Opportunity Zones on the March

In 2017, Driftwood Acquisitions and Development purchased a 218-room dual-branded Hilton Hotel in Fort Lauderdale, FL, with its joint venture and co-development partner Merrimac Ventures. The partners commenced ground-up construction on the development promptly after.

The 2017 Tax Cuts and Jobs Act was released soon after the purchase, outlining the benefits of a new investment program for some 8,700 designated Opportunity Zones throughout the country. The rules were incomplete, but they did state that you could not receive the benefits if you owned the property prior to 2018.

The executives at Driftwood were disappointed in the regulation and wrote off the otherwise perfectly-suited project as an Opportunity Zone investment.

However, the Treasury Department was not finished seeking feedback and detailing possible regulations. In a later round of proposed rules, Driftwood executives found a way in.

“When the second round of proposed regulations came out a few months ago, the Treasury department did a good job of addressing the reality that a lot of investors had been land banking or already started some developments in these zones and wanted to take advantage of these benefits without having to sell to a third party,” says Jorge Gomez-Moller, general counsel at Driftwood Acquisitions and Development. “We have relied on the provisions in the proposed regulations that have allowed for related party leases.”

Now the proposed rules state that if the properties were acquired after December 31, 2017, they can either be substantially improved by a qualified Opportunity Zone fund or if the properties have never been depreciated or have been vacant for five years, the original use can start with a qualified Opportunity Zone fund, Phil Jelsma, a partner at law firm CGS3 and an expert on the Opportunity Zone regulations, explains. “Properties acquired prior to December 31, 2017, generally must be acquired by purchase by the qualified Opportunity Zone fund from an unrelated party. Typically this means the current owners must own less than 20% of the capital or profits of the qualified Opportunity Zone fund,” he says.

A HOT PROSPECT

Opportunity Zone projects are officially underway. This new investment model has quickly become a hot prospect, largely because it allows investors to defer capital gains taxes on qualified investments. While the total fundraising is difficult to track so far, the most prominent funds have an aggregate fundraising target of $12 billion, according to CBRE’s research.

This capital will flood into more than 8,700 designated Opportunity Zone markets across the country. As companies launch projects in these areas, they are uncertain as to what the final rules will look like against a ticking clock: December 31, 2019 is the deadline for investors to maximize tax benefits.

The uncertainty has not stopped developers from moving forward. As prospective rules continue to roll out, companies such as Driftwood are plunging ahead as it becomes clear that their projects could well qualify after all.

Driftwood Acquisitions, along with private equity firm Virtua Partners, are among the first movers in the Opportunity Zone space. Both investment firms are employing their standard business strategy on Opportunity Zone investments. Driftwood has two developments underway: the Hilton Hotel in Fort Lauderdale and a 136-room IHG-branded urban hotel in Wilmington, DE. “Our historic business practice and about 70% of our fund’s capital is committed to cash flowing existing hotels—we work entirely in the hospitality space—and about 30% of our business has been in new hotel development,” says Gomez-Moller. “We focus primarily on major franchise hotels, like Marriott and Hilton.”

Virtua Partners focuses on social impact investment and utilizes a handful of local and national incentives. The firm sees the Opportunity Zone tax benefits as another incentive to raise capital for challenging projects in blighted communities. “Our focus prior to Opportunity Zones was residential and hospitality, and within the residential component, we were focused on entry-level, medium-density housing in the Sunbelt states,” Nick Montague, president of Quip Development, which oversees all of Virtua development, says. “That includes townhouses and detached single-family projects. There are a lot of local-level incentives to make these projects more viable, like new market tax credits, development impact fees that can be waived and city participation. Then, the Opportunity Zone benefits came out in the 2017 tax reform bill, and we jumped on that because it fit a business model that we were already interested in.”

