This article comes from First Tuesday Journal Online
This article introduces the federal Small Business Administration (SBA), and explains how real estate brokers can take advantage of SBA lending programs to generate income property transactions.
Opportunities in SBA-guaranteed loans
The owner of a small business seeks to take advantage of the current low property prices to purchase a larger space for his operations. He enlists the assistance of a commercial real estate agent to find a suitable property to relocate his business.
It is quickly established that the business owner will need purchase-assist financing to acquire a property. His business operations are relatively small and the real estate loan he will need is under $2 million. He and his agent understand banks are unwilling to offer financing to small, privately-owned businesses such as his, due to the general financial instability of banks following the 2008 financial crisis. [For more information about the financial crisis and Great Recession, see the July 2011 first tuesday article, The rocky roads: recession and financial crisis.]
The owner’s agent suggests his chances of acquiring financing may be improved by seeking a 504 loan guaranteed by the Small Business Association (SBA). With an SBA guarantee, bankers are more willing to take the risk of lending to the owners of smaller-sized businesses.
Fixed-rate 504 loans are available to small businesses to enable the purchase of fixed assets (such as machinery, real estate and supplies) for expansion and modernization. As such, many SBA-insured loans are provided to industrial or commercial businesses that are not service-based.
Introducing the SBA
The SBA, a federal organization created by the Small Business Act in 1953, arranges and acts as guarantor for numerous small business loans originated by lenders for business development and disaster relief. Perhaps the best known and most accessible of its lending options, 504 loans divide the funding of the financing the businessman needs between a bank and a Certified Development Company (CDC) in a 50%-40% split, with the borrower putting up the final 10%.
The bank receives the first lien in the division of funds, and the CDC’s subordinated interest in the loan is guaranteed by the SBA. Thus, if the loan goes bad and losses must be taken, the bank has priority over the CDC to recover its losses from the financed property. As a result, banks are encouraged to make loans to businesses which might otherwise appear too small or too risky to be worth their time.
SBA-insured loans are attractive to borrowers because of their (usually) lower down payment requirements, longer repayment periods and slightly looser underwriting standards. For example, lenders will generally refuse to make loans for business purposes if annual payments are higher than two-thirds of the borrower’s operating profits in the previous year. The SBA, on the other hand, permits annual payments of up to the entire amount of the previous year’s operating profit.
On the advice of his agent, the business owner approaches a local CDC to commence the loan application process.
The SBA 504 loan application and requirements
Unlike other lending programs, 504 loans are administered only through collaboration with non-profit CDCs, independently-owned and operated nonprofit organizations chartered by the SBA. Banks (or other commercial lenders) participate in the funding of these loans, but their role is diminished by sharing the funding of the financing with a CDC. [For information about local CDCs, see website of the National Association of Development Companies (NADCO).]
Restrictions exist on the amount available for SBA guarantees and how the money will be spent. The maximum amount of an SBA-guaranteed loan is $5 million ($5.5 million for manufacturers).
504 loans are originated solely to fund the purchase or construction of real estate and the purchase of business equipment and machinery. Funding of the financing is broken down as follows:
- a commercial lender – generally a bank – provides 50% of the financing. The bank’s loan is not guaranteed, but is backed by a senior lien on the collateral;
- a CDC provides up to 40% of the financing through a 100% SBA-guaranteed note (debenture); and
- the borrower provides a minimum of 10% of the financing in the form of a down payment. If the borrower provides a higher down payment, the CDC’s share of the loan will be reduced, but the bank will always provide 50%.
The SBA application process is more complex, and thus more time consuming, than other commercial loan applications. To qualify for a 504 loan, the business is generally required to create or retain one job for every $65,000 guaranteed by the SBA (every $100,000 for small manufacturers). The loan application submitted to the CDC (but not the one submitted to the bank) must include projections for meeting these requirements.
An application for an SBA loan may be submitted directly to commercial lenders, including (among the largest) Bank of America, Wells Fargo and Citibank. Since 504 loans require collaboration with CDCs, they can also be applied for at any regional CDC office. SBA-chartered CDCs in California include such groups as TMC Development Co. in Los Angeles and Southland EDC in Santa Ana. [To find a CDC in your area, see NADCO’s directory of CDCs.]
Rates on CDC loans are set based on the 10-year Treasury Note rate, and are amortized over ten years for capital equipment loans and 20 years for real estate loans. If the project includes significant amounts of both real estate and capital equipment, the amortization period will be based on whichever element occupies a larger proportion of the funds. Projects can also be separated by two different loans, if two separate sources of collateral are available. [For a detailed overview of loan terms and timelines for both 7(a) and 504 loans, see the SBA guidebook, Lender and development company loan programs.]
Rates on non-CDC loans can be either fixed or variable. If variable they are generally tied to either the Prime Rate or the London Inter-Bank Offered Rate (LIBOR). The SBA permits banks to charge up to 2.75% above these rates, and it is not uncommon for them to do so since maximums tend to become minimums in the lending industry. At the time of this writing, the Prime Rate was set at 3.25%, and the one-year LIBOR was 0.75%. Fixed-rate loans are extremely uncommon in commercial mortgages. [For detailed charts tracking pertinent market rates, including the LIBOR and Prime Rate, see the first tuesday Market Chart, Current Market Rates.]
504 loans also require an additional 3% bonding insurance fee, which is payable up front or can be added to the regular loan payments.
The prospective borrower must also meet the individual lending standards of the bank which agrees to fund 50% of the financing in an SBA guarantee situation. Lending standards vary from bank to bank, but they are always intended to insure that the business loan is a prudent investment. Approval in this regard depends far less upon debt-to-income ratios and credit ratings (which are de rigueur for residential home loans) than upon the viability of the business itself, and the likelihood of a positive return on a long-term loan.
