The mechanics of DIY gearing

Debt is roaring back onto the agenda for SMSFs, as a happy confluence of investment triggers motivate trustees to consider taking on more risk.

Virtually zero real cash interest rates, continuing low property prices, thickening rental yields and the eight-month-old buzz on equity markets has piqued the interest of those with an interest in higher risk/return potential. And that may include taking on debt.

So, where’s the evidence that gearing is back on the agenda? Super fund service provider Multiport’s most recent poll of its SMSF client base’s use of limited recourse borrowing arrangements (LBRAs) took a big jump in the December quarter.

LRBAs are, as the name states, a “limited recourse” loan that restricts the lender to taking possession of the asset that was loaned against.

Multiport said that approximately 29% of all property held by its nearly 2,000 clients held a limited recourse borrowing arrangement over a property in the December quarter, compared with 24% using LRBAs in the previous quarter.

“It appears the majority of new property purchased during the quarter utilised a limited recourse borrowing arrangement,” Multiport said.

The interest is not totally unexpected. Debt (both deductible investment debt and non-deductible consumer debt) has been a dirty word for a very long time. Certainly in the media – and by most investment professionals operating across many investment markets – debt reduction has been a virtually unquestioned holy grail that all investors should aspire to.

Before the Global Financial Crisis, debt was rampant across the board in investment circles. Between 2003 and 2007 in equity markets, if you weren’t using debt you were getting inferior returns.

From late 2007, the heavily indebted (including myself) had their leveraged positions smacked twice as bad, if not more, as investment markets tumbled, slumped, then spiralled.

In a cyclical sense, debt might have hit a low point quite recently. Potential proof of this was another survey released this month by debt collection agency Dun & Bradstreet that said consumers’ intentions to take on new debt fell to its lowest level in three years in early 2013.

But anyone who’s had medium-term involvement in investment markets knows that investment debt is different. Debt is a tool that creates leverage – both good and bad.

Using “other people’s money” has the potential to ramp up potential returns, and can play a vital role in wealth creation (although in recent years it has, largely, aided wealth destruction).

We’re a world away from 2007

Prior to 2007, SMSFs and investment debt were close to a no-go area. Not quite, but the ability of SMSFs to gear was extremely limited.

SMSFs, traditionally, have not been allowed to borrow. Before September 2007, SMSFs were effectively limited to three types of investments that involved debt.

1. Self-funded instalment warrants;
2. Internally geared managed funds; and
3. Instalment shares (such as the Telstra IPOs).

But in late September 2007, just five weeks before the peak of the Australian market on 1 November, 2007, the rules got changed and gearing was opened.

Without going through a considerable history of SMSF gearing, which I’ve covered in previous columns, the rules have changed a few times since 2007.

They’re now known as limited recourse borrowing arrangements (LRBAs).

LRBAs allow SMSFs to gear into, potentially, any asset that a super fund would normally be allowed to invest in, which could potentially include cash, rare coins, wine, fixed interest, currency, artwork, collectibles, cars and many other things.

Largely, however, that’s going to be shares and property. And here are the main ways that SMSFs can get some gearing into them.

LRBAs – the basics

LRBAs are, as the name states, a “limited recourse” loan that restricts the lender to taking possession of the asset that was loaned against.

That is, if a lender loaned $300,000 against a property purchased for $400,000, and the borrower (the SMSF) ran into difficulty and failed to make repayments, then the lender would only be able to sell the property to recover its loan.

If the property was sold for $200,000, then the lender would lose $100,000. It’s not that simple, but that’s the theory.

In practice, the loan needs to be used to purchase a “single acquirable asset”. It needs to be made via a “bare trust” that holds the asset on behalf of the super fund.

LRBAs – property

As I wrote in this column (Property gets a bigger tick in SMSF changes), the LRBA rules seem to be set up for property gearing. A building on land is seen to be a “single acquirable asset”.

If you are purchasing an existing residential investment property with an LRBA, then you need to understand that this is essentially what the new laws are designed to encourage, but that it’s still not something you can do without the aid of SMSF professionals, potentially including financial advisers, lawyers and accountants.

For more about how LRBAs work for property investment, punch “property” into Eureka’s search engine, then refine your search by ticking “Bruce Brammall” under author.

LRBAS – shares

The “single acquirable asset” rule is a problem for shares. It means that if you want to have a diversified portfolio, but have them all geared, you’re going to need to spend quite a bit on bare trusts and the ensuing corporate trustees.

