Assyat David looks at how property trusts can be used to satisfy clients’ income needs.
The turmoil of the global financial crisis (GFC) over the past 18 months has resulted in many traditional investment strategies coming under scrutiny. This is particularly the case for strategies and investments used to generate income from a portfolio. Advisers have an opportunity to demonstrate the value of advice to clients seeking to generate an income from their superannuation and ordinary money portfolio. They can do this by discussing a number of strategy options and by working through these to match the attributes of the strategy with the client’s income requirements and risk profile. This applies to clients establishing their portfolio to provide an income return as well as to clients with an existing portfolio that needs to be reviewed in light of the impact of the GFC on their investments. Some of the traditional asset classes that used to generate a high level of income have been adversely affected by the GFC and this has reduced their attraction. These include listed property trusts, mortgage funds and cash.
Listed property trusts (LPTs) traditionally generated a reasonably reliable and attractive income return (with tax benefits in the form of tax-free and tax-deferred components of the distribution) as well as modest capital growth. However, recent returns have been highly volatile and LPTs have underperformed shares. For the year to July 31, 2009, LPTs returned a negative 37.7 per cent (ASX 200 Property Accumulation Index) while Australian shares returned negative 10.2 per cent (S&P/ASX 200 Accumulation Index). Furthermore, as a result of the fall in earnings and lowering of debt, income distributions from many LPTs have been cut substantially. At the same time the underlying property market collapsed as many property investors had to raise cash by selling their assets. As the valuations fell, so did the share price of the LPTs.
Many mortgage funds placed a freeze on redemptions (with some limited exceptions), particularly following the Government’s announcement that it would guarantee bank deposits of up to $1 million. Cash returns have fallen substantially as the Reserve Bank of Australia reduced official cash rates from 7.25 per cent in March 2008 to the current 3 per cent. Given these circumstances, it has become increasingly challenging to structure an income portfolio, particularly if the client also wants their portfolio to produce tax-effective returns and some capital growth over time. Two asset classes that provide these attributes are Australian shares and direct property. Many of us are familiar with the notion that there is a trade-off between return and risk. The same principle applies to investments that offer an attractive income return, with the potential for capital growth, against the risk of that investment.
Advisers and clients need to be wary of this trade-off when structuring the portfolio to meet the client’s needs and risk profile. Australian shares provide franking credits which increase the grossed up (before tax) income generated by Australian companies. The current dividend yield from Australian shares is competitive relative to the income returns from other income assets. The income returns for the various sectors in the Australian sharemarket, separated into net dividends and the additional franking credit component, are shown in the chart above. The chart is based on forecast dividends for the 2010 financial year. The banks, telecommunications and financials (ex property) sectors are trading at levels that provide high levels of income. Banks, for example, are providing a grossed up dividend yield of almost 9 per cent, and telecommunications are providing grossed up returns of almost 12 per cent.
These income returns need to be considered in light of the highly volatile nature of Australian shares, as has been demonstrated by the recent global financial crisis. Clients need to understand and accept the higher risk inherent in this asset class and should have an investment time horizon of at least five years. When it comes to property investments, both direct and listed property often contain a tax-deferred component in their distributions. The tax-deferred component is attractive because clients can defer paying tax on this component until the investment is sold. The tax-deferred component is deducted from the cost base when the investment is redeemed and forms part of the capital gains tax calculation. If the investment is held for more than 12 months, the tax-deferred component can benefit from the rule that only 50 per cent of the capital gain is taxable at the investor’s marginal tax rate. The tax deferral can be of particular benefit to clients who redeem the investment when they retire and move into a lower income tax bracket.
