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March 30, 2011

Firm News for March: Best Practices: Financing Residential Space

By: Katie G. O’Brien, Esq.

Often, SBA lenders receive requests to finance the purchase or the construction of improvements to real property that are mixed use – containing both commercial and residential space.

The SBA rules regarding whether SBA financing may be used to purchase, refinance or construct a building which will be used for business purposes, but which also contains residential space are somewhat unclear and often leave lenders wondering if their proposed project is eligible, or not. This article will examine the different scenarios involving the financing of residential space with an SBA loan and will discuss the various eligibility concerns that lenders must keep in mind when processing these loans.

Resident Owner or Manager

The SOP 50 10 5(C) (“SOP”) at page 147, clearly states that SBA loan proceeds may be used to purchase a building or construct a new building that includes residential space when (1) the residential space does not exceed 49% of the total property, (2) the nature of the business requires a resident owner or manager, and (3) the residential space is an essential part of the business. The SOP sets forth a horse-breeding facility as an example of a type of business that requires a resident owner or manager to be on-site at all times to care for the animals.

But what about a funeral director who lives at a funeral home? Or a dentist who lives on-site to treat patients needing emergency services at night and on weekends? Because there is no bright line rule as to when residential space is considered to be an essential part of the business, Lenders must clearly document their files with their analysis and reasoning and should get as much supporting documentation as possible from the applicant to demonstrate the essential nature of the residential space.

Third Party Residential Tenant(s)

The SBA allows residential space to be leased to a third party residential tenant in certain circumstances. However, the SOP is unclear whether all residential space, whether occupied by a resident owner or manager or leased to a third party, must be an essential part of the business if the premises are financed with SBA proceeds. The SBA states that residential space must be an essential part of the business when loan proceeds will be used to purchase or construct a building which will contain a residence for the owner or manager, but that this restriction does not also apply to third party residential leases.

Accordingly, SBA loan proceeds may be used to purchase or construct a building, a portion of which contains residential space that will be leased to a third party tenant, as long as the following requirements are met:

• Occupancy by the operating company –

o If an existing building, the business must occupy 51% of the rentable property (as defined below) and may lease up to 49% to third parties;

o If constructing new building, the business must occupy 60% of the rentable property and may permanently lease up to 20%, and temporarily lease up to 20% (but must use some of this temporarily leased property within 3 years and all of it within 10 years)

• The rental income must be independently verified if is included in the Lender’s repayment analysis.

Rentable property is defined as “the total square footage of all buildings or facilities used for business operations” excluding vertical penetrations (i.e. stairways, elevators, etc.) and including common areas (i.e. lobbies, vestibules, bathrooms, etc.). Rentable property excludes outdoor areas.

Because this analysis involves an eligibility determination, an incorrect determination could lead to a complete denial of the SBA guaranty. Therefore, it is imperative for Lenders to do a thorough analysis and clearly document their decisions. When in doubt about an eligibility determination, it is always safest for Lenders to submit their loans through general processing. For more information on SBA documentation and closing issues, contact Katie at 267-470-1207 or kobrien@starfieldsmith.com.