Bo Kemp explains what the US opportunity zone programme means for UK real estate developers.
The opportunity zone (OZ) initiative has the potential to be one of the largest US federal economic development programmes in history. With an estimated $6tr of unrealised capital gains in the US stock market, the likely capital pool that will result from investors taking profits out of the market will provide enough “dry powder” to fund transformative development in these designated areas.
UK-based investors can take advantage of this programme.
The programme
The OZ programme was born with the signing of the Tax Jobs and Cut Act of 2017 by president Trump on 22 December 2017. But the back story of the creation and approval of the legislation has all the elements of a great story. A successful entrepreneur, Sean Parker – of Napster and Facebook fame – takes up a US president’s offer to suggest a “big idea” for implementation. Another president is moved to support the legislation as a means to address racial tensions after violence in Charlottesville. With a call from Air Force One, the OZ legislation is added to the 2017 budget. And the rest is history.
The bipartisan OZ bill, co-sponsored by Democrat Cory Booker and Republican Tim Scott, was designed to “replace” the urban empowerment zone programme and encourage investment in low-income communities. The programme, managed by the Treasury Department, is currently approved through 31 December 2026, but the latest regulations allow for investments to take advantage of the programme’s tax benefits beyond that date.
How it works
The legislation allows individuals and corporate tax payers to defer capital gains on the sale of stock, business assets or other property if invested in a qualified OZ fund and, in turn, invested in a qualified OZ business or property. While invested, the tax liability can be deferred for the length of the investment or until 31 December 2026. Partial forgiveness of deferred capital gains tax liability, as well as a permanent exclusion of the gains from future appreciation of the OZ investment, is possible if the investments are held for five, seven or 10 years respectively.
Although the OZ programme encourages investment across a variety of asset classes, including student housing, affordable and workforce housing, agricultural and industrial development and infrastructure, the majority of completed deals to date have been in two real estate categories: market rate housing and commercial development. Many of the transactions completed would probably have closed without the OZ programme, but the additional tax benefits have in many cases hastened their timing.
The hope and expectation of the programme is that commercial developers will begin looking at deals in locations that have suffered long bouts of disinvestment, and that any new investment will be purposeful in its efforts to avoid displacing existing businesses and residents.
Many US cities and states have taken an aggressive approach to attracting capital to their locations. The top two population centres in the US – New York and Los Angeles – have an overwhelming number of highly attractive locations for OZ investments based on population density and market rates. As such, these top markets have not been as aggressive as many of the “mid-major” markets in soliciting new development.
Cities such as Louisville, Nashville, Austin, Birmingham, Tampa and New Orleans have been developing comprehensive plans to move commercial development sites to an “investment ready” status, and to couple these efforts with state, local and federal incentives in an effort to attract commercial developers.
The UK opportunity
UK commercial developers can combine or “stack” many of these incentives to take advantage of the OZ programme alongside federal HUBzones (historically underutilised business zones), foreign trade zones, state enterprise zones and other more typical incentives, such as tax abatements and tax increment financing. Stacking these incentives can have a substantial impact on your return on investment profile.
The key for UK-based commercial developers is to be strategic by targeting specific cities and neighbourhoods for investment, so that the focus of the potential capital commitment encourages a direct discussion with state and local municipal executives. Many, if not most, investors are wary of developing too close a relationship with municipalities, fearing that too many demands will be made in exchange for its support. Albeit that some of these concerns may be warranted in some locations, the benefit of working more closely with municipal executives outweighs the risk, especially for these “mid‑major” markets.
The cities that are taking a co-ordinated effort to attract OZ investments are also identifying and funding “pre-development” activities that will reduce the cost/risk to, and enhance the return of, your commercial development. Many of these cities have designated planned development areas where they are not only providing incentives to developers, but also securing state and federal funds to make infrastructure improvements, engage stakeholders to ensure local support for projects, and in some cases even make direct public investment alongside your private investment in the OZ transaction.
Perhaps one of the best development strategies for commercial developers is to target underutilised shopping malls to turn these locations into planned, walkable, mixed-use neighbourhoods. Some commercial developers have taken this idea one step further by adding direct investments in some of the operating businesses that also serve as tenants of these commercial properties. The idea behind this strategy is to combine both a real estate investment with an operating business investment, thereby taking full advantage of the OZ programme’s ability to defer and reduce investor tax liability, as well as to exclude all capital gains taxation on the appreciation in the operating business.
The commercial developer that builds the headquarters for the next Amazon and takes a small equity stake in the company can get both a tenant and an investment with unlimited upside.
Looking forward
Although this programme is new, an ecosystem of both capital and support services is rapidly developing around it. An estimated $35-45bn of capital has been announced by potential OZ funds representing more than 200 groups, ranging from asset managers, REITS and family offices to corporations and specialised sector-focused funds targeting vertical farming, clean energy and even electronic sports businesses within OZ designated areas. Early investors began consummating deals in late 2018 and the pace of deals has picked up. 2020 is poised to see a substantial number of OZ deals close now that the regulations are substantially completed, and the ecosystem of capital and supporting services are forming.
Bo Kemp is a senior director at Faegre Baker Daniels
