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By now, you’ve probably heard the term “Opportunity Zones” more times than you can count. But if you haven’t dug deeper, you may not know how this program can affect you as a real estate investor. Let’s start with an overview of how it all works.
You can invest any kind of capital gain into a Qualified Opportunity Fund. As long as the Qualified Opportunity Fund is buying qualified property inside the fund, there are a number of tax advantages available to investors. Qualified property is any piece of real estate, corporate security or real property used and operated inside an Opportunity Zone (OZ).
This means that capital gains from the sale of a business, stocks, bonds, cryptocurrencies or any other type of investment can be placed into a Qualified Opportunity Fund, and the owed tax on that gain will be deferred for seven years. This alone is great news.
But it gets better. Your basis in the original gain increases by 10% after seven years and another 5% after 10 years, for a total of 15% increase in your basis. This reduces the size of your original gain and causes you to pay less total tax due to this “step up” in basis. And, all the money that investors earn on the gain itself during the 10-year holding period is not taxed at all.
Let’s say you have a $100,000 gain. You invest it for 10 years into a Qualified Opportunity Fund and get your taxable basis increased to $85,000, improved by 15%. Then if you earned $50,000 on this $100,000 after 10 years, you would pay zero tax on the $50,000 gain — that’s pretty amazing.
So how are real estate investors reacting to this? They’re chasing great OZ real estate transactions. And, since many OZs are located within already gentrifying neighborhoods, markets like my home base of Nashville are seeing even faster accelerating demand for land in these areas.
The typical profile of an OZ real estate investor is someone who is interested in tax savings, wealth-building and preservation with a medium- to long-term hold period. Consequently, the number of build-and-hold, ground-up development projects is increasing, as this is one of the best avenues for realizing higher yields over a longer (expected 10-year) term.
Now, instead of investors analyzing ground-up development deals based on a for-sale basis (18- to 36-month project timeline) or a buy-and-hold basis (five- to seven-year hold), the project pro-forma, and thus internal rate of return (IRR), needs to work over a 10-year time frame.
The establishment of OZs and the resulting new class of investors is creating several interesting effects on the market, in my observation. These include:
• More emotional sellers results in over-inflated property prices, as sellers with properties located in OZs get dollar signs in their eyes and think the value of their land has just doubled, when in reality it has not.
• More inexperienced players are entering the investment arena. Real estate is the simplest to access and the most straightforward type of qualified property, so a large portion of the gains being placed into Qualified Opportunity Funds is going to be used to purchase real estate.
For example, if you have $10,000,000 of gains from selling your business, you want something safe for your retirement, so the best choice for a “safe investment” that satisfies the definition of a qualified property is likely to be real estate inside an OZ.
• More capital allocation is being placed into real estate than would otherwise traditionally be allocated due to the potential tax savings. People who would have otherwise purchased stocks and bonds with their capital gain proceeds will be incentivized to place it in real estate instead.
• Fewer condominiums and more apartment buildings will be built. As strange as that may sound, fewer condos will be built in some markets, as expensive land that otherwise only made sense for condominiums is being purchased for long-term build-and-hold multifamily projects instead.
• There will be less focus on fundamentals and more “bad deals” being done by investors as the “fear of missing out” mentality overshadows sound investment principles, especially later in the economic cycle where staying in strong primary and secondary markets near the urban core is the prudent move to make.
Also worth noting is that established private equity groups that are now making OZ investments have successfully raised hundreds of millions of dollars in the past few months alone, so the amount of available capital is only increasing. However, since the tax benefit must be passed through directly to investors, syndicating money on a deal-by-deal basis may make more sense than pooling money into a larger fund.
For investors to intelligently participate the OZ program, they must:
1. Focus on strong primary and secondary markets, avoiding lower-tier markets.
2. Focus on projects where local demand is strong.
3. Focus on product types where supply is constrained (not oversupplied).
4. Invest near the urban cores of these stronger markets.
5. Work with proven developers with strong local market presences.
Happy Opportunity Zone hunting.