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Evaluating an EB-5 Project’s Source of Capital

For foreigners pursuing an EB-5 visa through a regional center, the investment process may seem mechanical, but deciding on an investment goes beyond immigration qualifications and compliance with relevant laws. Investors should scrutinize if the investment not only secures permanent residency but also ensures a high likelihood for repayment of their capital.

EB-5 investments are changing, and this shift is driven in large part by savvy investors and a poor reputation for regional centers not repaying EB-5 capital in full. Investors no longer just focus on meeting job creation and immigration requirements; they now examine a project’s capital stack for the likelihood of repayment and potential for success. Understanding a project’s financial structuring is key for applicants to predict how their investment will fare, helping them make informed decisions and protecting their capital.

What is a Capital Stack?

In the world of real estate and finance, a capital stack (or structure) refers to the different contributions of equity and/or debt in a project and the respective priorities for payment.

Historically, there have been four main types of capital contributions: Senior Debt, Mezzanine Debt, Preferred Equity, and Common Equity. Traditionally, EB-5 capital has been deployed to projects as a form of Mezzanine Debt; however, more projects in the market are beginning to offer different types of EB-5 investments through Senior Debt, Preferred/Common Equity, or a combination of the above.

Each form of capital has its own advantages and disadvantages. Understanding the hierarchy and risks associated with each type is crucial. Let’s break each of these down.

Senior Debt

Positioned at the bottom of the stack, EB-5 senior debt holders have the highest priority for payment, ensuring they are first in line to be paid interest/dividends as well as the first source of capital to be repaid through a refinance or sale.

Senior Debt positions typically account for 50-60% of a project’s cost and earn significantly less than the other forms of capital as they are less risky regarding payment priority. While the dividend is limited to the agreed-upon interest rate, the security can be reinforced by a first-lien mortgage on real property or through a repayment guarantee (personal or corporate), minimizing loss of capital in the event of a default.

However, in the event that the senior EB-5 loan is secured by the real estate, it’s worth noting that often the value of said real estate is much less than the total EB-5 capitalization unless the project is fully developed. Also, it’s worth noting that a project is not financially more viable or less risky just because the EB-5 capital is the senior debt.

EB-5 prospects should always gauge the degree of sunk-financing costs within a project. This figure can be easily calculated by subtracting the dividend paid to the EB-5 investor from the rate at which the capital is charged to the project/developer. Then, multiply this delta by the total EB-5 capital invested in the project to yield the degree of sunk-financing cost that a third-party regional center is burdening a project with.

Projects with poor structures and high sunk-financing costs can still be successful in strong economic conditions; however, they are usually the first projects to fail if they deliver in an unfavorable economy.

A question to ponder is why is the developer seeking EB-5 capital as a senior loan? The answer might lie in the fact that a traditional bank/financier is unwilling to finance the project for a variety of reasons.

Mezzanine Debt

Above senior debt is EB-5 mezzanine debt, offering higher potential returns but also increased risks. Mezzanine debt holders are subordinate to senior debt with regards to payment priority, and their security is typically a pledge of ownership interests if the note defaults, not real property.

In case of foreclosure due to the developer’s failure to pay the mezzanine debt interest payments or principal when due, mezzanine lenders face the challenge of operating the business, making it riskier than senior debt. Usually, mezzanine debt can account for 25-40% of a project’s capital stack.

Most EB-5 debt offerings involve mezzanine financing; however, EB-5 mezzanine loans differ vastly from traditional mezzanine debt. As mentioned above, mezzanine lenders can take over a developer’s equity shares if the mezzanine loan is in default (failure of the developer to pay interest or the principal balance when due).

Most mezzanine financiers have extensive experience in real estate and finance, and are therefore prepared to take over a project to bring it to fruition and a point of profitability. This can only be done if the language in the intercreditor agreement permits it.

An intercreditor agreement is a legal document outlining the payment/satisfaction of debt priorities across multiple loans in a project. Most EB-5 debt offerings do not contain intercreditor agreements. If there is no such agreement, then virtually no senior lender would allow for the mezzanine lender to take over the equity shares of a developer, especially if the senior note is in good standing.