Borrowers with the best chance of securing a small business loan will have a well-researched and comprehensive business plan
Indeed, loans are so scarce for small businesses that the Los Angeles Times recently reported even SBA-insured loans are far less likely to be approved than they once were. Borrowers with the best chance of securing a small business loan will have a well-researched and comprehensive business plan, and will likely benefit greatly from having their own cash reserves available in addition to the property and any equipment offered as collateral. [For a snapshot of the current market for small business loans, see the LA Times article, Do your homework before applying for SBA loans.]
Of course, commercial lenders do make loans without the guarantee of SBA insurance, and mortgage default insurance is sometimes available through those banks. Nonetheless, borrowers report that commercial mortgage lenders tend to be especially reluctant to make loans for small business projects, like those for which the SBA 504 program is designed, without the shared risk and loan guarantees available through the SBA.
The business owner refinances commercial real estate
Now consider a real estate broker who currently runs his business from a commercial property he purchased during the Millennium Boom in the years immediately preceding the recession. His real estate business is financially viable, but his property loan is now due. Payments are fixed at their pre-recession rate, dramatically higher than they would have been had he obtained the loan at a later date. The loan-to-value ratio (LTV) has now risen to 80% due to the decline in local real estate values.
Worse, the broker is unable to refinance the loan amount due to the property’s current appraised value. Commercial lenders are unwilling to refinance loans with LTVs of more than 65% to 70%. As an alternative, the broker seeks to refinance his mortgage with a 504 loan arranged in collaboration with both a bank and a CDC.
However, the broker is concerned he will not be eligible for a 504 loan, since he wishes to refinance his debt on an existing property rather than purchase a new one. Is the broker potentially eligible for an SBA 504 loan to refinance his commercial mortgage debt?
To promote business activity in the economic downturn, the SBA’s lending authority has been extended to encompass mortgage refinancing by the Small Business Jobs Act of 2010.
Refinancing with the SBA
Over the last four years, during the financial crisis which began on Wall Street in 2008, the SBA’s relationship to business became more complicated and more essential. Suddenly, the greatest challenge facing small business owners was not acquiring new property or equipment, but dealing with the abruptly decreased value of the property they already possessed, especially in a time of generally lowered wholesale and retail sales volume and accompanying economic torpor.
Although SBA 504 loans were formerly available only for the purchase of fixed assets, (including the construction of property), the collapse of the commercial mortgage market caused Congress to extend the SBA’s loan guarantee authority to commercial mortgage refinancing. The SBA is authorized to guarantee up to $7.5 billion in refinancing loans during 2011, and the same amount again in 2012. Combined with funds issued by banks as a first mortgage (always set at 50% of the total loan amount), this program is expected to provide up to $33.8 billion in total loan funds to benefit as many as 20,000 small businesses, according to the SBA.
The 504 refinancing loan application process is substantially similar to the application for a standard 504 loan. Funding remains a two-part system involving both a bank and CDC. This program provides for borrowers who seek loans to refinance up to 90% of their current appraised property value, or 100% of the outstanding principal, whichever is lower, plus 504 eligible refinancing costs.
However, additional requirements do apply. Significantly:
- the loan must be current, with all past payments made on time;
- refinancing is not currently permitted for loans guaranteed or issued by the SBA or other government agencies;
- 85% or more of the original loan must have funded the purchase of fixed assets of the type traditionally insured by 504 loans. This must be certified by the borrower and the original lender;
- the loan must have been recorded at least two years prior to the application to refinance;
- the SBA performs all underwriting directly, without the assistance of intermediary lenders; and
- SBA-guaranteed refinancing is available only for loans with LTVs between 50% and 90%. Typical 504 loans, both for refinancing and purchase-assist, are arranged with LTVs at or below 50%. Note that this LTV restriction continues to restrict those with underwater commercial property loans from obtaining SBA financing. [For a review of common questions about 504 refinancing loan qualification, see the SBA list of Frequently asked questions.]
Small businesses during the recovery
The success of the economy as a whole is driven by innovative small business owners, since they are able to react quickly to changing market situations. Small business owners target specific opportunities often missed by larger conglomerates, and are thus likely to be the first to spot the signs of the approaching economic recovery.
Because small businesses can react more quickly to market fluctuations, they tend to act as the firemen in an economic downturn, clearing back the brush of business strategies that are no longer successful and making room for new opportunities. The entrepreneur of necessity effect, an unwritten rule of economic behavior, states that when a demand is present, a business will be created to meet it. For this reason, first tuesday reported recently that small business owners are the key players in reversing the economic recession. [For more on the role of entrepreneurs in the economy, see the November 2010 first tuesday article, Entrepreneurs may “start up” the recovery.]
Before businesses can begin to increase production, however, many must escape from crippling mortgage debt. Numerous business owners took out five-, seven-, and ten-year adjustable-rate commercial loans at the height of the Millennium Boom, and are now seeing those loans come due with high rates and little likelihood of extension. Without the reassurance of an SBA guarantee, most lenders remain unwilling to refinance or extend the term of the loan.
The government is often termed the “employer of last resort,” and has a duty to provide work when no other employment is available. The SBA, as well as its analogues in residential housing like Fannie Mae and Freddie Mac, and the Federal Housing Administration (FHA) itself, demonstrate that the government can also be termed the lender of last resort. That is, the SBA makes loans possible, for the presumable benefit of the economy at large, when commercial lenders are unwilling to take the risk. With the economy in its current state of crisis, the need for that last resort has certainly arrived.
The refinancing authority temporarily granted the SBA is thus well in line with its other role as provider of disaster relief loans. SBA-guaranteed refinances will prove to be a valuable resource for some small businesses, and for commercial real estate brokers who profit by knowledge of financing variables for commercial property transactions.