© Reuters. FILE PHOTO: Shoppers make their way through Fashion Centre at Pentagon City, decorated for the holidays, in Arlington, Virginia, U.S. December 23, 2019. REUTERS/Jonathan Ernst/File Photo

By Timothy Aeppel

(Reuters) – After Ron Hall took out a $407,000 Small Business Administration loan last year to open a franchised sandwich shop in his hometown in Tennessee, business boomed.

He hired 15 employees and even snapped up a used Honda (NYSE:) CR-V that he covered in his store’s logos to sell sandwiches in the parking lots of local factories during lunch hours. Early on, the 49-year-old father of two said he was seeing $3,000 a day in total sales.

But monthly payments on his SBA loan, which carried a 7% interest rate in May 2022, snowballed by almost $1,000 a month to $6,000 as the rate rose to more than 11% over the past year, in step with aggressive Federal Reserve rate hikes to tame high inflation.

Other financial pressures bore down. The price of lettuce and french fries surged, he said, and his mostly working-class clientele, struggling with higher grocery and fuel prices, cut back on eating out. Daily sales now seldom exceed $1,100 and Hall has cut his workforce to seven.

“It feels like everything went sideways,” he said.

That sentiment seems to be shared by many U.S. small businesses. A recent survey of its members by the small business networking group Alignable found that 58% said they were being hurt by high interest rates – up from 45% who said so in June. In a follow-up question, 24% said paying back SBA loans or securing new ones from the government agency has become much harder.

Higher rates add to other headwinds. The effects of the inflationary surge hampered most businesses, regardless of size. Smaller companies, however, are more vulnerable because they often lack the leverage of bigger firms to pass along higher costs to consumers.

VULNERABILITIES

The good news is that inflation has been slowing, which should eventually bring relief on borrowing costs. The Fed held interest rates steady at the end of a policy meeting last week, with officials flagging plans to start gradually cutting borrowing costs in 2024. The U.S. central bank’s actions have boosted optimism about a “soft landing” in which inflation continues to slope down to the Fed’s 2% target without a sharp rise in unemployment or a contraction in economic activity.

“The economy has been doing reasonably well – so many of these small businesses are still cash-flow positive,” said Thomas Simons, senior U.S. economist at Jefferies. “But the environment overall isn’t really conducive to expansion or hiring.”

Simons said conditions were ripe for small startups in 2020 and 2021, with interest rates low and a surge of demand for some goods as the COVID-19 pandemic struck. “Now, with rates much higher, that doesn’t seem to be the case,” he said.

The SBA said loan defaults, after falling sharply as a result of pandemic relief programs, are rising but are still lower than they were before the start of the pandemic.

There is no evidence yet that smaller employers are cutting lots of jobs, Simons added, although for some time he has been flagging small businesses with floating-rate SBA loans as increasingly vulnerable on that front. According to the U.S. Department of Labor, U.S. job growth accelerated last month, and the unemployment rate fell two-tenths of a percentage point to 3.7% – signs of underlying labor market strength.

The surge in interest rates, meanwhile, hasn’t prompted a rash of bankruptcies. Data compiled by the American Bankruptcy Institute (ABI) on the type of bankruptcies declared by small companies shows these filings have edged up over the past year, said Soneet Kapila, ABI’s current president, “but the main cause may be a combination of general economic pressure from poor business performance,” not interest rate pressures.

There are signs cost pressures are limiting growth. The same survey of small businesses by Alignable that found companies felt burned by higher interest rates also showed constraints on hiring, with 58% of respondents saying they couldn’t afford to hire the employees they need. That’s up 14 percentage points from October, and is 8 percentage points higher than in September.

TAKING A GAMBLE

J.B. Brown, the CEO of BCI Solutions, a metal foundry in Bremen, Indiana, watched his business surge during the pandemic. But demand has cooled in the past year.

Although Brown still needs to add workers with advanced technical skills, he has enough basic production workers to meet the softened demand. The challenge is mounting costs. He estimates wages are up 35% compared to before the pandemic, and the cost of his property and liability insurance policy just doubled.

Still, he’s gambling on the future: In an uncharacteristic move for a conservative family-owned business, Brown just took out a $7 million bank loan to buy a new machine.

“We’ve pulled out of improvements and expansions in the past because it seems like whenever you’re getting ready to do it, the economy tanks,” he said. “But then we always look back and say: ‘We should’ve done it anyway.'” The new machine, however, will produce twice the output of the two older machines it is replacing while requiring half the number of workers to operate, he noted.

Brown’s decision cuts against the larger trend. This type of fixed business investment has been weak in recent quarters, putting a drag on otherwise strong GDP growth. Fed Chair Jerome Powell noted last week that high interest rates have curbed this type of spending.

Brown said higher rates are a challenge but added that “it’s time to invest.”

Hall, the owner of the sandwich shop in Harrogate, Tennessee, has a gloomier view. He just managed to get his bank to issue a home equity loan that will replace his SBA loan with an interest rate closer to his original 7%.

He once dreamed of opening a second shop but has dropped that idea, and now regrets getting into the business at all.

“If I could find a way to sell it, I would do it in a heartbeat,” he said.