Download Audio file
Tax reform passed in December 2017 created a huge incentive for real estate investors in low-income areas that are designated as “opportunity zones.” Investors in these areas may defer capital gains taxes and avoid paying taxes on gains if the investment is held for at least 10 years. The legislation has set off a flurry of activity among fund managers, developers and investors that are looking to take advantage of the new rule. While transaction activity has so far been muted as industry players try to understand the ground rules and raise capital in vehicles that will meet the needs of investors and withstand structural scrutiny, one thing is for certain: The opportunity is enormous.
A study of the Yardi Matrix database found that within opportunity zones there are either in place or under construction 1.9 million multifamily units, 960 million square feet of office space and 180 million square feet of self-storage space. As a percentage of total space, properties in opportunity zones that are in place or under construction represent 13.1 percent of total multifamily units nationwide, 13.7 percent of total office space and 11.4 percent of total self-storage space. The development pipeline in those zones — projects that either have or are in the process of getting government approvals to build but have not broken ground — encompasses 450,000 multifamily units, 120 million square feet of office space and 12 million square feet of self-storage space.
Ground-up development is likely to be a major focus of opportunity fund capital, since the law requires investors to significantly increase the basis of assets purchased. For properties in place, that would mean buildings in need of wholesale improvements, which limits the pool of potential assets that would qualify. The potential for opportunity zone development is highest in the multifamily sector, where the number of planned and prospective units represents 24.2 percent of total stock. In office, planned and prospective projects represent 12.6
percent of total space in opportunity zones, while the percentage is only 6.7 percent in the self-storage segment.
While it would seem intuitive that average rents of properties in opportunity zones — defined as areas with below-average income and higher-than-average unemployment — would be less than the market average, the data shows no clear pattern. Rents in opportunity zones are below the market average in many metros.
The heart of the program is an incentive to reinvest capital gains, which must be placed in a qualified “opportunity zone fund.” Funds can be single-purpose vehicles or commingled. Shareholders who keep their investments for five years will pay no taxes on 10 percent of the investment’s gains. After seven years, 15 percent of the gains will not be taxed. Shareholders who hold opportunity zone investments for 10 years can avoid paying taxes on all gains. Among the qualified investments are real estate, businesses and infrastructure.
The aim of opportunity fund legislation is to stimulate investment in distressed and low-income areas. Opportunity zone tracts have above-average unemployment rates and income significantly below the regional median. More than 8,700 areas in the U.S., encompassing roughly 10 percent of the U.S. population and 12 percent of the land, were designated by states and certified by the Treasury Department as opportunity zones. On average, income of residents in opportunity zone funds is about 60 percent of the area median income. The tracts are a mix of rural, urban and suburban.
When broken down by volume of commercial real estate opportunities, urban areas naturally had the most potential property investments. However, the amount of properties in opportunity zones is not strictly correlated with total metro size. Manhattan, for example, is by far the largest U.S. office market, but is among the lowest in terms of percentage of opportunity zone space because office buildings are generally located in areas with high-income residents.
An example of this disconnect on the multifamily side is the Richmond, Va., metro, which has 45,000 apartment units located in opportunity zones, the fifth most in the nation. Richmond has almost as many multifamily units in opportunity zones as Manhattan and Brooklyn, despite being a fraction of the overall size of those metros. The discrepancy has to do with the average income of residents and the way states composed the zones.
There are significant differences in metro results by property type.
Metros with the most in place and under construction multifamily units include the Washington, D.C., metro (55,000), Phoenix (54,000) and Brooklyn (49,000). Combined, Brooklyn and Manhattan total 96,000 units and west Houston and east Houston account for 82,000. The highest proportion of in-place units in opportunity zones are in Brooklyn (32 percent), Portland (23 percent) and Cleveland (22 percent). The lowest proportions are found in high-income submarkets Fort Worth (1 percent), north Dallas (3 percent) and the San Francisco Peninsula (4 percent).
The largest development pipelines in designated opportunity zones are in Miami (27,300), Los Angeles (25,400), Washington, D.C. (25,000) and northern New Jersey (20,000). Metros with the highest percentage of units in the pipeline in opportunity zones are Cleveland (70 percent), Detroit (57 percent), Brooklyn (41 percent) and east Los Angeles (40 percent).
Metros in which apartment rents in opportunity zones lagged the metro average the most include urban Chicago ($869), the San Francisco Peninsula ($792) and West Palm Beach ($522). Metros in which apartment rents in opportunity zones were higher than the metro average include urban Philadelphia ($410), Brooklyn ($344), Bridgeport-New Haven, Conn. ($310) and East Los Angeles ($257).
Metros with the most office square feet in place or under construction in opportunity zones are Houston (61 million), Detroit (41 million), Portland (37 million) and Los Angeles (32 million). By percentage of stock, the metros with the most are Portland (51 percent), Cleveland (45 percent), Brooklyn (38 percent) and Detroit (35 percent).
