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Opportunity zones capital commitments remain lackluster despite late surge

December 31 was the cutoff for investors to achieve the full tax benefits of the federal program, but many managers have raised no capital

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The end of 2019 brought the first significant deadline for the program and, with it, a surge of capital for the federal initiative that offers tax breaks in exchange for investments in distressed US neighborhoods.

More than $2 billion in equity was raised for opportunity zone funds between December 10 and January 8, according to a survey of managers conducted by California-based consultant Novogradac. This haul increases its tracked total from $4.46 billion to $6.7 billion. Those familiar with the program credit the rush of investment to the December 31 cutoff to the maximum benefits receivable as well as newly established regulatory certainty.

The opportunity zone program allows investors to defer taxes on capital gains by rolling them into investments in designated low-income areas. Capital committed to these funds before the end of 2019 qualify for a 15 percent step up in basis, meaning the value of the initial taxable gain will be reduced by 15 percent. After 10 years, investors pay no tax on new gains from the fund.

The concept piqued interest among real estate investors and managers alike. Yet, fundraising for the program remains short of expectations. In 2018, US Treasury Secretary Steven Mnuchin estimated $100 billion could be invested through the program. Novogradac identified 502 funds nationally targeting $68.55 billion in opportunity zones. Only 292 of the funds in its rolling survey reported raising any equity.

However, Novogradac’s database – compiled from public disclosures and voluntary participation – only covers third-party managed funds. Factoring in independent direct investments and undetected funds, the full market could be two or three times larger than what the firm has tracked, managing partner Michael Novogradac told PERE. Also, the 50 percent jump in the final month of the year indicates growing interest in the program.

A race to the finish

Part of the uptick can be attributed to the December 31 deadline. Moving forward, gains rolled into opportunity zones can only receive a maximum step up of 10 percent for their initial gain upon exit. Also, certain gains – such as net income for partnership structures – could not be committed until the end of the year.

The Cresset-Diversified Qualified Opportunity Zone – a partnership between two Chicago-based firms, Cresset Partners and Diversified Real Estate Capital – brought in $60 million in the closing weeks of 2019, bringing its fundraising total to $450 million. Roughly 70 percent of its commitments came directly from wealthy individuals. Similarly, Washington, DC-based OPZ Bernstein placed a $50 million equity commitment from a group of family office clients into a mixed-use opportunity zone development in Virginia just ahead of the deadline.

Some bigger managers have participated also. Indeed, managers in PERE’s signature PERE 100 ranking have launched opportunity zone funds include Bridge Investment Group, CIM Group, Starwood Capital Partners and Brookfield Asset Management. Starwood declined to comment for this article, Brookfield and CIM Group did not respond to requests for comment.

While some smaller managers have been able to secure commitments directly from individuals and families, most have leaned heavily on banks and wirehouses to capitalize their opportunity zone vehicles, PERE understands.

Investors have grown more comfortable with the opportunity zones program over time, Craig Bernstein, principal of OPZ Bernstein, told PERE, particularly since the Treasury Department finalized regulations in mid-December. He expected the comfort to continue, especially as investors build up their real estate exposures to balance against their highly appreciated stock holdings: “As portfolio allocations continue to stray away from targets, we’re seeing investors harvest gains, specifically from US equities and other highly appreciated assets, and redeploy the capital in real estate to fulfill their investment mandates.”

Managers also have an increasingly clearer view of the program. Some of that clarity was bureaucratic, coming in the form of regulations. The rest was learned through trial and error. For example, Bridge pivoted its strategy to accommodate the timing nuances of the program. Originally, the Utah-based firm targeted $1 billion for a single fund, but opted to split that into two separate vehicles, one valued at $500 million, the other at $450 million. This was because, unlike traditional private real estate funds, managers cannot simply compile commitments then draw capital as needed.

Moreover, when equity is committed, it must be deployed quickly. Investors have 180 days from realizing a gain to roll it into an opportunity zone fund then managers have 180 days to put that capital to work, or at least establish a viable plan for it. David Coelho, chief investment officer of Bridge’s opportunity zones strategy, told PERE the firm has deployed all $950 million of equity into 20 assets, most of which are multifamily-anchored developments.

Coelho said Bridge would continue raising capital for opportunity zone investments as long as investor demand is strong and the pipeline for deals is full. However, he noted, the process is challenging given it does not align with private equity fundraising in the way some managers had hoped. “Aggregating capital for these structures is very difficult,” he said. “You’re ultimately dealing with taxable investors, which has generally not been a big target for institutional-quality real estate shops like Bridge and our peers. It’s a very different market than trying to raise an institutional fund and much harder to aggregate capital.”

Regulatory certainty

Since the opportunity zone legislation passed into law as part of the Tax Cuts and Jobs Act of 2017, the real estate industry has waited to see how government regulation might alter it. After nearly two years of tinkering, the Internal Revenue Service finalized rules for the program on December 19 and, for the most part, they favored investors.

The new rules allow proceeds from the sale of non-capital assets – such as buildings or machinery, also known as 1231 property – to be counted as capital gains. They also provide more flexibility about when the 180-day window to reinvest begins counting down and establish a mechanism for managers to sell individual assets instead of forcing them to liquidate entire fund portfolios. “The tenor of the regulations is very tax-payer friendly,” Ira Stechel, a tax lawyer with law firm Akerman, told PERE. “Treasury could have gone either way on a lot of issues, toward the government or the taxpayers, and in every instance, they favored the taxpayers.”

Simply having regulatory certainty has been enough to some embolden otherwise-hesitant investors, Bernstein said. “We’ve seen an uptick in activity from investors that were previously waiting on the sideline until there was clear visibility on regulations.”

Even though the deadline has passed for the full 15 percent step up in basis, opportunity zone investors still have two years to get a 10 percent reduction on the gains and until 2028 to access the biggest potential reward: the ability to realize gains on opportunity zone investments tax free after 10 years.

Yet, the program is not without issues, Stechel said. Some investors are unwilling to lock up their investments for 10 years at a time. Those that are, are not guaranteed to make money. Even if the assets appreciate over time, investors might see returns diminished by a more aggressive future capital gains tax structure.

Jeffrey Bowden, a partner at the New York-based accounting firm Anchin, Block & Anchin, told PERE many prospective opportunity zone investors remain ultimately deterred by the nuances of the program.

“As they started educating themselves, as guidance came out, people realized it wasn’t a free home run.”