Intro to the SBA 504 Program (Part 2)

• There are more fools among buyers than among sellers.
• The buyer needs a hundred eyes, the seller but one.
• Caveat Emptor (Buyer Beware)

All these quotes act as warning to buyers everywhere, encouraging them to perform their due diligence with every purchase. “Purchasing” an SBA 504 loan is no different. A few weeks ago, we discussed the basic structure of SBA 504 loans and some very real and powerful characteristics that bring value to entrepreneurs. If you have not had an opportunity to read part one of this series, click HERE.

However, as with every transaction, there are costs and risks involved with SBA 504 transactions. I challenge entrepreneurs to educate themselves in order to determine if this is a good fix. As part of that education, I offer up a few points of costs and risk associated with SBA 504 loans.

The cost of multiple title policies

Most SBA 504 loans are for the purchase or construction of real estate, which requires two closings – one for the bank loan and bridge loan and another for the SBA Debenture loan (which pays off the bridge loan). Each loan requires a separate title policy; however, the entrepreneur does receive credit for a recent title policy when they do close the SBA Debenture title policy. This is a meaningful credit (up to 40% of the cost of the policy).

The SBA Debenture rate is not locked until the funding

This is most impactful in construction loans, as the entrepreneur is bearing all the interest rate risk, until the rate is locked. Imagine, for example, that you close on your construction loan in March of this year and the current 25-year SBA Debenture rate is 4.88% (quite a deal for a fully amortizing and fully fixed loan). Fast forward 12 months, construction has completed as planned, and you are ready to refinance the bridge loan and lock in your interest rate. The only problem is that in the last 12 months, the SBA Debenture rate has climbed to 5.88%! Historically, this is still a very good rate, especially for 25 years; but psychologically this is a kick in the gut. The good news; however is that the SBA 504 rate is based upon the 10-Year Treasury rate. Meaning these rates tend to be less volatile (similar to home mortgage rates) compared to other types of loans.

Strict Prepayment Penalty during years 1-10

Technically (sorry for following bank-nerd speak) the SBA long term loan is financed through a bond (debenture) that is generated to pay off multiple bank loans. These bonds are issued once a month (usually around the 15th) and all the associated fees for administering these are rolled into the bond. These bonds are then sold, and the investors are guaranteed a specific rate of return. If the entrepreneur pays their loan off early, the investors do not get the benefit of the monthly payments but must be compensated never-the-less. The prepayment period lasts for the first five years on 10-year loans and 10 years for 20- and 25- year loans. The penalty does decrease with every year that passes. This is bank nerd speak for a prepayment penalty. It is important to note that this does not apply to note 1 (bank note), but the bank may charge a prepayment penalty, based upon loan documents.

While it may seem like a downside to have this penalty included in the loan, this does help keep the rate low. In fact, according to professionals that help sell these bonds, the price of these bonds may be an entire percentage point higher, if they didn’t include the prepayment penalty.

Disqualification of excess land

Some entrepreneurs are fortunate to be able to find and purchase a large amount of land that will not only meet the immediate building needs, but will also provide excess land for expansion. However, any land that is considered excess to the immediate project may be disqualified from the SBA funded project. This is determined by the appraiser that is providing a value of your project. If this is the case, then the excess land may have to be financed with ANOTHER loan that is outside of the SBA structure. It is critical to understand the bank’s typical structure on unimproved (no buildings) land financing as it may be different than improved land financing.

Restriction on the amount of profit recognized in the real estate holding company

Many of the entrepreneurs that I work with choose to have an operating company that rents their real estate from a sister real estate company, as this can be a very effective tax reduction strategy. However, the SBA 504 loan documents will restrict the amount of rent that can be charged to total debt service, insurance, taxes, and other “reasonable” expenses associated with building operations, maintenance, and repair. This restriction may impact tax strategy, and it is something to consult an accountant with prior to agreeing to an SBA loan.

Depending upon the specific situation, there may be additional risks or costs that are applicable and it is important to get all this information up front from the banker and/ or the CDC representative. The SBA 504 program is a great program that has helped millions of entrepreneurs achieve their strategic goals. But every entrepreneur must make that decision for themselves.

Being an entrepreneur is one of the most difficult and demanding things you can do. The good news is that entrepreneurship today is a team sport. Hit the connect button on LinkedIn or Facebook NOW and together we will start maximizing your profit, strengthening your leadership skills, controlling your business finances, and using your bank as a strategic advantage. When we connect, tell me about your experience with any SBA 504 loans and how they have helped you achieve your strategic goals.

Greg Martin is an entrepreneur’s insider to the banking industry and passionately believes that every person was uniquely designed for a higher purpose and calling. Greg guides entrepreneurs in defining and achieving their purpose and calling. His deepest passion is living life with his wife of 17 years and their wonderful son.