‘Concentration risk’ can put SMSFs in jeopardy
SMSFs with significant leverage are exposed to an elevated risk of “concentration”, says the founder of a specialist property investment company.
David Ingram, CEO and co-founder of CrowdProperty Australia, a residential real estate debt fund and investment platform, noted that in 2019 the ATO cautioned SMSF trustees about the risk to members' retirement savings goals associated with holding a single property.
“It later said that this ‘concentration risk’ was heightened in highly leveraged funds, such as where the trustee has borrowed money to acquire the asset,” he said.
Mr Ingram said that concentration risk can leave members vulnerable to the potential devaluation of their retirement savings should the asset's value decrease.
“There’s also the risk of a forced asset sale if loan covenants are breached, for example, the loan to valuation ratio,” he continued.
“This has once again become a key conversation for accountants and SMSF auditors to be having with their SMSF clients following the series of interest rate rises Australia has just experienced.”
He continued that one of the ways to avoid this risk was through diversification.
“For SMSF clients who are comfortable with residential property investment because they understand it, residential real estate debt could potentially be a way for accountants to help them diversify their portfolio,” he said.
He explained that residential real estate debt involves investors like SMSF trustees lending money to developers for residential property projects.
“They aren’t funding the whole project, they are lending an amount alongside other investors. This is an alternative to the developer borrowing from a bank,” he said.
“Investors can potentially build wealth through earning a fixed income in the form of target income returns. Then, once the project is complete and the project loan repaid, their capital is returned with interest income.”
Mr Ingram highlighted the benefit of this approach, explaining that SMSF trustees can diversify their risks by acquiring smaller stakes in various property project loans across different geographical areas, property types, developers, and investment terms throughout the country.
“That’s where the diversification comes from, having smaller exposures to more projects rather than buying one direct property investment,” he said.
With interest rates potentially rising again in the coming months, Mr Ingram said this model can potentially offer investors a level of protection.
“As interest rates go up, investors may get a higher return while borrowers are charged more just as they would be if they went to a bank for a loan,” he said.
“But not all residential real estate debt opportunities are the same. When assessing an opportunity, you want to be looking for investments that are secured by a first mortgage.”
He said advisers should discuss structures with their clients to determine which would suit their needs better.
“Whether it's SMSFs, family trusts, or other entities, each has its nuances,” he said. “It's crucial to understand these before venturing into real estate debt funds, ensuring that the chosen structure aligns with the client’s investment goals.
“For example, when considering the integration of real estate debt in an SMSF, it's crucial to understand how much income is required and whether the interest rate provided will meet that need, especially if the SMSF is in the pension phase.”
