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“The number of dollars that are flooding to the space right now, far outpace the pace that we can actually deploy that capital responsibly,” says an executive at one investment firm.
Investors and others interested in “Opportunity Zones” are eagerly awaiting federal regulations—expected out any day now—that are seen as a prerequisite for getting the nascent economic development program up to full speed.
Created under the massive tax law that President Trump signed last year, the initiative provides people and companies with a tax break on capital gains that they pour into special “Opportunity Funds.” The funds are supposed to then use that money to make investments in business ventures in lower-income communities designated as zones.
Even without specific guidance from the Treasury Department there are signs of strong interest in the program, as firms move ahead building funds and in some cases making investments.
“We actually don't think that this wait-and-see approach is at all the right move,” said Kendall Davis, vice president of investments for Fundrise, a company actively raising and investing money as part of its plans for a $500 million Opportunity Fund.
“We think there's a first-movers advantage," Davis added. But she also noted that the “dollars that are flooding to the space right now far outpace the pace that we can actually deploy that capital responsibly.”
Many people in the investor community are hoping the forthcoming Treasury rules will provide answers to a raft of technical questions.
States have also taken an interest. Rhode Island’s Secretary of Commerce, Stefan Pryor, along with top economic development officials from Connecticut, Colorado, Pennsylvania, Vermont and Utah, discussed the pending rules with Treasury and White House Office of Management and Budget officials on Oct. 5.
Examples of lingering questions include: What types of gains can be invested in Opportunity Funds? How quickly does cash funneled into the funds need to flow to businesses? And how much of a business's assets must be located in a zone for it to be eligible for investment?
Michael Novogradac, managing partner with Novogradac & Company LLP, which provides accounting and consulting services, said that his company held a conference on Opportunity Zones in New Orleans earlier this month that drew over 1,000 attendees.
“Everyone was talking about getting this guidance so they can start to get off the sidelines,” he said. “A lot of folks are talking about a rollout in early next year, just on the presumption that they get the guidance now, and there’s talk of a second tranche of guidance by end of year.”
The first round of guidance, he said, is unlikely to answer all the questions people have. “But it is a big step,” he added.
Treasury last month sent a set of proposed rules for the program to the White House Office of Management and Budget for review. An IRS spokesperson said by phone Wednesday morning that the proposed regulations could be issued this week, possibly as soon as Thursday.
How the rules shape up could have implications for how much money invested through the program flows to real estate, as opposed to other types of business activities. And for how much capital is likely to go to zones in areas that are better off, and gentrifying, rather than poorer.
These are major considerations because some Opportunity Zones boosters have framed the program as a way to generate more venture capital for start-up businesses in struggling areas.
“There is a strong concern that the guidance provided by Treasury will lead to a slant towards real estate,” Novogradac said. “There’s a host of technical reasons why that’s the case.”
One person who works for a private equity firm, and is tracking the program, said timeline requirements could affect where projects take off. “There are certain projects that were going to happen anyway,” they said. “These are in high-growth areas, they’re no-brainers.”
“There are others that are going to be a little bit more challenging,” the person added. “Some of these projects are probably going to require a slightly more flexible approach. The question is going to be: Will the rules, when they come out, allow for that?”
As it stands, without the regulations issued, there has been less uncertainty about how the law works when it comes to real estate.
“Pre regs you're going to have folks hew towards the most risk averse and straightforward types of transactions,” said John Lettieri, president and CEO of Economic Innovation Group, a bipartisan think tank that has championed Opportunity Zones. “And those are going to be disproportionately real estate oriented.”
“You have meaningful signs of activity within the marketplace, but it’s not anywhere close to the scale of the interest,” he added.
Fundrise has moved forward with investments in two Opportunity Zone real estate deals. One involves a $2.5 million investment in the renovation of commercial space in Washington, D.C. The other is a $5 million investment in an office redevelopment project in Los Angeles.
Davis said the company was already deeply involved in the real estate markets in both of those cities prior to the launch of Opportunity Zones. “We already have huge pipelines and these are two projects that we probably would have done anyway,” she said.
