David R. Evanson
Entrepreneur Magazine, Fall, 1999
SBA Guaranteed Real Estate (And Fixed Asset) Loans
Resume: Certified Development Company (504) Loan Program
Definition Or Explanation: Established in 1980, the 504 Certified Development Company (CDC) Program provides long-term, fixed rate financing for major fixed assets such as
real estate, facilities construction or expansion or other fixed asset needs.
Appropriate For: For profit businesses that fall into SBA size ranges and who are interested in reducing the costs of real estate and equipment loans.
Supply: Availability of funds is not a problem. However, access to funds is limited by CDC locations since their mission is to fund businesses within their community or region. Thus, if there is no CDC in your area, availability of these funds may present a problem. In fiscal year 1997 alone, the 504 program produced 4,130 loans amounting to more than $1.44 billion.
Best Use: Proceeds from these loans may be used for fixed asset projects such as, purchasing land and improvements including existing buildings, grading, street improvements, utilities, parking lots and landscaping; construction of new facilities, or modernizing, renovation or converting existing facilities; or purchasing long-term machinery and equipment.
Cost: Interest rates on 504 loans are tied to an increment above the current market rate for five year and 10 year U.S. Treasury issues. Fees total approximately three percent of the loan amount and may be financed with the loan. Generally, project assets are used as collateral and personal guarantees from the principal owners are required.
Ease of Acquisition: Chellenging. Federal regulation combined with several parties involved in the transaction make for a complex application process.
Range Of Funds Typically Available: $50,000 to $750,000 for up to 10 years on equipment and 20 years for real estate. The maximum amount may be increased to $1 million under certain circumstances. The private lender contribution is unlimited.
PROS AND CONS
The CDC 504 Loan Program provides low-cost fixed-rate, long-term financing to small businesses that cannot obtain funds from conventional sources. Lower down payments than traditional lenders require — usually 20 to 25 percent — and below-market rates allow small businesses to conserve working capital and longer terms reduce monthly debt payments.
On the other hand, start-ups, without adequate capitalization may find it difficult to obtain a 504 CDC loan due to the equity requirements. To make it more difficult, if the borrower has been in operation for two years or less, the equity requirement increases to 15%, from the 10% equity requirement for more mature companies.
Companies that are considering refinancing or moving after a few years might rethink the 504 loan due to prepayment penalties attached to the CDC portion of the financing. Finally, due to employment requirements, these loans are not for companies that are looking to reduce their staff through the acquisition of high-tech equipment, etc.
CERTIFIED DEVELOPMENT COMPANIES
“CDCs (Certified Development Companies), which are licensed by the SBA, are the eyes and ears for this program,” says Diane McDonald, Deputy Director for Alacom Finance, based in Memphis, TN.
Shop Talk: Loan-to-value ratios describe the percentage of an asset which can be financed with a loan. If a CDC lending policy requires a 90% loan-to-value ratio that means it will lend $90,000 for every $100,000 of assets which the borrower is purchasing with the loan proceeds.
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CDCs are nonprofit corporations sponsored by private interests or local governments. Their mission is to contribute to the economic development of their community or region through job creation, thus the requirement that a CDC portfolio must create or retain one job for every $35,000 of debenture proceeds provided by the SBA. These companies operate under the jurisdiction of a board that includes local government officials, private sector lending institutions,
and business and community organizations. There are about 300 CDCs nationwide.
CDCs also offer assistance to small business borrowers in organizing the loan package, and completing SBA paperwork. Since the CDC processes, closes and services the loan, a close relationship between the borrower and the CDC can develop, often to the benefit of the small business. Participants in the Premier Certified Lender Program (PCLP) enjoy additional authority and can approve loans on their own. This can cut the approval process time dramatically.
Premier Certified Lender status is a consideration for a borrower in a hurry. Eligibility for the PCLP program was recently extended after a 30-month pilot program, thus expanding the availability of this service.
WHOzzS INVOLVED AND WHATzzS QUALIFIED?
The 504 Certified Development Company Program provides an alternative source of long-term, fixed rate financing generally to established companies with a proven track record.
Typically, these loans are secured with a senior lien from a private sector lender, for up to 50% of the total loan amount. Forty percent is funded through the sale of 100 percent SBA-backed debentures sold in the capital bond market by the SBA and which are guaranteed by the SBA. The remaining 10% takes the form of an equity position required from the borrower.
In terms of eligibility, the 504 programs requires that machinery and equipment financed must have a useful life of at least 10 years and that real estate be primarily owner-occupied. Check with the CDC regarding specific occupancy percentages which differ depending on if the
property is new construction or a renovated site.
It is important to note that the 504 Program provides so-called, permanent financing for long-term assets. Thus temporary financing, such as a bridge loan or a construction loan, is usually required to start a project. Once the project is underway, CDC financing can permanently replace the temporary financing.
