One of the reasons trustees decide to establish a Self-Managed Superannuation Fund (SMSF) is to be able to invest in property. For many trustees the two key options are residential and commercial property.
Residential property means a house, cottage, apartment or unit in which someone is going to live. Under SMSF rules, the property cannot be owned or used by a member of the fund or any relative of a member.
Commercial property includes business premises and is generally sub-divided into a number of sectors such as office, hotels, rural and agricultural, industrial, retail and healthcare.
Under current superannuation legislation, a super fund may borrow to purchase a property, provided the borrowing is a Limited Recourse Borrowing Arrangement (LRBA) adhering to strict rules. This means in the event of a default the security for the loan is limited to the specific property and the lender is not able to take any other fund assets. If the LRBA is not set up correctly, there may be significant stamp duty and taxation implications. It is important to obtain specialist advice in this area and to use a lender experienced with LRBAs to ensure compliance with the legislation.
Before deciding a residential property is the right choice for your fund, there are a number of factors to take into consideration, such as:
- Anticipated rental income
- Potential vacancy rates (time when the property is not tenanted)
- Interest on any borrowings used to purchase the property
- Repairs and maintenance (note that you are unable to borrow money to improve a property under a LRBA, you may only repair it. If you want to improve the property you must use money that is already in the fund)
- The time taken to manage a property if you do not use an Agent
- The risk of being over-invested in residential property if additional residential property investments are held including the investor’s home.
Other less obvious considerations include the age of the members; and whether holding a large illiquid investment in the fund is appropriate if the members are approaching retirement. Minimum pensions will be required to be drawn from the fund and this may not be possible unless the fund has other investments to provide adequate cash flow. Another consideration is whether the fund should hold insurance to be able to pay a death benefit to non-dependant beneficiaries if a member dies while the property is still held in the fund.
In addition, diversity across other assets, property types and areas is not possible with a single property. Unless the area has been chosen well, the returns can be less than expected. For example, many investors bought properties in remote mining towns during the resources boom but found later that the property values declined severely and they were unable to find tenants.
Further, any gearing higher than 50% may lead to negative gearing (interest and expenses are higher than income) but within a SMSF the investor cannot claim the loss against their personal income. It can only be claimed against other income of the fund. If the property is the single largest asset of the fund with no cash flow then this can compromise the ability of the fund to provide appropriate retirement benefits.
An alternative method of holding property in a SMSF is through unlisted or listed property trusts, which are also known as syndicates. Unlisted single property trusts invest across all the types of commercial property outlined earlier.
Single property trusts are usually established to purchase a specific commercial property and have a limited duration (which can be 5 to 10 years) and are managed by specialists in the field, such as Trilogy Funds.
Property trusts have the major advantage of being more affordable, i.e. you can invest t $50,000 into a trust instead of outlaying $500,000 for one property; and the assets are managed by experienced property managers. Because the dollar entry point for property trusts is lower than for a single residential property, it is easy to develop a portfolio of property trusts. This enables the investor to achieve diversification by choosing a portfolio where the underlying investments are diversified by type of commercial property (retail, office and industrial), location (urban, regional and rural) and duration (anticipated term to redemption).
Rental returns on commercial property are generally higher than for residential at around 8% to 8.5%pa. Also for property trusts, much of the return is tax-advantaged due to tax deferred components, which are usually not available to residential property investors. Management costs of around 1%pa are generally offset by the income benefits of borrowing 50% of the property at around 6%pa. The net effect is to deliver a 7.5% to 8.5%pa annual income return to investors.
Overall, while commercial properties are harder to lease if they become vacant, they should provide a greater income return than residential properties geared to the same level. Another key benefit is that the property trust managers arrange for any borrowings within the trust, whereas direct residential property borrowings must be arranged by the trustee of the SMSF. The managers of property trusts are also not limited in their ability to improve properties.
In terms of capital returns, residential properties have generally provided greater returns than commercial properties largely due to the lack of supply of new properties. While residential leases are usually for no more than twelve months they are generally easier to re-lease.
The lower capital gains on commercial properties are partly because commercial property may need more frequent refurbishment than residential properties. However commercial properties with long leases provide greater certainty in growth as annual rent increases are normally locked in over the period of the lease contract. The skills and experience of the manager of the property in obtaining high quality and high profile tenants is of paramount importance in determining the long term value of the property.
Comparing the two
The following table provides a summary of the differences between direct residential property and commercial property owned indirectly through a property trust when held in a SMSF.
|Taxation||Direct Residential||Indirect Commercial|
|Income at 15%||Applies||Applies|
|Capital gain at 10% but no tax on capital gain in pension phase||Applies||Applies|
|Negative gearing only against profits in the super fund||Applies||Applies|
|Cannot live in the property||Applies||N/A|
|Debt Funding||Need to arrange your own debt funding||Manager arranges debt funding|
|Security for loans is limited to the property||Applies||Applies|
|Ability to improve property||Limited with strict rules||Not limited|
|Income returns||Low||Normally higher|
|Management||Usually requires more direct management||Professional manager|
|Depreciation benefits||Need to source a quantity surveyor report||Manager arranges for benefits to be claimed by the Trust|
|Diversification||No||Able to achieve sector and geographical diversification by purchasing units in different syndicates|
Investments in property, either directly or indirectly through well-managed property trusts should be undertaken with the guidance of a suitably qualified adviser.
Find out more about Trilogy Funds’ managed trusts at www.trilogyfunds.com.au
Disclaimer: While every effort is made to provide accurate and complete information, Trilogy Funds Management Limited does not warrant or represent that the information in this article is free from errors or omissions or is suitable for your intended use. Subject to any terms implied by law and which cannot be excluded, Trilogy Funds Management Limited accepts no responsibility for any loss, damage, cost or expense (whether direct or indirect) incurred by you as a result of any error, omissions or misrepresentation in information. Note: All figures are in Australian dollars unless otherwise indicated. This information is issued by Trilogy Funds Management Limited (AFSL 261425) and provides general information only. It does not provide financial product advice nor is it an offer of securities. Applications may only be accepted by completing the applicable application accompanying the relevant PDS. If you require personal advice on the suitability or other aspect of this investment, consult a licensed adviser, who will conduct an analysis based on your circumstances. Past performance is not a reliable indicator of future performance. Mortgage trusts are not bank deposits and are not government guarantees.