Super is an alternative avenue for property investing that has very little, to no, impact on personal finances or your future borrowing capacity.
Even though the superannuation space is highly regulated, with a thorough understanding, the rules and regulations serve to make a property purchase in super a very straight forward and predictable process.
If you already have a property outside of super, you may be familiar with the standard purchasing requirements. This article serves to highlight the differences between purchasing a property within an SMSF to a standard property transaction.
On completion of this article you should have a better understanding of how a property is purchased in super, the purchasing timeline and the investment road blocks to avoid that can cause delays.
There are 10 ways we have identified where buying property in super differs from normal property purchases…
The following differences have been ordered intentionally. Failing to satisfy one of these steps and proceeding with a property purchase in SMSF could see you incur unnecessary and avoidable costs or the purchase being unable to complete…
#1 A reasonable fund balance
Just like any standard property purchase you need borrowing capacity, however, within the Superannuation environment lending criteria is far stricter – there are no guarantors from non-members and generally, lenders won’t approve high loan-to-value ratios (in excess of 80%). In order to facilitate borrowing for an investment property purchase, you will need a reasonable fund balance, at a minimum $150,000 or approx. 40% of the investment property value.
For more detailed information on property investing using your super, we have prepared a comprehensive beginners guide available for download here.
See #4 for more information on lenders requirements.
#2 You will need an SMSF
You are unable to purchase direct property within retail or industry superannuation funds and you are unable to purchase a property using your superannuation funds outside of an SMSF. There are establishment costs and are approximately $3,000.
Note: If your primary reason for establishing an SMSF is to invest in property, it is important you have a reasonable fund balance (capacity for property investing) before spending the money to establish an SMSF.
Prior to establishing an SMSF you should also be confident in your investment choices or the investment advice you are receiving (See #5 and #7) and are informed about your responsibilities and obligations as an SMSF trustee.
#2a Updated trust deed
If you are already a trustee and your SMSF trust deed pre-dates 2007, you will need to update the trust deed to allow for borrowing. It is also recommended your deeds are reviewed regularly to ensure they reflect current legislation and regulation changes.
In September 2007, the rules relating to borrowing within a self-managed super fund were relaxed, although the specific type of borrowing arrangement now permitted within SMSFs is still subject to strict requirements. The borrowing rules were further fine-tuned and on 14 September 2011, the ATO released a draft SMSF ruling clarifying the rules applying to limited recourse borrowing arrangements (LRBA).
#3 Put in place an appropriate trust structure
Fund balances and investments are held within your SMSF; this also applies to any property investments as long as the Fund owns the property outright. Where you have to borrow to invest, a specific holding trust is required for the investment until the loan is repaid.
Even though your geared property investment will be contained in a specific holding trust (bare Trust), the SMSF will have beneficial ownership. This means your SMSF will be credited with income and capital growth from the investment, while the trust has legal ownership. Legal ownership can be transferred to the SMSF once the asset is fully repaid. This structure is in place to protect other investments held in your SMSF.
Note: Borrowing arrangements also differ for investments held in your Self-Managed Superannuation Fund, more information is available in #4.
This type of structure favours the SMSF more so than the lender, resulting in:
- An increase to the amount of paperwork required to establish the loan
- Lenders minimise excessive risk through stringent lending criteria
Important Note: You as the Trustee are unable to sign any contracts to purchase property until the Trust Deeds have been properly executed. We have seen too many investors caught out by signing a ‘contract to purchase’ in the wrong entity names thereby making the whole process longer and complicated, not to mention costly.
#4 Source an appropriate SMSF lender
Just like standard mortgages, SMSF loans are subject to lending restrictions which will vary from lender to lender.
Unlike standard mortgages, there are a limited number of lending institutions that will lend to SMSFs and due to the holding trust requirements, you will need a Limited Recourse Borrowing Arrangement (LRBA). A LRBA limits the lenders liability to the asset within the trust and does not include any other investments within the SMSF.
When borrowing in an SMSF the lending institutions will generally restrict you to a loan-to-value ratio (LVR) of 70% or below. Whilst you can get up to 80% LVR for residential security, lending criteria is stricter and more funds are required to remain in your SMSF after the transaction is completed.
As a general rule lending institutions will require 10% of the proposed property value to remain in the SMSF as liquidity post transaction (this can be cash or managed funds). Having a cash buffer within the fund to allow for loan repayments and investment expenses would be wise.
Note: While some lenders will allow you to use all funds without the liquidity requirements, this would be reserved for SMSF’s with strong servicing capacity (covered in the next article).
Borrowing requirements in the SMSF space can vary greatly between lenders, so you should speak to an experienced SMSF broker to establish your borrowing capacity.
#5 Have an investment mind set
An SMSF must satisfy the Sole Purpose Test, which means your superannuation fund is maintained for the purpose of providing benefits to its members upon their retirement (or attainment of a certain age).
