SMSF Property Investment: Why Debt Reduction is a BAD Strategy

With Australia’s culture of not wanting to be in debt, it’s easy to understand how investors can fall into the trap of applying debt reduction strategies to investment vehicles such as self-managed superannuation funds (SMSFs).

Surely Debt Reduction can’t be that bad?

Newsflash! It is.

If you have a SMSF Property that was financed with Limited Recourse Borrowing Arrangement (LRBA), a Debt Reduction Strategy will leave you in the WORST POSSIBLE POSITION.

The main reasons for this are:

1. Sharemarket returns significantly outperform mortgage interest rates (~10%+ vs  ~4%). The compounding effect of the difference over time is significant.

2. You cannot redraw from the equity in your SMSF property – the only way to access your equity is to sell the property.

3. A debt reduction strategy leaves you undiversified and dependent upon one dominant asset – if this asset doesn’t perform as expected, you’ll be in a significantly worse financial position compared to a diversified strategy that can be tailored to suit ongoing market conditions as they evolve.

Using licensee benchmarks we’ve compared the following strategies side-by-side, over 10 years:

1. No SMSF Property: Leaving your super where it was

2. The VCo Strategy: 80% loan to purchase price ratio, investing remainder in ‘sandwich’, allocating ongoing surplus cash flows to ‘sandwich’

3. Debt Reduction: Allocating all upfront and ongoing surplus cash flow to mortgage

The results are…

In simple terms, if you’re planning on doing a debt reduction strategy with your SMSF Property Investment, then you may as well not do the strategy at all. Or better yet, do it The VCo way 

Assumptions

Investors

• Couple with starting super balances of $200k each
• Net contributions of $10k p.a. each
• All contributions, rental income and dollar-based expenses indexed at 3% p.a.

No SMSF Strategy

• Benchmark net rate of return of 8% p.a. applied to super balance and contributions
• Returns are net of fees and taxes

The VCo Strategy

• Setup SMSF cost of $5,500
• Strategy implementation fee of $6,600
• Property purchase price $500k
• Loan to purchase price is ratio is 80%
• Property purchase costs are 5% of property value
• Buffer to remain in cash is 5% of property purchase price
• Rental income of $500 per week
• Rental expenses are 20% of rent
• Mortgage interest rate is 5%
• Mortgage amortisation is 30 year principal & interest
• Annual salary sacrifice equal to ongoing advice fees and SMSF tax & admin costs
• SMSF tax & compliance fee of $3,300 p.a.
• All upfront and ongoing surplus cash after 5% buffer transferred to ‘sandwich’ investment
• Property capital growth rate of 4% p.a.
• Benchmark net rate of return of 10% p.a. applied to ‘sandwich’ investment

Debt Reduction Strategy

• Setup SMSF cost of $5,500
• Property purchase price $500k
• Property purchase costs are 5% of property value
• Buffer to remain in cash is 5% of property purchase price
• Rental income of $500 per week
• Rental expenses are 20% of rent
• Mortgage interest rate is 5%
• SMSF tax & compliance fee of $3,300 p.a.
• All upfront and ongoing surplus cash transferred to mortgage account
• Property capital growth rate of 4% p.a.