Originally posted – Oct 01, 2013
Growing up, did you ever have someone make you toe the line in a certain way and all you could do was gripe about it, and it was only later that you realized they were doing you a huge favor? That’s how I feel about my local bank.
They introduced me to the SBA 504 loan.
Actually, they kind of pushed me into getting a 504 loan nine years ago when I was first getting into the laundromat business, telling me it would be to my advantage. I went along with it, thinking, “Yeah, they just want to mitigate their risk. I just know there’s going to be a ton of paperwork involved.”
But, like a kid trying to keep from getting grounded, I decided to play along. After all, it was a business startup, and if I wanted to play the game, I figured I would need to play by their rules, even though I had heard a lot of horror stories about getting SBA funding.
Was there a lot of paperwork involved? I thought so at the time, but having never applied for a commercial loan of any kind before, I had nothing to compare it to, so I felt justified in muttering stuff under my breath as I slogged through all of the financial information needed by the bank and the SBA. Now I realize it wasn’t that bad.
In the nine years since that first from-the-ground-up project, I’ve built a second laundromat and have a third one in the works, and it turns out the amount of paperwork required on a 504 loan is actually not much different than what is required for a conventional loan; just a few more documents to sign and the fact that you are actually dealing with two entities. But the advantages gained by a little extra effort are well worth it. In fact, I’m financing the construction of the third laundromat with another 504 loan, which is offered for the specific purpose of commercial real estate and other fixed assets, such as heavy equipment.
Does that sound like a laundromat to anyone else?
I feel it’s necessary at this point to post a disclaimer: I am not dispensing financial advice. You should make your financial decisions based on your own individual needs and circumstances and get professional help in your own neck of the woods. However, as someone who has been through the 504 loan application process twice, I thought sharing my experience might be of some benefit to owners who are looking for funding alternatives.
I also should give credit to Chris Hurn, the author of “The Entrepreneur’s Secret to Creating Wealth,” a book that does a great job of explaining what the 504 loan is, and the process for obtaining the loan. I relied heavily on information from that book to help write this article.
Yep, it’s true. I got two SBA loans, read a book, and now I’m writing an article. Those are my credentials, so take it for what it’s worth!
A Little Background
The Small Business Administration has two primary types of loans. One is known as the 7(a) loan and the other is the 504 loan. Of the two, the 7(a) is the more prevalent, mainly because it’s favored by lenders because the lender makes more money on it. According to Hurn, 7(a) loans have up to 75 percent guarantees from the government and the guaranteed portion is often sold out to investors in the secondary market, and the lender gets a very nice premium fee for doing so. That also increases the liquidity for the lender, who then has new money to issue more loans. The theory is that this greases the wheels of commerce, and more capital becomes available for America’s small businesses.
The 7(a) loan is actually more flexible than the 504, meaning it can be used for more things, such as business acquisitions, partner buyouts, refinancing and working capital, as well as startups, real estate and equipment. The downside is that the 7(a) loan must be “fully collateralized,” which means all the assets of the business may be tied up in a blanket lien, as well as the owner’s house or any other assets necessary for collateralization.
Although your firstborn child is not required, the interest rate is usually higher and the loan fees are always higher than a 504 loan. The down payment is also higher in most cases. The 7(a) is a broad-based loan program that has been of significant benefit to countless entrepreneurs. Nonetheless, it’s the 7(a) loan that’s the source of many of the horror stories you’ve heard about the SBA.
Now let’s talk about the 504 loan. Designed approximately 30 years ago for the express purpose of financing commercial real estate and equipment, the program is a good option for laundromat owners who are considering buying their own real estate and either remodeling an existing building or building from the ground up. The two times I have received a 504 loan, it was for projects that included the purchase of land, constructing a new facility, and purchasing the laundry equipment and furnishings for the facility.
It’s important to me as a fiscal conservative that the 504 loan does not use taxpayer money. This is not a government handout. The money for the loan is paid for through the sale of a debenture (similar to a bond).
Here’s an interesting factoid: the SBA does not actually lend money (except for federal disaster aid.) The agency is simply the facilitator through which the government guarantees small business loans – loans made by private sector lenders.
50-40-10
Borrowers who obtain a 504 loan actually use funds from three sources. The first is the borrower’s own money, the down payment, which is usually 10 percent. The next 50 percent is financed through your lender as a conventional loan in a first mortgage position. The remaining 40 percent and second mortgage position is through a Certified Development Company (CDC) and is funded by the sale of the debenture. The SBA has certified more than 250 CDCs around the country. Most of them are non-profit entities engaged in economic development in their communities. In that role, they perform a variety of services, but they are mainly tasked with processing the 504 loan program.
Advantages of a 504 Loan
Low down payment: The down payment required is typically 10 percent if the borrower meets all the criteria. However, a larger down payment might be required under certain circumstances, such as a business startup. Nine years ago, I was fortunate to be approved for 504 funding, but my bank (which, of course was in the first mortgage position) required a much larger down payment, which wound up being around 30 percent. However, the large down payment was more the result of an unfavorable appraisal than SBA requirements.