When it comes to investing, professionals take a very analytical approach to investment selection and property is no different.
When selecting property, consideration of the income and capital growth potential may provide better long-term benefit to an SMSF than choosing a property based on somewhere you might like to retire.
For more information on property investing and determining the potential income and growth drivers, see this short video – achieving the best results when investing in property.
#6 Not all property types are appropriate
Both Commercial and Residential property can be purchase in an SMSF. Whether you are considering commercial or residential, if property is the funds main asset, this could be considered risky due to the lack of diversification.
Commercial Property includes office space, factories, warehouses etc and offer the SMSF investor the opportunity to buy their own premises and lease it back to themselves. For self-employed this can offer a way to increase contributions in super as rents are paid into the Fund.
Note: If you are not self-employed, commercial property is generally more expense than residential property and may require a larger fund balance to meet purchasing obligations.
Residential property includes houses and units and can offer a lower entry cost and provide the opportunity to invest in an asset class you understand and are comfortable with.
#6a Not all property is eligible
There are defined rules set for the types of property you CANNOT purchase within an SMSF; these include:
- Buying the property from a related entity (this includes yourself)
- Transfer a property you currently own (unless it’s a commercial property) into your SMSF
- Rent the property to someone you know, such as your children
- No renovators – If using a loan to fund the purchase, you are not allowed to improve the value of the property
- No developments – The property must be a single acquirable asset, so no land and build or developments allowed
Note: While the SMSF cannot use the borrowings to ‘improve’ a purchased asset, the borrowed money can be used to ‘repair’ or ‘maintain’ an asset.
#7 You need an investment strategy
An important area for an SMSF that is often overlooked (and not a requirement for standard property purchases) is an investment strategy.
An investment strategy is a written document of what your expected rates of return should be, how incomes will be paid (especially important in pension phase), how your investment holdings will be split, what your SMSF can and cannot invest in and considerations for your insurance requirements (see #9 for more information on risk management requirements).
An investment strategy can be limited or broad in its definitions.
Note: During an audit the first thing your SMSF auditor will look at is the Funds investment strategy to ensure your investments meet the set guidelines. E.g. if you have specified that your investments will not include derivatives, you could be in breach if your chosen investment fund is investing in derivatives.
#8 Not all property developers and agents will accept SMSF purchases for property
Property investing in SMSF is still a relatively new investment avenue. Buyers, mortgage brokers or financial planners inexperienced in the SMSF space can unintentionally delay the settlement process causing problems for developers and vendors. For this reason, it is not unusual for developers, and to some lesser extent vendors, to exclude sales to SMSFs.
Note: To avoid investment roadblocks, be clear with your vendor that you will be purchasing property within an SMSF.
#9 You need a Risk Management Strategy
A risk management strategy should consider two main areas, everything that can be covered by insurance and everything that cannot. While this is broad, it is a legislative requirement for you to consider your insurance needs particularly where borrowing is in place (this forms part of the investment strategy).
A risk management strategy should consider an exit strategy…
Members should consider potential changes in mental capacity or a provision for the simplification of affairs (winding up an SMSF). Where a property investment is held, how will the property and associated loan be handled in the event of death or disability of the member(s)?
Where members have pooled assets, and these are not easily divisible, such as in the case of property, consideration should be given to the exit requirements, if there is insufficient cash available and a member/s exit will assets need to be sold? In the case of death or disability, insurances could be the mechanism used to meet cash flow shortfalls.
Important: It is Murphy’s Law, at the time of an unexpected pay out “the market will be falling” and as a result you may not realise the actual value of an asset being disposed.
#10 Ensure longer settlement timeframes
In an ideal situation, a property purchased in SMSF should settle in a similar timeframe to property purchased outside of super, however if it is your first property investment in SMSF it is recommended you opt for a longer settlement period.
Plan ahead for an SMSF property investment …
Performing your SMSF due diligence prior to placing an offer to purchase is highly recommended, doing so afterward could see you struggle to meet purchasing requirements, incur unnecessary costs and fail to settle on the property.
What you should have prior…
- An SMSF with an appropriate trust structure in place
- An appropriate lender sourced and financial capacity to meet their stringent lending requirements
- An investment strategy documented
- An understanding of the types of property you can invest in
There you have it – 10 Ways Buying Property in Super Differs from Normal Property Purchases.
The superannuation space is highly regulated
It should be clear there are a few more steps to complete when purchasing a property in SMSF.
We hope reading this article has made you better informed about the rules and regulations associated, and that you view the differences we’ve highlighted as a straight-forward and predictable process rather than a prohibitive one.
Our goal is to highlight your responsibilities during the purchasing process and show you the importance of taking a process-driven approach.
If you are still considering property in SMSF, completing your SMSF due diligence will help you determine if this strategy is affordable; and if you choose to proceed, ensure the SMSF setup, lending and investing process is a smooth and enjoyable one.