The pitfalls of property valuations Part 3 of 3
Part 3 of 3: Borrowing, renting and leasing
The complexities surrounding property development within super mean more onerous obligations and responsibilities for SMSF advisers and auditors.
Unless an SMSF has invested in property through a limited recourse borrowing arrangement (LRBA), the fund is prohibited from borrowing under s67 SIS.
The most common way to verify a borrowing is to review the results of a property title search to see whether there are any mortgages listed.
Where the title search reveals a mortgage registered on the fund property, and there is no evidence of an LRBA, the fund will be in breach of r13.14 SIS.
In most cases, using fund property as collateral for borrowings by a related entity is not allowed. The same restrictions apply to property held by a related trust or company in which the fund invests.
Are there any exceptions?
There is one allowable exception for a mortgage to be listed on the title: where a pre-99 unit trust holds property and the loan value is a liability on the trust’s balance sheet. Loan statements will show the correct value of the loan and whether it’s in the name of the unit trust.
Conversely, a pre-99 unit trust can also have a mortgage on the title of the property without a related loan recorded on the balance sheet.
Under the grandfathering rules, this situation is acceptable if there are no off-balance sheet borrowings. The trustees may prefer to keep the mortgage listed on the title because they want to use the property as security (for the pre-99 unit trust) in the future.
In this situation, a letter of comfort from the bank must be obtained to verify that the mortgage was not used as security for any other entity. If the trustees cannot provide the letter (or other such evidence), the auditor is obliged to qualify on s62 SIS sole purpose test.
Sole purpose test
The reason for the sole purpose test breach comes from the 2012 Montgomery Wools case. The Montgomery Wools Pty Ltd Super Fund invested in a pre-99 unit trust that had a property mortgaged to the Commonwealth Bank as security over loans held by another entity.
The proceeds of the sale of the property were used to repay a debt of a related family trust. The fund breached the sole purpose test because fund assets weren’t being held for the retirement benefit of the members. The commissioner issued the fund with a notice of non-compliance.
Caveats or encumbrances listed on the title will also be queried to ensure there are no additional borrowings. In a lot of cases, these won’t be a contravention of SIS but will relate to a registered interest in the property by a person who’s not the owner. These can include leases, easements, memorials and restrictive covenants lodged by potential purchasers, government and tenants.
By way of example, corporate tenants that have longer-term leases may register their interest on the title. This type of caveat can add value to the property if it gets sold to a potential investor.
All lease agreements should be on commercial terms that identify the term of the lease, expenses to be paid by each party, the rent and the method for calculating the annual increase. An SMSF auditor will also check that any expenses included in the accounts agree back to the provisions of the lease contract.
Rent should be received monthly in advance, and the timing of rental receipts will also be checked to ensure that the fund is receiving the rent on commercial terms.
In the situation where the fund leases the property to a related party, the fund must ensure that the terms of the lease are no more, or no less, favourable than what they would receive from an unrelated party in the open market under SIS s109.
If the related party lease agreement is set up on terms whereby the agreed rent was materially higher than that offered by a similar property in the same area, this may give rise to the fund receiving “hidden” contributions.
Alternatively, if the rent was deliberately set at a level significantly lower than the acceptable market rate, this could be giving financial assistance to members or their relatives (SIS s65).
Rental market valuations
Many SMSF trustees find it a challenge to obtain current market rental information for properties owned by the fund.
It’s best practice to request a rental valuation before the start of a long-term lease when the property is valued. This will provide certainty that the rent is at market value and that all transactions taking place are at arms-length.
Only a significant event that changes the property’s value since the last valuation will result in the need for a new valuation. Otherwise, the lease agreement will suffice in the intervening years as it will stipulate how rent is to be increased (such as increases in CPI).
Determining the real rent
One way that developers attract quality tenants is by offering inducements. This practice commenced in the 1990s where substantial incentives were offered rather than lowering rents in line with the market. Some examples include fit-outs or several weeks' free rent as a lure to potential lessees.
The problem is the impact it can have on property valuation. Incentives are usually confidential which can prevent valuers from obtaining comparable evidence. As the set of incentives varies from situation to situation, different methodologies used will deliver varied effective rents.
Given the prevalence of incentives in relation to fit-outs, this could almost be considered a fit-out funding line of credit. But it’s not an issue that will go away soon as landlords continue to use these incentives to secure long-term tenants with quality cash flow.
The path to SMSF property investment is paved with legislation. The complexities surrounding property development within super means more onerous obligations and responsibilities for SMSF advisers and auditors.
As long as property remains a sought-after investment by SMSF trustees, keeping ahead of legislation is critical to ensure that funds with property investments continue to operate in a compliant manner.
Shelley Banton, executive general manager, Technical Services, ASF Audits