Our SMSF Finance Guide

About The SMSF Finance Guide

Self Managed Superannuation Finance is a highly specialised area where relevant skills and experience are required to succeed. Our SMSF Finance Guide offers insights into best practices for structuring and obtaining mortgage finance or commercial finance.

Borrower Enquiry Form

Please read the general borrower information below which will assist you to complete the SMSF Borrowers Enquiry Form at the end. The preferences you provide will form a basis for further discussion.

Disclaimer
The information in this Guide is general information only. It is not intended to be a recommendation or constitute advice. We recommend you seek advice as to whether this information is appropriate to your needs. Whilst every care has been taken in the preparation of this Guide, the author and associated entities, its directors, or consultants expressly disclaim all and any form of liability to any person in respect of this Guide. This includes any consequences arising from its use by any person in reliance upon the whole or any part of this Guide.

PART A: SECURITY PROVIDED FOR DEBT

Security or Collateral are the assets that an individual or entity borrower provides to a lender, as security for credit (debt). For the credit provider, this serves as a protection against potential loss of capital.

For SMSF arrangements, a property will be the sole security for any lending arrangement. As a result, a mortgagee (e.g. credit provider) only has a recourse on the property and not against any other assets within the SMSF.

Property is owned by a “bare trust”, with the SMSF having a beneficial entitlement. The bare trust holds ownership until all debt is paid. After the loan is repaid, the SMSF has the right to acquire the legal ownership of the asset.

LOAN SERVICING

1. RENTAL INCOME

For investors, the rental income received from a property investment is not sufficient on its own to demonstrate loan servicing.

Take the following example of a new property acquisition of $1M, with borrowing to 80% of valuation under an SMSF arrangement:

SMSF Loan Servicing Table

The property has a Gross Yield of 5.0% (Being $50,000 / $1,000,000). For a credit provider this is less than the headline interest rate of 6.75%. The gap gets wider as we sensitise both the income, and the interest rate “buffer” applied to the loan as well:

Loan Servicing table 2

2. CONTRIBUTIONS

This shortfall ($43,101) needs to be supported by other income means. The lender will include earnings inside the existing SMSF structure or, less preferred, the ability to make future concessional or non-concessional contributions in the future.

Tip: When determining yield, always allow for lenders to sensitise rental income and add interest rate buffers.

OTHER FACTORS

FINANCIAL POSITION & BACKGROUND OF THE MEMBERS AND TRUSTEES

In most instances, the personal financial position of the applicants will be reviewed, as the capital base accumulated should indirectly reflect their “story”. A lender will look to connect that to some extent.

In all cases, financiers will request a completed Asset & Liability Statement for all individuals. Despite the non-recourse nature of these arrangements, this will help assess the ability of the borrowers to make future contributions to their SMSF.

RETIREMENT OF DEBT

The financier will want to see how the debt will be retired (repaid in full). Given the nature of SMSF, the primary strategies they look for are:

Rental Income received from the Property
Income generated from other assets in the SMSF
The ability to make ongoing SMSF contributions in the future

Tip: The sale of the primary security is not a sufficient debt strategy in most instances. Credit providers want to see the “first way out”.

THREE COMMON REPAYMENT TYPES

1. PRINCIPAL & INTEREST (P&I)

A crucial and misunderstood component of lending.

Principal and Interest or “P&I” repayments are designed to ensure after a specified term (usually 15 years for commercial property) that the loan balance is fully repaid after a specified term.

The P&I repayment is a contracted ongoing repayment, based on the outstanding loan limit (not balance), the interest rate and term remaining. The repayment can change over time as interest rates move as a result.

Repayment basis will vary on the type of facility. There is generally less flexibility on the timing of repayments compared to home loans.

2. INTEREST ONLY (IO)

Interest Only or “IO” repayments do not require the repayment of principal for a period of time (usually a maximum term of 5 years). These loans typically attract a higher interest rate.

Upon the IO term maturing, the following P&I term will be based on the total period, less the IO period. As a consequence, borrowers will usually find themselves with higher residual repayments.

For example: If your loan term was 15 years with 4 years Interest Only, the residual term is 11 years P&I.

IO may suit businesses that want to preserve cash flow. However, Principal & Interest from the outset can be desirable in many cases. The best option will ultimately come down to the opportunity cost of the “saving” and borrowers need to be aware of this consideration.

TYPES OF SMSF PROPERTY INVESTMENT

1. RESIDENTIAL PROPERTY

Using a residential property as security for a business loan generally enables borrowers to access “better” terms in comparison to commercial property security.

2. COMMERCIAL PROPERTY

The essence of the original SMSF borrowing structures was usually for a business owner occupying their business premises. It is now more diverse.

