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The Impact of High Volatility Commercial Real Estate Rules on EB-5 Investments

By: Mark A. Katzoff, Arren Goldman, and Gregory L. White

NES Financial is saddened by the sudden passing of Gregory White on June 11th. Greg was very
intelligent, extremely warm, and highly respected in his field. Our thougJ-1ts and prayers are vvith
his family, friends, ar1d colleagues. 
Investments made by EB-5 funds (New Commercial Enterprises or NCEs) are typically structured as loans to the job-creating enterprise (JCE). It is also common for such investments to be made in connection with construction projects which also have a senior loan from a commercial lender providing the bulk of the so-called construction fi­nancing. Rules adopted in recent years with respect to how banks must treat High Volatility Commercial Real Estate {HVCRE) loans have implications for the structuring of EB-5 investments. This article provides a brief summary of
the implications of the HVCRE rules and potential ways to address them. 
Loans that finance the acquisition, development, or construction of real property (ADC) prior to the replacement of such loans with permanent financing (for example, following completion of a project) may be HVCRE loans. HVCRE loans are deemed riskier than other loans and require banks to maintain greater reserves. The greater reserve requirements, in turn, can result in higher borrowing costs. In general, for ADC loans, in order to avoid HVCRE status, the project must meet the following criteria: 

1.    A loan to value ratio not exceeding the maximum level allowed, generally 80% for a construction loan.
2.    The borrower has contributed capital to the project of at least 15% of the real estate1s appraised "as complet­ed" value prior to the funding of the bank loan. Capital can include cash, cash paid for land (but not anyappreciated value thereof), unencumbered assets, and out-of-pocket payment of development expenses.
3.    All contributed capital and any capital generated by the project, i.e., net operating income, must remain with the project until the senior loan is repaid in full or replaced by permanent financing. This requirement must be a covenant in the senior loan documents.

These rules have the following impact on EB-5 loans:

1) The senior lender may have an incentive to reduce the amount of the AOC loan to the borrower to achieve a favorable loan to value ratio.

2) Since capital must remain with the project for the duration of the senior financing, there would not be cash available for the JCE to make interest payments on a loan from the NCE or to make prepayments of principal to fund return of capital to EB-5 investors who either have their 1-526 petitions rejected or their !-829 petitions fully adjudicated prior to the end of the terms of the NCE loan.

One potential solution is the creation of a wholly-owned subsidiary of the NCE (Borrower Sub) to which the NCE would loan the funds received from the EB-5 investors. The Borrower Sub could then use the loan proceeds to make an equity investment in the JCE. 
This approach limits the debt incurred at the JCE level (thus lowering the loan to value ratio). However, it also raises the following issues: 

1.    As the Borrower Sub would be structured as the parent of the JCE, the senior lender may also want to limit debt incurred at the parent level and accordingly, may resist the creation of a loan from the NCE to Borrower Sub.
2i    The equity contributed by the Borrower Sub to the JCE would have to remain in the JCE for the life of the senior loan. As a result, the JCE could not make distributions on the contributed equity to the Borrower Sub, and the Borrower Sub would not have resources to repay the loan from the NCE

Another alternative would be for the NCE to loan the funds received from the EB-5 investors to an affiliated devel­oper entity which could use the proceeds to pay development costs on behalf of the JCE under a development agreement, in turn being reimbursed for such costs by the JCE. This approach could offer the following benefits:

1.    As the developer would not be an owner of the JCE, this avoids the parent of the JCE incurring debt and should satisfy this lender concern.
2.   Since the developer would not be contributing equity to the JCE, the JCE should not be restricted in reim­bursing the developer for the expenses advanced. 

This approach also has some potential drawbacks:

1r    The total development costs would need to be at least equal to the total EB-5 funds proposed to be invested. This is after the case, however. This should be "built-in" to the ban.k documentation.
2.    The senior lender would need to approve the reimbursement of expenses.
3.    In order to fund the interest payments on the EB-5 loan from the NCE to the developer, the development agreement would have to provide for reimbursement of the advanced expenses with interest, and the payments would need to synchronize with the timing of required payments on the EB-5 loan.

If the structural alternatives are not feasible for the project for whatever reason, the JCE may be able to persuade the senior lender to nevertheless make an HVCRE loan, but this would likely drive up the interest costs of the loan due to the additional reserve requirements. 
In short, the HVCRE rules impose additional challenges on structuring an EB-5 investment in a commercial real estate project but none that should prove insurmountable with proper planning. 

David Kowert