That is, if you want to buy a portfolio of eight shares – just as an example, BHP Billiton, CBA, ANZ, Telstra, Wesfarmers, Rio Tinto, CSL and Westpac – then you’re going to need eight bare trusts and potentially, depending on who is lending you the money, eight corporate trustees.

And a bare trust/corporate trustee set-up isn’t cheap. Depending on the quality and the supplier, they might cost you several thousand dollars each.

If, however, you were intending to “just gear into the market” with an exchange-traded fund, a listed investment company, or something broad in which you only needed one trust, then it can be far more cost effective.

But even then, to justify the cost of a few thousand dollars in set-up costs, per investment, might require each investment to be “property sized” and in the vicinity of several hundreds of thousands of dollars.

Borrowing – equity based investments

There are cheaper gearing options, and they’re more traditional.

Geared equity funds, which generally use about 50% of investor funds and 50% gearing, can do quite well, partly because they are constantly able to regear (which the above scenarios cannot).

The two biggest in the geared Australian equities space come from Colonial First State and Perpetual. For your interest, since 1 July, 2012, they have returned approximately 50 % each for the current financial year.

Several providers also offer options to do geared investing in international shares.

Instalment warrants and instalment shares

One conspiracy goes that the whole reason that the door got opened on SMSFs being able to use geared investments is because the then Howard government wanted to help ensure the success of the first Telstra float – Telstra T1.

But prior to that, self-funding instalment (SFI) warrants were available – as were internally geared share funds – so the door had always been at least slightly ajar.

SFIs died, at least temporarily, in late 2008. Instalment warrants, often with annual resets, replaced SFIs, but have not enjoyed the same popularity they had prior to the GFC. If gearing is going to return as a serious investment proposition, then you can bet the major providers will be back with more products soon.

Is debt-based investing making a comeback?

In all likelihood, it is. And, if not now, then it will at some stage in the future.

The last time that debt was a serious wealth creation tool was in 2007. Well, that’s the last time it worked properly.

Actually, that’s not completely accurate. Geared residential investment property has been a good contributor for wealth generation over much of the same period, even if the last two years haven’t been fabulous. And that includes for SMSFs.

If ramping up your risk, via debt, inside your super fund is something you’d be willing to consider, then the options are broad.

But gearing is not for everyone. If you’ve never geared in your personal name, outside of super, then inside super is unlikely to be the place for you to give it a try now.

However, gearing does have its place for those who are aware of the risks and do have a long-enough time frame to make gearing work.

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, through his SMSF, is a long-term investor in both Colonial First State’s and Perpetual’s geared Australian share funds and is an investor in self-funded instalment warrants. He was also a client of Lift Capital, an early lender in the SMSF gearing space, which collapsed on customers in April 2008.

Outside of super, he is also a strong user of gearing strategies, for both property and shares.

He is director of Castellan Financial Consulting and the author of Debt Man Walking. E: bruce@castellanfinancial.com.au

• The Australian Securities and Investments Commission (ASIC) has confirmed it has received more than 1,300 applications for SMSF auditor registration, less than three weeks after registrations opened. Speaking at the SMSF Professionals’ Association (SPAA) national conference last week, ASIC commissioner Greg Tanzer outlined the importance of competency for those conducting SMSF audits and the standards that would have to be met.

“Competency requirements are a very important part of the process ... we expect some people won’t meet the new standards,” Mr Tanzer said.

• As detailed above, Multiport Investments has found that SMSF investors are increasingly taking advantage of limited recourse borrowing arrangements to buy property.

Multiport’s SMSF Investment Patterns Survey found that in the December quarter, 29% of direct property holders had a gearing arrangement in place, up from 24% in the previous quarter.

“Some clients have become more conscious of where their money is and the attraction of property is that it’s a known asset,” AMP SMSF administration head of technical services Philip La Greca said.

• A leading lawyer has warned that many SMSF trustees are unaware of the risks associated with a director becoming incapacitated and that it’s an issue needs to be addressed.

Speaking at the SPAA national conference, Bryce Figot of DBA Lawyers, said that many people are ignorant of the legal issues that can arise and have an impact on the fund if one of the directors becomes incapacitated with a serious illness or injury. 

“Planning for loss of capacity is vital but it is rarely talked about,” he reportedly said.