DIY and property: you be the banker

PORTFOLIO POINT: People can’t take their eyes off property but the banks are reacting with typical glacial speed to the “new” rules for SMSFs. Have you considered being your own banker?

If, like Reserve Bank governor Glenn Stevens, you find the continuing strength of Australia’s residential property market a little hard to fathom, consider this: it could be even stronger if only the banks could get their act together.

The rules were changed in September 2007 to allow SMSFs to gear into residential property, but bank inertia means they have been glacially slow in offering products so trustees are having trouble getting loans.

Initially after the change a few lending institutions had products available to meet the new requirements. The exceptions included Calliva and Babcock & Brown, which soon became victims of the GFC.

The rule change came as property and equity prices were reaching a crescendo. Australian property and global stockmarkets peaked the following quarter then went into a year-long slide.

Now it’s more than a year since property and shares bottomed; the world has resumed spinning on its axis again and there’s no threat of economic meltdown – at least not in Australia. Bills are being paid. The unemployment queues are stubbornly short.

But you can’t walk into an Australian bank and ask for to arrange a loan for your SMSF – the tellers will laugh at you; the branch lending manager is likely to shrug his shoulders. Someone at the regional branch might know what you’re talking about, but they won’t know who to refer it to.

You’ll need patience. Or someone with experience. Or another way to skin the cat.

The lack of lending product is potentially costing SMSFs money. Banks are not marketing their SMSF-specific loan products/packages particularly well or widely. Those that do often have one or a number of the following: high valuation or establishment fees; compulsory bank custodianship (with their own fees); high interest rates; and inflexible loan structures.

Because the new regulations stipulate that loans for SMSFs be limited recourse – that is, they can only seek redress against the asset that was purchased – banks have tended to limit the ratio to which they will lend to 60–75% for residential property.

SMSF trustees are, as a result, increasingly becoming their own banker for their SMSF gearing strategies.

Yes, you can be the lender to your super fund. Becoming your own banker can remove a whole lot of hurdles for investing in property through your SMSF.

It starts with you, as the trustee, having access to plenty of equity outside of super, presumably against your home or another property (although the money could feasibly come from another trust or company).

Alternatively, you’ll need access to plenty of cash that you don’t, for whatever reason, want to put into super as a non-concessional contribution; or access to enough money that could you take you both you and your partners non-concessional contributions and still have plenty left to spare for lend into your SMSF.

For example, if you own your $1 million home outright and you have some income to service a loan, banks will usually consider lending up to 80% of the value of the property as a line-of-credit loan. This money could, potentially, be lent to your SMSF for geared investments. (It could also be used by yourself to invest in non-super geared investments, but then you wouldn’t have the tax advantages available to super funds.)

This would also give you access to home loan interest rates, which are usually going to be considerably lower than those offered commercially for SMSFs. Further, it would give you more flexibility on the duration of the loan. So long as your loan document allows it, your super fund can pay out the loan at the time of its choosing. It can also determine the amount of money that is lent.

It’s a path being turned to by more and more trustees, partly out of frustration at getting nowhere with the major banks, or being unhappy with the eventual terms that have been offered by them.

It’s not just a simple case, however, of sending a sum of money across to your SMSF bank account as a loan, then buying a property.

You still need to follow the new rules, as they relate to borrowing for SMSFs. And those rules include that the asset be held in a bare trust (a custodian trust or debt instalment trust); that there be proper loan documentation; and that your SMSF trust is allowed to invest in geared assets, making this a good time to update your trust deed.

What to do

• Make sure you trust deed allows your SMSF to borrow. If it doesn’t, update your deed to one that does allow gearing.
• Make sure you purchase the property inside a special purpose bare trust (also known as a debt instalment trust or a custodial trust).
• Have a properly documented loan agreement in place between the lender (you) and the SMSF.
• Ensure the loan is limited recourse.
• Make sure it is a new asset, if you’re purchasing residential property. Residential property cannot be purchased from an existing related party.

What not to do

• Don’t just transfer some money into your super fund and call it a “loan”. The loans need to be properly documented and the asset needs to be held on trust for the super fund.
• Don’t charge an interest rate that is too low or too high, as they will be seen as either gaining a benefit from your super fund before retirement or trying to put extra money into super.
• Don’t invest outside of your SMSF’s “investment strategy”. Take the opportunity to update your investment strategy to allow for geared investments.
• Don’t leave too little money in the fund. You will need to cover interest repayments, the other expenses of the fund (accounting, audit, insurance, etc).
• Don’t become a one-asset fund that holds a single property and no other investments. Super funds still need diversification.

Make sure the interest rate you charge your super fund is realistic. Passing on the interest rate exactly as you are being charged by the bank that you are lending it from might would seem reasonable.

I’ve heard it argued that a small premium might also make sense, due to the higher risk (that is, if your bank is charging you 6.5% for the money, then you charge your super fund a premium, say 7%, because of the higher risk that is inherent in limited recourse lending).

But this is a grey area. The important point is that you shouldn’t charge a considerably higher, or lower, interest rate. If you charge your super fund a very high interest rate, you could be accused of breaching the sole purpose test by trying to gain benefits for yourself prior to reaching a condition of release.

Charge yourself too little interest and they could be seen as de facto contributions, which could be a big problem if you’re already at your concessional and non-concessional limits, or it causes you to breach them.

Also don’t forget that your loan to the super fund is limited recourse. If the property investment turns bad, or needs to be sold at a bad time, then you, as the lender, can only seek redress over the actual asset that was lent for.

If a $400,000 property was bought with a $300,000 loan, but the property is later sold for only $200,000, then the lender (you) will only be able to get back a maximum of $200,000 on your $300,000 loan. Or so the theory goes.

More so than almost any other area, if you’re looking to go down the path of geared property in super, particularly with the industry in its infancy, seek professional advice from a financial adviser or SMSF law specialist, or both.

We got an official update yesterday on Jeremy Cooper’s upcoming report in regards to the already reported “MySuper” plans. This plan would see all platforms and super managers being forced to offer a cut-down, no-advice, no-commission offer within what they currently do.

The recommendation springs from Cooper’s understanding that far too many people are disinterested or disengaged from their super. The point of the “MySuper” option within any fund would be that it would be cheap as chips. The MySuper option would also be likely to have the ability to be charged a fee for service, with no ongoing trail or percentage-based fees.

It might well save thousands of people from losing more in fees that they should. However, it still has the potential to legislate for indifference – far too much of which already exists within current options. More detail, please.

Two short notes this week: First, thanks to those Eureka Report readers who joined us for the first Eureka Report superannuation webinars yesterday. Next month we will be running a webinar on investing in property through your SMSF. Keep a lookout for the date. Second, this is my last column before I take a short break. My column will return on May 12.

Bruce Brammall is director of Castellan Financial Consulting and author of Debt Man Walking.