SUMMARY: Lending for SMSFs has been turned on its head. Does it still work as a strategy? It’s tighter, but yes.
Property investment is a honey pot. It attracts everyone interested in making a dime.
And not just from an investment perspective – developers and the lending industry too.
Property’s role, from a SMSF perspective, has never been more keenly considered, as returns in the largest eastern seabord states continue to lure investors.
But the landscape for property investors has been slowly changing. SMSF lenders, at the behest of APRA, have made it tougher for trustees to turn a buck on this much-loved investment asset class for so many Australians.
The changes have been having an impact on the financial attractiveness of the strategy for investors. Property is, largely, a leverage play. And for SMSFs, like all other investors, it’s the terms that come with that leverage that has a big bearing on the success of the investment.
Two of the most important determinants in a property strategy is (a) how much money you can borrow, and (b) what is the cost of that money.
Both now have hurdles that are far, far higher than they were a couple of years ago, even just a year ago.
Loan-to-valuation ratios slashed …
When it comes to SMSF loans, most lenders have dropped the loan-to-valuation (LVR) ratio substantially. The LVR is the percentage of the value of the property that the bank will lend against. That is, if the bank restricts lending to 70%, then you may only borrow $350,000 on a property valued at $500,000. And 80% LVR means they will lend $400,000 for a $500,000 property.
If you went back to pre-April 2015, most institutions who were in the space of lending to SMSFs, were prepared to lend up to an 80% LVR.
There are few fringe lenders who will still lend at 80%, but the majority of the bigger name lenders have dropped to a maximum of 70%.
And AMP, who were once a serious player in the SMSF loans space, is now at a maximum of 50% LVR! Seriously? They can’t still be writing loans!
… while interest rates hiked
And the second half of the equation is the considerable increase in the cost of money – interest rates.
Since April 2015, most major SMSF lenders have lifted their interest rates many, many times. Rates in April 2015 for SMSF loans were sitting at an average of around 5.5-5.6%.
They are now sitting at an average of about 6.4%, an average increase of 80-90 basis points, during a period in which the Reserve Bank has actually cut interest rates by 75 basis points.
Interest is the cost of money. And with some lenders now charging interest rates starting with 7, the cost of that money has moved more into focus.
Leaving a very different equation for investors
Leverage is not THE point of buying investment property. But it is an important part of it, as the magnified returns, weighed up against the associated increase in risk, is what investors are making their calculations on.
What does a property investment look like now?
Let’s assume the purchase of a $500,000 investment property. We’ll compare what an 80% LVR looks like, compared with a 70% LVR.
Assumptions. Interest rate of 7% interest only, rental yield of 4% ($20,000 a year), with costs (agent’s fees, insurance, rates and general maintenance) of $6300 a year.
With an 80% LVR and a loan of $400,000 the total “costs” are $34,300, with income of $20,000.
This is going to leave the property negatively geared to the tune of $14,300 a year.
SMSFs only get a tax deduction of 15%, so will get a tax return of $2145 on the negative gearing. Meaning a cash loss for the year of ($14,300 minus $2145) $12,155.
With a 70% LVR and a loan of $350,000, the total costs are going to be $30,800. This will create a cash loss of $10,800 and a tax return of $1080 and a total cash loss for the year of $9720.
Interest has always been the biggest cost associated with property investment in the early years. The increase interest rates, particularly if the Reserve Bank increases them in the coming year, will further put a squeeze on the calculations.
Impact on the fund
Ignoring non-cash deductions such as depreciation, the difference between the two leads to the lower LVR investment having a better cash flow of approximately $2435 a year.
The real impact, however, is on the cash left in the fund after the property purchase.
The fund with the 70% LVR has had to tip in an extra $50,000 for the property purchase, which, depending on the size of the fund, leaves a lot less to get extra diversification, away from the property.
Let’s assume a SMSF starting with $300,000. If they went with a lender with a 70% LVR, they needed to tip in $180,000 (30% for the deposit, plus costs, including stamp duty) into the purchase. This leads to just $120,000 left to get some diversification. And, depending on the level of income coming in to the fund via contributions, will be much harder to get loan approval.
One that went with an 80% LVR had to tip in about $130,000.
The higher LVR borrowing has allowed the SMSF to retain an extra $50,000 in the super fund for further investment and to meet cash flow requirements. That leaves $170,000 in the fund, to help fund higher cashflow requirements to fund the loan.
The information contained in this column should be treated as general advice only. It has not taken anyone’s specific circumstances into account. If you are considering a strategy such as those mentioned here, you are strongly advised to consult your adviser/s, as some of the strategies used in these columns are extremely complex and require high-level technical compliance.
Bruce Brammall is managing director of Bruce Brammall Financial and is both a licensed financial adviser and mortgage broker. E: firstname.lastname@example.org . Bruce’s new book, Mortgages Made Easy, is available now.