Originally published by Cuffelinks
Residential property has long been a popular asset class for Australian investors who enjoy a high degree of comfort from tangible investments they can touch and feel. This contrasts with financial assets, such as shares and bonds, which have a paper value based on the market’s interpretation of their value, a process best described as the action of the ‘invisible hand’. It is therefore surprising to see only 4% of SMSFs’ $636 billion in total assets invested in residential property (according to the ATO).
Rather than vilifying SMSFs that borrow to invest in residential property, we should welcome the stability provided to the market and a source of long-term rental stock.
There are positives and negatives associated with SMSFs investing in residential property which are unique to SMSFs. Let’s look at five of these factors in more detail.
1. In it for the long term
A long-term appreciating rental income stream is ideal for SMSFs. If a residential property is acquired during accumulation phase, when income is not so important, by the time the fund enters pension phase, the rental stream should have appreciated to a level more suitable for a self-funded retiree. For example, if an SMSF purchases a property today at a net yield of 3% and the property value appreciates at a long-term rate of 6% pa, the net annual rental yield (pre-tax) after 20 years would be 10% based on the original purchase price of the property. This type of return needs to be compared to other investments available such as finite and discrete returns offered by fixed income (including term deposits) or equities which also a have a tendency to appreciate in the long run.
‘Long-term’ is the critical assumption here. While in the short term, yields and property values will go up and down, over the long term, they are likely to revert to their means. SMSF trustees should be truly long-term investors, usually accumulating wealth over a 30-40 year period.
Residential property is a good investment over such a long-time horizon because of its utility value. We don’t know if people will be buying iPhones in 30 years’ time, but we do know they will need somewhere to live. Few individual stock or bond investments can provide this level of long-term utility.
2. Maintaining diversification
Concentration risk poses the biggest challenge to SMSF investors. If the median dwelling price in Australian capital cities is over $600,000, there are few SMSFs in the early stages of accumulation that would have enough capital to invest in residential property, let alone justify such a high allocation to a single asset. In fact, 57% of SMSFs have assets in excess of $500,000 and most of these will be in the latter stages of accumulation or in pension phase. This means they will be less inclined to make long-term investment decisions requiring a 20 year+ time horizon.
Also, while the residential property market is relatively liquid, transaction costs are high, including stamp duty and agent fees, and liquidation periods long. Again, the best hedge for this risk is having a very long-term investment horizon. The best way to establish a long-term investment horizon, without running into concentration risk, is to borrow.
Borrowing utilises someone else’s capital to purchase an asset. In exchange for a capped return, the lender gets priority over the borrower for the repayment of their capital. An SMSF with $700,000 in assets intending to purchase a property for $500,000 could borrow $200,000 and maintain diversification and liquidity with the remaining $400,000.
3. The downside to borrowing
Borrowing doesn’t make a bad investment good, but it can make good investment bad. Leverage on the upside is good, but on the downside it can be bad, particularly if an investor is forced to liquidate an investment due to an inability to meet interest and principal repayments. Liquidating on the downside can reduce the value of an investment to zero, even if the investor thinks its value in the long run will recover.
This is the risk that plagues highly-leveraged households when they find one or more breadwinners temporarily out of work and no longer able to service a mortgage. This is the biggest systemic threat to the Australian housing and financial markets, not prudently leveraged residential property investment.
A prudently-managed SMSF should not have a problem with leverage, particularly if it maintains diversified assets that generate income. In the event of servicing stress (i.e., an extended period of vacancy or negative cash flows after debt servicing), the SMSF should have other assets that provide income or liquidation potential to generate cash flow to service the debt.
4. Limited recourse loans
The net effect of prudent borrowing by an SMSF allows it to consider a long-term investment early in its accumulation phase when it is most prepared to make long-term investment decisions. The requirement (by law) for the SMSF to borrow on a limited recourse borrowing arrangement (LRBA) also allows the fund to make a considered leveraged investment decision without compromising its other assets.
It’s not that an LRBA is the only way for an SMSF to gain access to leveraged property. An SMSF can invest in a pooled-property managed investment scheme that is leveraged. The trade-off is flexibility and cost. At the very least, the ability for an SMSF to make a direct leveraged property investment provides healthy competitive pressure to ensure these schemes are priced fairly and offer a good service to investors.
5. Effect on housing market
Finally, what impact will SMSF borrowing and investing in residential property have on housing affordability and market stability?
Several attributes of an SMSF investor differ from other investors and even households aspiring to enter or upgrade residential property by borrowing.
1. The SMSF trustee should make an economic, rational decision to purchase an asset that will generate a long-term appreciating income stream to fund the retirement of its members. A long-term economic decision is less influenced by short-term yields and housing prices. This creates more stability for the housing market.
2. The SMSF is not driven by tax distortions like negative gearing and capital gains tax that drive other investors. This means the SMSF investor is less likely to drive house prices higher than their true economic value.
3. The long-term investment horizon and financial stability of SMSFs mean they are less likely to be short-term opportunistic or forced sellers of property. This reduces systemic risk and creates greater market stability.
4. SMSF investors increase the amount of housing stock available to renters, which increases housing affordability. This may reduce the incentive for households to move from rental to borrowing and owning where the household may become more financially vulnerable.
SMSFs make up a small part of the demand for residential property, but they are more likely to have a stabilising impact on the market than a negative impact on housing affordability.