Creating or saving jobs is a requirement for commercial real estate borrowers that use the U.S. Small Business Administration's 504 program. Ninety percent of cost is typical for small-business owners who build, buy or rehabilitate an office building, warehouse, restaurant or other kind of commercial facility. Borrowers are required to occupy more than half of the building.
The funding has two parts.
First, a lending institution, such as a bank, makes a mortgage for 50 percent of the total cost. The cost usually includes the building, machinery, furnishings, fixtures and equipment. It also includes some transactional costs, including fees and legal expenses. Notably, some 504 loans can be for large expenditures on machinery and equipment without real estate.
Second, In addition to the bank's participation, a SBA-licensed certified development company, or CDC, arranges for a subordinated debenture representing up to 40 percent of the cost. Think of it as a second mortgage. SBA guarantees the debenture against default so it is attractive to investors.
President Barack Obama is pressing Congress to increase the guaranteed debenture amount to $5 million. If he gets his way, the total funding would comfortably support projects that cost $13 million. He wants $5.5 million to be the maximum debenture size for manufacturing facilities. That supports a cost of $14 million.
Prior to the credit crunch, banks that made these loans had the option of selling the conventional first mortgage to investors in the secondary market. But the secondary market is frozen and SBA is trying to reinvigorate it.
The agency's plan is to guarantee 80 percent of the first mortgage against default. That traditionally means the originating lender will keep the unguaranteed 20 percent portion in its portfolio. In turn, investors unwilling to take any credit risk buy the 80 percent, guaranteed portion.
But in an unexpected twist, SBA is requiring that the unguaranteed portion be parceled out 15 percent to the originating lender and five percent to the broker-dealer who pools the loan with a group of other 504 loans.
The risk is shared equally by the SBA, the lender and the pool assembler, SBA's James Hammersley told me. So in the event of default, the remaining assets are divvied up according to each of their percentages.
"The five percent risk retention by the pool originator was a requirement of the enabling legislation," Hammersley says.
I did not expect the poolers to take any credit risk, since they are not involved in originating the loan or underwriting its quality.
I asked Chris LaPorte of Coastal Securities, a Houston, Texas-based broker-dealer, why this requirement is being imposed on poolers.
"It is unfortunate that the 5 percent retention is a requirement for the pooling process and this will certainly be a determining factor as to whether broker-dealers who are not lenders will want to become pool originators," LaPorte says. "It is our understanding that the lenders can also serve as pool originators and thereby retain 20 percent and sell the pools into the secondary market."
But it is apparent to me that originating banks are in a better position to understand the credit risk and hold the full 20 percent of unguaranteed portion in their portfolio. Furthermore, it is a way for large Wall Street banks that originate these loans to also become poolers and eliminate competition from broker-dealers like Coastal Securities.
We will learn if Wall Street's heavy hitters win and broker-dealers lose when SBA announces its list of poolers.
"It would be fair to note that, we believe, SBA has received many questions with regard to this program and we expect that there will be further clarifications on procedures," LaPorte says. "Because of this, I don't think we can answer your questions with any certainty."
The good news is that a reinvigorated secondary market for 504 loans will eventually make more highly leveraged, commercial real estate loans available to small-businesses. Until then, local and regional lenders will continue to make 504 loans and hold them in their portfolios.
"Participation in the new program is voluntary," SBA's Hammersley says. "Lenders that want to originate and hold 504 first mortgages may continue to do so."
Jerry Chautin is a volunteer SCORE business counselor, business columnist and SBA's 2006 national "Journalist of the Year" award winner. He is a former entrepreneur, commercial mortgage banker and business lender.
Follow Jerry Chautin on Twitter: www.twitter.com/JerryChautin
Loading comments…
When I was in the business, questions like what are current interest rates and how many points are typical, were signs that the asker needs to be mentored on how to originate commercial mortgage loans. Experienced brokers don't ask these questions. Instead they want to know if the deal is economically feasible and should be financed. They are able to underwrite the proposal and see it through a lenders eyes before they take on the assignment.
Are you able to do that? Do you understand how to arrive at net income available to pay debt service? Are you familiar with how much of a cushion lenders require in addition to the borrower's ability to pay debt service? Are you able to determine the value of income producing property by analyzing the rent roll and gathering basic operating expense data? Do you know how to compare the borrower’s operating statements with industry standards?
I'll stop here. But there are many more questions I would ask before how many points do lenders pay. Most importantly, how do you ensure that you will get paid at closing? Borrowers use the “Call Girl” principle to avoid paying you. After the deed is done, they question if you are worth the fee that they previously agreed to. Getting paid is a whole new discussion for another time.
Thanks for reading my column.
Jerry Chautin
JKChautin@aol.com