June 2007 Franchising World
Little known SBA 504 program can be key to savings.
Gary King has owned the Management Recruiters of Tampa North franchise since 1989, leasing Class A office space. In 2002, he and his wife, Gail, purchased land and built the 4,500-square-foot King Professional Center where MR is the primary occupant. Just prior to closing the deal with conventional financing, the Kings discovered the U.S. Small Business Administration 504 loan program. Their successful application reduced their equity contribution from 25 percent to 10 percent, saving them more than $50,000.
New and current franchisees should seriously factor this underutilized financing alternative into their business plans when expanding through buying commercial real estate and may be surprised at the cash that can flow from it.
The SBA last year made $7.5 billion available for such loans and unlike the better known 7(a) working capital loan program, $1.5 billion or 24 percent of the funds went unused. Why has bricks and mortar taken a back seat? There are at least three reasons:
Franchise systems are primarily interested in generating income through royalties of the core business of the restaurateur, hotelier, day-care center operator or assisted-living caregiver. The additional wealth that comes from reducing capital outlays or saving on leasehold and equipment costs is rarely foremost in their business modeling.
Property, construction and equipment financing is the core business of local commercial banks. 504 loans compete favorably against conventional loan products in rates, terms and availability for small- to medium-sized businesses, despite requiring one-third to one-half of the down payment requirement. They also shift part of the decision-making process away from local loan committees.
Because of the popularity of the SBA 7(a) program, many franchisees look exclusively to this source for real estate and equipment financing, as well as other capital needs during initial capitalization.
Two simple examples illustrate how 504 loans can contribute to financial success:
1. By reducing the owner-equity requirements on a $1 million property and construction loan from as high as 30 percent to 10 percent available through the 504 program, business owners can reduce initial cash outlays by as much as $200,000.
2. Because the SBA backs 40 percent of each 504 loan and a private-sector lender funds 50 percent (resulting in 90 percent loan-to-cost financing), smaller businesses are able to contemplate owning property instead of leasing it. They can negotiate better interest rates and terms up to 25 years. The business builds equity and good will as the loans are paid off. As owners reach retirement age they can consider selling the business, but retaining and leasing the facility as a continuing source of income.
A look at the SBA 504 statistics for loans granted in 2006 shows a close parallel between the types of businesses taking advantage of the program and key franchising categories.
• Hotels led all borrowers with 753 loans worth $800 million or 13.9 percent of the total.
• Full- and limited-service restaurants borrowed $370 million.
• Child day care facilities were loaned $103 million.
• Assisted care retirement centers borrowed $25 million.
• About 16 percent of loans went to start-up businesses, which proves that the 504 program is an invaluable resource for new franchisees across all industries.
These loans are granted to almost any type of for-profit U.S. small- to mid-sized business owner with the exception of financial service providers, passive real estate investors, companies having a tangible business net worth greater than $7 million or companies with net profits after taxes that averaged more than $2.5 million during the past two years. Being a community lending program, the 504 program requires applicants to demonstrate job formation, export potential or other economic development goals. Other requirements:
• The loan must be used for capital expenses including land, buildings, construction and capital equipment. Tenant improvements and renovations, most some soft costs, and virtually all closing costs can also be included.
• Applications are submitted to Certified Development Company (the SBA’s representative on these loans) and require a lender willing to fund 50 percent of the project cost. The SBA funds up to 40 percent of the project costs and borrowers as little as 10 percent. New ventures or properties considered to be “special-use” in nature may be required to provide equity of 15 percent to 20 percent.
• Owner occupancy requirements come with SBA 504 financing, 51 percent for existing buildings and 60 percent for new construction. Multiple businesses may be able to jointly “pool” 504 financing if they meet occupancy requirements together.
Recent experience has shown that SBA 504 loans require about the same amount of documentation and due diligence as ordinary commercial loans. Approval processes, too, are about the same as conventional loan processing and the disbursement process is no more complicated.
In addition to the $50,000 the Kings, of Management Recruiters, saved on the down payment at closing, the low interest rate on the SBA 504 portion of the financing package actually enabled them to their lower the monthly occupancy expenses for this location and also enabled them to design the new space to their exact specifications.
“In a service company, occupancy cost is second only to salaries and benefits,” said Gary King. “We determined that the cost of ownership was comparable with the cost of leasing in the rapidly appreciating Tampa real estate market and ultimately the office building is boosting our equity in the business.”
The 504 loan program was crucial for Melting Pot franchisees Dale Wallace and Robert Frady, owners of Seminole Restaurants of Florida, with two Central Florida locations. The owners were able to purchase instead of rent a site best suited to give the restaurant its upscale, free-standing, distinct identity consistent with the unique, fun dining experience they were trying to create.
“The numbers just worked out,” said Frady. “With rent and taxes in the neighborhood of $7,000 a month and to purchase at only $8,000 to $9,000 per month, we were able to create exactly the dining experience we sought and have an investment that gives us options in our retirement years.”
The duo, which worked during college at the original Melting Pot, also own and lease-back a separate unit in Gainesville, Fla. “We’re both in our forties and a 20-year mortgage puts us into retirement time. We can make decisions from an ownership position at that time.”
Rich and Carol Kendall, owners of three Culver’s restaurant franchises near Cedar Rapids, Iowa, drew upon previous real estate experience to make an ownership decision on all three restaurants. A “baby boomer” couple, they entered the restaurant business following other successful careers. They feel the combination of property ownership and 150 trained and enthusiastic employees gives them maximum control, but also flexibility in planning for the future.
“They’re not making any more land, so it’s better to own a piece of it,” said Carol Kendall recently. “We thought, ‘if we can purchase the property, make the payments and support our employees and their families,’ we’d really have an investment. SBA 504 financing helped us realize that goal.”
The Kendall’s son and long-term manager is now involved in the Iowa burger and custard restaurants. With management succession already in place, the couple is exploring expansion to Sun Belt locations as they approach retirement.
Analysis of the financial nuts and bolts of the SBA 504 program reveals significant economic differences to conventional financing. Here are the details:
• Borrowers are actually granted two loans, one (50 percent) from a lending institution and the other, (up to 40 percent) from a CDC representing the SBA. Fees, closing costs and other soft costs are rolled into two loans and amortized over the life of the loans.
• SBA 504 loans feature very competitive fixed interest rates when compared with conventional financing–6.08 percent (fixed for 20 years) as recently as last month. The resulting overall rate (from both loans) is often well below conventional financing alone. SBA funds are drawn from a permanent trust, established via bond issue and available exclusively for small- and medium-sized businesses.
• SBA 504 loans are amortized over 20 years. Participating financial institutions typically offer parallel programs and are not permitted to deviate significantly from the SBA structure.
Borrowing from the SBA 504 program does not preclude franchise owners from also applying for funding from the 7(a) program. To the contrary, working with a financial counselor to develop a comprehensive plan may enable better use of the cash being invested in the franchise, 7(a) funds and 504 loans.
A new franchisee faces a challenging financial equation. Lenders are not always eager to help owners address the short, medium and long-term aspects of their business at the outset. Placing the hard collateral in a long term SBA 504 loan for the property and building increases flexibility and reduces cash flow pressures during the first years after startup.
Christopher G. Hurn is the president and CEO of Mercantile Commercial Capital, LLC. He can be reached at 866-622-4504 or churn@mercantilecc.com .