I recently had the honor of giving a presentation at the Northeast Wisconsin Manufacturing Alliance (NEWMA) full membership meeting, along with fellow ICB business banker Mark Maurer. Though those in attendance represented businesses of all sizes, our presentation focused on the small to medium-sized business hoping to expand, and that hasn’t had to borrow a substantial amount of money in some time. I want to recap our presentation here.
So what’s new when it comes to borrowing?
Interest rates have increased several times over the past few years, with Prime now at 5.0%. It’s widely anticipated that the Federal Reserve will increase the Prime rate again in both the third and fourth quarters of 2018, and three more times in 2019. That means it’s quite possible that a year from now, the variable overnight borrowing rate (think lines of credit) will be 6.25%. Generally, longer-term fixed rates (3 to 25 years) are priced higher than overnight borrowing rates. If you’re planning an expansion relatively soon, you may need to revise your borrowing rate assumptions. Given that we had almost a decade of flat interest rates, some still believe rates are where they were a few years ago.
In addition, if you’re of the mindset that current economic growth will continue for some time, it may make sense to take what debt you currently have and fix the rate so you know your costs. With labor costs, healthcare and some material costs increasing, locking down your interest expense into a known number may help you control one of your larger expenses.
With these concerns in mind, what are my options?
Looking at fixed rate loans to mitigate your interest rate risk takes some understanding of where you are in your business life. There are a variety of good programs that make sense to use, including conventional, SBA, USDA, Interest Rate Swaps, local revolving loan funds, and Industrial Revenue Bonds. Generally, there isn’t a perfect answer to what’s best, or an “only” option for financing your business expansion. However, some structures provide more flexibility than others.
Conventional loans are the simplest to use. You’ll usually be able to get up to a 5-year fixed rate for real estate and equipment loans. These loans are required to be repaid over 5 to 7 years for new production equipment, or up to 20 years for real estate. Most banks impose a prepayment penalty if you refinance early, but allow you to prepay the debt with excess cash flow generated without penalty.
Government guaranty loans (SBA 7(a), 504 and USDA) allow you to obtain a long-term fixed rate (up to 25 years for loan primarily secured by real estate from SBA and 30 years from USDA). The SBA 7(a) and USDA programs allow the borrower to combine the use of proceeds (equipment, working capital and real estate) into one loan if desired. The USDA has higher loan caps: up to $25MM versus $5MM for the SBA 7(a). The USDA is for borrowers who are located in rural communities. Both programs do have upfront costs with a sliding scale and are likely best used when expecting to have the financing structure in place for some time. Otherwise, you pay for the upfront fees and don’t get the long term benefit. Both programs offer fixed vs. variable rate loans. Given the current interest rate environment, I believe you may want a fixed rate to have payment and cost certainty. Some banks will only offer these loans if done via the variable rate. At Investors Community Bank, we generally offer clients the long-term fixed rate, as it removes their interest rate risk. The SBA 504 program is for fixed asset financing (equipment and real estate). These loans can be done for purchases and refinances for terms of 10, 20 and 25 years.
All of these government guaranty programs can aid borrowers who want long-term fixed rates, help with minimizing a required down payment (as little as 10% for some of the projects) and basically limit default risk to making your loan payments. I most often use these programs for major expansions or fast growing companies that have limited equity, strong forecasted earnings.
Interest rate swaps are for more sophisticated borrowers who are looking for longer-term fixed rates. To utilize a swap, you’re entering a trade and converting a variable rate loan from your bank to a fixed rate loan to you. There’s risk in this type of loan and the borrower needs to understand the variables. The bank gets to continue to fund its balance sheet with variable rate deposits (checking, savings and money market accounts) and the borrower gets the desired long-term fixed rate (we can go up to 25 years). Generally, these loans only work for financing that will be in place for a long term and secured by real estate. The prepayment language is inflexible, as it’s a market-based trade, so paying early out of cash flow leads to a change in the trade and either a prepayment penalty (you pay) or premium (you receive).
Industrial Revenue Bonds are ideal for expanding real estate with some equipment added. Given that rates are increasing, these will be more popular with borrowers in the coming years, as they’re a way to tap tax-exempt financing. If desired, these can be combined with a swap to achieve a long-term fixed rate and tax-exempt status (though not all banks have tax-exempt interest appetite). Additionally, this should be used for a long-term structure, as there are material upfront financing costs that cause the starting point to be projects of around $2MM and greater. As of today, the interest rate savings can be around 1% less than a normal taxable conventional loan. This gap will widen as interest rates increase.
Local Funding. Depending on where you’re located, there may be local revolving loan funds available for job creation. These borrowing rates are typically several percent below your conventional bank loans, but need to be paired with a financial institution being the primary lender into the project. The benefit is below-market financing. You’ll need to get loan approval from another group of people at the revolving loan fund in addition to your lender.
As you can see, there are a number of options when seeking financing for an expansion. Talk with a business banker to understand the benefits of each and get practical guidance to help you select the most appropriate for your needs. In the meantime, you can learn more about one of the SBA loans appropriate for financing an expansion by downloading SBA 504 Loans: Basics Businesses Should Know.