Making commercial property work

What are the the merits of owning commercial property, including business real property, inside an SMSF?

SMSFs can reap real rewards from allocations to commercial property. Lauren Ryan takes a look at the merits of owning commercial property, including business real property, inside an SMSF, as well as some of the pitfalls.

Bill and Judy have always had the cooking bug. Back at university, when they were studying law, they liked nothing better than throwing a dinner party for select friends and spending all day preparing the food. On graduation, jobs beckoned in the legal field and Bill joined a large company as part of the legal team, while Judy took a role in a mid-tier firm specialising in commercial law.

But they never lost their interest in all things food, so much so that in their early-40s they decided to say goodbye to their legal careers and open a restaurant. They knew the odds were stacked against them, seeing as 80 per cent of small businesses survive the first year, but only half exist after five years. Compounding these numbers is the fact the restaurant business is highly competitive with failure often just one poor food review away.

But their passion for food, coupled with Judy’s understanding of what it takes to run a business, gave them the confidence to try their hand. Three years later they haven’t looked back. Sure the hours are long, but the business is growing with some tasty food reviews and word of mouth (especially in the legal fraternity) doing the trick, so much so that when the premises they were leasing came up for sale, they decided to use their SMSF to buy it.

It was a sound commercial decision. Their SMSF leases the property back to the business on normal commercial terms, allowing the business to claim the rent as an expense while the SMSF gets income. The lease payments will be deductible to the business up to 46.5 per cent, but inside the SMSF the rent is only taxed at 15 per cent.

The tax benefits do not end there. Bill and Judy’s SMSF has held the property for more than 12 months, so if they sell it, any capital gains tax on the property is levied at 10 per cent. And if they are taking a pension when they finally sell, they will be exempt from any capital gains tax.

There are other benefits, too. Superannuation is typically protected from creditors in the event of bankruptcy. As owners of the property, lease negotiations are a thing of the past, as too are any discussions over any changes they want to make to the property. All Bill and Judy must do is ensure the commercial relationship between the business, property and SMSF meets all the requirements of the Superannuation Industry (Supervision) (SIS) Act, for which they use the services of an SMSF specialist to guarantee they meet the letter of the law.

So, what are these requirements? They include:

  • before acquiring a property, it must be valued by an independent and qualified party,
  • the sale price must reflect market price,
  • the lease must be commercially competitive. The ATO takes a dim view of ‘mates’ rates’ and will want to be satisfied the rent is in line with the market rate,
  • in the same vein, the business cannot take a rental holiday; payments must be made in full and on time,
  • the premises can only be used for business purposes,
  • under the legislation, the property will need to be valued regularly, and
  • the investment must meet the sole purpose test, that being providing retirement benefits for the members of the SMSF.

What Bill and Judy have done is not exceptional. A growing number of small to medium-sized enterprises (SME) are using their SMSFs to buy their business premises. And of this number some are using debt – limited recourse borrowing arrangements – to make the acquisition following changes to the superannuation rules in 2007.

A growing number of small to medium-sized enterprises are using their SMSF to buy their business premises.

Lauren Ryan

But while there are sound commercial and tax reasons to use an SMSF to acquire business premises, there are also risks. As noted above, the transaction must be conducted on a commercial basis. If, for example, the business struggles and it becomes necessary to vacate it, will it be easy to find a suitable tenant? Remember, too, the SMSF is responsible for insurance and maintenance, which can be costly.

But perhaps the biggest risk is whether it is a sound investment. Over time will the property give the fund a healthy rate of return? For some individuals, the commercial reasons for using their SMSF to acquire a property can overshadow the long-term investment goal: to provide financial benefits on retirement. This can be particularly difficult when an SMSF has most of its funds in a large, single asset.

In this instance, it’s critically important to ensure the property acquisition meets an SMSF’s informed and best-advised investment strategy and in this sense it’s no different to buying any other asset.

As with any investment it’s impossible for it to be risk-free. But with property investment there are guidelines to help SMEs make this critical decision. In our opinion the market conditions are sound for SMEs to acquire commercial or industrial property. We are a little more cautious about retail.

In the commercial sector the secondary market (where many SMEs acquire premises) can be closely linked to the primary market, so rising prices in the latter will often have a flow-on effect on the former. At the moment, tighter vacancy rates in Sydney and Melbourne are pushing prices up across both primary and secondary markets, with the latest Property Council of Australia (PCA) figures showing there has been an improvement in all central business district markets’ vacancy rates, with demand the key driver.

In Sydney, landlords are predicting vacancy rates of well below 4 per cent, with the latest PCA figures showing they fell from 4.8 per cent to 4.6 per cent in the six months to July. And the Melbourne market is even tighter, with the vacancy rate hitting a 10-year low at 3.6 per cent.

A similar opportunity exists for SMEs in the manufacturing, construction and trades sectors of the economy, with the industrial property market benefiting from a stronger manufacturing sector as shown by the ACCI-Westpac Survey of Industrial Trends for the June quarter rising 4.4 points to 63.8.

Manufacturing continues to benefit from local apartment and infrastructure projects that are still boosting demand, with 37 per cent of businesses expecting the general business environment to strengthen over the next six months.

The end effect is a positive picture for industrial property, with the commercial and industrial real estate agent Savills highlighting stable rental levels across the country (except Perth), but with yields continuing to tighten everywhere (including Perth).

The outlook for retail is far more problematic, with this sector losing considerable ground in income returns over the past year. Recent MSCI data shows retail’s total return fell two percentage points from 10.4 per cent for the 12 months to June 2017 to 8.4 per cent for the corresponding period in 2018. While large retail had a better result at 10.7 per cent for the 12 months to June 2018, it was still 1 per cent less than the All-Property Index. More concerning was regional retail, with a return of only 5.6 per cent, down from 9.4 per cent in 2017, and capital growth becoming slightly negative compared with a gain of 3.4 per cent in 2017.

It’s too soon to draw definitive conclusions from these numbers for retail. But the long-term challenges facing retail have been well documented, including its likely follow-on effect on property in this sector. SMEs could be well advised to hasten slowly when adding a retail property to their investment portfolio.

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