Guest Contributor: Opportunity Zone Investing in the Age of COVID-19
By: Greg Genovese, principal and president of Sound West Realty Capital
By: Greg Genovese, principal and president of Sound West Realty Capital
The article first appeared in the Summer 2020 issue of ADISA’s AI Quarterly and was republished with permission.
The Check-up
Although slow to pick up speed due to the sluggish rollout and opaque nature of the on-again, off-again, and then on-again governing rules and regulations for opportunity zone investing, which were established as part of the 2017 Tax Cuts and Jobs Act, the investment community has now made opportunity zone investing a staple investment strategy. At least for the next few years, investors can benefit from the deferral of the recognition of capital gains until December 31, 2026, and the reduction of those taxable capital gains by as much as 10 percent, plus the benefit of full elimination of capital gains taxes on their opportunity zone investment if held for 10 years or more.
When the final iteration of regulations was delivered by the U.S. Treasury Department on May 1, 2019, investing in opportunity zones has been enthusiastically embraced by the investment community and was gaining exponential steam each month, all the way up to when COVID-19 hit the scene in February 2020.
In fact, as reported by Novogradac & Co. LLP, there were approximately 406 qualified opportunity funds listed with the total raised of more than $10 billion before the onset of the COVID-19 impact on March 13th (when the President declared a national emergency).
The Health and Welfare of OZ
There are striking similarities and useful correlations between how we take care of our personal health and how we take care of our investment health as well. Being the son of a dentist, my brothers and I learned at the earliest age, that taking care of our teeth and gums as adolescents would be the foundation for the long-term health of both. He called it preventative dentistry.
Preventative medicine has grown to be the foundation of most all medical disciplines now and has quantitively proven to be the most valuable aspect for all of our long-term health and welfare. The same is true for our investing lives, and in particular here, the health and welfare of opportunity zone investing during the pandemic and post COVID-19 due to the long-term nature of this investment initiative, in which non-compliance at any time during the planned minimum 10-year hold could invalidate the deferred capital gains taxes and disqualify the full elimination of future capital gains taxes as stated in the opportunity zone regulations.
The Shot Across the Bow
Interestingly, just as with our own health, we sometimes need a shot across the bow so to speak to motivate us to take care of our financial health as well. The dramatic drop in the stock market in March 2020, and then its subsequent steady rise, has turned out to be the shot across the bow many investors needed to realize gains in many investments (such as traded stocks) and recognize the benefits of opportunity zone investing.
Since January 2020, as reported by Novogradac & Co., there has been more than $3.3 billion invested into opportunity zone funds, with the great majority of the new equity raised since the economic slowdown due to COVID-19 on March 13th. This displays great wisdom by many investors and their advisors are willing to take profits off the table now.
It’s historically rare for this to occur, and one of the least discussed benefits of opportunity zone investing is the fact that OZ investing has finally given investors a platform to take profits from non-exchangeable assets and reinvest them into an asset class that fills a tax-advantaged need and makes sense to them. The increase in opportunity zone investing seems to suggest that this is in fact the case.
In this case, the investment community is wisely protecting gains, taking advantage of tax initiatives, such as the opportunity zone initiative, and planning for the long-term health of their financial portfolios. Additionally, given that there is common agreement that taxes will likely increase at some point, due to all the additional government spending during COVID-19, opportunity zone investing now adds an extra hedge against this anticipated increase in taxes.
Protecting your invested capital, maximizing returns, decreasing risk, keeping costs under control with proper oversight, transparency, and verifiable accountability, are paramount to the success of all investments, especially in the world of non-traded illiquid direct investments, of which qualified opportunity funds (QOFs) belong. This is due to investors’ reliance on the QOF sponsor, asset manager, and in the vast majority of QOFs, the reliance on vendors of the fund itself, such as a developer and general contractor, whose ability to perform will ultimately dictate the success or failure of the project and fund.
Success will be determined by how the investment strategy was crafted to begin with, the strength created by building a proper OZ investment platform that allows for not only risk mitigation by asset class diversification but also by flexibility in strategy to allow for a cost efficient pivot (if necessary) in asset class and/or investment strategy if called for during times of uncertainty or economic downturns as we’re experiencing during the pandemic.
So, when an economic illness should strike resulting in economic diseases such as a recession, a stock market crash, higher costs, sudden adverse lending environments, or a drop in product demand; the investment products and strategies that are best prepared for these possibilities will ultimately be the most successful.
COVID-19 has negatively impacted the normal course of business, the economic health of the world economies, and disrupted the normal course of all of our lives to a significant and equal degree. This is no small point. Although COVID-19 may have negatively affected, in the greater scheme of things, a minority of the world populations, it has negatively affected the entire world economic markets.
Many investors are now turning to opportunity zone investing, not only due to the limited time left to take advantage of the tax initiatives and return potentials, but also due to the longer term nature of the investments which likely will not be negatively impacted on a realized valuation bases in the intermediate to long-term. Most funds will not liquidate for 10 or more years, and this will allow the economies to sort themselves out over the next few years.
Diagnosis – From the Great Recession to COVID-19
The similarities and differences between the Great Recession of 2007-2009, and the COVID-19 era of March 2020 – present, is an interesting study. For the first time since the last three recessions we have the same net effects with initial large drops in valuations of both the stock and real estate markets, lower corporate and real estate income, tighter financing, higher unemployment, and less liquidity, but the illness this time is quite different.
It’s been more than 10 years since our last recession. The Great Recession, as we all know, was triggered by the subprime mortgage crisis, and although many of the symptoms between pre-recession 2007 and pre-COVID 2019 are quite similar, the diagnosis of the illness could be quite different and here’s why.
