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Are Opportunity Zone Funds Right For My Real Estate Investment Portfolio?

by Richard Surek / Friday, 01 March 2019 / Published in US Lending News

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The Opportunity Zone (OZ) tax incentive has now been widely written about, and experts predict that $100 billion will flow into Opportunity Zones this year. Real estate developers should be evaluating each land purchase and each deal to make sure that any government incentive available supports the bottom line of their investments. The new Opportunity Zone incentive affects a handful of projects in my firm’s current development pipeline, and in order to monetize Opportunity Zone pipeline projects, we had to understand the answers to a few key questions: What are Opportunity Zone funds? How do we evaluate them? Are they right for every investor? Are they right for us?

Examine the answers below to help inform your next real estate investment decision in the OZ space.

What are Opportunity Zone Funds?

Opportunity Zone Funds (OZF) are primarily a way to roll capital gains into new business or real estate investments with tax deferrals and overall reduction. In order to enjoy the full benefit of the Opportunity Zone tax incentive, an investment must be held for 10 years to reach forgiveness for additional capital gains.

How do I evaluate an Opportunity Zone Fund deal differently?

As the key to this process is holding a deal for 10 years, it goes without saying that it is important to study the hold/disposition strategy for each deal. Competition upon disposition will also be something to consider for many of these projects. Ultimately, good deals can become great upon disposition, but bad deals cannot become good. The internal rate of return (IRR) is sensitive to the time value of money, so many investors will examine cash-on-cash metrics instead of heavily relying on IRR. Cash flow from 12% to 14% will ensure that investors can actually hold the property for the required amount of time and generate income while waiting for the maximum tax benefit to become available.

The OZF rules favor ground-up real estate development due to the requirement that invested capital gains must “substantially improve” the property or business, which means the entire initial investment must be matched in improvements to the property. While this can be achieved in a myriad of ways, the most straightforward way to meet this requirement is to purchase land within an Opportunity Zone and build something on the raw land.

It is paramount that good underwriting is in place for any real estate deal, but Opportunity Zone deals must be analyzed specifically for their time requirements. Investors seek to invest quickly so that the benefit is greatest, which will require you find expert underwriters.

Another piece of the Opportunity Zone puzzle is understanding the perishability of returns over time. Returns decrease from 3.08% for investments made in 2018 to 1.74% for investments made in 2025. The rush to deploy capital in these locations will certainly impact strategy and favor those funds and groups that are able to act swiftly.

Data presented (registration required) by Marcus & Millichap last year demonstrates standard after-tax IRR compared to the returns available when the Opportunity Zones capital gains deferrals increase in basis over time (10-15%) and eventual forgiveness. Assuming a standard after-tax IRR of 6%, reported jumps are from 35% to 51%. These benefits are significant, and we anticipate a good deal of competition for not only land in Opportunity Zones, but for “half-baked” deals that groups with capital to deploy can take over.

Are OZF deals right for my real estate investment portfolio?

Opportunity Zone Funds are a fantastic opportunity, and the benefits cannot be understated. If you already have existing capital gains, a solid Qualified Opportunity Zone Fund (QOZF) project could deliver higher returns compared to one not in an Opportunity Zone.

That being said, it is important you consider the implications of QOZFs when evaluating existing deals and consider the risks of funds that do not have a pipeline to execute, expert underwriting and post-tax return analyses. The benefit of this tax incentive will be extremely meaningful; however, it cannot make a bad deal a good one.

Bottom Line

QOZFs will make sense for some pipeline developments and not for others. The strength of any real estate development project is held in a conservative pro forma. Smart developers will seek to invest in QOZFs with strong fundamentals that can demonstrate speed to market.

Tagged under: home-purchase, madison, Real Estate, us-lending

About Richard Surek

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