Small Business Administration Loans: New Challenges and Changes

As posted on Commercial Property Executive

What’s new at the Small Business Administration’s 504 loan program?

Last year, changes to the program included increased down payments for certain borrowers and tighter eligibility requirements for applicants who have other financial options. The modifications may have had an impact on lending activity; volume declined slightly during the last fiscal year to  $25.6 billion, according to the Small Business Administration’s annual report. Nevertheless, said TMC Financing CEO Barbara Morrison, “Demand for SBA loans remains relatively stable.

Other changes, which took effect April 1, include increasing the credit threshold to 20 percent for borrowers who qualify for other types of financing. The threshold ratio for job creation was raised from $65,000 to $75,000 of project debenture per new job.

The SBA 504 loan continues to offer a competitive fixed rate set at 4.5 percent for 25 years, lower than its direct competitor, the 7a loan, whose rate is 6.5 percent. Morrison also revealed that manufacturing facilities represent the largest single asset class in her company’s portfolio, but that more office facilities have also been entering TMC’s portfolio in recent years.

In a wide-ranging interview, Morrison shed light on what entrepreneurs should know about the challenges to the SBA loan program.

From your experience working with SBA loans, what are three main things borrowers don’t usually know about this type of lending?

Morrison:What we run into most often is that small businesses do not realize that the SBA 504 Program exists. Because of this, businesses are often priced out of their area because they can’t afford their increasing rent and they don’t think they can afford to purchase a building. However, learning that they can purchase real estate with only 10 percent down has proven to be a game changer.

Then, there’s eligibility. Because the program is part of the Small Business Administration, many of our clients were surprised to learn that they qualify as “small” under the SBA’s size standards. The SBA’s definition of “small” is substantially larger than what most people assume. The truth is, most for-profit businesses qualify.

There are also many misconceptions about how long it will take to get SBA financing and how much paperwork is required. The CDC (Certified Development Company) can prequalify potential borrowers in 24 to 48 hours. Then they are approved by SBA in approximately seven days. The documentation for the 504 application is generally the same as the documentation required by first lender. The CDC underwrites the loan simultaneously with the lender.

What has become the most challenging aspect when closing a financing deal and why do you think that is?

Morrison: For the borrowers, working with the right partners is vital to success when it comes to SBA 504 financing. While the rules and regulations are written in black and white in the Standard Operational Procedure system, understanding policy interpretation is something that takes extensive experience. Policy interpretation can change. Choosing a CDC and lending partner with consistent and extensive experience will make the difference between a frustrating experience and a timely and efficient closing. Since most 504 projects involve a real estate purchase, adhering to the time line of a purchase agreement is critical to a successful transaction. As a CDC for 38 years, TMC Financing has had to keep on top of changing policies to ensure a smooth and streamlined closing.

Has the demand for SBA loans changed in recent years? How is this indicative of the current status of the lending market?

Morrison: Demand for SBA loans has consistently increased over time as the SBA programs gained visibility. While credit markets are cyclical, demand for SBA financing remains relatively stable throughout the cycle. Currently there is plenty of available capital, and the conventional lenders are eager to lend. During this market cycle, when the banks are flush with capital, SBA financing represents a small percentage of a large market. During a recessionary cycle, banks become more selective lenders, and SBA loans represent a larger share of a smaller market. During one particularly tight market in the early 1990s, almost every comp on the appraisals we submitted to SBA had been financed by an SBA loan.

For what property types does TMC provide financing most frequently and why?

Morrison: Our portfolio of roughly $1.4 billion (representing 40 percent of total project cost) is comprised of more than 1,800 well-diversified property types. The largest single asset class in our portfolio is manufacturing facilities. Our borrowers come from professional services such as doctors, dentists, veterinarians, attorneys, and CPAs.  As a result, office facilities represent a majority of properties added to our portfolio more recently.

We also finance a significant number of properties classified as special purpose.  For example, we have financed wineries, car washes, bowling alleys, auto repair shops, gas stations, hotels, assisted living facilities, and fitness facilities. SBA financing is particularly attractive for these properties. While SBA provides better leverage and more favorable terms for all property types, it is especially attractive for properties classified as special purpose, due to the more restrictive conventional financing generally available.

How does the competitive lending environment impact SBA 504 lending?

Morrison: SBA 504 lending competes with both conventional loans and the SBA 7a loan program. The latter is a bank guaranty program (the bank provides the loan and SBA provides a guaranty for a percentage of the loan) that provides financing for general business needs in addition to real estate.

The primary difference between 7a and 504 is the interest rate. A 7a loan is often a variable rate tied to the Prime rate, for example Prime +1 percent, which today would be 6.5 percent adjusted quarterly. Some lenders will offer a fixed-rate 7a loan; however, today, the rate is typically about the same. The SBA second mortgage for 40 percent of the total project cost is a fixed rate tied to the 10-year Treasury. Today, that rate is 4.5 percent fixed for 25 years. Therefore, given the current yield curve, the 504 loan offers much more competitive interest rates.

The value of the SBA program relative to conventional loans is in the leverage as well as below-market interest rate it offers. The 90 percent financing allows businesses to retain their working capital to grow the business rather than use it to purchase real estate. Currently, while banks are eager to lend, 80 percent of financing is available for certain general purpose properties. As the lending environment tightens, conventional loans are generally limited to 70 percent loan-to-value, which requires a significantly larger down payment of 30 percent.

Regardless of the lending environment, the term of the conventional loan will typically have a long-term amortization but a seven-year or 10-year due date, meaning the borrower will have a balloon payment and need to refinance at the end of the term. In comparison, the SBA 25-year, fully amortized second mortgage provides small business owners with affordable monthly payments and enables them to control their overhead costs for the long term.

How do you expect this program to evolve in the coming years?

Morrison: Since the creation of the SBA 504 Program in 1980, the basic outline has changed very little. It is one of the few government programs that operates at “zero subsidy,” meaning it receives no Congressional appropriation. It is supported by loan origination fees paid by the borrower, the conventional lender, and the Certified Development Company. Both political parties have continued to express support for small businesses, the “engine of the economy.” Removed from political winds, I believe the program will remain popular on both sides of the aisle.

Since inception, the primary change to the program has been to increase size standards so that larger businesses are eligible and to increase the maximum amount of the SBA second mortgage so that larger projects can be financed.  The size standards and SBA loan amount will most likely continue to increase over time to accommodate more growing businesses.