New SBA 504 Loan Term Makes Purchasing Commercial Real Estate More Affordable

By John Reichard

On April 4, 2018, the U.S. Small Business Administration (SBA) announced a new longer-term SBA 504 loan to further assist small businesses with financing owner-occupied commercial real estate. Historically, small businesses had the option of a 10-year or 20-year fixed rate SBA 504 loan. The 10-year loan is typically used to finance equipment purchases and the 20-year loan is used for real estate. Now the SBA has a third option – a 25-year fixed rate loan.

What is an SBA 504 loan?

The SBA 504 loan is a government-backed loan that can be used for fixed asset acquisitions (long-term machinery or equipment, or commercial, office, industrial, agricultural, or warehouse properties), building construction and renovations, and in some cases the refinancing of existing equipment and/or real estate debt. Other costs such as engineering and architectural fees, permits, environmental studies, appraisals, and interest during construction can also be included. Real estate must be owner-occupied, meaning that the small business borrower must occupy at least 51% of the space (60% initially for new construction, with no more than 20% leased out on a permanent basis).

How does an SBA 504 loan work?

SBA 504 loans work in partnership with a commercial loan from a financial institution. Typically, the financial institution provides 50% of the financing, the SBA 504 loan provides between 30-40% of the financing depending on the history of the business and the type of property being occupied, and the small business provides the remainder.

Small businesses work with a Certified Development Company to underwrite and submit an application to the SBA for approval. Once approved, the financial institution closes on their permanent loan as well as a temporary or bridge loan to cover the SBA 504 loan until the acquisition or construction is complete. In some cases, third-party financing could be involved to cover the bridge loan, especially for construction projects. Then, when the SBA 504 loan funds, the proceeds pay off that temporary or bridge loan. The small business will then have two monthly payments – one to the financial institution and one to the SBA.

Who can qualify for an SBA 504 loan?

To qualify for an SBA 504 loan, a small business must be organized as for-profit. The SBA defines a small business for the 504 program as having a net worth less than $15 million and an average net income of less than $5 million over the past two years. For existing businesses (minimum two years of operations), the 504 loan can finance up to 40% of the project cost. For start-up businesses (those operating less than two years or in some cases with a change in ownership), the SBA 504 loan can finance up to 35%. If the real estate being acquired or constructed is special-purpose in nature, the SBA 504 loan is further reduced by 5%. In the case of a start-up or special-purpose property, the financial institution must provide at least 50% of the financing. For existing businesses, the financial institution’s loan must be equal to or greater than the 504 loan.

What are the benefits of an SBA 504 loan?

There are several benefits to small businesses using an SBA 504 loan:

• SBA 504 loans have a fixed rate for the life of the loan. As interest rates rise, the risk small businesses have in financing real estate on a variable or short-term fixed rate is that the monthly payment may increase as the loan matures. With the SBA 504 loan, the monthly payment on that portion of the financing will never increase as rates rise. So an SBA 504 loan matched with a conventional commercial loan can partially hedge against rising interest rates.
• Use of the SBA 504 loan allows the borrower to put less money down than if they were financing their real estate through a normal commercial loan. Most lenders will require a minimum of 20% (sometimes more depending on the type of real estate). For existing businesses, the use of the SBA 504 loan can lower the down payment to as little as 10%.
• SBA 504 loans are fully amortizing. This means the small business owner will not face a balloon payment at some point during the loan.
• The SBA 504 loan has a competitive rate compared to conventional financing, especially considering that most financial institutions typically do not fix their rate for more than five or seven years. The SBA 504 loan is loosely tied to U.S. Treasury rates (5-year Treasury for 10-year SBA 504 loans and 7-year Treasury for 20 or 25-year SBA 504 loans). The current 20-year effective rate is 5.03%. The first 25-year loans will fund in July 2018 and are expected to run about 35-40bps higher than 20-year rates. For the current month, that would equate to a 25-year fixed rate between 5.38% and 5.43%.

Benefit of a 25-year SBA 504 loan

Assume you are an existing business and qualify for 40% SBA 504 financing. For a $1 million building acquisition at the current fixed rate, a 25-year SBA 504 loan will save about $220/month in debt service compared to a 20-year SBA 504 loan. For a $3 million acquisition, the savings becomes around $650 each month. Also, the requirements for the minimum term of the partnering financial institution loan and the prepayment penalty on the SBA 504 loan are the same for a 25-year loan as they are for a 20-year loan. The minimum term of the financial institution loan is 10 years and the prepayment penalty on the SBA 504 loan ends after the tenth year.

Refinancing ability of the SBA 504 loan

Small businesses that wish to refinance their real estate and/or equipment debt might be able to use a SBA 504 loan. While there are some restrictions on what debt would qualify, an SBA 504 loan could be used either if the sole purpose of the loan is to refinance debt or if the refinancing is part of an expansion (i.e., additional money needed for new equipment or real estate). Generally speaking, if a loan is secured by fixed assets (equipment and/or real estate), the assets have equity based on a current appraisal, the loan has been on the books for at least two years, and payments have been current for the last 12 months, it might qualify for 504 financing.

What is the difference between SBA 7a loans and SBA 504 loans?

While there are some overlaps in what each SBA program can finance, SBA 7a loans (which are loans made by financial institutions guaranteed by the SBA in case of a loss) are best suited for working capital, inventory, furniture and fixtures, leasehold improvements, and business acquisitions. SBA 504 loans were designed to finance long-term fixed assets such as equipment and real estate. Another factor is that for larger deals, the fees for SBA 7a loans increase as a percentage of the loan, while the fees for the SBA 504 loan are the same regardless of the loan amount.

Successes with the SBA 504 loan

A manufacturing company was looking to expand by acquiring the assets of another business. The acquisition consisted of real estate and equipment. The company actually received two separate SBA 504 loans — one toward the real estate (20-year loan) and the other for the equipment (10-year loan). The two SBA 504 loans were key in completing the overall financing package for the deal.

A service and retail company needed additional space to consolidate into one central location. By using the SBA 504 loan, the company saved on its down payment, which left more money available for their growing business.

A seasoned hotel owner and operator wished to purchase and renovate an existing hotel. Through the use of the SBA 504 loan, he was able to secure financing for the project and save 5-10% on his down payment compared to the amount that would have been required had he financed it solely with a conventional commercial loan.

New 25-year 504 loan provides greater financing options

Now that small businesses have the added option of a 25-year SBA 504 loan, various financing structures can be tailored to meet their needs. If they are interested in the lowest monthly payment, then a 25-year 504 loan would be a good option. If they want the benefit of a long-term, fixed rate loan but wish to pay it off sooner, then a 20-year 504 loan might be what they need. If they have a need for both real estate and equipment and wish to match the repayment with the useful life of the asset, then possibly a combination of a 10-year 504 loan for equipment and a 20-year 504 loan for the real estate would be a good option. Either way, the SBA’s introduction of a 25-year SBA 504 loan is another reason why small businesses should look at the SBA 504 loan program for their real estate or equipment financing needs.