Planner paper trail widens

The Australian TaxationOffice (ATO) estimates there are currently over 370,000 self-managed superannuation funds (SMSFs) holding approximately $245 billion in assets. Trowbridge Deloitte has forecast this will rise to a massive $490 billion by 2011.

While many industry commentators have speculated that with the advent of ‘simpler super’ the growth in such funds may slow down, this certainly doesn’t seem to be the case, with SMSFs forecast to hold more assets than any other superannuation structure by 2021.

Given the new incentives for transition to retirement arrangements, tax-free income streams from superannuation after age 60, greater awareness of salary sacrifice potential and the combined structuring of transition to retirement and income replacement strategies, there is likely to be even greater need for advice from professional advisers.

The need for advisers to find suitable investment products that generate consistent, tax-advantaged income streams is likely to generate more interest in unlisted property trusts.

According to the IFSA/Investment Trends (February 2006) SMSF Trends Report, “60 per cent of SMSFs hold property of some kind (residential, commercial or listed property trusts). In total, 31 per cent of SMSF assets are in property.”

Added to this the recent changes to superannuation contribution limits and the ‘last chance’ for the $1 million undeducted contribution, it is likely that a significant part of the flow of pre-June 30, 2007, contributions into SMSFs has come from ‘contributions’ of business real property. Clearly, SMSF trustees view property as a favourable asset for SMSFs.

One of the important restrictions placed on SMSFs under the Superannuation Industry (Supervision) Act 1993 (SISA) is that funds cannot borrow (with limited exceptions) to invest.

SMSFs are therefore prevented from gearing to acquire direct property investments.

However, they can invest in managed funds that have the ability to borrow and thus effectively acquire direct property investments in a geared environment.

Listed below are some of the advantages of using a managed fund, specifically an unlisted property trust, to invest in direct property assets.

Diversification

The SMSF itself is likely to be able to hold only one or maybe two direct property assets (generally residential property or business real property assets) because of the high cost of the assets and because the fund is unable to borrow for this purpose.

Pooling the SMSF investment allows the fund to participate in a managed investment vehicle that can borrow and which, due to the pooling of many investments, can acquire any number of properties.

Low cost of entry

Most unlisted property funds will accept initial investments from around $10,000. If the SMSF is looking to acquire a property directly, even a modest property may cost $200,000-plus.

Liquidity

Property held in an SMSF may be highly illiquid. Take, for example, the business premises from which the members/ trustees may be conducting their day-to-day business. If one member ‘retires’ or otherwise leaves the fund this may result in the premises having to be sold in order to pay a benefit. Some unlisted property trusts do have liquidity facilities. While these facilities may be limited, in general, this is sufficient to pay withdrawal benefits under normal circumstances.

Tax deferred distributions

Unlisted property trusts pay distributions most often on a quarterly basis while some pay monthly distributions. Often a significant proportion of the distributions paid to investors is likely to be tax deferred.

Tax-deferred distributions are not required to be declared as taxable income by the investor (SMSF) in the year they are received, but will reduce the closing tax value (previously known as the cost base) of the investors units in the trust. This reduction in the closing tax value may, depending on the investor’s circumstances, result in a higher taxable capital gain on disposal of the investment. Should the SMSF be in pension phase, with all assets of the fund being used to support the pension payments, then, of course, the income and capital gains of the fund are not then assessable.

What this means to your client is the possibility of tax-deferred distributions in accumulation phase and zero tax on distributions and capital gains in pension phase.

Leverage

SMSFs can invest in unlisted property trusts. These unlisted property trusts can borrow to increase their access to capital in order to acquire more property than they would otherwise be able.

The level of borrowings is described in a fund’s Product Disclosure Statement generally as a loan to valuation ratio (LVR). A higher LVR is indicative of a more aggressive borrowing policy. This gives the trust the opportunity to achieve greater diversification, by asset type and also geographically. The trust can generally borrow at much more favourable rates than an SMSF would be able to if it were allowed.

Yield

The typical direct property investments for SMSFs are residential and relatively low cost business real property (generally commercial or industrial). Current yields on properties changing hands today are residential 3.5-4.5 per cent and commercial 5-7 per cent. Some of the income generated may be tax deferred.

Typical unlisted property trusts, with diversified assets of commercial, industrial and retail properties, are today generating yields of 7-8.5 per cent, sometimes with up to 100 per cent tax deferral.

However, it is true to say that yields are tightening and the differential between achievable yields and interest rates being charged on borrowings has also been contracting. Longer term, it may become difficult to source quality properties at yields that justify the added risks inherent in borrowing.

Other Considerations

When looking to invest in an unlisted property trust, one should consider such other matters as the current portfolio of assets, type, geographic location, occupancy/ vacancy rates, weighted average lease term, quality of the tenants, ability of the trust manager to add value (their experience and past record) and, of course, the costs of investing in a particular trust.

Property will no doubt continue to be a significant asset of SMSFs.

Stephen Payne is a business development manager (Victoria, SA and Tasmania) for the Cromwell Group.