PERE firms turn an eye to Opportunity Zones

New legislation aimed at boosting investment in distressed US neighborhoods is beginning to attract the interest of private equity real estate firms.

The Investing in Opportunity Act, which was part of the US tax reform package enacted in December, encourages long-term investments in so-called Opportunity Zones, or low-income communities in the US. The policy provides a tax incentive for investors to re-deploy capital gains into qualified funds set up for the program, with taxes either temporarily deferred or permanently excluded, depending on the length of the investment. Funds must invest in a selection of low-income Census tracts that were approved by state governors in June.

“There are as many questions that we have as answers”

– Daryl Carter

Some investment managers are now evaluating potential investments and actively raising capital for Opportunity Zones. New York-based RXR Realty, which declined to comment, is reportedly seeking $500 million for the strategy. Meanwhile, Revolution, the venture capital firm started by AOL co-founder Steve Case, hired two executives from Hines in July to launch a direct real estate strategy that will invest in Opportunity Zones, among other strategies, PERE previously reported.

Because opportunity zones do not limit investments by property type or other parameters, they have attracted interest from a variety of investors that include private equity firms and the crowdfunding platform FundRise, according to John Lettieri, co-founder of the Economic Innovation Group think tank.

Lettieri explained that part of the hope for the zones is that they’ll draw in those that have not traditionally been community development investors. “This has given them a reason to seek dealflow in places they haven’t otherwise prioritized,” he said. “They get the upside of doing good by doing well. The tax incentive itself doesn’t change the fact that you have to be making a good investment, because you have to have capital gains to see the upside of this. This can help otherwise marginal returns pencil in as more attractive.”

Many early movers in Opportunity Zones had already invested in low-income markets before the passage of the legislation, Lettieri noted. This includes multifamily-focused private equity real estate firm Avanath Capital Management, which already owned 13 properties in areas that were later designated Opportunity Zones, according to founder Daryl Carter. He was not familiar with Opportunity Zones until he met a co-sponsor of the Investing in Opportunity Act, South Carolina Senator Tim Scott, at the beginning of the summer. Scott  pointed out that some of Avanath’s assets were already located in the target areas.

“What’s interesting about it is that we don’t need to change much of our investment strategy,” Carter said.

Avanath may undertake more development in Opportunity Zones, because the policy requires investors to match the cost of the building with capital expenditures. Carter said the firm is evaluating opportunities to tack on more properties to its existing holdings, perhaps by redeveloping a neighboring site or acquiring an adjacent property.

The opportunity zones policy could also change Avanath’s approach to capital structuring. About half of the firm’s fund investors are subject to tax, while the other half – which includes pensions, foundations and charitable trusts – are tax-exempt. In the future, Avanath may offer funds intended specifically for the taxable investor base that invest in opportunity zones, as they would benefit from from the tax incentives. Carter predicted that family offices and high-net-worth individuals in particular will seek to take advantage of the policy’s capital gains deferment.

Regardless of their tax exemption status, investors could benefit from any appreciation in property values in the communities in which Avanath invests.

“At a minimum, it certainly enhances our exit strategy for these assets, because it makes them in greater demand for people who want to do redevelopment,” Carter said.

While Carter noted that Opportunity Zones are the topic du jour for investor calls and at conferences, he warned that the strategy is not for every group.

“I’d caution that investors be leery of people who haven’t operated in some of these communities,” he said. “Who shouldn’t invest in those communities? People who don’t understand them or who lack the diversity to be able to have a good sense of what the residents in these places need.”

Carter and EIG’s Lettieri also highlighted Opportunity Zones’ infancy, noting that the Treasury Department and the Internal Revenue Service are still working to develop guidance around the policy. Lettieri expects initial guidance in the next few weeks, with the bulk of the policy framework to be clarified by year-end.

“There are as many questions that we have as answers,” Carter said. “One of the things I’ve known from 37 years in this business: when things come out, there’s a frenzy to figure it out. You never want to be too early or too late. You don’t want to necessarily be the first ones out there, but you certainly want to know what’s going on and be thoughtful about it.”