On October 11, 2023, USCIS gave guidance on the minimum investment timeframe for new EB-5 investors. Their interpretation of the EB-5 Reform and Integrity Act of 2022 (RIA) is not yet in the USCIS Policy Manual and may get challenged in court as there are regional centers that’re trying to lobby against this provision. However, it is fueling high hopes of fast EB-5 capital repayments as some Regional Centers are promising to now repay new EB-5 investors in 2 or 3 years.
As transparency is a core value at Houston EB5, we would like to explain how high interest rates affect investment returns and timelines. We will also demonstrate how quick capital repayment on projects can be feasible at lower interest rates but may no longer be realistic in a high interest environment by introducing basic real estate investment concepts.
How Interest Rates affect Capital Repayment
A project’s ability to return EB-5 capital depends on a liquidity event. The developer must either sell or refinance the asset to generate the necessary cash to retire its repayment obligations to the EB-5 investors.
The feasibility of these capital events is highly dependent on the movement of interest rates. The average commercial real estate loan rate is about 9% at the time writing of this article in mid-January 2024. High interest rates have a huge negative impact on real estate sales, development, and capital markets activity (i.e., refinances).
If you live in the United States, you may have observed that new construction activity has slowed down significantly; this is largely due to high interest rates.
Refinancing of projects also becomes more difficult as the cost of borrowing increases. A project’s cash flow may no longer cover the increased debt service at higher interest rates caused by a refinance.
A purchaser of an asset likely needs a senior loan to help fund the purchase. With high interest rates, the cost of borrowing money to purchase or develop properties increases. Since the expected cash-flows from properties do not increase proportionally to the high interest rates, returns on investment (ROIs) decrease and investors hold off from taking on new projects. This decrease in demand in turn depresses prices, which causes sellers to wait for rates to fall in hopes of achieving a sales price that would enable the repayment of EB-5 funds.
Key Real Estate Concepts
In order to evaluate whether a high interest rate environment is favorable for a quick repayment of EB-5 funds, we need to introduce a few basic real estate investment concepts.
Net Operating Income (NOI): NOI represents the income a project generates from operations, minus all operating expenses (revenues from rent, fees, and other sources). It excludes capital expenditures, debt service, and income taxes.
The formula for NOI is:
NOI = Gross Operating Income – Operating Expenses
The NOI is crucial for evaluating a project’s profitability, value, and potential return on investment.
Going-In CAP Rate (Going-In CAP): Going-In CAP Rates represents the yield on the cost of a project resulting from its NOI divided by the cost to construct the project.
The formula for Going-In CAP is:
Going-In CAP = NOI / Cost of the Project
The Going-In CAP is crucial for evaluating a project’s profitability when considering the cost of constructing an asset and the future value of a refinance/sale.
Exit Capitalization Ratio (Exit CAP Rate): Exit CAP Rates represents the yield on a project resulting from its NOI divided by the future value of a refinance/sale of the project.
The formula for Cap Rate is:
Exit CAP Rate = NOI / Target Refinance or Sale Value
Exit CAP Rates allow developers to estimate a property’s future value based on income. A higher CAP Rate typically indicates a higher potential return or a less valuable asset.
Developer Spread: Developer Spread represents the profitability of a project resulting from the difference in the Going-In CAP Rate minus the Exit CAP Rate.
The formula for Developer Spread is:
Developer Spread = Going-In CAP Rate – Exit CAP Rate
A larger Developer Spread signifies a larger profit margin for the project. This is a key metric for developers when evaluating whether to exercise a sale of the project when considering the cost of constructing the asset.
Debt Service Coverage Ratio (DSCR): DSCR represents a project’s ability to cover its debt-service requirements.
The formula for DSCR is:
DSCR = NOI / Total Debt Service (DS)
Commercial lenders use this critical tool to evaluate a borrower’s ability to cover its loan payments. A DSCR of less than 1.0 means insufficient cash flow to cover debt service. Most banks in the US require a DSCR of 1.3 to issue a loan.
