All the way with LRBAs

There has been much debate and commentary in the press in recent weeks regarding the use of Limited Recourse Borrowing Arrangements (LRBAs) by SMSFs to acquire real property assets.

It has been suggested by some commentators that legislative changes allowing SMSFs to borrow for property assets has created another investor class competing within property markets that has, or will lead to, increased property prices, making it more difficult for first home buyers to purchase a property.

Subject to strict operating criteria, under the LRBA regulations, an SMSF can borrow to acquire a property with the lender’s loan security limited only to the property itself with no claim on the remaining assets of an SMSF, in the event the borrower defaults on repayments. However, it is commonplace for lenders to seek further security by way of personal guarantees from the members of the SMSF, whether they are individual trustees or directors of a corporate entity.

Whilst it is difficult to obtain the exact data on the number of SMSFs that have acquired residential or commercial property assets under LRBAs, it is accepted the number is on the increase given the growth in SMSFs with a greater number of individuals seeking to take direct control over their retirement savings. The recent Australian Tax Office SMSF Statistical Report at June 2013 reveals that around 15% of total SMSF investments are held in residential and non-residential property assets, with the majority being in the latter category.

Whether an investment of this nature is appropriate or not ultimately comes down to the investment objectives of the individual fund member(s), bearing in mind the requirement under the Superannuation Industry Supervision (SIS) Act that the trustee(s) of the SMSF must formulate an investment strategy for the fund with sufficient diversification to meet the retirement objectives of the fund member(s).

We consider the case of an existing SMSF with a fund value of $700,000 invested in a range of shares, fixed interest and cash purchasing an existing residential property for $500,000 and financing 60% of the purchase price under a LRBA by borrowing $300,000. To facilitate the purchase , existing SMSF assets would have to be realised to meet the $200,000 equity contribution, together with up to another $35,000 to cover stamp duty and other legal costs of establishing the LRBA.

Based upon assumptions of a gross rental yield of 4.7%, property agent management fees of 7%, interest-only expense repayments of 6.5%, council rates, maintenance & insurance expense of 0.5% and depreciation of 2.5% per annum of the purchase price, indicative cash flows to the SMSF inclusive of 2.5% increase per annum, with the exception of interest and depreciation expense over a five year period would be:

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What are the benefits?

It’s important to stress the outcome will vary as it’s dependent upon the nature of the property purchased, level of rental income, loan as a percentage of the purchase price, interest rates, depreciation allowances etc. However, under the above scenario, the SMSF has created a net tax deduction that can be offset against other assessable income, including any concessional superannuation contributions and, as such, has the potential to improve the overall cash flow position.

The addition of direct property provides further diversification of the SMSF’s asset allocation and has the potential to enhance the long term return for the fund members within a superannuation environment, which enjoys lower tax rates in comparison to personal or corporate entities under existing taxation regulations.

What are the risks?

Investing in property is not without risk and, similar to equities, it is traditionally classed as a growth asset. Therefore SMSF trustee(s) must carefully do their research and homework to ensure any property purchase suits the investment profile of the fund members. Direct property is an illiquid asset and whilst property values can go up, they can also go down.

Initial upfront costs such as stamp duty and legal costs associated with correctly establishing the LRBA can be high at around 6% - 7% of the purchase cost.  

Whilst direct property offers asset allocation diversification benefits, this can potentially be lost if the SMSF is too small and invests too large a percentage of its overall value into a single property asset. In our example purchase of the property would result in 50% of the SMSF assets being in one sector in a single asset.

The property cannot be leased to a related party of the trustee(s) or fund member(s) and is subject to tenancy and vacancy risk so it’s important that surplus funds are available to meet the ongoing interest and other expenses should that scenario arise.

This article by David McCrorie (Principal- Private Client Advisor at Lachlan Partners) is an extract from The Investing Times newsletter which is published by Lachlan Partners.