Opportunity Zone Investing Series: Investment Strategy Prerequisites—Coloring within the Lines (part 2)
In this posting we address investment constraints that derive from the definition of Qualified Opportunity Zone Business Property (“QOZBP”), building on the list of conditions developed in the last posting on the interwoven topic of vehicle structure. Note that to date we have only covered the implications of direct investing (from a QOF directly into real estate). After this post we will have set the stage for a discussion of the implications of indirect investing through a Qualified Opportunity Zone Business. Collectively, these three postings will serve as a basis for our review of investment geographies and ultimately the development of a coherent investment strategy.
IRC Section 1400Z-2(d)(2)(D): Qualified opportunity zone business property
i. In general, The term “qualified opportunity zone business property” means tangible property used in a trade or business of the qualified opportunity fund if—
I. such property was acquired by the qualified opportunity fund by purchase (as defined in section 179(d)(2)) after December 31, 2017,
II. the Original Use of such property in the qualified opportunity zone commences with the qualified opportunity fund or the qualified opportunity fund substantially improves the property, and
III. during substantially all of the qualified opportunity fund’s holding period for such property, substantially all of the use of such property was in a qualified opportunity zone.
ii. Substantial Improvement: For purposes of subparagraph (A)(ii), property shall be treated as substantially improved by the qualified opportunity fund only if, during any 30-month period beginning after the date of acquisition of such property, additions to basis with respect to such property in the hands of the qualified opportunity fund exceed an amount equal to the adjusted basis of such property at the beginning of such 30-month period in the hands of the qualified opportunity fund.
iii. Related Party: For purposes of subparagraph (A)(i), the related person rule of section 179(d)(2) shall be applied pursuant to paragraph (8) [1] of this subsection in lieu of the application of such rule in section 179(d)(2)(A).
The main stipulations of investment strategy herein are (i)(II) on the topics of original use and substantial improvement followed by (i)(I) regarding the way a current, non-QOF owner of a site or asset could harness QOZ capital to develop it. Tangibility (i) and fixed location (i)(III) are intrinsic to real estate. In the following we focus on the prior.
Investment Strategy Implications
The related party rule shifts QOZ capital toward new development positions under new sponsorship. The CDFI limits overlap in ownership structure[i] between the prior owner and a QOF purchasing it to 20%, reflecting the CDFI’s intent to catalyze fresh investment as opposed to rewarding those developing sites that penciled on a conventional basis. While an internally financed developer may struggle to comply with this requirement, a developer entitling optioned land, or seeking to contribute owned land to a development joint venture with a majority equity partner should be able to design an attractive deal structure wherein its GP stake comprises ≤ 20% of capital and collects ≤ 20% of total profit across scenarios[ii]. Note that while development and asset management fees generally don’t improve alignment of interests between developer and capital, in this instance they could serve as structuring levers in addition to the ability of LP equity to resize the developer’s equity / land contribution through up front liquidity.
Depending on how defined, Original Use could allow long vacant assets, newly developed but vacant assets, or assets never used within a QOZ (e.g. relocated mobile homes on code compliant land) to qualify. In the context of the Enterprise Zone facility bonds code (IRC Section 1394), Original Use is defined to allow qualification of assets that have been vacant for over one year, with that period including the date the Enterprise Zone was designated. Shearman & Sterling notes that, regarding CFR 1.168(k)-1, which relates to bonus depreciation, “In that context, “original use” means the first business use to which the property is put…,” meaning that if the property has ever been used, that first use was the original. The CDFI could require that Original Use apply to the land itself, a near impossible standard to meet for urban land, or at the less restrictive end of the spectrum, it could allow, for example, an existing office building to qualify on the basis of fresh tenant improvements. It appears the CDFI has favored binary metrics such as capital spending or long-term vacancy thresholds versus qualitative measures of renovation extensiveness for the sake of clarity. As such, I would expect that if the CDFI seeks to ease the path to qualification of QOZBP, it is more likely to do so by reducing the substantial improvement capex threshold than by widening the qualitative interpretation of original use. Furthermore, I suspect the majority of QOZBP will qualify by substantial improvement, particularly in the near term, wherein a building’s protracted vacancy, nine years into a recovery, could intimate incurable obsolescence or market deficiencies[iii].
While the CDFI’s high bar on the extent to which QOZBP investments should be transformational (at the asset level) in nature is well-intentioned, it is likely that a lower bar, allowing moderate value-add deals could catalyze more growth and a non-negative impact on efficacy per USD deferred (depending on prevailing market conditions)[iv]. The disparity in total project cost (per unit of space) between ground up development and building redevelopment can be substantial. Rents can justify (less cost intensive) existing asset redevelopment much earlier in an area’s revitalization than ground up construction. Such redevelopment can still kindle vibrancy within an area, transforming the streetscape and generating product with modern finishes and features attractive to new employers and residents, albeit without necessarily expanding total stock. This activity can engender conditions supportive of ground up development. That said, allowing this lower bar may expand the extent to which QOZ program capital displaces conventional equity.
The 30-month Substantial Improvement time frame could shift investment into shorter term development such as industrial, strip retail and suburban multi-housing on sites that present lesser risk of development delays. While the 30-month time frame sounds reasonable on a proforma basis, one could envision several scenarios in which exogenous factors prevent a developer from deploying capital according to plan. Tishman Speyer’s Infinity development in San Francisco involved the unexpected excavation of a historic whaling ship that required Tishman to conduct a swift and complex multi-party negotiation with various museums and the highway system (oversized load) to keep the project moving without damaging the historic object. Tishman’s neighboring Lumina development was delayed by shipments of glass held up at port of departure (coup in Thailand) and port of arrival (strike at the Port of Oakland). These types of idiosyncratic delays aren’t unusual; development being a complex coordination game, initial delays can be amplified by second and third order effects.
IRS guidance may address the excess compliance risk longer (or higher variance) development periods currently engender. As noted in a briefing by the Real Estate Roundtable, The IRS and Treasury have provided relief under analogous circumstances in the energy credit code under Section 45, which takes into account a taxpayer’s continuous efforts to complete construction and disruptions beyond the taxpayer’s control (e.g. severe weather, natural disasters, licensing and permitting delays, labor stoppages, financing delays of less than six months, delays caused by federal or state agencies, supply shortages, the presence of endangered species, and the inability to acquire specialized equipment). The 30-month timeline appears to derive from a misunderstanding of typical development time frames rather than the US Treasury’s implicit desire to favor the shorter-term development business plans noted above.
[i] While we know that new ownership is subject to this 20% standard, the IRS has not clearly denoted the metric to which this 20% applies. While Section 954(d)(3) defines related persons in terms of voting power in the case of corporations and “beneficial interest” in the case of partnerships, likely to mean profit and capital, etc, the metrics could be defined differently herein.
[ii] Depending on deal risk profile and developer profit expectations, structuring an attractive ex-ante GP equity multiple may become more challenging as the GP equity contribution nears 10%. E.g, if a deal is expected to generate a 3x multiple by stabilization (e.g. in FY3), a developer contributing 6.66% could expect an 8x+ return on its equity if capturing 20% of the upside (depending on preferred return and other levers).
[iii] Absent idiosyncratic factors such as under management or an undercapitalized owner
[iv] When rents don’t justify development, lower intensity value-add may still be supportable, in which case value-add provides greater benefit per dollar of deferred gain. When both pencil, program efficacy per dollar of capital gains deferred could be lower in value-add business plans, which may simply replace class B space with class A (no net addition to total stock). That said, development often entails demolishing older structures albeit typically lower density or truly obsolete ones.