Israel’s housing market and the law of unintended consequences

The law of unintended consequences is the observation that an action may have results that the actor didn’t intend. The unintended consequences may not have been foreseeable and also may not be immediately observed. The consequences may be neutral, beneficial or harmful. In a best-case scenario, the action produces both the intended result and unintended benefits.  In the worst-case scenario, the intended results don’t occur, and there are negative consequences that worsen the original problem or generate a new set of problems.

How does the law of unintended consequences apply to the current housing market in Israel?

Take the capital gains tax on investments in apartments. Generally speaking, politicians on both the right and left blame investors for the high cost of apartments and want to move them out of the apartment market. This is the intent of several policies trying to make investing in apartments less profitable.

A popular investment model in Israel is to buy an apartment, make the minimum down payment and finance the balance with a mortgage. The investor then rents the property to a renter and charges enough rent to cover the mortgage, property tax and housing committee. With apartment prices rising 7-10% a year, the investor can sell the property after three or four years and make 100% or more on the original investment.

But then the investor will have to pay a capital gains tax of 25% of the profit — unless they reinvest the profit in another apartment within a year. If they reinvest the money, they can avoid the tax. Obviously, at some point they will want to keep the profit and end up paying the tax. But as long as they keep rolling the investment over, they delay paying the tax and they make a profit on the very money they would have paid in tax. The result is that investors are encouraged by the tax code to keep investing in apartments, and with their profits, to even buy multiple apartments. This is not the result the political leadership wants.

Another unintended consequence of a law or policy is a drop in fertility rates. In the US, many people are convinced that there are two government policies reducing the country’s fertility rate, now 1.7 children per woman (in Israel the fertility rate is 3.1 children per woman). The population replacement rate is 2.2 children per woman, so the US isn’t replacing itself.

The two policies are the environmental policy encouraging Americans to buy smaller, fuel-efficient cars; and the law requiring care safety seats for small children. The first has resulted in more Americans buying smaller cars, which have smaller back seats. Second, whereas the larger cars have room for three safety seats, the smaller ones have room for only two. Researchers have found that due to the second, owners of smaller cars tend to have two or fewer children. The unintended consequence is young couples having fewer children.

The Israeli version is the local authority’s general preference to zone neighborhoods for four room apartments: three bedrooms. The reason is to maximize property taxes while minimizing the infrastructure needed to support the neighborhood: electric lines, water and waste pipes, etc. The unintended result is that many young middle-class couples are stopping at three children. The reason is simple enough: with three children, two share a room and one gets a room. But what if the fourth child is different from the one with its own room? The middle class isn’t going to put a boy and a girl in the same bedroom. Rather than risk this situation, most simply stop at three children. Hence, a policy intended to reduce infrastructure costs has reduced Israel’s fertility rate.

Speaking of fuel-efficient cars, there is a general policy of the government to encourage people to buy smaller cars, and to drive less. In Tel Aviv they have passed zoning laws limiting the number of parking spots available in new neighborhoods. The intended consequence is to reduce pollution, which seems laudable in the era of climate change. However, there have also been unintended consequences. One unintended consequence was a spike in the price of apartments with parking spots. Another is the greater fuel efficiency of smaller cars has encouraged people to drive more, since they get more kilometers per liter of gas. This is similar to the reduction of nicotine in cigarettes: smokers hold the smoke in their lungs longer to get the same high. The consequence is to neutralize the effect of reducing the nicotine, and possibly worsening the impact of smoking.

When it comes to housing, one in three Israelis lives in a rental apartment. Investors, not the government, provide apartments to renters. However, the logic of the mantra seems to appeal to voters: for every apartment an investor buys there is one less apartment for a young couple to buy. Politicians want to scare investors from the rental market on the premise that this will reduce the price of apartments for young couples.

However, if we scare investors from the rental market, there will be fewer apartments for renters, pushing rents upward. In 2022, rents in the Tel Aviv area rose 19%. If rents rise, the price of apartments will also rise. Hence, an unintended consequence of chasing away investors in rental apartments is to raise the price of apartments for young couples. The intended results don’t occur, and there are negative consequences that worsen the original problem. Voter beware.