Should SMSFs be allowed to borrow?

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An irresistible combination of four massive numbers is causing a headache for financial regulators but a gold mine for many financial advisers and real estate agents: $4 trillion in residential housing, $1.9 trillion in superannuation, $600 billion in SMSFs and one million trustees. And Australians love property.

Reigning in the grab for a piece of this action is rightly in the sights of David Murray’s Financial System Inquiry, which has an entire section on superannuation borrowing: “This Inquiry shares the Super System Review Panel’s view that leverage should not be a core focus of SMSFs — or any superannuation fund — and is inconsistent with Australia’s retirement income policy.”

Financial adviser responsibility

The first priority for any financial adviser meeting a new client should be an explanation of investment risk. Only by determining risk appetite can a portfolio be constructed. Those who start with fund or property selection have the wrong foundation.

The risk discussion must be in terms the client can understand. It’s not volatility or standard deviations, but the risk of losing money. For example, the client must realise that over a typical 10-year period, the sharemarket will deliver negative returns in two or three years.

This is where problems with borrowing start, especially for superannuation and SMSFs. The sole purpose of superannuation, and the reason it is given favourable tax treatment, is to fund a retirement, and to do this, it must generate income.

These are the two main issues when a SMSF buys a residential property: risk and cash outflows.

Risk profile

SMSFs can usually borrow up to 80% of the value of a property, requiring the fund to have capital of at least 20%. If the value of the property falls 10%, the SMSF will lose half its capital. The impact of leverage is dramatic, in this case, equivalent to falls in sharemarket values seen in the Global Financial Crisis that nearly brought the banking industry to its knees.

There is too much price complacency among residential property buyers. The Reserve Bank Governor, Glenn Stevens, recently warned on property prices, especially in Sydney, “… in forming expectations about future price gains and deciding their financing structure, people should not assume that prices always rise. They don’t; sometimes they fall.” The Reserve Bank issued a paper entitled “Is Housing Overvalued?”, which quotes research by The Economist (2013) and the OECD (2013) that Australian house prices are 24% and 21% ‘overvalued’.

Cash outflows

On an apartment valued at $700,000, an SMSF may borrow 80% or $560,000. With an interest rate of 5%, the annual borrowing expense is $28,000, plus fees. In NSW, the stamp duty on a $700,000 apartment is about $27,000. There are many annual costs which new property buyers often overlook, such as body corporate fees $8,000, agent leasing fees $5,000, council rates $3,000. By the time these bills are paid, and allowing for a month of vacancies, the income will be about 2.5%, or $17,500, or at least $10,000 less than the interest cost. For a complete explanation of costs, see this article.

The SMSF trustee will need to find $10,000 a year from within the SMSF plus at least $30,000 up front to buy this property, and probably a lot more on furnishings and fittings. What happens when interest rates rise, or the property has a long vacancy period, or a major repair is required? What if the SMSF trustee loses their job and is not making other contributions to super? It’s not possible to sell the bathroom, and the SMSF trustee may be forced to sell the apartment at the worst time in the property cycle.

Property spruikers

The main problem in allowing SMSFs to borrow is that the unwary are targeted. Unscrupulous agents sell off-the-plan apartments at inflated prices paying big commissions to advisers. A few years later when the rental return guarantee has finished the SMSF trustee realises the initial property price was overvalued. There have been many examples in Australia, including the Gold Coast, Melbourne’s Docklands and various backwaters, where resales have been 50% of the original purchase price.

In a recent speech to CPA Australia, ASIC Commissioner Greg Tanzer warned the regulator is monitoring websites and media for evidence of misleading conduct, and attending SMSF seminars. He said that making a recommendation to set up an SMSF to buy property is financial advice, for which a person must be properly licenced, even though the underlying investment – the property – is not itself a financial instrument. “The promoter may not be complying with the law.”

I attended a property seminar aimed at SMSFs, organised by one of the highest profile agents in the country, and was shocked at the material presented. It contained many half-truths and exaggerations, and the audience seemed to lap it up. Most of the presentation was made by an SMSF administrator whose fee for the complete package of putting together an SMSF and arranging the property loan was $7,995.

