Looming Deadline Kicking Off A Flurry Of Opportunity Zone Investment
A key deadline is approaching for investors looking to maximize the benefits of the opportunity zone program, and fund managers are preparing to receive an influx of capital in the coming months.
The opportunity zone program, passed into law in late 2017, comes with a series of incentives for investors to finance real estate projects and businesses in census tracts designated as needing investment. While the program will still provide benefits to investors for several more years, one of its incentives has a deadline for investors to place money into funds by the end of this year.
"It's a big deadline, it comes up every day in every conversation," said Javelin 19 principal Jill Homan, who advises opportunity zone investors. "Investors are motivated to not miss this deadline, so you have a lot of investors looking at allocating capital before the end of this year."
Investors who place money into opportunity zone funds allocate that investment from a separate capital gain, and the program allows them to defer the capital gains tax on that initial investment to 2026.
The Dec. 31 deadline is for an incentive that gives investors a 10% step-up in the basis of their investment. This means that for an investor who places a capital gain of $1M into an opportunity zone fund before year-end, they can only be taxed on $900K when the deferment period ends.
Additionally, investors are worried that the capital gains tax rate may soon be increased if Congress passes President Joe Biden's spending proposals, so they see the opportunity zone program and the 10% basis reduction as a way to mitigate the impact of a potential tax hike.
An attorney who represents opportunity zone fund managers, Snell & Wilmer partner Marc Schultz, said on a Bisnow webinar Tuesday he has worked with a large number of clients who are forming funds that can receive investments before year-end. He said that urgency is driven by the Dec. 31 deadline combined with the ongoing debate over Biden's $3.5 trillion spending proposal, which he said could increase the capital gains rate by 5%.
"We expect we're going to see a tremendous amount of activity at the end of this year," Schultz said. "A lot of folks are looking at this 10% reduction as a hedge against that potential for rising income tax rates on the gains. So our clients are rushing to get [funds prepared] now to capitalize on this surge of folks looking to invest by the end of this year."
Opportunity zone funds have raised more than $17.5B of equity from the beginning of the program through June 30, according to consulting firm Novogradac, which has tracked more than 1,100 opportunity zone funds. Fund managers and other opportunity zone experts believe that number will be significantly higher by the end of the year.
One fund manager preparing for a major year-end surge is PTM Partners. The firm launched its second Qualified Opportunity Zone Fund in September 2020, targeting a $250M haul, and it is raising capital up until the end of this year.
PTM Partners Chief Financial Officer Scott Meyer said it is timing its fundraising window specifically around the Dec. 31 deadline. He said it used the same timeline for its first fund ahead of a Dec. 31, 2019, deadline, when the step-up in basis was reduced from 15% to 10%, and it saw a surge in investment in the final months.
Now, with the basis step-up incentive fully disappearing, he expects to see another strong fourth quarter. He said the second fund has currently raised around half of its $250M target.
"We expect a flurry of activity here in the fourth quarter," Meyer said. "Based on the trajectory of our first fund, the fourth quarter before closing was by far the busiest."
While the incentive that reduces the basis of an investment for tax purposes is disappearing at the end of the year, the opportunity zone program will still provide other tax benefits for investors after that.
The most attractive benefit, Meyer said, is that investors don't have to pay any capital gains taxes on the value appreciation of the project itself when they eventually sell it. The program will also still allow them to defer the tax on the initial capital gain that they rolled into the opportunity zone fund, even if it will no longer reduce the basis of that investment.
Those incentives will still be enough to draw investors to opportunity zone funds in the future, Meyer said, but he thinks those that have gains they are preparing to invest in the near future will be motivated to make the investments before year-end.
"It's the tax-free exit that is really the biggest driver of value," Meyer said. "If they're thinking about making an opportunity zone investment, rather than wait until January or February because they will lose that 10% basis step-up, on the margin it definitely will push people toward funding by the end of the year."
Homan said she has one client who is looking to place a $1M gain from a real estate investment into an opportunity zone fund, and the client considers the Dec. 31 deadline a make-or-break factor for his investment decision.
"Our conversation with him was, 'If I can't meet the deadline, I’m not interested,' so he’s very motivated to meet the deadline, identify an appropriate investment for him and execute the investment," Homan said.
She said she has seen multiple opportunity zone funds that are scheduling the end of their fundraising period around the Dec. 31 deadline, and she expects it will be a busy time for them.
"We were joking about how there's going to be a few vacations cut short or postponed until after the first of the year," she said. "It'll be Christmas or Hanukkah in January when the folks on the fund management side will be celebrating in order to meet what I expect to be a lot of transactional and investment activity by the end of the year."