Metros with the most office space in the development pipeline in opportunity zones include Washington, D.C. (59 million square feet), the Bay Area (58 million), Dallas-Fort Worth (50 million) and Atlanta (41 million). Metros in which the development pipeline in opportunity zones represents the highest percentage of existing stock in those zones are Cleveland (67 percent), Columbus (60 percent) and Philadelphia (55 percent).
Metros in which office asking rents in opportunity zones are the most below the metro average include San Francisco ($37.43), Manhattan ($23.61), Brooklyn ($11.86) and Austin ($11.45). Markets in which average office asking rents are higher in opportunity zones than the rest of the metro include Portland ($7.45), Houston ($6.55), Central New Jersey ($6.41) and Tampa ($5.52).
Metros with the most in-place and under construction self-storage space in opportunity zones include Richmond (6.2 million square feet), Phoenix (5.9 million), the Inland Empire (5.3 million) and Brooklyn (4.2 million). The most concentrated metros as a percentage of square feet include Brooklyn (54 percent), Richmond and Miami (22 percent) and Washington, D.C. (18 percent). The data measures 10x10-foot storage units.
The most planned and prospective self-storage space in opportunity zones are in Portland (1.2 million square feet), Phoenix (734,000), Miami (642,000) and Central New Jersey (526,000). Metros with average self-storage rents in opportunity zones most below the metro average are Manhattan ($74), the San Francisco Peninsula ($62), the Bay Area ($30), Fort Worth ($26) and Northern Virginia ($23). The highest percentage spread is in San Francisco (39 percent), Fort Worth (38 percent), the suburban Twin Cities (26 percent), Manhattan (24 percent) and Atlanta (21 percent).
DIVERSITY WITHIN OPPORTUNITY ZONES
A common strategy of investors in distressed areas is to buy assets that are relatively
inexpensive and add value by redeveloping the structure and bringing in tenants at higher rents. Key to this strategy is to find properties or submarkets that have below-market values and rents. However, just because a property is in an opportunity zone doesn’t mean there is potential to raise rents. In most metros, the average rent in opportunity zones is less than the average rent of properties in the metro outside of opportunity zones, but by no means is there a clear pattern.
There are several reasons for the lack of clarity in the rent data, mostly owing to the way the zones were drawn. For one thing, the employment and income data used to identify eligible census tracts was from an average of the 2011-2015 American Community Survey. Some communities have experienced growth and gentrification in the intervening years and might not qualify if more recent numbers were used. About three-quarters of the jobs
created since the global financial crisis have been in the top-25 urban areas, and many rural communities have not recovered from losing a manufacturing plant or other major industry.
In some cases, the numbers are skewed by small sample sizes: There are few properties of one type or another in some low-income areas. Another factor is that the states were given a fair amount of leeway to set up the zones, and they employed different strategies. Some states focused more on urban areas, while in others the designated zones were spread throughout the state.
What’s more, as small as they are, many census tracts designated as opportunity zones have a range of neighborhoods that defy simple characterizations such as high-income or low-income. One well-known example is Long Island City, a section of the borough of Queens in New York City. Long Island City has had its struggles as industries have left in past decades but has rapidly gentrified in recent years and was selected by Amazon as the location of an East Coast headquarters before the company changed its mind.
STRATEGIES FOR INVESTING
Opportunity zones have become an area of intense interest in the commercial real estate market. For one thing, the segment represents an entirely new area of outlays in a market that has for years had far more capital seeking assets than available investments. Opportunity zones also provide the potential to draw from a new base of largely untapped investors and the
possibility of new markets that were thought to be too small or risky as investment strategies.
Another attraction is that opportunity zones give commercial real estate investors the potential
for higher yields at the tail end of a nine-year bull market, when acquisition yields are at or near all-time lows. The spread between returns on stable assets in primary markets and
value-add/secondary market properties has slowly tightened over the course of the cycle. Properties in opportunity zones could provide higher returns more in line with expectations of value-add investors.
However, the risks are significant, as well. Investing in low-income areas or those starved of business investment is inherently more volatile than core, stabilized markets. Performance of real estate in tertiary markets and low-income areas historically has been spotty.
Having favorable tax status is a good start, but it is no substitute for demand that produces income. There is money to be made injecting much-needed capital in markets that have been ignored, but to be successful funds need to be prepared to be in it for the long haul and have a holistic approach to development. Otherwise, investors could find themselves rehabilitating properties that are underused. The long-term benefit of the program — no taxes on gains — only works if the projects create value.
Investments should be carefully thought out and made in conjunction with local governments
and businesses. Areas most likely to see growth in demand are those where there are public and private investments made in education, transportation and infrastructure to stimulate
economic activity. To find the right zones to place capital, investors should have detailed submarket knowledge, relationships with local stakeholders and access to data that enables them to analyze the relative strengths of submarkets, neighborhoods and even individual buildings.
Paul Fiorilla is director of research for Yardi Matrix.