If you had asked me pre-COVID-19, whether or not I believed we were heading for a recession, I would have answered that I’m not in the prognostication business, I am however in the accessing and managing risk business. What’s most important is accessing the investment environment we’re presently in against the current phase of the investment cycle to past trends and the likely market triggers and potential market reactions.
Pre-COVID-19, we had the lowest interest rate environment ever, with short term rates crossing into an inverted yield curve three times during the previous six months. We had the highest stock market valuations ever, the greatest amount of student debt ever, the greatest level of government debt ever, and the highest real estate valuations ever, all at or near the end of the current real estate cycle.
All of this was a perfect witch’s brew for a recession, so prognosticating a recession wasn’t as important as watching and accessing the indicators and properly preparing your portfolio to withstand the risks from all of the above; and in the world of sponsored real estate programs it would mean crafting and managing programs in the current environment for an intermediate to longer term hold with the least amount of risk possible.
You simply cannot invest in 2020 the same as you did in 2010, which relied upon real estate valuations to rise steadily. Given that we are at or near the end of this real estate cycle, new real estate investment deals must now rely more on operating income, stable tenants, and more conservative valuations to hit their intended return marks.
It might always a good time to be invested in real estate (same with the stock market), but how you’re invested is what matters most, especially in the world of opportunity zone investing with 10-year-plus hold times, and although total return is of course extremely important, most investors are attracted primarily to the tax benefits, the assessment of the fund’s ability to stay compliant with the regulations in order to not risk their substantial tax benefits, before evaluating the return profile and deal points of the investment.
To be quite clear here, investors should evaluate opportunity zone deals based on the merits of the investment itself, aside from any tax benefits; however the simple fact is that investors are rightfully evaluating the tax benefits and the sponsors ability to protect their invested capital and tax benefits before moving onto the deal points and potential ROI. This makes perfect sense, and as I’m fond of saying, “Who you are investing with is just as important as what you are investing in.”
Since differences between the factors associated with the Great Recession and the COVID-19 era are profound, it is important to recognize them and discuss. The Great Recession in 2008 was cause by a domino style collapse of many interconnected yet different markets, each one pulling the next further down with greater inertia.
The full recovery which took from 2008-2011 in order to match all pre-recession highwater marks, resulted in an almost perfect U-shaped recovery. The economic downturn due to COVID-19 however wasn’t really a collapse at all, it was more of a full stop, as if someone pressed the emergency stop button on an assembly line. That’s the big difference here.
There wasn’t enough time or the ability for interconnected markets to drag each other down and allow for negative speculation to take hold, as in 2008, and cause an overcorrection.
Interestingly, this quite possibly has allowed for the proper amount of air to be released from the asset valuations and pricing bubbles associated with varies markets and industries, setting up the economy to move forward into continued pre-COVID-19 positive territory, extending the gains cycle for both, but now with less risk than there may have been pre-COVID-19, with a recovery resembling the look of the Nike swoosh logo perhaps.
The Prescription and Prognosis
The COVID-19 era has produced two very important factors to pay close attention to. First, the past few months have served to be the first serious stress test for any existing QOF structure already in the marketplace, and the second factor is an assessment of the various elements that make up the development costs, operational costs, and the expected revenues associated with each opportunity zone project, post-COVID-19.
A good number of opportunity zone programs have either failed or are in the process of failing during COVID-19 primarily due to the rigid rules of the deal structure and the compulsory commitment to a now unfavorable asset class or multiple unfavorable asset classes, in which financing is now next to impossible to obtain during the near to intermediate term.
Moreover, the expected operational revenues and demand for these asset classes now have put the projects in jeopardy of not being completed altogether. Projects which have exclusively focused on hospitality, retail, and multi-tenant CBD office buildings are finding it very tough right now to find proper financing, and the fact that expected revenues from these asset classes during the early years of the project’s stabilization period, has depressed the desirability for these projects.
On the other hand, project locations that have fund structures allowing for flexibility to pivot to more feasible or attractive post COVID-19 asset classes with high demographic demand and favorable financing, could be the big winners primarily due to the opportunity zone area’s ability to facilitate more than one desirable asset class with more readily available financing and adequate operational revenue in the near future.
Multifamily, storage, and industrial projects have seen favorable, and even competitive financing during COVID-19. Of course, expected return profiles for newly “pivoted” programs and projects may be less than expected from the original project game-plan, but the great majority of investors and advisors have indicated their contentment with the fact that these projects can offer the highest likelihood of successful long-term compliance with the regulations to maximize opportunity zone tax benefits over the next 10-plus years with professional oversight, even with a lower than originally expected return profile.
Some good news is that constructions costs will likely decrease due to the drop in the cost of some materials and a general decrease in labor costs which is being seen right now in a number of opportunity zone locations. This said, each project is its own demographic so demand for materials and labor will ultimately dictate whether there is a savings or not for each project, however, overall project costs are not expected to increase in the post-COVID-19 era.
Additionally, the COVID-19 era investing environment has brought to light the value of those QOFs that took the early initiative to work with their local communities in a public-private partnership and took action to apply for project tax opinions specific to the opportunity zone initiative, and employ on-going social impact reporting to display their commitment to honor the spirit and intent the opportunity zone initiative was created for in the first place.
All of this should pay dividends for investors and the opportunity zone communities as many QOF sponsors look to guide their projects to the best possible solution right now.
Click here to visit The DI Wire directory sponsor page.
The views and opinions expressed in the preceding article are those of the author and do not necessarily reflect the views of The DI Wire.
