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Written by Per Amundsen, Head of Research, Thinktank
Since Limited Recourse Borrowing Arrangements (LRBAs) took effect in 2007, they have never been far from controversy. First, the Cooper Review put them under the microscope in its 2010 final report, suggesting future scrutiny without calling for an outright ban.
Four years later, the Financial Services Inquiry went a step further with its December 2014 final report recommending a ban, one of the few recommendations the Coalition Government chose to ignore. But this form of credit remains on the regulator watchlist. In its 2019 review, the Council of Financial Regulators opined that because of small percentage of SMSFs using borrowings, “LRBAs are unlikely to pose systemic risk to the financial system at this time”. Another review is due in 2022.
As Thinktank has often said, SMSFs considering using gearing need to carefully consider the risks, and certainly need to get specialist advice. LRBAs can go wrong, from young people with limited resources using this form of leverage to get into the real estate market to older investors still servicing loans while having to make pension payments. [Statistics from the Australian Financial Complaints Authority show about 590, or almost 20% of complaints received in 2020, involved advice to establish an SMSF to invest in property. But this number, while high, must be seen in context; it was less than 3% of SMSFs set up in 2020.]
That said, the evidence still suggests those encountering difficulties with an LRBA are a small minority, and that to deny all SMSFs (and they remain a minority of funds as the Council of Financial Regulators noted) access to this form of leverage is to restrict their opportunity to use debt to increase their funds under management.
The importance of this is highlighted by the fact that while the ATO’s quarterly statistics to 31 December 2020 show more than $41.3 billion invested in residential property investments by SMSFs, non-residential real estate investment is nearly double that figure at 78.0 billion. Of this latter number, a large portion are owner occupied “business real property” that can be acquired directly from members or family trusts, including via in specie contributions, which have several advantages not available to residential property.
Thinktank, active in the LRBA market since 2013, takes a conservative approach to this debt instrument, having about three times the volume of non-residential investments – many are in the business real property category with related-party tenants – compared with residential loans. We also require SMSFs to have a minimum net asset figure of $250,000, a level recommended by ASIC, helping alleviate the relative cost issue often raised with smaller SMSF when compared with APRA-regulated funds.
None of this denies there are still commercial risks with direct investment in real property, as has been highlighted by the COVID-19 pandemic when many tenants were unable to maintain their rental payments with the ensuing hardship flowing on to landlords.
But, again, this should not be exaggerated. Our experience shows a very low incidence of these hardship circumstances in our LRBA portfolio. Across all our loans, both SMSF and other, hardship loans peaked at 23.5% across our portfolio in April/May 2020, with SMSFs being only half that amount.
Our approach differed to the major banks in that we provided three-month deferrals with regular monthly contact and then provided a further round of three months if required. This saw a steady decline in hardships in each round with round 2 in July 2020 falling to 13.9% and then 4.7% by October 2020.
By the final round before the 31 March 2021 cut-off for the Federal Government’s deferral scheme, there were only 38 loans approved amounting to about $33 million or less than 2% of the loan book. This was no different to the best of the big four banks, the ANZ, when they reported their half-year earnings.
The number of loans that have required ongoing assistance at Thinktank has halved again since 31 March. The recovery rate was also about 50% better within SMSF borrowers and, by 31 March 2021, when COVID-19 hardship ended, literally only one SMSF requested and was granted an extension of payment deferrals while they awaited settlement on the sale of a property. It was their decision to sell, although it was prompted, in part, by COVID-19.
Although Thinktank is just one lender in the LRBA space, we strongly suspect our experience does not differ greatly from other responsible lenders in this debt market. For our part, conservative LVRs, ensuring SMSFs have net assets of least and giving preference to business real property loans helps ensures a healthy loan book that can even survive a once in 100 years pandemic. It’s an outcome that LRBA critics should consider next time they argue against this debt instrument.
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