The Tax Cuts and Jobs Act of 2017 passed by Congress created the concept of Opportunity Zones, a tax incentive tool to encourage long-term investments in low-income urban and rural neighborhoods across the country.
What are Opportunity Zones?
Opportunity Zones provide a tax incentive for investors to re-invest their unrealized capital gains (via the sale of real estate, stock, a business, etc.) into real estate projects that meet certain parameters.
Opportunity Zones in Philadelphia
Here at MMP, we are no strangers to investing in communities in Philadelphia that are now designated Opportunity Zones, such as Brewerytown, Francisville, Powelton Village and University City. We have spent the past 18 years successfully investing in these neighborhoods well before they were “Opportunity Zones.” We had been tracking this legislation very closely from when it was first announced to its passage in December 2017, as we feel it’s an integral tool that will make investing easier.
Don’t get me wrong. Investing in emerging neighborhoods is not easy by any stretch. Construction costs are construction costs whether you are building in Center City or Brewerytown – it’s all the same. The variables are land cost and end rents you can achieve, and then the sale price/property value post construction. Obviously you can buy land or buildings cheaper in Opportunity Zone neighborhoods than in the heart of Center City Philadelphia, but there is a ceiling on the rents you can charge and in turn the end values of properties (which of course is derived from the rental income stream) so you have back end risk on the appraised/sale value.
As a developer, to make projects pencil out in emerging neighborhoods, i.e. Opportunity Zones, you need subsidies such as Historic Tax Credits and low interest financing to make the risk associated with the project worth taking. Otherwise, you simply must be willing to make less return on your investment, which runs counter intuitive to the idea of investing in a riskier neighborhood. You typically would need a higher rate of return on your invested dollars to compensate for the risk of developing in an emerging neighborhood. Most developers do not have the appetite to take the level of perceived risk in investing in these neighborhoods and hence it becomes a vicious cycle that these neighborhoods stay underdeveloped. The Opportunity Zone legislation is designed to counter this problem.
We have always been attracted to investing where others are scared to go. We are long term investors and will place bets that may take time to pay off. This style of investing has been popularized by Warren Buffet and Charlie Munger, and we are strong proponents of it.
We began investing in Brewerytown in 2001 because we loved the location of the neighborhood, its access to transportation, its large stock of architecturally distinctive properties and its rich history. It certainly hasn’t been an easy journey and there were many times when people thought we were crazy to be investing in Brewerytown at all.
We have poured our blood sweat and tears into the Brewerytown neighborhood. It didn’t happen overnight and it required very “patient” capital. We also took a holistic view to developing the entire neighborhood and acquired a great deal of property so that the risk was worth taking as there were years and years where we made no return on our investments, but we took the long view and kept our heads down and kept building/investing knowing at some point others would recognize how great Brewerytown is.
Our view of Opportunity Zones is that they will help solve the major impediments to risk capital being driven into emerging neighborhoods because the capital is required to be “patient.” That is, you need to hold the investment for at least 10 years in order to get the full tax benefit. Our experience in Brewerytown (and in other neighborhoods we have invested in) has shown that patience is the key when developing in emerging neighborhoods. By having investors who are on the same page it will go a long way to ensuring a successful outcome.
In addition, because there is a very attractive tax benefit to the investor (deferred capital gains on the front end of whatever asset they sell and no capital gains on the sale of the new property upon a sale after 10 years) the investor can earn a lower return on their investment (and still be happy with the return) then they would typically require but for without the OZ status. Said another way, investors view the value of the Opportunity Zone tax treatment as worth anywhere from 300-600 bps in return (we have heard some instances where investors value it even higher) meaning if an investor typically needs a 15% IRR on a non-OZ deal, they will do an OZ deal for 9-12% IRR and get to the same place.
Since the passage of the act we have seen huge interest from investors interested in getting into OZ deals. To date, we have closed two OZ transactions and we have two more in the pipeline, that are closing this year. We continue to look for OZ transactions recognizing there is a short first mover advantage and we want to be at the forefront as we are very uniquely positioned to take advantage of this legislation with our long track record of success of investing in emerging neighborhoods.
End of the day, doing Opportunity Zone deals are simply business as usual for us as we have successfully been doing these types of transactions for the past 18 years without the benefit of the Opportunity Zone incentives.