Mon 17 Sep, 2018
A Guide to Buying Commercial Property with an SMSF
The ability to invest in property, such as commercial property, is one of the main reasons why self-managed super funds are emerging as a popular choice for Australians. Whether you own your own business, or you’re simply looking for an asset to diversify your portfolio, investing in commercial property can help contribute to your wealth portfolio.
In this guide, will focus primarily on the how to purchase commercial property with an SMSF. For information on buying residential property with your SMSF, visit our guide on residential property investments for SMSFs.
What is Commercial Property?
A commercial property is a property from which a business operates (or can operate). So, your local coffee shop is a commercial property. Real estate agencies, office blocks, shops and accountancy practices are all examples of commercial properties, too.
Why Commercial Property?
Many Australians are quite knowledgeable on property, and as a result, feel more comfortable investing in one. In fact, according to the ATO, SMSF investments in ‘business real property’ have grown by 47% in a little under 5 years (as of March 2017).
When compared to other investment assets such as shares, property has one distinct advantage: you can physically touch, feel and see it.
This concept is what draws many Australians to invest in property. However, it’s important to remember that investing in property, especially with your super, is a serious matter. That’s why it’s important to consider all the factors associated with that choice when contemplating investing in property. These include considering all the additional costs and responsibilities associated with managing a property investment, as well as what effect having one large asset in your SMSF means for diversification.
Costs Associated with Commercial Property?
When contemplating investing in property, remember there are additional costs to consider other than the value of the property and the loan. Here are some additional costs an investment property could incur:
- Stamp duty. This can add up to a lot more than you might think. For example, the NSW stamp duty for a $2.1m commercial property would be $100,990 on top of the purchase price;
- Rates, taxes and strata fees. Make sure you are aware of these costs as sometimes they can be larger than you expect. For example, larger business unit complexes with amenities like lifts or car parks can have strata fees of $10-15,000 per year, which can potentially reduce your investment return;
- Safety net cash balance for regular maintenance of the property and for unexpected emergencies;
- Cost of insuring the property, and potentially landlord insurance to cover against any unforeseen tenant damage;
- Cash buffer to account for any period of time when your property isn’t rented;
- Costs associated with managing your property. Will you be finding and managing tenants for your property, or will you work with a professional property manager? Generally, professional property managers charge 5-7% of any rental income you receive, which will reduce your investment return.
Benefits of Commercial Property
For many Australians, using a property investment to grow their wealth for retirement has been a great strategy. However, it’s important to note that this is not the case for everyone. That’s why you should consider all the factors before pursuing a property investment.
The potential benefits of investing in commercial property that you should be aware of are:
- Low volatility. Property can often be less volatile than other growth investments such as share markets which can go up and down;
- With an investment property, you will most likely receive regular cash flow from rental payments;
- Longer leases. Commercial properties are generally leased out for longer periods of time than residential property.
- Capital growth. If the value of your property grows over time, you will benefit from reduced capital gains tax compared to that charged outside of the superannuation environment;
- Reduced tax. During the accumulation phase of your SMSF, rental income is taxed at 15% (vs your marginal rate of tax for non-super property investments). Capital gains tax is 15% in the first year, and is fixed at 10% afterwards. When your SMSF is in the Pension phase, these taxes generally go down to 0%;
- Physical asset. An investment property is something physical that you can touch and feel;
- Run a business in the property. SMSF members that are businesses owners can lease the property back from their superfund, rather than paying rent to a landlord. However, they must pay their superfund rent at market value (see below for more information).
Interested in learning more about the benefits of investing in commercial property with an SMSF? Book your free consultation with our SMSF experts!
Risks of Commercial Property
There are also risks of investing in commercial property to consider. The potential risks that you should be aware of are:
- Costs of purchasing. There may be additional costs your fund is subject to when purchasing property. These include stamp duty, pest and building checks, loan application fees, conveyancing and etc.;
- Ongoing Costs. After purchasing the property, there are additional ongoing costs your fund will need to cover. These include loan repayments, property maintenance, building insurance, etc. You’ll need to make sure your rental income and super contributions cover these costs.
