What is a Limited Recourse Borrowing Arrangement (LRBA)
There are still some myths and misconceptions about SMSF loans, how they work, what they do and what they don’t do. So today I thought I would shed some light on the most common questions I come across.
What is a Limited Recourse Lending Arrangement (LRBA)
Unlike a normal loan, when a bank is lending to an SMSF, it is not allowed to exercise any recourse against any other asset held by the fund.
For example, if the SMSF fails to make the repayments on the loan, the bank can repossess the property securing the loan. However, even if the fund has $1,000,000 in cash, the lender can’t go after that money.
This is the reason why LRBA require an additional trust (bare trust) to hold the asset over which the bank is taking a mortgage, to separate it from all the other assets within the SMSF and limit the lender’s recourse.
Banks don’t like anything sounding remotely like “limited recourse” and so while they can’t by law secure these loans with any other asset from the SMSF, they can ask the trustee to guarantee the loan personally.
This means that whilst the bank won’t be able to access the $1,000,000 in the SMSF, they will be able to go after any assets the trustees own personally (outside of superannuation).
Aside from a few scenarios with low loan to value ratio, all the banks require personal guarantee with their LRBAs.
Why they are more expensive?
These loans have higher interest rates due to regulations. SMSF lenders have to hold more capital per dollar they lend than they do when lending to individual.
Allow me to illustrate with a purely conceptual example:
If a bank wants to lend $1 to an SMSF, it has to hold 15 cents. However if that same bank wanted to lend that same $1 to an individual, it only has to hold 5 cents.
Now let’s imagine that this bank holds $100,000, it could either:
a) Lend $666,667 to an SMSFs or
b) Lend $2,000,000 to individuals
If they charged the same interest rate, lending to an individual would obviously be more profitable.
This is why when lenders decide to allocate funds toward SMSF lending, they have to charge a higher interest rate for it to make commercial sense.
It’s very much the same story for commercial loans in general, which is why commercial loans in SMSF are at about the same cost as a commercial loans outside of super.
Lenders generally consider a few items when ascertaining how much a SMSF can borrow:
- Super guaranteed – 9.5% of the wage of the trustees. It is worth noting that the older the applicant(s), the less the bank will rely on this item
- Salary sacrifice – If the trustees have been salary sacrificing or are going to salary sacrifice it can be taken into consideration. Lenders have very different rules for how they use this.
- Rental income from the property being purchased
- Projected income from other assets in the SMSF
Most lenders will lend between 72% and 80% of the value of a residential property being purchased through an LRBA.
There are a number of limiting factors to be aware of:
- Size – The property should ideally be over 50sqm internally and no less than 40sqm
- Serviced apartments – They are deemed unsuitable securities for most lenders
- Student accommodation – Same as serviced apartments
- Postcodes – Some lenders have restriction around locations of properties they will accept as securities, always check before you sign if you are not buying in a capital city
- Age – A number of lenders will not accept properties less than 2 years old as security. If you are considering a brand new property, check with your lender
Most lenders will lend between 65% and 70% of the value of a commercial property being purchased through an LRBA.
A number of items to be aware of:
- SMSF will need to be GST registered
- If the property is not leased at the time of purchase, the SMSF will have to pay GST on top of the purchase price. That GST can then be claimed back when completing the next BAS but it can present a cash flow challenges in the meantime
- The lender may restrict the term of the loan to the duration of the lease in place if the rental income is needed to service the loan
- Generally, the maximum loan term is 15 years (some exceptions exist)
- Valuation fees can be high, especially on more complex securities
Progress payments are not permitted under LRBAs, meaning that house and land packages, where the builder is expecting intermediary payments as the house is built, are impossible.
Redraws – Equity
Unlike what is possible for most other entities, including individual borrowers, a SMSF is not allowed to:
- Redraw money paid in advance on the loan
- Use equity in an existing property to purchase the next propertyFor example, even if a SMSF owned an investment property outright, it would still have to pay a 20% deposit on the purchase of the next property. It could not use the equity in the first property to secure any lending.
Using an offset account can be a powerful tool to get around the redraw limitations. Unfortunately, even though offset accounts are permitted and available for SMSF, only two lenders currently offer them.
Related Party Lending
A SMSF is not only allowed to borrow from a bank, it can borrow from anybody who is willing to lend.
This can include the trustees themselves, which can allow them to reduce the loan fees and interest rate as well as increase the loan to value ratio. It can also allow an SMSF to borrow in order to purchase a property which may not have been suitable for a bank.
One of the most classic scenarios we see for related party lending goes like this:
Clients have equity in their house => they borrow against the equity in their house, under normal terms (low rate and fees) => they then lend these funds to their SMSF at the same rate => the SMSF starts to make repayments to the clients => the clients make the same repayments to their bank.
LRBAs are currently under review and an outcome is expected in the near future. It’s possible that they are banned altogether, although it seems more likely that they will be amended.
The most discussed and scrutinized features are the ability of lenders to take personal guarantees, which is almost certain to go, as well as the required qualification/licensing to organize such loans.
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