SMSFs: Don't buy the property spiel

PORTFOLIO POINT: If you don’t have any experience with property investment outside of super then don’t start with your SMSF.

With stockmarkets swan diving back into the pool of schizophrenia in recent weeks, expect the sales pitch volume for other asset classes to be turned up. The “safety of cash”, the “low volatility of bonds” will be catch cries that you’re sure to hear (if you haven’t already) from manufacturers and providers.

The psychological damage of the 20% fall in Australian equities in recent months will be considerable. Many investors will be nursing their second case of burnt fingers and will be wary of returning.

And when it comes to being pitched slickly packaged investment opportunities, we mustn’t forget the “fourth” asset class of property. Property tends to be, by its nature, more volatile than fixed interest, but less volatile than shares. That said, the bigger and harder fall of real estate investment trusts (REITs) over equities during the 2007–2009 crash can be difficult to reconcile with that claim.

No matter which way you look at it, direct residential property is a favourite of Australian investors. Sure, it has its down times but crashes aren’t as frequent or as quick. And they seem a little easier to predict.

The residential property “crash” of the late 1980s and early 1990s was, in comparison to stockmarket falls, pretty tame. The two biggest markets of Sydney and Melbourne fell about 20% and 10% respectively. It took years to recover, but you’d have to go back decades to get a comparable property price crash to what’s happened in equities in recent years.

(You can, of course, find great examples overseas, including Japan since the mid-1980s and Northern America even now.)

Disclaimer

As the author of two books on property investment (The Power of Property, 2006 and Investing in Real Estate For Dummies, 2008), I’m a paid-up, card-carrying fan of property investment. And I think gearing is an important, if not almost essential, part of the property investment process.

And like any property proponent, there are types/styles of property I would and wouldn’t recommend. Two of those golden rules are that I would never recommend high-density housing anywhere (because the land value is usually tiny) and I wouldn’t buy property investments outside major metropolitan capitals.

I’m also wary of nicely wrapped “property solutions”. It’s not that they can’t work. I just come at them from a position of high scepticism: it sounds too easy because someone is probably making a meal of you. However, usually, it’s because they’re breaking my rules of the previous paragraph.

The great super gearing rule changes

Since September 2007, purchasing geared property in your super fund has become, firstly, possible, and secondly, a lot more appealing.

SMSFs have always been able to buy residential property (with certain restrictions, such as not buying from related parties), but the 2007 changes, which were refined in 2010, meant that geared property was now a reality for SMSFs.

Then the GFC struck. It meant virtually no one was interested in geared anything inside super. Of equal importance, there were few product providers that were prepared to lend money into the sector. Many who started in the sector vanished in the credit crisis of 2008 when funding sources dried up.

The lending rules are different

Gearing strategies inside super for directly held assets are complex. You are required to have a standalone trust (variously referred to as a “bare trust” or a “debt instalment trust”) that holds the asset on behalf of the SMSF until the final instalment (that is, the loan) is repaid.

As I wrote in a column last September (click here), you can be your own lender through either cash or equity against another property. And property gearing strategies could potentially see your super fund pay no tax (for that column, click here).

The offers on the table

Any brief search of the internet will show you that the offers to help with property gearing inside SMSFs are flourishing. Increasingly, product manufacturers are now providing gift-wrapped opportunities for people to have geared property inside their super fund. Such opportunities are what have prompted my warning today.

SMSF property gearing is not like buying a regular investment property. There are similarities, but the rules are very, very different. You can’t just walk into a bank and get a loan based on your own income and balance sheet and then take your SMSF trust deed off to buy a property.

The asset has to be held through specific purpose trusts, which are not cheap to set up, and there are dozens of traps for the uninitiated just in the SMSF side of the equation. The consequences of getting it wrong could be, arguably, even more disastrous than getting it wrong outside of super.

If you don’t do it outside super, don’t do it inside

Directly held residential property investment is a complex enough strategy. It’s not like owning shares, where the management is taken on by someone else. With shares, your decision, outside of research, is largely when to buy or sell.

When it comes to property management, YOU are the manager. You might hire someone to do the tenant vetting and rent collection, but you are still in charge of the investment itself, including the hiring and firing of those managers.

It takes a few years for newcomers to get used to property investment. I’d argue it takes at least five years before you a comfortable with the ups and downs of property management, cash flow issues, interest rates, costs and the tax implications, to name only the major areas.

