Borrowing to invest
An SMSF is allowed to borrow money to acquire an asset which the fund is not otherwise prohibited from acquiring, however strict rules apply. All loans must be undertaken through a limited recourse borrowing arrangement (LRBA) which means the lender’s rights are limited to the asset that’s being acquired, this is to minimise the risk to other assets within the fund.
It must comply with the sole purpose test which states that your fund needs to be maintained for the sole purpose of providing retirement benefits to your members, or to their dependants if a member dies before retirement. Therefore buying a property should be looked at objectively in terms of whether or not it represents a good investment in the first place, with particular consideration given to timeframe.
Another limitation imposed under the LRBA rules is that, while normal repairs and maintenance may be undertaken, improvements and renovations are not allowed using money borrowed under the LRBA. So you can’t, for example, use borrowed money to add additional rooms to a residential property. However, you can use non-borrowed money, such as accumulated funds held by the SMSF, to improve (or repair or maintain) an asset. However, any improvements must not result in the acquirable asset becoming a different asset.
For this reason, it’s recommended that specialist advice is sought before buying property within an SMSF.
Does property investment align with your strategy?
Two other considerations for SMSFs investing in property are:
- How the property aligns with the investment strategy of the fund
- Whether it enables the desired level of diversification within the fund, rather than concentrating risk in one single asset
“It’s important to look at expected return and how that matches up with what you need to fund retirement expectations,” says Craig Day, Colonial First State’s Executive Manager, Technical Services.
Day adds that another important consideration should be the ages of members, given the impact on cashflow that ongoing property costs can represent.
“Consider maintenance and property management fees and all those other things,” he says.
“Once you are in pension phase your fund has to pay out a minimum amount as a pension and as you get older that steps up."
For example, a 65 year old with an account based pension will need to receive a minimum pension of at least 5% of the account balance calculated at the beginning of each year. However, at age 75 that jumps to 6% and then again to 7% at 80.
“So you need to take into account the fact that a property may not be able to generate enough rent to cover all the costs as well as fund the required minimum pension payments at some point in the future. Even where the property does generate enough rent, a property could still cause cash flow problems where the property becomes untenanted for a period," says Day.
Consider situations where people, particularly in their 50s and 60s make use an LRBA, and then one of the members of the superannuation fund is injured, or need to retire earlier than expected. Not only can the initial plans be interrupted, but there may be pressure to sell the property to either meet repayments or to provide a pension or both. This forced selling may be at an inopportune time in terms of realisable value.
There are also the general risks of investing in property that it’s important to be aware of – particularly when borrowing to invest. This includes risks such as interest rate volatility, potential decrease in market value of the property, and the possibility that it may be difficult to sell the property when you need to.
Other options to gain exposure to property
Beyond so-called ‘real’ property, which can have steep entry and exit costs attached, there are other methods for both SMSF and non-SMSF investors alike to access this asset class.
Real Estate Investment Trusts (REITs), which pool money from many investors and use this to buy and manage property assets, are one method to gain indirect exposure to the property market. The portfolio of properties within a REIT might include retail space, office space, aged care complexes, residential units or a mixture of these.
Units in a listed Australian REIT (A-REIT) are publicly traded on the ASX, for example through an on-line broker such as CommSec, and provide income to unitholders in the form of distributions and if the properties within the REIT’s portfolio increase in value over time then this also has the potential to provide capital gains to investors.
Another option for investors looking for easy access to a range of property investments are managed funds.
Providers, such as Colonial First State (CFS) offer a range of different funds that invest in property globally, actively managed by professionals who select and review investments with the aim of delivering on the fund’s stated risk and return objectives.