Business startups are more often asked to cough up a 15 percent or 20 percent down payment, according to Hurn. Not having a proven track record makes it more difficult to get financing. (Did I just state the obvious?) Now my company has cash flow from two laundromats. The financials look pretty darn good, and I was able to get financing for the new location with only 10 percent down, which allows me to build the new location earlier than might otherwise be possible and frees up cash to be used for any unforeseen snags during construction. (This is the third time I’ve built new, but I guarantee you I’ve overlooked something!)
Longer term: An SBA 504 loan is typically for a 20-year term, which means you will have a much lower payment than is possible with a shorter, conventional loan. Both of my 504 loans have 20-year terms. Even longer terms are available, but I don’t have any experience with that.
Fixed interest rates below anything you can get elsewhere (except from your rich aunt): OK, this gets just a bit tricky to explain, but here goes: When the CDC sells the debenture to get the funds to pay their 40 percent of your financing needs, they do so by offering it to investors in a monthly public market. Because these bonds carry a government guarantee, buyers are willing to accept a lower yield on them. That means the interest rate you will be paying on the SBA’s portion of your loan is below any rate you will ever receive on a conventional loan. And those low rates are fixed for 20 years!
But, remember, the debenture funds are only 40 percent of the total amount, while 50 percent is a conventional loan with your lender of choice, and will most likely be a variable rate that is reset every few years. So what you wind up with is a “blended” interest rate that is still below almost any other commercial loan. Because your local lender’s rates may be variable, it behooves you to pay off that one first.
Collateral: Only the owner-occupied real estate and/or equipment being financed is required as collateral on a 504 loan.
Loan fees: Very low loan fees, usually 1.0 percent to 1.25 percent of the loan amount. In addition, the loan fees and closing costs can be rolled into the loan.
Assumable: If you decide to sell your property, you will be able to transfer the remainder of the commercial loan balance to the new owner. This can be a very important part of your exit strategy or a strong selling point.
You Don’t Qualify If…
The SBA has three major tests to determine if a small business is eligible for a 504 loan.
First, a borrower cannot have a tangible business net worth greater than $15 million dollars. I know some of you laundry operators out there are very successful, but a business net worth of more than $15 million? Well, we can all aspire to that.
Next, you cannot have an average net income greater than $5 million over the previous two years. That’s a lofty threshold, and one that’s not going to knock too many laundry operators out of contention.
The final test is one of personal liquidity, and this is one that might keep a few laundry operators out of the 504 ball game. If you’ve got enough personal liquidity available to pay for the total project cost of the proposed 504 loan, you are not eligible. Personal liquidity is defined as non-retirement, unencumbered liquidity. This could be a problem if you’ve built up a large stock brokerage account of stocks, bonds and cash. You would not be eligible for a 504 loan in that case, but you’d probably have a number of conventional lenders all wanting to take you to lunch.
How Long Does It Take?
The first and possibly most important decision is selecting the commercial lender who will be in the first mortgage position on your loan. It is wise to find a lender who is very familiar with the SBA 504 loan process. Otherwise, you could wind up being someone’s guinea pig as they figure it out. That’s another source of SBA horror stories, only it’s the lender who’s at fault for that delay of six months, not the SBA.
Once you have selected the commercial lender, you have the usual set of hoops to jump through. You have to prove to the bank that you are worthy and your project is worthy, that you have the means and the business plan, and that you know how to fill out the documents required to get a commercial loan – as well as complete a financial statement, print off your P&L and balance sheet, provide three years of income tax documents, be willing to sign a personal guarantee, get an appraisal, etc. You know… the usual. The lender then underwrites the loan request and approves it internally.
Now, it’s time for the extra stuff. The lender usually has a favorite CDC with whom they prefer to do business. My local CDC is named the Small Business Capital Corp. The SBCC provided me with a checklist of items it needed to approve the loan. Guess what? It’s pretty much the same stuff you already have on hand because you just gave it to the bank for their underwriting process. Plus, there are a few extra forms to fill out. I received my checklist on a Friday and took all of the completed paperwork to the SBCC on Monday – and I still had time to go to church and grill hamburgers for the grandkids on Sunday.
It took the SBCC 10 days to underwrite the loan a second time and give its approval.
After the SBCC Board’s approval, the entire package was sent electronically to the SBA’s central processing center in Sacramento, Calif. They approved the loan in three business days. The entire SBA 504 process from getting the checklist to getting SBA approval was 20 calendar days. Earlier, the bank took 11 calendar days (eight business days) to approve my loan application. Add to that the time it took me to put together all of the documentation and you’re looking at maybe six weeks for the entire loan process.
That was my experience. However, keep in mind I have been through this process once before, and I am blessed to have a very competent bank and CDC to work with. Your mileage may vary.
There are still a number of things left to do to implement the loan. For instance, since the sale of the debenture will not take place until after we have a Certificate of Occupancy for the new building, the bank will be the source of all of the upfront funding. The SBA then reimburses the bank for its portion of the loan with proceeds from the sale of the debenture.
The Debt Paradox
I love the idea of being debt free. But I also love the idea of building and owning revenue-generating assets, which in my case happen to be laundromats. Ultimately, I hope to be able to pay cash for new facilities – but until my cash flow catches up with my dreams, I will be using debt to pursue them.
The key is managing that debt in a way that the dreams don’t become a nightmare. To that end, the SBA 504 loan is one of the most effective tools I have encountered. With a low down payment, low interest rates and very long terms, the 504 is less expensive than any other loan alternative, making it possible to preserve capital and grow the business.
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