SMSF property: Understand the risks

I’ve never seen anything like it. And I’ve been writing about superannuation for well more than a decade.

While superannuation “issues” occasionally get plenty of column centimetres in the mainstream media (and specialist media cover it ad nauseum), it tends to be pretty general and inevitably short-lived. It usually peaks around federal budgets and elections.

But, in the last two months, the column centimetres devoted to self-managed super funds (SMSFs) and property gearing has reached fever pitch.

Investment experts recommending SMSF trustees to dive in, government instrumentalities issuing concerns, spruiker advertising becoming all pervasive, how-to guides from parties with vested interests, industry body warnings ... and in recent days, a state government (NSW) even decided it needed to weigh in, threatening regulation.

Everybody is concentrating on their own bit of turf, but everything is focussed on the perceived trend itself – that SMSFs are madly scrambling (or should be) into geared residential property investment.

I’m not going to enter those arguments today. I love property as an investment, including geared, for the right investor. And I do believe that property is about to go for a canter, after two years on the slide. My name is on four books specifically on property investment, so you can put me in the corner as a card-carrying property nut.

My concern is that some of the recommendations for SMSF trustees to dive into property have been a little bit light on when it comes to the risks associated with geared property investment. Some have lacked balance. Others have been truly biased.

My point today is to add back a little realism. There are no guarantees with SMSF property investment. But it’s also not as scary as some authorities are pointing out either.

SMSF property gearing risks

Geared property investment, particularly inside a SMSF, is different. It does come with different risks. It is more complex. The structures are not as simple as outside super.

And there are government penalties for getting things wrong, which simply don’t exist outside of super.

A property boom is not guaranteed

Sure, interest rates are low. Yes, property prices are lower in actual terms than they were three years ago, and in inflation adjusted terms even longer than that. And there seems to be huge demand and a supply deficit.

But that is no guarantee that property is about to boom. No matter how many experts you read who tell you that it’s probable (including myself), the future is uncertain and it might not.

And if you invest in the belief that interest rates are low and will stay there, that a boom is coming and that you will never lose your job (and the concessional contributions that go with it), then you’re taking a considerable risk.

Single asset investing

For a SMSF to gear into a property investment, it will usually need to put up a minimum of about 25-26% of the purchase price.

Banks will lend up to 80%, with a 20% deposit from the super fund, plus another 5-6% to cover costs including stamp duty.

If you’re looking to buy even a $450,000 property, that will require cash of a minimum of around $120,000, probably more. If you’re not starting with a fund of at least $200,000, you won’t have too much room to soak up negative gearing losses and potentially extended periods without rent.

Too many SMSF trustees start off a property gearing strategy with just enough in their super fund to get the gearing strategy started. They lack diversification and deep pockets.

Thankfully, banks have been leading the way on conservatism here. They have put considerable barriers and restrictions up for new SMSFs, which knock many potential trustees out before even the application stage.

Making your super fund a single asset fund is plain dangerous. Make sure your fund has some diversification. If the property strategy goes horribly wrong, at least you’ll have something to fall back on.

Targeting of SMSFs by sharks

The sharks are, as repeatedly warned by ASIC, circling. Property spruiking seminars, directly targeting SMSF trustees, are being advertised everywhere.

They are usually offshoots or related parties to property developers and they almost always offer a one-stop shop. They’ll set up your SMSF (plus up to three other entities that are often required), organise the loan, guarantee a rent return for you and “will take away all of the stress”.

(Of course, it’s all built into the price. But most won’t figure that out for years.)

More often than not, you’ll be investing in out-of-town property that is predominantly rubbish. And always will be. No matter how easy it was, or how good the tax deductions were.

Once the developer settles on that property for you, all their projections and promises become worthless – so long as they were not actually lying to you, neither you nor the Australian Securities and Investments Commission will be able to do anything if you belatedly discover the investment was clearly destined to be a disaster.

But you probably won’t figure it out until years after the developer has gone broke or changed entities.

