Wealth Intelligence

SMSF Investment: when concentration fails

The risks of just one egg-filled basket

One of the great attractions of SMSFs is that they allow the trustees/ members great investment freedom.

However, often this freedom leads to poor investment decisions.

There has recently been considerable media coverage about SMSFs borrowing to invest in property. The concern is the effect on property prices, especially apartments and how this might keep owner-occupiers out of the market.

ASIC is also expressing its concerns, especially about the inducements being offered to investors.

Both miss the key investment risk.

What’s happening?

Why do an increasing number (but still small overall) of SMSF trustees invest in just one asset, typically a property of some sort?

I have warned ad infinitum (and ad nauseum) of the poor net returns that are generally achieved from investment in residential property. This return paucity is compounded for apartment investment, where the opportunity for long term capital gain is negligible.

NB: I hasten to add that my antipathy to property investing is limited to residential property.

Given agreeable circumstances, there is merit in considering investing in diversified commercial, industrial or retail property.

Six reasons to be cautious

As the table shows, there are three types of direct property investment, giving rise to six problems:

1. Regulation and compliance

2. Undiversified investing

3. Failure of a business

4. Property not having appropriate capital gain

5. Failure to assess all the costs of the investment

6. The opportunity for capital gain is insufficient to make up for the low net rental yield.

First Hand has previously warned of the last three items, so will focus on the first three.

A. ATO – best not to prod this bear

SMSFs are subject to a high level of regulation, supervised by the ATO. Two of the major requirements for all investments in a SMSF are: 

Arm’s length transactions & sole purpose test

All investment transactions in a SMSF must take place at arm’s length (at market value) and must meet the sole purpose test.

So structuring rents too low (e.g. to provide working capital to a business) or too high (e.g. to get assets into the fund) is a regulatory breach and may lead to trustees facing civil and criminal penalties. There may also be deemed contributions or withdrawal implications.

Diversification

All SMSFs must have an investment strategy which considers (along with other factors) diversification of assets.

I fail to understand how SMSF auditors can certify that a SMSF is compliant if its investments consist of just one investment in just one asset sector. Watch this space.

B. Undiversified investing – all eggs broken

This sort-of mirrors the above ATO directive for diversification. The reason is simple: if you have all your super fund invested in a single property and that property either fails or its returns are not as expected, then your retirement income will considerably suffer.

C. Business failure – double jeopardy

Where a business rents a property from a SMSF and is also the principal source of income for a member of the SMSF, then if the business fails, the member suffers double jeopardy; (a) as a business owner they have lower income now because of the business failure; and (b) as a SMSF member they will have lower retirement income in the future.

Problems of a single property investment in a SMSF

Situation

Problems

1. Commercial/ industrial where investor’s SMSF owns business premises and rents to investor’s business

Rent is set high to increase fund’s assets 

 1. Rent is not at arm's length. Compliance problems.  

 2. Undiversified investment, if no other fund investments.

 3. If business fails or slows – a compounded problem: both investor’s personal services income (i.e. salary) and/ or dividend income and SMSF’s investment income falls.

 4. Will property have appropriate capital gain if/ when sold?

 Rent is set low so as to provide working capital for business

 Above problems: 1, 2, 3 & maybe 4

 Rent is at market

 Above problems: 2, 3 & maybe 4

 2. Residential –  house

 Market rent

 Above problems: 2 and 4; and

 5. Have all costs (e.g. land tax; maintenance; possible periods of zero rental  income; owner’s corporation fees; agent’s fees; rates; etc) been considered in assessing net yield?

 3. Residential – apartment

  Market rent

 Above problems: 2 and 5; and

 6. The opportunity for capital gain is very limited.

Summary

If you have enough funds in your SMSF for just one property investment, don’t do it! If you like property, invest in a diversifed fund. And, in any case, seek personal financial advice from an expert. For example, First Samuel.

IMPORTANT NOTICE:  Any advice contained in this document is of a general nature only and has been prepared without taking into account your personal objectives, financial situation or needs.
Because of that, before acting on any advice in this document, you should consider whether the advice is appropriate for you having regard to your personal objectives, financial situation and needs.