Self-managed superannuation funds continue to grow at a significantly faster rate than the broader superannuation and wealth management industry. SMSFs now represent in excess of 35 per cent of the total $1.3 trillion retirement savings pool in Australia. Two commonly stated reasons for the inflow to SMSFs are the ‘flexibility’ and ‘control’ they offer compared to traditional industry and retail funds.
Direct property investment within SMSFs is an important illustration of those two perceived benefits, being an investment alternative that is not available within traditional funds and which offers direct ownership, control and a unique tangibility.
Although direct residential property investment within SMSFs currently only represents 3.6 per cent – approximately $16 billion – according to the Australian Taxation Office (ATO), it is growing. This can be evidenced by a recent Genworth survey that found more than 50 per cent of surveyed SMSF trustee respondents consider direct residential property investment an “attractive investment” and would consider it in coming years.
This effectively indicates the trustees’ interest in and awareness of their options is likely to flow into greater SMSF investment in direct residential. To illustrate this point, assuming the sector remained constant in size but allocation to direct residential increased to 10 per cent, then residential investment would represent $45 billion (an increase of 178 per cent from today or around $28 billion in inflows).
Property as a tax-effective SMSF strategy
Superannuation is a lower tax environment and this is one of its main attractions. Tax effectiveness also increases with the age of the trustee. The applicable tax rate for SMSF earnings and capital gain drops to zero for trustees who have reached 60 and shifted their SMSF on to the pension phase.
Direct residential property is well suited to SMSFs. It offers long-term, relatively stable returns in the form both of rent and, ideally, a capital gain upon eventual sale. Both the rental return and eventual capital gains subsequently benefit from concessional tax rates within the fund. Rental income is taxed at 15 per cent until the trustee reaches 60 years of age, after which there is no tax payable on the income. For capital gains, the starting rate is 15 per cent and is reduced to 10 per cent if the asset is held for more than 12 months. Capital gains tax also does not apply for assets sold after the trustee has reached 60.
Managing the allocation issue
An obvious hurdle when managing a client’s portfolio is the appropriate fund allocation to the sector. In the context of model portfolio construction, given the sheer size of the average property value, this can occasionally be challenging. The median Australian house price is $429,500 (higher in Sydney and Melbourne) and thus the problem is obvious in the case of a typical SMSF with a balance of less than $500,000. Until recently, this has tended to exclude direct residential investment for most super funds.
Changes to the legislation in 2007 have made property investment a lot easier for SMSF trustees. Until recently, borrowing within SMSFs was either impossible or at best very difficult, meaning that property investment was only available to those clients with significant cash deposits within their fund.
Assuming a 20 per cent allocation on a $500,000 SMSF, $100,000 might be sufficient to purchase a direct property, depending of course on the level of borrowing available. Not only is borrowing now permissible, it is accessible with a broad range of loan products available that specifically cater to the SMSF sector.
Borrowing to buy property through SMSFs
Borrowing to buy property through an SMSF can be a great way for your clients to manage their long-term goals for a comfortable retirement. However, any such borrowing can also be time-consuming, complex and – unless structured properly from the outset – can end up costing the trustees more than necessary, possibly making the SMSF non-compliant.
Checklist for buying property with an SMSF
• Right structure first
It is important that the SMSF client has a properly established SMSF structure. The trust deed needs to be compliant – and have the appropriate powers for owning direct property – while the SMSF’s investment strategy needs to be clearly defined to include both real property and borrowing. Generally, deeds before 2007 do not allow for borrowing and will require review and amendment. In addition, it is advisable for a corporate trustee to be put in place as it is a requirement of some lenders. Other lenders may encourage it, offering favourable terms and conditions. It is therefore always advisable to establish an SMSF before a particular investment property is identified.
• Constituent documents
Before acquiring a property, the SMSF trustee must establish a trust structure that allows for legal title to the property to transfer to the SMSF trustee upon full payment of a loan without legal and/or tax implications. Therefore, it is important that the trustee get its legal structure right from the start to mitigate any problems as far as possible.
