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Opportunity zone investments off to an uncertain start

Opportunity zones, the tax break included in the Tax Cuts and Jobs Act that encourages real estate investors to develop projects in economically distressed communities in exchange for deferring capital gains taxes for years, have come under fire for not living up to their promise.

The zones in many cases have been located in areas that were already gentrifying or attracting investment before the tax law was enacted in December 2017. One of the more successful opportunity zone developers is Cresset, a $6 billion financial firm that is partnering with Diversified Real Estate Capital on one of the biggest opportunity zone funds. It has made seven investments in the fund so far and attracted $330 million to its fund, with a possible eighth project under consideration. Dan Terlep, senior managing director in Cresset’s CFO Services group, acknowledged that many of the investments to date haven’t been in economically distressed communities, but he predicted that will change in future waves of investment.

“The first wave of properties are really in zones that have been turning and gentrifying, but we believe that wave 2, wave 3 and wave 4 will be in impactful areas, and you can’t get to those waves unless you go through wave 1 first,” he said. “These really are on the path of progress to really developing in these blighted areas. With that said, it’s bringing a lot of jobs into the area, a lot of construction jobs, and a lot of ancillary jobs that get underreported, but that I think are important.”

Boarded up residential buildings in the Port Morris neighborhood of the Bronx
Boarded up residential buildings in the Port Morris neighborhood of the Bronx

So far, Cresset has decided to develop projects in Houston, Denver, Portland, Nashville, Silver Spring, Charleston and Omaha. “It’s probably about 65 percent or so multi-residential, about 25 percent office, and the rest are ground floor retail,” said Terlep.

He contended that all of the projects are being developed as a result of the tax law’s incentives and weren’t underway already in a significant way. “All of these are ground-up development,” he said. “There wasn’t a pre-existing shell or any development there. In a couple of cases, there were plans to move forward. But we all know plans are plans. This is all ground-up development.”

He believes critics will need to look at the impact of opportunity zones over the long term, instead of expecting an immediate impact on low-income communities. “When you look back on this over a period of 10 years, that span in the rules there, I think it will do what it was intended to do,” said Terlep. “It’s hard to go directly into these blighted areas from an investor return and a fiduciary standard. It doesn’t make financial sense, and we’re beholden to our investors. However, when you start laying out the path of progress, when you start developing the first wave, the second wave, the third wave, you start seeing it. And I think after you look at this over a period of 10 years or so, I think the rules will do what they were intended to do.”

He anticipates that his firm will begin to make investments in more economically disadvantaged areas in the next wave. “We’ve looked at a number of these areas,” said Terlep. “I think, consistent with that second wave, fund two will have more of these areas in the fund there. When you look at it from a return perspective, you’re not only looking at the tax breaks, but you’re looking at a long-term hold asset, a 10-plus year hold asset. Usually these assets are a mix of development and stabilized property. The returns are condensed a little bit because of that fact.”

The IRS recently previewed a draft version of a tax form that will be used for reporting on opportunity zone projects (see IRS and Treasury propose opportunity zone tax form). But some Democrats in the Senate and the House want to go further and have proposed new legislation to require more detailed reporting to prevent abuses in the program, while calling for an investigation by the Government Accountability Office (see Democrats probe opportunity zone abuses with investigation, GAO report and legislation).

The draft tax form seems to be in line with what the industry had been expecting, but calls for more detailed reporting are likely to encounter resistance from developers and investment funds.

“I’ve taken a look at the draft forms,” said Terlep. “The information they’re asking for is fine. They’re asking for tract-specific information, and holding company information, and from a transparency perspective, I think that’s great. I know there’s draft legislation out there asking for more information. I think that might be difficult. They still have to define what type of information they ultimately want to gather and in what format do they want to gather it in. Does it belong on the tax return or on some other form with some other agency?”

Developers will likely be willing to provide some information about the projects, but only up to a point. “I think they’re open to providing as much transparency as possible,” said Terlep. “There’s going to be a back and forth in determining what is that transparency and can you easily provide it. It’s one thing to ask for that data, but where is it published and how can you provide it while balancing the privacy concerns of investors. I think it’s really hard to comment on draft legislation because that legislation can change a hundred times before it even sees the light of day.”

Some of the opportunity zone funds have been slow to attract the amount of investment initially anticipated given all the hype, but Terlep is pleased with how his firm has been doing so far. “It’s probably been a little bit longer than we thought it would be to raise the capital,” he admitted. “Our fund has been, from a raise standpoint, one of the top three funds in the marketplace, and so I think a lot of our competitors have dropped out because of that fact. I think it goes to show you that if you have good properties with the characteristics that we have, with a geographically diverse nature and with the risk management effort that we put in place of having good development partners and so forth, they can be attractive to investors, and we’re seeing that from our investors.”

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