SBA 504 Loans: What They Are & How They Work
Tom has 15 years of experience helping small businesses evaluate financing and banking options. He shares this expertise in Fit Small Business’s financing and banking content.
This article is part of a larger series on Business Financing.
The SBA 504 loan program from the Small Business Administration combines two loans—one from a lender and one from a community development corporation (CDC)—that can be used for commercial real estate and other fixed assets like equipment. The lender portion covers up to 50% of the loan, the CDC portion covers 40%, and the borrower is responsible for providing the remainder.
What an SBA 504 Loan Is
SBA 504 loans are commercial real estate loans that are a combination of two loans, one from a traditional bank and one from a nonprofit lender known as a CDC. Both the lender portion and CDC portion of the SBA 504 loan are closed at the same time. SBA 504 loans are available up to $14 million, with terms up to 25 years, and at interest rates that are lower than those offered by traditional banks.
What SBA 504 Loans Can Be Used For
An SBA 504 loan can be used to purchase land and existing buildings, to pay for property improvements and renovations, or to build a new facility. Additionally, SBA 504 loans can be used to finance other fixed assets, such as equipment and machinery, or to refinance debt that was used to acquire fixed assets.
According to Andrea Roebker, Regional Communications Director for the SBA:
“A 504 loan is designed to assist with fixed assets, including the purchase or construction/renovation of real estate, as well as the purchase of long-term machinery and equipment.”
Under the SBA loan regulations, CDC/SBA 504 loans can be used for these specific purposes:
- Buying land and existing buildings on the land
- Paying for property improvements such as adding parking lots, connecting utilities, and landscaping
- Renovating or expanding an existing facility
- Building a new facility
- Buying other fixed assets like long-term equipment and machinery
- Refinancing debt: An SBA 504 refinance applies to debt that was incurred primarily to acquire 504-eligible fixed assets; the existing debt must be at least two years old and in good standing
What SBA 504 Loans Cannot Be Used For
SBA 504 loans are great for commercial real estate, but there are several uses of the loan funds that are prohibited.
Some of the restricted uses for SBA 504 loans are:
- Working capital
- Materials, supplies, or inventory
- Advertising or marketing
- Normal operating expenses
- Speculative real estate investments
- Rental properties
If you need an SBA loan for any of those purposes, read our article on SBA 7(a) loans. SBA 7(a) loans can also be used in conjunction with an SBA 504 loan. If an SBA 7(a) loan better matches your business needs, SmartBiz offers very fast approval and funding times for SBA 7(a) loans up to $350,000. Plus, it can prequalify you in minutes.
SBA 504 Loan Qualifications
Qualifying for an SBA 504 loan is very similar to qualifying for a traditional commercial real estate loan. You will need to be able to demonstrate repayment ability and have a clean financial history.
Some of the basic qualifications include:
- Minimum credit score: 680
- Debt service coverage ratio (DSCR): At least 1.25x; you can calculate your DSCR by dividing your annual net income by the sum of the annual principal and interest payments on your loans, which are the SBA 504 loan and any other existing debt obligations
- Down payment: 10% to 20% of the combined CDC/SBA loan amount
- Clean financial history: There should be no recent bankruptcies, foreclosures, tax liens, or delinquent government loans in your personal or business financial history
In addition to the general SBA loan requirements, the SBA 504 loan program has four specific requirements: the property must be owner-occupied, jobs must be created or retained as a result of the loan, the business must have a net worth of less than $15 million, and any equipment purchased with the loan must have a service life expectancy of at least 10 years.
1. Property Must Be Owner-occupied
For the property to meet the SBA 504 requirements, it must be at least 51% owner-occupied. You can rent out part of the building but must be using the majority of it for your business. If the loan is for new construction, the building must be at least 60% owner-occupied at initial occupancy, increasing gradually to 80% owner-occupancy within 10 years.
2. Jobs Must Be Created
As part of the loan process, you will need to explain how your use of the loan proceeds will create or retain jobs that would otherwise be lost or how you’ll support public policy goals. Currently, the rule is that one job must be created or retained for every $65,000 of funding. This increases to one job per $100,000 borrowed for small manufacturers.
You can also qualify for an SBA 504 loan by enhancing other public policy goals like energy conservation and supporting minority business development.
3. Net Worth of Less Than $15 Million
Your business must have a tangible net worth of less than $15 million and an average net income of less than $5 million after taxes for the last two years.
4. At Least 10-Year Equipment Life
Any equipment purchased with the funds must have at least a 10-year economic life. Some acceptable items include machinery and larger manufacturing or commercial-use equipment.
