Most lenders know the EPC/OC rules, but calculating the proper rent payment on an EPC/OC lease can be complicated. The SBA does not permit lenders to make SBA loans to passive entities, that is, entities that do not actually use or occupy the assets acquired or improved with loan proceeds. The one exception to this rule is if a passive company qualifies as an eligible passive company (“EPC”) under the SOP. Among other conditions, in order to qualify as an EPC, a lease between the EPC and the business applicant, or operating company (“OC”), must contain a rent payment that does not “exceed the amount necessary to make the loan payment to the lender, and an additional amount to cover the EPC’s expenses of holding the property, such as maintenance, insurance and property taxes.” In essence, SBA allows for the loan to be made to a passive EPC as long as the EPC does not make a profit from the lease with the OC. As a transaction evolves, circumstances may change, so lenders must track how different scenarios may require changes to the rent calculation.
For example, let’s assume that the borrower provides the lender with a lease for review that contains a rent payment high enough to cover the debt service on the loan and taxes and maintenance on the property. Later in the process, the borrower decides that it is going to have the OC pay the loan payment directly via ACH. This subsequent decision regarding the ACH payment has rendered an otherwise acceptable rent payment non-compliant. If the OC pays the debt service directly, it cannot additionally pay the EPC rent that would include funds for the debt service. This would result in the EPC making a profit off of the lease, rendering it an ineligible passive entity. Therefore, the lender would need to require the lease be amended to reflect the fact that the OC will pay the debt service in lieu of rent to the EPC.
Similarly, many borrowers utilize a triple net lease, although this is not necessarily required by SBA. A triple net lease traditionally requires a tenant to pay taxes, insurance and maintenance on a building in addition to the base rent. If the OC pays these costs directly then they cannot be rolled into the rent payment made to the EPC. Again, this would result in a profit being directed to the EPC, and therefore is non-compliant.
Another complication that we have seen comes when a borrower is advised by its CPA or other tax advisor to rent the property for “fair market value”. In certain scenarios there may be tax consequences to renting business property below fair market value. Nonetheless, lenders must ensure that borrowers are limiting the rent payments as required by SBA. In guaranty purchase, the SBA will not accept mitigation of taxes as a justification for non-compliance with the EPC/OC rule.
Keep in mind that a lease may contain a provision for a reserve account if carrying costs of the building (e.g. taxes and insurance) will be paid by the EPC. The lender should ensure that the amount of any reserve is reasonable for the costs that the reserve will cover. If there are doubts about whether the reserve or estimate for maintenance expense are reasonable, the lender should request that borrower provide an itemized list of how the rental payment was derived in order to analyze it in further detail.
It is critical that the rent on an EPC/OC be calculated precisely, since the SOP 50 10 5 (I) states “because the EPC rule is an exception, it is interpreted strictly.” Failure to comply with these rules may result in a denial of the guaranty.
For more information regarding EPC/OC leases, please contact Jessica at email@example.com or at 267-470-1188.