Cornell: EB-5 Financing Can Distort Development
A federal program that encourages foreign residents to invest in U.S. commercial real estate can distort the hotel development cycle, reported Cornell University’s Center for Hospitality Research.
Created by the Immigration Act of 1990, the federal Employment-Based Immigration Fifth Preference EB-5 program allows foreign citizens to obtain U.S. green cards by investing $500,000 or more into a project that creates or preserves at least 10 full-time jobs.
“This program has attracted considerable attention from foreign nationals, particularly those residing in China, and we’ve seen considerable recent growth in investment volume,” said Arian Mahmoodi, financial analyst with Wells Fargo’s Hospitality Finance Group in Los Angeles. He co-wrote the study Creative Capital: Financing Hotels via EB-5 with Cornell Associate Professor Jan deRoos.
Hotel developers can use the EB-5 program as a source of relatively inexpensive capital. But Mahmoodi called the market for this financing opaque and inefficient. “Without proper checks and balances, we believe that the availability of EB-5 financing may encourage development of speculative hotel investments,” he said.
EB-5 capital can serve as equity, but most agreements are structured as interest-only debt, the report said. “EB-5 loan agreements tend to be biased toward the borrower, who is the project developer in almost all cases. In basic terms, in an EB-5 loan document the borrower essentially tells the investor: lend us $500,000. In return, we will pay you no more than one percent interest per annum for at least five years. We have the right to extend the loan for one or two additional years at the same interest rate with no penalties. The loan is non-recourse to the borrower with no minimum debt coverage ratio and no maximum loan-to-value ratio.”
In addition, the loan will likely be subordinate to all other debt in the capital stack, the report said. And EB-5 investors generally have to pay an administration fee, usually $50,000, beyond their half-million-dollar investment.
Mahmoodi and deRoos illustrated how EB-5 financing can more than double the developer’s profit and said that a higher allocation of EB-5 financing may motivate sponsors and developers to pursue projects not feasible under a conventional capital stack. “As a result, we speculate that EB-5 financing may cause hotel rooms to be developed in markets where the economics would not make sense if the projects were financed conventionally,” the report said.
“Renewal of the EB-5 program is currently being discussed in Congress,” deRoos said. President Obama and Congress reauthorized the program for three years in 2012. Some in Congress such as Sens. Patrick Leahy, D-Vt., and Charles Grassley, R-Iowa, propose reforming the EB-5 program before renewing it. The Leahy-Grassley proposal would limit the program’s “targeted employment areas” to only one census tract per metro area, require increased disclosures to investors regarding business risks and conflicts of interest and demand more oversight of projects and closer monitoring for securities compliance, among other reforms.
