Real estate investors in U.S. Opportunity Zones (OZs) are likely hold onto their assets for longer than typical, which could result in development and revitalization reaching areas that were often ignored in the past, increasing the value of surrounding assets.
U.S. investors tend to hold commercial real estate assets for an average of three to five years. But a 10-year hold period is the expected norm with OZs given the tax rules, says Jordan Angel, Managing Director, Capital Markets, JLL, who says that such a hold period promotes “behavior commiserate with longer-term ownership including a focus on operations, the health of the neighborhood and durability of the asset,” revitalizing areas ignored in the past and increasing the value of surrounding assets.
“Investors have to double their typical basis or create the original use of an asset in the OZ, which means developing a new building or major rehab,” he says. “This will both revitalize those areas and bring up the value of surrounding assets, including those that don’t qualify for OZ treatment by not being able to meet the requirements set in the tax code.”
The introduction of OZs has been central to discussions among property investors since a buzz erupted around the first round of rules in October 2018. Back then, there was uncertainty over whether a developed asset could be sold during the ten-year-hold period — the period of time needed to gain maximum tax benefit from the program.
“The question was whether investors could sell and reinvest the proceeds of that sale into a new OZ development during this window,” says Jason Cordon, Principal at SixtyWest Funds, a development firm that specializes in tax-incentived projects and has its own QOF (Qualified Opportunity Fund). “The practice is commonly referred to as ‘churning’ assets.”
Clarification came in April 2019. Regulations now state that an asset sale and reinvestment of the proceeds do not reset the ten-year hold period, as long as the reinvestment occurs within days of the sale.
However, the important piece is that any capital gains are taxable, making selling less appetizing, according to Cordon.
With “churning” off the table, “funds are more likely to invest in one or more project at one time, and hold those projects for ten years,” he says.
Transactions are unlikely to freeze, however, There are likely to be partial transactions, as the development partner sells out of the development during the normal timeframe, while the equity investor stays on, Cordon says.
Typically, investors hold a property for three to five years and sell it when it is fully leased to achieve maximum returns at a time when the building is still fairly new, says Amy Kelly, Chief Operations Officer at Sixty West Funds.
If only ten-year holds are tax effective in OZs, only well capitalized developers, or investors that can negotiate for the ability to receive debt financed distributions earlier in the deal, are likely to get involved in the program, eliminating investors who need immediate liquidity, she says.
“The program was set up for patient capital, so potential investors were already aware of this – the new guidelines just clarify this,” Kelly says.
While IRR decreases over time, equity multiples of an OZ investment should be higher without even considering the tax benefits of the program, she says.
“OZ investors are not looking for 20 percent IRR, they are looking for low double-digit IRR over the ten year period,” Cordon says. “Most deals will not support a 20 percent IRR over a ten year period because of how the IRR calculation works. But, for a taxable investor, the comparison of a QOZ investment to a conventional short-term transaction end up with effectively similar returns. The benefits are amplified even further when the tax incentives are added, especially in states that have pledged to conform to the OZ abatement with respect to state and local capital gains.”
Considerations for developers
OZ investors and developers should be wary of design and finish selections that will require a refresh around that ten-year hold horizon and aim for durability, Cordon says.
“Investors are focused on durability — whether cabinets, systems, building exteriors and other touches will stand the test of ten years — because otherwise they will need to be replaced,” Cordon says. “They are looking at higher-quality components that can handle the wear, and more durable commercial mechanical systems in order to manage any potential future capital outlays.”
Click to read how the recent Fed rate cut could increase deal-making.