Roadmap to Opportunity Zones

The clock is ticking for you to take advantage of the latest economic stimulus program. Do you have what it takes?
Developer AB Capstone is partnering with Starwood Capital Group on a mixed-use Opportunity Zone project in the South Bronx, N.Y. The 147,000-square-foot development will be the future home of Zeta Charter Schools. Located at 425 Westchester Ave., the 10-story facility will also feature office space for a non-profit organization and ground-floor retail. Starwood launched its Opportunity Zone business in January, with plans to raise $500 million for investments in these federally designated census tracts. Image courtesy of AB Capstone
Developer AB Capstone is partnering with Starwood Capital Group on a mixed-use Opportunity Zone project in the South Bronx, N.Y. The 147,000-square-foot development will be the future home of Zeta Charter Schools.  Image courtesy of AB Capstone

A recent report by Cushman & Wakefield found that the 138 Opportunity Zone funds it tracks are targeting an aggregate total of more than $44 billion in equity. When some 200 smaller funds are factored in, overall capital inflows are expected to be anywhere from $100 billion to more than $6 trillion. Cushman & Wakefield also cited an MIT study that observed a 20 percent price premium for redevelopment of properties in the Opportunity Zones vs. outside the zones and a 14 percent premium on vacant development sites.

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From the large equity fund sponsors to the local and regional development set to the online platforms, Opportunity Zones are what’s hot in the commercial real estate investor universe—even though all the rules are not yet hammered out. So if you haven’t already jumped into the Opportunity Zone investor pool but you think you might want to, here’s some information to help you decide if this is the right opportunity for you.

What makes this time different?

Source: Newmark Knight Frank, “Opportunity Zones: Navigating a Path to Investment”
Source: Newmark Knight Frank, “Opportunity Zones: Navigating a Path to Investment”

What started out as a buzzword two years ago—when the Tax Cuts and Jobs Act of 2017 created the Investing in Opportunity Act to revitalize underserved neighborhoods or zones—is now a bona fide method for raising and deploying capital. By investing your realized capital gains in the 8,700 census tracts now designated Qualified Opportunity Zones, you can defer and reduce your tax liabilities on those gains, and you will get favorable treatment on gains realized in the zones through April 2027.

The TCJA didn’t pave the way for revitalizing underserved neighborhoods, but there are several key differences between the Opportunity Zone program and earlier incentive programs, like the Low-Income Housing Tax Credit program and the New Markets Tax Credit Program. Those programs mostly function through government agencies and come with a higher price tag. They are also subject to annual approval from Congress or a tax credit allocation authority. The number of credits issued each year is limited, so fewer investors can participate.

Opportunity Zones, on the other hand, are regulated by two sections of the Internal Revenue Code. Investors enter the program through privately managed Qualified Opportunity Funds—partnerships or corporations invest at least 70 percent of their assets in Opportunity Zones—that self-certify to the IRS (Form 8896). There are few limits on the number of funds that can exist or the amount that can be invested in them. There are restrictions, however, on the types of properties the funds can invest in. Qualified Opportunity Zone properties include partnership interests in businesses that operate in a Qualified Opportunity Zone, stock in businesses that conduct most of their operations in an Opportunity Zone and new construction, redevelopment or land in an Opportunity Zone.

“Taxable investors range from individuals who have capital gains that need to be triggered to create a Qualified Opportunity Zone Fund,” explained JLL Senior Vice President Jonathan Paine, “to institutionally robust asset managers with access to high-net individuals and corporations with taxable gains looking for abatement and future tax deferral.”

EJF Capital joined Donatelli Development and Blue Skye Development on a 262-unit multifamily project within a Washington, D.C., Opportunity Zone. The $95 million project received $59.5 million in construction financing from Eagle Bank in May, and is scheduled for completion by August 2020. Located at the intersection of 19th Street and Massachusetts Avenue, S.E., the property will be adjacent to the Stadium-Armory Metro station and will feature 13,000 square feet of retail space at the ground level. Image courtesy of EJF Capital and Donatelli Development
EJF Capital joined Donatelli Development and Blue Skye Development on a 262-unit multifamily project within a Washington, D.C., Opportunity Zone. The $95 million project received $59.5 million in construction financing from Eagle Bank in May, and is scheduled for completion by August 2020. Image courtesy of EJF Capital and Donatelli Development

Cash upfront

Sounds easy, but there are financial and time-related challenges to investing and enjoying the tax benefits: a 5 percent reduction in capital gains liability if you hold the investment for five years, a 15 percent reduction if you hold the investment for at least seven years, and if you keep the investment for 10 years and then sell, no capital gains tax on the new gains you realize in the zone.

