Inclusive Commercial Real Estate Financial Products: What Small Businesses Need to Help Them Acquire Property
By: Prince Osemwengie
Introduction: Owner-Occupied Commercial Real Estate Financing
Imagine being a restaurant owner renting a space for the past 18 years or a new local boutique clothing store owner seeking to purchase your first property located in rapidly gentrifying neighborhoods such as Echo Park, Boyle Heights, and Crenshaw. A few questions you might begin to wonder are, where does one begin to look to locate available commercial property? How does one contact a seller? Where does one secure financing, or what is my expected down payment? Unfortunately, for business owners with limited or no experience in commercial real estate, the process to acquire commercial property is anything but clear. To make matters worse, in Los Angeles County, the competition to secure prime commercial real estate (CRE) storefront and small retail space is hyper-competitive, expensive, and showing no signs of slowing down.
In conversation with Tom De Simone, President, and CEO of Genesis LA, when asked about the challenges small business owners face when seeking to purchase a commercial property, De Simone noted:
“Securing financing is always a challenge [for small business owners]. Even if one can negotiate the right purchase price, loans do not 100% cover everything. Solving for the equity piece is hard, which is further complicated by the racial wealth gap [in marginalized communities of color]. Many local nonprofits do not have enough equity to support [ small business owners acquire property].”
In Inclusive Action’s previous blog post - Combating the Displacement of Small Businesses, we explained that before the COVID-19 pandemic, small businesses had, on average, a 15-day cash reserve for expenses. For small businesses already operating on a tight budget with limited cash reserves, existing real estate financial products do not adequately address their needs in a competitive and expensive real estate market. Three financial barriers that impact small businesses' access to commercial real estate ownership include providing enough funds to cover down payment and closing costs, getting approved for large enough loans to place a competitive bid, and loan product eligibility restrictions.
There is a need for new, inclusive financial products that address the limitations of existing products and the challenges small businesses and nonprofits face when seeking to buy commercial property. It’s important to ensure new financial products such as “gap financing” for down payments and/or closing costs and guaranteed financing for nonprofits are non-extractive, accessible, and quick enough to be administered to small business owners to compete with real estate investors.
Small Businesses & Non-profits: Access to Capital Challenges for Commercial Real Estate
The processes to acquire financing for owner-occupied commercial property can be overwhelming for first-time property buyers. The terms and conditions of a CRE loan for a small business owner can vary depending on four factors typically assessed by lenders: (1) small business owner's personal attributes - personal FICO credit history, (2) business financial health - business FICO score, liquid capital, profit margins, operation cost, debt to income ratio, years in business, business sector/type, (3) loan product - the size of the loan, down payment, appraised value (4) property/site characteristics - geographic location, projected rehab and improvement cost. Depending on a lender’s assessment of a small business owner, the lender can approve or deny an applicant of loan, as well as adjust loan terms/rates for approved applicants.
Typically small business owners have three standard financial products available to finance the development and/or acquisition of commercial property: SBA 7A, SBA 504, and a conventional bank loan. The SBA 7A and SBA 504 are federal loan products originating from the Small Business Administration (SBA) that offer small businesses guaranteed loans. In contrast, conventional commercial loans originate from private financial institutions such as JP Morgan Chase, Wells Fargo, local banks, etc.
The three primary challenges with existing loan products in hyper-competitive seller markets are:
SBA Loans Competitive Disadvantage in Hot Real Estate Markets
Exclusionary Loan Eligibility Requirements
Loan to Value Dilemma
SBA Loans Competitive Disadvantage in Hot Real Estate Markets
While SBA loans offer great benefits on paper as CRE loan products, such as a high loan to value coverage of 90% and no minimum credit score requirements. In practice, SBA loans' longer approval time due to tedious paperwork makes them non-competitive. The processing time for these loans can range from 30 - 90+ days. In competitive real estate markets, such as Los Angeles, small business owners are at a disadvantage to investors who can pay entirely in cash in 7 - 10 days or with a conventional loan in 7 - 30 days.
Exclusionary Eligibility Requirements
Both conventional bank loans and SBA loans have their own set of distinct drawbacks that impact small businesses' and nonprofits' ability to access capital. While conventional loan products offer a few advantages, such as faster approval times and more flexibility in loan terms and rates for well-qualified applicants, they can also be more challenging for small business owners to attain. Conventional loan products are not readily accessible to all small business owners without a credit score of at least 700 and require a 20%-30% down payment. This poses a challenge for small businesses that do not have cash on hand. Recently, due to the economic instability of small businesses caused by COVID-19, traditional lending institutions have tightened their lending credit standards to small businesses. As a result, traditional banks are actively denying commercial real estate mortgages to limit banks’ exposure to the risk of default and are requiring higher down payments between 25%-35%.
Nevertheless, the SBA excludes nonprofits from being eligible to receive 7A and 504 commercial loans. The exclusion of nonprofits from SBA coupled with the tendency of conventional banks to deny small businesses from commercial makes it especially difficult for community-based organizations to obtain capital to acquire commercial real estate and hindering the ability for community-centered ownership models like commercial community land trusts
Loan to Value Ratio Dilemma
In hot real estate markets, sellers have the advantage to leverage market conditions and demand exorbitant asking prices for properties while buyers have to submit competitive offers to outbid their competition, further driving up property prices. A significant challenge small business owners face when seeking to acquire a loan for a commercial property is that the property's appraised value can be tens to hundreds of thousands, and in some cases millions, below the property's asking price. As a result, this creates a loan to value ratio (LTV) gap in which the appraised value by a lender is below the asking price of the commercial property set by the seller. Appraised values are important because lenders determine the size of the mortgage they offer borrowers based on a percentage of a property’s appraised value. On average a traditional loan from a bank has a loan to value ratio ranging from 65% - 85%, and SBA loans have an LTV between 80% - 90%.