- Interest rates. If you secured lending to purchase the property, it’s important to be aware that your interest rate can hike up, which will affect your SMSF’s cash flow;
- There may be times when your property doesn’t have a tenant, and thus isn’t earning rental income. It’s your responsibility to ensure you have enough cash balance in your super to make the loan repayments and maintain the property;
- You can’t simply sell a unit in your property if you need cash in fast, like you’d sell a portion of a share portfolio;
- Capital Loss. If the property market suffers a down turn and the value of your property decreases significantly, you can end up owing more than what your property is worth;
- 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. So, if you’re selling your commercial property to your fund, remember to factor in the capital gains tax you’ll have to pay when assessing the strategy’s viability;
- Owning commercial property may expose you to insurance obligations, which may further complicate when you factor in leasing the property to a business. These are all things you’ll need to assess. It’s always wise to obtain professional advice before getting involved in a new investment class.
Borrowing to purchase a property with your SMSF
SMSFs are only allowed to borrow when it’s conducted via a “Limited Recourse Borrowing Arrangement (LRBA)”. This is a structure that means the property and the loan are separate from other assets held in the SMSF.
This simply means that if the fund cannot meet its loan obligations and the lender seeks to recover its loan, the lender only has recourse to the one asset (the property) that’s held in the LRBA structure. The lender is prevented from accessing any other assets or money held in the SMSF.
However, an LRBA can only be used to purchase a ‘single acquirable asset’. This means you will need one LRBA for each and every property you hold within an SMSF that has a loan against it.
Benefits of an LRBA
- SMSF could borrow additional funds to assist buying a property that is dearer than the assets of the fund would allow it to buy outright;
- SMSF might have greater diversification by not using 100% of its assets to buy a single property asset;
- Buying a property with pre-tax money. If you’ve made concessional contributions into your super (ie salary sacrifice) you would be using pre-tax dollars to pay the loan on the property. This could potentially help you pay the loan off faster than if the property was held outside the super environment.
Risks of an LRBA
While borrowing to purchase a property within an SMSF is a strategy used by many Australians, it’s important to be aware of the risks and associated consequences of using an LRBA:
- Just like all lending/gearing, the investment returns depend on the rental income you receive and the capital growth of the property being greater than the borrowing and ongoing costs to maintain the property;
- The higher the level of borrowing against the value of the property, the greater the risk that the costs of your property could be higher than your returns.
- Establishment costs like stamp duty can add up significantly, which can reduce your superannuation balance. This means it could take quite some time to recoup these costs before you start to see positive capital growth of your property;For example, buying a property for $500,000 in NSW will come up with a Stamp Duty of $17,990, therefore you will need the value of your property to increase by 3.6% before you start to generate true capital growth.
- While a property is in an LRBA structure you are prevented from significantly changing it. As a result, it may be best to avoid investing in un-renovated property with your SMSF. However, the loan is paid back, you are free to renovate your property as you see fit.;
- Rising interest rates can also impact the returns of the property. A significant increase in rates could mean the rental income might not be sufficient to cover the loan repayments and you might have to contribute additional funds from your pre or post tax salary in order to meet your loan repayments.
- The value of the LRBA might impact your total super balance or transfer balance cap. These are complex issues and should be discussed with a professional.
Investment Strategy for Commercial Property
Property investors tend to fall into one of two categories: cash flow investors and capital growth investors. Consider what your goals are for your golden years as well as your fund’s investment strategy.
Buying or Transferring From SMSF Members
With residential property, the SMSF also cannot buy property from any member, but with commercial property, the rules are slightly different. SMSFs can buy or transfer property from a member or an individual related to a member. Commercial property can be transferred as a non-cash contribution (known as an in specie contribution), providing it complies with contribution caps and small business retirement exemptions.
When you invest in commercial property with an SMSF, there’s a golden loophole:
Your business can rent the commercial property back from your SMSF.
However, your business must rent the property at an arms-length agreement. This means your business must rent the commercial property for market value – exactly the same figure as if it were leased on the current market. There can be no missed payments, no discounts or skipped dues. Your business must pay your SMSF as though it were a regular landlord. That said, this is still beneficial for your fund. The rent you’d ordinarily be paying to a landlord is now going into your SMSF.
Things to Remember
- The commercial property (or business real property) must be independently valued – and regularly;
- Rental payments must be adjusted accordingly to remain in line with market value;
- As with residential property, an SMSF cannot use borrowed funds to improve the commercial property;
- If your business is leasing the commercial property from your fund, it must be on-time and as though the landlord were a complete stranger;
- Capital growth on commercial property tends to be lower than smart residential property investments;
- That said, cash flow and rental yields may be higher;
- Your commercial property must classify as ‘business real property’ to be eligible for purchase by your SMSF. Obtain professional advice before purchasing a commercial property to make sure the asset complies.
