Is 2012 your year of DIY property?

PORTFOLIO POINT: Property price declines are raising the interest of SMSF trustees. If the thought has crossed your mind, here’s what you need to do to be ready to pounce in 2012.

I don’t know about you, but I’m REALLY looking forward to Christmas. Professionally and personally, it’s been an eventful year, in a completely over-the-top way. I’ll relish the break. As an investor and SMSF trustee, I’m also looking forward to closing the door on 2011. Actually, slamming it shut would be more honest. And I won’t be alone.

Equities have been heartbreaking. After starting the year around 4850 points and managing to pop its head above 5000, the index fell back below 3900 points and is currently sitting around 4250 (as at close on 13/12/11). Cash has had an average year, but has ended on a low note, with two interest rate cuts, and more predicted. At least, as you can rely on cash to do, it hasn’t gone backwards. Fixed interest has performed well. For the year to November 30, Vanguard’s Australian Fixed Interest Index fund is double digits, with a total return of 10.28%!

And then there’s property. Commercial property, including A-REITs, the sort of property most commonly purchased inside managed-fund super, hasn’t fared well either. Round it out at zero.

And Australia’s great investment love – residential property – hasn’t made too many home buyers smile, either. Depending on which figures you look at, actual prices are off around 4%. Add the negative of inflation into that and the real return has been around minus 7–8%. However, hardcore property investors are wringing their hands. Property is an asset class on the nose. Out of favour. So is it time to take the punt? And take that punt inside super? A once-in-a-decade opportunity?

Residential property doesn’t have the volatility of shares and the changes to the super gearing rules in 2007 mean it is now possible to gear inside super. I agree with fellow columnist Monique Sasson Wakelin (see Melbourne doomsayers wrong again) that the residential property market will probably bottom out around mid-2012.

If you also believe that to be the case, considering a geared property investment could make sense. You’ll have to make your own judgement on that. But if you have been thinking the same, here’s what you need to do to get your super fund ready to pounce on any opportunity that may come your way in 2012.

A supportive trust deed

Super gearing for property was only really allowed from September 2007. If your super fund trust deed predates that, then it’s quite likely that it won’t allow for the sort of gearing that’s allowed within super so it’s probably time to update your trust deed. This doesn’t have to be difficult, but requires a specialist to read your current trust deed and request an update accordingly.

Even if your SMSF trust deed post-dates September 2007, it’s no guarantee that it will allow for geared property investing. Either check it out yourself, or get a professional to do it for you. Updating your basic trust deed needn’t cost the earth, but set aside somewhere between $500 and $1500 to get this done properly.

Find a lender

When considering borrowing for property, the first thought is usually a bank. And going to a bank can be done with a SMSF gearing loan. The bank will generally charge a slightly higher rate than if you were purchasing a property in your own name, but the rates gap has fallen significantly in recent years, so it really doesn’t cost too much more than if you were to borrow the money in your own name.

But banks are not the only option. You can be the lender. For more information on this topic, see a previous column DIY and property: you be the banker. If you are going to be the lender, you still need proper loan documents in place between yourself and the SMSF and you need to charge a market interest rate (often whatever your ultimate lender, which may still be a bank) is charging you.

If you have plenty of equity to lend against in your existing property or properties, then becoming the lender yourself might make sense. In a technical sense, the bank will probably lend the money to you, as an individual, then you lend the money to your SMSF as the lender. These sorts of arrangements require proper documentation. Don’t do it yourself. See a professional.

The vehicle - bare trust and corporate trustee

The lending can’t be directly to the super fund. The lending needs to be via a special trust (variously referred to as a bare trust or a debt instalment trust). It is best to have a corporate trustee of the bare trust and, in fact, some lenders will insist on it.

The cost of setting up bare trusts has come down in the past few years. However, setting aside somewhere between $1500 and $3500 for a quality trust deed from a recognised professional SMSF supplier would be a good idea.

There’s no need to panic on this front. Bare trusts and company trustees can be set up fairly quickly. But don’t let it be something you leave until the last minute, particularly if your property acquisition has a short settlement period.

Negative gearing

From a tax perspective, being negatively geared can turn your super fund into a zero-tax zone, as I have discussed (see Pay no tax). And, if you are comfortable with negative gearing outside of super in your personal name, then negative gearing inside super might also be suitable, or relevant, to your situation.

Banks will generally lend up to about 60–70% (some a little higher) of the value of the property. And in most cases, the borrowings will be enough to make the property negatively geared, which may advantage those in accumulation mode. Unless you are borrowing less than about 40–50% of the total property value, your super fund is likely to be negatively geared.

If you are negatively geared, it will be very important to understand that you will need to cover any shortfall. If the fund is negatively geared to the tune of $15,000 a year – and you borrowed to a point that drained your available cash – then you will need to ensure that you are able to contribute enough money, usually via concessional contributions, into the fund to make sure it can still meet its responsibilities.