SIDEBAR: 7(A) REAL ESTATE LOANS
The SBA offers another alternative for real estate financing under the SBA 7(a) program. This option differs from the 504 CDC Program in a number of significant ways.
– The 7(a) program offers a longer term–25 years versus 20 years with the 504 program.
– A 7(a) loan does not incur the level of prepayment penalties of the 504 loan.
– 7(a) loans offer an adjustable rate product (with interest caps available) vs. the fixed-rate only feature of the 504 program.
– 7(a) loans are funded by lenders with SBA guarantees as opposed to the private debenture sale used in the 504 program.
– 504 borrowers are generally well-established businesses, while 7(a) borrowers may be newer businesses without a strong track-record.
– Job creation is not a factor in obtaining 7(a) financing.
– In some cases, 7(a) loans can be used to refinance owner occupied real estate. Check with your CDC.
– 7(a) rates are negotiable with lender. For loans under 7 years, the maximum is prime plus 2.25% or 2.75% for loans over seven years. CDC (504) loans are tied to market rates for five and 10 year treasury issues.
APPLYING FOR A 504 CDC LOAN
Typically, 504 loan requests are initiated by a private lender. So, if you think this is a viable option for your financing needs, it is in your best interest to find a banker who is familiar with 504 financings.
Donzzt Forget: The SBA guarantee which is imbedded in the 504 loan process will increase the documentation you will need to produce and increase the degree of difficulty associated with the application process.
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Just as is the case with all small business loans, borrowers should be prepared with three years worth of financial statements, plus personal financial statements for company principals. This is in addition to other qualitative information having to do with management, the company,
the market, and usage of loan proceeds.
Once a banker in convinced of the viability of the loan, and the credit-worthiness of the company, the bank may recommend the loan as a candidate for 504 financing. And, in fact, banks have a great deal of incentive to recommend this program. First, since the bankzzs portion of the loan is 50%, their exposure is lower. Also, since their investment is less than that of traditional financings, they can spread their investments out over a number of projects, reducing their financial exposure, increasing their customer base, and stimulating the local economy through job creation.
Finally, this program gives the bank a senior lien position on 100% of the assets being financed. Thus, the 504 program offers benefits to both borrower and banker.
Once the bank has preliminarily approved a 504 request, the prospective borrower is turned over to a local CDC. The CDC works with the applicant on a true management level. A CDC may, for example, offer financial and technical assistance, or help businesses obtain such assistance from other sources. This is in addition to assisting the borrowers with the preparation of the application and the closing documentation.
The CDC then recommends the package to the SBA for approval (unless it is a PCLP and has approval authority). SBA approval means that the SBA will guarantee the CDC portion of
the loan (roughly 40%). Funds are then raised through a monthly debenture sale, which are guaranteed 100 percent by the SBA.
A Good Deal: Financing through the 504 program is a good deal for borrowers because the required downp ayment is as little as 10%, compared to the 20% to 25% that would be required from a conventional lender. For a $200,000 property, a borrower seeking a CDC loan would need just $20,000 in equity, but $40,000 if they were looking for a traditional real estate loan.
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Once the loan is approved, the funding process begins. A hypothetical example makes this process easier to understand.
Assume there is a $1 million project, with proceeds to go towards purchasing land and constructing a building. The bank provides $500,000 and assumes a first mortgage. The CDC takes a second mortgage for $400,000. The remaining $100,000 comes from the borrower. Depending on the terms of the loan, in most cases the bank will, for an interim period, actually assume $900,000 (their $500,000 plus the CDCzzs $400,000). This period may extend from one month — if no construction is involved and the wait is just until the next debenture sale — up to six or eight months if there is construction. Longer interim terms are possible given extenuating circumstances. (Remember, these loans provide permanent financing and do not cover construction. But remember also that construction loans are not permanent either. At some point them must be replaced with a longer term vehicle such as a CDC loan.)
Once the debentures are sold, funds are wired to the bank, the bank receives its $400,000, and retains its senior lien on the $500,000. Of course this is not the end and most CDCs stay involved with their loan customers, providing valuable and on-going consultation even after the
CHART: CERTIFIED DEVELOPMENT COMPANY LOAN PROGRAM OVERVIEW
The chart below summarizes many of the most important features of a Certified Development Company loan.
PRIVATE LENDER 504 FINANCING EQUITY
Percent of project 50% 40% 10%
Security 1st lien 2nd lien n/a
Dollar amount no limit $50,000-$750,000 n/a
($1 mm in some cases)
Interest rate variable fixed n/a
Terms, Real Estate 10+ years 20 years n/a
Equipment terms 7 years 10 years n/a
Taking Action: The first thing to find out about CDC loans is not whether you qualify, but if there is a Certified Development Company in your area. Start asking bankers, accountants or real estate attorneys. Or go to www.sba.gov and click on “Local SBA Resources.” Select CDC Lenders and check your region for a list with contact information and
area of operation.
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