Unlisted property funds had a stellar 2017, with total returns three times stronger than those of Australian equities, making it one of the year’s best-performing asset classes.
Average returns for unlisted property were 23.4 per cent for the calendar year compared to 7.7 per cent for Australian equities.
In addition to strong return potential, the high-income yields and low volatility offered by unlisted property are drawing the attention of SMSF investors.
SMSFs have traditionally had high allocations to equities, cash and residential property within their portfolios, but many are now looking beyond the softening residential market for their property exposure.
For SMSF investors who are considering an investment in unlisted property, here are some of the key characteristics of this varied asset class.
Monthly income and capital growth
Unlisted property funds provide an easy way for SMSFs to invest in professionally managed commercial property, which can produce stable monthly income and capital growth over the term of the investment. Commercial property is considered a mid to long-term income investment of five years or more, with returns and income that warrant a closer look. Over the past five years, commercial property has achieved an average return of 11.5 per cent and an income yield of 6.6 per cent.
Unlisted property funds can be either open-ended or fixed-term (syndicates). Open-ended funds don’t have a maturity date or a finite number of units. Instead, they continue to issue units so long as they raise money, using the new funds to purchase new property.
Alternatively, syndicates contain one or more properties that will be held for a specified period of time, usually five to 10 years, and at the end of that period investors vote on the future of the fund – whether properties are sold and investors paid out or if the fund will roll over.
If chosen correctly, unlisted property can offer a secure, affordable and lower-risk way for SMSFs to diversify portfolios using the commercial property market.
Diversification benefits
Diversify is a buzz word in the investment vocabulary, but what does it actually mean? SMSFs should consider diversification from a few angles, including asset classes, time frames and investment strategies.
For many SMSFs, their portfolio is diversified through property but with exposure solely to residential property, with most residential investment properties located in the same town as the investors’ principal place of residence.
Residential property returns could be affected by rising rates and tougher lending criteria. For these reasons, SMSFs should be looking at property options beyond residential investments.
When considering an unlisted property investment to increase diversification, it is important to consider the time frames of investments. For example, syndicates are generally illiquid assets and there is an expectation investors will remain for the full term, which is around seven years. Therefore, these time frames need to be considered in the investment strategy and investors should choose syndicates that come to fruition at different points in time to avoid losses due to a market downturn.
Furthermore, SMSFs should consider their investment strategies, such as growth, income or value. Unlisted property is an income investment, which is an important strategy for those SMSFs transitioning to retirement as it generally offers reliable, regular income.
Potential tax savings
In 2017, new superannuation rules provided a further incentive for SMSF investors to consider unlisted property. The new rules include restrictions on lending, which make it more difficult for SMSFs to undertake borrowing to finance direct investments in residential or commercial property.
A key measure is the new $1.6 million cap on tax-free savings held in a super pension account – a figure that includes the balance of any outstanding property loans. Funds with more than that amount must remain in the accumulation phase and are subject to tax (15 per cent on earnings and 10 per cent on capital gain).
While residential property in an SMSF can potentially leave investors with a tax liability, unlisted property funds can help investors to defer tax.
With unlisted property, a portion, usually 50 to 100 per cent, of a property fund’s distribution consists of a ‘tax-deferred’ component, representing a distribution of non-assessable income. Tax is deferred until investors have to pay capital gains tax (CGT), usually on the disposal of units. Depending on the individual situation, the tax benefits of this can be significant.
Below are some of the ways to take advantage of tax-deferred income:
- The tax-deferred component can be reinvested and the compounding benefit over time may be substantial.
- If units are held for more than one year, investors may be able to significantly reduce their tax liability by applying the 50 per cent discount for individuals or the 33.3 per cent discount for superannuation funds.
- Tax deferral allows for tax planning opportunities. For example, for those SMSFs transitioning into retirement, tax-deferred distributions received before transition to the pension phase may effectively be received tax-free if units are disposed of after transition.
How do you know which fund is right for you?
Unlisted property can be a secure, reliable, high-yield way to diversify an SMSF portfolio, but how do you know which fund is right for you? Here are some key considerations:
- Illiquid v liquid assets: Open-ended funds hold cash so investors can exit at any time. Syndicates are illiquid with an expectation unitholders will hold the investment to term, usually five to 10 years.
- Gearing: Unlisted property funds usually use gearing. It’s critical to ensure the gearing on the property asset is suitable to the situation. Gearing levels should consider the asset’s age and quality, the capital expenditure required on the asset and leasing metrics, among other things.
- Risk: Open-ended funds are slightly riskier as investors don’t have certainty over what the manager has invested in, whereas syndicates are transparent about the properties held in the portfolio.
- Management: Management expertise is an essential consideration as commercial property tenants usually have more complex requirements. Strong management will lead to longer leasing terms and better investment outcomes.
- Leasing terms: Investors in syndicates should ensure leases don’t expire before the syndicate closes.
- Fees and returns: Consider whether the fund has upfront, ongoing performance fees.
Unlisted property offers many attractive features for SMSF investors, including high yields, portfolio diversification and tax benefits. Yet it is also a diverse and varied asset class, so SMSF trustees should consider the investment objectives of their fund to select the investment option that best suits their individual needs.
Hamish Wehl is head of retail funds management at Cromwell Property Group.