The wave of commercial real estate capital that investment managers expected to flow into federally designated Opportunity Zones has had a slow start. The reasons for the slow start are numerous – the newness of the program, delayed clarity from the Department of the Treasury and the lack of commercial properties worthy of investment consideration, according to fund organizers. Fundraising has also been slower due the level of education it takes with investors to show them the powerful tax advantages that opportunity zone funds provide. The pool of potential investors is also smaller.
Opportunity Zones, created in one of the few bipartisan successes of recent years, allow capital-gains holders to defer taxes on those gains by investing them in designated Opportunity Zone areas. If an investor holds the gains in an Opportunity Zone fund for 5 years, they can exclude 10% of those gains from taxation. If they hold them for another 2 years (for a total of 7 years), they can exclude another 5% from taxation ó meaning that taxpayers can exclude up to 15% of the value of reinvested capital gains from their taxable income. Finally, any gains achieved after the investment is made in an Opportunity Zone fund are tax-free if the investment is held for at least 10 years.
“I think in general the problem is that most of these funds are being started by entrepreneurial people trying to capitalize off of this new law instead of existing real estate investors who might have done the deals anyway,” said one chief investment officer who asked to remain anonymous.
The funds with the most success meeting their targets are smaller funds focused on single-property investments, according to the reports. Funds targeting capital raising of less than $10 million reported being halfway to their goals. The best way to make sure to meet Internal Revenue Service requirements and investor expectations has been to create a fund for each development project individually rather than for a larger project.
In commercial real estate, what’s known as a 1031 exchange defined by IRS code allows investors to defer paying capital gains taxes on an investment property when it is sold, as long as another similar property is purchased with the profit gained by the sale of the first property. Some individuals in these situations may see more value in that type of exchange than in Opportunity Zone investments.
The vast majority of Opportunity Zone funds are “blind pools” that raise money first and hope to identify projects later. Multifamily and commercial office real estate investors, as well as high net-worth individuals, have been hesitant to allocate capital, fund managers report. Larger investors want to see the deal before allocating capital, and deals in many Opportunity Zone areas do not match their investment criteria.
Despite the slow start with Opportunity Zone funding, fund managers remain optimistic that a larger flow of investment dollars is coming. Data also backs up that optimism.
A federal government shutdown delayed the US Treasury’s release of a second round of clarifications for investing in Opportunity Zones. The clarifications that finally came out offered greater flexibility for investing in businesses and properties located in Opportunity Zones. It also has produced a surge in new Opportunity Zone fund filings, from major institutional investors, including Brookfield Asset Management, Caliber Companies, Cantor Fitzgerald, Starwood Capital Group and Arden Group.
A significant number of larger investors are still interested in taking advantage of this once-in-a-lifetime opportunity. The reality is there is still billions to be harvested and there is still plenty of time to still invest. To take full advantage of Opportunity Zone tax incentives available in the program through 2026, investors would have to invest their capital gains by the end of 2019.
“Our belief has been that investments would be slow through the first half of the year and would substantially increase in the second half,” said Michael Walker, managing member of the Pilot and Legacy Opportunity Fund, a joint fund of Pilot Properties and Legacy Opportunity Group, which has raised about 40% of its $12.3 million target. “The Treasury guidelines released in the second quarter, however, has eased investors’ concerns, and we have experienced an increased focus by potential investors on the details of our investment.”
A new Preqin survey shed some light on prospects for Opportunity Zone funding increasing in the 2nd half of 2019. At the end of 2018, only 8% of the 51 US based institutional investors in real estate surveyed by Preqin in January 2019 were already invested in Opportunity Zone funds. But 51% of those surveyed were considering doing so in 2019, and an additional 12% are interested in such funds over a longer term.