Strategy Considerations
In this section we will look at four simple issues for SMSF’s and their gearing and investment strategies, namely:
- Self Funding Warrants [ Goto ]
- Servicing the Shortfall [ Goto ]
- Diversification [ Goto ]
- Covering Your Bases [ Goto ]
These cover the most common and important issues to ensure that SMSF trustees will have a positive experience in investing via PowerSuper warrants into direct property.
IMPORTANT: When it comes to using an instalment warrant, a number of long term planning issues need to be addressed, some of which pertain to the non super environment. Hence ideally a holistic perspective should be used to assess the suitability of the use of instalment warrants for SMSFs.
From a funding management perspective solely, it is assumed that trustees and their advisers will have addressed the following issues:
- Capacity to service any shortfall in the returns via contributions to super, keeping in mind the contribution caps.
- The timeframe for which the SMSF will hold the asset; the use of instalment warrants may not be appropriate for older superannuants.
- The amount of superannuation to establish a fund.
- The needs and requirements for insurance such as life cover and salary continuance.
- Cashflow management in the fund to cover taxation, and running costs of the fund, and insurance (if applicable).
Self Funding Warrants
Using SGC contributions to pay off the loan, this strategy minimises exposure to interest rate issues.
Gearing will generally be around the 50% LVR to allow for property expenses etc.
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Servicing the Shortfall
In a case where the investment loan interest exceeds any rental return on the property, the SMSF will be operating on a balance between the LVR and the cashflow/contributions required to service the loan interest and ongoing costs to the fund.
This type of strategy is generally suitable for trustees who want to contribute sufficient funds until retirement and then crystallise property assets as required to provide cashflow for a pension - and particularly to be able to sell the property with no capital gains tax implications - or to retire on the rental income generated from unencumbered property.
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SMSF Diversity is Key. Or is it?
All superannuation funds are required by the Superannuation Industry (Supervision) Act 1993 to "give consideration to the benefits of diversification" in formulating the investment strategy for the fund.
And indeed, this is somewhat the cornerstone of the financial planning community, as it should well be. It's a key plank in the armory of the public offer superannuation funds, and, obviously, the index funds. In truth it's also a cornerstone in many managed funds even if they have a mandate such as 'Australian shares'. Funds invest in a range of stocks across the niche they've chosen.
Diversification has its place
All well and good. Perfect for Joe Punter, and clearly in line with what trusteeship of a SMSF should be all about. As the legislation implies, the trustee of a SMSF must accept that they are acting in a reasonable third person capacity. This is the average person who is presumably intelligent with reasonable ability to rationalize decisions, who has the norms and behaviors of an average person. (No, I've never met him either.)
But let's consider again those lines in the Act; "give consideration to the benefits of diversification". How should that apply to our reasonable man, our Mr X.
What about Mr X?
What if Mr X was a stockbroker by trade and had a strong and ardent belief that a company was undervalued with very good prospects for growth? What if Mr X had met with the managing director and has confidence in the company board? Mr X after much analysis believes the company could be a strong long term investment for a SMSF. Why should he not, after such significant research, invest heavily into that company, and perhaps even have a top 20 shareholder position in the company?
Lumpy property investments?
Could the same logic apply if Mr X was an ardent follower of property investing? If he applied similar analysis to property? For example; is this a growth suburb, what infrastructure does the suburb have? Is it close to transport, shops, shopping centres? Is the property in a cul de sac or main road, what zonings will impact on the property price, what other developments are being built in the area, etc...?
Don’t discard diversification
Now, none of this is to steer SMSFs away from diversification. What this article is focusing on is the choice and discretion of the trustee to make intelligent, rational investment decisions. There has to be significant analysis of the available information, consideration of the timeframes to retirement, the benefits of diversification, the risk mitigation choices if an investment does not perform, and the expected returns, growth and general performance of the proposed asset. And after, in other words, due 'consideration to the benefits of diversification'.
The reality of investing
It's also, in some senses, reality. SMSF's trustees do appear to prefer having lumpy assets in their fund, whether this is shares in Commonwealth Bank or a property in Sydney CBD. Does this really matter? How do you criticize the person who bought $20,000 worth of Commonwealth Bank upon floating which are now worth $250,000? And still paying a decent yield!
Your responsibilities
Diversification can provide protection. It's also a must for someone approaching retirement when cashflow and stability in the fund performance is crucial, as is the ability to provide consistent pension payments. But it's also a slow way to grow. Pouring much of the super fund's cash into one or two assets might provide the growth many are looking for. The responsibilities incumbent on a trustee are:
Review your asset’s performance regularly
- Give serious and considerable analysis to lumpy asset allocations
- Have a thorough knowledge of the lump investment
- Fully consider the risk management that diversification enables
- Have due regard for the age of the beneficiaries
Having an SMSF is a decision that should be carefully thought through before jumping in. The benefits of diversification are many, and are very well founded. However, for those people who prefer taking a specific investment prerogative with a full understanding of the risks they are taking, it does not mean that the SMSF will be non compliant.