Commercial is broadly defined as Standard or Non-Standard. Standard commercial properties are preferred and the best terms can generally be extracted. Standard security generates more lending options and terms.

Standard Commercial examples:

Commercial Offices
Industrial Warehouses & Factories
Retail Premises & Shopfronts

Specialised commercial properties are generally a higher risk to credit providers, as they have a smaller available market on exit.

Non-Standard Commercial examples:

Specialised Accommodation (Motels, Hotels, Caravan Parks)
Aged or Child Care Facilities
Agri/Farms/Rural Properties

LOAN RATE OPTIONS

1. VARIABLE RATE LOANS

All credit providers have varying sources of funding. A variable facility can be packaged by lenders in several ways.

Like mortgages, which typically move in the same direction as the Reserve Bank cash rate, SMSF rates are correlated to changes in these broader funding costs.

Variable rate loans are most popular with borrowers as there are usually few or no restrictions. Most variable loans are flexible, and they allow unlimited extra repayments.

2. FIXED RATE LOANS

SMSF interest rates can be fixed usually for a term of 1 to 5 years. Fixed rates can be restrictive, extra repayments can trigger “break costs”.

Break costs occur when you repay more than what is allowed under the product. A larger prepaid amount and a longer fixed period can potentially mean a more significant break cost. If interest rates continue to decrease after fixing, your break cost liability increases.

Some short term fixed SMSF facilities can be combined with variable rates, allowing the borrower to choose a structure to suit cash flow.

LOAN SERVICEABILITY MEASURES

1. INTEREST COVER RATIO (ICR)

ICR is a measure of how easily a business can pay interest on outstanding debt.

2. DEBT SERVICE RATIO (DSR)

A measure of how easily a business can pay total debt repayments on its outstanding debt.

Tip: DSR can be a more relevant measure of liquidity, unlike ICR it includes the actual cash commitment to reducing debt. Where strong amortisation is needed, the gap between DSR and ICR can be wide.

3. DEBT TO INCOME RATIO (DTI)

A more holistic measure of outstanding debt, against the total gross income of the borrower.

PART E: CHOICE OF LENDERS

SMSF lending has evolved rapidly over its relatively short life. Initially, this structure was the domain of major lenders and was funded against commercial property assets. A broader explosion to smaller residential properties opened a new pipeline for SMSF investing.

The risk aversion, regulation and capital adequacy requirements imposed on major and second-tier banks meant they retreated broadly from this market over the last decade.

This opened the door for a range of non-bank financial institution (NBFI) lenders to enter the market with increased sophistication. There was strong government lobbying for this structure to be banned, with fears that it was used as a vehicle to promote lower-quality property investment.

SMSF CREDIT POLICY

In recent years, the market has been more aggressive, and we have seen the volume of credit providers returning, along with an expansion of credit policy, such as:

REMOVAL/REDUCTION OF LIQUIDITY REQUIREMENTS

SMSF loan liquidity requirements refer to other readily liquid assets held in the Fund. Credit providers traditionally want to see at least 10-20% of the property value available, which supports statutory purchase costs and other expenses associated with a property.

For example, for a property acquisition of $1,000,000, the credit provider would previously look for at least $100,000 (10%) in liquid assets in your SMSF. This requirement has softened in recent years.

HIGHER MAXIMUM LOAN TO VALUE RATIOS (LVR)

As competition has returned, so has the extension of loan value against security value. As a rule, this extends to 80% of independent valuation for residential property and up to 70-75% for eligible commercial property.

PART F: BASIS OF RECOMMENDATIONS

A basis of recommendations is a best practice step in the SMSF lending process. Understanding lending structures and costs will assist you in making an informed decision.

CHOOSING A LENDING STRUCTURE

Structuring SMSF Finance is restrained by the limited pool of participating lenders.

Many expected second tiers would fill the void as major banks retreated from SMSF lending. However, most adopted a credit appetite that sits alongside or behind the majors.

Instead, specialist lenders have developed specific credit products for SMSF. These include Liberty Financial, Latrobe, Pepper Money, Bluestone and Bank of Queensland, which all source funding differently.

In our experience, the structure and subsequent conduct of borrowings are more material than the credit provider selected. Therefore, it is critical to focus on identifying the needs of the SMSF first before jumping straight into a credit solution or provider.

UNDERSTANDING LENDING COSTS

All prospective lending terms depend on the borrower’s relative risk of default, combined with a “score” calculated by bespoke risk grading systems that capture qualitative and quantitative measures.

This score presents a required Return on Equity (ROE), which forms the ultimate basis of the lender’s rate pricing and fee model. The modelling considers the probability of default based on risk grade.

Then, it calculates the “loss given default”, which generates the capital cost requirement based on the lender’s cost of funds.

