It's no secret that small businesses in the U.S. face difficulties accessing credit. According to a survey of a random sample of 751 small businesses conducted by Gallup at the end of 2009 for the National Federation of Independent Business Research Foundation, 44% of small businesses seeking credit in 2009 received only some or none of the money they sought. This level of credit access compares poorly with mid-2000, when nine of every 10 companies seeking credit received it.
While there is broad agreement that a small business credit problem exists, there is less consensus about its causes. As a result, formulating viable solutions has proved difficult.
Although many factors are contributing to current credit problems, one that is under-appreciated is the degree to which small business credit is linked to difficulties in the commercial and residential real estate markets.
Real Estate Plays an Important Role in Small Business Lending
Falling real estate prices impinge on the ability of small employers to borrow the money they need to fund their operations because small businesses use real estate to obtain credit in a variety of ways. According to the NFIB study, 21% of small employers have mortgaged real estate for business purposes and 11% use real estate as collateral for other business assets.
Moreover, according to the NFIB, during the period of easy credit, some small business owners obtained loans by using real estate whose value turned out to be inflated. As a result, the owners were able to borrow more than their credit, and perhaps their businesses, could support. When real estate prices fell, the value of the collateral pledged against these loans dropped, and some these loans could no longer be supported. In fact, 13% of small business owners have a property that is under water, according to the NFIB survey.
Falling real estate prices also have weakened small business balance sheets and made them less creditworthy borrowers. Lenders have responded to the worsened financials by cutting back on credit to small businesses. Thus, even when small businesses seek loans to pursue promising business opportunities, their weakened balance sheets mean fewer of them can borrow than when credit was easier.
Personal Borrowing Is a Big Part of Small Business Finance
To obtain capital to finance their business operations, many small business owners make use of their personal credit. Analysis of the Federal Reserve Survey of Consumer Finances shows that 18% of business-owning households used personal assets to guarantee or collateralize business debt.
Homes are the main assets that small business owners can pledge to obtain loans, making residential real estate an important source of small business finance. According to the NFIB's report, Small Business Credit in a Deep Recession, 16% of small employers use a residential mortgage to finance a business and 6% use their homes to collateralize business assets.
During the home equity lending boom, small business owners were disproportionate users of these loans. According to an analysis of the Federal Reserve Survey of Consumer Finances, the share of self-employed with home equity debt increased 182% from 1989 to 2007, compared with only 121% among those employed by others. Moreover, the median value of home equity debt increased 48% among the self-employed from 1989 to 2007 but shrank 29% among those employed by others over the same period.
Because home values account for a large portion of the value of household assets, declining home prices reduce the amount of personal credit that small employers can obtain. As Federal Reserve Board Governor Elizabeth Duke explained in recent Congressional testimony, "With declines in house prices since 2006 and consequent weakened household balance sheets, the ability of many small business owners to borrow has likely been impaired."
In some cases, homes are no longer an asset against which small business owners can borrow at all. The NFIB reports that 9% of small business owners are underwater on their home mortgages.
Small Business Lenders Have Heavy Real Estate Exposure
Many banks are suffering from heavy exposure to nonperforming real estate loans that have weakened their financial positions. Unfortunately, small business borrowing is relatively concentrated in the banks with the highest exposure to bad real estate loans. According to the February 2010 Congressional Oversight Panel report Commercial Real Estate Losses and the Risk to Financial Stability, "smaller banks with the highest exposure—commercial real estate loans in excess of three times Tier 1 capital—provide around 40% of all small business loans." The heavy exposure of small business lenders to bad real estate loans makes Federal Reserve Bank of Atlanta research economists pessimistic about the "near-term outlook for growth in small business borrowing," as they wrote in a December blog post.
Moreover, a vicious cycle has now emerged in small business credit. As the Congressional Oversight Panel report explains, declining real estate values hinder small business borrowing. The inability to borrow causes more small businesses to fail. The higher failure rate, in turn, results in vacancies that reduce real estate values.
Given the reliance of small business owners on commercial and residential real estate values to finance their businesses and the high exposure of their primary lenders to bad real estate loans, it's difficult to see how small business credit problems can be resolved without a fix to the real estate problems plaguing this country.
Because small business capital investment and hiring depend, in part, on their access to credit, the real estate-induced drag on small business credit has led to the depressed hiring and investment plans reported by small business owners in recent surveys. Given the role that small business has played in stimulating economic recoveries historically, that's bad news for all of us.