For those comfortable with regular, personal-name property gearing, the allure of recreating geared property returns inside super has to be appealing. But I think that property investing inside an SMSF, particularly where gearing is involved, should start with a solid understanding of property investment outside of super.

There is likely to be a considerable push of SMSF property solutions in the coming months.

Any fears or concerns over your recent bath in the stockmarket should not be replaced with blind faith in a “SMSF geared property solution” plonked in front of you.

One of the reasons you are a Eureka Report reader is partly because you enjoy making your own investment decisions.

If you’re not building on an already solid understanding of property through previous investing experience outside the SMSF environment, don’t fall for sales pitches about how great SMSF geared property can be. One steep learning curve is enough. Climb two mountains at the same time can be positively dangerous.

An industry group has all but admitted defeat on its alternative proposal to the government’s contribution caps. SMSF Professional Association (SPAA) technical director Peter Burgess exclusively told Eureka Report that he “suspects” the proposal for a $35,000 contribution cap with no upper limit on fund balances would be passed over in favour of the government’s plan for a $50,000 cap for over-50s with balances under $500,000. He said industry funds, which make up about 18% of the sector, were opposed to the alternative as were some retirees who felt they were better off under the higher cap. The Federal Court has upheld a severe $86,000 fine for breaching contribution caps after a botched attempt to switch from an SMSF into an industry fund. On advice from her financial planner, Gillian Player withdrew $355,000 to close out a DIY fund in 2007 and deposited the cheque into her personal bank account before being placing it in the new public fund. The ATO said the manner in which it was transferred was a breach of contribution caps, and Federal Court Judge Richard Edmonds said Player had received the funds legally and beneficially as she was over 60, but this meant it couldn’t be treated as a rollover, suggesting that the only remaining avenue for the investor would be to sue her adviser for bad advice. Insyt CEO Darren Wynen says SMSFs should be careful about rolling assets and money from one fund to another because they could attract capital gains tax (CGT), whether one or both are in pension mode or not. Even if both funds were in pension phase, the ATO would apply CGT against the original price of the asset. He said that divorce was the only situation where capital gains wouldn’t be applied against assets being moved into a different fund, and said that where, for example, business partners wanted to split a joint fund CGT would have to be paid on the share of the assets being moved. It was possible to reduce the amount of CGT payable by taking an unsegregated approach by splitting assets between members of the fund in accumulation and pension phase. SPAA has reiterated its call for a fund to compensate SMSFs for losses due to fraud or theft. In a statement released yesterday, CEO Andrea Slattery said a levy should be imposed on product providers and not directly on investors to fund a statutory last resort scheme, because as this stage APRA-regulated fund members would be compensated for losses in events such as the Trio Capital fraud, but SMSFs would have to seek damages through the courts. She said a decision should not be included in the FOFA reforms because a levy would cover more than just the financial advice sector. The tax office is warning SMSF trustees not to be tempted to access their funds early if they are suffering financial hardship. There are strict rules around using this justification, and while members of APRA-regulated funds have to apply to the regulator, SMSF trustees have direct control and any early access deemed illegal could see the fund deemed non-compliant. Research house Super Ratings estimates that an average fund has lost 4–4.5% over the past six weeks, while the market closed almost 3% lower on Monday. SPAA is working on a way to help SMSFs that aren’t able to use SuperStream’s new data standards for rollovers and employer contributions, but is recommending that trustees embrace the reforms. Technical director Peter Burgess said the push for all member information and contributions to be made solely via an electronic format would save time and be more efficient, but keeping information in some kind of standardised email format could be a way for the 30,000 or so self-administered DIY funds that didn’t want to, or couldn’t, fully streamline their backend operations to get around this situation. SMSFs keen on investing in ethical shares have a new tool to pressure companies into reporting their environmental, social and governance (ESG) risks. The Financial Services Council (FSC) and the Australian Council of Superannuation Investors (ACSI) have launched their new ESG reporting standards, which outlines the information that companies need to include in the report. ACSI CEO Ann Byrne hoped the guide would help the 30 ASX-listed companies that don’t do ESG reporting (and the 76 that report only basic risks) understand that ESG standards were not “nice to haves” but a key indicator of business stability.

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 and the author of Debt Man Walking.