A still-novel tax code provision promises plenty of opportunities: Investors get an opportunity for tax savings. Communities get an opportunity for development of neglected or on-the-cusp areas. Real estate developers get an opportunity to access new capital, notably capital with a long-term investment horizon.
But an unresolved question hangs over the Opportunity Zone program. As phrased by ULI Senior Resident Fellow Tom Murphy: is it a swindle, or a good deal for the changing dynamics of a neighborhood?
Murphy, a former mayor of Pittsburgh, acted as the moderator of one of two sessions focused on Opportunity Zones at the 2019 ULI Fall Meeting in Washington, D.C. Real estate executives, tax law specialists, and others discussed projects that have taken advantage of the program in its early days. They also looked ahead to the program’s challenges and possibilities.
“We really view Opportunity Zones as a way to incentivize job growth within communities that currently are underserved,” said Garett Bjorkman, first vice president for portfolio oversight at CIM Group, a national real estate and infrastructure owner, operator, lender, and developer. The program lowers the cost of capital for developers, he said. It also speeds up the timeline for those investments because the law specifies time windows for the most attractive incentives.
“From the investor side, they think this is a once-in-a-lifetime opportunity,” said Jill Homan, president of Javelin 19 Investments, a Washington, D.C., real estate development, investment, and advisory firm.
The Opportunity Zone program was created as part of the 2017 tax overhaul, the Tax Cuts and Jobs Act. It offers incentives for long-term investment—five to 10 years—in designated low-income communities. Investment takes place through what is called a Qualified Opportunity Fund, set up to meet specific legal requirements. While many types of business investments might qualify, much of the attention and action has focused on real estate.
The investor gets three tax breaks that together make it attractive to invest soon and then hold. Tax on capital gains of the invested money is deferred until 2026 (or until the investment is sold or exchanged). A portion of the investment is excluded from capital gains tax—15 percent if the money was invested by the end of 2019, or 10 percent for money invested in 2020 or 2021. (There is no exclusion for later investments.) And if the investment is held for 10 years, appreciation is basically untaxed because the basis is increased to market value at the time of sale. That final break is “most compelling” to investors, said Abraham Leithner, a tax lawyer who is a partner at Goulston & Storrs in New York City. Congress’s Joint Committee on Taxation estimated average annual tax savings of $1.5 billion from 2018 through 2025.
The earliest Qualified Opportunity Funds were formed in 2018. Estimates of how much money those funds will attract vary. Homan said that anecdotally she knows of deals that total $2 billion in equity actually raised, not just talked about. Assume, she said, “I know about 10 percent of the market. We are at inning one of what will be a growing market.”
Critics of the program say that much of the benefits have gone to rich investors rather than to the poor communities the program was touted to aid. In particular, the ULI panelists repeatedly cited a lengthy August 2019 New York Times article, “How a Trump Tax Break to Help Poor Communities Became a Windfall for the Rich.” That article outlined how investors are reaping breaks on projects that were already underway or that serve well-off communities.
But the ULI panelists said that as the Opportunity Zone program matures, it should bring more of the desired type of investment. Most deals that have been completed were already well into the planning and financing process when the program came along, Bjorkman conceded. “That’s not really what the program was intended to do.”
Especially over the first year or so, regulations were unclear, so capital was difficult to come by. As tax rules were clarified in 2019, investor interest picked up. Bjorkman said, “As we go to 2020 and 2021, I really think there is going to be more capital raised.”
Capital at Work
For instance, Bjorkman said, his company worked for five years to entitle development of a solar power project on a 20,000-acre (8,100 ha) tract of contaminated farmland in California’s Central Valley. “This legislation opened the funding door for this project,” he said. “We’ve been able to capitalize this project much quicker than we had ever anticipated.”
Target investors for Opportunity Zone projects are those with significant capital gains to shelter—family offices, high-net-worth individuals, and perhaps the fabled tech billionaire who wants to roll over the profit from a stock sale into what could be a socially conscious venture. “The moon and the stars have to cross,” with an investor who has a taxable gain and is looking to put the money into, say, affordable housing, said John Williams, president and chief investment officer at Avanath Capital Management, an Irvine, California–based real estate investment management firm that owns about 10,000 housing units, most of which are classified as affordable.
