SBA(504) Loan Lessons Learned on Commercial Real Estate

[Geoffrey Buscho]

Hi BP Community!

We are getting set to close our biggest CRE investment here in about two weeks and since it is a hybrid of creative financing and an SBA 504 loan, we wanted to share some lessons learned since we have not seen much in the way of discussions on the SBA(504) process on BiggerPockets.

First a little background on the deal details.

Type- 6 Bay Self Service Car Wash 

PP- $1.2M

Down Payment- 20% (5% from us & 15% from a partner)

Source- Loopnet

Financing- SBA(504) & Seller Carry

Cap Rate- 9%

This deal has been in the works for just about all of 2022. I posted in the Real Estate Rookie FB group after the seller accepted our offer on the background of how we got the deal under contract (https://www.facebook.com/groups/realestaterookie/permalink/793823081664715/).

Now that we are nearly at the finish line, I made it a point to try and summarize the top 5 lessons we've learned in this process that would have been very helpful in the beginning stages. I hope this helps anyone considering the SBA(504) route for commercial real estate and if anyone is interested in more of the behind the scenes detail we are happy to share as much as we can.

Lesson 1- The SBA(504) process is extremely arduous and time consuming. We had planned on a 75 day escrow period (Aug 15th to Oct 31st) after discussion with the bank on the generally accepted timelines, however what I was not aware of is the behind the seen process of a 504 loan underwriting. We primarily interfaced with the bank who would be carrying the 1st position loan, but in a 504 loan there is another bank behind the scenes called a CDC (Certified Development Companies) who are the interface with the SBA on the 2nd position portion that is backed by the federal government. In this instance their underwriting process was difficult, very slow, and created a couple of weeks worth of delay. Not only does the CDC have their own underwriting timeline, once it is submitted to the SBA for review the SBA has their own timeline which can take another couple of weeks. For anyone considering a 504 loan, highly recommend talking with the primary bank and discuss who the CDC will be and make sure there are more than one to ensure the package can be issued to the SBA as quickly as possible.

Lesson 2- Fees for an SBA loan are extremely expensive. We did not get a good understanding of the entire fee structure until it was ultimately too late to try and find a lender with lower lending fees. The way and SBA 504 works is, there are two loans against the property. One is held in 1st position by the primary bank and there is a 2nd position held by the SBA and backed by the government (less risk for the bank). However, there is what is called a debenture where the primary bank has to carry the 2nd position loan for a period of time until the SBA takes over the loan. As a result, there are fees charged by the bank for this and they are expensive (in our case the Debenture fee was $10,000 plus up to 6 months of interest only payments to the bank). There are many banks out there that are 504 lenders, and we were not informed enough to ask about these fees until we were further along in the process and could not easily switch lenders. 

Lesson 3- All about interest rates. Since SBA 504 loans have a 1st & 2nd position loan they carry two different interest rates. In our case the 1st position is tagged to the 5yr CMT Yield + 3.75% and the second is the SBA 504 rate at the time of SBA approval. Notice the phrase "at the time of SBA approval", this is critical and we were not aware of this nuance at the very early stages of the underwriting process. When the bank started underwriting the deal (August 15th), interest rates looked like this: 1st position @ 2.9% (5yr CMT yeild) + 3.75% = 6.65% & 2nd position @ 4.99% for a blended rate of ~6% on the deal. Now, 12 weeks later, rates look like this: 1st position @ 4% (5yr CMT) + 3.75 = 7.75% & 2nd position @ 6.75% for a blended rate of 7.4% on the deal. On SBA 504 loans, rates won't lock until the the SBA gives approval on the loan which means we have had to wait 12 weeks for SBA approval and rates have increased dramatically since the early stages. Ultimately, this has decreased the year 1 projections of the deal from a 15% CoC return to a 10% CoC return (still pretty good in our book but not as great as it initially was on paper). We were fortunate the deal had enough padding to absorb the spike in rates but that was not intentional, going forward it is critical to make sure our own analysis reflects interest rate trends if we pursue another 504 loan to make sure we account for the time it takes for rates to lock. 

Lesson 4- Honing our own analysis. Fortunately, we have the benefit of living in the same area as this property and our intention is to manage the site ourselves (that is our partner's job after close). this means we have been able to become extremely familiar with the site while being under contract and have been able to more effectively understand how it operates, what the common recurring issues are, and what the immediate opportunities for improvement are. We visit the site almost daily to check if anything surprising has happened or to validate our assumptions. We've been able to quickly identify ~$2,000 in immediate annual expense reductions, an opportunity to generate an additional $3-5k in revenue with some minor improvements, and we are working with the equipment vendor to help convince the bank to reduce the insurance requirements on the equipment and save another ~$1,000 on insurance costs annually. All of this has been added to our analysis and projection narrative that is required to submit to the bank and SBA for consideration in their approval process. Not every investor will be investing in the market where they live, and that really isn't the point I'd like to make for lessons learned. The true point I'd like to make for lessons learned is recognizing the value of being able to physically see and touch the location for the simple purpose of solidifying our understanding of how the site operates and being able to stand behind our numbers confidently. Could we have done okay if the site was in a geographically different location and we only visited a handful of times? most likely the answer is yes. But I will certainly say we would have been screwed if we had never visited the site and talked to the people operating the location (not the seller but the site management staff, the contractors, vendors, etc) and tried to justify our position to the SBA without this background knowledge because the SBA has a vast amount of data that they can reference and compare the structure of this deal against. 

Lesson 5- Learn to think and pivot quickly. There have been no shortage of surprises in this process. From the appraisal risking the deal, to the CDC underwriting risking the deal, and once we were confident that the SBA would approve (still haven't received formal approval yet but all signs are GREEN) we wanted to get a more firm understanding of what the total cash to close figure was going to be through the title company. Up until this point, the bank and title really hadn't been communicating all that much, which seems off but whatever, so I requested that they exchange relevant closing cost information even if it is still preliminary and put together a draft settlement statement so we could make sure we had enough cash in the bank to close and still have a reserve left over. I was concerned that we would be cutting it close and wanted to know well in advance so we could create a solution if necessary. Lo and behold total cash to close was more than we had planned for and we need a solution. Fortunately enough we have enough time and with it being winter and snow already accumulating where this property is located, we knew that the seller would be committed to closing the deal (since they have been trying to sell it since March of this year) and if the deal fell through they would likely have to wait until spring next year before another interested buyer came along. To make sure the deal closes and the bank has confidence in our cash reserves, we were able to negotiate a credit from the seller to cover all of the closing costs which leaves us with ~15k in the bank at close. At every stage of the process we have been met with some kind of challenge and for us we had to pivot or think of alternative solutions with the help of the whole team (our broker, the banker, and ourselves) in order to keep making forward progress. The key for us was to stay in a clear headspace and try to attack each surprise logically and collaboratively with everyone involved.

I hope this insight into the SBA(504) process for our deal helps answer other new investor's questions in considering leveraging the SBA as a lending option on commercial real estate. Their loan program is a great product and a lot of banks treat 504 loans favorably because they have a lower risk profile for the bank. That being said, the process is more complicated and we had to learn a lot along the way that will certainly serve us well in the future.

Cheers!