Australians love property. You can understand why when fortunes have been made through decades of rising prices. But beware….this enduring love affair has a dark side that is making regulators and lenders very nervous.
This great romance is now leaving the SMSF sector vulnerable to aggressive advertising and the hard sales tactics of unscrupulous property spruikers driven by huge commissions.
The Australian Securities and Investments Commission has issued repeated warnings to SMSFs about the dangers. Now, lenders are taking steps to protect their loan books from the fallout of what some say is a disaster waiting to happen.
Even astute and experienced investors, who are buying real estate for all the right reasons, have trouble with the technical requirements of holding property through an SMSF. Complicated rules overlay buying property inside super that don’t apply when holding property in your personal name.
But these complications shouldn’t put you off. For some, borrowing through an SMSF to buy property may make perfect sense.
The following checklist outlines how to avoid the potential pitfalls.
1. Make sure the strategy fits
The first step is to ensure buying a property is in line with your SMSF’s objectives and suits all of it’s members.
SMSF trustees should consider each member’s risk appetite, age and the suitability of holding an asset that can’t be sold at short notice. Funds with members who are approaching retirement and will soon need to pay pensions should take particular care.
Can you imagine if you can’t rent the property and you want to draw down a pension?
2. Assess the investment
Assuming property investment does suit all fund members, the next step is to objectively assess whether the property is a good investment.
Lenders that finance property purchases through SMSFs are wary of risky transactions and have started tightening their lending criteria to protect their loan books from exposure to deals that may go bad. Bank of Queensland is restricting the loan-to-value ratios it allows on loans to SMSFs. Bank of Queensland is also asking SMSF’s to retain a portion of their assets after settlement in cash or listed shares.
Westpac asks every borrower to have a financial advice certificate signed by a qualified financial planner or accountant. The advice certificate is about the borrower providing an undertaking to the bank that they have sought independent advice.
The adviser confirms there’s an investment strategy in place, that property investment is part of the strategy, that gearing the property is part of the strategy and that they have considered the risks of gearing in proceeding with this type of borrowing. It’s one way of ensuring the trustees understand what they’re getting themselves into before they proceed with the loan.
3. Fund the purchase
It’s wise to check ahead of time what loans are available if you plan to borrow to finance the investment. SMSFs must use a special type of borrowing called a limited recourse borrowing arrangement to buy property. With this type of loan facility, the lender has recourse to the property itself if the borrower defaults on repayments. With a standard loan, the borrower has recourse to the borrower’s other assets as well.
As a result of the limited recourse nature of any lending, most major banks tend to offer limited recourse borrowing arrangements on conservative terms.
RateCity has just started comparing SMSF loans.
Based on its initial research, the maximum loan-to-value ratio was 80 per cent, meaning SMSFs need a minimum 20 per cent deposit to buy the property. The rates on offer may not be as competitive as rates available with standard mortgages. The average advertised rate for SMSF borrowings on the mortgages RateCity assesses is 5.7 per cent, compared with advertised variable rates as low as 4.5 per cent for regular residential mortgages.
Lenders also carefully consider the risks of a particular property, forming a view on the expected rental yield and how easily the premises can be tenanted before deciding whether to lend. For example, Westpac won’t fund some commercial properties that were built for a specific purpose and can’t readily be used for another purpose, such as a freestanding McDonald’s store, pubs or petrol stations. Nor will it fund vacant land or rural property.
4. Set up the borrowing facility correctly
To comply with the super rules, the property ownership and borrowings must be structured correctly.
SMSFs can’t own mortgaged property directly. Instead, the property must be kept in a special holding trust. Your SMSF is the holding trust’s beneficiary. The property must be purchased in the holding trust’s name (not in the name of the SMSF or the individual members). The SMSF (not the holding trust) borrows the money that is then used to purchase the property. Rent from the property gets paid into the SMSF and the SMSF makes the mortgage repayments, and pays for any bills and repairs.
5. Plan ahead
You need to allow a bit of lead time to establish the SMSF and funding arrangements.
It’s a consideration to set up the SMSF and other borrowing entities before the property is purchased. This can sometimes be done later but it does complicate matters.
Investors should allow at least three weeks to establish the necessary trusts. People who are transferring money into their SMSF from another super fund, or who have to make extra contributions to cover the deposit, should allow more time for that money to enter the SMSF. It can take a month or two for money to be transferred from another super fund into an SMSF.
Borrowers should expect SMSF loans to take longer to originate than ordinary mortgages. Westpac says SMSF loans can be approved within a six-week settlement period as long as all documents are in order. Westpac recommends borrowers see an adviser, lawyer or accountant so when they come to the bank they are well prepared. Being prepared will help with loan approval.
6. One loan, One asset
Regulations require that a property purchased through a SMSF using a limited recourse borrowing arrangement be a “single acquirable asset”. Simply put, that means each loan must purchase one asset. There are a few instances where that gets tricky. One is with strata properties where the car space is listed on a separate title to the apartment. Another potentially contentious area is off-the-plan purchases.
SMSF members need to take care if buying properties with borrowed funds that need maintenance. You can borrow to cover the cost of initial repairs so long as the repairs don’t improve or change the property significantly. Changing or improving the original asset with borrowed funds is against the rules.
7. Manage the cash flow
Your SMSF has to maintain the property as well as make loan repayments. If the rental income is not sufficient to cover all of the expenses, the fund has to dip into its cash reserves or rely on member contributions to make up the shortfall.
Members who are too old to contribute to super may find it difficult to get necessary money into their SMSF. Similarly, members may not be able to contribute any more to their SMSF if they have already hit their contribution limits.
8. Have an exit strategy
Because property acquisitions are generally large you need to think about an exit strategy at the same time as you are contemplating an acquisition strategy. It’s unlikely the best result will be achieved if the property has to be sold in a hurry. SMSF trustees should have contingency plans in place to avoid becoming forced sellers.
There’s plenty there to think about isn’t there.
As I said earlier, people have made fortunes through property so there is no reason you can’t be one of them. All I ask is that you think about it long and hard before you take the plunge.
Bye for now
Source Zoe Fielding The Australian Financial Review Published 14 August 2013
Any advice contained in this webpage is of a general nature only and does not take into account the objectives, financial situation or needs of any particular person. Therefore, before making any decision, you should consider the appropriateness of the advice with regard to those matters. Please click here Financial Services and Credit Guide V10.10d to find out more about our financial advice services.