The SBA developed the 504 Certified Development Company Loan Program (the “SBA 504 Program”) to promote economic development and create jobs.
Under the SBA 504 Program, a bank, credit union, insurance company or other financial institution, including investment-grade rated institutions regularly engaged in commercial real estate lending (“Financial Institution”), or other non-bank lending institution (“Non-bank Lender”) partners with a certified development company (“CDC”), a specialized SBA-certified nonprofit corporation, to make a loan to a qualifying small business. The borrower makes two loan payments, one to the Financial Institution or Non-bank Lender (a “First Lien Lender”) and one to the CDC. The First Lien Lender’s loan (also referred to herein as a “504 First Lien Loan”) is secured with a first lien, typically covering 50% to 60% of the project’s cost. The CDC’s loan (referred to herein as a “504 Second Lien Loan”) is secured with a second lien, covering a maximum of 40% of the project’s cost. Please see the table below for a sample loan.
* Federal regulations require that, in most cases, the 504 Second Lien Loan must create or maintain one job per $65,000 of federal funding. In this example, ($800,000/$65,000), 12.3 jobs.
The Fund may purchase 504 First Lien Loans through assignments, co-originations, originations or participations. The Fund may purchase the whole loan or a fractional interest in a loan. 504 First Lien Loans may be fixed rate or variable rate loans. All 504 First Lien Loans will be current on the payment of interest and principal at the time that they are purchased by the Fund. Many, but not all, of the 504 First Lien Loans purchased by the Fund will have been originated in the last 12 months.
504 First Lien Loans are not guaranteed by the SBA or any other federal agency. Rather, 504 First Lien Loans benefit from a low loan-to-value ratio (averaging 55% to 60%). If the SBA chooses to protect its interest in the 504 Second Lien Loan, it can, but is not legally obligated to, pay off the 504 First Lien Loan or purchase the property at a foreclosure sale.
The SBA considers a number of variables when determining whether or not to proactively protect its 504 Second Lien Loan position. Key variables include the amount of net equity present in the collateral based on an updated appraisal, liquidation costs, marketing time (also determined by the appraisal), and holding costs. The more equity in the property, the more likely it is that the SBA would either purchase the 504 First Lien Loan or purchase the property at the foreclosure sale (thus retiring the 504 First Lien Loan). By way of example noted in the table above, if the property value at the time of liquidation was determined to be $1,600,000 (a 20% drop), the SBA would expect to realize a gross recovery of 75% of the original loan balance ($400,000/$600,000) less an estimate for liquidation and holding costs. The SBA’s incentive to protect its position would be higher than if the current market value at liquidation was only $1,200,000. In the latter scenario, the amount of recoverable equity after liquidation and holding costs would be minimal and one would expect the SBA to not proactively protect its position. The SBA is not legally obligated to purchase the 504 First Lien Loan, or purchase the property at the foreclosure sale (thus retiring the 504 First Lien Loan) under any circumstances.
There are potentially two key benefits in having the SBA in the 504 Second Lien Loan position in the event of borrower default. The first potential benefit is that, as noted above, the SBA elects to proactively protect its position and retires the senior loan in full (either before or at the foreclosure sale). The second potential benefit is the substantial first loss position funded on any one real estate transaction. For the senior lender’s principal balance to be negatively affected, the liquidation proceeds would have to be less than the combined original down payment or equity position contributed by the borrower and the 504 Second Lien Loan. The combination of borrower equity and SBA investment provides a 25% to 45% buffer between the original purchase price and the liquidation proceeds prior to the Fund incurring a loss. The Fund expects to have an average loan-to-value ratio of 55%. However, the Fund will consider loan to value ratios on multi-purpose properties of up to 65%, and up to 60% for hospitality and special purpose properties. The total investment in any one loan (outstanding investment plus liquidation costs) may be higher than proceeds recovered during liquidation which would result in a loss to the Fund.