Property warrants are complex financial arrangements that grant an exception to superannuation rules that normally prohibit funds from borrowing to make investments. With many investors cautious about shares, property is seen as a lower-risk alternative.

But property does have its own risks, especially for those who don't have the financial resources to deal with such situations as not being able to pay the ongoing interest expense, which can happen for any number of reasons.

The worst possible thing a super fund that pursues a property warrant strategy can do is default on a loan, warns Mark Wilkinson, a partner with Deloitte Private Superannuation. Such an outcome could result in not only the super fund suffering the financial losses that can accompany property loan defaults but individual fund members suffering financially. In addition, there is the potential for breaches of super rules and regulations.

These include the possibility that any loan payment by a member on behalf of their super fund made under a loan default payment arrangement could be treated as an excessive super contribution. Such payments could mean the fund paying penalty taxes if a view expressed by the Australian Taxation Office in a draft ruling being finalised is confirmed.

Property warrants are modelled on share warrants - also known as share instalment warrants -financial products that package a parcel of shares with a loan provided by a commercial lender.

With share warrants, investors pay an initial instalment that represents between 40 to 50 per cent of the value of the shares when the warrant is bought. They also pay interest on an interest only loan that lasts until the warrant's maturity date when the loan is required to be repaid or rolled over to a replacement warrant. If the loan is repaid the payment converts the instalment shares into fully paid shares.

A share warrant also has a built-in risk protection feature that deals with the risk of any loss the lender may face and avoids the lender, having to chase the investor for any outstanding loan amount. This makes the warrants different to share investment loan arrangements such as margin loans, where individual investors are personally liable for any loan shortfall if the value of the shares is less than the outstanding loan.

It highlights an often stated feature about share instalments -that investors can walk away from any loan obligation if the shares plunge below the value when the warrant was first bought to a level where the loan will cost more than the share value.

The risk protection feature of share warrants is a financial arrangement described as a share put option. These are provided by specialist option dealers who receive a premium payment, much like an insurance premium, in exchange for accepting the obligation to repay the loan in full if the shares are worth less than the loan when the warrant investment matures.

Because property warrants offered to super funds have no risk protection features as there are no such products as property put options, different arrangements have been developed. They include shifting the obligation to pay any possible loan shortfall in the event of a default to fund members as individuals. Fund members are being asked to provide personal guarantees that they will honour any outstanding loan balance should there be a default.

However, such guarantees come with other super-related risks and according to Vince Scully of SMSF Finance Specialists should be avoided. While most lenders will ask for guarantees from members and most property warrants are being sold with guarantees, Scully says most lenders will (or should) waive this in the right circumstances.

These circumstances could be a super fund being prepared to put up a higher deposit and therefore borrow less money. A 50 per cent loan to valuation ratio, where the fund borrows 50 per cent of the value of a property, should be more than enough security for a lender. If lenders are not prepared to waive any demand for a personal guarantee, trustees should approach another lender, suggests Scully. There are around 10 lenders offering property warrant arrangements.

Scully says that super funds trustees who can't negotiate a property warrant without having to give a personal guarantee should think seriously about whether these are a suitable investment for their fund.

What many DIY fund trustees do not seem to be aware of when it comes to property warrants is that the prospect of a loan default actually comes from poor strategic planning by the trustees and any advisers they may have.

One of the most important rules in super is to ask whether fund trustees would agree to a strategy if they were investing on behalf of someone else.

Property warrants have features such as generally higher interest rales on loans compared with other investment loans.

John Wasiliev