The Pitfalls of Property Valuations – Part 1

Property development is a popular investment choice for SMSFs because in many cases the returns are greater than investing in a single property. At audit time, however, the pitfalls of obtaining a satisfactory SMSF property valuation can result in a headache for everyone involved.

It’s easy to blame the SMSF auditor for being too pedantic in accepting a market valuation, but remember that it’s not always their fault.

An SMSF auditor must obtain an understanding of the trustees’ rationale for determining market value and then exercise their professional judgement in assessing whether those values are true and correct.

Property valuations are now under intense ATO scrutiny, who will be closely monitoring them to ensure compliance with the new transfer balance caps and total superannuation balances.

The risk is that SMSF trustees may deliberately undervalue assets to stay below the new caps and balances

Remember, too, that it’s not the role of the SMSF auditor to undertake a valuation themselves but to review the evidence provided by the trustee of the underlying value of the property.

How is Market Value Determined?

In most cases, the term ‘market value’ takes on its generally accepted meaning developed from a judicial authority, such as the test provided in Spencer vs The Commonwealth of Australia (1907) 5 CLF. This established the concept as being the price that a willing but not anxious purchaser would pay to a willing but not anxious seller.

There are three (3) main valuation techniques that establish the framework for measuring fair value and an overall fair value measurement approach:

1. Market approach – uses prices and other relevant information generated by market transactions that involve identical or comparable assets and liabilities, most commonly used for business valuations.
2. Cost approach – reflects the amount that would be required currently to replace the service capacity of an asset, adjusted for obsolescence.
3. Income approach – coverts future amounts to a single current (i.e. discounted) amount

The valuation basis used will depend on the purpose of the valuation. Depending on property type and the development stage, a valuation may contain multiple valuation techniques to measure fair value.

Another method is the discounted cash flow valuation (or residual method). This method requires the prediction of future cash flows discounted by the weighted average cost of capital to represent a net present value. This model typically uses a lot of assumptions that, depending on what they are, can impact the valuation.

What do SMSF Auditors Look For?

SMSF auditors must be assured that a valuation report constitutes appropriate audit evidence, by looking for relevant issues such as sources of data used, assumptions and methods used and their appropriateness and consistency with the prior period.

To this end, the valuation must be determined not to be unreasonable.

When a property is purchased or sold by a fund to an unrelated party, the sale price is considered at market value and the contract of sale is acceptable audit evidence.

Where the transaction involves a related party, it must be supported by an independent valuation from a licensed real estate valuer.

In subsequent years, acceptable property valuations may also include:

• Trustees’ estimation of property value – this should be supported by evidence such as recent comparable sales in the area
• A real estate agent’s estimation of the value of the property – some real estate agents now charge for this service as a response to increased demand.

SMSF advisers should be aware that when using comparable sales, they must withstand the objective scrutiny of their comparability. Often, supporting sales data in property valuation is provided without any explanation as to why the data is comparable.

Where using post-valuation date sales or remote area sales, the best practice is to include a commentary as to why the trustees consider it reasonable to use these sales to establish the property value.

Property websites that provide an estimate of the value of the property may not be a reliable source of evidence. Typically, the data entered on these websites is incomplete, and they provide a range of values based on property sale averages which may not be accurate.

Also, be aware that the ATO has said that it is not acceptable to use the lower end of the range for one purpose (such as for transfer balance cap purposes), and the higher end of the range for another purpose (such as transitional CGT relief purposes).

Is the property Insured?

The auditor must also confirm that the property is insured, to protect fund assets. Copies of the insurance policy for the property should show that the fund is both the owner and the beneficiary of the policy.

All premiums must be paid for by the fund (except in the case of strata title), and the cover should be adequate to replace the asset in the event of a fire or other damage.

In the circumstances where a related entity has taken out the policy, the policy should note the fund as an additional insured.

Security of fund assets is extremely important, especially in a claim where the corporate trustee acts in other capacities. This could result in the insurance proceeds channelled to a different entity and not the fund.

Where there is no evidence that the property is insured and the property is a material asset, an SMSF auditor will consider qualifying part A of the audit report as fund assets can be at risk.

Read Part 2 and Part 3 of this series

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