Are Opportunity Zones the Next Boom in Commercial Real Estate, or Just a Bust Waiting to Happen? [Updated: January 30, 2020]
All signs point to 2020 being a very good year for the commercial real estate (CRE) industry. Investor confidence in CRE assets — from retail to industrial — remains high, with some experts projecting that investments for the year could top $500 billion.
Consequently, 2020 may also prove to be the Year of the Opportunity Zone. How so? Read on to learn more about the past, present, and potentially bright future of this novel impact investment vehicle.
What Are Opportunity Zones?
Congress created the Opportunity Zone program when they enacted the 2017 Tax Cuts and Jobs Acts. Its goal is to increase the flow of capital to “low-income” areas (as determined by the U.S. Census Bureau) by incentivizing business development within those communities.
Specifically, the Internal Revenue Service allows those who invest in a Qualified Opportunity Fund (QOF) backing an income-generating Qualified Opportunity Zone Business (QOZB) to defer the tax on their eligible capital gains until the investment is sold (or December 31, 2026, whichever comes first). If the investment is held for five years, a ten-percent exclusion of the deferred amount is added. If the investment is held for more than seven years, that figure rises to 15 percent.
The program offers additional incentives to investors who make a long-term commitment to Opportunity Zones. Once a decade has passed, Opportunity Zone investments become eligible for an increase in basis relative to their fair market value. Further, investors have a 180-day window after acquiring gains to invest them in a QOF and defer the tax on any invested gains until 2047.
Opportunity Zone investments are also flexible and scalable. For example, while QOZBs must be located in an Opportunity Zone, qualified investors may participate in the program regardless of where they live or work.
Where Are Opportunity Zones?
Qualified Opportunity Zones may be found in urban, suburban, or rural areas across all 50 states as well as Washington, D.C. and six of the 16 U.S. territories. Governors may nominate a census tract (or tracts) for Opportunity Zone classification, but the U.S. Department of the Treasury oversees the approval process. As of the summer of 2019, 8,764 individual census tracts have been certified as Opportunity Zones.
Texas is home to 628 Opportunity Zones. Only California (879) and Puerto Rico (865) outrank the Lone Star State in this capacity. Moreover, those 628 Opportunity Zones account for nearly 12 percent of Texas’ census tracts, or approximately half of the federally mandated maximum for the program. According to a recent report from the Austin Business Journal, a mere 13 other states “have a higher percentage of Opportunity Zones than Texas.”
Taking Stock of Opportunity Zones
Opportunity Zones have garnered a great deal of buzz in their brief lifetime. Shortly after the program’s creation, Treasury Secretary Steven Mnuchin announced that “there's going to be over $100 billion dollars in private capital that will be invested in Opportunity Zones.” Yet the program’s relative immaturity also means that evidence of the resounding success Mnuchin predicted remains scarce. Nevertheless, a handful of statistics suggest that more and more investors are seriously investigating the benefits associated with Opportunity Zones.
- Over 280 “entrepreneurship incubators or accelerators” are currently operating within Opportunity Zones.
- According to the National Council of State Housing Agencies, almost 200 real estate funds were on pace to raise nearly $50 billion in capital earmarked for Opportunity Zones as of Q4 2019.
- More than $87 billion in Opportunity Zone-based raw land and development sites changed hands between 2018 and 2019. That figure represents a 14.6-percent increase over the year-and-a-half preceding the program’s creation and nearly matches the amount of similar investment made outside of Opportunity Zones.
- Multifamily properties are particularly hot. In the past 18 months, investment in apartment buildings, townhomes, condominiums, etc. in Opportunity Zones has risen sharply — just over 66 percent. During that same period, multifamily accounted for slightly more than half of all new Opportunity Zone construction (when measured by dollar value).
- In the last two months of 2019, total Opportunity Zone investments spiked by 40 percent. A December 31 funding deadline no doubt helped generate the $4.5 billion raised over those 60 days, but that number looks more impressive given the recent bad press Opportunity Zones have received.
What’s Holding Opportunity Zones Back?
Indeed, not all of the buzz about Opportunity Zones has been positive. Those skeptical of the program have characterized it as a “tax giveaway” for the wealthy that has done little to uplift economically depressed communities. Preliminary case studies even suggest that Opportunity Zones exacerbate the ill effects of gentrification. Whether Opportunity Zones are encouraging further investment in neighborhoods that have already experienced a significant influx of private capital or allowing current residents to grow equity and stay put largely depends on who is talking about this contentious issue.
The rules governing Opportunity Zones and Opportunity Zone investments are complex — to say the least — and not without loopholes. Some contend that these have been far too easy to exploit. For example, census tracts with high student population density often report higher unemployment and poverty rates, even though full-time students were never meant to be the primary beneficiaries of the program. In other instances, local power players have used Opportunity Zones as a cover for securing tax relief on their private holdings, including one now-infamous marina in West Palm Beach.
Worse, news stories such as the October report that convicted felon Michael Milken — a figure synonymous with Wall Street’s excesses of the 1980s — was actively lobbying for further relaxation of Opportunity Zone regulations have done little to silence the program’s critics.
Where Do Opportunity Zones Go From Here?
