Written By: Eric D. Dean
The EB-5 Visa Program allows an applicant to obtain a United States green card based on making an investment that meets the requirements of the program. The investment may be passive in nature so long as the investor maintains some level of broad management control over major policy or business decisions (such as, the right to vote on the terminate the manager if the manager breaches his duties, the right to vote on approving a change in the purpose of the venture, the right to vote on the sale of the major asset owned by the venture or the right to vote on dissolution or liquidation of the venture). The applicant may be one of several investors in the business and may be a minority owner of the business.
A business structure called a “limited partnership” is most often used to accommodate an EB-5 Visa applicant’s investment. Under this structure, in a real estate transaction, a corporation controlled by the developers or promoters will typically be the “General Partner” and the EB-5 Visa applicant will typically be one of a number of “Limited Partners”. As a general rule, the General Partner is fully at risk for the debts and liabilities of the venture while the Limited Partners are only at risk to the extent of their respective capital contributions. The developers or promoters also generally are required to execute personal guarantees of loans to the venture.
An investment by an EB-5 Visa applicant must be a true investment not a disguised loan and therefore “at risk” to the extent of the qualified investment. A qualified investment must meet the one of the two following criteria:
Alternative One
- An investment of no less than $1 million, which must be “at risk” in the venture;
2. The venture must hire ten (10) or more employees within two (2) years;
3. The investment can be in a new or existing project; and
4. The investment is typically held for a minimum of five (5) years to accommodate the immigration process.
Alternative Two
- Invest no less than $500,000 in an area designated as a “Regional Center” by the INS. These are typically areas of high unemployment in the US; and
- Create no less than 10 jobs within the designated regional center. Unlike Alternative One, these do not need to be direct employees of the venture but may instead be jobs created in the geographic area as a result of the investment.
In the current economic environment, there are many attractive opportunities for investors, including EB-5 Applicants, for investment in commercial real estate business projects, such as hotels. The EB-5 Applicant has two concerns when investing in a real estate business venture (1) qualifying for a green card and (2) protecting the investment and maximizing the return on the investment. This article assumes that the proposed investment qualifies for the EB-5 Program and focuses on business considerations as to the investment.
Considerations As to the Real Estate Venture
While there is not absolute certainty in any investment, including an investment in commercial real estate, it is essential for the real estate investor to understand and evaluate all aspects of the proposed project and the terms of the proposed venture before investing and monitor the investment after it is made. The best property is the worst investment if the deal structure results in a skewed or excessive fees or returns to the promoter or developer or high operating costs or mismanagement result in an ineffective operation. The venture itself can have attractive terms but is a bottomless pit if the real property does not create sufficient upside to make the investment a success. Therefore, the investor directly or with the assistance of qualified professionals must investigate and evaluate the potential upside in the real property and the proposed deal structure before committing to a real estate investment.
The Asset There are four fundamental concerns as to a potential asset acquisition in any potential real estate investment (1) the condition and nature of the property itself (2) the geographic location of the property (3) necessary property operations and (4) the economic climate.
The Condition of the Property Whether the property is being developed as a ground up project or an improvement project the passive investor must, where possible, have the developer and promoter represent as part of the transaction that the property is properly zoned for the anticipated development and that there are no known or anticipated conditions that would impede or delay the development of the project as designed. The investor also wants the developer and promoter to provide a timeline and construction budget and represent in an agreement with the investor that the timeline and budget are accurate and reflect the complete cost and realistic time for the completion of the project development. The investor also wants a representation and warranty that the developer has fully investigated the real property and knows or has no reason to know of any undisclosed environmental conditions or structural defects on the property or if there are disclosed conditions a representation and warranty as to the budget and timeline for the repair of those conditions. The promoter and developer should be able to provide environmental and other reports in this regard. The investor should also ask to see any property improvement plan required by any franchisor as a condition of the granting or retention of a franchise and require representations and warranties by the developer and promoter in this regard. The investor should also require representations and warranties as to any pending or anticipated citations by any governmental authority resulting from the condition of the property and the costs to repair or abate such conditions.
The Nature of The Property The existing structure or configuration of a property will in many cases determine whether it is practical or possible to convert the property to the vision of the developer on a practical or cost effective basis and whether, once converted, there will be a sufficient market for the property at a high enough price point to result in a positive return.
The Geographic Location of the Property Evaluating whether the socio-economic conditions in the geographic location of the property makes the project a likely success or fraught with risk is essential. Developing a large five star hotel in a lower socio-economic area is simply not financeable or practical. Understanding what other competing properties exist in the locality and what other projects are potentially on line for the future and how existing properties have performed is also essential.
The Cost of Operations The design of the project can either create operating efficiencies or escalating and out of control costs of operation. The documentation provided by the promoter and developer needs to be evaluated in the context of whether the costs of operation of the completed project are commercially reasonable and realistic for the project and geographic area. Representations may be provided by the developer or promoter in this regard.
The Economic Climate Serious consideration needs to be given to the economic climate both time wise and geographically. Considerations may include the availability of necessary financing, the availability of grants or tax abatements, the influx or reduction in population in the area, employment and job prospects, the business environment, taxes imposed by governmental authorities, a growth or anti-growth atmosphere in the surrounding community, transportation and access to the property etc. It is key for the potential investor to inquire how realistic are the sources of capital available to make this project work. If the capital sources are uncertain, the investor does not want to invest in a project which may lay dormant for an extended period of time with ongoing costs being incurred while the developer attempts to raise sufficient funds for the project to move forward.
