Every year at Halloween, people of all ages around the world dress up in an array of costumes: from favorite cartoon characters to ghoulish monsters. While dressing up for Halloween may be innocent fun, unfortunately, some EB-5 projects like to dress up, too. High-risk EB-5 projects will sometimes try to disguise themselves in low-risk costumes.
If you do not know what to look for, you may not notice these disguises—and that can end in a horror story. In this article, we discuss six common EB-5 horror stories and offer tips for how to identify and avoid them.
Highly Subordinated Position
Lack of Sufficient Financing
Cost Overruns
Related Parties
Entitlement and Permitting Issues
Lack of a Clear Exit Strategy
Highly Subordinated Position
An EB-5 investment is riskier if the EB-5 financing is in a subordinated position in the capital stack. In such cases, EB-5 investors may be the last individuals to receive repayment after senior lenders and other creditors.
A low position in the capital stack leaves little margin for error. If a project fails to meet financial expectations, a lack of revenue can lead to a total loss of capital for EB-5 investors.
One way a subordinate position in the capital stack is disguised is by having it start in a senior position and become junior later. Another way a project might try to downplay a subordinated position in the capital stack is to offer minimal to no collateral.
How to Avoid This Risk:
- Assess Senior Debt Terms. Review the terms agreed upon with senior lenders. Ensure that these terms do not place EB-5 investors at a big disadvantage in the event of foreclosure or default.
- Understand the Capital Structure. Before investing, scrutinize the project’s capital stack. Watch out for future financing that can take a more senior position than EB-5 funds. Aim for investments where EB-5 capital holds a more secured position.
- Understand What Secures the Investment. Determine what is securing the EB-5 funds. This could include a repayment guaranty from a parent company, recorded mortgages, and/or a pledge of 100% of the equity interest in the project company. Make sure that the collateral securing the EB-5 loan is reasonable based on the amount of EB-5 investment in relation to the total development cost of the project.
Lack of Sufficient Financing
A project’s success depends largely on securing enough funding to cover all phases of development and operation. A shortfall might occur if the developer overestimates its ability to raise funds or if planned funds from other sources fall through. A lack of financing can cause projects to stall or even fail.
What costume might such a project wear? When a project does not have all of its funding lined up, it might point to potential lenders or developer equity. But if a loan agreement is not fully executed or developer equity is not committed, these cannot be counted on.
How to Avoid This Risk:
- Verify Total Capitalization. Ensure the project has secured all necessary funding. Look for committed equity from the developer, executed loan agreements from senior lenders, and invested or committed capital from other investors.
- Examine Funding Commitments. Request to see documentation of committed funds rather than projected or anticipated financing.
- Review the Developer’s Financial Health. Investigate the developer’s history in securing project financing. Also, understand the financial stability of the project by reviewing the balance sheet of the project company.
Cost Overruns
Projects often face unplanned increases in construction or operational costs. These overruns can stem from many factors, including regulatory hurdles, labor disputes, or low initial cost estimates. In highly regulated areas, labor costs can grow due to union requirements, which can add obstacles to the process. When costs go up, profits tend to go down. And if the project is not profitable, EB-5 investors may not see a return of their funds.
Cost overruns may be unpredictable, but the risk of cost overruns can be weighed before investing.
Because the factors that cause cost overruns are out of a project company’s control, any project can be impacted. But some projects are going to be at higher risk of cost overruns than others. The key factors to assess include the developer’s experience, the market, economic trends, and more.
Watch out! If the developer is not willing to share basic financial documents that confirm the current financial position of the project itself and any other related entities involved, it may be hiding something.
How to Avoid This Risk:
- Evaluate the Developer’s Track Record. Invest in projects managed by developers with a proven history of completing projects on time and within budget.
- Review Financial Projections. Analyze the pro forma financial statements with a critical eye. Look out for overly optimistic revenue projections or underestimated costs.
- Look for Projects with Guaranteed Maximum Price Contracts. If a project has a guaranteed maximum price (GMP) contract, the risk of cost overruns is lower.
- Understand Market Conditions. Check the local real estate market for properties like the project. Do planned sales prices or rent amounts match what you see in the market? Also, pay attention to economic conditions and look for issues that could impact the project’s ability to earn a profit.
Related Parties
Conflicts of interest can arise when the regional center and developer are related entities. When this is the case, the interests of the developer may take priority over those of the project’s EB-5 investors. As a result, if something goes wrong with the project, the interests of its EB-5 investors may not be well represented.
Some developers also serve as the EB-5 regional center sponsors for their projects. This is referred to as vertical integration. Many vertically integrated EB-5 projects will tell investors how much this benefits them since this approach avoids any middleman. But this is just a costume that hides risk. An independent regional center sponsor is not a middleman—it is a key protection for EB-5 investors.
How to Avoid This Risk:
- Conduct Due Diligence on Affiliations. Investigate any relationships between the regional center and developer.
- Seek Independent Oversight. Invest in projects with third-party oversight to ensure transparency and accountability.
- Choose Trustworthy Partners. Align yourself with regional center sponsors who are known for advocating on behalf of their investors.
Entitlement and Permitting Issues
Delays or issues with entitlements and permits can stop a project before it starts. Local regulations can be complex, and obstacles in gaining the required approvals can stall or derail a project entirely.
If a project says it is in progress but will not provide proof of permits and approvals, it may just be make-believing.
How to Avoid This Risk:
- Verify That a Project Is Ready to Build. Prioritize projects that have already secured all the approvals needed to start building. Note that for even the most experienced investors, this can be difficult due to local regulations. The safest choice is to find a project that is under construction.
- Assess the Developer’s Experience. Invest with developers who have extensive experience with projects of the same type as the investment. They should have local or regional market experience and a successful track record with projects of the relevant type.
- Verify the Project’s Construction Status. If possible, visit a project and verify that construction has started and is making progress before you invest. Observable construction progress is a good indicator that the necessary entitlements and permits are in place.
Lack of a Clear Exit Strategy
A well-defined exit strategy is crucial for recovering your investment. Without a clear mechanism for repayment, you risk tying up your funds indefinitely—or losing your money entirely.
A project might disguise a lack of a realistic exit strategy behind a loan maturity or equity repayment date. Just because an investment is set to be repaid does not mean the project company will be able to repay it.
How to Avoid This Risk:
- Understand the Repayment Plan. Before investing, ensure the project has a solid plan for how and when investors will be repaid.
- Assess Liquidity Options. Investigate the project’s potential for generating cash flow or assets that can be sold at the time of repayment.
- Review Legal Agreements. Carefully examine the terms outlined in the investment agreements regarding exit strategies and investor repayment. Having some kind of security is key in the event something goes wrong.
Transparency and Quality Protect EB-5 Investors from Experiencing Their Own EB-5 Horror Stories
The EB-5 program presents a valuable opportunity for foreign investors seeking U.S. residency, but it is not without risks. By thoroughly vetting projects, understanding potential pitfalls, and working with trustworthy partners, you can limit these risks.
Due diligence can be almost impossible if a project is not transparent. You should only work with reputable companies and developers who make all relevant information available for you to independently review. Transparency is your right as an investor. If you cannot verify a project’s claims, look to invest somewhere else.
Always perform comprehensive due diligence to safeguard your capital and your path to a Green Card.
For information on available EB-5 projects, please schedule a one-on-one call with EB5AN.
