This week I met Ken Smith of BDC Capital at an SBANE event on “Lending Outside the Box”. Ken’s group offers SBA 504 loans, which are a helpful tool for small business owners. As part of its mission to promote the development of businesses, the US Small Business Administration (SBA) offers a number of different loan programs tailored to specific capital needs of growing businesses.
What is a 504 Loan?
The SBA 504 Loan (or Certified Development Company loan) program is designed to provide low-cost debt financing of up to $1.3 million for the purchase of fixed assets, (typically real estate, buildings or lease-hold improvements, machinery, and equipment). The SBA participates in these loans through a Certified Development Company (CDC). Certified Development Companies are established under the 504 code as non-profit corporations set up to support economic growth in their local areas. There are several hundred CDCs now operating in the U.S., most of them affiliated with a state or regional economic development authority.
The 504 program requires that the borrower put up at least 10% of the required capital, but works by distributing the loan among three parties: (1) The business owner; (2) a bank or other conventional lender (who puts up 50% of the capital); and, (3) a Certified Development Company puts up the remaining 40%.
The maximum amount of an SBA 504 loan is $1 million (1.3 million in special circumstances), and if the borrower defaults, the private sector lender is paid off first, reducing the risk to the lender and encouraging lenders to make small business loans.
Does my business qualify?
In order to qualify for the program, over half (51%) of any real property being financed must be occupied by the borrowers within one year of ownership. These loans are not meant for real estate development, but they are intended to spur job creation and economic growth. As of 2009, the 504 Loan did not contain any restrictions or ceilings; however, there are three criteria for eligibility:
- The company’s average net income (after-tax profits) cannot surpass $3 million over the past two years;
- The anticipated project size must be greater than the personal, non-retirement, unencumbered liquid assets of the guarantors/principles;
- Book value (net worth) of the operating companies must be $8.5 million or less.
Example Demonstrating the Benefits of an SBA 504 Loan
Joe Bloggs is the owner of Joe’s Machine Shop. Joe leases his 10,000 square foot shop from a landlord at a cost of $100,000 per year. He wants to expand to 15,000 square feet, and he has found a building for sale that has the ideal location. It will cost Joe $500,000 to acquire the building, $400,000 for new machinery and equipment, and another $100,000 for expenses related to the move.
Joe approaches his local bank for a loan. The bank knows Joe, and wants to give him a loan. In fact, they offer him two loans. One loan would be a mortgage for $375,000 on the new building (75% loan-to-value, fairly standard for a commercial mortgage). The mortgage would be a 10-year note with a 30-year amortization at an interest rate of 6.0%. The second loan would be a 5-year fully amortized equipment loan for $320,000 (80% loan-to-value) at an interest rate of 6.5%. In total, Joe needs to come up with $305,000 in cash and pay principal and interest of $102,132 per year on the two loans.
As an alternative, Joe asks the bank if he would qualify for an SBA 504 Loan. The bank calls a local CDC and together they agree to provide Joe loan. The loan will be structured in two parts: (1) the Bank will provide $500,000 (50%) for a 20-year fully-amortized mortgage at 6.0%; and, (2) the CDC will provide $400,000 (40%) for a 20-year fully-amortized term loan at 4.0%. In total, Joe needs to come up with only $100,000 in cash (10% of the total project) and pay principal and interest of $72,072 per year on the two loans.
The Fine Print
As stated above, a conventional lender (typically a bank) will provide 50% of the financing on an SBA 504 Loan. The applicant business is required to contribute equity in the amount of 10 to 20% (a down payment that is 50 to 66% less than with conventional loans). A Certified Development Company (CDC) provides the remaining 30 to 40% of the total project costs through the 504 loan, taking second lien position.
With the SBA 504 program, the total project costs can include the costs for land and existing building or equipment; hard construction/renovation; fixtures and equipment; furniture, soft costs; and closing costs. Project costs can be financed in their entirety with a 504 loan, whereas most commercial bank loans only finance a percentage of the purchase price/appraised value and borrowers would have to come up with closing and soft costs out of pocket. For the first mortgage–the bank loan–the term is 25 years at market rates, and is fully amortizing. For the second mortgage–the CDC portion–the loan will be a 20-year fixed rate term for real estate projects or a 10 year fixed rate term for equipment. Weighted averages are used to determine the term of the loan when the project includes both real estate and equipment. For example if 55% of the total project costs are the real estate costs and 45% equipment, the project qualifies for the 20-year term. Additionally if borrowers decide to sell their property, a 504 loan can be transferred to the buyer with the consent of the lenders.
U.S. Small Business Association 504 Loan Program: http://www.sba.gov/financialassistance/borrowers/guaranteed/CDC504lp/index.html