Consider three of the messages from this seminar:

  • If you don’t have enough money for a deposit, four people can pool their money to fast track to wealth.
  • You can reduce the purchase price of the investment property by 40% using concessionally-taxed superannuation compared to after-tax salary for loan repayment.
  • If you don’t have enough money in super but you have equity in your house, you can borrow against your house and lend the money to your SMSF.

Anyone who defends SMSF borrowing should attend one of these seminars for a real eye-opener. Imagine the future problems if four people own one illiquid asset requiring ongoing management as they head to retirement at different times.

Should property borrowing be banned?

An estimated 85% of borrowings for property by SMSFs is for commercial premises, often leased to the business of the SMSF trustee. It will be difficult to wind this back , and the valuation and cash flow issues are less of a problem than aggressively-marketed residential apartments. The SMSF Professionals Association (SPAA) is not in favour of a ban on borrowing, except in the case of spruiker-type promotions. It points out that in 2012, the latest official statistics, SMSF borrowings amounted to only 3.7% of SMSF assets. “This hardly suggests that trustees are borrowing without giving it due consideration,” said Graeme Colley of SPAA. However, more recent work by CoreData suggests this has risen significantly in the last two years.

There are clear signs the Murray Inquiry plans to reintroduce a borrowing prohibition: “Removing direct leverage in superannuation is consistent with the concept that superannuation tax concessions should apply to funds that have been saved and not borrowed. There are ample opportunities — and tax benefits — for individuals to borrow outside superannuation.”

Many highly leveraged SMSFs would lose all their own equity if there is a decent residential property price correction. Then they’ll find an adviser to sue and bad financial advice will be back on the front page. At least the SMSF trust deed has provisions to cover member insanity.

 

Graham Hand was General Manager, Capital Markets at Commonwealth Bank; Deputy Treasurer at State Bank of NSW; Managing Director Treasury at NatWest Markets and General Manager, Funding & Alliances at Colonial First State. 

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18 Responses to Should SMSFs be allowed to borrow?

  1. Sarah Penn August 28, 2014 at 8:30 PM #

    Agree with many that tighter reigns are what’s needed, not an outright ban. Outright ban smacks of yet another attempt by certain market participants to reduce the appeal of self managed super so as to feather their own nests…

  2. Warren Bird August 6, 2014 at 9:52 AM #

    If a fund owns a share it owns a geared asset.

    I agree that the issue shouldn’t be whether a fund can borrow or not. In one sense, the only way to get a return above cash is for someone, somewhere in the chain, to gear.

    The question should be management of risks – all risks, combined, at the portfolio level.

    A fund that owns one asset, be it a property or BHP shares, is too risky. It has to be diversified properly, so that no one investment can blow the overall outcome if it doesn’t work out.

  3. Alun Stevens August 5, 2014 at 10:01 PM #

    I don’t think that the question should be about SMSFs borrowing. It should be about borrowing in a super fund. The original reason why gearing was prohibited was risk – i.e. that the gearing would magnify downsides and wipe out an asset based in part on tax concessions. This blurred over time with property trusts gearing themselves internally and also warrants. I still think it is a good question because although I can think of good reasons for some gearing in some circumstances in a fund, it is also plainly obvious that at some level it becomes irresponsible and unreasonable.

    APRA regulated funds can invest in geared assets (i.e. the gearing is inside the asset structure) so I can’t see why SMSFs should not in principle be able to invest in equivalent structures. There is however a big difference in the level of prudential scrutiny of the APRA funds so there would be a case for more onerous restrictions on SMSFs.

    Eric’s suggestion, I think, is a good one. The problem I see is how to police the approach. I can visualise a well reasoned case being presented as to why an 85% LVR loan on a single property representing (say) 80% of the asset of a fund is an appropriate method to produce the end value required to provide a comfortable retirement income.

    To the extent borrowing is allowed, the loan will of necessity need to be limited recourse to the asset purchased with the loan. It should not involve guarantees provided outside the fund.

  4. Michael Rafferty August 5, 2014 at 10:00 PM #

    It’s not about the Borrowing provided it is a legal transaction. It’s the purpose. Ethics could come next.Looking at primary purpose, to provide income in retirement,LVR’s should play a big role.Should we limit the LVR to say Max 50%? Take the decision away from the Banks. People will always try to maximise to self advantage, be they developer, realestate agent,adviser, and the client. Guidelines and ethic sare paramount.
    A great need for a debate.

