Direct property investment remains a popular investment option for SMSF investors, but it requires careful consideration before taking action. And could other property asset classes help SMSF investors achieve the same outcome, but perhaps in a better way?
One of the most appealing features of SMSFs is the control trustees and members can exercise over their investment choices. Property is the third most popular asset class for SMSFs, according to the ATO, and an asset class most investors are familiar with. However, investing within an SMSF poses a specific set of risks, rules and possible outcomes, which should prompt trustees to compare the risk, return and tax scenarios of all the different types of property investment vehicles available to them, including direct property investments, unlisted funds and trusts.
SMSFs and direct property investment
Superannuation funds have always been able to invest directly in property, but historically many SMSFs didn’t have sufficient funds to do so. The introduction of limited recourse borrowing arrangements (LRBA) in 2007 put direct property investment within reach of many more SMSF investors by allowing them to borrow funds to purchase assets within their fund.
Since then, SMSF borrowing has gained momentum, reaching $25.4 billion in 2016, according to the ATO, with 93 per cent of that borrowing being invested in real property assets. However, if borrowing through an LRBA, an additional level of cost and regulation can be added to the fund and its assets, which should be considered.
Whether investing in direct property within your SMSF via lending or accumulated capital, the investment should be evaluated for its suitability based on characteristics such as diversification, liquidity, management and cash flow, and the ability of the investment to contribute to the main purpose of superannuation, which is the ability to provide an income in retirement.
Depending on the overall fund balance, the level of capital required to invest in direct property can restrict diversification within the fund and therefore increase overall allocation risk. Investing in direct property can have a sentimental element, particularly when investors have an affinity with a certain type of property (such as residential or industrial) or a location, or based on past market experience.
While choosing direct property on this basis may appeal to the control element desired by many SMSF trustees, this same sentiment can potentially cloud some of the inherent risks of holding such a large amount of the fund in the one asset.
Lack of diversification can also increase the risk of breaching SMSF regulations. SMSFs are required to report their investment strategy to the ATO, and if the majority of capital is directed into a single asset, such as an investment property, the tax office may find the investment strategy is not robust enough to provide sufficient stability and achieve returns in line with the fund’s investment objectives. This can have unintended and often negative consequences for the SMSF.
Liquidity is a major consideration for SMSFs and again can be challenging if a significant proportion of members’ financial resources is tied up in an illiquid investment. This can be a significant issue on the occurrence of an unplanned event, such as the death or disablement of a trustee, or a divorce, each of which can require the fund to sell part or all of the investment.
This in turn introduces its members to sequencing risk as the trigger for the sale might be during an inopportune time, for example, a dip in the market, preventing the other members of the SMSF from being able to realise the capital growth they had estimated in their own retirement planning.
The fund also needs to cover the costs to hold and manage the property, including council rates, strata costs, water rates, maintenance and property management fees. Familiar direct property capital growth strategies, such as renovating an older property to sell at a higher price, can still be implemented, but must be funded from money outside of any LRBA borrowing arrangement. The strength of the property’s lease and tenants must therefore be considered when evaluating its suitability for the SMSF.
While the risks discussed can all be present in various degrees across all property asset classes, the concentration of a large amount of capital in the one asset within an SMSF requires additional consideration given the heightened overall risk to the fund.
Unlisted property funds and REITs
A more flexible option could be to invest in an unlisted commercial property fund or a property trust that can provide liquidity, diversification, capital growth and regular returns that may be more in line with an SMSF’s investment objectives, particularly for smaller funds.
Reports reveal unlisted property funds are one of the best-performing asset classes in the country, with an average annual return of 20.5 per cent for the year ending March 2018, and total annualised returns of 19.6 per cent over the five years to the same period, according to the Property Council of Australia/IPD Australia Unlisted Retail Property Fund Index.
Borrowing to invest in unlisted property funds or real estate investment trusts (REIT) is still an option for SMSFs as the rules allow for investment in a collection of identical assets that have the same market value, including parcels of identical shares (in one company) or units (in a managed fund). Gaining their property exposure in this way also relieves SMSF trustees of the responsibility of asset management, leaving the leasing, maintenance and financing elements to expert managers.
Fund selection can be tailored to capital growth or regular distributions, or both, depending on the objectives of the SMSF strategy and life stage of members. Liquidity can vary depending on maturity terms, with suitability again depending on the needs of the fund’s members.
REITs offer investors a property investment with the liquidity of shares. This can be especially useful when investors need access to cash or in the case of insurance payouts and pension payments, or when SMSF members exit the fund, where a partial selldown of the investments is required while still protecting the long-term interests of the remaining members.
Distributions from unlisted property funds and REITs can also include a tax-deferred component, representing a distribution of non-assessable income. This is made possible when the taxable income for the fund is less than the distribution income paid to investors, due to factors such as depreciation. The distributions have the effect of reducing the cost base of the units, ‘deferring’ the tax payable until capital gains are crystallised on sale.
For SMSF investors, this allows for tax planning opportunities around the timing of the sale of the units. Reduced or nil tax is payable on the distributions when received within the accumulation phase of superannuation due to the non-assessable portion. By deferring the sale of the units until the SMSF account is in the tax-free pension phase, the tax payable on the distribution income can potentially be eliminated altogether.
Summary
Superannuation and property can be complicated, so it’s a good idea to do your research. This should include finding an accountant or adviser who is qualified to provide advice on SMSFs and who can explain the complete range of options, including, but not limited to, borrowing to invest in direct property and the advantages of the potential alternatives such as unlisted property funds and REITs.
Hamish Wehl is head of retail funds management at Cromwell Property Group.