With the advent of the “Small Business Jobs Act of 2010”, the most significant piece of small business legislation in over a decade. The new law is providing critical resources to help small businesses continue to drive economic recovery and create jobs.
The Law permanently increased 7A and 504 Limits from $2 million to $5 million (for manufacturers in 504 loan program, up to $5.5 million). For the New York Metropolitan Area, this increase was important based on increase cost and asset values that correspond to our regional area. With banks concentrating on increasing capital and reducing loan exposure since 2008, the Small Business Administration Loan Programs virtually became the only game in town for most small businesses.
Each program has its advantages and disadvantages for a borrower. The following is a recap of those programs.
SBA 7A LOANS
This is the most common SBA loan program. Through participating lenders or directly from the SBA, a loan is granted for the purpose of purchasing fixed assets, working capital or to finance start-ups or the purchase of an existing business, additionally, some debt payment is allowed. 10% borrower equity is required for the loan. This is a tremendous advantage in today’s marketplace where 25-30% equity is required by banks for conventional business loans or mortgages.
As a participating lender (Bank) they receive a 75% loan guarantee from the federal government. What that means if a loan is made for $1 million dollars and the borrower defaults for non-payment, the bank can “put” the loan back to the federal government and receive payment of $750,000 on the $1 million dollar loan. As liquidation is made of the loan collateral the government will receive 75 cents on the dollar with the bank receiving 25 cents on the dollar.
For a bank it mitigates having a million dollar loan on your books as a non-performing loan and reduces the balance to $250,000. With the scrutiny of bank regulators, this becomes an important tool in managing the bank’s balance sheet and loan loss reserves.
This SBA loan program interest rate has a floating loan rate tied to the “Prime Rate”. The maximum rate is Prime Rate + 2 ¼% for loans maturing in 10 years or less, and Prime Rate + 2 ¾% for loans maturing in 25 years. Most Banks price at the maximum interest rate and rates adjusted monthly with the increase/decrease of the Prime Rate. Today’s Prime Rate is 3.25% so a loan maturing in 25 years, the starting rate would be 6.0%.
This loan has a prepayment penalty of 5% for the 1st year, 3% for the 2nd year and 1% for the 3rd year. There is no prepayment penalty after the 3rd year. With the Federal Reserve Bank stating recently that they see no increases in short term rates until 2014 this program disadvantage of being tied to a floating rate, with rates currently at historic lows, gives an opportunity to borrow at the lower rate and refinance in the future once the prepayment penalty period expires. Of course, as seen over the last 3 years, there are no guarantees of where rates will go in the future, and at historic low rates, there is probably only one way they will go——-up.
Banks favor this type of loan not only for the federal government’s 75% guarantee, but also because they can sell the guarantee portion of the loan into the secondary market.
Having a 75% government guarantee makes the guaranteed portion act like a government bond. Additionally, this guarantee has a floating rate variable, thereby eliminating interest rate risk to the investor. Having a government investment with no interest rate risk is highly sought by pension funds, hedge funds and other investors who seek low risk investments. Currently, these investors will pay 10 to 15 points over par to purchase this investment. What this means that if a bank makes a $1 million dollar loan to a business, they can sell the $750,000 guaranteed portion for a profit of $75,000-$112,500 dollars. That is a substantial profit for any bank to turn down while still receiving loan servicing income going forward and reducing its future funding cost.
SBA 504 LOANS
This program is utilized strictly for real estate and/or fixed asset acquisition or renovations/improvements to existing real estate asset. On March 29, 2011 the SBA approved utilization of this loan program to refinance existing bank loans that will mature after 12/31/12 where interest rates are high, and based on the current real estate market, the original value of the property has been dramatically reduced to where the originating bank may not be able to refinance the existing mortgage at time of balloon maturity.
It is important to note that this program will expire on September 27, 2012 unless extended prior to that date by the federal government.
How this program works is based on the loan structure. A bank will lend 50% of the loan in the first mortgage position, the SBA through a Certified Development Company (CDC) will lend 40% in the second mortgage position, with the borrower to support the remaining 10% in the form of cash equity or asset valuation.
The bank portion (50%) is lent on a conventional commercial mortgage basis with a fixed rate based on market conditions fixed for 5 years, reset to a designated rate indices for the next five years, with a balloon maturity at the 10th year. Most loans are granted based on a 20-25 year amortization. Current rates are ranging between 4.50%-6.50% based on strength of borrower and industry.
The CDC portion (40%) rate is based on their borrowing from the federal government usually set to the 10 year Treasury Rate with a 20 year maturity/amortization. What this affords the borrower is a low fixed rate loan with a straight 20 year maturity with no balloon payment. Current rates are ranging between 4.50%-5.00%. Under the refinancing program, the rate will increase to 6.50%.
The prepayment penalty for the bank is usually a 5-4-3-2-1 prepayment penalty for the first 5 years and sometimes it resets again for the remaining 5 year term until the 10th year maturity. For the CDC portion, it is more restricting. The prepayment penalty is for 10 years at a 10-9-8-7-6-5-4-3-2-1. This makes any repayment over the first 10 years very expensive, but the loan can be assumed by the buyer, subject to the CDC approval, which can be very attractive sale feature for the seller based on the interest rate and providing approved secondary financing. For someone who is thinking of selling within the next 5 years, this might not be the program for you and should be address prior to application.
For the bank, the advantage is having a more established borrower with a 50% Loan to value ratio, which is considered a lower risk loan, although it does not afford the bank a 75% government guarantee and the liquidity of a 7A loan provides if the loan becomes non-performing. The bank also gives up the substantial premium it would receive in the secondary market. There is a secondary market for these loans, but the premium is about 3 points above par and most banks originate these loans for portfolio and not resale. The initial risk in the transaction is providing the “bridge” financing in the loan. What this means is the bank fully funds both portions of the loan at time of closing until the CDC raises the funds through a bond sale to fund its portion. This can take as little as 30 days after closing up to 6 months, depending on the market and CDC funding requirements. The risk is providing 90% financing with the risk of future funding by the CDC due to adverse changes to the borrower or market conditions prior to funding.
Any bank can participate in this program, versus the 7A program where a “Preferred Lender Status” dominates that marketplace. A Preferred Lender Status gives the government approval to the bank, without submitting the loan for approval directly to the SBA, as longs as it meets all SBA guidelines. This eliminates the time factor in the approval process, but a Preferred Lender Status is only granted to banks that originate a number of loans over time to expedite the process going forward and is not granted to a new banks in the program until sufficient volume and time has been generated.
For the borrower it eliminates the interest rate risk by having a fix rate loan versus a floating rate loan under the 7A program with the CDC portion fixed for 20 years with no balloon maturity. Like the 7A program, only 10% equity is required by the borrower versus current conventional bank loans requiring 25-30% equity. The disadvantage is the lengthy prepayment penalty on the CDC financing.
Since the financial meltdown in 2008, both SBA programs have been a valuable loan vehicle for small businesses. The choice of programs should be tailored to your need and ability. Based on the realities of today’s marketplace, start-ups without the benefit of historical financial statements or businesses with insufficient cash flow or principals with limited experience, resources and income/assets are still very difficult to obtain financing, if not impossible. Banks and the government will not make SBA loans if they perceive the risk is too great in today’s marketplace. But for the business person that demonstrates the necessary ability, these programs are a positive weapon to grow your business.