Over the past four years, hundreds of thousands of Aussies have bought properties, and a growing chunk of them have purchased the property, and even taken out a loan, within their DIY fund. The number of self managed super funds investing in property has almost doubled in just over two years to June 2010, according to the ATO.
As discussed last week, there are myriad tax savings from buying an investment property within a DIY fund relative to purchasing it in your own name – and in a buoyant property market, the ability to leverage into a market characterised by rising prices seems bullet proof.
TheBull has spoken to many DIY super investors with a large exposure to property investments. Some, at almost age 60, have taken out million dollar loans to buy property, with the intention of selling the properties for a quick profit, and a tax-free one at that.
The strategy of borrowing (or gearing) to boost assets is second to none if the underlying investment rises in price. Let’s say you buy an investment property in Melbourne for $600,000, using $180,000 of cash from your DIY fund and borrowing the remaining $420,000 from the bank. Your intention is to sell the property for a nice round figure of $700,000 sometime later.
The theory is, once the DIY fund moves into pension phase, the $100,000 potential gain on the property is tax free. Clearly, there are costs involved in the transaction such as stamp duty and conveyancing fees, application, settlement and legal fees to the lender, as well as annual loan fees – and let’s not forget the interest costs – but on a profit of this size, don’t worry there will be plenty of profit left over.
But what happens if property prices tread sideways, or worse begin a steady trend down? What happens if your $700,000 sale price doesn’t eventuate?
Over the past 20 years, Australian property has been on an upward march, and rents have climbed ever higher. The far majority of Australians purchased property with just one view in mind, that the market will continue to boom, and to date this opinion has largely paid off.
Thanks to a raft of Government policies to keep the property boom on its upward trajectory – the first home buyers grant being the most significant contributor to rising prices – the market has barely taken a breather.
Except for now.
The most recent housing and lending data suggest that cracks are appearing in the Aussie property market.
According to the ‘7th Annual Demographia International Housing Affordability Survey’, Australia pulled in first place for the most severely unaffordable property in the world for the second year in a row. The financial magazine, The Economist, concurred, noting Australian property as the most unaffordable in the world and 56 per cent overvalued, based on the ratio of house prices to rents between 1975 and 2010.
In March, Morgan Stanley global strategist Gerard Minack also spooked investors with his comment: “We’ve had 20 years where the Australian consumers have been willing to borrow more to buy an asset that they believe always goes up in value. The classic sign of an asset bubble. You buy it because it’s going up and you don’t take account of the underlying fundamentals such as the rental return or the price relative to average income.” Minack argues that Aussie property is 30 to 40 per cent overvalued.
So where does that leave the thousands of Aussies with the bulk of their DIY fortune tied up in property?
The big problem arises if the intention was to buy and sell the property quickly, and to never repay the loan. When the property market hits leaner times, offloading a property isn’t as simple as auctioning it off to the highest bidder. There are fewer and fewer bidders in the market and it’s possible for a property to sit unsold for months. In other words, when the market becomes illiquid, the strategy of buying and selling for a quick profit goes out the window.
The other concern is when investors are negatively geared. Negative gearing means that the interest payments on the loan are greater than the rental income. In this scenario, there is a funding shortfall that must be met by cash within the DIY fund, or by topping up the fund with personal contributors (provided they’re within the annual limits). This will be an ongoing drain within the account – and may force the retiree into selling the property, possibly at the wrong time in the market cycle. If the property cannot be sold and the investor defaults on the loan, then the super fund would suffer significant financial loss as a result.
Many investors hold investment properties for the rental yield, and the good news is that this yield is tax free once the DIY fund enters the pension phase.
Therefore, a sluggish property market is not as concerning for those whose major intention is to rent the property out for the foreseeable future – provided that they have paid off the investment loan before retirement. The trap here is liquidity. Investors must ensure that the fund has sufficient cash to pay out pension payments when they’re due. If a tenant suddenly stops paying rent, there must have sufficient cash available to fund the shortfall. Relying entirely on rental income is not advisable.
If the investor cannot pay off the loan before retiring, interest costs on the loan can become a burden, particularly if the loan is large. They may be forced to use cash from other investments within the fund to service the loan – becoming a major drain on the account. It may force the investor to offload the property – and a quick sale may not deliver the sale price that they were hoping.
The message here is that if you intend to buy property within your DIY fund, ensure that you will be able to pay off the loan before retirement. Plus, be aware of where the property market sits within its long-term cycle. Due to escalating property prices over the past two decades, rental yields have come back and are hardly as attractive as they once were.
A final point worth mentioning is diversification. When most Australians have the majority of their wealth tied up in their family home, is it sound to pour one’s remaining funds into an investment that’s exposed to exactly the same market cycle?
Please note that this is general information that does not take into consideration your personal circumstances.You should seek professional advice before making any investment decisions.