EJF Capital Head of Real Estate Development Asheel Shah, whose firm launched its second opportunity zone fund in April, said he has seen a meaningful increase in investors looking to place money ahead of the Dec. 31 deadline. But he said he doesn't think the program will lose its appeal to investors after the 10% step-up incentive goes away, and he expects fundraising activity will remain strong next year.
"Investors get excited about monetizing all of the incentives that are out there, and the 10% step-up is an incentive, so we definitely expect there to be a push amongst investors in the fourth quarter to realize gains and invest more money into opportunity zone funds," Shah said. "It's not a make-or-break, but it's a little bit of extra juice."
The money that pours into opportunity zone funds at the end of the year will then need to be deployed into projects quickly. Meyer said the law requires funds to have 90% of their investment allocated to opportunity zone entities by certain time periods, and the first testing period for funds closing at the end of this year is June 30.
"Just because you formed an opportunity zone fund, that’s the easy part. The hard part is finding quality deals to invest in," Meyer said. "While we’re targeting investments in these neighborhoods, it all operates under the larger macroeconomy of real estate, where it’s a very efficient market, and everyone’s looking for good deals."
Because of the tight timelines, funds have been identifying and making commitments to deals while they are raising money, Meyer said. PTM is focusing on multifamily and industrial projects, two of the hottest asset classes in commercial real estate.
PTM has already identified two investments for its second fund, Meyer said: a 318-unit project in Woodbridge, Virginia, and a 900-unit project in Miami's Edgewater neighborhood.
As he is looking for projects, Meyer said he is looking for major public infrastructure investments like the new bridge in D.C. next to its Buzzard Point project, and he thinks Congress passing an infrastructure bill could create a host of new development opportunities.
"One of the biggest drivers is infrastructure investment," Meyer said. "We're keeping close tabs on what those projects will be. Those are the places we want to invest."
EJF Capital has invested in more than a dozen opportunity zone projects between its first fund, a $280M vehicle that closed in January, and its second fund, which launched in April. It hasn't disclosed a fundraising target for its second fund, but Shah said he expects it will be larger than the first.
The firm has invested in several opportunity zone projects that have finished construction, including a 262-unit project with retail in D.C.'s Hill East neighborhood, a 284-unit project in Jacksonville, Florida, and projects in Oakland, Georgia and Washington state.
Shah, speaking to Bisnow on the phone from the Phoenix airport, said he is also looking for investments in that market. And he said EJF is eyeing the Richmond, Charlotte, Raleigh, Tampa and Orlando markets for potential opportunity zone investments.
All of EJF's opportunity zone investments thus far have been in multifamily and industrial projects, and Shah said it has competed with many types of investors as it looks to finance developments.
"We compete with sometimes opportunity zone, but sometimes just traditional capital, which is coming in and looking for good deal flow," he said. "Just because you're in an opportunity zone, that doesn't mean you're exclusively looking for opportunity zone capital. It's competitive."
Falcone Group Executive Vice President Alfonso Costa, who previously worked on the opportunity zone program at the Department of Housing and Urban Development, said his firm was recently selected to develop a 94-acre opportunity zone project in Eatonville, Florida.
Costa, speaking on Bisnow's webinar, said the firm's proposal includes affordable housing, workforce housing, a range of commercial uses that will generate job activity and civic space.
"Undertakings like that are really exciting and emblematic of what the opportunity zone initiative can and should be," Costa said.
Developer Menkiti Group has used opportunity zone capital for developments in D.C.'s Anacostia neighborhood, where it is bringing new office and retail tenants to a historically underserved area, and in Worcester, Massachusetts. Menkiti Group CEO Bo Menkiti said the program has made it easier to finance and break ground on the projects.
"It has been beneficial," Menkiti said of the opportunity zone program. "It hasn't made or broken something, but it helps attract capital and it helps new projects that are harder to do, like those projects in Anacostia, and it gives you a little more way to make the leverage work."
The program has received some criticism for not creating the benefits for underserved communities that it was designed to spur, but opportunity zone experts said they expect more community benefits will soon become evident.
Because of the timing of the program, which had its regulations finalized in late 2019 just before the coronavirus pandemic struck, and the typical two-year timeline of a construction project, they expect a wave of opportunity zone projects will deliver over the next year or two.
"We’re still in the early days of opportunity zone investing, and there’s some interesting opportunities for folks to be more creative on executing transactions," Homan said. "That’s what’s going to be really exciting in the years to come as we go into the fourth, fifth and sixth innings of what does the opportunity zone marketplace look like."
CORRECTION, SEPT. 30, 11 A.M. ET: A previous version of this story misstated the month that PTM Partners launched its second fund. This story has been updated.