Best Practices: Clarifying Eligibility for Leased Spaces

With the issuance of SOP 50 10 8 and the changes it brought to SBA lending, now is a good time to review your internal policies to ensure that when the proposed applicant wishes to purchase, renovate or refinance real property which is or will be leased, that there is no eligibility issue.

First and foremost, developers and landlords who do not actively use or occupy the real property to be purchased, improved or refinanced with loan proceeds, or meet the definition of an Eligible Passive Company, as discussed in 13 CFR §120.111, are not eligible borrowers.  This includes owners who subdivide real property into lots and develop them for resale, those that lease land for the installation of cell phone towers, solar panels, billboards, or wind turbines, and those that are primarily engaged in leasing property for ineligible purposes. Such ineligible purposes include shopping centers, office suites (also known as salon suites), ghost kitchens, and other business models where income is generated by renting space to accommodate independent businesses that provide services directly to the public, unless all of the following apply:

• Revenue is earned through membership dues; and
• The customers do not have an assigned space that they can return to each time they visit; and
• The business is responsible for upkeep and maintenance of the real property, and is supplying the equipment necessary for a fully functioning office/kitchen where customers can drop in and begin working.

If an applicant has a combined business model (i.e. part of revenue earned from membership dues and part earned from rent) then the applicant would not be eligible for SBA-guaranteed financing.

The Eligible Passive Company (“EPC”) Rule is an exception to the prohibition on financing real property that is held for their passive income.  The EPC and the operating company (“OC”) must comply with all of the conditions in 13 CFR §120.111 and each condition is interpreted strictly (also see pages 40 – 45 of SOP 50 10 8). If all conditions are not complied with, the SBA may deny liability on the guaranty if there is a default under the loan.

Lender must also confirm that the SBA’s occupancy requirements, discussed on pages 52 – 55 of SOP 50 10 8, are met.  When loan proceeds are used to purchase or improve real estate, or when debt secured by real estate is refinanced with loan proceeds, the following applies:

• For an existing building, the applicant must occupy 51% of the Rentable Property and may lease to a third party up to 49%; or
• For new construction, the applicant must occupy 60% of the Rentable Property, may permanently lease to a third party up to 20% and temporarily lease an additional 20% with the intention of using some of the additional 20% within 3 years and all of it within 10 years.

When the real estate is owned by an EPC, the following applies:

• The EPC must lease 100% of the Rentable Property to an eligible OC(s).
• For an existing building, the OC(s) must occupy 51% of the Rentable Property and may sublease up to 49%; or
• For new construction, the OC(s) must occupy 60% of the Rentable Property, may permanently sublease to a third party up to 20% and temporarily sublease an additional 20% with the intention of using some of the additional 20% within 3 years and all of it within 10 years.

Rentable Property is defined in SOP  50 10 8 as the total square footage of all buildings or facilities used for business operations excluding stairways, elevators, and mechanical areas and including common areas. Rentable Property may also include exterior space (except parking areas) that is actively used in Borrower’s business operations such as outdoor storage yards for general contractors, trucking companies, and moving and storage companies, or boat slips and docks for marinas.

Lenders should remember that no loan proceeds may be used to improve or renovate any Rentable Property to be subleased to a 3^rd party.  It should also confirm that no real property pledged as collateral or where applicant conducts business is leased or occupied by any business that the applicant knows is engaged in any activity that is illegal under Federal, state or local law or any activity that can reasonably be determined to support or facilitate any activity that can reasonably be determined to support of facilitate any activity that is illegal under Federal, state or local law.

Please remember these lease requirements apply during the life of the loan, not just when the loan closes, so lenders need to have policies in place to ensure compliance with same throughout the life of the loan.  For questions regarding the eligibility of leased spaces, contact the attorneys at Starfield & Smith at 215-542-7070 or email us at info@starfieldsmith.com.