A Shift to 7A from 504?

For decades, the SBA 504 loan program has been the go-to financing package for industrial owner/users. But, with the recent run-up in the cost of debt, a new trend may be emerging and we think it may be for good reason.

In a 504 transaction, the buyer of the property typically pays 10% down, with a conventional mortgage of 50% of the purchase price with a second mortgage of 40% funded through the SBA. The SBA portion can be as much as $5,000,000, which enables buyers to purchase a building of up to $12,500,000 in value with just a $1,250,000 down payment. That is much better leverage than is available with a conventional-only loan. But, most owner/user purchases are transacted for far less than the maximum value, and here is where the new trend may be coming from.

Enter the SBA’s 7A program, which has been around for decades and is generally used for the purchase of equipment, inventory and other business purposes. But, the 7A can also be used for real estate acquisitions, though it is structured differently. In a 7A scenario, a commercial bank makes the entire loan, which has a limit of $5,000,000. With 10% down this allows the purchaser to acquire a property with a value of $5,555,000, enough to buy a building up to approximately 15,000 square feet at today’s price point. Most owner/user deals in Orange County are for buildings under that range. This makes the 7A program a potentially good option for those buyers. Let’s take a look at why that is.

With interest rates double where they were at the beginning of 2022, many buyers have relegated themselves to sidelines to wait until rates come down again. That may or may not happen in the near term. Nobody has that clear of a crystal ball. But, if they still need space, many would rather buy now to avoid getting tied up in another long term lease at today’s high rates. This is where the 7A program becomes attractive.

A 7A loan only has a prepayment penalty period of 3 years versus 10 years on a 504 loan. There may also be a prepayment penalty clause in the conventional first loan in a 504 scenario. This gives the 7A borrower more freedom to refinance the property in the near term if the Fed gets off the brakes and rates move back down. Sounds like a winner, right? It might be, but there’s a couple of catches to consider.

In a 7A scenario, the borrower pays an upfront, one-time ‘guarantee fee’ of 2.7% of the loan amount that is essentially an insurance policy for the lender against the borrower’s default. This is why the conventional lender is willing to loan up to 90% of the purchase price. The borrower is allowed to add that fee onto the loan balance rather than part with more cash, which slightly increases the monthly mortgage payment. That’s catch number 1.

Catch number 2 is that when a borrower puts just 10% down, the 7A loan is cross-collateralized with other property owned by the borrower, usually a personal residence. For many borrowers, this is a deal killer and for good reason. However, if the borrower increases his down payment to 15%, the cross-collateralization requirement goes away.

So, for buyers optimistic that rates will return to previous levels and who have the extra cash to put 15% down, they will be in position to lower their occupancy cost down the road and still get themselves into the functional space they need now. Plus, at the moment, our banker contacts tell us that the 7A interest rate is in the 5.8% range versus the current 6.32% rate on a 504 loan. That difference more than makes up for the 7A guarantee fee added to the loan balance.

Is this strategy an obvious play for all owner/user buyers? Probably not, but it is worthy of consideration and there is no downside risk to choosing it. So, if you are looking to buy a building within the limits of the 7A program, we recommend you give it your full consideration. If you need help modeling your options, give us a call. We are here to help.