Opportunity Zones - Next Big Thing or Government Boondoggle?

larry david's picture
larry david - Certified Professional
Rank: King Kong | banana points 1,600

Fellow RE Monkeys,

Wanted to hear everyone's thoughts on Opportunity Zones. Personally, I'm very skeptical this program will work for 3 reasons:

1) Required Hold Period - material tax advantages only kick in after 10-yr hold period. For anything shorter, basis step-up is nice, but can't see how it makes sense to deals in the OZs for a measly 10%-15% step up in basis.

2) Raising Equity vs Generating Yield - this is the biggest one to me. The legislation obviously makes is easier to raise equity. However, that is not the key bottleneck in today's development environment. RE is awash in equity capital. The primary constraint in today's development environment is yield. Given where construction costs are, it's hard to hit more than a 6.75% stabilized RoC on suburban MF and a 6.25% on urban product in my markets. How in the world are these deals going make sense? Assuming market rent is 15%-20% less in OZs, yields on both suburban and urban product will be 75 bps to 100 bps lower than non-OZs. At that point, you are probably talking about underwriting negative leverage and high single digit / low-double digit IRRs on medium to long-term holds. In what universe does this return profile justify development risk?

3) Lots of Capital Chasing Few Deals - In order to build projects with decent yields, the only OZ deals that make sense will be ones on the edges of the OZ boundaries in close proximity to high-income/desirable neighborhoods. The amount of deals that fit this criteria are slim in comparison to the amount of OZ designated capital chasing them. I fear that land numbers in these deals will be comparable to those in non-OZs. At the end of the day, a lot of these funds may end up with undeployed capital past their investment periods or overpaying for the "good" OZ deals.

Any and all discussion is welcome. I've been stupendously wrong in the past, so feel free to insult, disagree and pick nits.

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Comments (24)

Dec 24, 2018

Hi larry david, just trying to help:

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Fingers crossed that one of those helps you.

Most Helpful
Dec 26, 2018
  1. On average, HNW individuals have a much longer hold duration than merchant builders. While having flexibility in terms of disposition is an advantage, many investors will gladly hold for 10+ years in order to not pay capital gains taxes. Further, there is a better than 50/50 chance that this next round of rules and regulations (which should be released mid-January) will allow Opportunity Funds to sell a property prior to the 10+ year period as long as they re-invest the proceeds in another qualified opportunity zone investment. This will have huge implications for opportunity zone investors who want to maximize the productive use of their opportunity zone capital while avoiding capital gains.
larry david:

Assuming market rent is 15%-20% less in OZs, yields on both suburban and urban product will be 75 bps to 100 bps lower than non-OZs. At that point, you are probably talking about underwriting negative leverage and high single digit / low-double digit IRRs on medium to long-term holds. In what universe does this return profile justify development risk?

The majority of Opportunity Zones are in census tracts that fit the narrative that you are alluding to above. However, there are dozens if not hundreds of census tracts in prime locations that will attract lots of capital. For instance, check out the OZ Maps in Portland, Los Angeles, Long Island City, Houston, etc. These are areas that already are attracting institutional capital in big ways. The OZ Program will just exacerbate that capital influx.

larry david:

3) Lots of Capital Chasing Few Deals - In order to build projects with decent yields, the only OZ deals that make sense will be ones on the edges of the OZ boundaries in close proximity to high-income/desirable neighborhoods. The amount of deals that fit this criteria are slim in comparison to the amount of OZ designated capital chasing them. I fear that land numbers in these deals will be comparable to those in non-OZs. At the end of the day, a lot of these funds may end up with undeployed capital past their investment periods or overpaying for the "good" OZ deals.

Any and all discussion is welcome. I've been stupendously wrong in the past, so feel free to insult, disagree and pick nits.

See response to #2. However, I do think that the tax arbitrage that the OZ program provides will continue to be priced into the invest opportunities, which aligns with your statement about OZ land prices converging with non-OZ land prices.

