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.