Let’s Use an Example
So, let’s go back to the question, “Can we expect a refinance or sale of an EB-5 project at today’s commercial loan interest rates?” The short answer is NO.
We will use a hypothetical example to illustrate our answer using the following assumptions:
- A hotel or a multi-family residential project that generates cashflows from rent.
- Cost of the Project – $100 million
- Net Operating Income (NOI)- $6.5 million
- Going-In CAP Rate (Going-In CAP)- 6.5%
- Debt Service Coverage Ratio (DSCR)- 1.3
- Capital stack:
- $30M – EB5 Loan
- $20M – Developer Equity
Is Refinancing Realistic?
Most EB-5 projects have a senior construction loan from a bank and equity from the developer alongside the EB-5 debt. No Senior Lender will allow a Junior Lender (EB-5 Debt) to be repaid before them.
Therefore, a Developer would have to use the funds from a refinance to retire the Senior Loan first before retiring the EB-5 debt. Using the example’s assumptions from above, the Developer needs to retire the $50 million Senior loan first or at the same time as the $30 million EB-5 Loan. Therefore, this example would necessitate that $80 million in refinance proceeds are available to first retire the Senior debt and then the EB-5 debt.
In order for the refinance lender to fund the loan, the Developer must show enough NOI to cover its new debt service for the $80 million loan. In other words, the project needs to have a healthy Debt Service Coverage Ratio (DSCR). The bank will not lend the funds unless the project can cover its finance costs by a reasonable margin.
Banks will typically require a minimum DSCR of about 1.3 to refinance a project. Since multi-family and hotel projects are operational businesses, this will be an unlikely metric to achieve in the first year of operations. It typically takes 2-3 years to achieve a 1.3 DSCR for a healthy project.
For the sake of the argument, let’s assume payment of interest only during the life of the loan and a balloon payment at the end. If so, the debt service (DS) will be the cost of interest only.
As you can see below, a bank refinance will not happen at a 9% interest rate. At a 9% rate, the yearly interest cost of $80 million is $7.2 million. Therefore, the DSCR will only be only 0.9, which is way below the minimum 1.3 that a bank normally requires.
$6.5 million NOI / $7.2 million Total Debt Service = 0.9 DSCR
For a refinance to occur at the 1.3 DSCR, the maximum interest payment on an $80 million refinance will have to be $ 5.0 million. This could only happen with a commercial interest rate of 6.25% or lower.
NOI / DSCR = DS
$6.5 million NOI / 1.3 DSCR = $5.0 million Total Debt Service
$5.0 million Total Debt Service / $80 million Loan = 6.25% Interest Rate
To give a perspective of how much interest rate movements impact a project’s cash-flows and likelihood of meeting its debt obligations. If Interest Rates decreased to that which they were 2 years ago of 5%, the interest cost of $80 million would be $4 million. The project would have a much healthier DSCR and would be in a secure position.
$6.5 million NOI / $4 million Total Debt Service = 1.625 DSCR
There is no indication that such a dramatic drop in interest rates could happen in the future. Therefore, the project would need to substantially increase the NOI through increased revenues and decreased expenses to be able to receive the refinance loan and cover its new debt service.
Is Selling the EB-5 Project Realistic?
As previously mentioned, high interest rates make the cost of borrowing more expensive. When interest rates rise, the increased borrowing cost directly reduces the purchasing power of investors and the affordability of the asset. This depresses the demand for real estate and in turn lowers overall prices.
Inversely, when interest rates decline, the cost of borrowing declines, which increases the purchasing power of investors, thereby increasing demand for assets, which pushes real estate prices higher.
From another perspective, increases in interest rates cause a decline in a project’s value, or increases the CAP Rate. Vice versa, decreases in the interest rates increase a project’s value, or decreases the CAP Rate. To summarize, interest rates and CAP Rates are directly correlated.