Questions to Ask
- What will happen to your SMSF if the business leasing the property goes bankrupt?
- Is there sufficient demand to maintain the asset should the leasing business wish to terminate their contract?
- What types of businesses could operate from the space? Is this diverse enough to generate enough rental demand?
- What types of businesses will you be looking to lease the space?
- What type of yield could you expect from the investment?
- Is your SMSF portfolio diverse enough to justify investing in a commercial property?
- Do you want to link your business to your SMSF?
This table shows the comparison between purchasing a property with a loan, and without a loan.
These numbers do not take into consideration the additional costs associated with owning an investment property:
|SMSF Loan (LRBA)||No Loan|
|Value of Property||$300,000||$100,000|
Property Value Increases (ie Market Rises) by 10%
|Capital Gain for SMSF||30%||10%|
|Equity in Property||$130,000||$110,000|
Property Value Decreases (ie Market Falls) by 10%
|Capital Loss for SMSF||(30%)||(10%)|
|Equity in Property||$70,000||$90,000|
Borrowing to purchase a commercial property through an SMSF
John has $150,000 of cash in his SMSF and as an employee, earns an annual salary of $100,000 per annum. He has decided that his SMSF would like to purchase a small coffee shop near a university which he intends to rent out.
Commercial property in NSW
Purchase Price: $350,000
Historical Rent: $1,517 per month
John used funds in his SMSF to cover stamp duty and a deposit of 30%.
As a result, his SMSF via an LRBA has a 70% loan to purchase the property, and John’s compulsory super contributions plus his rental income is enough to cover the loan repayments and operating costs of the SMSF.
However, any changes to the loan size, income and deposit can dramatically change his outcome. If the property was un-rented for an extended period or if John’s personal income was, for example, $55,000 per annum, his super contributions + rental income wouldn’t be sufficient to cover the loan repayments, property and SMSF operating costs.
Capital Gains Tax Potential
Once John retires and his SMSF commences pension phase, he decides to sell his property. Over the last 2 decades, the property has increased in value to $600,000. Since John held the property within his SMSF, and is selling it during pension phase, the capital gains tax rate he pays on selling the property is 0%. The capital gains is $250,000 so John gets to keep the full $600,000 (minus cost of sale).
If John held the property outside of an SMSF, the capital gain he received upon the sale of his property would’ve been assessed together with his income, and taxed at his marginal rate. Given John’s annual salary of $100,000, and the capital gain of $250,000, he would’ve been taxed at his marginal rate of 45%. As a result, John’s would’ve had to pay $52,350 in capital gains tax.
Purchasing a $350,000 Property in NSW
|Property Cost / Value||$350,000|
|Bank Loan||$250,000||LVR 71%|
|Stamp Duty & Transfer Fees||$11,518||Paid from SMSF|
|Legal & Conveyancing||$3,500||Paid from SMSF|
|Total Acquisition Cost||$365,018|
|Deposit from SMSF||$100,000||Paid from SMSF|
|SMSF Balances||Before Property Purchase||After Property Purchase|
|Cash / Other Investments||$150,000||$34,982|
|Less Property Loan||$0||$250,000|
|SMSF Fund Income / Contributions||Monthly||Annually|
|Cashflow Positive / Negative||$347||$4,173|
|Compulsory Super Contributions (9.5% of salary)||$792||$9,500|
|Total Inflows (Money In)||$2,308||$27,700|
|SMSF Fund Expenses|
|SMSF Administration Fees (inc GST)||$121||$1,452|
|ATO Supervisory Levy||$22||$259|
|Property Loan Repayments (6% Interest, P&I)||$1,479||$17,748|
|Est. Property Running Costs (Insurance, Fees, Rates)||$350||$4,200|
|Total Outflows (Money Out)||$1,961||$23,527|
Investing in commercial property with an SMSF can be a complicated and daunting process. That’s why it’s important to be aware of all the responsibilities, risks, costs and benefits of property investment first. And remember, if you are ever unsure of whether an SMSF or commercial property is right for your personal situation, it’s best to speak to a personal financial adviser.
To learn more about how you can invest in commercial property with an SMSF, watch our Squirrel School video below!