What Is A 504 Small Business Loan?

At its core, the SBA 504 loan is a fixed-rate, mortgage-style agreement that allows business owners to purchase commercial real estate for the running of their business.

For example, if you want to open a restaurant, you could apply for an SBA 504 loan in order to do buy the building or land to do so.

It’s a popular choice for young businesses, as you’re only required to put down a 10% borrower contribution on loans as large as $20,000,000, although a more typical 504 loan agreement maxes out at around $5,000,000.

This small borrower contribution allows you to conserve your working capital as you develop your business.

What Is A 504 Small Business Loan

Say, for example, you needed to borrow the maximum $20 million dollars for an epic brick-and-mortar business expansion. As the borrower, all you’d need to bring to the table is $2,000,000.

Granted, that’s still a heck of a lot of cash, but considering you’re getting ten times that in the way of mortgages to support your expansion dreams, it’s a pretty sweet deal.

You’ll notice that I mentioned mortgages - plural. This is because the sum of whatever loan is agreed upon is paid out in two separate mortgages. The first is a typical mortgage payment drawn from a third-party lender, usually a bank, that covers 50% of the agreed loan amount.

The next installment is backed by the SBA themselves and covers 40% of the remaining project fees. All that’s left to finish things up is your 10% small business owner contribution; however, do bear in mind that in certain circumstances, the owner contribution will rise to 20%.

I wouldn’t worry too much about this, though, as it only ever really applies when trying to acquire or construct startup or special-purpose properties.

504 loans are orchestrated by CDCs (Certified Development Companies). CDCs are non-profit organizations that exist solely to promote local economic growth via responsible lending.

This is why there’s an emphasis on purchasing property with 504 loans, as it helps to invigorate local economies, but does a 504 loan have to be used on real estate?

Well, there is actually little bit of wiggle room in the parameters of a 504 small business loan. For instance, the borrowed amount could be used to pay for construction on acquired land or to pay for essential long-term machinery and equipment.

You can also put your 504 loan to good use by modernizing any streets, landscaping, parking lots, land, or utilities that you may own as part of your business property.

Perhaps what makes the stipulations of a 504 loan clearer is by focusing on what spending is strictly prohibited. When you borrow on the 504 format, you are not under any circumstances allowed to allocate portions of the loan to…

  • Working Capital or Inventory - You cannot use the 504 loan to purchase stock.
  • Business Acquisition - You cannot buy out a pre-existing business. It must be your own.
  • Consolidating, Paying or Refinancing Debt - It cannot be used to settle the scores on other debts.
  • Speculation or Investment in Rental Real Estate - You cannot simply buy a property to lease.

This last rule is of particular interest. The 504 loan law of the land states that 51% of owner-occupied pre-existing facilities must be business-oriented. If the 504 loan has been used for an entirely new build, that figure jumps to 60%.

This means that you cannot use a 504 loan purely for acquiring real estate to later rent out, as that’s not considered a small business operation.

What you are permitted to do, is lease out any surplus space beyond the 51 or 60% occupied by you and your business operation. Say your dream is to open your very own brewery.

You can build or acquire facilities via a 504 loan because said facilities are going to be your base of operations. Once you’ve occupied 51-60% of the property, you can then rent out the remainder to another person or business.

What’s more, you cannot apply for a 504 loan if you’re simply an investor. To qualify for a 504 payment, you’ll be the hands-on owner of your business.

Now let’s talk terms. One of the best things about 504 loans is that they’re a fixed interest agreement, which, of course, means that the interest rate stays the same for the entirety of the repayment term.

This is exactly what new and small businesses need to get a foothold on the market and start pulling a profit. 

In addition, the fixed APR will almost certainly be below market rate, meaning you’re not getting hung out to dry by greedy investors, hungry for huge gains on their contribution to your business. The 504 loan is a fair leg-up in whatever industry you’re trying to break out into.

As 504 loans can be thought of as large-scale borrowing, repayment terms tend to be spread over a long period,  but that’s not to say there isn’t plenty of flexibility in the repayment format.

You can choose between ten, twenty, or twenty-five-year terms, ensuring that you can make the loan work for you and that it scales appropriately with the growth of your business.

This all sounds pretty neat, huh? So how do you know if you’re eligible, and what steps should you take to get the 504 ball rolling? Well, there are a few fundamental requirements of the 504 application process, and they are…

  1. You have to be or plan to operate within the United States or on U.S.-owned land. If you’re planning on upping sticks to set up business bases in foreign countries, you will not be eligible for a 504 loan, even if your HQ is on US territory.

The 504 loan is all about stimulating economic prosperity via localized business growth and job creation, so taking the money and setting up shop in Taiwan, the UK, or Mexico, etc. is strictly prohibited.

  1. You must be a for-profit organization. Nonprofits are not allowed to apply for 504 loans as they have less of an impact on the local economy.
  1. You must have a tangible net worth of less than $15,000,000. This net worth cap is to ensure that businesses or entrepreneurs that are already lucrative and self-sufficient don’t take advantage of the 504 loan.

It’s not supposed to be a supplementary figure to add muscle to already strong businesses. The 504 is to cover the essential costs of getting a promising business going and making a profit.

If this cap wasn’t in place, the people that really needed the funds would be at risk of losing out to more dominant organizations that are already stabilized in the market.

  1. You have to have been in business for a minimum of two years. This is a fairly standard loan requirement. Whether you’re applying for a 7a loan or another variant of a small business loan, a two-year business history is expected.

This is because there is no better barometer of the potential of your business than the records of your previous two years of financial losses, gains, and investments.

If your business has been an official entity for more than two years, you’ll be required to provide records of the two years of operation prior to your 504 loan application.

  1. Your two-year records must show that you have earned an average net income of less than $5,000,000 after federal income tax.

Again, this is to ensure that the businesses that most need the aid get exclusive access to loans. Although it has a lofty maximum borrowing amount, the 504 is a small business loan after all.

  1. You must exist within the SBA size guidelines as a corporate entity. Simply put, you have to actually qualify as a small business in the eyes of the SBA.

The definition of a small business changes from industry to industry, so you’ll need to assess your own operation within the remit of the sector your business exists in.

For example, a small eatery is never going to be as expansive as a small factory, yet both could be considered small businesses in their field.

To decide what classifies as a small business in each industry, the SBA offers maximum employee and receipt figures. Say, for instance, that you wanted to apply for a 504 loan to grow your agricultural business.

The SBA defines a small agricultural operation as having a maximum of $750,000 in average receipts. A small mining business, on the other hand, will have a maximum 250 to 1500 employees depending on subsector of the industry.

In regard to what steps you should take to get the ball rolling on a 504 loan, I advise that you ensure your eligibility, then seek guidance from a local CDC. Best of luck.