In the seldom occasion that there is an intercreditor agreement in an EB-5 offering, most regional centers do not have any experience in developing real estate and are incapable of taking over a project and bringing it to a profitable point to protect the EB-5 capital. Also, taking over the equity shares from a developer can be an expensive and drawn-out legal process.

That being said, regional centers often will extend the term of the EB-5 mezzanine debt to allow the developer more time to stabilize a project. This has two benefits for a regional center; they’ll earn higher interest rates since the EB-5 loan is now in default and the regional center avoids an expensive legal process that might not work out in their favor.

A question to ask third-party regional centers is whether the increased default interest rate is shared with the EB-5 investors as additional compensation for an extended investment timeline. If not, there is a moral hazard present, as the regional center profits more the longer the EB-5 capital is extended to the project.

As previously mentioned in the senior debt section, EB-5 investors should inquire about the level of sunk-financing costs the regional center is imposing on the project.

Preferred Equity

Placed above mezzanine debt but below common equity, EB-5 preferred equity offers investors higher returns than debt instruments and a priority of payment compared to common equity after satisfying debt obligations. Preferred equity is typically the first partner/member to receive distributions from a project as their equity contribution is in an elevated or preferred position.

The returns are usually locked at a certain percentage of their original investment, i.e. 4%. The preferred returns must be paid out to the partners before the common equity can receive distributions. In the same manner, the preferred equity capital is first to be repaid before the common equity capital.

Most preferred equity investments are accrued (or deferred) until the project is cash-flowing positive. This is to say that preferred equity does not burden a project with high sunk-financing costs, as the returns are paid when the project is in a viable position to make distributions. This can strongly position a development to have financial success by avoiding costly burdens on its cashflows and give it more flexibility and room to be successful.

Common Equity

At the top of the capital stack is EB-5 common equity, offering the highest potential return. All other debt obligations or preferred equity commitments must be satisfied before common equity investors receive a dividend or share of profits. In other words, common equity investors are last in line to be paid both dividends and their original capital, but they stand to gain significantly if the project performs well.

There are usually different classes/shares of common equity between a project’s partners, so the terms of the profit-sharing and capital repayment vary widely. Reviewing the offering documents carefully is important to understand the priority for dividend and capital repayment.

Understanding Equity and Debt

Understanding the dynamics of your investment model is crucial, especially considering the potential risks and returns. One key aspect to assess is the equity cushion within the project.

Knowing the amount of equity in the project is vital because it serves as a safety net for EB-5 capital ahead of the equity in the project.

In a worst-case scenario where the project sells for less than anticipated, having a substantial equity cushion provides a protective measure for investors who selected an EB-5 debt or preferred equity investment as they must first be repaid before the equity partner; in other words, the equity in a project is the first form of capital to incur a loss.. However, it’s not just about having high equity; the debt cost must also be considered.

Evaluating the financing cost of the project is equally important. If the total sunk financing costs, including debt, exceed the equity, it can significantly impact the overall viability of the investment. Striking the right balance between high equity and low sunk financing costs is ideal, but it’s crucial to recognize that lower financing costs can offset a lower equity amount over a project’s duration. This consideration is significant because sunk financing costs cannot be recovered.

Investors should also investigate the project’s specifics, including the actual cost of acquiring the land. Requesting the deed or purchasing agreement, along with a balance sheet from the development company, can provide valuable insights.

Developers may sometimes present the land value based on the future development, which can differ from the actual purchase price. Therefore, understanding the genuine acquisition cost of the land is essential for a comprehensive evaluation of the real equity invested in the project.

In conclusion, EB-5 investors should not only focus on immigration requirements but also assess their investments’ repayment and profitability potential. Seeking guidance from immigration and financial advisors will provide a comprehensive evaluation of whether an investment aligns with an investor’s goals, considering the diverse outcomes associated with each type of investment in the capital stack.