Virtua’s first Opportunity Zone project is a 128-Room Springhill Suites by Marriott in Phoenix, which was hailed as the first such investment, while the firm has additionally started development on a 90-unit entry-level apartment complex in Tempe, AZ

Like Driftwood’s Florida hotel project, Virtua Partners has also used an existing asset for its first Opportunity Zone project. While Driftwood applied the Opportunity Zone benefits to a project under development, Virtua was under escrow on the 90-unit apartment development at the time of the Opportunity Zone announcement. “We actually went into escrow right before the tax reform bill came out, so we were already looking at this project,” explains Montague. “We hadn’t purchased it, but we were in a long-term contract so that we could look at the project and the viability. This particular project is in the Broadway revitalization corridor, which is an older more distressed corridor that has not seen the level of new development as the areas near the university.”

To take advantage of the Opportunity Zone benefits, Virtua transferred the property to its qualified fund. “Effectively, there is a closure of the original investment and a transaction. We are definitely in compliance with those rules, and they are something that you need to navigate through,” says Montague. “Structuring these projects is really critical, and I think that we are doing a good job of that.”

To bring its partially-developed project in compliance with the rules, Driftwood set up an Opportunity Zone fund targeting $50 million. The fund will serve as a parallel investment vehicle that will co-develop the project alongside Driftwood and Merrimac. “The fund will complete the project, and it will be part of the current ownership with our joint venture partner and us on one side. The qualified Opportunity Zone is going to have the ability to deploy $25 million in capital into the deal and take advantage of the benefits over the next 10 years,” says Gomez-Moller.

NEW BENEFITS, OLD PORTFOLIO

These early projects have illuminated a growing trend. Many of the early movers in the Opportunity Zone space are looking to apply the benefits to projects within their company’s existing portfolio. Affordable housing developer Avanath Development is similarly looking to build and expand its existing portfolio under the Opportunity Zone model. It has launched a $300 million fund with the intention of acquiring and redeveloping four of its existing properties. “We have four projects that we currently own that are in Opportunity Zones, and those projects will be sold to our Opportunity Zone fund at fair market value,” Jun Sakumoto, president of Avanath Development, says. “That fund will make the improvements to meet the requirements of the Opportunity Zone legislation, which is doubling the basis. Our Opportunity Zone funds have not acquired those properties yet because we are still raising capital for the fund. Once the capital raise is complete, we will move forward on the improvements.”

Like Driftwood and Virtua, Opportunity Zones complemented Avanath’s existing strategy, allowing the firm to move quickly in launching a fund. “The Opportunity Zone initiative complements our existing strategy, which is to invest in affordable and workforce multifamily housing,” says Sakumoto. “Our properties are, in general, located in Opportunity Zones, which are essentially lower income census tracts. The incentives allowed under the program enable us to build more units.”

According to Jelsma, many owners are looking to take advantage of the benefits on existing properties. “We have seen many existing owners wanting to talk about Opportunity Zone benefits,” he says. “Unfortunately many of the existing owners either weren’t aware of the Opportunity Zone rules or acquired the properties before December 31, 2017. We are frequently advising the owners on how to access the Opportunity Zone benefits.”

For investors looking to take advantage of Opportunity Zone benefits on assets purchased prior to the Opportunity Zone announcement, Jelsma says owners have two options. “If the property was purchased before December 31, 2017, owners can either get the property into a qualified Opportunity Zone fund or potentially ground lease the property to a qualified Opportunity Zone fund. Ground leases are often a solution to the related party rules.”

MAKING IT PENCIL

These early developments underscore what has become a central covenant for Opportunity Zone investors: these projects must pencil without the tax benefits. “Investors aren’t going to put their money into a 5% or 6% IRR deal just because they can defer gains,” says Gomez-Moller. “Everyone wants to defer taxes, but if you are better off paying taxes and putting the money into a better deal, the market is going to do that.”

Gomez-Moller estimates that Opportunity Zones increase returns by 3 to 4 points in IRR over the 10-year hold.

For the Fort Lauderdale deal, Driftwood is estimating 13% to 14% net returns to investors. “We have told our prospective investors that in order to achieve the same bottom line without the tax benefits, you would have to find an opportunity that would deliver a 17% IRR. It does give you a little more wiggle room, but you still have to hit certain returns,” he explains.

