Disclaimer: I’m not a banker. The following is upon information and belief only, provided here for general familiarity. Do not rely on content in this post for investment or borrowing related decisions. Confirm/obtain all your information on SBA financing from a financing institution or lending professional.
In the world of business, seizing opportunities often hinges on having access to the right resources at the right time. For entrepreneurs eyeing expansion or acquisition of commercial real estate properties, securing financing can be a significant hurdle. The Small Business Administration (SBA) offers a powerful solution through its financing programs, enabling business owners to fund up to 90% of their commercial real estate needs. Let’s delve into how SBA financing works, its qualifications, the calculations involved, and why both borrowers and lenders find it advantageous.
Understanding SBA Financing for Commercial Real Estate:
The Small Business Administration doesn’t directly provide loans but instead guarantees a portion of the loan provided by approved lenders. This guarantee mitigates the risk for lenders, making them more inclined to offer loans to small businesses, including those seeking commercial real estate financing.
How It Works:
1. Lender Identification: Business owners first identify SBA-approved lenders who offer commercial real estate loans. These lenders assess the borrower’s eligibility and the project’s viability.
2. Loan Application: Once a lender is chosen, the borrower submits a loan application, providing details about the property, business financials, and personal financial information.
3. SBA Review and Approval: The lender submits the application to the SBA for review. If approved, the SBA provides a guarantee to the lender, covering a significant portion of the loan amount.
4. Loan Disbursement: Upon approval, the lender disburses the loan to the borrower, who can then use it for purchasing, refinancing, or renovating commercial real estate.
Qualifying for SBA Financing:
To qualify for SBA financing for commercial real estate, businesses typically need to meet the following criteria:
1. Business Size: The business must meet the SBA’s definition of a small business, which varies by industry.
2. Good Credit Score: Borrowers need a strong credit score, typically above 680, although requirements can vary among lenders.
3. Business Financials: Lenders assess the business’s financial health, including revenue, profitability, and cash flow.
4. Property Evaluation: The property being financed must meet certain criteria, such as being owner-occupied for at least 51% of the space.
5. Personal Guarantees: Business owners may need to provide personal guarantees and collateral, especially for larger loan amounts.
Calculating Loan Amounts:
SBA financing can cover up to 90% of the total project costs, including:
- Purchase Price: If purchasing a property, the loan can cover up to 90% of the purchase price.
- Renovation Costs: For property renovations, the loan can include funds for construction or improvements.
- Soft Costs: These may include fees for appraisals, surveys, legal services, and other associated expenses.
The borrower is typically responsible for covering the remaining 10% of the project costs, plus any closing costs and fees.
Debt Service Coverage Ratio (DSCR) and its Impact:
The Debt Service Coverage Ratio (DSCR) is a critical factor in evaluating the financial health and feasibility of a commercial real estate investment. It measures the property’s ability to generate enough income to cover its debt obligations, including loan payments and related expenses.
For SBA financing, lenders typically require a minimum DSCR to ensure that the property can generate sufficient income to meet its financial obligations. A higher DSCR indicates a lower risk for the lender, making the loan more attractive and potentially allowing for better loan terms. I believe the minimum DSCR it typically 125% today, but this may vary.
The DSCR is calculated by dividing the property’s net operating income (NOI) by its total debt service (TDS), which includes principal and interest payments on the loan, property taxes, insurance, and any other related expenses.
Income Calculation for SBA Financing:
When assessing a property’s income for the purpose of SBA financing, lenders typically consider the following:
1. Net Operating Income (NOI): This is the total income generated by the property minus operating expenses such as property management fees, maintenance costs, utilities, and vacancy allowances. NOI is a key determinant of the property’s cash flow and its ability to service debt.
2. Rental Income: For income-producing properties, such as multifamily residential or commercial buildings, rental income is a significant component of the NOI. Lenders may require documentation, such as lease agreements, to verify rental income.
3. Other Sources of Income: In addition to rental income, lenders may consider other sources of income generated by the property, such as parking fees, vending machines, or laundry facilities.
4. Vacancy Allowance: Lenders may apply a vacancy allowance to account for potential periods of vacancy or unrented units. This helps ensure that the property’s income is sufficient to cover expenses even during periods of reduced occupancy.
5. Pro Forma Income: For properties undergoing renovations or lease-up, lenders may also consider the property’s projected income, known as pro forma income. This allows borrowers to factor in potential future income once the property reaches stabilized occupancy levels.
6. Living Expense Consideration: When assessing income for SBA financing, lenders may consider adjusting the net operating income (NOI) downward to account for personal living expenses, ensuring that the borrower’s financial obligations are sustainable and realistic in the context of their overall financial well-being.
