Industrial Impacts Episode 1: Opportunity Zones

Industrial Impacts is a brand-new podcast by Cresa’s Denver Industrial team. Each month Mike Statter and Matt Burton will discuss a trend impacting industrial real estate markets. In this first episode, Mike has a discussion with Damian Ederoff, Partner at Wipfli Bauerle and Doug Elenouwitz, Co-founder and Principal at Trailbreak Partners.

 

 

How did Opportunity Zones come into existence? What was the rationale behind them?

Damian: They came into existence with the tax cuts and jobs act of 2017. It was a way to nationally take underutilized areas and zone them in order to put the legislation together that was attractive to investors to develop or revitalize those areas. I believe there are 80-100 of them in the state of Colorado alone.

It was a way to entice investors with the trillions of dollars of unused capital gains dollars in the market into investing in those specific areas.

Mike: I believe the governors in all 50 states, plus the District of Columbia were given the opportunity to identify these opportunity zones. Without getting into specifics in the zones that were created inhabitants had to be a certain percentage below the poverty level.

Doug: Mike, I believe that’s right. There has been some question out there has to how areas were designated. As it has come to light that certain areas might not naturally be perceived as distressed. Understanding how these zones were created will be helpful. As I understand it, 25% of the census tracks in the state were eligible to become opportunity zones but of that 25%, 20% must have a poverty rate of at least 20%. So, 80% of the median income needs to be below a certain level. That’s why you see a large part of the opportunity zone investments in designated areas is largely distressed areas, but there are pockets in each state where they have the designation to encourage long term investment but may not be quite as distressed.

The view at that time was that it was an opportunity to reinforce investment in areas that may already be experiencing a little bit of growth. So, a shot in the arm if you will.

Mike: Another thought given to this was to help offset the effects of gentrification. Where previously distressed areas being revitalized without any type of incentives but thereby displacing people from those areas.

It appears that there was some good thought behind the creation of these zones.

How does an Opportunity Fund work? What are the rules for investing?

Damian: An individual could set up a fund or you could do a public fund with offerings. This would be typically investors that have capital gains that are still in the 180 days of rolling over into a tax-free exchange. Similar to the old 1031 exchange, but much more flexible in the sense of Investing those capital gain dollars and deferring those gains. In an ideal situation eliminating the capital gain on a property, they invest in though that funds. So that’s generally what you have going on in the market is funds being set up and/or individuals setting up a fund and investing in those zones either through a property or a business.

Mike: So, the currency, so to speak, for a qualified opportunity fund is the capital gains realized from the sale of real estate, stock or business, any type of capital gain is that correct. 

Doug: That’s correct. The incentive applies to capital gains. So, it’s not that unqualified dollars couldn’t also be an opportunity zone investment, but in doing so it would receive none of the beneficial attributes of the tax program.

Mike: I am correct in saying that the initial investment in the real estate or the opportunity zone asset needs to be made in 180 days of the capital gains being placed in the fund.

Damian: You would have to invest in a fund that is set up within 180 days of the capital gains realization. That doesn’t necessarily tie to the fact that fund must invest in a property and/or business within that time frame. It just has to have a plan to be invested.

Doug: Some of the nuance around that as best as we understand it right now is that the fund itself must have 90% of its assets invested in an opportunity zone business or property. Twice annually they will be certifying that they are compliant with that. Some of the flexibility that sits around this right now is what’s known as the working capital exemption. And what that is essentially providing for is a 31-month period during which committed but not necessarily fully invested to the point of substantial improvement you can have capital that would be treated as working capital and quality as long as it’s with conformance with a stated business plan.

So, there is some open question on documenting how that allocation of working capital works. People assume your business plan, schedule, and identification of the budgets associated with that are the presumptive basis for demonstrating that that working capital is committed into the opportunity zone property or business.

Damian: I would add that working capital exception and safe harbor is afforded to qualified opportunity zone businesses and not necessarily as written currently the opportunity zone property, although it is believed that the final regulations will include both. But currently, it is only afforded to the opportunity zones business which has a 70/30 participation as far as assets versus the qualified opportunity zone property having 90/10.

Mike: That is an important distinction. One of the key components or rules so to speak of the qualified opportunity fund is that if invested in real estate the value of that real estate needs to be doubled in a 30-month period. Or an additional investment needs to be made equal to or greater than the original investment.

Damian: So, if you invest in a qualified opportunity zone property you must improve or develop the property equal to as much or more than the original investment. But, in the case of the typical investments that will go on in at these zones, that should not be a problem in most cases.

Doug: The market is still trying to figure that out. The way we have been looking at it from the development and investment perspective is doubling the depreciable asset. There has been some guidance around the exclusion of land basis when trying to make that determination. We are seeing more interest in clarity around the ability to perfect that substantial improvement during that 30-month window of time with new construction projects. Rehab projects need to be in dire shape. You need to be substantially changing the nature of the building to double the investment. We are seeing more activity in ground-up construction than we are in rehab.

