Since borrowing to buy property through your self-managed super fund (SMSF) was made legal in 2007, thousands of Australians have added real estate to their retirement portfolios.
The flurry of property market activity driven by SMSFs has recently been noted with some concern. In September, the Reserve Bank of Australia (RBA) warned residential property investment through SMSFs may be contributing to the formation of a property bubble.
Yet a vast majority of real estate assets held in SMSFs are commercial in nature. As of June 2013, the Australian Taxation Office (ATO) reports non-residential properties worth a total of $58,604 million were held in SMSFs, compared to only $17,509 million worth of residential assets.
As Australians clamour to secure a worry-free retirement, commercial property provides an alternative strategy for SMSF investment.
Arranging to buy commercial property through an SMSF
Borrowing money to buy property through an SMSF, whether residential or commercial, is more complicated than borrowing as an individual.
Before any transaction can be made, the super fund trust deed and the investment strategy documents must be updated, according to the SMSF Professionals’ Association of Australia (SPAA).
In addition, SMSF members must ensure the correct trust structures are in place.
“The investment must be held in a trust that’s called a holding trust or a bare trust,” SPAA director Graeme Colley says.
The bare trust holds ‘legal’ ownership of the property, while the SMSF is given ‘beneficial’ ownership over any profits or liabilities.
In practical terms, this means the holding trust is the owner of the property, but the SMSF profits from the rent and makes loan repayments, Mr Colley explains.
“On the repayment of that loan, it’s possible to transfer that investment back to the self-managed superannuation fund,” he says.
Ideally, Mr Colley suggests the trustees of the bare trust should be different from the trustees of the SMSF.
The trustee of the bare trust could be either an unrelated individual or a company, with the SMSF members as directors.
This corporate option is preferred by many banks and non-bank lenders, Insight Accounting senior partner Anthony Karadeas says.
With the correct legal structures in place, the would-be investors can now talk to their lenders.
By law, an SMSF can only borrow money through a limited recourse borrowing arrangement (LRBA). In case of default, the bank’s claim is limited to the specific property under mortgage.
“If something were to go wrong with the loan, the actual funds within the super fund itself are 100 per cent protected and not at any risk,” Mr Karadeas explains.
However, many lenders may also require a personal guarantee from an SMSF member, Liberty Financial general manager, commercial finance Suresh Pillai says.
As a result of the guarantee, the member’s private assets may be at risk if loan repayments are not met.
Most banks require a loan-to-value ratio (LVR) of 60 to 70 per cent for a commercial SMSF loan, Bellevue Capital Financial Services director Julian Fadini says.
e bank may also consider the strength of the premises’ primary business and the five- to 10-year outlook for the industry when making a decision, he explains.
The fund member’s business can deduct the cost of the rent from their tax bill, while the incoming rent is added to the super fund’s balance
Limitations on SMSF investment
The government has placed strict limitations on what SMSFs can do with their borrowed funds.
SMSFs are only able to invest in a single acquirable asset when taking out a loan.
“A general rule is that a single acquirable asset, when you’re looking at land, is the title over that land,” Mr Colley says.
The ATO commissioner has ruled a property will be considered “a single acquirable asset” where either a substantial structure covers multiple titles or where the titles must legally be dealt with together.
Examples given by the ATO include a piggery built over two titles, or a parking lot and shopping complex that can only be sold together.
For residential properties, super fund regulations prohibit the SMSF from buying from, or renting to, a relation or friend of an SMSF member, Mr Karadeas says.
However, these restrictions do not apply to commercial property.
As a result, a business owner could sell their work premises to their SMSF, then lease them back.
However, these assets must be dealt with on an arm’s length basis, Mr Colley says, meaning they must be sold or rented for a fair market value, as certified by a valuer.
In addition, superannuation laws state the property must be used for the sole purpose of improving the balance of the fund.
“If I use the property because it’s my super fund, then I must pay a market rate for the use of the property,” Mr Colley explains.
Finally, investors should keep in mind borrowed money may only be used for maintenance or repairs of the property, not improvements. ATO guidelines suggest renovating the office kitchen may be acceptable, but adding a second kitchen may not.
Where renovations are financed by the SMSF outright, the asset cannot be changed so fundamentally as to create a new asset.
As a result, the owners of a car wash could add additional car washing bays but could not convert the facility into a retail shop, according to the ATO.
Benefits of buying commercial
The greatest advantage of buying commercial over residential property is that fund members can sell to, and rent from, their own SMSF.
The fund member’s business can deduct the cost of the rent from their tax bill, while the incoming rent is added to the super fund’s balance, Mr Karadeas says.
Rather than spending hundreds of thousands of dollars with no asset to show for it, the money goes towards paying off property in the SMSF portfolio, Mr Fadini explains.
In addition, when a business goes bankrupt, property held within an SMSF will not be liable to creditors, according to SPAA.
Tax effectiveness is a major incentive to buy your commercial premises through your SMSF rather than buying it in your business name, Mr Karadeas says.
“SMSFs have the concessional tax treatment, which is 15 per cent. And then further to that, once the members hit over 60 years of age, the income and capital gains can become tax free if they enter into pension phase,” he explains.
