It’s a hot topic in the mainstream media right now.
Hardly a day goes by without SMSFs being implicated in the Sydney & Melbourne property bubble.
It’s also an issue causing some of my Gowdie Family Wealth members concern as well. Here is an email I received from George T.
‘Like you I have three daughters, two of whom are trying to get into their own homes. As is the norm these days, they are looking to borrow $300,000 to $400,000. Even with deposits of their own savings of $100,000 plus, in Melbourne, this puts them in the ‘first home-buyers’ end of the market.
‘Last year as executor for a deceased estate, the residential property I had to sell was purchased by a SMSF. Today I read about the concerns of some authority (forget who) suggesting that this SMSF market is well and truly into the property market utilizing the gearing strategy opened up by the government a few years ago.
‘So, apart from the issues as to whether SMSF’s should be allowed to ‘gear’, the issue concerning me is that the young new generation, trying to get their first home, have a fresh, access to funds, new competitor, in their market.
‘Apart from the potential social issues (between the haves and the have not’s) and the dangers that this new market player is adding financial fuel to the housing pricing bubble, my personal question is: What is the right advice to give to my two daughter’s? Enter this potentially overheated market or stay renting, stay cashed up and stay saving??
‘Life was not meant to be easy. I would very much appreciate your thoughts and input.
Before addressing George’s concerns, here’s a general overview of borrowing to invest within a SMSF…
Borrowing to Invest Within SMSFs
Until late 2007, legislation prohibited SMSFs from borrowing to invest. The borrowing rules were amended in 2007, and again in 2010. This opened up a whole new world to a myriad of SMSF advisers/consultants/planners/property developers/financiers etc. to eagerly market this opportunity to investors.
Not surprisingly the take up rate has been phenomenal.
However, for those not familiar with the machinations of borrowing within a SMSF, it’s not quite the free-for-all it has been portrayed to be.
Borrowing is restricted to limited recourse borrowing arrangements (LRBA).
The LRBA together with available funds within the SMSF are used to buy a single asset that is held in a separate trust.
Should the loan default, the provisions of the Superannuation Industry (Supervision) Act 1993 (SIS Act) are intended to protect the assets of the superannuation fund, and member entitlements.
The LRBA limits lender’s rights to the asset held in the separate trust. The lender cannot seek recourse against any of the other assets within the SMSF.
Any losses are quarantined to the asset the borrowed funds were used to purchase. This safeguards the remainder of the SMSF assets (if there are any).
SMSFs are also restricted to using LRBAs to purchase a ‘single acquirable asset’. If the SMSF wishes to acquire more than one property, then separate LRBAs and trusts need to be established for each additional property. Again, losses are contained within the individual trust.
In 2009, the Government launched the Cooper Review into the Australian superannuation industry.
One of the findings of the Cooper Review was ‘the amount of borrowing within SMSFs is excessive and poses a potential risk to retirement savings.‘ This finding was four years ago. Borrowing levels have only increased since then.
Another finding of the Cooper Review was:
‘The 2007 relaxation of the borrowing provisions and the consumer protection measures that have recently been announced should be reviewed by Government in two years’ time to ensure that borrowing has not become, and does not look like becoming, a significant focus of superannuation funds.‘
The Government’s response to the finding was:
‘gearing can magnify investment losses and reduce liquidity [and] given the significant role SMSFs play in Australia’s superannuation system, it is important that there is appropriate oversight of SMSF service providers; that fund investments are consistent with the purpose of superannuation; and that fraudulent activity is curbed.’
The ATO has also voiced its concerns about the level of gearing in SMSFs.
In November 2012, the ATO issued a Taxpayer Alert TA 2012/7 ‘Self-managed superannuation funds arrangements to acquire property which contravene superannuation law’. The alert was a warning to SMSF trustees and advisers to exercise care when investing in property. This was a shot across the bow.
There is approximately $440 Billion in SMSFs. Of this, around 15% ($66 Billion) is invested in direct property.
No surprise property is the major asset class borrowed funds have been used to purchase.
Given the recent press from the Reserve Bank of Australia, my guess is the new government will look to eventually tighten the SMSF borrowing rules. Possibly:
– increase the amount of equity the SMSF has in the property purchase
– an SMSF must have $200,000 before it can be established
– trustees to sit a multiple choice test to ensure they are aware of their responsibilities
Squashing property speculation and naïve investor exploitation from SMSFs would, in my opinion, be a step in the right direction.
