Written by Per Amundsen, Head of Research, Thinktank
The numbers are revealing. According to the consultancy firm Plan1, the non-bank lending sector’s slice of the commercial real estate debt market is set to grow rapidly over the next three years to an estimated $50 billion by 2024. As the banks, especially the Big Four, step back from commercial lending (at its peak they had 85% of the market and currently have about 72%), non-bank lenders – any lender that isn’t a bank, credit union or building society – have been stepping up the plate to service this market.
Nowhere is this lending phenomenon more evident than with limited recourse borrowing arrangements (LRBAs) where the Big Four, as well as Macquarie Bank, have vacated the market to the non-banks. The big end of town has essentially decided this market sector is too time-consuming and challenging, with a nimbler non-bank sector better suited to this lending product. [Besides, the Big Four provide much of the funding to the non-bank sector, especially senior debt, a far more efficient use of their capital without having to manage the compliance aspects at a retail level.]
Even the Federal Government has recognised the importance of this market trend in providing credit, especially to SMEs. It’s not just moral support. During COVID-19, the Australian Office of Financial Management advanced $2.3 billion to the non-bank sector to keep it well supported through the pandemic with most of this sum since repaid.
So, while the simple answer as to why LRBAs, which reached $59 billion at 31 March 2021, are the preserve of the non-bank sector is that the Big Four and Macquarie don’t offer them, the correct answer is far more nuanced than that.
LRBAs, especially when it’s related to commercial property, are often part of a borrower’s total financial situation. A husband-and-wife SME can use an LRBA to facilitate their self-managed super fund (SMSF) buying their business premises (it’s called a business real property transaction) to give them long-term lease security – it must be at the market rate – as well as their SMSF having an appreciating asset that will contribute to their retirement savings in a highly tax effective environment.
All this is both time-consuming and requiring a diversity of skills within a tightly disciplined process that simply makes it a sphere of business activity that the Big Four and Macquarie don’t want to pursue. After all, for SMEs to pursue a LRBA and all that involves in terms of their business, it is likely to involve a mortgage broker, financial planner, lawyer and accountant. Certainly, any SME and/or SMSF considering an LRBA should get informed specialist advice.
Consequently, the non-bank lenders, which have extensive commercial property underwriting skills in the SME space, have carved out strong relationships with these differing professional advisers to ensure the borrower gets the correct advice. It’s a highly competitive market and that’s helping to further underpin best practice across the sector.
There’s another factor at play. With LRBAs for business real property transactions, the loan terms can be up to 30 years. For SME borrowers, it means they have lower monthly loan repayments, with the cash flow savings better utilised to grow their businesses. For mortgage brokers, it is another way in which they add greater value to their SME clients and remain preferred as a professional financial resource taking over the traditional place of the bank manager.
Recent regulatory and legislative changes are also expected to facilitate non-banking lending to SMSFs. First, from 1 July 2021 tax-concessional superannuation contributions rose to $27,500 (they were $25,000) and non-tax-deductible contributions increased to $110,000 (previously $100,000). This will give SMSFs more financial scope to service an LRBA.
Second, SMSFs can now be six-member funds (previously the maximum number of members was four). Although the industry is not expecting a huge uptake of this legislative change (remember the bulk of SMSFs have two members), what might be interesting is whether business partners who share an SMSF might be inclined to increase their membership to six to allow other business partners to join enabling the purchase of larger or multiple properties.
The advantages are obvious. It would give an SMSF looking to execute a business real property transaction more financial muscle, both in terms of its equity contribution and the capacity to meet mortgage repayments. Remember, though, an existing LRBA cannot be renegotiated to increase the debt level. Once they are signed, they are set in stone. But an expanded fund could undertake to set up another LRBA to acquire a different property.
One final point is worth making. Despite all the media comment about LRBAs and the impact they are having on the residential market, the fact is SMSF investment in this asset class stood at $44 billion at 31 March 2021, or, as a percentage of the $5.5 trillion residential market, 0.76%. Hardly market moving, which has been a long-held concern by many, particularly those not close to the sector.
What’s far more significant is the $82 billion in commercial property that SMSFs have in their portfolios. Much of this property is business real property such as factories, industrial units, shops, strata offices and child care centres, demonstrating that LRBAs are not only helping these SMEs/SMSFs better manage their businesses but giving them a means to finance an asset that will make a substantial contribution to their retirement income strategy.