Commercial Real Estate Financing Options for Owner-Users
by Mike O'Donnell, Executive Director, Colorado Lending Source
When it comes to business loans for commercial real estate transactions these days, small business owners and entrepreneurs have more choices to explore than ever before, and every option is worth considering - at least in passing.
Traditional sources of financing, such as banks, continue to provide the primary financing opportunity for businesses looking to acquire the real estate they primarily operate out of, and the role of government enhanced programs, such as those offered by the US Small Business Administration (SBA) or US Department of Agriculture (USDA), tend to expand that opportunity by mitigating bank risk and allowing a business owner to acquire / finance their property sooner rather than later.
Banks began easing lending standards on commercial real estate loans, including construction financing, in 2013, although this varies by purpose, loan terms, and geographic location. From low points in 2009 and 2010, regional and community banks, now buoyed by healthier balance sheets and an increased risk appetitive, have gradually been originating an increased number of commercial mortgages every year since, and this trend appears set to continue.
Particularly in a fast growing state like Colorado, where supply and demand considerations typically have rents increasing at a faster rate than profits, a small business growing at a predictable or controlled rate may wish to own their property at some point in time so they can better manage overhead costs and start building equity for future growth, expansion, or even an exit.
The primary types of government enhanced programs to assist small businesses in acquiring their real estate fall into two broad categories: (1) guaranteed loan programs; and, (2) public sector / private sector partnerships.
In the first category, the best example is the SBA Guaranteed loan program, also often referred to as the 7(a) loan program. This is a program that allows a private sector lender, like a bank or credit union, to make a loan to a small business with the federal government / the SBA in the background as an additional guarantor on the loan. For loans greater than $150,000 up to a maximum of $5,000.000, the bank will receive a 75% guarantee. In return, the bank will pay a small percentage of the interest rate they charge the borrower (the SBA defines the maximum interest rate that can be charged) to the SBA and agree to not charge the borrower a packaging fee. The small business borrowers themselves pay a guarantee fee through the bank to the SBA to access the 7(a) loan, which ensures that the program doesn't have to be supported by the taxpayers.
From the perspective of owner-occupied commercial real estate, if the property being acquired or improved is an existing building, the SBA only requires that the active business (or active "businesses", because it is possible for unrelated businesses to band together to get an SBA loan) occupy 51% of the property. This allows small businesses to acquire a property larger than they currently need, hopefully with the intent of providing space to grow. Even if that doesn't happen, sometimes the rent role from 49% of the property can be enough to service the debt on almost the whole building.
The USDA has its own version of the SBA Guaranteed loan program, but, as you might expect, it is restricted to less urban communities (locations where the population is 50,000 or less). The USDA program is definitively less stringent when it comes to the percentage of the building occupied and can actually help with much larger projects, dollar wise, than the SBA can.
The second broad category of a government enhanced lending program is the SBA 504 loan program, which is a public sector / private sector partnership program that dates back to 1986. It is the only SBA program that defines how much of a down payment a small business will need to finance the purchase, improvement, expansion or construction of a facility. That is part of its appeal. Unlike the 7(a) program, the 504 program will very rarely attach a residence or personal assets, which doubles the appeal to most small business owners and entrepreneurs.
On a typical 504 project, a private sector lender, like a bank or credit union, will provide 50% of the needed financing. In return, the lender will have the first security position on the property being financed. A nonprofit public entity, like Colorado Lending Source, is allowed to step in behind the bank and provide 40% of the necessary financing in the junior lien position up to a maximum (for the 40% share) of up to $5,500,000. The private sector lender doesn't have a government guarantee in this particular case but they do only have 50 cents on the dollar at risk. In addition, it is a conventional loan, so they don't have to make guarantee interest payments to the SBA. In the event of a default, the nonprofit lender will basically have to pay off the bank to retain control of the property to get any of the money owed to the junior lienholder.
The funds for the 504 portion, the 40% share of the financing project, come from the sale of a bond on the market in New York to institutional investors like pension funds and insurance companies. Essentially, Wall Street is helping to finance Main Street through the SBA 504 loan program! The SBA becomes involved by adding the full faith and backing of the US government to the bond instrument created, which makes the monthly 504 pools attractive investments for institutional investors and drives down the cost of funds for small business borrowers accessing this program. In October 2015, the rate for small business borrowers utilizing the 504 loan program was fixed at 4.801% for that junior, and the 504 loan is fully amortizing over 20 years. The banks will set their own rate and terms on the senior loan.
Beyond these traditional and government enhanced sources of financing for owner-occupied commercial real estate projects, there are many non-traditional sources, such as borrowing against retirement accounts, using investor groups to acquire properties, raising funds via green bonds, and many of the various crowd funding / crowd lending platforms that have been created in the last few years. These will be all be topics for future articles.
