By Bryan Shaffer
The Tax Cuts and Jobs Act of December 2017 opened the door to potentially tremendous tax savings, along with up to $2.2 trillion in capital that could be poised for reinvestment in underserved markets throughout the U.S. This has the potential to be a major win for the commercial real estate industry.
Opportunity Zones provide powerful tax incentives to encourage capital reallocation into designated regions throughout the U.S. Opportunity Zones exist in every state, and roughly 12 percent of the nation’s land mass, including all of Puerto Rico, lies in an Opportunity Zone. Every major city has at least one Opportunity Zone, and the zones also exist in suburban and rural areas. Some Opportunity Zones in the West and Southwest appear to be larger than some of the smaller states in the Northeast.
The Taxpayer that is eligible to defer gain under section 1400Z-2(a)(1) includes individuals, partnerships, REITs and S Corporations. With many unanswered questions in the legislation, the challenge remains: What do we know now, and what is the best next step?
Today, it is difficult to secure financing for development because of several changes in banking regulation and where we are in the cycle. As capital advisors, we are looking closely at the potential impact these new regulations will have for our clients and the overall impact on capital markets.
Key capital sources
Private REIT lenders: Many groups have started raising funds to invest in Opportunity Zone Funds, including several private REITs. Opportunity funds (“QO Funds”) require 90 percent of assets acquired by these funds to be located in designated Opportunity Zones. Major fund companies that already operate mortgage REITs are likely to pivot to QO Funds as a new way to make debt or equity investments in real estate. Operators such as Fundrise, which currently crowdfunds private REITs, have been quick to jump into the opportunity fund sector, offering individual investors the chance to take part in these new fund vehicles.
Community development financial institutions (CDFIs): Smaller community lenders will quickly follow, setting up their own QO Funds in an effort to spur economic development in their individual regions. The good news for this type of lender is that much of the new law was based on the same zones as the New Markets Tax Credit (NMTC) Program, which has been in existence for several years. This means that many lenders are already poised to lend in markets now defined as Opportunity Zones.
Impact on Borrowers
Ground-up commercial developers are most likely to benefit from more capital in Opportunity Zones, as well as new tax savings.
In Los Angeles, for example, Koreatown and parts of the outskirts of downtown are designated Opportunity Zones. While these are key submarkets with less capital investment to date than some other areas, they are also prime locations that offer tremendous potential for developers and owners.
The new law offers unique benefits over a 1031 exchange, specifically the ability to roll an investment into a new zone and realize substantial savings.
The challenge is that the law also requires a 30-month period in which “the fund must substantially improve the property.” This may limit the investment to new construction. This doesn’t mean that the law will only support developers, but the industry is waiting for more feedback on the limitations.
Either way, there is incentive to hold these properties for the long term. Investors who buy property in Opportunity Zones will benefit by having a:
- Deferral of capital gain
- Reduction of the capital gains tax realized
- No tax on any capital gains from an investment in the Opportunity Fund
From a financing perspective, the Opportunity Zone law offers a new stream of found equity, which is likely to bolster development and support increased risk-taking among both lenders and developers.
The key to navigating that risk, however, is ensuring that the nuances of the law are fully understood before taking a leap.
While it is too early to begin buying in Opportunity Zones at the moment, we are helping clients to look closely at designated zones and analyze opportunities in order to plan for future financing.
By keeping a finger on the pulse of this new law, borrowers, lenders and cities alike are likely to benefit from a tremendous influx of capital in the months ahead.
George Smith Partners is a national commercial real estate capital advisory firm that has arranged more than $52 billion in financing since its inception.