The Gem in the Crown

Why the U.S. Small Business Administration’s 504 Loan Program is still the best thing since sliced bread.

The U.S. Small Business Administration (SBA) was created in 1953 under the Eisenhower administration to help mitigate private sector risk by encouraging banks to make more loans to small businesses than they would normally make because then, as now, small businesses, especially the new and younger ones that are most critical to the well-being and growth of a vibrant economy, have a different risk profile to the bigger curmudgeon-like ones and thus have many challenges accessing loans from banks.

In today’s economy, banks face more competition around small business lending than they did sixty-six years ago, particularly given the proliferation of new non-regulated, on-line, alternative lending sources in combination with the lingering after-effects of four trillion dollars’ worth of Monopoly money masquerading as U.S. currency that was pumped into the economy through a sustained period of quantitative easing. For the very same reasons, the role the SBA plays has been changing too because more small business lenders are exploring non-traditional financing options to start, grow and expand their businesses. But there is one big exception. The SBA 504 loan program which is more relevant today than it has ever been before.

I first became aware of the SBA 504 loan program in 1990 when I headed up the Small Business Development Center at the University of Kansas. The 504 program was only four years old at the time and then, like now, wasn’t very well known.

A far-sighted and bi-partisan Congress had created the program midway during the second term of the Reagan administration as a private sector / public sector initiative to encourage small business owners, when they were ready and only if it made sense, to use SBA financing to become the owners of the real estate that housed their business.

Interest rates were high in the ‘80s. (and if you weren’t “of age” in the ‘80s you should look up just how high they were, if only to appreciate how low they are now) and this made it hard for small businesses to keep costs under control. The 504 program was created to uniquely combine a conventional bank loan (private sector) for 50% of the purchase or project construction costs associated with a small business investing in their own space, with a 40% SBA 504 loan (public sector) facilitated by a nonprofit “certified development company”, like Colorado Lending Source, thus allowing a small business to finance a building with a down payment of usually 10%.

Banks usually consider owner-occupied commercial real estate is worth 75% of whatever the value is so because they have to ensure that a loan is fully collateralized, they only like to lend 75% of whatever it costs to buy or build a building. This means that a small business has to come up with a down payment of 25% and sometimes more so that they can finance a building using a regular loan from a bank.

When the SBA 504 loan program was created, the “quid pro quo” from Congress for allowing a small business to make that financing decision sooner by not having to save up as much money for such a large down payment, and start paying rent to themselves rather than a landlord, was that the small business had to create jobs in their community. The rationale being that the money the business was saving by not having to tie up 25% or so in a building, could stay in the business to help it grow and add new jobs.

To this day, the SBA 504 loan program is still the only one of the twelve distinct SBA loan programs that has an economic development / job creation focus, which is just one of many unique characteristics the program enjoys.

There is also a very strong community benefit associated with the SBA 504 program. When you have local businesses owning the buildings they operate out of, as opposed to some absentee landlord, you create a much stronger community because locally-based property owners are more likely to maintain properties to a higher standard as well as support all the things that happen in that community.

But back to my story. In the early ‘90s, the SBA 504 program wasn’t very well known or even popular. Where I was located in eastern Kansas, the program was being used at that time by the local certified development company to finance non-viable businesses like turkey farms, most of which failed. Banks didn’t really consider the program an option for their regular small business clients because the program was perceived as scary and the “I’m from the government and here to help you make a better loan to a small business trying to buy their own building” argument wasn’t very compelling.

Congress was also allocating taxpayer funds to operate the program and it was costing a bushel barrel full of cash because of the type of loans being made. I even publicly jabbed at the program in testimony I provided at a field hearing of the Senate Small Business & Entrepreneurship Committee in Kansas City in 1992 (or 1993?) because I thought the program was a waste of taxpayer funds.

All that changed in 1996 when Congress required the program to stand on its own two feet.

Significant fees were imposed on users of the program to remove it from the public purse strings and many thought it would go away. That next year, loan volume did fall dramatically nationwide, yes, but 1996 was also the turning point for the program and also for me as I switched from being an opponent to becoming one of its biggest supporters.

I accepted, that same year, an opportune invitation to lead the local one-person, one-county certified development company and set out to embrace the challenge of building a viable SBA 504 loan portfolio for our small community. My journey from Kansas in 1996 to Colorado Lending Source today is a story for another time but let me share with you with the EIGHT amazing reasons why I still feel just as strongly and passionately about the 504 program today as I did in 1996. Perhaps even more so.

And these are my reasons why the SBA 504 loan program is the gem in the SBA crown and the best thing for every small business owner since sliced bread.

1.    The program defines the down payment for a small business at typically 10%. If the business is less than two years old or if the property being acquired/constructed is a “special purpose” property (like a gas station), the small business will need to contribute an extra 5% on each of these two counts but that still positions the maximum possible down payment at 20% which is still better than most banks require. And I’m a huge supporter of small businesses controlling their operating costs by owning their own space if it makes sense for the business to do so. I’ve worked with way too many erratic landlords over the years to want any business I’m ever involved in, lease space ever again.

2.    The SBA 504 financing share of the project can’t be more than 40% of the total project, up to a maximum of either $5 million or sometimes $5.5 million. There is no limit on the size of bank’s loan in front of the 504 loan which means that you can use the 504 program on some fairly large projects. Certainly, much larger projects than are possible using the SBA 7(a) / guaranteed loan program.

