by Jason Huljich

According to a recent statement issued by the Reserve Bank of Australia (RBA), as at June 2013 approximately 15% of the $500 billion SMSFs sector was invested in direct property. In fact, the RBA makes the comment that for a number of investors, the sole purpose of setting up an SMSF is to invest in property. This trend shows no sign of abating in the near future, and there is no question that a defensive growth asset, like property, plays an important role in a diversified investment portfolio, including for an SMSF.

But is it better for an SMSF to invest directly into property, or for the investment to take a different form, like an unlisted property trust, for example? Jason Huljich, CEO of Centuria Funds property looks at the similarities and differences.

At Centuria, as manager of 27 unlisted property trusts, we are very much aware of the rise of the SMSF sector. Approximately 80% of the funds invested in our unlisted property trusts come from SMSFs, with half of these invested through private banks and advisers, and the other half directly via word of mouth recommendations.

There are a number of reasons why an SMSF would choose to invest in an unlisted property trust which invests in commercial property, rather than directly into a residential or smaller commercial property. The most obvious is that unless the SMSF is very large, with significant assets, investment in a syndicated form, like an unlisted trust, gives investors access to larger, higher quality buildings with larger tenants than most could not afford themselves.

For most SMSFs, direct investment in property takes the form of a residential property or small commercial property, both of which have different return profiles when compared with larger, higher quality commercial property. For example, income returns from our unlisted funds are currently in the order of 8-9% per annum, whereas residential property is returning between 2-3%.  For investors to choose residential property, their clear expectation must be that capital growth in the future will make up for lower income returns now. However, it’s important to remember that capital growth from a residential property is by no means a foregone conclusion.

When it comes to investing in commercial property, there are tax advantages which flow through to investors regardless of whether they buy the property directly, through an SMSF directly, or invest in an unlisted property trust through their SMSF. The advantages relate to depreciation. A property owner can depreciate the cost of the building as well as plant and equipment over time, with the result that an investor’s taxable income is reduced by the amount of the depreciation as follows.

If the income you receive from your property investment is, say, $1,000 per annum, depreciation means that the property might be written down by $200, and the plant and machinery by $300. This leaves investors with an income of $1,000, but a taxable income of $500. And if the investment is held in an SMSF structure, the income will be further tax advantaged, as the investor will pay only 15% tax on $500.
The newer the property, the greater the benefits of depreciation. For example, the income flowing from our 8 Central Avenue Fund is 100% tax deferred for the first two years.
When it comes to borrowing money to invest in property, there are some similarities between SMSFs and unlisted property trusts. Both use non-recourse loans, which means that if there is a default on the loan, the lender only has recourse to the property asset attached to the loan, and not to anything else.

There is also the question of the interest cover ratio (ICR), which is a ratio used to determine how easily the trust or SMSF can pay interest on outstanding debts.  An ICR of 1 means that income from the property is the same as interest repayments, 2 means it is twice as much, and so on. Centuria’s ICR is generally between 2 and 3, which is a very conservative level.  This means that for any given property in one of Centuria’s funds, around two thirds of tenants would have to either default or vacate before income from the trust fell to the point that it could no longer service the interest on its debt. 

For SMSFs investing directly in property with borrowed funds, the ICR will generally be lower.  In fact this is one of the major risks associated with investing directly.  The risk of a residential tenant defaulting, or a smaller property having its income affected by vacancy rates is much higher than for a large commercial property. Therefore, unless an SMSF is large enough to generate significant income from other investments or assets, the risk of running into trouble if a property stops generating income can be high.

Overall, as with many investment decisions, there is no absolutely right answer, and there are pros and cons associated with both options. The trick is to look carefully at your own situation, investment objectives and horizon, and act accordingly.