By Paul Fiorilla
The Treasury Department’s release of guidelines for opportunity zones has unleashed a flood of managers raising funds to invest in low-income areas and take advantage of tax breaks.
It’s taken a while to gain momentum, but there are dozens of managers raising upwards of $25 billion to invest in real estate within the 8,700 zones that have been established. Opportunity zones—created by the 2017 tax reform late last year—allow investors to defer capital gains taxes and avoid paying taxes on gains if the investment is held for at least 10 years. Qualified investments, which must be made through opportunity zone funds, include real estate, businesses, infrastructure and more.
Enthusiastic is the best way to describe the initial reaction to opportunity zones in the real estate market. For one thing, investors are sitting on a large amount of capital gains that qualify for opportunity fund zones. U.S. Senator Cory Booker, the New Jersey Democrat who co-sponsored a bill to create opportunity zones with South Carolina Republican Senator Tim Scott, says there are $6 trillion worth of unrealized capital gains sitting on the sidelines.
Another factor is that opportunity zones give commercial real estate investors the potential for higher yields at the tail end of an eight-year bull market when acquisition yields are at or near all-time lows. The spread between returns on stable assets in primary markets and value-add/secondary market properties has slowly tightened over the course of the cycle. Properties in opportunity zones have the potential to provide higher returns more in line with expectations of value-add investors.
“I really think this will be the biggest economic development (incentive) to come out of Washington in this generation,” Booker said, speaking at a recent seminar on opportunity zones sponsored by the Rutgers Center for Real Estate in New Brunswick, N.J.
At a time of heightened partisan squabbling in Washington, the bipartisan sponsorship highlights the appeal of opportunity funds. Generally speaking, Republicans like the tax incentives for developers, while Democrats like the potential for investment to help revitalize low-income communities.
Booker said the idea came in part from his experience as mayor of Newark, N.J., and the effort to partner with corporations such as Goldman Sachs and Prudential to invest in the city. “We want to create a business case for low-income areas,” he said.
Guidelines Closer to Being Set
Although no money has yet been invested in opportunity zones, the path became clearer recently when the Treasury Department released proposed guidelines to answer many questions that were not covered by the legislation that created the zones.
For example, the proposed guidelines say that the cost of land is not factored into the requirement that investors double the basis in a property. The guidelines state that REITs and partnerships can participate in addition to individuals, S corporations, trusts and estates. Also, investors have 180 days from the time the capital gain is recorded to transfer the money to a qualified fund, while funds have up to 30 months to invest the proceeds. The Treasury guidelines cannot be finalized until after a 60-day public comment period, but the fact that investors now have a good idea of the government’s thinking has helped to spur fresh activity.
Specialized Investments in Low-Income Zones
Panelists at the Rutgers conference expressed some caveats about investing in opportunity zones. For one thing, it will be important for states to match the federal tax incentives since investors are likely to focus on states where the tax benefits are maximized. Another concern is whether revitalization will change the character of neighborhoods and make it too expensive for existing residents and businesses to stay.
What’s more, the potential for income growth is less in low-income areas. Consequently, the success of projects in low-income areas might be dependent on government support beyond the tax breaks for opportunity funds. For example, tenants in apartments in low-income communities don’t have the means to pay higher rents that might be needed for a project to produce the kind of yield sought by developers.
Investors should be prepared to access the “alphabet soup” of government programs available for projects in low-income communities, said Sherry Wang, a managing director in the Urban Investment Group of Goldman Sachs. Wang said Goldman, which has invested in more than $1 billion in low-income areas of New Jersey over the past decade, sometimes uses up to seven incentive programs for individual projects. “Most projects (in low-income areas) don’t pencil without government support,” she said. “You need sophisticated partners that know how to work through (government) incentives.”