    • 5
Dec 26, 2018

1) Makes sense on the HNW front. Think that being able to roll OZ funds into other OZ investments is CRUCIAL.

2) Sounds like results may vary across cities. The markets I deal in got shafted. Almost no neighborhoods in the path of progress.

3) Completely agree

Dec 27, 2018

Hi Larry and Duke,
I work in LIHTC. My two cents is this incentive will, like all government programs, have unforeseen consequences, but perhaps some benefits as well to both investors and the zone's residents.

larry david:

1) Required Hold Period - material tax advantages only kick in after 10-yr hold period. For anything shorter, basis step-up is nice, but can't see how it makes sense to deals in the OZs for a measly 10%-15% step up in basis.

To piggy back off the Duke, think about LIHTC deals with 15 year hold periods that still have decent IRR's for institutional investors. If your main goal is to not lose money, like many HNW investors, then it could make sense to invest in an O-Zone. Back of the napkin if you save 15% basis at a 20% tax rate you add 3% to your after tax yield. If your property appreciates just 30% over ten years (less than 3%/year) at a 20% tax rate you add 6% to your after tax yield. These built-in cushions are marginal but I think they get credit comfortable, and the ability to enter a new market they might not have previously been in could have longer term benefits for the investor. I think a more analytical plan to transform a chunk of the neighborhood would have to be in place for these incentives to give meaningful returns in some cases (rather than one-off builds). This would lend itself to "double bottom line" investors in the impact investing space, which seems to be growing.

larry david:

2) Raising Equity vs Generating Yield - this is the biggest one to me. The legislation obviously makes is easier to raise equity. However, that is not the key bottleneck in today's development environment. RE is awash in equity capital. The primary constraint in today's development environment is yield. Given where construction costs are, it's hard to hit more than a 6.75% stabilized RoC on suburban MF and a 6.25% on urban product in my markets. How in the world are these deals going make sense?

How about building solar farms in the desert with tax equity?
Or, forget about the real estate, grow a business in an O-Zone instead of a suburban industrial park. If you were going to do it anyway, why not do it in an O-Zone?

larry david:

3) Lots of Capital Chasing Few Deals - In order to build projects with decent yields, the only OZ deals that make sense will be ones on the edges of the OZ boundaries in close proximity to high-income/desirable neighborhoods. The amount of deals that fit this criteria are slim in comparison to the amount of OZ designated capital chasing them. I fear that land numbers in these deals will be comparable to those in non-OZs. At the end of the day, a lot of these funds may end up with undeployed capital past their investment periods or overpaying for the "good" OZ deals.

After trying to play the devil's advocate, I have to agree with both of you that many areas seem overpriced and one consequence will be further speculative appreciation in less attractive areas, institutionalizing ownership in O-Zones that were previously more mom-and-pop owned. I think this is a general trend in first and second tier MSA's and it makes me wonder if there will be a significant correction.

    • 4
Dec 26, 2018

From a real estate perspective, I don't think it matters much. OZ's won't be the determining factor in whether or not to invest. Deals that work will be a bit richer, and deals that don't still won't happen.

Basically I don't see any developers or equity investors passing on a deal 18 months ago and now coming back and deciding that the Opportunity Zone legislation makes it worthwhile.

    • 1
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Dec 26, 2018
Ozymandia:

From a real estate perspective, I don't think it matters much. OZ's won't be the determining factor in whether or not to invest. Deals that work will be a bit richer, and deals that don't still won't happen.

Basically I don't see any developers or equity investors passing on a deal 18 months ago and now coming back and deciding that the Opportunity Zone legislation makes it worthwhile.

Agreed. Mostly talking about OZ targeted funds developers are raising.

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Dec 27, 2018

I've been working closely with Opportunity Zone deals on the capital formation front at a major brokerage firm for the better part of this year, so feel free to message me directly if you'd like to speak, but I can answer some of those questions below. They're all good and reasonable questions.