After announcing plans in June for a $200 million Opportunity Fund, Virtua Partners, a private equity firm that focuses on commercial real estate, is eyeing projects in Miami, Atlanta and near Phoenix, says Quinn Palomino, a principal with the company.
She said Virtua’s investors have shown a high degree of interest in the program. Possible projects include housing. There’s also a project now in its early stages that could involve development around a culinary institute. One of Virtua’s affiliates specializes in hotels.
‘Geekier, Wonkier’ Questions
Lettieri said the initial rule-making for the Opportunity Zones program will likely address issues that fall into two broad categories.
One has to do with defining and clarifying a number of key terms and tests in the legislative text that created the program. For instance, how a test in the law is applied to confirm that Opportunity Fund investments lead to “substantial improvement” of property.
The other category has to do with various timing issues.
The law stipulates, for example, that at least 90 percent of a fund’s assets need to be in Opportunity Zone property. This is supposed to be tested twice a year. But it isn’t clear how long a fund can hold cash from investors before it’s subject to this requirement.
“Nothing should prohibit Treasury from saying, for example, when the fund receives cash that there’s a certain period within which that cash is treated as compliant with the 90 percent asset test, while you’re going out and building your portfolio,” Lettieri said.
State officials, including some of those who discussed the rules with Treasury and OMB earlier this month, sent a letter to OMB in September highlighting some of their concerns.
They emphasized the need for clarifying the definition of “substantial improvement” and said that some interpretations of the language in the law could disincentivize certain building rehabilitation efforts and the redevelopment of “brownfield” industrial sites.
They also said the regulations should provide a grace period before new Opportunity Funds are subject to the 90 percent asset test.
Novogradac described nailing down guidelines for which gains are eligible for the program as a basic but important question. Drilling down further on this issue, he said there’s uncertainty about whether gains taxpayers are allotted from business partnerships would qualify.
“Until you know you’re going to get to defer the gain,” he said, “you’re not going to invest in a fund.”
There are other questions related to gains that get into more esoteric territory, like “depreciation recapture,” that Novogradac jokes “only an accountant could love.” But he said that “until we know the answers to these geekier, wonkier sort of questions you kind of can’t tell your client exactly what level of benefits they’re going to get.”
Novogradac also brought up the “substantially all test” in the law, which has to do with what portion of a business’s assets need to be located in a zone. Applying the test to real estate might be fairly straightforward—a building is either in a zone or out of a zone.
But with operating businesses Treasury could, theoretically, say 90 percent of assets need to be used in the zone 90 percent of the time.
“Treasury has to decide what the 'substantially all' test is,” Novogradac said.
Lettieri raised the issue as well.
“Businesses don't perfectly conform to census tract lines,” he noted.
‘As Local as it Gets’
About 8,700 census tracts, in all 50 states, have been designated as Opportunity Zones. Palomino, with Virtua, said local governments began reaching out to her company earlier in the year for feedback and consulting on how to attract investors to their zones.
Since well before the program was launched, Palomino said, Virtua has worked closely with local government officials. “We just don’t drop in and force our projects,” she said. “You really need to work closely with the city, find out what their short-term goals are, what their long-term goals are.”
Oliver Schwab, executive vice president for public policy with the company, says that a core part of his job is to build relationships in communities where Virtua is interested in projects. He said Tuesday he’d met with a group of pastors interested in Opportunity Zones.
“Even though this is a federal program,” Schwab said, “this is as local as it gets.”
Novogradac said that among some of his firm’s clients, projects in Opportunity Zones have moved to the forefront of their investment portfolios. “Those are getting the big spotlight,” he said.
“In some ways the most powerful part might be that all of us are talking about Opportunity Zones, and Opportunity Zone investments and developments are moving to the front of the line,” he added. “It has to lead to more investment, it’s just a question of how much more.”
Bill Lucia is a Senior Reporter for Government Executive's Route Fifty and is based in Washington, D.C.