The Land of OZ

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7 min read

Multifamily is flavor of the day; NH&RA panelists share approaches & preferences

We are still in the very early stages of Opportunity Zone deals, and with this new incentive for a variety of businesses in designated underserved communities, it appears as if one size isn’t going to fit all. But, according to Ricky Novak, co-managing partner of the Strategic Group of Companies, an Atlanta-based firm focused on delivering tax efficiency through business solutions and private equity capital, “Most investors are looking at real estate at this point rather than businesses. Multifamily is still the flavor of the day investment, but also mixed-use in certain markets,” particularly redevelopment in previously underutilized or blighted areas.

Like other elements of the affordable housing and urban rehabilitation spheres, Opportunity Zones offer the potential to be triple-win propositions: for investors, for municipalities and for the people who will live and work in those designated areas. But this is still a new investment vehicle with a fair number of significant questions yet to be addressed. An expert panel at NH&RA’s Annual Meeting in Miami in February demonstrated a whole menu of approaches.

Since only the capital gain itself, derived from whatever source, has to be invested to secure tax benefits, it does have certain advantages over 1031 deals, to which it has been compared. “It’s a legitimate alternative to a 1031 exchange and can provide an exit strategy,” states Novak. “It’s a major opportunity to pull basis off the table and put it in liquid investments instead of real estate.”

“We don’t want to be the pioneer who creates the opportunity,” says Billy Huger, managing director of Atlanta’s Monarch Private Capital Advisors, which invests in low-income housing and other tax-advantaged vehicles. “For example, we went into Indianapolis and got involved with an Opportunity Zone directly across the street from [an already] very successful development. And we tend to go with single-asset vehicles.”

“You can have two different funds invest in the same deal: one that’s an Opportunity Fund and one that isn’t,” Beth Mullen points out. She is a CPA and affordable housing practice leader in CohnReznick’s Sacramento, CA, office. “But is triple-net real estate an ‘active business’ for an Opportunity Zone as far as Treasury is concerned? The jury is still out. It may not be active enough.”

And, “How do you sell diversified fund assets to someone who only wants certain of those assets?” asks Jerome “Jerry” Breed, a principal in the Washington, DC office of the Miles & Stockbridge law firm, which specializes in state and federal tax incentivized transactions, and the panel’s moderator. “We hope Treasury will issue regulations on this.”

The Target Investors
Opportunity Funds are a new way to shield capital gains from federal, and some states’ taxation through reinvestment in real estate or a business in a designated zone. But who are the target investors, and what types of investments are they looking for?

“At Monarch, we’re seeing all types of investors,” Huger said. He particularly noted family offices and banks that were reallocating gains and looking for Community Reinvestment Act (CRA) credits. He notes, however, that, “Not a lot of money is moving yet.”

“It has to be a good investment,” Novak states, though he says it must be taken into consideration that this is tax-advantaged capital, so, “Investors are comfortable with a ten to 15 percent haircut on returns.”

As far as what types of entities are competing for attention other than with real estate: “We like self-storage and redevelopment of historical areas, particularly in secondary East Coast markets,” Novak says. “On top of that, I like technology centers driven by major universities.”

“Sometimes you have false low-income figures around university and military bases because of student and enlisted housing,” Breed notes.

“Give me the top ten cities with Millennials – that’s where you’re going to see the growth,” Novak asserts.  “We’re also paying very close attention to Baby Boomers moving back into urban cores. As crime issues get resolved, that flight back into walkable urban cores is something you’re going to be seeing a lot of.”

The preference for buildings over businesses may be due to two factors. First, the kinds of investors who are initially attracted to Opportunity Zones may be real estate professionals. Second, it is not yet clear at this point what types of businesses will qualify for the designation and how the requirement that at least 50 percent of gross income from the active conduct of business in the zone will be interpreted.

“More clarification is needed,” says Novak. “What does it mean to be in the zone? Is it simply the source of income?” A now-standard example is whether a delivery company physically located in an Opportunity Zone, but whose drivers and trucks spend most of their time outside the zone, will qualify.

Mullen believes the key determinant will be whether the income is generated in the zone because, “The purpose is to stimulate economic activity within the zone. If [for example] people running an Internet business are coming to work in the zone, I think you’re basically accomplishing that.”

“There are no real structural problems with LIHTC or Historic Tax Credits,” says Breed, though Huger says, “Lots of investors are not looking for tax credit benefits. It’s more reallocating gains, with some double dipping on credits.”

“The primary driver is no tax on appreciation,” says Novak. “Other aspects are nice, but not the primary focus. Driving 99 percent of the decisions is what is the best bang for the buck.” He adds, “Layering of benefits de-levers the risk. Historic is the program that will get the most play. With LIHTC, there is not necessarily an alignment of interests.”

Single-Asset vs. Diversified O-Funds
“We deal with two types of clients,” Novak continues, “family offices with deep knowledge of real estate, who will never go into diversified funds; and people selling businesses or [wide-ranging] stock positions – they don’t have the first clue how to underwrite real estate. So, we have a dual-track approach to single-asset and diversified funds.”

Huger notes, “With a single-asset fund, the investor can underwrite that asset and determine how it figures into his or her investment needs. This empowers the investor to have more flexibility than going into a comingled pool. It is also easier for us to manage.”

Future Unknowns
It is clear from the regulations that a five-year investment in a qualified Opportunity Fund excludes ten percent of the original capital gain, a seven-year investment excludes an additional five percent, more than ten years will mean no federal tax on appreciation, and the basis will be deemed no lower than the fair-market value of the property or business in 2026. What is unknown at this point is the tax rate at which any gains will be taxed at that point. Mullen believes that it will probably be the 2026 rate, which could be considerably higher than it is now, as investments are being made.

An even greater unknown is whether this time-limited program will be renewed beyond its projected end date. “Treasury and IRS would consider this a statute rather than a program at this point,” Breed observes. Beyond its current statutory cutoff point in 2027, “There could be more of a focus on measuring community benefits if the program continues.”

“I think it is extremely important for this program, for us to be able to show that jobs have been created in areas where otherwise jobs would not have been created and affordable housing was produced as a result,” Novak says. “If we can’t accomplish those two things, I think you’re going to have a difficult time getting Congress to extend it. But deals are getting done that are further out on the frontier.”

Story Contacts:
Jerry Breed, [email protected]
Billy Huger, [email protected]
Beth Mullen, [email protected]
Ricky Novak, [email protected]