Damian: I agree with that. The regulations don’t clearly define if horizontal construction, meaning infrastructure as far as water, sewer, curb, and gutter or streets qualify or is it ground up only? So, if you buy a piece of raw land, does your investment in the infrastructure qualify as that improvement in the property? I don’t believe the regulations at this time address that but, I believe when the final regulations come out that it will be included.

Doug: We have not seen any clear guidance, but we are aware of people on the policy side advocating to make that true. Frankly, from my perspective it does make sense, because if the underlying intent is to encourage long term capital investment into these areas then, we don’t want to preclude the program from working to incentive that. It’s a real demonstrable change in the value of land when you have made those improvements.

Damian:  The land around the Gaylord hotel is primarily all raw land, so for that provision not to be true would make it very difficult for an investor to meet the rules as currently written.

Mike: From an industrial real estate perspective, given the escalating costs and sales prices of industrial properties It makes more sense that an opportunity zone would be created for ground-up development versus buying an existing property and having to double the value via redevelopment, just because they are so expensive to buy right now. If we were in a more depressed part of the United States, for example, Rochester, New York, where property values haven’t gone anywhere for the last 30 years or so you might be able to buy an industrial property there and double the value in 30 months. But you’re not going to be able to do that in Denver. This is going to apply more to ground-up development.

Doug: I think that’s a pretty good assessment, at least in the central core areas. If you look at the distribution of the opportunity zones they are widely spread throughout the state. There are some rural areas. So, I think there are some opportunities in other submarkets or regions, but certainly, in the central region, things are substantially going to be redevelopments or ground up construction.

What are the benefits for investors?

Damian: Let’s go through an example. This is created for assets invested in after December 31, 2017. So, if I were to take one million and invest it in 2018 and/or by the end of 2019 in a qualified opportunity zone. The rules state, if I invest in that zone for up to five years, then I can increase my basis on that capital gain, which is really zero at the time, by 10% of that asset. So in the case of one million dollars, I would increase my basis from zero to $100,000. If I kept that investment to the seven-year term, I can add another 5% of basis to that capital gain, which would be 50,000. So, now I have a capital gain of one million dollars with a basis of $150,000. Therefore, the rules state that the future mark of December 31 of 2026 then I will have to pay tax on my $850,000 of capital gain. Once you hit that mark then the $850,000 becomes taxable. If you keep the investment for a total of 10 full years then any time after that tenth year of ownership investment in that zone, at the point in which I relinquish or exchange my interest in that opportunity zone, the basis in that property becomes the fair market value at the time I dispose of it. At that time no additional gain over and above your investment of one million dollars would be taxable. Therefore it’s 100% tax-free. So, in the event that I sold that fund or investment for two million, I would have no gain on that two-million-dollar sale price, because I held the asset for 10 years or more.

So that is where the big savings are. Which is what the legislation is really there for, long term investments in these zones.

There is a sunset at 2047 with no understanding of what is going to happen after that.

Doug: There are really three pieces to this. First is to gain deferral from current capital gain at year five and seven where you get the partial forgiveness. So, you get to defer the gain. Then when you pay it on December 31, 2026, you’re either going to pay 90 cents on the dollar or 85 cents on the dollar depending on how long you’ve been in the investment. 

As a separate concept, the new capital gain that is generated by virtue of the investment into the opportunity zone provided you are in it for 10 years there is a 100% forgiveness of gains on that.

Damian: That is a good distinction that Doug brings up.  The $850,000 potential gain at December 2026 would be due and payable at that time. And then any future gain established by being in the fund would not be taxable going forward.

What are the most likely sources of funding?

Doug: We have met with a wide range of folks in the Denver metro area as well as from other markets throughout the United States. We met with family offices that are frequent investors in real estate, we met with institutional funds that are being established specifically for the purpose of investing in opportunity zone real estate projects and a wide range of high and ultra-high-net-worth individuals.

My conclusion is that on the surface everyone is excited about this. But, when you get down into the weeds on this, what we are seeing is that for many folks this is more about a tax management/ wealth management strategy versus a more typical investment strategy.

For many of the traditional private equity funds that are out there, opportunity zones are not a very exciting tool. They have fund timelines and requirements in terms of duration, they have necessary issues regarding compliance and liquidity and the restrictions around the zones were probably more brain damage than just staying the course on the current model. A lot of the interest that we have found is from individuals who have an ultra-high net worth. They have business interests that are generating gains that have nothing to do with real estate and they look at an investment of this nature as part of their long-term tax and liability management paradigm.

Some of the family offices similarly had that view, although many of them are still governed by folks that come from more traditional real estate investing background, so the duration and illiquidity of the opportunity zone are somewhat troubling or not as attractive as one might expect. But I suspect that with the passage of time we will see more family offices moving into space as well.

