Tip of the Week
How about 504 Loans?
Many of our readers are CDC employees and bank 3rd party mortgage lenders under the SBA 504 program. 7(a) isn’t their top priority. We get that. To date, we have endeavored to highlight issues and trends of both a technical and a practical nature that will be generally of interest to most if not all of our readers. So in an effort to reach all our readers with topics of interest, we will spotlight the SBA 504 program from time to time – starting this week. Thanks to those of you who suggested we do this. We appreciate your input and we agree with the approach.
According to friends and clients in the CDC industry, one of the more interesting and perhaps controversial issues that arose out of the recent rewrite of the SOP 50 10 (5) for SBA loan processing as it relates to 504 – are new requirements when a 504 borrower’s equity contribution contains borrowed funds.
SBA’s SOP 50 10(5)-Lender and Development Company Loan Programs, Subpart C, Chapter 1, Paragraph 3.c. (7) states the following:
(7) If the borrower’s equity contribution is borrowed:
- (a) Any lien position on the Project Property must be subordinate to the 504 loan;
- (b) The borrower may not pay the loan for the equity contribution at a faster rate than the 504 loan (13 Code of Federal Regulations (CFR) 120.912); and
- (c) If the borrowed equity is collateralized by assets other than the Project Property, the borrower must demonstrate repayment of the loan for the equity contribution from sources other than the cash flow of the business. (Note: The salary of the business owner does not qualify.)
Clauses (a) and (b) are pretty straightforward – direct from the Regs with a dose of common sense. Clause (c) touched off some fireworks apparently in 504 lending circles. In fact, there was so much heartburn over this change offered up by the industry that SBA issued a Procedural Notice 5000-1065 temporarily suspending these changes for 9 months until April 30, 2009 to allow time for the agency to further analyze the issue. So for now, CDC’s and 3rd party mortgage lenders need to:
“Determine whether any portion of the equity injection is borrowed, and, if so, ask the applicant if there is an additional source of repayment other than the funds from the applicant business that could be used to repay the borrowed equity”.
SBA plans to collect the source of equity injection information for all loans where any portion of the equity injection is borrowed and will “develop a database that provides information on the portion of the portfolio that does not provide a 10 percent or greater equity injection in the form of cash.” The notice goes on to say: “The industry has asserted to SBA that there are a number of businesses that have ample cash flow and such a sound financial position that making a loan that is essentially 100 percent financing does not present an unacceptable risk.”
The collection of this information on the borrowed equity will permit the Office of Financial Assistance and the Office of Credit Risk Management to develop an understanding of the scope of this issue and provide the Agency with the background necessary to develop appropriate policy.
So for now at least, it appears that there is some “wiggle room” on this issue, provided the CDC documents as required above and presumably makes a sound argument and provides mitigation to the 100% borrowing. This will sound familiar to 7(a) lenders, as the old 90% financing rule is gone, replaced by a “prudent lending” standard which means you better adequately justify what you’re doing.
Our tip of the week is simply this. First, be aware of the “winds of change” and be prepared to address these issues, regardless of how you personally feel about them. This is true both in the interim period leading up to April 30 of next year as well as for the longer term. When you’re structuring a 504 package, ask yourself: does 100% borrowing really make sense? Does it provide adequate “skin in the game” from the borrower? Remember, the bottom line principal of leverage, for it to work; you have to have something to leverage. This generally means something tangible like cash equity or other tangible equity. In an era of possible deflation, we all need to think and even rethink our approach to credit fundamentals such as how much equity is adequate. We believe the authors of the SOP had this top of mind when they addressed this issue.
The principals of sbaAccess are well grounded in the SBA 504 program. We are members of NADCO and interested in getting even more involved in this important industry segment. Karen started her career with a CDC in Texas in the early days of the program and Brian has partnered with CDC’s all over the country to get quality 504 projects done right. He currently serves as a director of one of the largest and most successful CDC’s in the land, Colorado Lending Source. We’re available to CDC staff, boards, and 3rd Mortgage Lenders to help you grow and manage your 504 program in these challenging but opportunistic times.
Take the right approach,
Brian Burke and Karen McHugh
