What if you could finance a real-estate development project, say a hotel, with minimal equity, very minimal debt and a lot of, what should I call it, easy money? sounds good, right? welcome to the wonderful world of EB5!
When I first arrived in LA I wasn’t sure whether I arrived i’m in China or in America. In the airport, I heard mostly Chinese and in many parts of LA County the shop signs were all in Chinese. The first day I went to get a haircut and no one in the shop could speak any English. So I wondered why do places like Arcadia, Monrovia, San Marino and San Gabriel feel like Shanghai? and how did they all get there? Please don’t get me wrong, I loved to see all the Chinese people around me and it made me feel like I’m in China — a country that I truly love.
When I lived in China, I heard many things about the EB5 visa program and how excited Chinese people were about it. You invest $500k in a Targeted Employment Area (TEA) and you get a Green Card. Many agencies and promoters took advantage of the opportunity and marketed, with varying degrees of success, the EB5 projects to Chinese people.
“If the will to believe stirs within the customer, the merchandise will be supplied — without warranty”
During my visit to LA, my good friend Todd invited me to a real-estate “seminar” to which Chinese people enrolled in order to learn more about EB5 “investment opportunities.” At the seminar, guest speakers told investors how great the American economy is doing, how good it is to invest in hotels and senior living facilities and so on. The reason that these types of properties are promoted is that they create employment, which is a necessary condition to qualify for the EB5 program. In those presentations the presenters ran the usual tricks of torturing the data to show phenomenal returns on what they had to sell. One very common technique is to start the measurement of the returns at the bottom of the recession and then show that in the last 5 years these properties appreciated so much in value. From that, most of us take a mental shortcut and interpolate straight into the future. For instance, if I were to sell you the S&P500 by using the same technique it would have sounded like that: “Over the last 5 years it appreciated by 150%, or a compunded average of 20% per year. Isn’t it amazing?” (Answer: Nope! because the long-term average is somewhat below 10%. But people don’t care about that).
Why do promoters go at such great length to raise money from Chinese people? After all, it’s a huge marketing operation and money for those real-estate projects can be raised locally in America. Fortunately, during the convention I met a nice young lady who promoted EB5 (and other) projects and after the convention she was kind enough to take me behind the scenes of the EB5 program — and it was very interesting.
Typical EB5 Project
For the uninitiated, here is a diagram of a typical EB5 project:
The stakeholders in the development project are the a project company that is owned by the agent who sometimes acts as the developer (as in the example above), the financing bank the EB5 agency and the “easy money” supplier — the EB5 investors. The money flow is as following:
1, Investors pay the EB5 money to the EB5 agent who acts as the project developer. This funding is structured as a loan that carries a very low interest rate, say 1%.
2, The project development company injects equity (say 20%) and the EB5 money (structured as junior debt) into the development project.
3, The bank contributes the senior debt trench (30% of the total cost), at a rate of 5%.
4, The project development company charges the project with interest on the junior debt, the rate in this case is usually slightly below the senior note’s rate so we will use 4%. Also, it takes a service fee that can amount to 10% of each EB5 investor’s contribution.
5. The agency pays the EB5 investors the promised rate on the note, which is about 1%.
So for a $100m project that is 50% funded with EB5 money, 30% bank debt and 20% equity the EB5 agent makes:
- Fees: 10% of the total EB5 money = $5m
- Interest: 4% of the amount lent to the project = $2m
- Less the 1% it pays the EB5 investors = -$0.5m
- Full equity in a project that cost $100m and by the time the development is done can be worth $150m.
So the EB5 company put down $20m as the initial equity. It receives $6.5m just from interest and fees. By the end of the project, which is now worth $150m, the company can pay the EB5 investors their principal of $50m and pay the bank the $30m (says $40m by the end of the project including interest). That leaves the EB5 company with full equity in a project with a net worth of $60m and fees received of $6.5m. Not bad for a $20m initial investment. Note that this is a base case because such a project can run some debt that can be paid as dividend to the agent. The returns are no doubt impressive.
But hey, it’s America. Why stop there? Some projects now offer a PIK (pay in kind) arrangement where instead of paying the EB5 money back to the investors they give the investors an apartment in a condo. They develop a complex of hotel and a condo and promise each EB5 investor an apartment in the complex based on very rosy projections (not commitments) of the future value of that unit. This way, the financing is really given for free with almost no risk for the EB5 agent. Brilliant!
Don’t be surprised if you see many new hotels sprout in areas where you never expected them to. Senior living projects are also hot and are marketed based on another selling technique where the promoter only talks about the expected growth in demand for senior living without mentioning the expected growth in supply. I heard one promoter of senior living projects saying that “by 2050 the number of people in America above the age of 65 will be greater than the number of the people who live in America today.” As I wrote in the subtitle… If the will to believe stirs within the customer, the merchandise will be supplied – without warranty.