• Trust work
Before any assets are placed on trust by the SMSF trustee, they must ensure the trust itself is properly constituted, which is generally known as seeding a trust. If this is not done, the trustee may find more stamp duty than necessary can become payable by the trust.
• Bare trust
In accordance with superannuation law, lending arrangements must be on a 'limited recourse' basis (this means the lender’s rights are limited in the event of default to recourse to the property, thereby ensuring the SMSF’s other superannuation assets are excluded from any claim). This means the lender only has recourse to the asset held by the bare trust and not to the trustees personally. This is an important protection mechanism and makes the arrangements required quite different from a ‘normal’ property purchase. There are many instances of non-compliance in this area so it is advisable to review your client’s documentation carefully and seek specialist legal advice where necessary.
• Lending guidelines
Before a client embarks on any property purchase, their adviser should look at funding needs and ensure they are realistic and achievable, based on the lender’s guidelines. The SMSF trustee must be capable both of funding the equity component of the purchase and making the loan repayments. Given the limited recourse arrangement, lending guidelines are more conservative and restrictive.
Banks’ loan-to-valuation ratios (LVRs) for SMSFs have increased in recent years and it is now common to be able to obtain 65 to 80 per cent. Generally, it is best to assume the client will require a minimum of 20 per cent equity after transaction costs and stamp duty. As with all debt-funded investments, proper servicing analysis should be undertaken. For SMSFs, both contributions and rental income after debt servicing are taken into account; generally, however, lenders will apply a discount to rents and only take into account demonstrable contribution history, not forecasts.
• Lender review of deed
The lender will need to have its legal department review and ensure that the SMSF trust deed and bare trust structure meet the lender’s requirements.
• Right asset
Selecting only ‘investment grade’ assets that offer potential for both reliable – and, ideally, growing – rental income and long-term capital growth is critical if the investment is to achieve the intended outcomes. Often, that requires the assistance of an external investment property specialist with a strong knowledge of current market conditions, outlook and importantly the requirements of your client for that asset within the context of their overall investment strategy.
• Negative gearing versus positive cash flow
Given the lending guidelines for debt servicing, not to mention the lower tax rates applicable, negative gearing may not be considered as attractive a strategy within an SMSF. With concessional tax on net rental income, properties that can provide higher income generation – even positive cash flow – are often targeted by trustees. Neutral or positive cash flow reduces reliance on contributions to demonstrate the ability to service a debt and potentially assists the undertaking of further purchases to construct a portfolio.
• Property management
Rent from the property will be paid directly to the SMSF (a property manager can coordinate this for clients). The SMSF can make loan repayments to the lender, according to the lending terms, and can deal with the property as desired – that is lease, repair or sell, just as with a ‘normal property’.
• Mortgage repayment
The SMSF can pay out or reduce the mortgage, depending on the terms of the loan. This is an important point and the documentation needs to be checked carefully if making additional or lump sum payments is contemplated.
Recent changes to the definitions of the types of work that can be carried out on an investment property within an SMSF have been widened, allowing certain types of improvements. In general, this means renovations can be done provided they do not substantially change the fundamental character of the asset itself. For example, new tiling and mirrors in a bathroom would be considered permissible whereas a new extension such as a new storey may not be.
• Exit goal
Finally, the trustee may wish to sell the property and move to the retirement phase of life or hold the property but repay the loan in full. Again, correct planning and structuring from the outset will ensure flexibility is provided and avoid unnecessary costs.
Direct property investment is an option being taken up by many SMSF trustees. It is an asset class many feel they can understand and feel comfortable with. The ‘control’ aspect of direct property ownership is also frequently a key driver. Given lower cash rates, ongoing equity market and foreign currency exchange uncertainty, as well as a troubled global economy, it is likely the trend towards property will continue. This is as trustees seek assets that are perceived to offer reliable income, capital protection and longer term capital growth.
Ben Anderson is managing director and founder of Future Estate, a property advisory, investment and funds management firm focused on residential markets.