With the Federal Reserve running wild with interest rate hikes, carwash business owners are asking how they can stop the madness. The reason for the concern is because many have variable rate mortgages, which are based on Prime Rate. So, when Prime Rate goes up, their loan payments increase.
In 2022, the Federal Reserve increased the Fed Funds Rate by 4.5%. The Fed Funds Rate is the rate that banks borrow funds. When the Fed Funds Rate increases, the Prime Rate increases. The impact of the huge increase in rates over the past year means to borrowers for every $1 million in mortgage balance, their mortgage payments increased by $3,000 per month. So, if you have a $5 million mortgage, your payments increased by $15,000 monthly or $180,000 annually — that’s big money.
With those kinds of increases and the uncertainty of the additional rate hikes, many carwash operators are asking how they can fix their future. They are looking to lock into a long-term fixed rate mortgage. One option available is the Small Business Administration (SBA) 504 Program.
What’s the SBA 504 Program?
The 504 Loan Program is an initiative of the Small Business Administration (SBA) that provides low rate 20- to 25-year financing to small businesses for the purchase or improvement of land, buildings and major equipment. 504 loans support the creation and retention of jobs in support of local economic development and are administered through Certified Development Companies (CDCs) regulated by the SBA.
The 504 Loan Program can help entrepreneurs refinance debt. A recently published revision to the program allows for both projects that involve the expansion of a small business and for those who do not need to expand. In the past, the SBA required expansion to be part of the use of proceeds to be eligible. The updated regulations significantly increased the scope of 504 debt refinancing programs to help more small businesses with stability and growth.
Another major benefit of the SBA 504 Loan Program is that it has allowed small business owners to refinance not only their commercial mortgages, but also any other business debts they carry. This government-backed financing has several big advantages, including:
• Low fixed interest rate for up to 25 years.
• Low down payments, which can often be satisfied by using your existing equity in the business assets to secure the loan.
• A cash-out option of up to 85% for eligible business expenses, including rent, repairs, salaries, maintenance and lines of credit. There are restrictions on the amount of cash out.
Can you refinance an SBA 7a loan?
Yes. You can absolutely refinance an SBA 7a loan with a 504 loan. This could make sense for your business if you are trying to refinance away from an adjustable/floating rate 7a loan to lock in a long-term fixed rate with a 504 loan. In addition, you can get real property released that is being held as additional collateral for the 7a loan. The 7a can require a lien on other real estate and the 504 does not.
Many borrowers who have SBA 7a loans refinance them before the end of the loan term since 7a loans have a very short prepayment penalty. In the case of an SBA 7a loan with a term of less than 15 years, there is no prepayment penalty at all.
SBA 7a loans for commercial real estate typically have a 25-year term and amortization and a prepayment penalty of just three years (5%, year one; 3%, year two; and 1%, year three). So, if you have as little as 15% equity after just two years it might make sense to refinance, especially if you have a floating rate SBA 7a loan that is currently very high due to the escalating Prime Rate.
The following are a few reasons to consider a refinance of a 7a with a 504:
• You may only need 15% equity to be able to refinance with the 504.
• SBA loans are usually easier to qualify for than a conventional or bank loan. Generally, SBA loans have a lower cash flow threshold for approval.
• The 504 program offers fixed rates. It is a two-loan structure: the first mortgage usually fixed for five to 10 years and the second mortgage is fixed for 20 or 25 years.
• You can release additional collateral that was used to secure your SBA 7a loan.
• The new SBA 504 refinance guidelines allow for some “cash-out” for business expenses.
• You only need to have had the 7a loan for six months to be eligible.
It is important to understand a few caveats to refinance a 7a loan with a 504, including:
• While you only need to have had your 7a loan for six months, you must have been in business for at least two years. So, newer businesses of less than two years are not eligible.
• At least 85% of the proceeds of the loan to be refinanced must be 504 eligible, which means that the loan must have been used for “hard assets” typically defined as land, buildings, machinery or equipment. This is because except for the limited amount of the “cash out” that the new SBA 504 refinance provision now allows, the 504, unlike the 7a, can only be used to finance fixed (or hard) assets.
• Refinancing debt for leased sites can be limited. You can refinance your equipment debt but not loans for goodwill.
• The current 7a lender must be unable or unwilling to modify your current loan.
• The refinancing of any federally guaranteed debt must provide a “substantial benefit” to the borrower. There must be a minimum 10% savings on the new installment amount for the debt being refinanced.
Can you refinance a conventional loan?
Yes. You can use the SBA 504 refinance program to refinance your existing conventional commercial loan (a loan that is not backed by a federal government guaranty). The rules and terms are virtually the same for conventional debt refinancing. The loan must be in existence for six months with a clean payment history for the past 12 months and there must be at least a 10% savings in monthly payments.
In addition, to qualify, you must be a for-profit company doing business in the U.S., be in operation for at least two years, and have a tangible net worth of less than $15 million along with an average net income of less than $5 million after taxes for the previous two years.
There are many benefits to refinancing conventional debt. They include:
• Reducing your monthly payments with a combination of a longer term and/or a lower interest rate.
• Avoiding hefty balloon payments. A balloon payment is a lump sum payment for the remainder of the loan balance that may be required in a conventional loan after as little as a couple of years.
• Eliminating interest rate risk by fixing your rate.
Items to consider
While the SBA 504 Refinance Program offers some wonderful benefits, there are some items to consider before making the move. These items include the following:
• Prepayment penalties. Some lenders charge a penalty fee if you try to pay off your loan early. In addition, the SBA 504 loan has a 10-year declining prepayment penalty.
• Fees and closing costs. The SBA 504 loan has fees and there are third-party costs that will be incurred. These fees and costs can include, but are not limited to: the SBA fee; costs related to the appraisal report; legal/title; survey; and environmental report.
What documents are needed for an SBA 504 refinance?
Here are some of the key documents needed when you apply for an SBA 504 refinance:
• A copy of the mortgage agreement and deed, including any amended or modified agreements.
• Payment transcripts for the 12 months leading up to the application date (the monthly statements from the current mortgage lender are sufficient, as long as they show balances and payments). You must be current on your debt payments for the previous 12 months.
• If you’re interested in using equity to fund eligible business expenses, you will need to provide documentation of business operating expenses. This includes breakdowns of expenses incurred, but not paid by the date of your application or that will be due within 18 months from the date of application. The types of expenses can include salaries, rent, utilities, inventory and other expenses that are not capital expenditures.
• Of course, you will have to fill out the standard application forms and provide business and personal tax returns.
Looking into the future
Everyone wants to know about the future. In this case, the question revolves around what’s in store for rates down the road. Will rates go higher, stay the same or go down? Are you locking into a fixed rate at the top of the market? Are rates at this level the new norm? Nobody truly knows. I certainly don’t.
For those of you who do not have a crystal ball, but are tired of experiencing the uncertainty of the rate hikes and are looking to stabilize your business and cash flow, the SBA 504 Refinance Program is one way to fix your future.
Michael Ford is the managing director of Coast Commercial Credit, a firm specializing in financing for the carwash industry. You can reach him at 800-400-0365 or [email protected].