3.    The 504 program is a loan-to-cost program and that means that in addition to the hard costs associated with buying, improving or building a facility, related soft costs like construction interest, the cost of an appraisal, environmental report, title work, etc., along with fees associated with the 504 loan, are all financeable as part of the project. The intent here is not to nickel and-dime the small business at the closing table, which pulls cash away from business operations. Ten percent is ten percent.

4.    The SBA 504 financing share of the project is provided at a FIXED interest rate for up to 25 years. Banks typically don’t like to fix interest rates on commercial real estate loans so the benefit a borrower gets from having 40% of the project financing on a fixed, predictable basis is HUGE for most small businesses.

5.    Unlike the SBA’s 7(a) / guaranteed loan program, which some banks prefer to use for owner-user real estate financing projects although it is rarely a better deal for the small business owner although it is definitely a more profitable deal for the bank, is that the 504 program usually never attaches personal assets as security for the loan. The primary collateral for a 504 loan is the second mortgage/second deed of trust behind the bank on whatever the commercial property involved with the loan is. Not the house that the small business owner’s family lives in.

6.    If a small business is buying and/or fixing-up an existing building, SBA rules only require them to occupy 51% of the available square footage. In Colorado, where commercial buildings and condos are in short supply already, it could make sense for a small business to buy a bigger building than they immediately need anyway. Renting out up to 49% of a building in today’s market can often provide enough rental income to support whatever the new debt will be on the entire building.

7.    [My favorite!!] The capital market in New York sets the interest rate on a 504 loan giving a small business in Anytown, USA, access to the same sort of interest rates that the big publicly traded curmudgeon-like businesses can get. Let me explain. The source of funding for a 504 loan is the sale of a bond (more formally known as a “debenture”) on the market in New York. The bond contains a monthly compilation of loan requests from individual small businesses across the nation, all facilitated by nonprofit entities like Colorado Lending Source. In August 2019, there were 388 small business requests bundled into two different bond pools, one a 20-year pool and the other a 25-year pool, totaling some $310 million worth of 504 loan requests. The SBA attaches the full faith and backing of the U.S. government to these pools and then an underwriter takes them to the market and solicits bids from pension funds, insurance companies, sovereign wealth funds and the like. The return is a little higher than a comparable Treasury instrument so there are usually plenty of institutional investors bidding for the 504 pools each month. This competition pushes down the interest rate that a small business ends up paying for their 504 loan. And remember, the rate is locked in for the 20- or 25-year life of the 504 loan once the bond is sold.

8.    The most recent effective rate for borrowers whose current fiscal year 25-year SBA 504 loan funded in August 2019 was just 3.630%, which is nothing short of amazingly phenomenal for an owner-user commercial real estate loan. But what most people don’t realize about the program is that because the 504 debenture is essentially a semi-annual coupon bond with fees built into the interest rate based on the outstanding principal adjusting every five years based on the then outstanding principal (yes, too much information, I know), the publicized 3.63% effective rate is the rate a small business borrower will pay ONLY if they keep the loan full term, which almost no one ever does. If the loan was paid off early, the effective rate will be less. For example, for current fiscal year 504 loans funded in August 2019, a borrower is really only paying an interest rate of 3.534% for the first five years they keep their 504 loan. The second five years, the effective rate increases to 3.556%. (The prepayment penalty on a 504 loan, which isn’t really very much anyway, expires at the end of year ten so if a small business borrower pays their 25-year loan off then, they will have decreased their effective rate to just above 3.54% odd.) The third five years they are paying 3.616%. The fourth five. years 3.755%, and, the last five years 4.451%. If rates are really low 20 years from now, although it is more likely we will be back into double digits by then, a small business could pay off their 504 loan at any time before full maturity to reduce the overall effective rate they pay. (What the economy might look like in 2049 is also a story for another blog post.)

So, there you have it in the proverbial enigmatic nutshell. The SBA 504 loan program is the only SBA owner-user real estate program that defines a borrower’s down payment. It can be used to help finance projects ranging in size from $60,000 (the minimum 504 loan is $25,000) to $20 million plus. The intent of the program is to minimize the borrower’s out-of-pocket costs so those funds can stay in the business to help it grow. A small business can rent out some of the space they acquire. The big-business capital market sets the interest rate for small businesses accessing the program. Interest rates are incredibly low at present. AND, the program is self-supporting, so it isn’t being subsidized by taxpayers like it once was.

As an aside, I find it interesting that although the Federal Reserve’s 2018 Small Business Credit survey found that the share of small business with employees who sought loans, lines of credit, or cash advances from online lenders has “grown markedly” to 32% of applicants last year, the FDIC’s inward-facing 2018 Survey of Small Business Lending by banks highlighted two observations: (1) “very few small or large banks accept small business loan applications online”; and (2) “credit unions and FinTech firms are emerging as competitors, but are currently not top competitors”.

Whether or not bankers and bank regulators are willing to accept or even admit it, the world of small business lending has been changing since the end of the Global Financial Crisis and will continue to do so for the foreseeable future. And even with the rise of co-working spaces, another recent phenomenon that will have an impact on bank lending in the future, well positioned small businesses will always be better off owning their own space rather than renting or leasing it. And because that will continue to be the case, the SBA 504 loan program is even more relevant today than it was when the program was created in 1986.

It is truly the gem in the SBA crown!