By Michael Gibson
Developers have and are increasingly using EB-5 funding for new projects. The flexibility, economic terms (i.e. interest rate, repayment terms) and general credit terms (i.e. conditions to funding and covenants) make EB-5 proceeds an attractive alternative to almost all other sources of capital for certain projects.
A report by the NYU Stern School of Business1 indicates that EB-5 capital for most projects is deployed as a loan to the project, rather than as an equity investment in the project. The report adds this trend has been consistent over the years.
Usually, EB-5 capital serves as what developers call “subordinate financing”. Subordinate financing is a loan that is subject to the rights of the senior loan on a project in terms of payment and rights to collateral following a default. Subordinate financing typically is structured as a “mezzanine loan” in EB-5 projects, a mezzanine loan is secured by a pledge of the ownership interests in the entity that owns the real property on which a project is constructed (it is not a pledge of the real estate itself but rather only of the entity that owns the real estate). As a general example, a developer typically is required to contribute as equity approximately 20 percent of the total cost of the project. Another 50 percent of the project cost typically comes from a construction loan secured by the real estate —the senior loan. The remaining 30 percent of the project’s cost is funded by a mezzanine loan. Following a default by the developer, the senior lender can foreclose on the real estate and become the owner of the property and a mezzanine lender can foreclose on the pledged ownership interest and own and control the entity that owns the real estate. Given the overlapping interest in the real estate that each lender has, the lenders often enter into an intercreditor agreement to govern their rights with respect to the real estate.
WHAT TYPE OF INVESTMENT DO INVESTORS PREFER?
Mezzanine financing (think of it as a hybrid of debt and equity financing) gives the lender the right to obtain an ownership or equity interest in the company that owns the real estate of the project in case of a developer default. As noted above, the mezzanine lender’s right to obtain this ownership interest is subject to the rights of the senior lender and is often governed by an intercreditor agreement which limits the mezzanine lender’s rights as to time and manner of exercising remedies.
“There are a handful of projects that have senior loans, but generally investors go the mezzanine route for bigger projects,” said Eric Orenstein, attorney at Rosenberg & Estis, P.C.
However, Chris Foulger, vice president at HomeFed Corporation, says as more Chinese investors are educating themselves, “many are showing a strong preference for senior loans.”
“There is still a strong preference for (mezzanine loans) in New York deals followed by other major gateway cities, (but the Chinese) have yet to recognize that a very safe deal in Omaha is better than a risky deal in New York,” he said.
John Shen, CEO and founder of Regional Centers Holding Group, agrees with Foulger, stating that although most investors chose the mezzanine route, “knowledgeable EB-5 investors worldwide prefer senior loans because their main goal is to obtain a U.S. Green Card, therefore getting the investment principal repaid back as the immigration process is done seems to be more important than achieving a higher return.“
“Investors typically do not receive a return high enough to offset the risk brought in by mezzanine loans,” Shen said.
If available as an investment, a senior loan certainly provides an investor with greater certainty of repayment on its initial investment. Given the greater risk profile of mezzanine financing, mezzanine loans obtained from a bank or another traditional lender typically charge an interest rate of up to 15 percent for a mezzanine loan. But because of the immigration purpose of an EB-5 investment, EB-5 investors taking mezzanine loan risk often obtain a return that reflects an interest rate between 1 and 3 percent.
A senior loan is a debt financing obligation issued by a bank or similar financial institution to a company or individual that is secured by a first lien on the borrower's assets, such lien and payment rights of the senior loan are superior to all other debt obligations of borrower or the related project. The senior lender structures all projects to maximize its chance of getting repaid in full, often to the detriment of the mezzanine lender and all other parties in the capital stack. The loan is considered senior to all other claims against the borrower, which means that in a distressed situation, the senior bank loan is the first to be repaid before all other interested parties receive repayment.
Because senior bank loans are usually secured via a lien against the assets of the borrower, if the borrower defaults on its obligations, the assets used to secure the senior bank loan may be sold to repay the senior bank loan in full before other creditors, preferred stockholders or common stockholders receive any proceeds or payments from the project.
Shen said taking out a senior loan provides the best loss protection for the loan capital in both bankruptcy and liquidation of the collateral. If EB-5 funds become part of a senior loan, with a strong commercial underwriting guideline in place, the risk of losing the investment principal is reduced significantly.
