Dozens of Opportunity Zone funds are racing to capture a wave of private equity dollars seeking value-add investments that come with the added perk of a hefty break on capital gains taxes. The frenzy is creating a bit of a Wild West mentality that has some raising concerns about the potential dark side to Opportunity Zones.
Many view the new Opportunity Zone program created by the 2017 Tax Cuts & Jobs Act as having the potential to be the most significant federal community development initiative in U.S. history, with billions—perhaps trillions—of dollars in private equity targeting investment opportunities in low-income communities around the country. Yet there are still numerous questions, concerns and potential pitfalls that could rewrite that history.
One of the biggest frustrations surrounding Opportunity Zones is that the rules to date are somewhat ambiguous and the IRS and Treasury Department have been slow to release additional guidance on key issues for stakeholders who are chomping at the bit to move forward. “Everybody is waiting anxiously to see what the regulations will provide for so that they can actually execute,” says Andrew Charles, a partner at Kramer Levin Naftalis & Frankel LLP in New York City. “I think activity will pick up exponentially once the final regulations come out.” The guidance was delayed because of the government shutdown earlier this year, but it is expected to be released in late March or early April.
Other key concerns related to Opportunity Zones include a lack of transparency, exposure risk created by inexperienced sponsors and the potential that tax incentives may end up hurting communities the program was intended to help.
The 8,700-plus designated Opportunity Zones across the country include a wide range of urban, suburban and even rural areas, from Brooklyn to rural Wyoming. One potential downside is a spike in property values in high-demand urban areas. “I’m telling clients to hold onto their property, because in one year the prices are going to double, because all of these private equity funds that are being formed to acquire property in Opportunity Zones [are] only going to accelerate,” says Schuyler M. Moore, a partner at Greenberg Glusker Fields Claman & Machtinger LLP in Los Angeles.
Moore recently wrote a letter to the editor of Tax Notes on the “Lunacy of Opportunity Zones” (subscription required). “The thesis is that they are completely and utterly absurd as a policy level, because they absolutely, without question, hurt the segment of society that they are supposedly intended to benefit,” says Moore. Opportunity Zones are a boondoggle tax subsidy for the rich and an absolute disaster for the poor, he adds.
Missing the mark on social impact?
The basic premise behind the Opportunity Zones initiative was to offer incentives in the form of deferred and reduced taxes on capital gains to attract private capital for investment into qualifying low-income areas of the country. One concern is that development won’t produce the intended positive benefits and could even have the opposite effect in terms of loss of critical affordable housing and gentrification of neighborhoods that displaces residents.
Some see a missed opportunity in how the legislation was written. A lot of the language that was included in the original bill as it relates to transparency and reporting was not included in the final legislation, notes Christopher Coes, vice president, land use and development, at Smart Growth America and director of LOCUS (a Smart Growth program). For example, funds do not have to track or report on community benefit requirements.
Transparency is important in commercial real estate to ensure that sponsors or developers are acting in good faith. The way the legislation was written, it forces investors and communities to dig deeper in their own due diligence, adds Coes.
“We think the Opportunity Zone program has incredible potential for transformation, but we think there needs to be a metric to measure that by,” agrees Quinn Palomino, co-founder and principal at Virtual Partners, a Scottsdale-based private equity firm. The long-term viability of the Opportunity Zone program is dependent on producing the social benefits promised to the community, she adds.
Virtua was one of the early entrants into Opportunity Zone investment arena with the launch of its Virtua Opportunity Zone Fund I in June. Jobs and entry-level housing have been a key focus for Virtua Partners as it continues to move forward with Opportunity Zone projects. The firm broke ground on its first OZ development in February with a new 130-room Springhill Suites by Marriott in the Phoenix suburb of Avondale. The fund also expects to start construction in April on 1950 Broadway, a 90-unit affordable/workforce housing project in Tempe.
Virtua Partners supports creating an Opportunity Zone Impact Policy group that will be charged with identifying a set of standards that can be applied to Opportunity Zone projects so communities and investors can evaluate the social impact of the capital poured into such initiatives.
Not so smart economic development
The first wave of Opportunity Zone investment is already targeting the low-hanging fruit with projects in high-demand areas, such as Downtown Seattle and Center City East in Philadelphia. “The question really becomes, can we get the next wave of investment to be more methodical and work with communities to ensure that those areas or projects that need more conversation or community buy-in actually attract investment,” notes Coes.
Research conducted by LOCUS and the Center for Real Estate and Urban Analysis at George Washington University ranked and assessed more than 7,800 Opportunity Zones by their “Smart Growth Potential” based on walkability, job density, housing diversity and distance to the nearest Top 100 central business districts. The study found a big disparity between zones, with only 2 percent that rated a minimum score of 10 or higher. The top five on that list include:
- Downtown Portland, Ore.
- Downtown Oakland, Calif.
- Downtown Seattle
- Center City East, Philadelphia
- Inner Harbor, Baltimore
Opportunity Zones will also keep communities on their toes to guide that investment. Are investment dollars going to target areas where they could have the greatest amount of impact on the community, or are developers instead going to choose the path of least resistance? That is a concern for local governments who may not have the capacity, whether it is the resources or expertise on latest economic development trends, notes Coe. “In 10 years, we may find that even though we created this large incentive, the market gaps for some communities were so big that we needed more resources to actually help them,” he says.
Investors adopt buyer beware approach
Additional guidance is needed on key issues, including the treatment of land, refinancing and whether a property can have debt in excess of the basis. Is recapture of depreciation exempt? How do you treat foreign tax payers? How do you treat trusts? “There are a lot of nuances in terms of refinancing assets and multiple assets and how to sell these assets that all have to be ironed out in the regs, and people are skittish until such time as they get more clarity on how to proceed,” says Charles.
Another downside to Opportunity Zone fund investment is liquidity and getting invested dollars out of those funds. Investors that pull their money out before the 10-year window to maximize tax savings are going to have some type of taxable event. What happens if someone dies with money still invested in a fund? For investors who don’t structure investments properly, such as by establishing a trust, the heirs will likely inherit the tax bill.
Ultimately, investors need to take a buyer beware attitude and vet OZ funds the same way as any other real estate investment opportunity, with thorough due diligence on the sponsor, the project, the business plan and the potential risk versus return scenario. “I think that it can be beneficial, but it’s not this holy grail that it has been made out to be,” says DJ Van Keuren, a vice president for the Hayman Family Office.
As someone who works in the family office investment sector, Van Keuren gets inundated with investment opportunities and has seen a flurry of pitches from new Opportunity Zone funds over the past six months. Yet he remains skeptical. Among the 8,700 designed Opportunity Zones around the country, Van Keuren sees a valid case for real estate development in less than 100 of those zones. “What’s happening is that you have to be very careful that the tail is not wagging the dog,” he says.
There are a lot of people selling tax benefits more so than the project itself. There are also a lot of people jumping into Opportunity Zones that lack real estate expertise and/or development expertise. “You’re having a lot of people run to the space that don’t know what they’re doing, and that is just a recipe for disaster,” says Van Keuren.