The apartment sized holes in FoFA

Happy New Financial Year, and that means welcome to the brave new world of FoFA.

Now it’s not every day a CEO raises concerns when one of their products is selling really well. So recent worries expressed by BoQ CEO Stuart Grimshaw about the rapid growth of leveraged purchases of real estate by SMSFs, particularly apartments in Melbourne and Brisbane, deserve some attention.

What’s that got to do with FoFA? Well, there are still some aspects of the wealth industry which are a bit like a balloon; ie squeeze it one place and the balloon expands somewhere else. There are some significant holes in FoFA, and one which many find troubling is the increasingly busy intersection of real estate, leverage, and SMSFs.

This Trialogue is not an SMSF critique. SMSFs are an approved super structure and a fit with changing consumer preferences and advancing technology. Our view is that market participants can and should look for opportunities in the SMSF segment. Incumbents in particular cannot afford to ignore a third of the market, and moreover have important benefits to offer the market.

That said, when a bank CEO – who after all is in the business of selling loans – rings the alarm bells about leveraged real estate and SMSFs, it flags potential problems which even incumbents need to keep in mind.

The intersection described above is the result of a confluence of regulatory outcomes over the past 10 years:

Few limits on formation have seen SMSFs moving down market. The average SMSF might be $800,000, but we hear reports from our super fund clients of smaller and smaller balances being used to commence SMSFs.

Relaxation of gearing in super. Dates back to the latter years of the Howard government. Originally intended to allow super funds to invest in Telstra instalment receipts, by far the most common application now is gearing of real estate by SMSFs.

FoFA applies only to financial products. It does not apply to wealth substitutes, including real estate. So you can have a situation where if a property is placed in an unlisted property trust, FoFA applies (ie it’s a financial product), but if sold stand-alone, FoFA does not apply. Commissions can’t be paid on the unlisted property trust, but can still be earned on an equivalent piece of real estate and on a related mortgage.

In isolation, each of these might have modest impacts, but together it’s a potent combination. Unfettered SMSF formation might be questionable policy, but in reality few SMSFs could buy real estate without gearing because of the large ticket size. The availability of gearing in super brings it within reach of the average SMSF, taking it from the top end to the mainstream. FoFA has then created a reinforcing remuneration incentive to promote this strategy. No wonder the distribution of real estate to SMSFs is becoming big business.

But is Stuart Grimshaw right? In the past, concerns about SMSFs and geared real estate have been dismissed as a non-problem by pointing at statistics indicating relatively modest exposures. But the data hints that such exposures may be creeping up:

– ATO data shows SMSFs gradually increasing exposure to commercial and residential real estate in 2011-12 (15.2% to 15.7%).

– Multiport data, notwithstanding it is a smaller and different SMSF sample, shows the trend continuing in 2013 (15.8% to 16.4% by March).

– Multiport also reports rapid growth in the gearing of real estate – from 29% to 34% of their SMSF real estate exposures in a single quarter in March 2013.

Mutiport noted that the number of SMSF real estate loans was rising, but the average loan value was falling. They ascribed this to more conservative LVRs, but an alternative explanation we suspect is more convincing is increasing numbers of smaller SMSFs being created for the purpose of geared real estate investment.

So Mr Grimshaw may not be right just yet. But it serves to remind that that FoFA leaves some holes big enough to drive a geared apartment through; and that there are worrying trends out there on the frontiers of the wealth industry. Perhaps counter-intuitively, it reinforces the potential SMSF role of mainstream competitors. This trend is happening; better for it to occur under the civilizing auspices of major financial services players than the cowboys of the frontier.

Posted In: Trialogue