Opportunity Zone investor incentives can sound compelling. Where else can an investor receive increased returns (by paying little or no federal capital gain taxes) and at the same time help revitalize a local community?
Although Opportunity Zones provide substantial tax breaks for investors, they can be risky endeavors for bridge lenders and sponsors alike. In this article, we will explain what Opportunity Zones are, why they were created, and how bridge lenders may approach their underwriting of projects within these zones.
What are Opportunity Zones?
Opportunity Zones (OZs) are designated areas throughout the United States that have been selected by state and federal agencies for economic revitalization. In order to invest in OZs and receive federal tax breaks, investors must invest in a Qualified Opportunity Fund (“QOF”). According to the legislation, a QOF is “any investment vehicle which is organized as a corporation or a partnership for the purpose of investing in qualified Opportunity Zone property…that holds at least 90 percent of its assets in qualified opportunity zone property.” The legislation imposes a “substantial improvement” requirement on the QOF. In order for an existing building to be designated as a qualified OZ project, the QOF is required to make improvements to the building in an amount equal to or in excess of the purchase cost of the building (less the land value). Additionally, these improvements must be substantially completed within 30 months of the QOF’s purchase of the building. As an example:
A Qualified Opportunity Fund buys a property for $1 million. The land is worth $250,000 and the building is worth $750,000.
In this example, an additional $750,000 must be invested into the building within 30 months of the purchase date.
Why Were Opportunity Zones Created?
Opportunity Zones (OZs) were created by the Tax Cuts and Jobs Act (TCJA) in December 2017 with the intent of creating jobs and raising capital for improvement of economically distressed communities. OZs seek to create wealth by giving significant financial incentive to voluntarily investors in these low-income areas. The legislation hopes to harness as much as $6.1 trillion in unrealized capital gains, according to the Economic Innovation Group. The intent is to encourage investors to sell an existing investment (stocks, bonds, real estate, or other appreciated assets), invest those capital gains in a low-income area for the tax benefits, and as a result, improve the economies of these areas. However, investing in “distressed” communities can be risky because very few investors—if any—have made investments in these areas to begin with. The legislation attempts to incentivize investors to overlook this risk by paying little or no federal taxes on capital gains.
How Do the Tax Breaks Work?
The process for receiving a tax break on an investment in an Opportunity Zone works like this:
- An investor has to realize capital gains in a recent transaction (i.e. sell an investment).
- From the date of the transaction, the investor has 180 days to reinvest his/her gain (referred to as “deferred capital gains”) in a Qualified Opportunity Fund to defer payment of the capital gains tax until a later date.
- After five years, the deferred capital gains qualify for a 10% reduction in the tax liability.
- After an additional two years (for a total of seven years), the deferred capital gains qualify for an additional 5% tax reduction (for a total of a 15% reduction).
- After a total of ten years, capital gains in the Qualified Opportunity Fund become tax-free (you still have to pay taxes on your previously deferred capital gains no matter what, but your new additional capital gain is free from taxation after a 10-year hold).
As a note, investors can defer the tax on the original capital gains no later than December 31, 2026 or until the OZ investment is sold, whichever comes earlier. Time is of the essence when investing in Qualified Opportunity Funds: investing by December 31, 2019 means getting the longest possible tax deferral and additional tax breaks. The timeline provided by fundrise.com shows how it works:
Opportunity Zone Projects and Bridge Lenders
Because OZs are more likely to be located in risky areas from an investment perspective, the hope is that the financial incentives will be sufficient to attract aggressive new investors. As a result, OZs have become a topic of great interest to real estate investors. However, basic real estate fundamentals can’t be overlooked and an “Opportunity Zone” designation does not enhance the real estate fundamentals of a deal.
The Opportunity Zone legislation requires that the QOF’s project must be “substantially improved” within 30 months. This could present an opportunity for bridge lenders because value-add strategies in (relatively) short timeframes are their specialty. However, the bridge lender underwriting process still requires questioning of the economic viability of a project located in a low-income OZ. Any QOF requesting a bridge loan should expect its deal to be subject to intense scrutiny. Investors in the QOF may be willing to bear higher risks in the hopes of a higher return, but bridge lenders are not as willing to take on such risks. OZs pose additional questions about the location and market surrounding the property, and thus, borrowers should be prepared to answer a plethora of feasibility questions when seeking a bridge loan.
