504 Loans: The Right Piece to a Financing Puzzle
By Colin McEvoy on January 15, 2015
This article was written by Barry Reifinger, a vice president and commercial loan officer with ESSA Bank & Trust, and originally appeared in the Northeast Pennsylvania Business Journal on Jan. 6, 2015.
Many business owners are familiar with the federal government’s Small Business Administration (SBA) and its popular 7(a) small business loan program. The flagship program is on track to lend out more than $3 billion to nearly 9,000 businesses this fiscal year.
However, a lesser-known SBA loan option, utilizing a Bank to obtain a Certified Development Corporation (CDC) sponsored 504 loan, can prove to be every bit as powerful for small business owners who are looking to start up or expand.
The SBA calls the 504 Loan Program a tiered financing vehicle that provides long-term, fixed-rate financing for major fixed assets such as land, buildings and equipment. The “CDC” portion of the name refers to Certified Development Companies, which are economic development organizations that work with the SBA and conventional lenders to offer the 504 loans to qualified borrowers.
The “tiered financing vehicle” explained
The 504 loan is a tool that banks can use to offset their lending risk and increase their likelihood of approving a loan. The 504 program works by distributing the funding of a project among three parties. The business owner provides a minimum of 10 percent, a conventional lender (typically a bank) lends about 50 percent and a CDC (with funding from the SBA) lends the balance of project, usually about 40 percent. (In higher-risk situations, the borrower may need to put more money down.)
The bank has a first lien on the assets being financed; the CDC has a second lien. That’s an important stipulation. If the loan goes into default, the bank gets the first opportunity to recover the value of its loan. The first lien position dramatically lowers the amount of risk the bank assumes. With reduced exposure to risk, the bank is more likely to approve its portion of the financing package. And although the CDC is in a second lien position, its total risk is less than half of the total financing package.
Given the 504 loan’s ability to distribute risk, it is often ideal for businesses that have a limited track record or may not have the required capital necessary to obtain conventional financing.
If the financing is for real estate, as many 504 loans are, the CDC’s loan is for 20 years at a fixed rate of interest. If the financing is for fixed equipment — such as printing presses, commercial laundry equipment, manufacturing equipment, etc. — the loan term is 10 years. A bank will offer its own terms which may include a fixed or adjustable interest rate and an amortization schedule to match the CDC’s offering.
Where does the CDC’s funds for the loans come from? The SBA bundles the loans into guaranteed bonds that are sold into the market each month. Proceeds from the bond issue fund additional loans. The bank must be willing to provide temporary “bridge” financing until the bond issue occurs at which point the bridge loan is repaid by the CDC.
Piecing together a win-win situation
Both borrowers and lenders benefit from this “piecing together” aspect of the 504 Loan. Partial exposure cuts the risk for both the bank and the SBA, creating a much more flexible lending environment. The borrower’s down payment – 10 percent instead of the typical 20 percent – makes the package more palatable to him or her. Moreover, the 20-year term and fixed rate provides more certainty to the borrower than they may have with a conventional commercial loan, and longer amortization periods help the small business owner with cash flow.
The bank must also make bridge financing available to cover the CDC’s portion until its loan is available. This bridge loan will be in place until any required construction is complete and the SBA completes the bond issue to fund its projects.
Requirements and specifics
A 504 loan is not available to everyone. Obviously, the borrower must meet the SBA’s definition of small business, and the borrower must plan to use more than half of any property purchased (or 60 percent or more if new construction) for its operations within one year of ownership.
Furthermore, the company’s average net income cannot exceed $5 million after taxes for the preceding two years. Loans must be to for-profit businesses that do not exceed $15 million in tangible net worth. In addition, 504 funds are restricted to a maximum of $65,000 per job created and/or retained.
Within a 504 loan, the total project costs can encompass the professional fees including appraisals and environmental investigations, soft costs and closing costs in addition to the assets. (With a conventional loan, borrowers generally must pay closing costs and soft costs out of pocket.)
Finally, if the borrowers decide to sell their property or equipment, 504 loans are assumable. With interest rates at historic lows and projected to rise, the ability to assume a loan with a low, fixed interest rate could be a valuable incentive to a prospective business buyer.
Get the ball rolling
If you think a 504 Loan might be the right solution to your borrowing needs, the best place to start is with an experienced banker. They will be able to provide names of CDC’s that will likely point you in the right direction. In the end, both will be instrumental in completing and submitting your paperwork.
The 504 program can be a powerful tool for financing major assets that ordinarily would be out of reach for some growth-minded small business owners. It’s yet another way that the SBA – and community-minded banks – can support an important backbone of our economy.
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