SMSF clients are often enticed by the income and capital growth potential of a property, but ignore issues around cost, liquidity and diversification. What are some alternatives to consider?
Australian investors’ love affair with property is enduring for many reasons. Property is a tangible, long-term investment that can provide a source of income through rent.
For anyone with property, particularly in the major state capitals, it’s been a stand out performer in terms of capital gains. For this reason, many SMSF trustees may be thinking that adding an investment property to their SMSF is an attractive proposition. As an SMSF adviser, there is an opportunity to help SMSF clients weigh up the pros and cons of adding direct property, and to discuss alternatives that may be better suited to the SMSF environment.
It’s easy to see the attraction with property. It’s tangible, and when inside the SMSF, any rent earned, as well as any capital gain made if the property is sold, are taxed at a maximum of 15 per cent. In addition, if the SMSF trustee is retired and has commenced a pension within their fund, any rental income or capital gain on the sale of their property may be completely tax free. However, these benefits are available for all investments within the SMSF and like any other investment, property isn’t without risk.
To enter the market in the first place, the client requires a sizeable deposit, which could potentially stretch the capacity of SMSFs with younger trustees and lower balances. For larger funds, investing in a property can result in a portfolio that lacks adequate diversification, increasing the risk of underperformance of the fund.
Any borrowing by an SMSF must be done via a limited recourse borrowing arrangement (LRBA), but many clients fail to understand that LRBAs have additional restrictions and costs that should be fully understood before making a decision to proceed to purchase. Interest rates are often higher under an LRBA than a standard investor loan and with interest rates currently at historic lows, the potential for them to rise over the life of the loan is high. Being stuck with a bad tenant or no tenant for an extended period could have a major impact on expected investment returns, and maintenance costs also need to be considered.
Advisers need to highlight that property is also a relatively illiquid investment. As part of an SMSF portfolio, property could limit the amount of cash a trustee can access when it’s time to pay a pension or other benefits from the fund. As a result, the trustee may be forced to sell at an inconvenient time in the property cycle, which could have a negative impact on the overall investment return.
All this doesn’t mean SMSF trustees should avoid property altogether. As an adviser, you can put forward other options for gaining exposure to the property asset class.
Here are some options to discuss.
Unlisted managed funds
For clients, managed funds remove the stress of being a landlord, while giving exposure to a wider range of residential and commercial property in multiple, geographic regions. Typically priced daily, investors can buy and sell units when they like, subject to any restrictions imposed by the fund manager, making property exposure via managed funds considerably more liquid than many other alternatives.
Exchange traded funds
Exchange traded funds (ETFs) can be an affordable way to gain exposure to the property market. Like managed funds, ETFs pool the money of multiple investors. However, unlike managed funds, most are passively managed. ETFs track a market index, covering a range of indices including property, and can be bought and sold on the stock market, like shares.
While their management fees can often be cheaper than managed funds, every time a client buys or sells units, they would need to pay brokerage fees which can add up over time. There are a range of both domestic and international exposures, so the underlying strategy and liquidity would need to be checked for suitability.
Unlisted property trusts
In unlisted property trusts, investors buy units in a trust holding an investment property or properties. The trust is managed by an investment manager who chooses, and often develops or improves the property, and manages the associated development, maintenance, administration and rent collection. The property could be commercial, retail, industrial or even some other class.
Unlisted trusts are less liquid than exchange traded or unlisted managed funds. Normally, in an unlisted property trust, you cannot withdraw your initial capital investment and must wait until the property is sold. When the property is sold, the trust ends and any net proceeds are distributed among the investors.
Throughout the life of the trust, investors also receive income distributions that are paid at set intervals. However, distributions are not guaranteed nor is the return of the initial capital invested. The client will also receive a share of any capital gain or loss on the original investment.
Australian real estate investment trusts (A-REITS) are similar to managed funds, except that they are listed on the stock exchange. While a client may be investing in a shared portfolio of commercial and industrial real estate, A-REITS often involve a property management function in addition to the ownership of physical property.
A-REITs are far more liquid than directly purchasing property because they enable clients to buy and sell units, rather than an entire property. By pooling resources with other investors, clients have an opportunity to gain exposure to high-value properties such as shopping centres and office complexes. A-REITs can also expose investors to a range of regions and sectors, lease lengths and tenant types, thereby diversifying the portfolio and reducing risk.
A-REITs are designed to generate wealth in two ways – by providing exposure to the value of the real estate assets owned by the trust and the accompanying capital growth, and by providing rental income. Similar to unlisted property trusts, the fund manager selects the investment properties and is responsible for all administration, improvements, maintenance and rental.
Some A-REITs specialise in particular sectors and usually fall into one of the following categories:
- Industrial trusts invest in warehouses, factories and industrial parks;
- Office trusts include medium to large-scale office buildings in and around major cities;
- Hotel and leisure trusts invest in hotels, cinemas and theme parks;
- Retail trusts invest in shopping centres and similar assets; and
- Diversified trusts invest in a mixture of industrial, offices, hotels and retail property.
Fractional property investment
A recent addition to the investment suite is the advent of fractional property investment. Here, instead of buying an investment rental property and receiving rent from the tenant, the investor instead buys a portion or a fraction of an investment property and receives part of the rental income and any capital gain if the property is sold.
Fractional property investment platforms for retail investors can allow clients access to the property market with only a small investment. However, there are also fees and charges associated with the investment. Like any investment, the valuation of the fraction can drift away from fair value in this case, driven by the low cost and liquidity of each unit, so homework is required.
The major benefit of these alternatives over direct investment in property is that they can provide access to assets that may otherwise be out of reach for individual investors, such as large-scale commercial properties. In most cases, they also provide a much higher level of liquidity and divisibility, which can be important considerations especially if the SMSF is approaching, or in, retirement.
By Marcus Evans, head of SMSF customers, Commonwealth Bank
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