Investors might be attracted by the social impact of a project, but they still expect to profit, the developers on the panel emphasized. “We haven’t found anybody that wants to take a lower return,” said Sean Burton, chief executive of Cityview, a Los Angeles real estate investment firm that builds urban mixed-use and multifamily projects in the U.S. West.
There are about 8,700 designated census tracts spread across all 50 states, the District of Columbia, and four U.S. territories. Each jurisdiction designated up to one-quarter of its qualifying low-income communities, and the list will not change unless the law does. Those designated zones “run the gamut from truly distressed . . . to others that are up-and-coming or have been magnets for capital,” said Leithner.
Opportunity Zone capital is, by its nature, long-term. The maximal tax benefits come to investors who stay invested for 10 years. That makes it especially attractive for a place that is attempting to revitalize and reinvent itself, according to James Gronke, an economic development specialist and president of the Erie (Pennsylvania) Regional Chamber and Growth Partnership. “We’re the kind of community Opportunity Zones were designed for,” he said.
There are eight designated Opportunity Zones within the Erie city limits, he said, and most of the developable land within them is bayfront. With the backing of Erie Insurance, a deep-pocketed local business mainstay, the Erie Downtown Development Corp. has raised $30 million. It now hopes to syndicate that into $150 million invested in downtown housing. In August, city development boosters sponsored a two-day event to inform would-be investors about the Opportunity Zones. About 300 people attended, Gronke said.
The Opportunity Zone program “gives us access to capital we wouldn’t otherwise get,” he said. In a place like Erie, where growth is flat, “without patient capital, you can’t get there.”
Location is not the only requirement for a project. To qualify, a project has to make improvements over 30 months that at least double the investment basis for a property.
“The problem is, how do you double the basis in a prudent way?” Williams asked. His company runs four affordable housing funds and works mostly with institutional investors that commit $2 million to $5 million. “If you own a parking lot in an Opportunity Zone, you’re golden,” he said.
Of the 80 properties in Avanath’s portfolio, 14 were in Opportunity Zones, Williams said. Analysis identified four properties with adjacent land that offered the opportunity to create affordable housing and thus increase the value of the land.
For example, at the Woodside Senior Apartments, an income-restricted age 55-plus community in Ontario, California, Avanath had two buildings with about 70 units each. An old office building sat between them. Avanath obtained control of that structure and plans to tear it down to add 100 to 120 senior units. Without the Opportunity Zone financing, it would not have made sense for his company to buy that office building, Williams said. It would have cost too much.
Similarly, at the Ravenna apartments in Orlando, a 228-unit income-restricted property that Avanath acquired in 2015, there was adjacent developable land. The company will build another 100 units there.
Avanath has structured its financing so that the firm is both the buyer and the seller, selling the development projects into an unlisted real estate investment trust that it created as its own Qualified Opportunity Fund. Williams estimated that the Opportunity Zone tax breaks could add about 300 basis points to the high-single-digit or low-double-digit returns that an investor would expect from one of his firm’s multifamily projects.
In some circumstances, it is possible for a project that started out with conventional financing to switch over to Opportunity Zone financing, Burton pointed out. One such circumstance can be if a Qualified Opportunity Fund buys a property before it is granted a certificate of occupancy.
That happened with one Cityview development, a 174-unit apartment project in an Opportunity Zone in California’s San Fernando Valley that was set for completion in late 2019. The company put it up for sale unleased, “which we never do,” Burton said. The company received 17 offers from Opportunity Zone funds. “It’s under contract to sell at what we thought it would have been worth a year and a half from now, fully leased.”
Other Cityview developments also will draw on Opportunity Zone financing. The company already intended to proceed with that work. “The advant-age for us was to broaden our investment base,” Burton said.
To date, developers and investors have focused on how to structure deals and investment funds, but it is time to move along from that, Bjorkman said. “Getting around the structure is no more complicated than any other tax issue that we deal with on a day-to-day basis,” he said.
“At the end of the day, you hire a real estate counsel like you always do,” Bjorkman said. If the lawyer signs off on the structure, move ahead. “Focus on your ability to execute on a project.”