The importance of diversity in your SMSF and one way to achieve it

In 2019, the ATO sent a letter to the 17,700 self-managed super funds (SMSFs) that it believed held 90 percent or more of their funds in a single asset or asset class, reminding trustees of their obligation to consider diversification and the potential risks involved with inadequate diversification. The ATO followed this up by releasing new guidelines for SMSF trustees in early 2020.

Tony Zulli, Chief Operations Officer and Director of CrowdProperty Australia, said it’s most likely that these funds had one single directly held property in them and potentially geared through a SMSF loan.

He explained the ATO’s investment strategy guidelines for SMSFs and trustees are similar to those that apply to larger superannuation funds that are regulated by the Australian Prudential Regulation Authority.

“Essentially, what the ATO was saying is like a trustee of a large super fund, SMSF trustees have an obligation to ensure the members are able to receive their retirement benefits,” Zulli said.

For example, if a member withdraws from the fund, you must be able to pay their retirement benefits via a lump sum.

But what happens if the single asset of the fund is a directly held property and is difficult to sell because of, say, its location, or if the property market has slumped? How can the trustees ensure that retirement benefits can be paid?

The dangers of concentration risk

As the ATO notes, investing the predominant share of your retirement savings in one asset or asset class can lead to concentration risk, potentially amplifying losses because most of your investments are correlated and will move in the same direction.

In this situation, the ATO said your investment strategy should document that you considered the risks associated with a lack of diversification. It should state how you still think the investment will meet your fund’s investment objectives, including your fund’s return objectives and cash flow requirements, and retirement goals.

The ATO added that concentration risk is heightened in highly leveraged funds, such as where the trustee has borrowed money to acquire the asset. This can expose members to a loss in the value of their retirement savings should the asset decline in value. It could also trigger a forced asset sale if loan covenants are breached (for example, the loan to valuation ratio).

On the other hand, there’s plenty of evidence that a diversified investment portfolio helps to even out risks. When the value of one asset class is falling, the value of another might be surging ahead, helping to maintain investment returns whilst mitigating losses.

When it put out its guidance, the ATO estimated 43% of SMSFs had three or fewer assets.

“But when you look at the typical large super fund, they have significantly broader diversification than three assets,” Zulli said.

This could include local and overseas shares, property, bonds, infrastructure, private equity and debt, and cash. It could also include a mix of different types of property investments such as listed and unlisted property funds, investing in different sectors such as residential, office, commercial and industrial property.

“The large superannuation funds have the resources and tools to be able to manage diverse portfolios and risks. Smaller SMSFs generally rely on one or more of the trustees to make investment decisions in the best interests of the fund members. It will be interesting to see how SMSF trustees address the new ATO investment strategy guidelines,” Zulli said.

A new way to diversify your portfolio

According to Zulli, investing with an unlisted non-bank lender, such as CrowdProperty, could potentially be a way to diversify your portfolio.

Investors join CrowdProperty via an unregistered managed investment scheme, called the CrowdProperty Investment Trust. They invest in loans to small-scale residential property developers.

“The advantage is you could spread your risks by taking smaller stakes in more property project loans in different areas or regions around the country and the investment could be uncorrelated to what’s happening on the stock exchange,” Zulli said.

CrowdProperty Australia is modelled on its sister company in the United Kingdom. The UK company has just under 18,000 investors on its platform and these investors, on average, have exposure to 72 projects spread across different locations throughout the UK, and in different types of projects, and different loan durations.

“That’s where the diversification comes from, having smaller exposures to more projects rather than buying one direct property investment.

“The project loans can be anything from six to 18 months, so there’s also diversification of duration as well and you’re not tying up your capital for a long time,” Zulli said.

Benefiting from higher interest rates

This model can potentially offer investors a level of protection from rising inflation and interest rates.

“The natural consequence of rising inflation is the Reserve Bank will generally increase interest rates. The loans CrowdProperty provides to developers need to reflect the increases in interest rates.”

That means 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.

With interest rates rising, CrowdProperty recently lifted its target income return rate for investors from up to 7% per annum to up to 8.5% after a careful analysis of the economic landscape and factoring in potentially another two increases in the official cash rate.

“Investments start from a minimum of $10,000 which means investors’ capital outlay is relatively small compared to acquiring a direct real property,” Zulli said.

Mitigating the risks

CrowdProperty has built up strong expertise in evaluating developers and projects and each application undergoes rigorous due diligence.

Each project goes through a 57-step due diligence process looking at a detailed feasibility study, independent valuation and quantity survey assessment, as well as understanding the developer’s experience, motivations, team, and more. CrowdProperty typically only funds around four percent of the project applications it receives. For example, in a little over eight years, the UK company has received over A$16 billion in project applications yet has only funded four percent with zero percent capital losses for its investors.

“We have certain protection and mitigation mechanisms in place to ensure that if something was to go wrong with a developer, we can step in to resolve it, including ultimately having the ability to take over and run the project to completion.

“There are no guarantees, but there is a level of security through the first mortgage, meaning we’re first in line for payments to come back out.”

A solution for small-scale developers is an opportunity for investors

Zulli said it appears the larger developers and builders that are facing challenges around Australia more than the small-scale developers CrowdProperty deals with. Yet, many small developers struggle to get a loan from the major banks.

“A key reason for this is that the banks have largely withdrawn from this market from a risk perspective and decided they would prefer to lend to other sectors.

“We’ve had situations where developers have waited up to six months for a decision and they finally get a negative one. If they had come to a non-bank lender, such as CrowdProperty, they would have either an indicative positive answer within a week, or at the very least, a fast no. It boils down to whether the banks have the appropriate resources and skills to be able to properly assess the development. And the answer is generally ‘no’ because they are not experienced in property projects.

“Our local borrower team and investment committee have property development experience and understand the process that a developer goes through.”

CrowdProperty’s marketplace lending platform has been established to manage significant numbers of investors.

“From an investor point of view, everything is done on the platform,” Zulli said.

“It’s an end-to-end solution. We don’t use any paper. You do everything on a dashboard. You can go into your dashboard at any time and see your progress and get updates.

“Ultimately, it’ll be a combination of the technology, the availability of great projects that have been curated by CrowdProperty, and the attractive target income returns paid to investors that set us apart.”

At present, CrowdProperty only admits wholesale and professional investors, but retail investors will be welcome later this year. Watch this space!

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