Investing in property within a DIY super fund is now a lot easier, if you don’t mind gearing and buying packaged products. Note that I used the word “easier” rather than “simpler”.
In September 2007, new laws came into effect that permit DIY funds (or self-managed super funds, SMSFs) to invest in an instalment warrant issued over any asset that an SMSF can invest in directly. For example, a product provider may offer an instalment warrant over property, Australian shares, overseas shares, managed funds or even private equity investment.
In May I predicted that, in this booming market, a flood of new products would be introduced into the market. More flexible and individually tailored warrant products are expected to be available from March/April of 2008 as product due diligence and legal reviews take time, although there are some commercial products available now as leading banks such as Macquarie and Babcock & Brown seek to position themselves in the market.
New property warrants
Product promoters have got excited about the possibilities of instalment warrants, particularly over property investments. For example, there is one product that allows your fund to invest in residential property, provided you have 25% of the funds needed plus purchasing costs and stamp duty.
Another product allows your fund to invest in commercial property provided your fund can cough up 45% of the funds needed plus costs. Traditionally a DIY fund had to have 100% of the funds, because borrowing in a super fund is not allowed.
Many providers and journalists are giving the impression that these products are just like taking out a loan and going for it. This is not the case. The fund does not take out a direct loan; rather it enters a contract to pay instalments for an underlying assets, and the fund does not secure any existing fund assets to invest in the warrants. The only asset at risk is the underlying asset linked to the warrant product.
The property warrant products available are not cheap, but debt rarely is cheap. You pay 9% to 9.5% on the money provided by the product promoter, plus 2% to 3% protection fee in the event that your fund defaults on the debt contract, and potentially other costs too if the promoter manages the property for your fund.
What this means is that your geared product has to deliver you a return of at least 11% to justify the costs involved, although cheaper products are expected to come on to the market next year.
Despite the hype you’re going to read about these products, property warrants or any other type of warrant are not some magic pill that will deliver you instant wealth. Instalment warrants can be legitimate investments for SMSFs, but as I continue to say, trustees need to appreciate the risks associated with geared products.
In rising markets, geared products enable to you to accumulate wealth at a much faster rate because you have access to the returns on more assets. In falling markets, however, your losses will be amplified.
Three main requirements
According to the new rules, an SMSF trustee can “borrow” money under an instalment warrant arrangement when the borrowing within the geared product is used to buy an asset that is held on trust by the provider.
The SMSF trustee receives the beneficial interest and a right to purchase the underlying asset. In addition, the product provider (lender) only has recourse to the asset in question if your fund defaults on the loan, rather than recourse to other fund assets. “Limited recourse” means that the maximum that your fund can lose is the original capital investment.
An important feature of the permitted instalment warrant products is that your fund can’t lose more than the amount invested in the first instance, although you can still lose your original investment. If you don’t make the payment, the asset held in trust is sold on-market and the proceeds of the sale are offset against the final instalment payable. If the final payment is greater than the sale proceeds, then your fund is not required to pay the difference because the product included loan insurance.
The third main requirement is that an SMSF can only invest in an instalment warrant over an asset that the fund is permitted to invest in directly.
If a super fund does invest in instalment warrants or any other derivative product such as options or warrants, then the fund must have a risk management statement or strategy.
Limited direct borrowing
Direct borrowing remains a no-no for super funds except in two limited circumstances. A trustee can borrow to meet benefit payments, provided the borrowing does not exceed 10% of the fund’s total assets and the loan period is 90 days or less. The other exception is when a trustee needs to settle a share transaction, although this loan can be for no longer than seven days and the need to borrow must have been considered unlikely at the time the investment was made.
SMSF trustees must not borrow money (directly), or use assets of the fund as security, or allow the fund’s bank account to go into overdraft. The rationale for this policy against borrowing is to maximise the chances that a fund will have money to pay member benefits when a member retires. It seems that the super rules are moving further away from this underlying policy.
Another wealth tool
You can expect that property developers will hook up with mortgage brokers, and finance houses and banks will hook up with accountants and financial advisers. Accountants and financial advisers may also potentially hook up with property developers as the underlying asset of property becomes enmeshed in the other services that are attached to the product, such as property management and leasing services.
You also need to be aware of what costs are involved if you want to get out of the arrangement, or buy out the warrant.
I am not that excited about the new products because the instalment warrants are simply a geared product that has been packaged for SMSF trustees. The principles of gearing are universal whether you invest inside or outside an SMSF, except the tax advantages of negative gearing are more significant outside the super environment (because personal tax rates are higher than DIY super tax rates). I imagine, however, that the new products will be popular partly because they are new.
For those SMSF trustees interested in investing in property, you don’t need to purchase warrants to get into the property market. If your fund has sufficient funds you can buy a property directly with no debt. Alternatively, if your fund does not have enough cash, you can also use personal debt to purchase a property that your super fund co-owns.
Gearing is not for everyone, although I do believe the relaxation of the indirect gearing rules may mean that the amount of funds needed to make an SMSF cost-effective could fall because gearing enables SMSFs to invest in assets with only a portion of the total value of the assets.
Further, such products may also mean that the industry sees a lot more younger people setting up SMSFs attracted by the high-growth (and higher risk) wealth accumulation strategies associated with property (or share) warrants, which potentially requires relatively small account balances.
This story first appeared in Eureka Report.