First, it’s vital that you have the capital gains available to take part in the program—and are able to tie up that money for a long-term investment—and you have 180 days from incurring the gains to find an economically viable deal in one of the designated census tracts.

“Development deals have their own timelines, and those gains may expire (before you can) find a viable opportunity to invest in,” said Michael Episcope, principal & co-founder of Origin Investments, noting most people would not invest in these projects without benefits.

You can invest in new construction or substantial improvements of vacant buildings. For a project to be considered substantially improved, investors must within 30 months make capital improvements that equal what they purchased the property for—minus the land value. For land parcels, there’s a loophole because you can do structural improvements of any kind.

Other looming deadlines are Dec. 31, 2019, to receive the maximum deferral benefit on invested capital gains for seven years; Dec. 31, 2026, when investors must pay the deferred capital gains tax on their invested capital gains; and Dec. 31, 2028, when Opportunity Zone status for the qualified census tracts expires.

*Assumes a long-term federal capital gains tax rate of 23.8%, no state income tax and annual appreciation of 6% for both the O Fund and alternative investment. Source: Newmark Knight Frank, “Opportunity Zones: Navigating a Path to Investment”
*Assumes a long-term federal capital gains tax rate of 23.8%, no state income tax and annual appreciation of 6% for both the O Fund and alternative investment. Source: Newmark Knight Frank, “Opportunity Zones: Navigating a Path to Investment”

Howdy, partner!

In addition to time and capital, you’ll need expertise in transforming distressed real estate. “There is an emphasis on sponsors with experience developing and investing in value-add or redevelopment projects,” said Daniel Littman, capital markets research analyst for Newmark Knight Frank. “Those who have a track record for success in dealing with struggling properties … are the types of investors who will find the most success.”

You’ll also need the local knowledge to identify the submarkets that would be optimal for investment. That makes partnering a good idea for companies that have less experience in a distressed or underdeveloped area, according to Jonathan Mazur, senior managing director of national research for Newmark Knight Frank. “They realize they can’t do this alone, without the proper understanding of what goes into making this program work.”

Noteworthy partnerships have included EJF Capital teaming up with Donatelli Development and Blue Skye Development on a mixed-use project in Washington, D.C.: Starwood Capital, on behalf of its $500 million Opportunity Fund, partnering with AB Capstone to develop a facility in the South Bronx that will house Zeta Charter Schools; and Avanath Development joining with Opportunity Assets Group LLC to launch a $300 million Opportunity Zone Fund.

According to Reid Thomas, executive vice president & general manager for NES Financial, you’ll also need management expertise. “A very important part of this program comes down to operating and monitoring (to ensure) that it is performing as well as intended.”

Something for everyone

It was always a given that large institutions, opportunity funds and developers would find a way into Opportunity Zones. If you are a smaller investor, online crowdfunding companies offer the chance to participate without a deep-pocketed partner.

“This is a good opportunity for smaller investors to take advantage of a platform that can represent their interests in this market,” Episcope said. His firm deployed a Qualified Opportunity Fund in November 2018 and raised $105 million within 17 hours.

Crowdfunding opportunities come in two forms: direct to real estate or fund investing. You can think of it as a branching tree, noted Camber Creek Senior Associate Nate Loewentheil. “The first branch is choosing an Opportunity Zone or not,” he said. “Once you have that, there are funds through wealthy investors or crowdfunding. Lastly, you decide whether to invest in just that project or you can fund that development and others grouped into a fund and then invest in that fund itself.”

Funds spread your risk, but it’s easier to track results with a single investment, said Arborcrowd Co-founder & Managing Director Adam Kaufman. “Focusing on one deal at a time helps to get full transparency when it comes to these transactions,” he said.

You’ll find more on this topic in the CPE-MHN Guide to Investing 2019.