If you’re thinking about purchasing real estate or long-term equipment for your small business, you should consider a 504 loan from the SBA. These loans currently offer below market rates and long terms, making them an ideal choice for many small business owners.
What is an SBA 504 Loan?
One of the lesser known SBA programs, a 504 loan can be used for real estate and long-term equipment or machinery purchases. The loan is composed of two loans: a conventional bank loan for 50% or more of the loan amount and a loan from a Certified Development Company (CDC) for up to 40%. As a borrower, you will be responsible for a downpayment of at least 10%. The SBA guarantees 100% of the CDC loan.
More specifically, 504 loans can be used for:
- Purchasing land, including existing buildings
- Making lot improvements, including street upgrades, parking lots and landscaping
- Construction or renovation of facilities
- Purchasing long-term machinery and equipment
504 loan terms normally come with 10-year terms for equipment and 20-year terms for real estate. The maximum loan amount for the CDC loan is between $5 to $5.5 million depending on the goals of the project:
- $5 million for job creation: a business must create or retain one job for every $65,000 guaranteed by the SBA.
- $5 to $5.5 million for public policy: a business must meet a public policy goal (e.g., expansion of exports, rural development and business district revitalization).
- $5.5 million for small manufacturing: a small manufacturing company must create or retain one job per $100,000 guaranteed by the SBA or achieve one of the public policy goals.
The total amount for a complete loan package will depend on the project, with amounts up to $10 million not uncommon. For example, if you’re financing a $10 million building purchase, a CDC may provide $4 million, a bank may provide $5 million and you would make a $1 million down payment.
Interest rates on the CDC loan are fixed. The rates are determined by U.S. Treasury yields and an additional spread. The 10-year loan is tied to 5-year U.S. Treasury yields, and the 20-year loan is tied to 10-year yields. A good rule of thumb is that interest rates will be 1.5 to 2.5 percentage points above the 5- or 10-year Treasury yields. Current interest rates for 2016 have been between 4.0% and 4.5%. Rates are set each month, so if you think they will be rising, it’s best to secure a loan as quickly as possible. These loans are amortized, meaning each monthly payment will be the same.
Interest rates on the bank loan are normally variable. Because the loan is backed by collateral (i.e., the real estate or equipment being financed), rates from banks will frequently be on the lower end. The bank loan is usually amortized as well.
SBA 504 Loan Requirements
The SBA outlines a set of requirements that a small business must meet to be eligible for the 504 program. These requirements include:
- For-profit company located in U.S.
- Net worth of less than $15 million and an average net income of less than $5 million after taxes for past two years
- 504 loans cannot be used for real estate speculation or investment
- Not have funds available from other sources, including personal sources
- Demonstrated ability to repay on-time and good projected cash flow
- Good personal character
- Owners have relevant management experience
- Strong business plan
- Personal guarantee of owners
- Collateral (the assets that are being financed)
The bank and CDC may require businesses to meet additional criteria. This will vary by lender, but most will want to see borrowers with good to excellent credit scores (which is defined as any FICO score of 690 or above) and no recent derogatory marks on their credit reports (e.g., foreclosures, bankruptcy, defaults, liens, etc.).
One advantage of 504 loans is that they can be made to new businesses and startups. “For 504 loans, about 85% of our business is to existing businesses that need expansion. But we can do a startup business, they just have a larger down payment,” said Zola Finch, Director of Finance at RMI (a CDC).
SBA 504 Loan Application Process
To apply for a 504 loan, you’ll need to start at your bank. “A small business and their bank will figure out if a 504 loan would be the best program for the business. If it is, they would apply to a CDC. With that application, we ask for the same information as the bank. Once we receive that application, we determine the borrower’s creditworthiness and submit it to our loan committee. If it’s approved by our loan committee, it gets forwarded to the SBA. The timeframe for submitting the application is dependent on the borrower—how quickly they can get us those documents. But from the time of the loan committee to SBA approval, you’re probably looking at two weeks,” said Finch.
The documents that the SBA requires for a 504 loan application include:
- Personal and business financial statements (profit and loss statements, one-year projections)
- Ownership and affiliation documentation
- Business certificates or licenses
- Loan application history
- Personal and business income tax returns for past three years
- Resumes for each owner
- Business plan and description
- Business or commercial lease agreement
Banks and CDCs may require additional documents and information, so it’s best to check with your lender to see what else is necessary.
Why Should You Get an SBA 504 Loan?
504 loans offer competitive fixed interest rates and longer terms, making them an excellent choice for real estate or equipment investments. “The 40% loan that we provide under 504 is at a fixed interest rate. Borrowers know exactly what their interest rate is and what their payments are going to be. From a budgeting standpoint, it’s a win for the borrower.
“That rate [on the CDC loan] is not going to change as interest rates start to trend up. The bank rate is typically a variable rate, so within a few years that interest rate would be adjusted. The nice part is that 40% of the loan is a good hedge against the rise in interest rates. The other advantage for the borrower is the borrower gets in for a 10% down payment whereas on a conventional loan they would probably have to put 20% to 25% down. It enables that business to keep some of their cash,” said Finch.