LTV Ratio = Loan Amount / Appraised Value
When the LTV exceeds a conventional lender or SBA lender's threshold range, lenders will either deny an applicant's loan or request more capital upfront to lower the LTV ratio. For small business owners already finding it difficult to make a down payment, having to pay additional capital upfront to lower the LTV ratio presents an even bigger challenge. Such added expenses can ultimately discourage small businesses from purchasing a commercial property in their community.
Last, in emerging and gentrifying markets, such as Echo Park and Leimert Park, the disconnect between property owners' asking price and lenders' appraised values are more severe. Tom De Simone recalls a case where a South LA community-based organization was in escrow on a property for $2.3M, and the appraised value of the property came back at $1.6M. The gaps in gentrifying communities tend to be more severe because when banks appraise properties, they derive their analysis based on comparable commercial properties in the neighborhood or surrounding neighborhoods which tend to be depressed values of heavily stigmatized communities. When banks appraise properties in historically stigmatized neighborhoods, they tend to appraise properties below market value because banks fail to consider said neighborhoods' nuanced value or real-time implications of gentrification. Ultimately, when small businesses owners seek to purchase a commercial property in their gentrifying community, at times they cannot secure a loan because a bank appraises a property far below a seller's asking price and creates a loan to value dilemma.
What Small Businesses Need Now
Small businesses and nonprofits need new tailored inclusive CRE financial products designed to help close the racial wealth gap and prioritize the needs of businesses that have historically not had access to capital. To address the issues laid out, Inclusive Action recommends the local government partner with private and philanthropic institutions to develop two financial products:
Gap financing soft loan
Non-profit guaranteed loan program
These loan products should support small business owners seeking to acquire owner-occupied commercial real estate property and be non-extractive, low-interest, and accessible to nonprofits. Additionally, these loan products must be designed to be deployed quick enough to compete with investors with access to conventional loans that can process 50% faster than SBA-backed government loans.
Gap Financing Soft Loan
The large upfront capital (i.e., down payment, closing cost, proof of operating cost, etc.) required to supplement a conventional CRE loan and/or SBA 7A or 504 loans is one of the biggest challenges impacting small business owners from acquiring commercial property. To better support, small businesses in need of additional funds, a modified gap financing product could help more small businesses close on a deal.
Traditionally, a gap financing product has a short repayment cycle (6 months to a year), and a high-interest rate (7%-30%). Rather than replicate a traditional gap financing loan, the local government can develop a modified gap financing soft loan product. A soft loan is a junior loan product, that is borrower-friendly and typically features either zero or below-market interest and lenient repayment terms. To ensure small business owners are best supported, the soft gap loan should have a deferred grace period for at least two years to give the borrowers a head start on their primary senior loan repayment. This loan product should prioritize small business applicants who have already obtained either an SBA or conventional loan and are financially capable of taking on an additional loan.
Partnerships are essential to implement the gap financing soft loan program. First, the government should secure private and philanthropic partnerships to fund a gap financing soft loan program. Second, the government should partner with local community banks, community development financial institutions, community development corporations, and minority depository institutions, to administer and underwrite the gap loan product. Lastly, funding should be provided to trusted community-based organization partners that provide comprehensive technical assistance and guidance. This will be an investment the government takes on to support small businesses that have been left out.
Guaranteed Loan Program for Community-Based Organizations (nonprofits) for Commercial Real Estate Acquisition
While for-profit small businesses are eligible for both SBA and conventional commercial loan products, these financial products are either not accessible or eligible to non-profits. Similarly, local programs like the County’s Economic Development Loan Program (CEDLP), developed to help local small businesses acquire commercial real estate, disqualify nonprofits as eligible applicants. There is a need for commercial real estate financial products that are readily accessible to nonprofits and support alternative community-ownership approaches to real estate. The County and City should consider referencing the SBA 504 loan program to develop a non-profit-focused guaranteed commercial loan program. To implement the program, the local governments should partner with philanthropic organizations to set aside a pool of funds for the guaranteed loan program. Similarly, trusted local financial institutions and partners should take the lead providing technical assistance, administration, and underwriting the loans. To ensure awarded nonprofits pursuing community ownership models work in the best interest of their community, considerations around annual rent caps clauses should be considered a requirement to obtain the loan.
Conclusion
Access to capital continues to be one of the biggest challenges hindering small businesses and nonprofits from acquiring owner-occupied commercial property for their business. In hot real estate markets such as Los Angeles, existing financial products do not go far enough to address the specific needs of small businesses and nonprofits. Inclusive financial commercial real estate products such as gap financing soft loans and non-profit guaranteed CRE loans have the opportunity to provide small business owners and nonprofits the financial security to close out on a commercial real property successfully. It’s essential to keep in mind these proposed recommendations alone will not solve the underlying affordability crisis in Los Angeles County. Additionally, it's important to be aware of the externalities that could arise from more small businesses assuming more debt to acquire high-priced properties. It’s also not guaranteed that these small businesses will succeed or turn around and flip their newly acquired commercial real estate property for profit. However, with adequate support from the local government, what can be guaranteed is that these new financial products can provide financially excluded small businesses and community-oriented nonprofits the opportunity to have a future in their rapidly changing community.