  1. The major tax benefit is not the 10-15% step-up in basis, but rather the relief in capital gains tax from the 10-year investment. The back-of-the-envelope math that is thrown around by the major tax firms is: OZ deals generate an extra 350 bps of IRR return on an after-tax basis. Only about 100 bps of that is from the 10-15% "rebate"; the rest is from not having to pay any capital gains taxes on your secondary investment at the end of year 10.
  2. Agreed that strong ROC yields are harder to come by, but there are always good deals out there, and like other users have commented, OZ census tracts are not always in low-growth areas. You'll find good OZ tracts in the suburban rings of strong secondary markets and there are developers who got the timing right by acquiring land in 2018, but before the census tract was designated as an eligible OZ tract.

In terms of the IRR return, the deals are really build-to-core, so, with a 10-year hold, investors are happy with a low-double digit IRR. The key is just structuring a deal so the development partner is incentivized to deliver and stabilize a building, but after that you're just managing a newly constructed asset in a solid market for 8 years. Many of these HNW investors are focused more on 1) capital preservation (don't lose money), and 2) multiple growth (if they can conservatively underwrite to a 2-2.5x multiple in 10 years, they're happy).

  1. This is a valid concern, and shared by most major investors looking closely at the space. Some funds that are raising capital have pre-identified and tied up development sites at a good basis, so they will find success deploying capital to those deals but there will be competition in 2019 and 2020 as those "low-hanging-fruit" deals get scooped up. I personally think there will be a stratification where the big players with access to top developers and lots of reach will find some success, but some of the mom-and-pop regional developers seeking to raise $500mm funds will falter or overpay. But that's just conjecture.

Feel free to PM me if you'd like to discuss more.

    • 3
Dec 31, 2018

It was my understanding that an investor had to stay in an opportunity zone fund for 10 years in order to realize the cap gains free after that time. But there is no requirement that an individual property be held for 10 years - just that the property qualify (located in a qualified census tract, meet the "substanital improvement" requirement, etc., completed within 30 months, etc.)

Dec 31, 2018

The rules regarding investment holding period have not been fully defined. As of today, the investor needs to be invested in a single property for 10 years. There's an additional wrinkle that an investor can sell their opportunity zone investment and re-invest it in another qualified opportunity zone investment. However, that would re-set the 10-Year Clock.

In January, it is expected that the IRS will release the official rules regarding this. There is speculation that these rules will allow an investor to realize their opportunity zone investments and re-invest into new opportunity zone investments WITHOUT resetting the 10 year clock.

    • 1
Dec 31, 2018

Obviously you know what you're talking about but structuring the regs that way makes no sense. If the whole idea is to stimulate investment and growth in underdeveloped census tracts, why would you want to keep equity kept in stabilized assets? Why not just allow investors to move it out and put in a value-add deal - if its in one in a designated census tract? And what if you're a LP investor and the GP decides to sell the property or refi you out - seems totally unfair to require the clock to be reset over something for which you had no control.

Also, I don't get why the regs discuss the concept of working capital. If you have to keep all your funds committed to a single project for a 10 year period, why would you have working capital outside of that project? My impression was that the working capital was for use when you've met the substantial improvement threshold with a project but before you move it to the next deal - if you have to remain committed to a single project, it makes no sense.

Jan 2, 2019

I'm somewhat unclear on what you are trying to say and/or ask. Are you asking why would the IRS allow investors to re-invest their Opportunity Zone gains into new Opportunity Zone deals? OR are you asking, why would the current regs require a person to re-start their clock if they re-invest?

Jan 2, 2019

Yeah that comment wasn't well written. With a ten year hold period for an individual project, the IRS is preventing investors from reinvesting gains into new OZ deals. Why? Its counter to the aim of the program.

Jan 2, 2019

Prob because the IRS eventually wants you to pay gains. Even deferred gains are still realized, just not paid. But eventually a portion of some gains are paid being that some folks do cash out here and there. Even if just some boot. Hope I understood correctly.

