Modeling opportunity in Opportunity Zones

Example of Opportunity Zones in New York multifamily building

Blog Post, by FUEL Valuation

When opportunity knocks, commercial real estate (CRE) investors often answer. Now, Opportunity Zones are what’s knocking. More than a few investors are aggressively seeking to make Opportunity Zone investments before year-end 2019 in order to capture the full tax benefits. Yet, as attractive as the tax advantages are, fundamentals still matter.

Created as part of the Tax Cuts and Jobs Act of 2017, the Opportunity Zones concept is intended to attract private investment to revitalize more than 8,700 economically distressed communities designated by state governors in all 50 states. As an incentive, investors can reduce their capital gains tax liabilities by rolling their gains into a qualified Opportunity Fund — a limited partnership or nontraded REIT created specifically to invest in Opportunity Zone enterprises or properties.

The Opportunity Zone tax incentives

The Opportunity Zone law allows investors who recognize a capital gain — from a stock sale, for example — to invest those gains in an Opportunity Fund and therefore defer capital-gains taxes. The catch? The deferred tax is due either when an investor sells an Opportunity Fund investment or on December 31, 2026, whichever comes earliest. That is, the maximum deferral opportunity ends seven years from the end of 2019. Hence, the rush to invest in Opportunity Funds now.

In addition to deferring previously recognized gains, you also can reduce the capital gains tax on an Opportunity Fund investment itself by 10% if you hold it for five years and by 15% at seven years. Hold the investment for 10 years or more, and the tax on its capital gains is eliminated altogether.

The Opportunity Zone tax incentive has a catch

For CRE investors, taking advantage of Opportunity Zone tax benefits potentially could produce returns in excess of, say, a traditional stock portfolio. Of course, the devil is in the details.

First, anyone can establish an opportunity fund to invest in Opportunity Zones, which is one reason several hundred have already been created. Opportunity fund-eligible investments encompass not only real estate development and redevelopment, but also start-up businesses like a restaurant, dry cleaner or movie theater. However, opportunity fund managers must ensure that any investment they pursue actually meets the Opportunity Zone criteria as defined by the U.S. Treasury Dept., which has specifically excluded certain types of properties and businesses.

Second, CRE investors need to be aware of the other tax implications. Some of the tax benefits available in traditional CRE investments, such as losses from depreciation, may not be available for qualified Opportunity Zone investments and will therefore impact expenses and net operating income. Investors also will need to check whether their state taxation law is aligned with federal taxation law concerning Opportunity Zone funds

Opportunity Zones and property valuation

The third catch is that not all Opportunity Zone investments are created equal or are worthy of pursuit. By investing in areas that investors traditionally have avoided, Opportunity Funds are inherently risky. Tax breaks subsidize the investments, but they don’t remove the risk.

Savvy CRE investors will view Opportunity Zone properties as they would any other property: what is the property’s income potential? What will expenses be today and down the road? How much capital will be needed to redevelop a property? What is the competition look like? What level of projected returns will compensate for the level of risk and long hold periods vs. the tax advantages at the federal, state and local levels?

Since Opportunity Zones are based on U.S. Census tracts, the markets with the most zones are some of the nation’s largest population centers. As discussed in a recent RealPage blog post, many of these zones are particularly ripe with multifamily investment opportunities. While a larger market may have seen a growth in multifamily supply, that growth may have bypassed specific neighborhoods within Opportunity Zones. You can hear a detailed example analysis in this RealPage webinar.

Rising Opportunity Zone property values

Despite the complex rules and potential risks, Opportunity Zones are generating significant investor interest. As of April 2019, Opportunity Zone property prices had risen by 20% over the previous year, according to a Zillow study. Price trends, of course, also affect the potential return on an investment, so that’s another factor to pay attention to — some Opportunity Zones and property types are seeing more activity than others. When opportunity knocks in the form of an Opportunity Zone investment, due diligence still matters.

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