Finding the right SBA loan to fit the right situation: 504 or 7(a)?

Moye White’s full-service banking group drafts and negotiates every aspect of loan transactions. We assist both borrowers and lenders with financing needs, including small business loan structures such as 504 and 7(a) loans discussed below. Marcus Weathersby, an SBA specialist, has provided the following information as a resource to understand some options available to small business borrowers.

This article touches on a critical issue in U.S. Small Business Administration lending: choosing the right SBA loan product for a business’ real estate financing needs.

Every year, an increasing number of small business owners realize the value of acquiring their own real estate to house business operations. A real estate purchase provides accumulated equity, as well as long-term stability in operating expenses—two benefits leasing does not afford.

Finding the right SBA loan to fit the right situation: 504 or 7(a)?

When considering the purchase or construction of real estate for their business, small business owners often turn to their attorneys, certified public accountants, or real estate brokers for advice. When conventional financing is not a feasible option, many advisors suggest a lender that offers SBA loans.

With a down payment of as little as 10 percent, an eligible commercial real estate transaction can be completed with an SBA program loan. This is in stark contrast to the 20–30 percent injection most lenders require to obtain conventional financing. But the specific SBA program a small borrower selects can have dramatic implications on its future.

Some SBA lenders have a tendency to focus more on their bottom line than on supporting borrowers’ financial well-being. Sometimes, these situations needlessly point a borrower to one type of SBA loan—the so-called 7(a) program—which might not be their best SBA financing option. Casually choosing a 7(a) real estate loan can later create an artificial limit to a company’s growth or subject it to undue interest rate risk.

Finding the right SBA loan to fit the right situation: 504 or 7(a)?

What to choose: SBA 504 or SBA 7(a)?

Two loan programs, 504 and 7(a), are used for real estate transactions. Some key differences include:

  • 7(a): A multipurpose product eligible for most business needs, including inventory, working capital, business acquisition, renovation/expansion—and, yes, even real estate purchases.
    • Structure: A bank loan that is partially guaranteed by the SBA and offers up to 90 percent financing of real estate.
    • Interest rates: Typically a variable-rate loan priced at least 1 percent over the Wall Street Journal prime lending rate.
  • 504: This product has been specifically designed for long-term real estate and fixedasset purchases.
    • Structure: A collaborative effort between the lender and the SBA, whereby the lender provides a first deed of trust mortgage for 50 percent of project costs and the SBA provides a second deed of trust mortgage for (up to) 40 percent of the project costs.
    • Interest rates: Depending on the partner lender, most first deed of trust mortgages offer 20–25-year amortizations and either fixed- or adjustable-rate pricing similar to that offered on conventional commercial mortgages. The SBA’s second position (40 percent) loan is a 20-year, fixed-rate product (in the low 6 percent range in 2007).

7(a) can limit future growth

These programs have one other significant difference. Most borrowers have access to a maximum of $1.8 million in SBA-guaranteed financing. When a business owner selects the 7(a) program over the 504 program, the entire loan applies to that limit. Thus, by utilizing the 7(a) program for the real estate loan, the business might limit its access to future SBA 7(a) loans—loans that may be needed to augment working capital or purchase equipment and inventory if the business grows quickly.

The table at left illustrates this difference: SBA lenders benefit by offering the 7(a) loan because they can make a larger SBA loan under the 7(a) program than the 504 program ($1.8 million versus $1 million). As with any similar loan, a larger loan amount, combined with a higher, fluctuating interest rate, results in more income for the lender. However, 7(a) loans cause considerable risk for the borrower.

First, 7(a) loans subject the borrower to changing loan payments caused by interest rate adjustments. Borrowers may trade lower payments over the near-term for the risk of escalating rates. Most business owners are well-advised not to purchase a long-term asset with a variable-rate financing vehicle.

Second, by taking the 7(a) loan, the business may unknowingly eliminate its access to additional SBA financing availability. For a concerned lender, it is disheartening to have to deny an SBA loan request for a $300,000 working capital/expansion loan for a growing business merely because the business owner unfortunately used his or her remaining eligibility via a “more simplified” 7(a) real estate loan. Without SBAeligibility,there can be no new SBA loan.

Each year, owner-user properties are acquired via 7(a) loans because borrowers did not understand the benefits of the 504 program or the risks of the 7(a) program. As counsel to the small-business financial advisory community, it is our responsibility to help guide our small-business clients towards making the appropriate SBA loan decisions for their business. After all, thriving and successful small businesses build a solid foundation for the growth of our entire business community.