Rural Development Loan Primer for Investors
When people are starting a business or a construction project, one of the biggest problems they face is how hard it is to get financing. USDA Rural Development loans make it easier to get financing for projects in areas with a population of less than 50,000 people. In that regard, rural development loans are another economic development incentive in the rural development toolkit. So, welcome to Bring Back the Bustle, a podcast about revitalizing rural America. I’m Shavon Jones, your host.
Episode Overview: Today we’re going to cover the ins and outs rural development loans: how to get one, what they cost, what we can use them for, how using these loans impacts the amount of money investors need to put in, and how the loans affect our return on that investment.
It’s a lot, and it’s heady. But I do these kinds of episodes so you can understand why an investment in the Rural Fund makes sense—the many ways that the law favors what we are doing and helps us succeed. As you’re listening today, just try to understand the broad concepts—you don’t need to understand this stuff enough to become a practitioner. And then next week, we’ll talk about something less technical and more about our impact on society. I like to alternate between the technical and the cultural and societal topics. But today, let’s talk about money—rural development loans.
Are Rural Development Loans Cheap?
Where do babies come from, I mean, where do RD loans come from? (See you were already going to sleep. I had to wake you back up). Rural development loans don’t come from the government, surprisingly. They come from participating banks—including some banks that aren’t located in rural areas. This is great for us, because it means if you already have a relationship with a lender (who has all that information about and history with you), that lender may be able to make your RD loan.
I used to think RD funding was dirt cheap. It really isn’t, but it’s available if you meet the lending criteria. The cost of this funding and the lending criteria directly impact our ROI. So let’s talk costs and criteria.
Cost: RD loans carry about 3 to 3.5% in loan origination fees and 1/2 percent in annual guarantee fees (almost like PMI—if you had that on your home loan) in addition to the interest rate, which historically runs around 3% but has been a little higher since 2022 when interest rates began to rise on all types of debt. To summarize, you’re looking at 3.5% upfront (which you can add to the principal and finance) + 3.5% each year. So, you’re looking at 7% or so for the loan cost.
Loan Size: In terms of loan size, there aren’t any hard caps, but there are additional admin requirements for loans where the guaranteed portion exceeds $1M. So if the government is going to be on the hook for more than $1M, the bank is required to dig deeper and that means extra red tape. If the guaranteed portion is less than $600K, on the other hand, the review process is somewhat truncated.
Also affecting loan size, are the size of the construction project (loan can be up to 100% of the prospective value) and the borrower’s debt to equity ratio (can’t fall below 4 to 1). So those are some factors that constrain the loan size, but these constraints are different from the hard caps that exist is some other loan programs that we’ll discuss later in the season.
The government’s overall budget for RD loans for for-profit companies in fiscal 2025 is $3.5 billion.
The Red Tape
Let’s talk about red tape.
Rural Development Loan Criteria: Importantly, the government doesn’t guarantee the loan, it guarantees part of the loss. That may sound like splitting hairs, but it’s actually important because it means the bank will lose some money if the loan isn’t fully repaid. And this exposure causes the bank to undertake a normal application review.
The RD statute does have some criteria that may differ from a bank’s usual criteria. I’m not going to get too far into the weeds, but I will point out the parts of the RD statute that relate to us at the Rural Fund:
- RD loans require a jobs analysis. Generally, you need to create jobs. The loan can’t result in substantial job losses nor can it move jobs out of the area to a non-rural location. At the Rural Fund, our projects create jobs in the local area which helps our applications score high.
- When any business gets a loan, it needs equity on its balance sheet. The BS equity requirements are lower for RD loans. This means rural projects qualify for a loan earlier than non-rural projects.
- Plus, we get to use other economic development incentives to meet the reduced Balance Sheet requirements. So, that’s why it is so important to stack incentives. Once you get one, other incentive providers get on board and give you more incentives. Even subordinate debt, so if someone loans us money, we get to use that as equity under certain circumstances.
No Capital Calls: Plus RD loans help us avoid capital calls. What are capital calls? If you’ve invested privately before, your paperwork likely explained the circumstances under which the Fund would ask you for more money—that’s called a capital call. We don’t have capital calls because we can use RD loan proceeds to buy out executive shareholders (not passive shareholders like you, but executive shareholders like me). This matters to you as well, because if I leave (and this is just a hypothetical, because I’m all in. I’m not going anyplace) but if one of the other co-founders leaves, we don’t have to do a capital call to buy them out. We can borrow the money through a RD loan to buy the executive out. So that’s pretty cool for those of you who are familiar with private investing.
