Should You Go to the SBA for CRE Loans?

The type of loan you choose to finance commercial real estate could decide how much you’re paying years into the future and whether the loan gets called for a tripped covenant. Here’s how to choose.

Commercial real estate (CRE) loans make up the majority of most bank balance sheets. From the vacant lot down the street to some downtown skyscrapers, you can bet they were financed with a bank loan.

If you’re looking to buy a skyscraper, however, this probably isn’t the article for you. We’re going to go over the pros and cons of using a conventional loan, or one of the two main SBA loan types, for your next CRE purchase.

When I say conventional, I mean a run-of-the-mill bank loan that you can get at your local branch office. The SBA loan types we’ll look at are 7(a) and 504. A lot of what we’ll talk about in this article presupposes basic knowledge about those two loan types, so if you don’t know much about them, click on those two links before you start.

Let’s talk about the things you should keep in mind when seeking a CRE loan, and we’ll rank the three candidates on each.

Interest rate

Interest rate is always the first thing you look at. My wife and I recently purchased a new home, and even though we jumped about $100K in value from our last home, the drop in interest rates since our earlier purchase made the monthly payment the same.

Generally, the more risky a loan is to the lender, the higher the interest rate will be. SBA loans are, by definition, riskier -- they exist to lend to borrowers who couldn’t get a loan conventionally. That suggests the two SBA loans should lose this round.

However, 504 Certified Development Companies (CDCs) can provide incredibly low fixed interest rates for the second 504 loan, and the first loan is generally priced the same as a conventional loan would be.

Winner: 504

Loser: 7(a)

Fees

Fees are the other part of the cost equation. Each of these options will come with plenty of fees, such as the fees for appraisal cost, closing cost, title insurance, and even plain old origination.

The highest is the SBA guaranty fee, which comes in at 3% to 3.75% of the guaranteed portion of the loan, depending on the loan amount. The guaranteed portion is equal to 75% of the loan amount, and the lender is also allowed to charge up to another $2,500 (they call this a packaging fee). So, with 7(a) loans, you’re looking at a potential 2.8%, plus a $2,500 fee, for CRE loans of more than $1 million.

The supposed upside is that the lender is not allowed to charge the traditional closing costs and document prep fees they nickel-and-dime you with on conventional loans. The trick is that the guaranty fee and packaging fee are so high, and the conventional origination fee and associated closing costs wouldn’t ever come close.

On 504 loans, the lender is allowed to charge an origination fee and on both loans, and the CDC charges plenty of fees.

Appraisal, title insurance, and other third-party report costs will generally remain the same among the three. We’ll declare conventional the winner because the SBA has stricter requirements for appraisal and environmental reports that sometimes makes them come in a little higher.

Winner: Conventional

Loser: 7(a)

Loan term

This one is a clear loss for conventional. Many businesses aim for SBA loans simply to get a longer term. Banks are loathe to lend on CRE using terms longer than 10 years. They’ll set your payment based on 20 or 25 years, and then the balance of the loan comes due after 10 years. Every time you refinance that balloon payment, your amortization schedule restarts, and you have to pay mostly interest all over again.

In contrast, 7(a) CRE loans can go up to a 25-year term and often do. In the past, 504 second loans would only go up to 20 years, but more recently, CDCs have started lending for 25 years. Therefore, we’ll give 504 and 7(a) the tie.

Winner: 504 and 7(a)

Loser: Conventional

Underwriting process

Like fees, the underwriting process is a pain you’re going to have to endure no matter which route you choose. This part is the easiest to grade.

Every 504 and 7(a) loan starts with the conventional underwriting process. The loans have to be underwritten to show there is sufficient cash flow, management has experience, and the collateral is worth enough to cover the loan amount. Both also have to do government eligibility tests.

So if conventional wins this round, who loses? I’m going to call 504 the loser because both loans are underwritten by different teams with different motivations, so it’s twice as bad.

Winner: Conventional

Loser: 504

Ability to refinance

It may seem strange to evaluate a loan by how easy it would be to get out of, but many businesses eventually refinance their loan. You could be looking to take advantage of increased real estate value to take cash out. You could be looking for a better interest rate. You could even need to increase the loan amount somewhere else for new construction to expand.

We’ll use prepayment penalties (PPP) as a proxy for how easy it is to refinance. Conventional loans almost always have them, although they’re negotiable. 7(a) loans have a 5-3-1 PPP, meaning a 5% penalty the first year, 3% the second year, and 1% the third. 504 loans often charge 5% if the loan is prepaid in any of the first five years.

Winner: 7(a)

Loser: 504

Covenants

This is another section with a clear winner. The only covenant that can be enforced with 7(a) loans is making payments on the loan. Nothing else can be used to call or default the loan.

Conventional CRE loans can have covenants for all kinds of things, including debt service, liquidity, originating loans for other purposes, and annual document requirements.

Winner: 7(a)

Loser: Conventional

Collateral guidelines

There are two ways banks look at collateral. The discount rate and the loan-to-value (LTV). The bank applies a discount rate to collateral values based on the perceived risk of the collateral and will not lend more than that amount. The LTV shows what ratio the current loan amount is to the collateral value. The lower the LTV, the less risky the loan.

Banks will require a lower LTV to do a conventional loan in order to lower its risk. Generally, the best LTV you’ll be able to pull off on a conventional loan is 80%, and that’s only if you have a long-term profitable relationship with the bank and are a great credit risk.

That leaves the two SBA types battling for the win. 7(a) loans will allow 90% LTVs, but often the lender requires an 85% LTV. 504 loans almost always have a 90% LTV.

Winner: 504

Loser: Conventional

Conclusion

I put together a matrix showing how each option graded. The total row is calculated with each plus worth one point and each minus worth one negative point. According to this chart, 7(a) loans are the clear winner.

Conventional loans do not prevail in this battle. Image source: Author

When I started working as an SBA underwriter a few years ago, I was surprised at the volume of loan applications we received for companies with plenty of cash flow and not much debt.

SBA loans are intended only for companies that can’t qualify for conventional loans, and lenders are even supposed to test that assumption in their credit memos by explaining why the business couldn’t qualify for a conventional loan. That test exists because there’s a clear incentive to get an SBA loan even if you don’t need one.

That said, conventional could certainly be the best choice for you. The matrix assumes each of the sections is weighted evenly. If you want to put more money down and not waste it on fees -- and you don’t have time to spend on the underwriting process -- apply for a conventional loan.