Beware of any property investment where everything is organised by related entities, or anywhere that is a one-stop shop.

Leverage multiplies the risks

Any SMSF trustee wishing to borrow to buy into property needs to understand leverage. If you borrow 80% of the investment, you’ll generally need to put up about 25% (the extra 5% for stamp duties).

Property only has to fall about 10-12% – and for you to be a forced seller – for you to have lost your total investment capital in those situations, given you will also have to stump up sales costs.

Limited recourse borrowing is not so limited anymore

Banks will only lend up to a maximum of 80% for residential investment property (70% for commercial) and will then seek personal guarantees of the directors/trustees.

While the intent of the legislation that allowed SMSF gearing was to be limited recourse – banks were supposed to be restricted to the asset purchased in the event of default – the fact is that it’s now not really limited recourse at all. Banks can, and will, come after trustees where they can.

Most commercial bank loan agreements nowadays make that pretty clear.

Limit to negative gearing

Those eligible to make concessional contributions to super can only contribute up to $25,000 each year (unless you’re over 60 for FY14). If your property is heavily negatively geared, you can miss out on valuable tax deductions.

Negative gearing is limited to income produced by the fund, which includes the income from other investments, plus concessional contributions.

And the tax concessions are limited to the 15% income tax rate of super funds.

Gearing outside of super is limited only by your income and can be at rates of up to 46.5%.

Don’t ‘lose your virginity’ to property inside super

Unlike shares, cash, fixed interest or even real estate investment trusts, direct property requires specific knowledge and active management.

If you’re not prepared to be actively involved in running your investment property, you probably shouldn’t be in it. You need to give a toss about your investment property – your tenant won’t and it’s also unlikely that your rental agent will much either.

If you have not invested in geared residential property in your personal name, or outside of your SMSF, then I would not recommend you make a geared SMSF property investment your first foray into this field. That’s unless you follow through on a promise to yourself to bone up on property investment to the point where you feel comfortable making active investment decisions.

Complex structures and getting it wrong

SMSF gearing usually requires trust deeds, corporate trustees, bare trusts and bare trust trustees that all line up. It’s too complex to go into here.

But getting it wrong – even getting the initial signature on the contract wrong – can be horrendously costly. Getting it wrong can lead to double stamp duties being paid in some cases, or worse.

The Australian Taxation Office is the regulator for SMSFs. And getting it wrong with the ATO can lead to penalty taxation or fines of, potentially, hundreds of thousands of dollars.

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 strongly advised to consult your adviser/s, as some of the strategies used in these columns are extremely complex and require high-level technical compliance.

Bruce Brammall is a licensed financial adviser and mortgage broker with Castellan Financial Consulting and Castellan Lending, and is the author of four property investment books. E: bruce@castellanfinancial.com.au

• Australia has retained its third place ranking in the 2013 Melbourne Mercer Global Pension Index, but increased its overall score to 77.8, up from 75.7 in 2012. Stronger regulatory requirements and an increase in the net replacement rate contributed to Australia’s improved score, the report said. Denmark and the Netherlands took first and second place, while Switzerland, Sweden, Canada, Singapore, Chile, the UK and Germany rounded out the top 10.
• Financial services firm Wealth Within has launched a new investment platform that allows SMSFs to gear into direct property. The Global One platform reportedly acts as the bare trust for the fund, while also offering SMSF compliance services. “Any entity can buy into property off the platform but it supports SMSFs, so it eliminates the need to have to set up a separate bare trust,” said Wealth Within executive director Lea Zerbes at the platform’s launch last week.
• The Australian Institute of Superannuation Trustees (AIST) and the Industry Super Association (ISA) have lodged a joint submission to the Australian Securities and Investments Commission (ASIC) asking that self-managed superannuation fund (SMSF) advisors undertake specialised training separate to those providing advice on Australian Prudential Regulation Authority (APRA) regulated funds. “AIST and ISN believe that the knowledge requirements for SMSFs are different enough from APRA-regulated superannuation funds to require a new specialist knowledge section,” the submission said.