One of the most appealing elements of a self-managed super fund (SMSF) is the flexibility to invest in a wide range of asset classes, including investment property.
But those who want to add real estate to their SMSF need to consider a number of factors before they jump into a residential or commercial property purchase.
As a trustee of a self-managed super fund, it is your responsibility to identify and understand the risks involved with any investment you choose to make on behalf of your fund and its other members.
When it comes to investing in property through your fund you need to consider the following aspects:
Diversity is an important element of most successful investment plans. Including a variety of assets within your portfolio will provide a safety net should the value of one of your investments decrease. If a large proportion of your fund is tied up in one single investment class, such as real estate, this has the potential to expose your fund to an unacceptably high level of risk should the value of that property fall.
If you need a loan to purchase a property, one of the most important elements to consider is your fund’s liquidity. Will there be sufficient cash to cover any difference between the rent you earn from the property and the required mortgage repayments? Will the fund be able to make those repayments if the property is not tenanted for any period of time, or if member contributions decrease for any reason, such as unemployment?
Even if you don’t have a mortgage over the property, you still need to consider your fund’s cash reserves, especially as members approach retirement. Once a member begins drawing an income stream (or pension), the fund must make minimum periodic benefit payments into that member’s account. Failure to fulfil these requirements has a number of consequences. You don’t want a lack of liquidity in your fund to force you to sell the investment property as a means of raising cash.
The flow of cash into the fund is crucial when those contributions are being used to make mortgage repayments. This needs to be assessed not only in terms of the fund’s ability to meet current obligations, but its capacity to absorb any future increases. While we are currently enjoying an unprecedented period of low interest rates, how would a string of rate rises impact on the fund’s ability to meet a higher level of repayments?
If you’re purchasing a commercial property through your fund, which is being leased by a fund member’s business, you’ll also need to consider the cash flow position of that business. If the business is not financially sound you could be introducing unnecessary levels of risk into your fund’s investment strategy.
As anyone who has ever been involved with a self-managed super fund would know, there are a host of rules that govern the process. As a trustee of that fund, you need to make sure you know and understand all of the guidelines, and stay on top of any changes that are made to these rules.
There are a couple of rules in particular you will need to pay close attention to when considering your fund’s investment strategy:
In order to receive superannuation tax benefits, your fund must be maintained for the sole purpose of providing a retirement benefit for members. This means you will need to be able to show how any investment you make, including purchasing property, will increase members’ retirement income.
Breaching the sole purpose test can have serious consequences, which could include the fund losing its concessional tax treatment, or trustees facing civil and criminal penalties.
Self-managed super funds must carry out all transactions on an “arm’s length” commercial basis. In the case of investing in real estate, this means that the price paid to purchase the property and any rent charged to future tenants should reflect true market rates. Residential property cannot be bought from or rented by a member or a related party of a member. Commercial property can be leased to the business of a fund member, but only if there is a formal lease arrangement in place and market rents are being charged. The member’s business must also ensure all rent is paid on time, as late payments could result in the property being classed as non-compliant.
Investing in property through your super isn’t limited to those SMSF that have enough cash to cover the full purchase price. However, there are strict rules and different conditions that apply to borrowing through your fund.
This is the term used to describe the type of loan available to SMSFs that need additional cash to purchase a property. This type of arrangement is designed to protect the other assets within the fund. If the fund fails to meet its repayment obligations, the lender only has “recourse” against the mortgaged property to recoup its money – it cannot access the remaining assets in the fund. Further there is a structure that must be established which incorporates the asset being held in a bare trust.
This “limited recourse” can make this type of loan a riskier proposition for banks, and as a result they will often have tougher eligibility criteria, such as requiring the fund to have a deposit of anywhere between 20% and 30% depending on the type of property.
These loans often have far higher costs compared to traditional mortgages, which need to be factored into the fund’s cash flow calculations, while the fund also needs adequate cash reserves to cover the other costs of buying a property such as stamp duty, government charges, legal fees and valuation fees.
You also need to be aware that while the asset remains in the superannuation environment it cannot be used as security for any other purpose such as to acquire further assets.
In recent years, and particularly in the wake of the Royal Commission into the banking industry, some lenders have started to move away from this type of loan arrangement, making it harder for SMSFs to access funds to purchase property. Most of Australia’s largest financial institutions, including the Commonwealth Bank, Westpac, NAB and AMP have either ceased accepting new applications from SMSFs looking to buy residential property, or pulled out of the space altogether.
This doesn’t mean there isn’t any money out there for this kind of investment, with many other lenders still offering Limited Recourse Borrowing Arrangements for eligible applicants.
Regardless of whether you’re an individual seeking a second income stream, or a self-managed super fund looking to diversify your asset classes, real estate remains a valid long-term investment option. It’s suitability however, as with any investment decision, comes down to your individual circumstances.
Booking an appointment to speak to one of the Partners at HQB can help you weigh up all the pros and cons involved, to ensure you make the best decision for your financial future.
The information contained in this blog has been provided as general advice only. The contents have been prepared without taking account of your objectives, financial situation or needs. You should, before you make any decision regarding any information, strategies or products mentioned in this blog, consult your own financial advisor to consider whether that is appropriate having regard to your own objectives, financial situation and needs.
Paul Chakos Limited Authorised Representative 1240159 of Merit Wealth Pty Ltd, Australian Financial Services Licence 409361, ABN 89 125 557 002.