Since the market rebound, EB-5 capital has become the most attractive source for many real estate developers to fill the gap in the capital stack for their projects. The EB-5 program provides a path to permanent residency for foreign citizens who invest at least $500,000 (pending reform legislation would raise this amount to at least $800,000) in a project that creates at least 10 jobs for U.S. workers.
EB-5 immigrant investors are ideal investors as they may accept the lowest returns and most flexible loan structure. A less publicized advantage is these investors lack the practical and legal ability to exert pressure on the developer. Furthermore, the investors’ goal to obtain a visa does not motivate them to be aggressive.
The investors’ pooled capital contributed to an EB-5 investment vehicle formed by a government approved Regional Center is deployed to the project as mezzanine financing, typically a mezz loan. Immigrants prefer the loan structure with its fixed maturity date and quick UCC foreclosure remedy, rather than preferred equity, because they believe it will lead to timely completion of the project and pay off of their loan. Project completion ensures that jobs will be created, the key to the issuance of the visa and green card, the investors’ primary investment motive. Although the investor expects his investment to be returned, in contrast to the conventional investor, the return on the investment is a very low priority. However, despite the rights and remedies granted by the loan documents, practical and legal constraints often render these theoretical.
Of course, developers recognize job creation is the key to the visa issuance. The structure required to comply with the immigration rules reduces the likelihood of monetary defaults — interest only, with no return of the principal until the visa approval and green card issuance. If a developer defaults during the construction process, EB-5 investors are likely to be even more flexible and less likely to make a legal claim than other mezz lenders. Job creation for visa purposes is calculated by using an economic-impact model, with actual construction expenditures as the key driver. If the money is spent on construction, the jobs are deemed created; otherwise, they are not.
Construction delays are the anathema of an EB-5 investor. If a dispute ensues, construction typically grinds to a halt and expenditures stop. Furthermore, to qualify, the jobs must be created within a limited window — generally 2½ years after the approval of the first step of the immigration process. Thus, the investor will think twice before vigorously pursuing the developer, unless it forces the investor’s hand.
Where the developer utilizes its own “in-house” Regional Center, the EB-5 investors’ inability to exert pressure on the developer is accentuated because the lender is often controlled by the developer. The EB-5 capital raised for many of the mega-developers (such as Related, Silverstein and Extell) utilizes this type of Regional Center. The developer wearing two hats, as lender and developer/borrower, rather than an unrelated third party regional-center lender, drafts the loan documents. These documents may not be heavily negotiated because the investors are eager to invest in these mega-projects. Thus, the terms are likely to be tilted in favor of the developer, such as the default definition, notice and cure periods, and remedies. This places the manager of the EB-5 lender in a position to make decisions that favor the borrower rather than the EB-5 immigrant investors, unless an independent co-manager is appointed to make decisions pertaining to the loan, such as declaring loan defaults. Despite these obvious conflicts, the investors favor these projects because the investors focus on the stronger likelihood of timely project completion, and thus, the creation of the EB-5 required jobs. Also, investors perceive these projects to be less vulnerable if a market downturn occurs while their loan is outstanding.
In contrast, where the Regional Center and lender are unrelated to the developer/borrower, the lender’s interest is more likely to be aligned with the EB-5 immigrant investors. It’s in the Regional Center’s interest for the loan to be repaid — its fee is dependent on that, and its reputation is at stake to support future business. Nevertheless, the EB-5 lender may not be able to negotiate as favorable terms with the developer as a conventional mezz lender. Regional Centers’ sophistication and experience in making these loans vary, with many not as experienced as institutional lenders. EB-5 investors are becoming increasingly knowledgeable. Many investors’ friends and family have moved to the US and invested here, through EB-5 or otherwise. They are more familiar with the major cities, and in some cases, with particular projects and brand-name developers. On the other hand, these investors don’t live in the US, this may be their first investment in US real estate and they lack the sophistication of US investors in conventional real estate projects.
In addition to these practical constraints, legal constraints apply. The intercreditor agreement that sets forth the respective rights and obligations of the senior and mezz lender is not recorded or publicly available. Although the agreement is negotiated and tailored to the transaction, the terms are somewhat standardized, and generally follow a similar format. The senior has leverage in the negotiation as it supplies the bulk of the project’s capital. Thus, the senior utilizes the intercreditor to restrict many of the rights and remedies granted by the mezz documents to the mezz lender.
The senior lender agrees to give notice to the mezz lender of a senior default, and the opportunity to cure. The senior readily gives the mezz lender the right to buy the senior note at par after the senior accelerates. If both the mezz loan and senior loan are in default, the mezz lender might prefer to foreclose on the mezz borrower and step into its shoes. However, if the senior lender has accelerated its loan, often the intercreditor provides that the mezz lender must pay off the senior before proceeding with the mezz foreclosure. If only the mezz loan is in default, the Intercreditor will present roadblocks to the EB-5 mezz lender’s ability to proceed with the foreclosure, unless substantial net worth tests and developer experience requirements are met and replacement guarantees are furnished. Thus, to avoid these adverse consequences, the EB-5 mezz lender must be prepared to act quickly to cure the senior default.
Institutional mezz lenders in conventional projects face many of the same intercreditor restrictions. However, as a practical matter, the EB-5 mezz lender is even less likely than the institutional mezz lender to be financially able to pursue any of these options. EB-5 investors seek to limit their investment to the original $500,000 minimum contribution required by the immigration rules (expected to be increased once pending legislation is enacted), with no capital calls. Few Regional Centers or their affiliates that manage the EB-5 investment vehicle have a net worth approaching that of conventional, institutional mezz lenders. Thus, they are unlikely to be unable to buy the senior debt or meet the conditions (such as replacement guarantees) needed to foreclose on the mezz loan.
If the mezz lender is unable to cure a senior default, the liens that quickly mount on a failing project will gain priority over the mezz. More importantly, while the mezz lender deliberates, the senior may sell the project, in which case the mezz ends up owning a single-purpose entity with no assets.
Obviously, project completion is in the best interests of the senior lender, the EB-5 mezz lender and the developer. A completion guaranty by a financially strong principal increases the likelihood of project completion. The EB-5 market has exploded during the recent market upturn, so few projects have faced a market downturn or other project-specific adversity. Until that occurs, the EB-5 mezz loan structure will not be tested.
Jeanne Calderon is a professor, and Gary Friedland is a lecturer and research scholar, at NYU Stern School of Business. She can be reached at jcaldero@stern.nyu.edu. He can be reached at gfriedla@stern.nyu.edu.