However, the tax benefits are incentive enough to drive billions of dollars in capital into qualified Opportunity Zone funds, and as a result the pipeline of projects is growing rapidly. Virtua is seriously considering nearly 100 projects. “We are looking at projects all over the place,” says Montague. “Our overall pipeline, which includes projects that we are initially looking at, is close to 100 deals. It is a big pipeline, and again those are not owned assets, but that is where the scope is. It is pretty robust.”

In addition, Springhill Suites is a two-acre project on a 60-acre site, and the firm plans to develop the entire land site with apartments, retail, a second hotel and single-family detached homes.

Driftwood is also actively and aggressively pursuing more opportunities, but Gomez-Moller says that the firm is being careful to maintain its standard business practices. “We are definitely being aggressive in looking at opportunities, but we are not modifying our underwriting parameters because we want to get that extra 5% step-up in basis. To date, we have considered 30 different deals,” he says.

A FEEDING FRENZY

Due to time parameters to take advantage of the benefits, there has been a frenzy to purchase projects before the end of the year. Investors who begin projects before the end of the year can take advantage of the full 15% step-up in basis prior to the 2026 deadline. In 2020, the step-up benefit falls to 10%. “There is a real value to doing something quickly and doing something right now; however, that isn’t the reason that people are excited about this,” adds Gomez-Moller. “People are excited because you get to defer your gains for 10 years, and most importantly, after 10 years, you will not pay capital gains taxes on those returns.”

With guidance on the regulations rolling out as recently as May, there is limited time left to find and secure deals this year to take advantage of those full benefits. This is especially true for some investors that waited for clarity on the regulations before moving on projects. “There was some reluctance on the private capital side to invest in these projects, but as the guidelines rolled out, there was an increase in private capital coming into the space,” says Montague.

Avanath was among the later funds to launch, however, it is aiming to complete fundraising and transactions by the end of the year to take advantage of the full benefits. So far, it has gotten a healthy response from investors. “We are still early in the fundraising process,” says Sakumoto. “A lot of the investors like our strategy of targeting workforce housing because it provides a social benefit in addition to providing a good risk-adjusted return profile.”

The opportunity to defer capital gains tax has driven the instant popularity of these funds, but for both Virtua and Avanath, which previously invested in low-income markets, Opportunity Zones will generate significant social benefits as well. “Because we are targeting affordable workforce housing, our projects are generally limited in terms of the rents that we can charge as opposed to a market-rate project,” says Sakumoto. “The cost to develop these projects is essentially the same, aside from the high-end finishes. To the extent that there are additional tax incentives, it would greatly expand the production or supply of affordable housing.”

Virtua sees Opportunity Zone funds as a way to bridge the gaps between mature submarkets and blighted communities. While early projects may be easily achievable deals that may have been built with or without the tax incentive, Montague believes that funds will get more creative with underwriting deals in challenging markets in need of capital investment. “My bigger picture view is that if you want distressed areas to get developed, you have to start somewhere. It is not going to be entirely distressed, blighted areas that are in Opportunity Zones,” he says.

“There are going to be projects that are on the fringe and there are going to be projects that would have gotten developed anyway. As we see the first low-hanging fruit get developed, now developers are working with cities and looking at how to get more projects to work. That is how you are going to get to the projects that truly need this incentive. In the coming years, I think more capital will come in and we are going to see more projects that fit the Opportunity Zone model.”

Driftwood falls into that transitional segment. The company is looking for evolving communities that can support a hotel development. “In the hospitality space, you don’t go into an underserved market and build a hotel,” says Gomez-Moller. “We are a lagging development component. First, you have retail and residential, and then there is a space to have a hospitality development. For us, the sweet spot is finding those Opportunity Zones that are growing and could benefit from capital infusion, but it is not a neighborhood starting from scratch. Investors need to look at the opportunities in each zone. It isn’t a one-size-fits-all model.”