The OZ location and surrounding area can make it hard or even impossible to find answers to many of the feasibility questions a bridge lender will have because these areas either do not have any track record or have a bad track record. Thus, business plans for properties in OZs are unlikely to be very strong. A bridge lender evaluating a property loan in an OZ, may think:
- Will this deal work even though it’s in an area that has been designated as economically distressed?
- Why is this area so bad that the government had to create financial incentives to invest in it?
Keep in mind: a bridge lender doesn’t receive any additional benefit or special incentive for taking the risk of extending loans in these zones!
The Importance of the Opportunity Zones Index
A critically important underwriting tool available to an Opportunity Zone bridge lender is the “Opportunity Zones Index” (“OZI”). The OZI is a relative measurement index, exclusively made up of low-income communities in the U.S. which ranks nearly 8,000 Opportunity Zones (OZs) on its economic fundamentals. This tool provides a comprehensive economic baseline analysis of OZs in the U.S. The OZI was created by Develop LLC, in partnership with Esri, a leading mapping & spatial data analytics firm and can be found here.
The index rates each OZ on a scale of 0-100. A score of 100 signifies the strongest economic fundamentals across OZs, while a score of 0 signifies the weakest. The rating is based on metrics such as population growth, unemployment rate, and household income. Keep in mind, the OZI is a relative index. If a bridge lender wants to look at any deal in an OZ, the lender will prefer a zone with the strongest economic fundamentals (i.e. a score of 95-100). The index shows that there is incredible economic diversity in these zones. For example, a bridge lender would be much more willing to make a loan in Old Town Scottsdale, Arizona with an OZI score of 99.92 (ranked #7 out of 7,823 total zones) than in Baltimore, Maryland with an OZI score of 0.63 (ranked #7,774 of out of 7,823 total zones). As can be seen from this example, even though a bridge lender will to be skeptical of deals in OZs, not all OZs created equally.
Top 10 Counties According to the OZI:
Bottom 10 Counties According to the OZI:
Bridge Lenders Can Find Deals in Opportunity Zones
As can be expected, a bridge lender will tend to be conservative when underwriting such an investment. They need to see a well thought out, in-depth business plan that demonstrates that proper execution of the proposed plan can credibly create substantial value for the project. The sponsoring QOF will need to have prepared thorough, well-reasoned, and well-documented answers to these 12 questions of project feasibility:
- What economic effect will new projects located in the general area—and specifically those located in the same competitive market—have on the future success of the business plan?
- What other Opportunity Zone projects are planned in the same competitive market area?
- Does the selected location enhance the potential for the project’s success?
- What governmental physical improvements are slated to be developed in the same competitive market area? Examples of governmental improvements are road improvements, security improvements, lighting improvements, public transportation improvements, parks or general beautification projects?
- What is the overall trend of the market? Is it improving or deteriorating?
- What is the product competition in the same competitive market area?
- Have independent market studies been completed by respected consultants that support the future economic viability of the intended use of the proposed project?
- What other economic forces are at work in the area that will help support and positively improve the economics of the use planned for the site?
- What is the past experience of the project sponsors in this type-specific project or business?
- Are the sponsors adequately funded to weather the surprises and delays associated with this type of pioneering project?
- Are the contractors successful and well experienced in the type of construction needed by the project?
- What bonds or other assurances can be supplied to assure all construction improvements will be completed on time and to budget?
In summary, the label “Opportunity Zone” creates a significant hurdle that the Qualified Opportunity Fund must overcome when attempting to obtain a bridge loan. Location remains the single the most important factor when determining the success of a project and the viability of the bridge loan. The Qualified Opportunity Fund must demonstrate that the proposed project location is viable even though located in an economically distressed or “needing-to-be-revitalized” area. Prepare for bridge lenders to more stringent in their underwriting process when considering any property in an Opportunity Zone.