Property is an actively managed investment

Understand that property investment is hands-on. If you haven’t invested in direct residential property before, you need to be aware that you have to make decisions. And those decisions will have an impact on the success of your investment.

Investing in equities, by comparison, is very different. You are investing in a company and management, who make the decisions for you. With direct property investment, you are the manager. You are partly investing in yourself. Start reading up on the sorts of commitments that you’ll have to make.

Not for the short term

Most importantly, get your head around the fact that property is not a short-term investment. And that, in no small part, comes down to the cost of getting into and out of property. Apart from the costs mentioned above in regards to updating trust deeds and the purchase of bare trusts and corporate trustees, there is the actual cost of property purchase itself.

Stamp duty and purchase costs vary around Australia, but allow for somewhere between 5% and 6%. Sale costs, including the cost of advertising and sales agent fees are around 3–3.5%. Add those together with the costs above and you’re talking somewhere in the vicinity of 10–12% in buy/sell costs.

It is possible to make money out of property in the short term. But it is generally a long-term investment. If you are buying, give yourself a minimum of a 10-year timeframe. In my opinion, property really should be forever.

But forever in an SMSF doesn’t have to be until the second coming. Don’t forget that super funds in pension phase pay no tax on capital gains or income. If you aim to hold it at least until you turn 60 and turn on a pension, then the (potentially) hundreds of thousands of dollars that you have made in capital gains from your property investment could be realised '¦ WITHOUT A SINGLE CENT BEING PAID IN TAX!

Patience '¦

Don’t buy property for the sake of it, for the sake of tax deductions or because you think it will make you a pile of money. Your purchase might not on any count.

Property is a wonderful asset class in which to invest. But bad property can be more harmful to your financial health (or the health of your super fund) than anything you have done previously.

If it makes sense, start reading on the topic. While there aren’t many tomes specifically on property investment in SMSFs (although I could probably combine what I’ve written over the years for Eureka Report and get a portion of the way there), there are plenty of good property books out there. And the fundamentals of property inside or outside a SMSF bear some similarities.

SMSF industry groups don’t think Bill Shorten will neglect the sector despite having a considerably larger portfolio under his watch. The chairman of the SMSF Professionals Association of Australia (SPAA), Sharyn Long, says Shorten is well across the issues in the SMSF and wider superannuation sector because he was the minister presiding over the Cooper review and the introduction of reforms such as the Future of Financial Advice. She thinks the addition of Workplace Relations shouldn’t impact on his involvement too much. Philip La Greca, director of SMSF administrator Multiport, says the alternative of having a new person parachuted into the portfolio is worse, particularly during large industry changes, though there are some worries that Shorten will take longer to address industry concerns as the features of the regulations are released. SMSF assets fell 3.5% to $397.2 billion in the September quarter compared to the previous period, according to APRA’s Quarterly Superannuation Performance report. This was better than retail, corporate and public sector funds, however, and compared to the same quarter in 2010 SMSF assets rose by 3.44%. As at September 30 DIY funds had the largest proportion of super assets than all other styles of fund, with 31.1% of the total pool. The number of SMSFs increased to 450,498, or by 1.78% on the prior quarter. SMSFs moved away from using corporate structures in 2010, with about 90% of those established in the 2010-11 financial year preferring individual trustees, according to the ATO’s statistical report on SMSFs. The ATO also noted a trend for new SMSFs to have younger members. Of the 6500 funds established in the 2010 June quarter, 11% of members were younger than 35 as compared to over 5% for the whole SMSF population; and 65% of those members were under 55, compared to 46% in the wider population. Over the five years to June 30, 2010, assets owned by DIY funds grew by 122%, compared to 60% for the whole sector. Operating costs in the years 2007, 2008 and 2009 were all significantly higher for funds worth less than $100 million and began to flatten out when assets exceeded that figure, while 98% of SMSF reports are lodged by tax agents although only 83% of funds are registered with an agent. The growing number of dominant trustees might give some in the SMSF industry sleepless nights but they are accounted for in super legislation, says Plaza Financial principal Peter Hogan. Superannuation legislation requires trustees act in the best interest of all members and if they aren’t doing this they will have to bear hefty consequences. “There’s nothing, for instance, that would say just because you have the largest amount of money in the fund you get to say what happens in the fund.” Hogan says problems are inevitable where there’s a relationship breakdown between trustees, but these circumstances can’t be legislated against and people need to accept that it can happen and mitigate against it as best they can.

The information contained in this column should be treated as general advice only. It has not taken anyone’s specific circumstances into account. If you are considering a strategy such as those mentioned here, you are advised to consult your financial adviser.

Bruce Brammall is director of Castellan Financial Consulting, the author of Debt Man Walking and two property investment titles, Investing in Real Estate for Dummies and The Power of Property.