Assume a lender has a business with a net operating income that is deemed to be, after reviewing multiple years of tax returns and financials, $375,000 annually. Further assume this is owned by one person that pays himself a salary of $80,000 a year, but whom a lending institution deems to require $240,000 to support his lifestyle. Also assume that the $375,000 in NOI is net of $250,000 a year in rent and associated expenses. I believe an institution would do something roughly like the following: NOI would be increased by $250,000 to $625,000 for the rent that would no longer be paid upon purchase of the subject property. It would then be decreased by $160,000 to $465,000 to account for the assumed living expense of the principal in excess of his salary. There are surely other adjustments, but I believe these would be the ones most impactful. If the income was deemed to be $735,000, at a debt service coverage ratio of 1.25 the maximum debt service number indicated would be $372,000 per year, $31,000 per month. At a rate of 7% with a 25-year amortization, that would support the principal & interest payment on a $4.4M mortgage. If the interest rate assumption is higher, borrowing capacity would be less, and vice versa. I’m not a banker and thus am not fully aware of how these calculations are made – and in my experience is doesn’t seem like the process is fixed and universal – but I’ve seen these enough to know this is more or less the process, roughly speaking.
Why SBA Financing Works:
1. Reduced Risk for Lenders: SBA financing mitigates risk for lenders by providing a government guarantee on a portion of the loan. This guarantee encourages banks to lend to small businesses and startups that might otherwise struggle to secure traditional financing, thereby expanding access to capital for entrepreneurs.
2. Flexible Terms: SBA loans often offer more flexible terms compared to conventional loans, including longer repayment periods and lower down payment requirements. This flexibility can make financing more accessible and affordable for small businesses, particularly those in the early stages of growth.
3. Lower Equity Requirements: With SBA financing, borrowers may be able to secure funding with lower equity requirements, allowing them to retain more ownership of their businesses and preserve capital for other investments or operating expenses.
4. Support for Growth Initiatives: SBA loans can be used for various purposes, including commercial real estate acquisition, expansion, equipment purchases, and working capital. This versatility enables business owners to pursue growth initiatives and strategic investments that contribute to long-term success.
Why Banks Like to Do SBA Financing:
1. Risk Mitigation: The SBA guarantee reduces the risk for lenders, making SBA loans more attractive from a risk management perspective. Banks can expand their lending portfolios and reach a broader range of borrowers without significantly increasing their exposure to risk.
2. Community Reinvestment: Participating in SBA financing allows banks to support small businesses within their communities, contributing to economic development and job creation. This aligns with many banks’ objectives to foster local growth and prosperity.
3. Stable Income Stream: SBA loans offer banks a stable income stream through interest payments and fees, enhancing their overall profitability. Since the government guarantees a portion of the loan, banks can generate revenue while minimizing the risk of default.
4. Customer Relationships: Providing SBA financing allows banks to establish and strengthen relationships with small business owners. By offering tailored financial solutions and personalized service, banks can position themselves as trusted partners in their clients’ growth journeys, potentially leading to additional banking relationships and cross-selling opportunities.
5. Compliance and Reputation: Participating in SBA financing demonstrates a bank’s commitment to regulatory compliance and responsible lending practices. This can enhance the bank’s reputation and credibility, attracting new customers and reinforcing trust among existing clients.
In conclusion, SBA financing serves as a catalyst for small business growth, particularly in commercial real estate transactions.
Comparing Approval Odds: SBA Loans vs. Commercial Loans
In the realm of business financing, the journey toward securing funding can often feel like navigating a labyrinth of options, each with its own set of advantages and challenges. Among the myriad choices available to entrepreneurs, Small Business Administration (SBA) loans and commercial loans stand out as two prominent pathways. But when it comes to approval rates, how do these options compare? Let’s explore the likelihood of getting approved for an SBA loan versus a commercial loan.
Before diving into approval odds, it’s essential to understand the fundamental differences between SBA loans and commercial loans.
SBA Loans:
SBA loans are backed by the Small Business Administration, a federal agency tasked with supporting small businesses. These loans are facilitated through approved lenders and come with government guarantees that mitigate risk for lenders, making them more accessible to small businesses. SBA loans often feature longer repayment terms, lower down payment requirements, and competitive interest rates.
Commercial Loans:
Commercial loans, on the other hand, are traditional loans offered by banks or financial institutions without government backing. These loans are subject to the lender’s discretion and typically require strong creditworthiness, collateral, and a proven track record of business success. Commercial loans may offer more flexibility in terms of loan structure but often come with higher down payment requirements and interest rates compared to SBA loans.
Likelihood of Approval:
When comparing the likelihood of approval for SBA loans versus commercial loans, several factors come into play:
1. Creditworthiness:
- SBA Loans: While SBA loans may be more forgiving of lower credit scores compared to commercial loans, a solid credit history still plays a significant role in the approval process. Borrowers with better credit profiles are more likely to secure favorable terms.