In November of 2019, Senator Ron Wyden of Oregon introduced the Opportunity Zone Reporting & Reform Act. True to its name, this bill would:
- Obligate QOFs to release more public information about their activities.
- Prohibit QOFs from investing in “sin list” projects such as stadiums, casinos, and luxury apartments.
- Eliminate the grandfathering of developments that were already in progress prior to Opportunity Zone designation.
- Rescind Opportunity Zone status awarded to any areas found not to have met the Census Bureau’s low-income criteria.
As of this writing, Wyden’s bill has not earned bipartisan support. It is unclear which, if any, of its provisions will become law. That said, most experts believe that the proposed reporting requirements stand the best chance of being ratified.
Congress is not the only entity prescribing treatments for the growing pains Opportunity Zones are experiencing. Newly minted regulations from the Treasury Department promise to reshape the program significantly, mainly by focusing on mitigating risk and improving transparency.
For example, these regulations will clarify who can benefit from the program’s tax breaks and would include businesses and start-ups funded by QOFs. Overall, the changes to the program are extensive, filling 544 pages of the Federal Register. From a strictly CRE perspective, among the most relevant changes to the program include the following.
- Updates to the original use test specifications. Now, buildings within any given Opportunity Zone need only to have been vacant for one year to meet the original use requirements, provided the building was unoccupied at the time of the Opportunity Zone’s designation. Buildings occupied at the time of designation must adhere to a vacancy period of three years.
- Easement of the program's substantial improvement test. Within 30 months, QOFs must match their original property investment (basis) with spending on additions and renovations. Under the new rules, QOFs may aggregate buildings for this purpose.
- Redrawn boundaries. Census tracts and land parcels do not always align perfectly. Consequently, QOZBs can choose to apply either a square footage test or an unadjusted cost test to determine whether real property contiguous to but technically external to an Opportunity Zone may be incorporated within it.
- Reclaiming brownfields. One-third of all contaminated land in the U.S. is situated within Opportunity Zones. To spur reclamation of these sites, these new rules permit QOFs to factor in both land and structures when meeting the requirements for brownfield remediation.
What Does The Balance Sheet Tell Us About Opportunity Zones?
Are Opportunity Zones really a rising tide that lifts all boats? Perhaps not, or at least in their original form. That’s the conclusion drawn by one group of economists. Alan Sage (MIT), Mike Langen (Maastricht University), and Alex Van de Minne (University of Connecticut) examined Opportunity Zone commercial real estate transaction data to test two hypotheses.
- Tax incentives will directly increase an Opportunity Zone investor’s post-tax internal rate of return.
- Incentivized Opportunity Zone investments will boost productivity, cause land to appreciate, and generate other benefits beyond tax relief.
While Sage et al. found support for the first hypothesis, they did not for the second. The valuation data these scholars reviewed suggested that “only properties that benefit from the tax break — redevelopment properties and vacant land — see their prices increase [by 13.5 percent and 9.6 percent, respectively].” The net result? Opportunity Zones are best at “passing through the statutory tax benefits to existing landowners” who may or may not be members of the communities the program is intended to serve.
That said, the Opportunity Zone program does give those same communities another means of controlling their own destinies. Even under the revised rules, local governments have leeway to draft and implement their own best practices for interacting with QOFs and QOZBs. Policies that prioritize transparency, champion inclusivity, and cooperate with broader community and economic development strategies stand the best chance of deploying CRE to help Opportunity Zones achieve their goal: creating wealth in areas that have historically struggled with underinvestment.
Update, 01/30/2020: On January 15, 2020, NBC reported that the Treasury Department had launched a formal investigation into the Opportunity Zone program. The focus on this probe, prompted by an October 2019 letter from the legislators (Senators Cory Booker and Tim Scott) to Acting Treasury Inspector General Richard Delmar, will be on how Opportunity Zones are identified, nominated, and approved. In their letter, Booker (a Democrat) and Scott (a Republican) caution: “It was not the intent of Congress for this tax incentive to be used to enrich political supporters or personal friends of senior administration officials, as recent reports indicate.” (Meanwhile, the Senate Finance Committee has taken no further action regarding the Opportunity Zone Reporting & Reform Act.)
What does this investigation mean for Opportunity Zones long-term? Most experts are taking the “sunlight is the best disinfectant” point of view and view this as a positive development. Steve Glickman, who helped draft the 2017 legislation that created Opportunity Zones, points out that, “Even in the worst-case scenarios, you are talking about [abuses in] a couple [census] tracts out of about 8,700.” Glickman is confident the program itself will emerge from the Treasury Department’s investigation — which should be completed by early spring of this year — mostly intact. The bullishness of Opportunity Zone investors would appear to give further credence to such optimism. According to Novogradac, a public accounting firm that maintains a rolling survey of QOFs, 2019 ended on a very high note, with December Opportunity Zone funding up 50 percent (to $6.7 billion) from November.
That said, Opportunity Zones clearly remain a work-in-progress. Although barely three years old, the program has already been subject to significant rule changes. Stay tuned to LPA Insights as we continue to track the evolution of Opportunity Zones through 2020 and beyond.