The institutions are still trying to figure it out. One of the challenges is the timing and the matching of the capital with the opportunity zone investment and the need deploy substantially and in crew the capital. It’s one thing to find projects that are in a zone. It’s another to have projects that are in a zone that make sense from a real estate standpoint and have enough visibility into the timeline of execution to manage the risk around complying with the substantial improvement. So, they really need to be shovel ready.

Mike: In our world advising clients that employ some type of warehouse, manufacturing facility or some type of industrial property in the course of their business, for tenants it doesn’t have any application. The strata of users we deal with would be property owners who might have multiple warehouses within a given area that they are looking to consolidate or looking to sell a property to move into a larger property to enable their business to grow. Those are the types of clients, I see this most applies to.

Doug: I wouldn’t dismiss it from a tenant’s perspective. We on this call have been talking about real estate in large part naturally given what we do, but the other side of Trailbreak Partners works with company investments and the opportunity zone construct does apply to what I would call more traditional private equity or operating company world. Similarly, to real estate, an opportunity zone fund could acquire stock or a partnership interest in a business. That underlying company needs to be located inside a qualified opportunity zone and it needs to derive 50% of its gross income from conduct within the zone. So this is where Damian can probably speak more intelligently, but when you have an asset-heavy company or you create a subsidiary within an Opportunity Zone from a tenant standpoint, they don’t need to own the real estate if they locate that business within the zone, then they too can qualify for the Opportunity Zone tax credits as it relates to the capital gains associated with their ownership of the business.

Mike: So, in other words, a tenant operating a business within an opportunity zone, utilizing capital gains to start or grow the business could benefit.

Are the rules the same for investing in a business?

Do the capital gains need to enter the fund in 180 days and the increase in value need to be made over 30 months do those rules still pertain to investing in a business?

Damian: A qualified opportunity zone business, only needs to meet the fact pattern of 70% of its tangible assets are within the opportunity zone and as Doug spoke, 50% of its income is to derive from within the opportunity zone itself. When those two qualify the appreciation of ownership in interest or stock in that business over a five, seven- and the 10-year period would be similar to a property.

Trailbreak has an operating Opportunity Zone Fund in a development off of Colfax, correct?

Doug: Yes. We have a limited partnership that is developing a project in a qualified Opportunity Zone. We have the opportunity zone business and property and the source of our equity investing is coming through opportunity zone investors.

What type of development? Can you share?

Doug: Sure, it’s a multifamily project, a transit-oriented development apartment community that is the next phase in a project that we’ve been involved with for a number of years where we have been developing for-sale housing adjacent to one of the transit-stops. We had a business plan we had been contemplating and after this program was created, it to some degree changed our business plan. Personally, I have always believed in the location and the project, but absent the Opportunity Zone, we may have had a more traditional merch and build view of how to capitalize and structure the project. Because of the designation, the source of capital that we have used to advance this project, as well as the duration of involvement, is different. We will be in this project for at least 10 years in order to maximize the benefits available to our investors.

Mike: In looking at the opportunity zone map of the front range area, specifically Denver and the surrounding counties, these are the areas we see as being the most interesting from an industrial perspective. One is a large area that stretches east from I-15 to Colorado Boulevard which extends south of I-70 and as far North in certain areas up to 88th Avenue. That submarket is highly sought after by industrial developers in the front range. Witness the Prologis new development which is about 630,000 SF in three buildings just North of 58th and Washington and Westfield has done a large five-building development called Hub 25 on the West side of Washington between 66th and about 62nd Avenue. So that’s a large industrial area, there is even a larger area East of Tower Road North of i70 up almost to Pena Boulevard that runs all the way out to Watkins, which encompasses the entire Aerotropolis area.

Does it encompass the new Gaylord of the Rockies Hotel?

Damian: It does incorporate the property adjacent to it, but the Gaylord, no. I know the parcel adjacent directly to the South and East of the Gaylord is.

That is one that is predominantly raw ground.

Mike: Right, so there are a lot of build-to-suit opportunities for industrial users. That area includes the Majestic Commerce Center. Which is an industrial park comprised of about 1,000 acres as well as Prologis’s Park 70, which stretches on both sides of E4-70 North of I-70 where the million square foot Amazon distribution facility was built in the last couple of years.

There is one other area that I would like to highlight, the area on either side of Santa Fe stretching for about a mile running South from Evans almost to Belview which is a big South-Central industrial area not a lot of raw ground there mostly build out with older product, but I think that is a pretty significant industrial area as well.

All these sites can be identified on the Colorado Opportunity Zone website. 

Well, I certainly have learned a lot from this dialogue, and I hope our listeners out there have as well. We really appreciate Damian and Doug’s participation. If you would like to reach out to them with comments or follow up questions their emails are linked below.

 

Damian Ederoff, Wipfli Bauerle

Doug Elenouwitz, TrailBreak Partners

 

 

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