Use Restrictions
There are use restrictions on RD loans, apply to us. Plus, there are some things that we can do with an RD loan that we can’t use many other incentives for. We can acquire property with an RD loan. We can also use RD loans for working capital including payroll and inventory. We can refinance most other debt with them. We can use them for construction or for equipment and machinery. So RD loans help fill in gaps in places where we’d otherwise need investor capital.
Now, of course, if we take a loan, the Fund must repay it. Although investors have no personal responsibility for the loan, the Fund’s balance sheet value decreases when we add debt which, in turn, decreases the value of your shares. If you have downloaded our Investor Guide—It’s called “A Investor’s Journey from Entry to Exit” that shows you how the value of shares fluctuates based on the activities of the Fund, such as borrowing.
Is RD Funding Worth the Effort?
So, is RD funding worth the effort. Well, I’ve only scratched the surface of the application process. It’s much more complicated. In fact there’s a scoring system for applications. Even with all the red tape, at the Rural Fund, we compare the cost of RD funding, in both money and time spent navigating the system, to what it costs to raise private capital—because that’s not free either. Raising private capital requires marketing. It requires legal fees to prepare contracts and ensure compliance with the law.
After making the comparison, we conclude that the RD money is worth pursuing, especially since we serve very small communities, and the smaller the community you’re going to serve, the higher your application can score.
Still, RD isn’t the first place to get money due to all the paperwork required and the soft costs that must be incurred to satisfy lending criteria. So, we favor rural development loans for working capital or to pay off construction loans or as an emergency source of funding to avoid capital calls on our investors.
Rural Development Loans in a Nutshell
So, I’ve said a lot. Let’s pull all of that together. Rural development loans, in a nutshell, are lowish-rate, long-term loans (up to 40 year term—I don’t think I mentioned the term earlier) loans with relaxed equity requirements, generous debt to equity ratios, but lots of red tape. They come from private U.S. lenders for projects in rural areas and there’s no cap on how much you can get. And although there are some restrictions on what they can be used for, none of what we do here at the Rural Fund is subject to use restrictions.
There are other government loan programs and we’ll look at some of those and compare them to rural development loans in a later episode. But we think RD loans are worth the effort.
Summary of Incentives and How to Combine Them
Now, we’re in episode 9 of this series. We’ve discussed many topics—some monetary and some cultural and societal. Today was a monetary episode, so let’s go back and recap the incentives we covered so far on the program, because rural development is all about incentives. They make rural revitalization possible because they make it profitable.
The first incentive we discussed is the patriarch of rural incentives—rural opportunity zones that were passed in the OBBBA. That, so far, is our most listened to episode. So I know you guys are aware, but here’s a link to the episode on opportunity zones if you want to listen again. The big benefit of OZs is tax-free appreciation. You get to park your money, let it grow, then take your money out tax free. That’s better than a 401(k) because a 401(k) just defers your taxes until you retire or reach the mandatory withdrawal age.
The second incentive we talked about was HTCs. HTCs basically shift the cost of constructing or rehabbing historic properties from the owner/developer to the taxpayers. HTCs do this by giving us money we can use to pay our federal and state income taxes.
And the third incentive, the one we covered today, rural development loans, is flexible cash that can be used for acquisition, development or even working capital. It has a slightly below-market interest rate although it does have a fee similar to PMI associated with it.
Stacking. So now let’s look at the combined effect of these 3 incentives. We tax professionals call it “stacking” incentives. If you stack rural OZ benefits, HTCs, and rural development loans, here’s what you get.
- You borrow more money than your balance sheet otherwise would support.
- You can use your HTCs to pay income tax on the business you put in newly redeveloped real estate.
- And when the property increases in value (because of the very rehabilitation that you received incentives to do) and when the business you’re running generates profits (a profit which is augmented because you’re not paying taxes on due to the HTCs), you use the OZ rules to get all of that appreciation and profit out—tax free.
Easy peasy. Well, actually it’s a great deal of work, but it’s work that we do for you while you sit back and make tax-free money. That’s why we do this podcast, because without an explanation it would seem too good to be true. So, I explain all the incentives and our location strategy so you can see that even though it’s a great deal it’s also true.
Now, this stuff can be pretty complicated. It’s heady. I realize that. So, that’s enough for today. Next week will do a social topic—one that doesn’t require us to get into the nitty gritty of tax and legal statutes. I love those episodes too, because they get into why we play the game, the positive impact that we can have on peoples lives—while making money. I’m Shavon Jones. I am looking forward to meeting again next Monday, and I hope you are too.
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