Buch the Trend — A Commercial Real Estate Blog
EB-5: A Thing of the Past and a Warning for the Future
EB-5 has been deployed extensively over the past decade as foreign capital lined up to procure US visas for a cool $500,000. The program was meant to spur development and the associated job creation in the U.S. for a variety of projects, but instead has led to aggravation for many developers and the EB-5 investors themselves. It is now very challenging to raise a substantial amount of EB-5 capital due to the complex challenges it has caused on both sides of the transaction.
For developers, EB-5 capital looked to be a cheap alternative to traditional mezz capital, similar to the PACE financing mentioned in the previous article. Interest rates, however, are only one part of the picture to consider when obtaining financing. Very often, our clients are focused on rate and points because economics are easily comparable between two different offers. However, funding structure, prepayment flexibility, security interests, covenants, stipulations and other terms are really what differentiate financing offers.
For example, if I lend you $20 million dollars at 6% with a 12% lookback IRR and someone else lends you $15 million dollar today at 8% and $5 million more in a year at 10%, which deal is better? The first transaction gives you more funds up front at a seemingly cheap rate but with a massive exit penalty. The second deal gives you less proceeds day one but blends to a cheaper rate despite the seemingly higher interest rate. A expert mortgage broker will model these scenarios solving for the lender IRR and advise the borrower know which deal is effectively cheaper.
Now let’s add a third alternative: I now say I can give you $20 million at 5%, but you cannot repay me at all for five years. This appears to be the cheapest of the structures mentioned and this was exactly the bait that many developers took in accepting EB-5 proceeds. This lockout however creates intractable problems:
- What if, in year 3, of the term you want to or, worse, need to recapitalize the transaction to buy out a partner or provide more funding because you are overbudget?
- What if you receive an unsolicited sale offer that you’d be a fool to refuse?
At that point, that 1% lower rate isn’t saving you anything, but instead costing you more than you could ever imagine. In the case where you couldn’t recapitalize the transaction, you may have lost all of your equity. In the sale scenario, you lost out on ideal timing to sell the property and make a massive profit. The 1% didn’t move the needle on returns but the structure that goes with the transaction can be a deal killer.
In addition to the 5 year lockout, EB-5 money has a variety of other problematic terms. It is an immovable piece of the capital stack. You cannot add a dollar of financing proceeds in senior to it or add additional capital that would prime it in any scenario. Because it typically comes in the form of subordinate debt (either mezzanine, preferred equity or the dreaded second mortgage), there is usually a senior loan in front of it that needs to be refinanced with the EB-5 still outstanding. This refinancing requires approval from the EB-5 provider in their sole and absolute discretion. These structural issues have made recapitalizing EB-5 deals nearly impossible, depressing deal returns due to its inflexibility. Forgoing the savings that refinancing a completed or stabilized property with cheaper capital can bring is yet another losing proposition.
For investors, EB-5 is possibly even worse. Promised a visa in a fast time frame, many EB-5 investors are still waiting. A Chinese national applying today for a U.S. immigrant investor visa may not be able to obtain one one until at least 2035. While the wait time is reduced for other countries like South Korea or Brazil, most of the EB-5 investment came from China resulting in a two-way catastrophe.
The challenges of EB-5 capital as a viable source of funding should serve as a huge warning to developers of the future in utilizing new alternative forms of financing. The economics of the capital deployed are not always worth the impact of its other terms. Cheap capital that cannot be easily refinanced, has non-traditional security, an abundance of rights and remedies, or otherwise prevents developer optionality and flexibility should be highly scrutinized and viewed with skepticism and caution.