Editor’s note: The Federal Reserve raised its benchmark interest rate by .75% on June 15, 2022, after this article was submitted for publishing.

Many private self-storage owners and developers have taken advantage of the Small Business Administration’s SBA 7(a) loan program to finance a new project or acquisition, and for good reason. It offers many benefits including a low down payment, short prepayment penalties, reasonable interest rates and no technical default. Plus, as long as you make timely payments, the lender can never call in your loan or force you to refinance. That said, if you’re currently in a 7(a) loan, now may a great time to refinance. Let’s examine why.

Rates in Flux

If there’s a downside to 7(a) loans, it’s that they usually have a floating rate pegged to the Wall Street Journal Prime Rate. This rate is set by banks and is meant to convey what they charge their most creditworthy customers, which at the time of this writing was 3.5%. SBA lenders generally charge a “spread” over the prime rate, usually ranging from 1.25% to 2.75%. When the COVID-19 pandemic hit in March 2020, the Federal Reserve swiftly lowered the federal funds rate to its minimum, and the prime rate followed suit. As a result, prime stayed at 3.25% for a full two years.

As expected, the Fed increased the fed funds rate by .25% in March, and prime followed suit at .25% to 3.5%. Prior to the hike, some pundits believed the Fed might delay an increase due to the war in Ukraine, but it seems the Federal Open Market Committee (FOMC) believes ignoring dogged inflation is a greater risk to the long-term domestic economy. The Fed’s “Dot Plot,” depicted in the table below, represents FOMC members’ expectations about future interest rates. It suggests that the Fed will increase rates an additional 1.5% this year and continue to increase rates in 2023, according to Bloomberg.

While the “Dot Plot” is a prediction at a given point in time—and there are myriad economic and geopolitical factors that may cause the Fed to shift course—right now, it appears the prime rate is set to increase more than 1.5% over the next 12 months. To put it in perspective, this means that a borrower who has a rate of prime plus 2.25% was paying a rate of 5.5% as recently as March 15 but may be paying as high as 7.25% (and potentially higher) by the end of 2022. That may not sound like a big deal to some, but a rate increase of more than 150 basis points will decrease cash flow and returns dramatically over a multi-year period.

Until 2021, options for refinancing 7(a) loans secured for self-storage were generally limited to conventional and commercial mortgage-backed securities (CMBS) loans, both of which come with challenges. Fortunately, a new and powerful solution emerged in July 2021 when the SBA authorized lenders to use SBA 504 loans to refinance existing 7(a) loans.

Background on SBA Programs

To understand why this is advantageous, it’s helpful to review the differences between the two flagship programs. An SBA 7(a) loan is simply a loan from a bank, credit union or finance company for which the government provides a guaranty (typically 75%) to the financial institution. As you might expect, this allows lenders to offer loans they wouldn’t normally make.

The 504 program is different. It marries a financial-institution loan with what’s called a “debenture loan,” a fully-amortizing, fixed-rate loan (10-, 20- and 25-year terms are available) that doesn’t balloon. What’s more, the rates on debenture loans are subsidized by a government guaranty, so they feature interest rates significantly below market.

For example, the 25-year debenture loans that funded in March did so at a fixed rate of 3.93%! In addition, if you use a 504 program to fix your rate for up to 25 years, you can also increase your loan amount to borrow funds for line items like salaries, utilities, real estate taxes and other operating expenses.

Why Refinance?

Let’s review a self-storage-specific example to see the power of this as a refinance opportunity. Suppose you used a $5 million 7(a) loan three years ago to finance an acquisition of $5.75 million. At the time, the property was 20% occupied, but now it’s stabilized with a net operating income of $350,000. Using a 5% capitalization rate, it’s worth roughly $7 million. Your loan started at prime plus 2.25%, so your current interest rate is 5.75% and expected to reach as high as 7.25% by the end of 2022. Your loan balance is about $4.7 million.

Below is a snapshot of what your financing on this property would look like after refinancing with a 504 loan. Please note that these sources and uses don’t include traditional closing costs for a commercial mortgage or program fees.

Assuming an interest rate of 4.5% on the senior bank loan, your blended interest rate (combined rate on the bank loan and debenture) using the 504 program’s 25-year debenture rate of 3.93% from March would be 4.22%. Further, you’d be able to lock in the interest rate on the debenture portion of your loan for a full 25 years and as much as 10 years on the bank loan (banks have discretion on how long they lock in their rate with a 504 structure). Thus, in this hypothetical scenario—and assuming six additional Fed rate hikes in 2022 of .25%—you will have lowered your rate by approximately 300 basis points and financed $450,000 for future operating expenses.

In short, this is a very powerful opportunity. I would encourage any self-storage owner or developer who’s currently in an SBA 7(a) loan to discuss their options with a bank adept at the 504 program. There’s significant upward pressure on rates right now, so the sooner you refinance, the lower your rate is likely to be.

Mac Dobson is a senior business development officer with LendingClub Bank, a U.S.-based digital marketplace through which members can access a broad range of financial products and services. He’s part of the bank’s government guaranteed lending team, which delivers a full suite of government-guaranteed loan products to businesses including SBA 7(a), SBA 504 and U.S. Department of Agriculture. Mac holds an MBA from the University of Chicago and a bachelor’s degree in business administration from the University of Colorado. He can be reached at [email protected] or 734.604.6962.