How Strong Are The Promoter and Developer A project is only as strong as the people behind it. The Investor should require concrete information as to the past history of the developer and promoter, determine what stake if any the developer has in the project, determine if the developer has successfully completed projects of this particular nature before, and determine what kinds of returns the developer and promoter have produced for investors on other projects. The investor should also ask for assurances and proof from the developer as to its capital sources to fund the project over and above the money the investor is contributing.
The Structure of the Proposed Transaction Understanding the structure of the transaction is essential for the protection of the investor. The following are some of the considerations that should be considered:
a. What Fees Are the Developer or Promoter Taking The developer and promoter will typically ask for a number of fees to be paid from capital contributions either at the initial stages of the transaction or from the operation or sale of the asset either directly or through entities they own or control. These may be described as an acquisition fee, a promote fee, an accounting fee, a development fee, a management fee, a success fee, a broker commission, a finder’s fee etc. These fees are not necessarily inappropriate so long as they are clearly disclosed and bear some reasonable relationship to the project. However, these fees must be reviewed and analyzed in determining the true financial structure of the transaction.
b. Controls Over The Costs of Operation and Budget Constraints A common area of negotiations between investors and developers is budget constraints and controls. These negotiations run a wide gamut in the terms agreed to and documented. However, in all circumstances the issues are (1) who is responsible for budget short falls and (2) Can the developer unilaterally move funds between budget line items without investor knowledge or approval. The agreement between the developer and investors can require the developer to fund all shortfalls, require the developer to fund shortfalls up to a certain amount or require the investors to fund all shortfalls. This is a significant issue and must be considered by the investor before investing.
c. Capital Calls and Loans This is another area where the agreements between the developer and investors can be at significant variance. The question is whether management of the venture can require the investor to make additional capital contributions to the venture when management deems it requires more funds. Some agreements prohibit additional capital calls by management while other agreements allow management not only to make additional capital calls but to dilute a non-contributing investor’s interest in the venture by twice the amount of the capital call that was not funded. Agreements can also be at great variance on whether management can directly loan money to the venture or borrow money in the name of the venture from third parties without investor approval. Some agreements require investor approval while others give management the unfettered right to lend money to the venture or borrow money in the name of the venture in whatever amount and on whatever terms management determines without any investor approval. Again this is an important area that can result in the dilution of the investor’s stake in the venture.
d. Management’s Commitment, Performance & Accountability Another key component of a real estate investment is the ability of passive investors to change or remove management. Some agreements are heavily weighted to management and make it virtually impossible to change or remove management barring embezzlement or fraud. Other venture agreements are drafted to protect the investors and allow the investors to remove management if certain financial projections are not achieved or simply on a majority vote of a majority of the passive investors. This is a critical factor when a project is not meeting projections or expectations because of weak or misdirected management. Under the “business judgment rule” courts are extremely reluctant to interfere with management or to protect investors from perceived mismanagement unless the venture agreement imposes clear and express rights in favor of the passive investors.
Another issue that must be of concern is how much time key management members must commit to this project and whether management personnel may engage in competing projects while also managing this project.
Empirically, the venture agreement may allow the developer to take so much out of the project at the initial stages of the project in fees that the developer no longer has the necessary incentive to focus necessary time and attention to the management of the project. Fees to the promoter and developer are common and may be appropriate and earned. However, the venture agreement should commit the developer and management to devote all necessary time and attention to the project and provide for their removal and other sanctions such a reduction in their venture interests and contributions towards the expense of alternative management if they do not do so.
e. Access to Books and Records The venture agreement should provide for full and immediate access to all books and records by the investor or the investor’s agent and that management will reimburse the investor for all associated costs in the event material discrepancies are found in management’s accounting or if management fails to provide accountings and tax returns timely.
f. The Projected Return and Distribution of Proceeds There can be substantial variance in venture agreements with regard to the return on investment. Many agreements require the investor to receive a one time or annualized preferred return on capital contributions plus the return of all capital contributions before the promoter or developer receives any distribution and then requires a sharing of any remaining net proceeds. On the other extreme, venture agreements favoring the promoter may not provide for any preferred return on capital and a pro rata distribution of net proceeds. Venture Agreements can also provide that the investors must receive an agreed internal rate or return before the developer or promoter share in net proceeds. Still other agreements will provide for the developer or promoter to receive a “success fee” from net proceeds before any distributions are made to investors. It is therefore essential for the investor to evaluate how the venture agreement provides for the distribution of net cash flow or net sale proceeds
Project Oversight
The passive investor cannot lose focus on the project when the capital contribution has been made. There are real estate professionals who will assist the passive investor in this oversight process at a nominal fee.
The passive investor directly or through a representative should keep a complete investment file on the project including all offering circulars, subscription agreements, operating or other venture agreements and marketing materials that were provided to the investor both before and after the investment is made. Too often, the investor has none of this background material available after concerns arise as to the legality of the investment. Secondly, the passive investor either directly or through a representative needs to monitor whether project and financial reports are being timely received and whether these reports appear accurate and complete and are in accordance with the projections and representations made to induce the investment. Lastly, if the investor has questions or concerns he needs to make inquiry and investigate promptly directly or through his representative.
Conclusion A quality commercial real estate business project can be both a qualified EB-5 Visa investment and a tremendous source of return on investment. There are many opportunities available for a passive investor to invest with a quality and reliable real estate developer or promoter and mutually beneficial terms. At the same time, there are promoters and developers who manipulate the transaction to provide substantial fees to the developer and promoter, provide unfettered control in the hands of the developer and promoter and place all the risks on the passive investor. An understanding of the proposed deal structure as well as the reality of the proposed project is essential before an investor commits to the real estate investment and monitoring the investment thereafter is essential for the passive investor. In most instances, the passive investor is wise to seek the assistance of a qualified professional in evaluating the potential investment and its terms and in monitoring the investment, once made.