  5. John July 31, 2014 at 5:14 PM #

    What I find interesting is the 5K price spread that I’ve been quoted by SMSF “conversion specialists” and the finders fees offered for referrals. One estate agent even told me not to worry about the fee because it wasn’t real money, the SuperFund pays for it!

  6. Ramani July 30, 2014 at 11:28 AM #

    In canvassing the options on LRBAs for SMSFs the discussion has now encountered the usual obstacles in wealth management and super: conflicts not merely tolerated but expected; why SMSFs are the focus when SIS rules apply to the bigger siblings; risks in LRBA and consequential costs.
    While gearing rules apply across all super, the inherent nature of SMSFs predispose them more to LRBAs than APRA funds, as individuals and their advisers focus more on the upside. The lack of any risk management scrutiny by ATO (would not know it even if it accidentally encountered it) makes this worse. The Aussie fixation with geared property (residential) adds to the risk. If things go pear shaped and liquidity freezes, trustees running their own destiny have nowhere to go, as the Trio victims found.
    LRBA risks are greater and the costs reflect them. Interest rates are often 2% pa higher because of limited recourse of lenders, and whether individual trustees could be pursued is still to be tested.
    Independent financial advice seems like an ideal never to be reached. With honourable exceptions, most would have links to lenders eager to expand their market share.
    Graham’s alert is timely, but let us accept that gearing in asset management is irretrievably entrenched.

  7. Greg Einfeld July 28, 2014 at 11:07 AM #

    Absolutely they should be able borrow. However the trustees should be required to obtain independent advice. In this case independent would mean an SOA prepared by a financial adviser that has no financial relationship with the property vendor or agent.

  8. Ivonne Teoh July 28, 2014 at 11:01 AM #

    If SMSFs could borrow to buy property, that is indeed a Gold Mine! The headache is how to manage the risk. If the SMSF cannot repay their loans, does it fall back to the Trustee or the beneficiaries (individuals)? Corporate beneficiaries could be a complication, their limited liability may get them off the hook? I expect the insurance premiums to be high…

  9. David O'Donnell July 28, 2014 at 10:56 AM #

    Is this question a too narrowly formed by referring to smsf’s? Do the provisions not allow superannuation funds in general to invest in geared unit trusts (ie borrow for investment)? A general question about whether superannuation funds should be able to invest in geared investments would make sense. This question I wonder about.

  10. Eric Taylor July 28, 2014 at 10:56 AM #

    While it no not something I would personally consider, I believe it would now be difficult to wind back. Maybe we should be more specific in the requirements of Fund’s Investment Strategies, in that they should be made to detail how the borrowing and related investment will meet the requirements of the sole-purpose test in providing for the member’s retirement, including a requirement of forecast investment growth. This may make the trustees stop and think how this will provide for their retirement, as I am sure that does not happen now. Alternatively, like where a Fund with reserves is required to have an investment strategy for its reserves, a Fund should have a separate strategy for borrowings.

  11. Sam Laser July 28, 2014 at 10:55 AM #

    Provided the Trust Deed and the Investment Strategy allows it AND the gearing is done in the appropriate manner as set out in the SIS Act, why shouldn’t it? After all, it is well known that done properly, gearing can enhance the creation of a portfolio that may otherwise take an inordinate time especially when a member is young and concessional contributions are compulsorily low.

  12. Ramanim July 26, 2014 at 4:26 PM #

    Liam,
    LRBAs have not been around for long enough to answer your query so we must go by past history, greed trumping prudence and spruikers’ predatory propensity. In SMSFs, add aging, lack of investment or risk control scrutiny by ATO and keeping up with Joneses to start your own SMSFS, the planetary conjunction foretells a disaster. As the victim is the taxpayer who funds the tax concessions and the unfounded age pension, caution is warranted.
    Sorry it mucks up some retirement plans dreaming of Hawaiian holidays, only to queue up before the local Centrelink in reality.
    Raging parties need periodical pooping!

  13. Liam July 26, 2014 at 9:06 AM #

    Mark, US and Canadian investors have access to a huge amount of leveraged products in their markets, just look at the range of geared ETFs available.

