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SBA 504 Guarantee Expanding, Albeit Temporarily

February 24, 2010

Parties to small-balance commercial real estate finance transactions might be willing to live with added layers of complexity in a popular funding program. That is, if the adjustments generate benefits such as greater secondary-market liquidity and tighter interest-rate spreads.

That's the expectation as participants await a far-reaching enhancement of the Small Business Administration's SBA 504 development finance program - and perhaps a couple more. SBA 504, which typically helps qualifying small business owners expand or develop facilities at taxpayer-subsidized debt costs, is already more complex than its more popular sister program SBA 7(a) (see related SmallBalance.com story).

It's described as a 50/40/10 structure: the business owner contributes 10 percent equity (and personally guarantees all the debt); the SBA guarantees in full a 40 percent debt tranche funded through a specialty Certified Development Co. (CDC); and a participating private lender funds the senior real estate secured "companion" loan comprising 50 percent of capitalization.

The adjustment just taking effect: through February 2011, the SBA will also guarantee up to 80 percent of the companion piece as those loans are sold into the secondary market. This essentially puts the federal government’s full-faith-and-credit behind nearly 90 percent of a transaction's total debt dollars, further reducing borrowing costs.

In its effort to jump-start small business hiring, the Obama administration has also proposed a couple of other 504 enhancements, both still awaiting Congressional approval.

One would permanently boost dollar caps of the CDC-funded component from $2 million up to $5 million for non-manufacturing facilities, and from $4 million to $5.5 million for manufacturing operations. This would allow for transactions as large as $13.75 million.

The other proposal would temporarily allow business owners in danger of maturity-related defaults to tap the 504 program to refinance existing mortgages or maturing 504 loans, with the SBA guaranteeing the CDC piece but not the companion tranche.

Based on solid growth in secondary-market demand for SBA-backed securities since the agency boosted the guarantee level for 7(a) program debt, veteran 504 dealmaker Kurt Chilcott anticipates stronger investor demand for 504 loan pool debentures as the program's new structure takes hold.

The SBA is expected to purchase its first pool of 504 loans originated under the bank loan guarantee by early April, adds Chilcott, who heads CDC Small Business Finance, a San Diego-based non-profit CDC.

"It could be huge for the 504 market; more lenders will look to originate and sell" companion loans, says Scott Evans, co-principal with Cleveland-based Government Loan Solutions, which helps lenders and investors value SBA-backed securities.

But he and Chilcott acknowledge that market participants will face a bit of an adjustment period. This will be particularly the case for smaller SBA loan pool broker-dealers that will need to retain 5 percent of each pooled companion loan's risk upon securitization (originating banks must retain the 15 percent balance).

"The SBA needs to get this launched and work out any kinks," Chilcott advises.

Applications for 504 loans have already jumped from depressed levels in recent months, after the SBA temporarily waived companion lender fees and CDC processing fees and also made 504 pool securities acquisitions eligible for Term Asset-Backed Securities Loan Facility financing (at the five-year Libor swap rate plus 50 basis points). Gross applications (typically 80 to 85 percent of approved loans actually close) grew from less than $172 million last February to $665 million in September.

Not only will the higher cap bring SBA-backed funding to larger deals, successful businesses with outstanding SBA loans can come back for additional financings, Chilcott stresses.

However Chilcott fears that if Congress doesn't extend 504's eligibility for TALF financing, interest rate spreads - which have narrowed dramatically over the past year - might widen a bit. Unless extended by Congress, that eligibility is scheduled to expire in March.

Spreads over comparable-term Treasuries that determine secondary-market debenture yields on 504 loans had been as wide at 350 basis points as recently as December 2008. They’ve since narrowed sharply to the prevailing 60-ish, pushing investor 20-year note rates generally into the mid-4s, meaning fixed-rate coupons of 20-year, fully amortized 504 loans are mostly in the mid-5s. Borrower fees are included in loan principal.

CDC-funded portions can also have 10-year terms (again, fully amortized) while the companion terms run 10 to 25 years. Cash flow tends to be the key qualifying consideration.

In addition to the extra 504 credit enhancement, Chilcott and Evans foresee the pending higher dollar caps and refi eligibility potentially boosting originations and secondary-market investment. Not only will the higher caps bring SBA-backed funding to larger deals, successful businesses with outstanding SBA loans can come back for additional financings, Chilcott stresses.

And given the prevailing commercial real estate lending environment and the amount of loans coming due over the coming couple years, it's likely a lot of small business owners exposed to refi risk will jump on the new 504 opportunity, adds Evans.

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