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Real Estate Financing for Businesses and the New Secondary Market Will Create Jobs but the Dybbuk is in the Details

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A new secondary market for the U.S. Small Business Administration's 504 loan program is up and running. As a result, it will be easier for you to get commercial real estate and capital equipment financing.

The program is for financing business real estate that is, or will be, mostly occupied by small businesses. A requirement is that jobs are created or preserved as a result of the financing. Hotels and motels have previously topped the list for getting the most dollars from 504 loans. Restaurants are high on the list as well.

Professional offices, gas stations, childcare services, stores and financing for most industries are on the list. A plastics manufacturer in Brooksville, Fla. landed $1.6 million to purchase machinery and equipment, according to a June 4 newsletter from GulfCoast Business Finance. Additionally, a moving company in Orlando, Fla. landed $5.9 million to purchase and renovate a building, and a funeral home in Boca Raton, Fla. got $4.9 to construct a new building.

GulfCoast Business Finance is a Florida-based, nonprofit Certified Development Company that is licensed by SBA to process and facilitate the agency's 504 lending program. CDCs' territories are statewide and may include counties of adjacent states.

504 financing comes in three parts. Traditionally, a banker makes a 50 percent conventional first mortgage, SBA guarantees a 40 percent subordinated debenture and the borrower injects 10 percent equity. The subordinated debenture is like a second mortgage and the percentages can vary according to a number of circumstances.

Because the debentures are SBA-guaranteed against default, they are easily sold to investors in the secondary market. But the conventional first mortgage is considerably more difficult to sell -- especially in the current market place.

Before the financial meltdown, there was a cadre of buyers for the conventional portion. But as values began to plunge, the 50 percent loan-to-value began to vanish and put the investors at unexpected risk. A few, including Utah-based Zions Bank, continued to buy the conventional loans, albeit more critically underwritten and at less lucrative terms for the seller.

Given this background, and the Obama Administration's desire to create jobs, SBA and Congress conjured up a secondary market guarantee scenario for the program's first mortgage. In their haste, they required poolers that make a market for the guaranteed paper, to retain 5 percent of the risk. That twist eliminated many of the usual broker-dealers and gave large Wall Street bankers somewhat of a monopoly.

David Hall, SBA's spokesperson was not willing to tell me who the approved poolers are. "We still don't have any information on this to share at this time," he wrote in a e-mail. "As soon as it becomes official and available, you will be among the first to know."

But in my opinion, the bigger glitch is flying below everyone's radar screen.

Before SBA agreed to guaranty 80 percent of the first mortgage, the lines were clearly drawn between the conventional first mortgage holders, investors and SBA.

In the event of default, the bank holding the first mortgage is not interested in forbearance or restructuring the loan when the real estate is worth more than their 50 percent portion. That is because the balance is in a subordinated debenture, 100 percent guaranteed by SBA and sold to third-party investors. So the first mortgage banker will say, "foreclose, let me sell the real estate and get back my money."

But now, SBA is a guarantor on both the subordinated debenture and also the first mortgage. And the guaranteed portions of each will be sold to different investors. Therefore, each has competing interests and SBA's strategy is unclear.

In the event of default, SBA's first mortgage guaranty is reasonably safe because there is lots of equity to burn through before it reaches the senior debt. But SBA is also a guarantor on the subordinated debenture and destined to take a big hit on that portion. The picture is even muddier when considering that 20 percent of the first mortgage is not guaranteed. All these layers have different risks. In the event of default, how will SBA reconcile these conflicting risks? Will the agency want to forebear to help the subordinated debenture investors? Or will it agree to a speedy foreclose to appease the first mortgage investors and originating lender?

The good news, however, is that more money will flow to small business owners and jobs will be created. So hurry up and get your financing before secondary market program expires on February 16, 2011. Alternatively, it will end when $3 billion in new pools are created.

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 on Twitter, www.twitter.com/JerryChautin.