Jan 2, 2019

@wso_4 If the OZ investor was to re-invest their OZ gains before 2026, they would still be eligible for the capital gains exemption at the end of 10 years (but the 10-Year clock would re-set). However, to your point, because the clock is re-set, it discourages certain investors from re-investing. This is something that the IRS/Treasury realized and thus is now working on amending the regs to allow re-investment without re-triggering the 10 year clock. We'll see if this rule is included in the new regs.

Jan 3, 2019

There's clearly a lot of uncertainty on this point. From The Real Economy

*Q: How do you think investment in OZ funds compares to other asset classes such as private equity?
Merkel: A typical private equity fund has a lifespan of approximately 10 years, which will likely match the typical lifespan of an OZ fund. In addition, both funds have the benefit of liquidating and reinvesting within the fund. We are still waiting on clarity regarding how long an OZ fund has to reinvest proceeds from a sale, but the ability to recycle capital exists with both types of funds. It also should be mentioned that nothing precludes the investor from only taking the five-year deferral and 10 percent reduction of the initial gain benefit.
*
It would be really misleading if he means (or the IRS means) "the ability to recycle capital exists...if you reset the 10 year clock"

Jan 3, 2019

Agreed. There is a lot of uncertainty. That's why many investors are waiting on the sidelines until the next round of regulations are released.

Jan 3, 2019

The problem is that there's still plenty of uncertainty about key points, but there's total certainty that the six months clock is running and you need to have 90% invested in order for your fund to qualify. I think I'm just going to do the deal and assume that I can exit before 10 years. I can't believe that the IRS would come after me for what is a reasonable interpretation of the guidelines - especially when others, including "experts" are doing it.

Jan 4, 2019

I would highly caution against telling yourself that you, "cant believe that the IRS would come after [you] for what is a reasonable interpretation." People have been prosecuted by the IRS for far less.

Also, if it's a QOZB (Qualified Opportunity Zone Business), you would only need 70% of the assets in the business to be qualified assets in order for the business to qualify. For example:

Capital Gains - $100
Non-Qualified Dollars - $10
Qualified Dollars invested in a QOZB ($90) - of which only $63 need to be qualified assets and $7 do not.

Therefore, you would only need $63 to be invested in qualified assets in order for your $100 to qualify.

So, in your case, execute the deal through a QOZB. That's what we're doing.

Jan 2, 2019

Just talked with a buyer. He's only buying right now in opportunity zones here in San Diego. Mixed use ground up deals. About 15 MF units + retail.

Jan 2, 2019

Like nearly every single government program or targeted tax break, this program fundamentally misdiagnoses the problem and, if it even works, creates counterproductive solutions.

This program is predicated upon the idea that a community is poor because it lacks investment capital, which is correct in a sense, but communities that lack investment capital lack it because of high crime, excessive regulatory burdens, and a poorly skilled workforce. If you artificially bring in outside investment without fixing the underlying problems (which often happens with local gov't incentives) then you'll just have new people move into the area ("gentrification") who will, by force of numbers, change things, and the current residents will be pushed out into other poor, mismanaged areas and will be no better off.

Also, there is opportunity cost. When the government favors investment into one community over another then there is a winner and a loser--the loser is the community that loses out on the capital investment because investors are targeting artificially higher returns.

Of course, my criticisms are somewhat theoretical with this program and assume that investors will even be moved to invest as a result of the program. However, more likely than not investors will invest in the same areas they were planning to invest before but will realize excess returns out of tax payer coffers.

Jan 3, 2019
real_Skankhunt42:

Of course, my criticisms are somewhat theoretical with this program and assume that investors will even be moved to invest as a result of the program. However, more likely than not investors will invest in the same areas they were planning to invest before but will realize excess returns out of tax payer coffers.

Exactly.

Jan 3, 2019

This is a really concise summary of some of my thoughts. Thanks.

Jan 3, 2019
Jan 3, 2019