SBA 504 Loan and How the 50-40-10 Split Really Works

A client of mine who runs a small commercial bakery spent four years paying $6,400 a month in rent on a unit she could have bought for about $900,000. Every time we talked about buying, she stopped at the same number: the 25 percent deposit her bank wanted, which was more cash than the business had ever held at once.

The SBA 504 loan exists for exactly that situation. It lets an owner buy or build the property the business operates from with roughly 10 percent down, at a long fixed rate on a big part of the debt. It also comes with two lenders, two closings, a job-creation test and a fee stack that nobody explains up front. This is how the 50-40-10 split actually works once you put it in a spreadsheet.

Who puts in what

A 504 project is financed in three slices. A bank or credit union lends about 50 percent of the project cost and takes the first lien on the property. A Certified Development Company, usually called a CDC, lends up to 40 percent through an SBA-guaranteed debenture and takes the second lien. You bring the remaining 10 percent.

That 10 percent rises in two cases. If the business is under two years old, or if the building is a special-purpose property such as a car wash, a hotel or a bowling alley, the owner contribution goes to 15 percent. If both apply, it goes to 20 percent. The bank's share stays at 50 percent and the CDC piece shrinks to make room.

The CDC portion has a ceiling. Under the limits I have worked with, the SBA debenture tops out at $5 million for most businesses and $5.5 million for small manufacturers and certain energy projects. There is no cap on the bank's piece, which is why some larger projects still fit.

The property also has to be mostly yours to use. For an existing building you must occupy at least 51 percent of the space. For new construction it is 60 percent, with a plan to grow into more of it. You can lease out the rest, and that rent can help with repayments, but a landlord buying a building to fill with tenants is not who this programme serves.

A real project, laid out line by line

Here is a version of the bakery numbers, rounded only slightly. The unit cost $905,000, she needed $120,000 of ovens and fit-out that could be financed as part of the project, and closing costs added about $25,000. Total project: $1,050,000.

The gap between the last two rows is $157,500. For her, that was most of a year of payroll, and keeping it in the account mattered more than any rate difference.

What the table hides is the fee load on the CDC slice. The SBA guarantee fee, the CDC processing fee, a closing fee and the underwriters' fee are added to the debenture rather than paid in cash. In the files I have seen they come to roughly 2 to 3 percent of the debenture. On $420,000 that is around $10,000 to $12,000, financed over 25 years. You do not write a cheque for it, but you pay interest on it for a long time, and the effective rate on the CDC piece ends up a bit above the headline.

The two-closing problem

This is the part owners find out about late. The CDC does not fund on the day you buy the building. SBA debentures are sold to investors in a monthly pool, so the CDC's 40 percent arrives weeks or months after you close.

In the meantime the bank usually provides an interim loan covering both its 50 percent and the CDC's 40 percent. You close once with the bank, take the keys, and then a second closing happens when the debenture sells and pays off the interim piece. On a purchase of an existing building the gap is often 45 to 90 days. On new construction it can be a year or more, because the debenture cannot fund until the building is finished.

Two practical effects follow. You pay interest on the interim loan at the bank's rate, not the debenture rate, for that whole stretch. And the debenture rate is not locked until it is sold, so the fixed rate you get is whatever the market says in the month your pool prices. I always tell clients to budget the interim interest as a separate line, because it has caught out more than one owner who planned only for the long-term payment.

Where the usual advice goes wrong

Most write-ups sell the 504 on its long fixed rate. That part is real, but it covers only 40 percent of your debt.

The bank's 50 percent is a normal commercial mortgage. In most of the deals I have reviewed it carries a 10 year term on a 25 year amortization, which means a balloon payment at year ten. On the bakery numbers, roughly $340,000 of the bank loan would still be outstanding when that balloon comes due. If rates are higher in ten years, or the business has a bad year just then, the refinance can be painful.

So the fixed rate gives you predictability on part of the debt and leaves you exposed on the larger part. That is still a good deal for many owners. It is not the fully locked, set-and-forget mortgage that some lenders' brochures suggest, and I would rather a client know that before signing.

The other overlooked cost is the prepayment penalty on the debenture. On a 20 or 25 year debenture it applies for roughly the first half of the term and steps down each year. If you think you might sell the building or refinance within ten years, ask the CDC for the exact schedule and put it in the model.

The job-creation test and the rest of the paperwork

Because the programme is tied to economic development, the CDC has to show the project supports jobs or meets a public policy goal. The rule of thumb I have worked with is one job created or retained for roughly every $90,000 of debenture, with a higher figure for small manufacturers. A $420,000 debenture would point to about five jobs. Retained jobs count, so a business that keeps its existing staff because it stopped paying rising rent often qualifies.

If you cannot meet the job number, there are policy goals that can substitute, such as rural development, energy reduction, or businesses owned by women, veterans or minority owners. The CDC will tell you which one fits.

Expect the same document pile as any SBA loan: three years of business tax returns, interim financial statements, a debt service coverage calculation that shows the new payments are affordable, a personal financial statement for each owner of 20 percent or more, and personal guarantees. The property will need an appraisal and usually an environmental report. For a bakery, a dry cleaner or anything near an old fuel site, that environmental step can add weeks and a few thousand dollars.

Is it the right loan for your building

A 504 tends to fit when the business is stable, profitable for at least two years, and paying rent that is close to or above what a mortgage would cost. It fits less well for a business that may move within five years, or for anyone who needs working capital, because 504 proceeds cannot be used for inventory or operating cash. For that you would look at a 7(a) loan, which I compare in term loan or SBA loan.

If you want to test it this week, pull your last 12 months of rent and add your current property costs. Then ask a local CDC for an indicative quote on a building you could realistically buy. Put both monthly figures side by side, add the interim interest and the balloon at year ten, and see if the numbers still work when you assume a rate two points higher at refinance. If they do, the 504 is probably worth the extra paperwork. More guides on lending options sit under business loans.

FAQ

What is the down payment on an SBA 504 loan?

Usually 10 percent of the project cost. It rises to 15 percent for a business under two years old or a special-purpose property, and to 20 percent when both apply.

Can I use a 504 loan to buy a building I will rent out?

Only partly. You must occupy at least 51 percent of an existing building, or 60 percent of new construction. The rest can be leased to tenants.

How long does an SBA 504 loan take to close?

The first closing with the bank often takes 60 to 90 days from application. The debenture funds later, typically 45 to 90 days after purchase, and longer for construction projects.

Is the SBA 504 rate fixed for the whole loan?

No. Only the CDC portion is fixed for 10, 20 or 25 years. The bank portion follows the bank's own terms, often with a balloon after ten years.