What you need to know about Investing in Property using an SMSF Loan
Investment in residential and non-residential property makes up about 15% of total SMSF assets in Australia, which makes it a very important part of an investment portfolio for many SMSFs.
So, what do you need to know about investing in property using an SMSF loan?
Let’s answer this question in two parts.
1. Why invest in property? and
2. Why use an SMSF loan to do it?
Firstly, every SMSF should have an investment strategy – the ATO will want to know if you have one (see the ATO’s discussion on investment strategy here). If you are not confident putting an investment strategy together you should seek the professional services of a financial adviser. A good place to start if you need to learn about this is ASIC’s Moneysmart website.
An investment strategy will articulate the investment decisions you (as the trustee of theyour SMSF) need to make to meet the financial objectives of the members in retirement. Investment decisions are typically what assets to buy and sell to best meet those financial objectives. Property forms one “class” of asset, alongside other asset classes like shares, bonds and cash, that your SMSF can invest in.
1. Why invest in Property?
Unfortunately, there is no precise answer to this question. It can only be considered in the unique context of your SMSF and the financial objectives of the members at a point in time. However, we can discuss in broad terms the things you may want to consider when you are working out whether property should be a part of your investment strategy.
High level, these include:
Long term stability of rental return and resale value
Let’s take a big step back. All asset classes are subject to volatility, which is a function of many things like market conditions and, to put it bluntly, the changing value of the asset to society. Volatility means the rate at which the income (returns) generated by the asset, and its residual or resale value, changes over time. It is common to say, “Volatility equals risk”, and also “The greater the risk the greater the return”, otherwise, why would you buy an asset with greater risk without getting compensated?
An SMSF’s investment strategy is GENERALLY to progressively invest in less riskier assets over time. That is, by the time members reaches retirement and starts drawing down on their pension they should be minimising as much risk as possible.
Here are some examples of assets with different risk/return profiles:
a. Cash. Cash has a very stable value, but its returns are low. You know with a very high degree of certainty what cash is worth and you have the ability to redeploy it quickly. But cash makes a very poor long-term investment, especially if an SMSF is trying to grow its value for its members in retirement. Alternatively, if the members are already retired then cash might be the best investment to ensure their retirement savings won’t change in value.
b. Bonds. Bonds can generate a higher return than cash but there is a very small risk (for most bonds) that the issuer may default and not return your investment. For some bonds you may also find it difficult selling them when you need the cash so you may have to hold a bond to its maturity. Also, an SMSF invested in 100% bonds may not deliver the investment returns sought by members in retirement.
c. Shares. Shares involves more risk, but the returns are also generally higher. There are a very wide variety of shares to invest in and they all perform differently so selection and diversification is very important.
For example, say a while ago you invested in the shares of a company that managed a chain of video stores. This may have been a very profitable business for many years paying large dividends. But quite rapidly, when videos lost their popularity to online streaming, your investment might have become practically worthless (unless you were smart enough to invest in Netflix which changed its business model from video delivery to movie streaming!).
d. Residential Property. If you select your property location and property condition well, you can be highly confident that an investment in property will generate a steady rental income that may even increase over time in line with property values. Of course, over time property values can go down as well as up, but the rate of change is generally lower than say shares. Unlike the video rentals example above, you know someone will want to live in your property because people need a place to live. It’s not like property will go out of fashion or become technologically obsolete any time soon.
e. Commercial Property. Alternatively, take your investment in shares of the video store business. If instead you owned the commercial premises that the video store rented, you might be exposed to that video store closing down, but its highly likely you will find some other business to rent your property when that happens. Therefore, you are not really exposed to the nature of a single underlying business like you are with shares.
For a better idea how asset classes perform relative to each other we recommend looking at the Vanguard Asset Class Tool. It can be used as a reliable source for comparing the performance of different assets classes over different periods of time. Australian Property has been a consistent performer over long timeframes.
But please note, this tool will not tell you how to construct a diversified investment portfolio for retirement. If you are in doubt, please consult with a professional financial adviser.
So, to summarise this point, property can deliver a stable income stream that is perhaps less volatile than other asset classes over the long term. This may suit an SMSF well into its accumulation phase and also into its early stage pension when the liabilities of the fund are predictable.
Familiarity with Property
Residential and commercial property have traditionally been popular and well-understood asset classes for Australian individual investors. Perhaps this is because property can be seen, touched and managed by the investor – very much unlike shares in a company. Other financial assets like shares or units in a managed fund for example de-couple management from ownership – mainly because it’s too time consuming and complex for an individual investor to undertake. Even though this is a sensible thing to do it is not preferable to all investors, particularly SMSF investors.
Familiarity with an asset class speaks not just to confidence in how it is managed, but also how it is valued. It is can be difficult working out how to value a company, so you rely largely on the value set by the forces of demand and supply in the stock market. The same forces of demand and supply impact property and rental markets but it’s easier for an individual investor to observe and understand how this works by looking at rental income (less management costs) of the investment property. It is also easier to compare properties and rentals in the area and make an assessment on how this impacts your investment and how its value may change over time.
Property may not be as quickly or cheaply saleable (or “liquid”) as other financial assets but the property market is very large and generally, for many of the reasons we have discussed here, you are very likely to find a willing buyer at the right price.
Buying and selling property is very expensive. On top of agent and legal fees you have stamp duty, which can represent a material portion of the property’s value. Therefore, an investment in property is not for the short-term. A sensible investment horizon should be around 10 years.
2. Why use an SMFS Loan to do it
Using an SMSF loan in most cases is the only practical way for an SMSF to acquire property. This is due to the large purchase price of property relative to the size of the fund.
But the SMSF investor must be aware of the risks associated with borrowing (otherwise known as financial leverage) that can impact the fund’s asset diversification, liquidity and risk profile during its investment lifecycle.
Let’s take a closer look at these elements:
a. Diversification. An investment in a single asset can increase the fund’s exposure to concentration risk, that is, the risk that a single asset comprising most of the assets of the fund may not perform to expectations. Borrowing allows the SMSF to deploy part of its capital to equity in the property investment, as well as other assets to balance out the risk of concentration. Borrowing does however increase financial leverage and the risk of a property investment, but this is somewhat mitigated by the limited recourse nature of an SMSF loan (see this link on what limited recourse means). We talk more about financial leverage below.
b. Liquidity. Here we are referring to the availability of liquid assets like cash to meet unexpected liabilities of the fund. Borrowing to meet part of the purchase price allows the fund to carry extra liquid assets for this purpose. Consideration of the right level of liquidity to carry in your fund should be a discussion with your financial adviser.
c. Risk Profile. As discussed, borrowing increases financial leverage, which increases risk, which, in some circumstances, can increase your long-term return (remember above where we said “The greater the risk the greater the return”). BUT borrowing doesn’t make a bad investment good, and it can make good investment bad. Borrowing creates a debt servicing commitment for your SMSF, which in certain adverse circumstances may exceed your SMSF’s income. This could force your SMSF to sell its property investment before planned at a potential loss.
This is why a full assessment of your SMSF’s capability to manage an SMSF loan is important to do with the assistance of your mortgage broker, the lender and your financial adviser.
The good news is that overtime the risk falls as the loan is gradually repaid, and this can match up very well with your SMSF’s investment strategy as the members move towards retirement.
In conclusion, an investment in property can be well-suited to some SMSF investors who are investing for the long term. However, the risks, especially from borrowing, need to be well considered. A good starting place is the Moneysmart website provided by ASIC. This link is to their discussion on Property Investment, which touches on some of the topics discussed here.
Take care and happy investing.