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Keys to holding residential property

Ben Anderson

Residential property is very popular among SMSF members. Ben Anderson identifies the important elements to get right when investing in this asset class.

It is apparent as trustees move towards greater ownership and control over their own investments that we will continue to see SMSFs grow at a significantly faster rate than the broader superannuation and wealth management industry.

SMSFs now represent in excess of 35 per cent of the total $1.3-trillion retirement savings pool in Australia. Two commonly stated reasons for the move towards SMSFs are flexibility and control when compared to traditional industry and retail funds. A residential real estate investment within an SMSF is an important example of those two aspects, being an investment alternative not available within traditional funds while also offering direct ownership, control and a unique tangibility.

Although residential real estate investment within SMSFs currently only represents 3.6 per cent (about $16 billion), according to the Australian Taxation Office (ATO), the take-up rate continues to grow year on year. A recent Genworth survey indicated over 50 per cent of SMSF trustees surveyed regarded some form of residential real estate investment as an ‘attractive investment’ and would look at it in coming years, considering the recent downward trends in the equities market (domestic and international).

That indicates trustee interest in and awareness of their options and is likely to flow into greater SMSF investment in residential real estate. To illustrate this point, assuming the sector remains constant in size, however, allocation to direct residential real estate investments increases to 10 per cent, then this would represent $45 billion in asset value – a jump of 178 per cent from today or around $28 billion of inflows.

 

Managing the allocation issue

An obvious hurdle for advisers when managing clients’ portfolios is appropriate allocation to the sector in the context of model portfolio construction, given the sheer size of the average property value. Given the median Australian house price is $429,500 (higher in the major capitals of Sydney and Melbourne), the problem is obvious for a typical SMSF with a balance below $500,000. Until recently that has excluded direct residential investment for most funds. Assuming an allocation of 10 per cent in a $500,000 SMSF, that implies only $50,000, which is clearly insufficient for most property assets. Assuming a 20 per cent allocation, $100,000 may be sufficient to purchase a direct property, dependent of course on the level of borrowing available and considered appropriate. Not only is borrowing now permissible, it is accessible with a broad range of loan products available catering to the sector specifically. The statistics outlined indicate why certain locations and property types are being favoured by SMSFs (that is, regional locations and apartments where the typical price point is lower).

 

Borrowing to buy property through an SMSF

Borrowing to buy property through an SMSF can be a great way for an adviser’s client to manage their long-term goals for a comfortable retirement. However, any borrowing by an SMSF to buy a property can be time consuming, complex and, unless structured properly from the outset, can end up costing the trustees more money than is necessary and possibly making the SMSF non-compliant.

Developing the right structure

It is important that the SMSF client has a properly established SMSF structure – the trust deed needs to be complying and also have appropriate powers for owning direct property, and the SMSF’s investment strategy should be clearly defined to include real property and also borrowing. Generally, deeds before 2007 do not allow for borrowing and will require review and amendment. In addition, it is generally considered advisable that a corporate trustee be put in place as it is a requirement by some lenders or encouraged by way of favourable terms and conditions offered. For these reasons, among others, it is always advisable that the SMSF be established before a particular investment property is identified.

Constituent documents

Before acquiring any form of residential real estate asset(s), the SMSF trustee must establish a trust structure that allows for legal title to the property transfer to the SMSF trustee upon full payment of a loan without triggering legal and/or tax implications. Therefore, it is important the SMSF trustee gets the legal structure right from the start to mitigate such implications.

Trust work

Remember, the SMSF trustee must ensure the trust itself is properly constituted, which is generally known as ‘seeding a trust’. The trustee must ensure this is completed properly, otherwise more stamp duty than necessary can become payable by the SMSF trust.

Holding trust

In accordance with superannuation law, lending arrangements must be on a limited recourse basis. That means the lender only has recourse to the asset held by the holding trust and not to the trustees personally or to the assets within the SMSF. This is an important protection mechanism and makes the arrangements required quite different to a normal residential property purchase. It is advisable that an adviser reviews their client’s documentation carefully and seeks specialist legal advice where necessary in order to complete this task.

Lending guidelines

Before a client embarks on any property purchase, advisers should look at funding needs and ensure they are realistic and achievable given bank lending guidelines. The SMSF trustee must be capable of both funding the equity component of the purchase and making the loan payments for the lending arrangement within SMSF lending guidelines. Given limited recourse, lending guidelines are more conservative and restrictive. The loan-to-value ratios offered by banks to SMSFs have increased in recent years and it is now common to be able to obtain 65 per cent to 80 per cent. Generally, it is best to assume the client will require a minimum of 20 per cent equity after transaction costs and stamp duty. As with all debt-funded investments, proper servicing analysis should be undertaken.

Right asset

Selecting only investment-grade assets that offer potential for both reliable, ideally growing, rental income and long-term capital growth is critical if the investment is going to achieve the intended outcomes. Often that requires the assistance of an external investment property specialist with a strong knowledge of current market conditions, outlook and importantly the requirements of the client for that asset within the context of their overall investment strategy.

Negative gearing v positive cash flow

Given the lending guidelines in regards to debt servicing, not to mention the lower tax rates applicable, negative gearing may not be considered as attractive a strategy within an SMSF. Given concessional tax on net rental income, properties that can provide higher income generation, even positive cash flow, are often targeted by trustees as part of the investment strategy. Neutral or positive cash flow reduces the reliance on contributions to show debt serviceability and potentially assists the ability to undertake further purchases to construct
a portfolio.

Asset allocation of residential real estate investments is a major theme within the SMSF sector. For many trustees, property is an asset class which they feel they can understand and feel comfortable with. The control aspect of direct property ownership is also often a key driver. Given lower cash rates, continued equity market uncertainty and ongoing global sagas, it is likely the trend will continue into the future as trustees seek assets perceived to offer reliable income, capital protection and longer-term capital growth.

 

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