The Complete Guide To Real Estate Financing

WRITTEN BY

EB-5 Insider Team

A group of professionals with years of experience helping people immigrate to the US

Note: This article is for informational purposes only. We are not providing legal advice or selling securities. The articles and content on this site are of a general informational nature only and should not be relied upon for individual circumstances.

Real Estate is a capital-intensive and expensive endeavor, and from an investment standpoint, it is discrete and lumpy.

Due to the capital requirements, developers must find alternative sources of capital beyond their own pockets, allowing them to increase their opportunities and maximize returns.

As commercial real estate (CRE) has evolved, two discrete forms of development financing emerged: debt and equity.

Debt

Debt is borrowed funds/financing that an Investor uses to acquire or leverage properties

  • Accounts for a substantial portion of the capital stack or purchase price
  • Typically structured as a mortgage loan secured by the Asset (property) [First Lien]
    • The investor makes regular payments to the Lender (principal + interest)

Within EB-5, most projects are structured as debt. Given high interest rates and the current CRE climate, you will find many projects providing a senior loan. This can be an excellent opportunity for investors to participate in a less risky position within a project, but it does not mean it does not come with risk. And just because you are in a senior position, it does not mean it is a safer project overall.

Another common debt structure you will find within EB-5 is mezzanine debt, which is covered later in this breakdown.

Equity

Equity is ownership interest that an Investor holds in a property

  • “Residual value” is the difference between market value and the amount of debt that is owed
  • Ownership interest can be bought, sold, shared, or used as collateral
  • Returns are based upon asset performance, primarily at the sale or exit

Within EB-5, this is a far less common structure. The reason for this is the fact that it is the riskiest position from a return standpoint, as well as from a return of capital standpoint. If a project underperforms, the equity is the first to be wiped out. This riskier position typically comes with the potential of much higher returns, whereas profit sharing means there’s no cap to the potential upside should the project outperform its underwriting assumptions.

However, most EB-5 investors are not chasing returns and are looking for the following order: immigration benefit, capital preservation, return of capital, and then returns. Given that most investors do not prefer EB-5 equity projects, there simply are not many out in the market.

Furthermore, most EB-5 operators are not developers or real estate private equity companies, and so they partner and rely on other parties for deal sourcing, deal underwriting, and deal execution. In other words, not all EB-5 shops have the skillset to source and execute EB-5 equity projects. Therefore, there are only a handful of operators who can and do provide these types of EB-5 investments, and only a small subset of investors prefer these investments. Full-service shops typically offer non EB-5 investments.

Another somewhat more common equity structure you will find within EB-5 is preferred equity, which is covered later in this breakdown.

Typical Sources of Financing

In traditional CRE, the developer, or syndicator, seeks lenders to cover a portion of the capital stack.

Lenders are seeking an appropriate return for their desired term and risk appetite. Here are some examples of various lenders and their preferences:

  • Long-term lenders (low risk): pension funds, insurance companies, government entities
  • Medium-term lenders (medium risk): banks, credit unions, savings and loans
  • Shorter-term lenders (higher risk): debt funds, private lenders

Why would someone borrow?

Let’s highlight a few reasons why a developer or operator might decide to borrow capital to fund construction, even if they could afford the asset without external capital. Here are some of the benefits:

Reduce capital requirements

  • Debt provides additional capital to fund development or acquisition
  • Development takes time and incurs negative cashflows before a project can begin generating revenues

Diversification

  • Improve overall portfolio risk profile, as single assets are illiquid and exposed to local and micro-level shocks
  • Economies of scale

Tax shield on interest

  • Borrowing can help shield taxable income
  • The IRS allows you to deduct interest payments from taxable income
    • In simple terms, the more debt you have, the higher your interest deductions will be, lowering your overall tax bill

Boost equity returns

  • Having debt can increase the return on equity
  • Positive leverage, where the cash flow yield is greater than the interest rate paid

This is a short breakdown of why a developer may decide to borrow or take on leverage into a deal. There are always risks, and there are important risks a developer will need to consider:

Negatives/Risks

  • Interest costs
  • Repayment obligations
  • Debt covenants
  • Increased risk = greater volatility

Other Types of Financing

Mezzanine Debt

This is where the financing is not secured by the real estate itself.

  • Mezzanine debt usually includes a claim on the LLC, acts as subordinated debt (subordination to the senior secured lender), and is often used by borrowers seeking higher Loan-to-Value (LTV)
  • A major downside is the risk of losing the LLC in the event of a default

[First priority/first lien is the Senior Debt, which is secured by the real estate. Common equity is secured by the legal entity that owned the property (LLC).]

Within EB-5, you will likely find a handful of projects structured as mezzanine debt. These projects will typically already have a senior loan in place from another lender as described above (such as a bank) and are utilizing EB-5 financing to boost the LTV.

It is important to look at the loan-to-cost (LTC)/LTV and ensure sufficient equity is in place should the project underperform, and the mezzanine position will not be impacted.

Preferred Equity

A higher “preferred” position over common equity, but still second to senior debt, and typically structured as a fixed rate of return.

  • Priority over common equity, which can provide some downside protection
  • Downsides:
    • Paid after all debt claims
    • More certain terms, but far less upside and participation than common equity

Within EB-5, very few projects are structured as equity, though many of those you will find will often be preferred equity. These provide more downside protection over common equity, will have a higher risk profile than debt, but will provide the potential of more upside without the participation in profits, as it is often capped. For some investors, these strike a better risk/return balance.

Benefits of EB-5 Capital

One of the most common reasons a developer will choose to use EB-5 as a source of capital in their project is straightforward—It is a cheaper source of capital. While not always the case, more often, it comes in at a lower rate than other comparative sources.

Those developers who are not well versed in EB-5 see this and think utilizing EB-5 is great because it’s cheaper and sticky, as investors want a green card. However, they fail to realize all the immigration nuance, risks, changes, and other pieces or simply think it is easy to secure investors and convince them this is a great deal for them.

It is anything but easy to raise capital, no matter if it provides an immigration benefit, or not. Projects are abundant out there, and there are some good projects that simply come back to each investor’s preference and risk tolerance. All investments and real estate projects come with risk, and in EB-5, the risk is confounded, as you not only have investment risk, but you also have immigration risk, and one can impact the other.

The EB-5 program is an immensely valuable tool for the US economy and US real estate development and continues to provide countless jobs. At any stage of the cyclical CRE cycle, EB-5 financing is a powerful tool that has been used in projects of all sizes across the US.

In our current climate, as banks and other lenders have tightened their belts and are focusing on limiting exposure, EB-5 financing allows projects to be developed today, and investors can participate in a qualified project in a lower-risk position.

Key Takeaways

Financing commercial real estate (CRE) projects is a capital-intensive endeavor, necessitating developers to seek external funding to maximize their opportunities and returns.

CRE financing generally falls into two categories: debt and equity. Debt financing, often secured by the property itself, includes senior and mezzanine loans, providing lower-risk options for investors. On the other hand, equity financing involves ownership interests, offering potentially higher returns but at greater risk, as equity holders are first to absorb losses if a project underperforms.

EB-5 financing provides cost-effective capital and attracts investors aiming for U.S. residency. Despite its benefits, EB-5 financing is complex due to its dual nature of investment and immigration risks. Nonetheless, it remains a powerful tool for developers, particularly in today’s tightened lending environment, enabling the continuation of diverse real estate projects across the U.S.

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