“That’s a huge tax advantage there, avoiding people paying tax at the marginal rate at two to even three times that amount.”
Purchases through an SMSF also attract a stamp duty concession, Mr Fadini says.
Even if the premises are rented to unrelated businesses, commercial tenants offer benefits over their residential counterparts.
With commercial property, tenants are responsible for ongoing maintenance costs, so that outgoings to the owner are minimal, Mr Pillai says.
In addition, loan periods for commercial properties tend to be more favourable to the owner.
“Commercial properties are typically leased for longer periods of time than residential properties and can command higher rental yields – in the five per cent to eight per cent range,” Mr Pillai says.
This can be especially attractive for older investors hoping to secure a steady income stream for their super fund, Mr Karadeas suggests.
Commercial properties are typically leased for longer periods of time than residential properties and can command higher rental yields
Pitfalls of buying commercial
While buying commercial property through an SMSF may seem attractive, this strategy is not for the novice investor.
“There are different risks associated with commercial property, which make it a little harder,” Mr Karadeas says.
Firstly, the pool of tenants is limited by the fit-out of the premises, its location and broader industry trends.
“Some commercial properties have a specialised nature, which means there will be a limited pool of potential tenants,” Mr Pillai warns.
To determine a tenant’s creditworthiness, owners may have to evaluate the strength of the business and its future growth. A failed business may impact on the value of the commercial property and limit its appeal to tenants of a similar nature, he says.
The high failure rate of businesses makes commercial tenancies an especially risky undertaking.
Data from the Australian Bureau of Statistics (ABS) shows one in four medium to large organisations failed between 2007 and 2011.
“Those businesses are going to be the tenants of these commercial properties,” Mr Fadini reminds investors.
Vacancies can also be longer than for residential investments, he says.
“If investors borrowed to get into that property and it stayed vacant for five years, or even six months, and they don’t have adequate cash flow to support that property, that could turn into a real disaster for them,” he explains.
Radical changes in a particular industry may also impact on the viability of a commercial property. Mr Fadini gives the example of a warehouse near a highway, which may lose value if the industry shifts from road transport towards rail.
As such, investors who are not up to date with industry trends may be putting themselves in a vulnerable position.
Many of these risks can be mitigated by leasing to a fund member.
“If you’re renting it from yourself and you’re involved in a viable business, you have certain control over that level of risk because it’s your business. If you’re operating in a viable fashion, you should be okay,” Mr Karadeas suggests.
Even for these investors, however, liquidity may be an issue.
For all but the wealthiest SMSFs, a property purchase will tie up a large percentage of the fund’s resources, Mr Karadeas says.
As such, cash flow may become an issue if the property is vacant or a fund member dies or retires.
Unlike shares or other nontangible investments, property cannot easily be converted to cash, Washington Brown director Tyron Hyde explains.
This may be especially problematic if the fund has no insurance covering death or incapacitation benefits for a fund member.
To ensure pay-outs can be made where necessary, SMSFs without insurance would need to hold some kind of liquid asset, such as a bank account, Mr Karadeas says.
A lack of diversification may also be a concern. Holding a large portion of the fund in a single asset may make a super fund vulnerable to property market downturns.
“You talk to financial advisers and they tell you that diversification is the key to investing, not to have all your eggs in one basket,” Mr Karadeas says.
However, he believes investment strategy is a personal choice that must be adapted to the investor’s comfort level.
“The feedback I get from clients since the global financial crisis is that a lot of people tend to steer clear of the share market and are more drawn towards property.
“They feel there is greater stability there and less volatility,” he says.
Who should consider it?
The people best placed to invest in commercial property are business owners intending to buy their own premises.
“We have seen a lot of owners seeking to invest in commercial properties so they can hold their premises via an SMSF,” Mr Pillai says.
Mr Fadini suggests companies with 15 or more employees are most likely to profit from this approach.
“Rent is a real cost to that business, even if it’s tax deductible,” he says.
Where people are considering buying to rent, Mr Karadeas advises caution.
“I would just say someone well suited would have some sort of experience dealing in commercial activity, whether by running their own business or being involved in commercial property,” Mr Karadeas says.
He suggests salary/wage-type earners, even mum and dad investors, could pool their funds to make up the deposit and the costs associated with the purchase.
However, they should be aware commercial property transactions come at a higher cost and are more difficult to administer, he says.
Buying commercial property through an SMSF has the potential for high returns, but also comes with undeniable pitfalls.
“I would probably lean more towards it being a good thing provided the investor gets the appropriate advice leading in to it,” Mr Karadeas says of this growing investment strategy.
However, he warns that property spruikers may lead people to decisions that are not right for them and their portfolio.
“Running your own self-managed fund is quite an involved affair and it’s a big commitment that you’re making because it’s usually a considerable sum,” he says.
“I think the key is seeking advice before you go into it because it can be a very good investment if it’s handled in the correct way.”
Commercial property investment remains the dark horse of the SMSF space, steadily growing but largely ignored in the public forum. While home purchases may be a safer, more familiar investment for a majority of Australians, the commercial strategy offers the possibility of great rewards – albeit with corresponding risk.