One of the reasons why self managed superfunds is becoming popular in Australia today is that it offers investors the opportunity to invest in commercial properties. Commercial property investment is one very viable way of diversifying your portfolio and growing wealth.
This article is focused on what you need to know to purchase a commercial property with an SMSF.
What Exactly Is Commercial Property
Commercial properties refer to those properties from which businesses operate, such as a shop, factory or office.
Why Invest In Commercial Property
Many Australians are comfortable investing in property, perhaps because they have some knowledge in the field. Some investors are more willing to invest on property than say shares perhaps, because of the fact that property is an investment that can be seen, felt and physically touched and as such, more people can relate to it. That said, we must understand that investing in property is a serious matter, especially when you have to do that with your super. It’s important to thoroughly research all factors before making a decision.
Purchasing Commercial Property Inside an SMSF
When it comes to investing in property, you have to realize that the cost of buying the property is not all that you would be required to pay for. There are some additional costs associated with this investment and they include:
- Cost associated with managing your property. Do you intend to get tenants in? Would you work as a property manager or employ someone to handle that for you, keep in mind that property managers get to keep 5% – 7% of the total income received and this could have an effect on your returns.
- You need a cash buffer because there will be short periods when your property won’t be occupied.
- Insuring the property also cost money, which is not part of the initial investment cost.
- You need some cash reserve for property maintenance and emergencies.
- Rates, taxes and strata fees. Ensure you know what each will cost before you begin
- Stamp duty. This could sum up to an amount more than you thought it would.
Advantages of Investing in Commercial Property
Many Australians over the years have seen property investment as a good strategy for wealth creation and growth, but it isn’t for everyone. You need to be sure it is right for you before you make the decision. below are some of the potential benefits of investing in property:
- Physical assets: it is an investment that you can see and feel physically and this makes it a little more desirable
- Reduced tax: According to the ATO – Income, including rental income is generally taxed at a concessional rate of 15% (for a complying fund). Capital gains tax is 15% in the first year with a 33% discount after 12 months. In Retirement phase (formally called pension phase), special rules apply.
- Capital Growth: over time, the value of your property appreciates and the tax reduces
- Longer Leases: on the average, commercial properties are leased for longer peroids than residential ones.
- Regular cash flow from rent payments.
- You can also run a business from a part of your property while renting out the other parts.
Disadvantages of Commercial Property
It’s not all Pros, there are some Cons associated with this type of investment as well. They include:
- You may be exposed to insurance obligations as a result of owning commercial property and this may further complicate when you factor in leasing the property to a business.
- Capital gains: If your fund is buying a commercial property from a fund member (i.e. you), the capital gains tax obligations lie with the original owner.
- Capital loss: the value of your property will suffer significantly if the property market suffers a down turn.
- If you need quick cash, you can easily sell a unit of your property.
- Your property wont always be occupied by tenants and in such periods, you wont be making any money
- Interest rates: you must understand that you could experience a hike in interest rates if you secured a loan to purchase a property.
- Costs of purchasing. There may be additional costs payable when buying a property.
- Ongoing Costs. After purchasing the property, there are additional ongoing costs your fund will need to cover e.g. building insurance, loan repayment etc.
How does borrowing to purchase commercial property work inside an SMSF?
SMSFs are permitted to borrow only when it is done through “Limited Recourse Borrowing Arrangement (LRBA)”. This implies that the loan and the property are separate from other assets in the SMSF.
In a situation where the fund cant meet its loan obligation and the lender wishes to recover the loan, the lender would only have recourse to the property that’s held in the LRBA structure. It is also important to point out that the LRBA can only buy a ‘single acquirable asset’, meaning you will need one LRBA for every property you hold within an SMSF that has a loan against it.
What are the advantages of an LRBA?
- SMSF could borrow extra money to help buy a property that is more valuable than the assets of the fund would permit it to buy.
- Purchasing a property with pre-tax money. If you have made any concessional deposits into your super, you would be making use of the pre-tax dollars to pay loan on the property. This would enable you repay the loan a lot faster than if the property was held outside the super environment.
- By not using 100% of its assets to buy a single property asset, SMSF might have more diversification
What are the disadvantage of an LRBA?
Although many Australians have adopted the strategy of borrowing to purchase a property, there are some risks associated with this approach. Some of them are:
- As expected, the returns on investment would significantly depend on the rental income you get and the capital growth of the property being higher than the amount borrowed plus the cost to maintain the property.
- The more money is borrowed against the value of your property, the higher the risk that the costs of your property may be greater than your returns.
- Your superannuation balance could be reduced by establishment costs like stamp duty.
- You can’t carry out major changes to a property in an LRBA structure. Hence it isn’t advisable to buy a property that requires major renovations. You can make all the changes and renovations you want when you fully pay back the loan.
- The returns on your property could be greatly influenced by rising interests. Significant rise in interest rates might mean that you may not get rental income enough to cover loan repayment.
What is the common Commercial Property Strategy?
Property investors usually fall into one of the following categories:
- Investors looking to rent the SMSF”s commercial property back to their business (at arm’s length).
- Investors after Capital Growth
- Investors After Positive Cash Flow
It is quite clear there are many different investment classes available to an SMSF. It is important to seek financial advice if you feel it necessary and to ensure your investments are permitted in the trust deed and in line with your investment strategy.
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