One reason why many people choose a Self-Managed Super Fund is because they want to invest in real property, direct property in particular. They are comfortable with brick and mortar investments, have a good understanding of how to make them work and believe that they are an important part of an investment strategy.
The nature of the SMSF property
While an ordinary superannuation fund can invest in property securities through managed funds and other means, they have very different characteristics than direct property. Managed funds will typically be limited to commercial property – offices and industrial property. They are a great way to get exposure to segments of the market that would simply be out of reach to the ordinary investor. But, for whatever reason, many such funds have struggled, especially through the Global Financial Crisis, and a number of investors are feeling a bit wary.
Direct property isn’t free from risk, by any means – whether or not it is held in a Self-Managed Super Fund. Careful research needs to be done, and because the SMSF property will often be only one individual property, the investor will be totally exposed to what happens with it. While their SMSF might only invest in one direct property, the overall portfolio can be diversified by including other classes of investments in the fund’s strategy.
The method of funding - SMSF borrowing
Given that you plan to purchase a property within your Self-Managed Super Fund, your funding choices are very limited. Historically you have only had one choice: pay cash. That can be a significant challenge for many Self-Managed Super Funds, especially if you also want the protection of diversification, which is very appropriate. In recent years, however, that has changed. Your SMSF can now set up a structure that will allow it to borrow.
It used to be that the SIS Act generally did not allow super funds to borrow. In Sept. 2007 that changed.[ii] As the government looked at the situation, the limited recourse borrowing involved in an instalment warrant seemed to be quite suitable for many superannuation funds. But as they mapped out the new rules covering instalment warrants in general terms it became clear that those rules could be applied to other types of investments as well, most notably, direct property.
So, under current legislation there is a way for a SMSF to invest in property and fund part of the purchase with a SMSF loan. There are very strict requirements as to the structures involved and other limitations.
Why should a SMSF borrow?
Just because you can borrow with your SMSF, it isn’t reason enough to go down that pathway. And the reasons why you would borrow to purchase an investment property outside of super don’t all apply to a purchase within super. For example, negative gearing isn’t much of a benefit for a super fund. It only pays tax at 15%, so there’s not a lot of tax savings. And negative gearing would mean that it would take the super fund longer to repay the loan and fully acquire the asset. But there are still good reasons why you might want to get a loan to purchase an investment property in your SMSF:
• It brings a SMSF property purchase within reach. As with any investment property, you may simply not have enough cash available to make the purchase. The loan makes it possible.
• You can purchase a higher quality property, which may equate to less worry. If all your SMSF can afford apart from the loan is a back alley rental special, you could find that the management and maintenance of such a property can be quite a hassle. But if you could afford a nice place targeting higher income earners, it might be easier sailing.
• It allows more diversification when holding property. Let’s say a Self-Managed Super Fund with two members has assets totalling $600,000. You would like to purchase a property for $550,000. That would take nearly all of the assets of the fund, and would leave you very exposed to the success or failure of that one investment. But if you borrowed 60% of the funds, you would have a little over half of your assets still available to diversify into other investments.
• As with any gearing strategy, using a loan multiplies returns. This can be good or bad, depending on whether the returns are positive or negative. However, given that you select a property well and it achieves significant growth, you generally should be better off as a result of the gearing. Essentially you would be targeting a total return (income + growth) that is greater than the average effective interest rate of your loan. See the box at the right for how to work out your total return.
Free SMSF Borrowing eBook
We have just begun to touch on what is involved in getting a SMSF property in this article. A great deal more is discussed in our eBook: SMSF Borrowing. To download your free copy, click here.
An important note about advice
As a lender, State Custodians has a credit licence under ASIC. They can therefore provide you with advice regarding loans, including a SMSF loans. Keep in mind, however, that any advice that we provide you through our website is general advice. It doesn’t take into consideration your situation or individual circumstances. You should seek professional advice from a variety of people with regard to the use of a Self-Managed Superannuation Fund, including an accountant, financial adviser, a credit manager and possibly a lawyer. Further details are included in the eBook mentioned above.
With regard to financial products we have done our best not to give you any advice. That is to say, we have not directed you towards any particular financial product or any class of financial products. You should seek such advice from a licensed financial advisor.
[i] Australian Taxation Office, “Self-managed super fund statistical report – March 2012,” www.ato.gov.au/superfunds, 8/6/2012.
[ii] Australian Taxation Office, “Limited recourse borrowing arrangements by self-managed super funds – questions and answers,” www.ato.gov.au/superfunds, 29/6/2012, pp. 2-3.