When evaluating whether to sell or hold an asset, a developer uses the difference of the Going-In CAP Rate and the Exit CAP Rate, otherwise known as the Developer Spread. The correlation between Going-In CAP and Exit CAP is crucial for determining the investment’s profitability. For the developer to profit from the project, the Going-In CAP Rate needs to be higher than the Exit CAP Rate. In other words, the project needs to cost less to construct it than the amount that it could sell for. An inversion occurs when the Going-In CAP Rate is less than the Exit CAP Rate, meaning the project costs more to construct than it could be sold for. According to a 2023 CBRE report, “an inversion or parity between cap rates has occurred in some markets, such as Chicago, New York, Phoenix, Seattle and Washington, DC”. An inversion signifies dark times ahead and a strong likelihood of a loss for the developer.
The larger the Developer Spread, the more likely a developer is to exercise a sale as the profit margin is larger. The minimum acceptable difference varies among developers, however, a common approach is to seek a Developer Spread of at least 1-2%. For example, if the Going-In CAP is 6%, a developer would likely not entertain a sale unless the CAP Rate is at most in the 4-5% range.
So, let’s take another look at the example above to evaluate how CAP Rates are correlated to the interest rate and consequently the likelihood of a sale.
In the example above, the Going-In CAP is 6.5% and the Exit CAP Rate is 6%.
$108,333,333 Target Sale Price = $6,500,000 NOI / 6% Exit CAP Rate
0.5% Developer Spread = 6.5% Going-In CAP – 6% Exit CAP Rate
$8,333,333 Profit = $108,333,333 Sale Price – $100,000,000 Cost
40% ROI = $8,333,333 Profit / $20,000,000 Developer Equity
This Developer Spread of 0.5% would barely be attractive for the Developer in this scenario. According to a 2023 CBRE report, “The spread between going-in and exit cap rates fell to [.15%] at the end of Q3 – the smallest spread since CBRE began a quarterly survey of its investment professional in 2014”. Knowing that the market averages for the Developer Spread have been compressed to historic lows, let’s evaluate a sale given current market conditions.
0.15% Developer Spread = 6.5% Going-In CAP – 6.35% Exit CAP Rate
$102,362,204 Target Sale Price = $6,500,000 NOI / 6.35% Exit CAP Rate
$2,362,204 Profit = $102,362,204 Sale Price – $100,000,000 Cost
11% ROI = $2,362,204 Profit / $20,000,000 Developer Equity
As you can see above, increases to the Exit CAP Rates have significantly reduced profits due to the increased interest rates. What could the developer have sold the property for when interest rates were lower, assuming a Developer Spread of 2%?
2% Developer Spread = 6.5% Going-In CAP – 4.5% Exit CAP Rate
$144,444,444 Target Sale Price = $6,500,000 NOI / 4.5% Exit CAP Rate
$44,444,444 Profit = $144,444,444 Sale Price – $100,000,000 Cost
220% ROI = $44,444,444 Profit / $20,000,000 Developer Equity
Granted that CAP rates have been increasing in correlation to the interest rate hikes over the last few years, the interest rates would need to decrease substantially to put downward pressure on the CAP rates to enable such a sale.
Therefore, the developer would likely choose to hold the asset until interest rates decrease, which in turn would decrease the CAP Rate leading to a higher Target Sale Price and larger Developer Spread.
Key Takeaways
Many Regional Centers are enticing EB-5 prospects on the hopes of having a quicker repayment of EB-5 funds. However, many Regional Centers and EB-5 investors do not have a solid understanding of how much interest rate movements impact liquidity events like a sale or refinance.
Unless interest rates drop significantly over the next few years, it’s likely that the developer will delay any liquidity event like a sale or refinance and will keep the EB-5 funds invested in the project.
HOUSTON EB5
At Houston EB5, we are a vertically integrated regional center and developer. We have a 100% success rate in project I-526 and I-829 approvals for over a decade. We have also maintained 100% success repaying EB-5 investments in full.
We choose to not profit as a regional center but rather aim to profit as a developer on the back-end of projects. However, in order for us to do that, we must fully repay EB-5 capital in each project before we can cash out as developers.
We always place EB-5 capital and its interests above our own. This is why we’ve had a 100% success rate in repayment of EB-5 funds. This is an accomplishment that only the gold-standard of regional centers can proudly stand-by.