    We tell people they will need $57k a year in retirement yet careers now are often broken and span 3-5 employers not to mention extended time raising children for women. Many realise that the 9.5% is not going to be enough and cannot add more as they have huge mortgages. So leverage is one of the only ways a GenX or GenY may actually raise enough funds to retire conformably.

    It’s easy to say don’t let them borrow in Super but what is your solution to fund that retirement gap?

    Long term investment such as necessary through Superannuation is actually well matched with reasonable leverage.

    How many people have actually lost funds if invested in geared shares or property for a 25 year period? I am looking at a geared investment in Aussie Shares for a client since 1997 and they have had a 12.3% return pa despite the tech bubble! gulf war 2 and GFC. I have seen similar results for clients who leveraged in to property in the the last 20 years.

    The aim should be to ensure good research , advice and management as well as risk minimisation and control. Full disclosure of all “related payments” including “marketing budgets” commissions, placement fees, etc should be compulsory on a 1 page summary.

  14. Mark July 25, 2014 at 11:22 PM #

    I’ve lived in several different countries and nowhere else that I’m aware of allows borrowing within a retirement plan to purchase property. It’s insane. I’m currently in Canada where one cannot even borrow within a retirement plan to borrow shares. Ditto USA. That Australia allows it, when there are so many who believe Australia has a property bubble, is putting the retirement plans of many Australians at risk.

  15. David July 25, 2014 at 1:36 PM #

    there should be no borrowing of money from outside of the SMSF – using leveraged warrants inside the fund is OK. If you borrow from outside of the fund then you are circumventing the contribution limits. Several SMSFs have well in excess of $10million in the funds and one is supposed to be $100million. these sort of levels can only be achieved by lending large amounts of money at zero interest rates so the fund can be grown to extreme size and then when in pension mode a huge pension is tax free. Tax free income should be limited to around $50,000 i.e. ~ 30% tax rate, anything above that should be taxed and the pension from the fund should have to pay Medicare which they don’t at present as the income is not declarable.

  16. Tim July 25, 2014 at 12:49 PM #

    They should have mandated an LVR no higher than perhaps 50% from the getgo. Very simple and effective.

  17. Ramani July 25, 2014 at 10:45 AM #

    This question belongs to the genre ‘how long is a piece of a string?’

    When the state-mandated super was born partly driven by the debris of the UK Maxwell fraud, the approach was against borrowing because it magnifies risk (and rewards). Later when it was realised that gearing is part of business life, some borrowings were permitted. Every company and government borrows, so their instruments are inherently geared. Funds do invest through geared managed funds.

    Also, in hedging super from market volatility, derivatives could be used, and the derivative charge ratio exempted related charging of fund assets.

    It could have stopped there. It did not, when CBA and Telstra were to be sold.

    The conflicted government permitted instalment warrants with a 50% gearing. Never averse to a fee-making opportunity, the banking merchants (known as merchant bankers) confected warrants with much higher gearing, close to 95%. Hot and sizzling warrants set the rising markets on fire. Till markets came down, as they regularly do.
    In its dying days, the Howard government put a rocket under the borrowings, by introducing limited recourse borrowing on any asset, including lumpy property and infrastructure (and possibly, grandma’s cardigans). Out of this has grown, like topsy, the current crowd of fee-seeking advisers and spruikers. And the risks with it.

    If done with eyes open, and properly risk managed, gearing need not bring about a disaster. But it can, without such safeguards.

    SMSF worries go beyond this: including age-induced infirmity and the lack of any risk scrutiny by ATO on any investments. This issue is a mere subset.

    Children can swim safely under supervision. SMSFs can gear safely with risk controls.

    Shall we ban kids from the pools?

    • Ben Smythe July 25, 2014 at 12:18 PM #

      I agree with the thrust of Ramani’s arguments – better safe guarding is required rather that outright banning. Despite what happened with Storm, etc, SMSFs can still access significant “indirect” gearing levels outside of direct property via ETFs, managed funds, warrants, etc, and which will have similar consequences for member balances in a significant market correction.

      There has been a lot of talk about improving the regulation of borrowing in super and bringing it within the financial product definition. This has been dragging on for too long, and there is a distinct lack of transparency as to the reasons for the hold up.

      In the interim, surely a couple of ASIC “spooks” in the audience at couple of these “free” seminars, and subsequent public execution would put the wind up the spruikers.

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