Opportunity zones have generated nationwide excitement since they were introduced, but a maxim has been repeated ad nauseum to temper that enthusiasm: An opportunity zone doesn’t turn a bad deal into a good one.
While the capital gains tax benefits only apply to equity investments, a real estate deal done without debt is a rarity. For commercial real estate lenders, the maxim holds true — opportunity zones don’t change the fundamentals of a deal.
“We look at how much equity is going into a deal, if the deal makes sense and if we like the area, then we do the deal [or not],” Capital One Senior Vice President Sadhvi Subramanian said. “From the CRE side of it, if it’s in an opportunity zone or not doesn’t have an impact on how I’m going to finance the deal at all.”
Since their introduction as part of the Tax Cuts and Jobs Act of 2017, opportunity zones have come under criticism as a program for its lack of restrictions and reliance on census data from 2010. The bulk of investments to make use of deferred and discounted capital gains taxes will flow to growing areas that don’t need extra incentives, neighborhood advocates worry, neglecting the areas the legislation was meant to benefit.
Financial giants such as Prudential and Goldman Sachs have made some deals in distressed areas using their social impact funds, and plenty of banks like Capital One have social impact branches of their own to give out low-interest loans, but the additional requirements for any project to qualify for other tax breaks can be a stumbling block for the pool of investors the law is meant to draw in.
“What [opportunity zones] are really doing is potentially bringing in non-real estate investors to the mix,” Madison Realty Capital co-founder and Managing Principal Josh Zegen said.
Inexpert investors will likely place their trust in fund managers to handle the transactions, but they do so to maximize return and to ensure compliance, not necessarily to maximize social impact.
MRC is among the vast majority of private equity and debt firms that does not have an impact fund. Even qualified opportunity funds interested in social impact have not been offering terms significantly better than non-OZ investors, according to Shift Capital Director of Development Nancy Gephart. Private debt sources may be more amenable to opportunity zone deals than banks because of the greater potential pool of equity sources. OZ deals need to cover potential cost increases associated with the improvements necessary to qualify for the program’s tax benefits.
“In an opportunity zone-related investment, the numbers need to work, but we know that there’s another source of income or cash that can come into the deal,” Zegen said. “So in some ways, it creates more liquidity [potential] for that deal.”
Like Subramanian, Zegen said he wouldn’t change his underwriting framework for the sake of an opportunity zone deal. But he said more potential avenues to covering cost overruns could serve as something of a tiebreaker when MRC is weighing projects to finance.
“If the deal didn’t work on the merits of the deal, I wouldn’t be interested in doing the deal,” Zegen said. “When it’s on the line, that could push me over the edge, I could say. If it meets our criteria, opportunity zones would make me more excited about the deal.”
It may not be all that surprising that private debt funds would be more flexible in making financing deals than banks; that has become the case across commercial real estate. In the early stages of the opportunity zone program, one of the most popular deal formats has been the recapitalization of a project that is already well underway, Zegen said.
“We’re seeing a number of recapitalization deals, where ownership is looking to restructure a deal to take advantage of opportunity zones, and where they need bridge loans or something like that to bring in a new investor,” Zegen said. “So if they were considering selling [a building], now they recapitalize.”
Zegen told Bisnow that MRC is in negotiations on several such deals, but has not closed on one to date. But as deadlines to maximize capital gains tax discounts approach, investors and developers will need to put together financing more quickly.
Being unregulated, debt funds can match the speed of dealmaking required more easily than banks, meaning they could take a larger and larger share of debt deals in the sector going forward, Zegen said.
Wherever the debt is coming from, the picture of opportunity zone financing is beginning to form as nearly indistinguishable from other forms of commercial real estate deals. As a method of encouraging business in disadvantaged areas, the legislation doesn’t appear to be doing the job.
“A lot of [Low-Income Housing Tax Credit] deals, say, would never get done without LIHTC, and with opportunity zones we’re seeing that for the most part, the deal works anyway, and OZs are an added benefit,” Zegen said.
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