If you’re looking to expand or improve your small business by acquiring real estate, building new sites, or modernizing your existing business facilities, the SBA 504 loan is often the best place to start.
Typically, SBA loans are slightly easier to secure because the SBA themselves guarantee them. You may be wondering how the lender can also guarantee a loan, but the truth is that the SBA doesn't actually lend you a dime.
The SBA loan system is funded by CDCs (Certified Development Companies) and partner lenders. These could be banks, life insurance agencies, lending-specific operations, or smaller independent lenders.
There are currently hundreds of lenders in the SBA’s working catalog, the sheer number of them increasing the chances one will see your business as a worthwhile investment.
The question is, though, does the 504 loan fall under this SBA-guaranteed umbrella? Well, I’m happy to report that yes, it does.
Much like the other popular SBA small business loans such as the 7(a) and their lines of credit options, the 504 is backed by the SBA; however, it’s important to remember that the SBA never fully guarantees any sort of loan.
What portion of the 504 loan does SBA guarantee?
The SBA currently has two standards of guarantee for the 7(a) and other loans: 85% of loans up to $150,000 and 75% of loans where the borrowed sum exceeds $150,000. However, the 504 loan marks a departure from this dual figure standard.
Before I explain what the SBA covers, we need to discuss how the loan is split. 40% of the 504 loan is funded by the selling of CDC debentures. This means the CDC’s part of the loan is sold off to investors as Development Company Participation Certificates (DCPC).
The remaining 50% of the payable loan is covered by the 3rd party lenders I mentioned earlier in the article - your banks, your insurance companies, your well-to-do individuals, etc.
As the borrower, you’re responsible for footing 10% of the desired sum. So, which of these payments does the SBA guarantee?
Although the SBA does bring a 100% guarantee to the table, this only applies to the 40% supplied by private investors via the selling of debentures. This means that the remaining 50% supplied by 3rd party lenders is not backed by the SBA.
A lot of people read that 100% coverage figure and assume it applies to the entire loan, but this isn’t the case. It only ever guarantees that 40% CDC debenture fraction of the total sum.
So, let’s say that you borrow $1,000,000 via a 504 loan. The CDC contribution would be $400,000. That’s the portion of the loan that is officially guaranteed by the SBA. The remaining $500,000 funded by 3rd party lenders is not protected.
Unfortunately, this does mean a 3rd party lender is less likely to agree to the terms as they are for, say, the 7(a) loan where they’re almost entirely covered by the SBA.
However, as the SBA does put its money where its mouth is on the CDC side of things, it still illustrates that there is real confidence in your business and that your expansion plans seem as though they’ll be lucrative.
Being that the SBA works with so many lending partners, as long as you make a strong case for your business and the SBA approves of your plans, there’s bound to be a few organizations in the lending pool willing to fork out.
You may be wondering where the rest of the guarantee comes from. Unfortunately, you and a personal guarantor are going to have to put your names down for the rest. It can seem like a scary prospect, but it really makes no difference.
If the SBA did guarantee the full loan and paid out when you failed to make repayments and the loan became default, you’d still be indebted to them rather than the lender. You will always owe the debt, no matter who guarantees it.
The only difference you’ll encounter is that you may end up paying a different financial body than you initially thought you would because the guarantor has essentially purchased the debt from the original lender.
It’s important to bear in mind that the SBA is usually the very last place the lender or CDC will go to recoup their investment. Before they contact them, they’ll be coming directly to you to seize business and personal assets.
With any luck, the CDC finds all they need from your assets alone, but there’s a good chance they won't, and that’s because they have a second lien on your assets.
As the majority lender, whoever provides the 50% fraction of the loan (usually a bank) always has a primary lien and first access to your assets.
If the CDCs still come up short, they’ll invoke your personal guarantee. Once all other methods of collecting the debt have failed, then they’ll turn to the SBA for a full return on their investment.
That’s not the end of it either, folks because your debt doesn’t magically disappear. Now you’re indebted to the SBA rather than the lender, and they can be just as tenacious when it comes to reclaiming what’s theirs.
Are there exceptions to this 40% SBA guarantee?
The 100% SBA coverage of CDC contribution is set in stone but for one circumstance, and that’s if the assets being acquired with the 504 loan are deemed “special purpose”.
An asset is labeled special purpose if a buyer would have to make severe renovations to use it in any other way, e.g. gas stations or certain medical clinics.
In the event that you’re developing a special purpose property, CDCs’ contribution goes down by 5%, amounting to a 35% total investment.
The SBA then only covers this 35% of the 504 loan, and as the borrower, you’re required to fill in the missing 5% on top, bringing your total contribution to 15% of the loan.
Let’s use our $1,000,000 loan example again. If you were using it to develop special purpose facilities, the CDC would contribute $350,000, and the SBA would act as guarantor. Then, what would normally set you back $100,000 would now cost you $150,000.
The reason CDCs aren’t willing to invest so wholeheartedly in special purpose projects is that there are simply more costs involved when seizing them and selling them off as collateral on the loan.
For instance, if they seize your gas station and put it on the market to reclaim losses. They won’t be able to sell it at market price because the buyer is going to have to foot the renovation bills to make it suitable for general use.
What does a guarantor do?
Some get the wrong idea about guarantors. They believe they exist to help the borrower, and to a certain extent, they do.
If a loan is backed by a guarantor, an application is much more likely to be accepted; however, the guarantee isn’t put in place to help the borrower; they exist to help the lender.
Both lending and borrowing money is a gamble. There are inherent risks involved for both parties. A guarantor essentially says to the lender…“Don’t worry. If things go south, we’ll foot the bill”.
So, in this scenario, the SBA would repay the entire CDC investment funded by selling debentures to private investors. Suddenly, what was a gamble seems like an incredibly safe and lucrative venture, stimulating investor confidence, and increasing investor response rates.
What if you can’t pay back the SBA once they’ve covered the CDC’s 40%?
Once the SBA has been forced to make good on their promise, you’ll receive a letter demanding payment within 60 days. If it’s gone this far, it’s unlikely you’ll be able to make the repayments, so you’ll have to formulate an appeal.
The purpose of this appeal is to politely request a more lenient repayment plan that works for both you and the SBA. Should the SBA decline this compromise, they’re within their rites to get the court involved to reclaim their investment.
Your case will be forwarded to the Treasury Department who will take an any means necessary approach to debt collection.
At this point, you may have to file for bankruptcy, as the Treasury Department will incrementally increase repayment pressure, constantly finding new legal paths to claim the money.
In the past, they’ve been known to freeze borrower accounts and garnish borrower wages to gradually settle the debt.