rate, this phenomenon persuaded the New Zealand Government to scrap building depreciation a couple of years back.

The Government’s logic was simple: why provide a tax break when buildings don’t depreciate?

The Australian Government’s Business Tax Working Group has now proposed the same approach apply to buildings on our side of the ditch.

Admittedly, it’s only an option. But given the recent withholding tax debacle, it’s important to address the issue decisively.

The Gillard Government says it wants to lower corporate taxes. A two percent rate reduction to 28 percent is on the table. However, the Treasurer insists any rate cut must be ‘revenue-neutral’.

Business is up for an evidence-based debate where each business tax reform proposal is assessed against its impact on long-term national prosperity.

Buildings, like other productive assets, have economic lives – their use-values decline and they wear out while generating taxable income. Numerous international studies catalogue the drivers of economic life, which are:

  • Physical deterioration – a building’s fabric, plant and fixtures simply wear out over the years.
  • Economic obsolescence – changes in market conditions and government policies can alter the “highest and best use” of a site and buildings move across economic segments during their lives for a wide range of reasons.
  • Functional obsolescence – technological changes can render buildings functionally inefficient. A building’s rental growth is tied directly to its ability to meet the changing productivity needs of occupants. For instance: buildings with floor configurations or services that don’t keep pace with trends in versatile, collaborative workspaces can be shunned by tenants. The Property Council’s own guidelines on building quality grading have changed markedly over the years in line with building performance expectations.
  • Environmental obsolescence – the revolution in green buildings has had a direct impact on design, competitiveness and, therefore, building construction cost. The Property Council/IPD Green Building index shows that non-green buildings are increasingly discounted by the market.
  • Legal obsolescence – the introduction of new legislation in relation to occupational health and safety, access for those with disabilities, or emerging resilience standards can speed up obsolescence.
  • Social and corporate obsolescence – trends in community expectations may result in occupiers demanding higher indoor environmental standards, working conditions and security, or lifestyle facilities in hotels and retail centres.
  • Aesthetic or visual obsolescence – a building may be architecturally outdated or simply unsightly.

These drivers shape the economic lives of different building types.

There is plenty of research into the quantified economic lifecycle of buildings.

While these estimates vary, there are no international studies that conclude buildings don’t depreciate.

This point was conveyed on numerous occasions by our friends at the Property Council of New Zealand to their heedless Government.

Will the absence of a rational depreciation regime condemn Christchurch and its massive re-building program to a second best outcome?

Why invest in state-of-the-art buildings if the tax system penalises you for investing beyond the bare minimum?

The Property Council first estimated the economic lives of offices, shopping centres and hotels in 1988.

We divided buildings into their 60+ elemental components and asked industry experts to calculate the life of each element as a share of original construction cost.

Our proposition was that one economic lifecycle of a building concludes when the net investment required to restore the asset to market competitiveness equals the original construction cost.

A new cycle then commences or the building is re-purposed (as they say in America).

On this basis, the estimated economic life of office premises in 1988 was 21 years, for shopping centres 18 years and hotels 15 years. International studies at the time endorsed these findings.

More recent research (and commonsense) indicates that the economic lives of buildings are getting shorter, which means official depreciation rates should be higher – not zero. This is due primarily to technological advancements, the greening of buildings, tougher laws and higher community expectations.

One recent study of office buildings calculates economic depreciation at 16 years. Another, based on the ‘survival ratio’ of assets – taking account of demolitions – estimates the economic life of offices at 13 years and industrial buildings at seven years. Still another puts shopping centres and hotels at between 15 and 18 years.

In 2007, the world’s most comprehensive economic lifecycle study concluded that actual depreciation rates for buildings are almost triple the official rates used in Canada and the United States.

A government that denies capital allowances will discourage innovation by forcing owners to pay tax on the capital they inject to improve competitiveness.

In a country hankering for major productivity improvements this is a perverse use of Australia’s tax regime.

Buildings are the central nervous system of the economy. They can act as productivity super chargers. They also wear out or are superceded by better models.

Australia deserves a capital allowance framework that directly recognises the economic lives of different building types. We ask for no more and no less.