We strongly encourage any person to seek professional guidance from an accredited financial adviser who specializes in SMSF's or SPAA Professional member prior to making investment decisions. This article is to highlight merely one element in developing a compliant strategy for an SMSF.
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Covering your bases
As many will know, the 24th of September 2007 will go down as a red letter day for anyone comfortable with property as a direct investment. Prior to the 24th it was a difficult proposition within a super fund, but not so now.
This was the day, of course, when instalment warrants within a super fund became law. You may be thinking, well, big deal – so let me remind you of the advantages:
- You can buy direct property and gear this investment within your super fund.
- The loan is non-recourse (that is, the maximum extent of loss to your fund is your deposit. Your fund cannot be liable for the debt).
- The investment is in an asset protected environment.
- If the property is sold after your retirement, than no capital gains tax is payable
- Your super guarantee and salary sacrifice contributions to super is going into a specific investment of your choosing
Hallelujah! But... (there's always a but, isn't there?) the reality requires a little sobriety. This is because charlatans and others of a similar ilk, have bolted from the stalls like a favourite in the Melbourne cup to promote the opportunities that arose on September the 24th 2007. Be wary of the vast array of people out there presenting this way and that way of doing it.
Some have harsh clauses, such as the ability to seize the property should the property value go down, or charge hefty entry or exit fees to leave. Some do not allow you to choose the property manager and in other cases, particular where small businesses are transferring their existing business premises into super, some schemes appoint a property manager where none is needed.
Some require third party trustees which is another additional cost burden, aside from the fact that clients are generally unwilling to give away control of their superannuation assets.
Many more require personal guarantees or other terms which may cause compliance problems down the line.
Even something that sounds as innocuous as an annual review can create an enormous headache, never mind the opportunity to slug you with another fee every year.
The questions to ask of any group promoting instalment warrants include:
- Is financing available (we’ll address this in a moment)?
- Are the owners or promoters of the properties associated?
- Is the developer or builder of the properties associated?
- In effect, is the instalment warrant promoter entirely independent of the properties for sale?
- If not, ask yourself why they need super fund sales to sell the properties. Could it be they’re targeting super fund people to garner better than market prices for the property? Surely not.
A healthy sceptic might also wonder, if a property developer is involved, is it because they are looking to offload properties that aren’t perhaps ideally located.
The rule of thumb, we suggest, is to make sure that at the very least, you select the property to invest in, not take their 'suggestions'.
Now to finance. The issue of bank funding is not a small one, as the current market conditions are placing constraints and limitations on anything the banks are unfamiliar with. Whilst banks still like bricks and mortar, as soon as the loan is attached to a trust structure, and is non-recourse in nature, they may kick up a little. PowerSuper has facilitated a competitive finance package, from a well-known global bank, but you should ensure that you qualify for a loan, by using the "How Much Can I Borrow" calculator and applying for a preapproved limit. Please note that if you have a bad credit history, we will not be able to help.
Finally, if you do not already have an SMSF, make sure a DIY super fund is the appropriate vehicle for you.
Regardless of how attractive the idea of controlling their own fund may be, it is important to remember that superannuation is a complex area and setting up a SMSF involves a substantial commitment. You need to be across all the details. That is one reason why we insist that all applications for a PowerSuper Warrant come via an accredited adviser.
It is also vital to know what superannuation entitlements can be transferred and which may not. For example, federal government employees and employees whose super is in a defined benefit fund, will most likely not be able to move.
Find out also if you can choose where to have your super contributions paid.
Investing in a super fund is a long term plan. Make sure adequate insurance is in place or contingencies, such as maternity leave, redundancy, illness and so on.
None of this means taking out an instalment warrant is bad, just be aware of your ongoing commitments and how and when you can get out the warrant and at what price.
Summary
- You can select your own property.
- Ensure you have the ability to establish your own self managed superannuation fund,
- You have at the very least $150,000 in super, and that you can transfer that superannuation to your own self managed fund,
- Ensure you have the ability to direct future superannuation contributions to yourself managed fund; and
- Most importantly, that your future contributions will be sufficient to cover the interest costs of the warrant, the running costs of the fund, and any insurance requirements i.e life cover and salary continuance.
Finally, be sure to ENJOY taking responsibility for your financial welfare in retirement into your hands. If direct property investment is in your comfort zone, let PowerSuper help your SMSF to achieve your goals with compliance and confidence.
Damien Palmer CPA SSA
Managing Director