- Commercial Loans: Commercial loans typically require higher credit scores and may be less forgiving of blemishes on credit reports. Lenders often scrutinize credit history extensively before extending credit.
2. Business Viability:
- SBA Loans: The SBA focuses on supporting small businesses with viable business plans and revenue-generating operations. Demonstrating a clear business strategy and financial projections can bolster the likelihood of approval.
- Commercial Loans: Lenders offering commercial loans prioritize businesses with strong financial performance, stable cash flow, and a proven track record of profitability. Established businesses with solid financials are more likely to secure commercial financing.
3. Collateral and Down Payment:
- SBA Loans: SBA loans generally require lower down payments compared to commercial loans, making them more accessible to businesses with limited capital. Additionally, SBA loans may offer more flexibility in terms of collateral requirements.
- Commercial Loans: Commercial loans often require substantial down payments and may be secured by specific assets or personal guarantees. Borrowers with significant collateral may have better chances of approval.
4. Loan Purpose:
- SBA Loans: SBA loans are designed to support a wide range of business needs, including startup costs, expansion, working capital, and real estate acquisition. The versatility of SBA loans makes them attractive to businesses with diverse financing requirements.
Commercial Loans: Commercial loans may be more narrowly focused on specific purposes, such as real estate purchases or equipment financing. Borrowers seeking financing for specialized projects may find commercial loans more suitable.
Personal Experience:
I’ve brokered numbers of commercial property sales that involved 90% SBA financing. I’ve found the process to be smooth. I only recall one SBA loan that was not approved, resulting in a sale falling apart, but that was a couple of months into the pandemic – for a hot minute we were all worried about a shutdown fueled depression – for a business whose revenues had fallen off of a cliff. I’m repeatedly mystified by brokers, sellers, or attorneys that do not like SBA financing. If you’re working with the right institutions and competent professionals – and we’ve got an excellent list with whom we’ve worked – financing is smooth, and a pre-evaluation can address likelihood of approval. It’s not just me, in 2023 the SBA reached nearly $43 billion in funding to small businesses, providing more than 62,000 traditional loans through its 7(a), 504, and Microloan lending partners. The only negative for a seller is that can take a couple of weeks longer to get approved.
Conclusion Regarding SBA Approval Odds:
In summary, the likelihood of getting approved for an SBA loan versus a commercial loan depends on various factors, including creditworthiness, business viability, collateral, down payment, and loan purpose. While SBA loans offer government-backed guarantees and more flexible terms, commercial loans may provide greater customization and faster approval for well-established businesses with strong financials. Ultimately, businesses should carefully evaluate their financing needs, assess eligibility criteria, and explore both SBA and commercial loan options to determine the best fit for their unique circumstances.
SBA Buyers are Desirable
Not that way! Actually, wait, that way also. Chuckle.
Contrary to what I’ve heard others say, SBA buyers, properly counseled, are highly desirable if not preferable. These are well-funded buyers – SBA financing cash clears the bank the last time I checked – with a business purpose for their purchase. They don’t typically mess around as the purchase is for property to help their business succeed. And, they get their loans. If I’m involved, I will have had some communication with the chosen lender to gain assurance of likelihood of approval. Where I’m not involved, I’d advise any seller to gain reasonable confidence in the strong likelihood of approval directly, or indirectly via a trusted source, from a lender that has revised a buyer’s tax returns and financials.
Who to Contact
One of the many value adds of working with us, Hawkins Commercial Realty, is our network of proven professionals and resources, including SBA lenders with whom we have successfully closed numerous transactions. Also, our ability to speak from experience with regard to SBA financing success helps with the sellers gain comfort, which helps smooth the negotiation process. Thus, Florida buyers would do well to simply contact us for recommendations. We can also speak generally to the math and considerations, in particular loan to value (LTV) and debt service coverage (DSCR) ratios, that a borrower can expect as he/she contacts a lender.
When seeking to obtain SBA loans and gather related information, entrepreneurs and business owners have several avenues to explore. One primary point of contact is SBA-approved lenders, which include traditional banks, credit unions, and other financial institutions that participate in SBA lending programs. These lenders have the expertise and resources to guide borrowers through the loan application process, assess eligibility criteria, and provide valuable insights into available loan options. Additionally, entrepreneurs can directly reach out to local SBA offices or Small Business Development Centers (SBDCs) for personalized assistance and resources. These organizations offer counseling, training, and networking opportunities to help small businesses navigate the complexities of securing SBA financing. Moreover, online resources provided by the SBA, such as their official website and online tools, offer comprehensive information, loan calculators, and application guidance, serving as valuable resources for those exploring SBA loan opportunities. SBA loan brokers can also be a valuable resource. By leveraging these channels and engaging with knowledgeable professionals, aspiring borrowers can streamline their journey toward obtaining SBA loans and accessing the support needed to fuel business growth and success.