“However, with many commercial banking competitors in the market, EB-5 operators typically have a hard time to become a senior loan lender,” he said. “That position usually belongs to a commercial bank.”
Eb-5 capital is not as suited to a senior loan position as the interest rates of senior lenders are more competitive with the interest rates of EB-5 loans and senior loans are distributed in construction draws which often require a construction management infrastructure that most EB-5 lenders do not possess.
THE ROLE OF REGIONAL CENTERS AND EB-5 LOANS
In 1992, a type of investment possibility was added to the EB-5 visa program involving regional centers that could initiate investment projects, allowing individuals to invest $500,000, not a million.
Instead of investing directly into the project, the regional center sets up an investment fund for the benefit of the EB-5 investors. Investors purchase equity stakes in the investment fund. Then, the fund either purchases equity in the job creating entity or loans the job creating entity money. The job creating entity then uses the investment from the fund in the project to create jobs indirectly.
Regional centers are best for EB-5 applicants who are more concerned with obtaining residency status rather than directly managing an investment on their own.
There are currently more than 850 United States Citizenship and Immigration Services-approved EB-5 regional centers in operation across the United States, with more being approved regularly. This is a sharp increase from the less than 100 regional centers that operated in 2010.
Regional centers can receive funding from multiple EB-5 investors, so long as each investor's investment creates 10 full-time jobs, which can enable them to accumulate more capital for their projects. Regional centers are also permitted to operate multiple EB-5 projects simultaneously.
However, the way in which an area is determined to be suitable for a EB-5 regional center had a few loopholes, leading to some of the more recent scandalous abuses of the program, such as the fact that money from the EB-5 program has gone to fund prime properties in Manhattan and Beverly Hills, or more recently in Florida, than the poor and impoverished areas that this type of investment was supposed to improve.
“I advise all investors to check the reputation of the regional center that is raising the money,” said Eric Orenstein, attorney at Rosenberg & Estis, P.C., which represents two regional centers. “Ask if they had any projects completed. It may seem obvious, but you will be surprised (at what you will find).”
CHALLENGES IN THE LOAN INDUSTRY
Whether by way of a senior or mezzanine loan, developers need capital, and that capital has become more and more difficult to source from China due to the impact of retrogression.
“In an environment where it is more difficult to find investors to whom the EB-5 investment appeals to their needs, the competition goes up and the cost of finding investors goes up,” said John Tishler, a partner at Sheppard Mullin Richter & Hampton LLP. “This has led to a market where credit quality is more sought after, and we are seeing that effect.” The smaller pool of available investors are demanding investments that are structured in a manner more typically seen in the traditional capital markets to protect EB-5 investors. This tightening of the marketplace may have an impact on EB-5 loan terms (including an increase in interest rates charged) in the near term.
In addition, the growing number of EB-5 lenders (including EB-5 lenders that are also the borrowers on their own projects), has changed the EB-5 marketplace.
The NYU report discovered several major developers have formed lending vehicles to make real estate development loans, including mezzanine loans, to fund construction of projects by unrelated developers. Some of these developer lenders include developers that seek EB-5 financing for their own projects.
Orenstein said nearly all EB-5 investors – especially those from China – should receive a tutorial on both the senior and mezzanine loan aspects because they “are somewhat foreign to overseas investors.”
“They’re not used to these structures,” said Orenstein. “Although the concept of senior loans has been around since Colonial times, in the Asian world – certainly in China and India - they don’t have these structures.”
Despite rumors of its demise, Shen says the perception of EB-5 as alternative financing has not changed.
“EB-5 funds continue to be treated as a secondary option to either fill the last budget gap or to fund projects that have a hard time to secure any primary bank financing,” he said.
EB-5 loans will continue to be appealing to both investors and developers if properly structured and competitive in terms of cost to other forms of financing. An EB-5 investor should understand what type of loan his or her investment is being structured as to understand what happens in a distressed situation at a project and to determine whether the investor is being adequately compensated for the capital at risk. An educated investor can invest in a project that is right for them in terms of economic return and risk profile and, although no outcomes are guaranteed, at least an investor will have made an educated, affirmative decision based on understanding a project in connection with his or her investment.