From a cost perspective, upfront fees for SMSF lending are higher than those for mortgage lending. A combination of legal, administrative and general application fees also contribute to the overall cost of borrowing.

COST COMPARISON

A comparison of upfront costs and the indicative interest rate should be taken into consideration by the borrower.

Consider the following example. Option 1 has a lower headline interest rate of 6.50% than Option 2’s 6.60%. However, after adding additional set-up and ongoing fees, Option 1 will cost $3,273 more than Option 2 over the 15-year loan term.

SMSF Cost Comparison Table

TIP: The above example highlights how interest rates, costs and fees all factor into the bottom line over a loan term.

APRA

Australian Prudential Regulation Authority. An independent authority that supervises institutions across banking, insurance and superannuation and promotes financial system stability in Australia.

BCOP

“Banking Code of Practice.” Sets out the standards of practice in the banking industry for individual, small business customers, and their guarantors.

BARE TRUST

A bare trust is a basic trust in which the beneficiary has the absolute right to the capital and assets within the trust, as well as the income generated from these assets. The trustee has no duties to perform beyond handing over the property to the beneficiaries when instructed to do so.

COLLATERAL

The Assets given by a borrower to a credit provider in order to secure a loan. It serves as an assurance that the lender will not suffer a significant loss.

DSR

“Debt Service Ratio”. A measure of how easily a business can pay total loan repayments on its outstanding debt relative to EBITDA. Considers principal and interest.

DTI

Debt-to-income (DTI) ratio used by lenders to determine borrowing risk. A DTI ratio represents the total amount of debt owed compared to the total amount of money earned. It is measured as the percentage of monthly gross income that goes to paying monthly debt payments.

FIXED INTEREST RATE

Where the loan interest rate is fixed, usually for a term of 1 to 5 years. Fixed rate loans can restrict features such as offset and redraw. Break-costs need to be considered. Suitable for borrowers who like to budget to a plan or are sensitive to interest rate rises.

GEARING

Gearing means to borrow money to invest. In lending, gearing (also known as leverage) is the relationship, or ratio, of a company’s debt-to-equity and is used to determine a company’s creditworthiness. (See Negative Gearing)

GROSS YIELD

The gross yield of an investment is its profit before taxes and expenses are deducted expressed in percentage terms. It is calculated as the annual return on an investment(before taxes and expenses) divided by the current price of the investment.

ICR

The interest coverage ratio (ICR) shows how easily a business can pay its interest expenses. This measure ignores any principal reduction.

IO or I/O

Interest Only. Where repayments are only covering the interest on the amount borrowed (the principal) for a set period of time. Repayments will vary due to the utilised balance, number of calendar days in a month.

LIMITED RECOURSE LENDING

A loan used to purchase a single asset or group of assets where the lender's claim on assets is limited to the asset(s) purchased with the loan, if the borrower defaults on the loan.

LVR

Loan to value ratio. This is the loan amount divided by the property or sometimes by the business valuation. Always expressed as a percentage.

NBFI

Non-Bank Financial Institution. In other words, a credit provider that does not hold a banking licence.

NEGATIVE GEARING

A rental property is negatively geared if it is purchased with the assistance of borrowed funds and the net rental income, after deducting other expenses, is less than the interest on the borrowings.

P&I

Principal & Interest - this is the most common repayment type, it requires a payment towards loan principal along with interest. Repayments are set based on the interest rate.

PRESERVATION AGE

You can access your super before 65 if you retire at your preservation age. Your preservation age is between 55 and 60 depending on when you were born.

ROE

Return on Equity divides Net Profit after Tax by Total Equity to measure how efficiently a business is using its equity to generate profit.

SERVICEABILITY

Capacity. This is a calculation, based on the overall net income position, that lenders use to determine what level of debt can be serviced without reasonable risk of default.

SMSF

A self-managed super fund (SMSF) is a way of saving for retirement. The members of the fund run it for their own benefit.

SMSF MEMBERS

Members of an SMSF operate the fund for their direct benefit and are responsible for complying with superannuation and taxation regulations.

SMSF TRUSTEES

Trustees are individuals, or a company appointed to manage the SMSF on behalf of its members.

SOLE PURPOSE TEST

A SMSF needs to be maintained for the sole purpose of providing retirement benefits to members, or to their dependants. A fund fails the sole purpose test if it provides a pre-retirement benefit to someone – for example, personal use of a fund asset.

VARIABLE INTEREST RATE

Also “Standard Variable” or “Basic/Base Variable” loans. The interest rate is changeable and typically moves in the same direction as the Reserve Bank cash rate. Suitable for borrowers who want features like extra repayments, offset/redraw facility or split loans and can plan to absorb interest rate rises.

SMSF Finance Guide

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