SBA 504 Maximum Loan Amount
Current SBA rules set the maximum amount you can borrow with an SBA 504 loan at $14 million. However, due to restrictions on the use of proceeds and qualifying projects, the amount your project qualifies for might be lower. Most banks prefer to provide SBA 504 loans for projects of $500,000 or more, due primarily to the effort required to close a 504 loan.
SBA 504 Loan Rates and Fees
With an SBA 504 loan, you can expect to pay low interest rates and minimum fees. In general, the annual percentage rate (APR) on the bank portion of the loan will range from 4% to 10%. The rates for the CDC portion of the loan are fixed and currently range from 2.5% to 3% APR.
Keep in mind there are two loans made as part of an SBA 504 loan. The first is a loan from a traditional lender, such as a bank, for up to 50% of the total loan package. The rates, terms, and fees for that portion of the deal have very few restrictions. As such, they can vary from borrower to borrower. Most people find the commercial real estate loan rates and terms for this portion of the deal to still be very favorable compared to other financing options.
The second part of the loan is issued by the CDC, up to 40% of the package. The rates, terms, and fees for this portion of a 504 loan are regulated heavily. The CDC loan is a 10-, 20-, or 25-year, fully amortizing, fixed-rate loan. It works the same way as a traditional mortgage loan. The borrower pays equal monthly payments for the life of the loan, at which point the loan is completely paid off.
SBA 504 Loan Interest Rates & Fees: CDC Portion of the Loan
The interest rate on the CDC portion of the 504 loan consists partially of an interest rate that is set to Treasury bills that are sold at auction on a monthly basis in the case of the 20- and 25-year loans and on a bimonthly basis in the case of the 10-year loan. The remainder of the CDC loan interest rate is made up of three fees:
- SBA guarantee fee: This is an ongoing SBA monthly guarantee fee of .914% of the principal balance of the note, calculated at five-year intervals, beginning with the first payment.
- Servicing agent fee: The Central Servicing Agent (Wells Fargo) collects an additional 0.10% of the principal balance of the note, calculated at five-year intervals.
- CDC servicing fee: This varies between 0.625% and 2.00%, with a maximum of 1.50% in rural areas. The CDC will pay 0.125% to the SBA each month and keep the remainder.
As of June 2021, the interest rates on the CDC portion of the 504 loan are:
- 10-year term: 2.612%
- 20-year term: 2.764%
- 25-year term: 2.883%
CDC Portion of the SBA 504 Loan: One-time Fees
When the SBA 504 loan is made, there are some initial one-time fees. These will be financed into and amortized over the life of the loan.
Common one-time costs include:
- Underwriting fee: 0.375% to 0.4%
- Processing fee: Up to 1.5%
- Legal fee: $2,000 to $5,000
- Funding fee: 0.25%
- Guarantee fee: 0.5%
While all of these fees may seem overwhelming when you look at them individually, even with all of the fees included, they only amount to 2.5% to 3% of the value of your loan and will be amortized with the loan note.
CDC Portion of the SBA 504 Loan: Prepayment Penalty
Prepayment penalties are common with commercial real estate loans and are also a feature of an SBA 504 loan. The prepayment penalty is calculated on a sliding, decreasing scale. The penalty is figured on the debenture interest rate―at the time the loan was issued―not the effective interest rate of the loan, and only on the CDC portion of the loan.
For a loan with a 20- or 25-year maturity, the penalty applies to the first 10 years of the loan and decreases by 10% each year. For a loan with a 10-year maturity, the penalty applies to the first five years of the loan and decreases by 20% each year.
Example: Assume when a 20-year loan was issued, the effective interest rate for the month of July 2019 was 4.060%, and the debenture interest rate was 1.980%. The prepayment penalty declines by 10% of the debenture rate each year. It drops by a factor of .198% each year.
For this example, the prepayment penalty percentages would look like this:
SBA 504 Loan – CDC Prepayment Penalty
Year | Prepayment Penalty |
|---|---|
1 | 1.980% |
2 | 1.782% |
3 | 1.584% |
4 | 1.386% |
5 | 1.118% |
6 | 0.990% |
7 | 0.792% |
8 | 0.594% |
9 | 0.396% |
1 | 0.198% |
Note: Although the prepayment penalty is small, don’t forget that SBA 504 loans are assumable. Don’t overlook the benefit of having a new borrower assume a 504 loan with 16 or 17 years remaining at a low fixed rate of 4.060%. What could be more appealing to a new buyer down the road than the opportunity to assume a fixed interest rate loan in these ranges?