OK, so what about this bubble?
From an outsider’s perspective, the Australian property market is in a bubble. In a recent interview, Jeremy Grantham said:
‘America is a very, very optimistic-biased society, as I believe, incidentally, Australia is, for whatever that means. We’re the two great optimistic societies. You can have a conversation about a housing bubble in England, and they’ll say, ‘oh, is that right? Let me see the data.’ If you have one in Australia, you have World War III! They hate you. They hate you for years! The idea that you could suggest that they were having a housing bubble.‘
Here’s what Quartz had to say in August 2013 about Grantham’s ability to spot a bubble:
‘Jeremy Grantham, the 74-year-old chief investment strategist of Boston-based investment fund Grantham Mayo van Otterloo (GMO), has made his career forecasting market bubbles- with remarkable success. When writing an article on the slowing pace of global growth last week-for which Grantham’s ideas provide significant fodder-my colleagues and I were spellbound by one statistic: of the 36 major bubbles GMO says it tracks, 33 have completely popped, or returned to their prior trends.‘
One of the three bubbles yet to pop (according to GMO) is the Australian property market. Rarely does someone have a 100% forecasting record, so Grantham could be wrong on this one.
However all markets have certain mathematical metrics – yield, price to earnings, etc. When these metrics move well away from the average and the collective thinking is ‘it’s different this time’ or ‘it’s different in Australia’, then this sends up a red flag to experienced bubble watchers.
The following graph is from macrobusiness.com.au and shows the real (after inflation) price movement of the Australian housing market since 1880.
Note the kick up in prices began in earnest after 1980. No coincidence that this also corresponds with the beginning of our love affair with debt.
If we step back a bit further and view the house price graph with the knowledge of the following graph on US long-term interest rates, we can see the 1950 spike in prices was influenced by the extremely low rates that applied at the time.
Some constraints on house prices at that time that do not exist today, were:
1. Higher deposit required
2. One income household
After the initial spike in 1950, house prices moved slightly upward over the next thirty years. During this period interest rates rose from their post-Second World War lows to over 16%.
The higher servicing costs acted as a handbrake on house prices. Another factor during the 1970s was government-capped home loan interest rates at 13%, irrespective of how high the cash rate went to.
A measure designed to relieve pressure on households that had borrowed at the lower rates in the 1960’s.
Rates peaked in 1980 and as rates fell (money became cheaper), debt levels grew.
Admittedly this is the US interest rate experience. However, our rates trended in the same direction (give or take a percent or two) over these periods.
The point I’m making is that cheap money has filtered into asset prices. The current low interest rates + SMSFs borrowing + Chinese buyers are the reasons being cited for a fire being lit under the property values in Sydney and Melbourne.
As mentioned above there are mathematical metrics that apply to all markets, and Australian property isn’t immune to the laws of math.
From an investment point of view, if price rises aren’t matched by equally strong rental increases then the yield on the property decreases. For example, a property valued at $800,000 with a weekly rent of $800 per week (say $40,000 per annum) is yielding 5% before expenses (rates, insurances etc).
If the property price increases to $1 million and the rent remains at $800 per week, then the yield is 4% ($40,000/$1 million).
When you deduct expenses (of 1-2%) from the gross rent, the net income is getting a little skinny. Now this is OK while interest rates are low, but what happens if interest rates rise (as they inevitably will from their historic lows)?
If we look at the US property market pre-2007, a whole lot of new buyers (sub-prime borrowers and home equity withdrawals) were introduced to the concept of owning a house or three.
Sure this surge in demand drove prices up and those who ‘missed’ out lamented the fact they were left behind. No different to the current argument about SMSFs and foreign buyers crowding out the Australian market.
Why did sub-prime implode? The sweetheart low interest period expired and borrowers faced with the higher rates folded.
There certainly appears to be heat in the major property markets at present. However unless there is a corresponding increase in rents (and this is unlikely with unemployment tipped to rise) prices will hit the outer edge of their mathematical metrics.
So, to sum up, the short answer to George’s question at the top of this essay is that I would advise my daughters to continue saving, exercising patience, avoiding the hype, and do the math on renting versus buying if interest rates tick up 2+% or more.
Chairman, Gowdie Family Wealth