SBA 504 Loan Interest Rates & Fees: Lender Portion of the Loan
The interest rate offered on the lender portion of an SBA 504 loan is at the discretion of the bank or nonbank lender and typically ranges from 4% to 10%. Ultimately, you and your representatives must negotiate the best possible rates, fees, and terms for your deal.
Summary of Lender SBA 504 Loan Interest Rates & Fees
Term and AmortizationTerm and Amortization | 5- to 10-year loan amortized over 25 years |
Interest Rates | 4% to 10%—No limit, open to negotiation |
Bank Fees | 0.5% one time fee—No limit, open to negotiation |
Third-party Fees | Varies and includes costs for attorney, appraisal, credit reports, environmental reports, etc. |
In most cases, the bank or nonbank lender loan will have a five- to 10-year term amortized over 20 to 25 years. In the case of loans with 10-year terms, the interest rates usually reset after five years. This means that after five years, your interest rate could go down, go up, or stay the same. It depends on what the market rates are at that time.
While the long amortization will keep your monthly payment lower, it means you will have a balloon payment due in five to 10 years unless you choose to refinance the remaining balance. Refinancing a first mortgage when a balloon payment comes due can be problematic in some cases. If your business sees a downturn prior to refinancing or if your property has significantly depreciated, it may be difficult to find a lender willing to work with you.
The bank portion of the loan may come with its own set of closing costs and third-party costs, such as appraisal fees, environmental fees, architectural fees, and legal fees. Fortunately, these can typically be included in the financing as well.
Loan Options for Commercial Real Estate: SBA 504 vs SBA 7(a) vs Traditional Loan
Top 4 Benefits of an SBA 504 Loan
The SBA guaranteed over 17% more 504 loans in Federal FY 2020 than FY 2019, an increase that is consistent over the past several years. The SBA 504 program’s popularity among businesses is due to the great advantages it offers borrowers. The four primary benefits to getting an SBA 504 loan are low interest rates, a low down payment is needed, long repayment terms are available, and no additional collateral is necessary.
1. Low Interest Rates
Interest rates for the CDC portion of the loan are limited by the SBA and currently range between 2.6% and 3%. That rate is fixed and will not increase for the life of the loan. The bank’s loan doesn’t have these limitations. The rates typically fall between 5% and 10% and can be either fixed or variable.
2. Low Down Payment
While most traditional commercial loans require a 20% to 40% down payment, an SBA 504 loan requires a down payment as small as 10%. If your business is a startup or the property you want to buy is a single-use building, you will need a 15% down payment. The down payment requirements increase to 20% for startups purchasing single-use properties.
Even if you’re operating a startup business and purchasing a single-use building, the 20% down payment requirement with the SBA 504 loan is advantageous. As a startup, many traditional lenders may be hesitant to offer financing and, if it were offered, it would likely involve a much larger down payment.
3. Long Repayment Terms
While most traditional commercial mortgages are five- to 10-year loans, the CDC portion of an SBA 504 loan has a 10-year term for equipment and 10-, 20-, or 25-year terms for real estate. Typically, the bank portion of the loan has a seven-year term for equipment and a 10-year term for real estate. The longer repayment term offered on the CDC loan reduces the monthly payment, making the payments more affordable.
4. No Additional Collateral
The real estate or other fixed assets being financed by the SBA 504 loan are generally sufficient as collateral. With no additional collateral required beyond the real estate or fixed assets you are financing, your remaining assets remain lien-free.
How to Apply for an SBA 504 Loan
The bank portion of an SBA 504 loan can be funded by any bank, credit union, or commercial lender that works with the SBA. Many financial institutions will partner with a CDC and be able to assist in finding a CDC partner. Conversely, a local CDC may partner with several banks in their area.
There are 243 CDCs nationwide. To find one that will work with you, we suggest using the SBA’s CDC Finder tool. Additionally, rankings of the top 504 lenders in your area may be available through SBA district offices.
When you apply, a business plan and financial projections will be required. Additionally, the past three tax returns for the business and any owners with 20% or greater ownership interest will need to be provided with the application.
A good lending option for SBA 504 loans is Lendio. Lendio is an online broker that works with more than 70 financial institutions and will provide numerous potential matches for your application. It may save you time searching for a bank or CDC to work with.
Bottom Line
An SBA 504 loan is one of the first types of financing you should consider if you’re purchasing commercial real estate to operate your business out of or if you’re buying long-term equipment that holds its value. The low down payment will allow your small business to preserve more cash for working capital, and the low interest rates and long repayment terms will be easier on your cash flow.
