Pandemic-Related Economic Struggles Could Ultimately Increase Investment in Opportunity Zones
Investment in the opportunity zones (OZ) incentive was expected to accelerate in 2020, as the incentive matured and the Department of the Treasury issued final regulations. Then the COVID-19 pandemic hit, the stock market plunged and the economy hit a bump.
This could benefit OZs.
“I sat down after the whole pandemic started and thought about what it means to our OZ business,” said Reid Thomas, executive vice president of NES Financial, a technology company that builds platforms for specialty investment programs. “Maybe it will be good for the OZ business. The more I thought about it, the more clients and industry leaders I talked to, it’s a real opportunity.”
Thomas isn’t alone. Several OZ stakeholders say that while a post-pandemic recession is bad news, OZ investment is suited to survive and to assist in the recovery. Even with the chaos, 2020 could be a good year for OZ investment.
Immediate Impact of COVID-19
When it became apparent by mid-March that COVID-19 would have a serious impact on American life, the stock market dropped and OZ investment–like most of the economy–slowed dramatically.
“It’s been pretty drastic–the last few months have slowed down,” Thomas said. “We are still seeing money moving, but not nearly what we expected. The year got off to a good start, but the last few months have been slower.”
The funding mechanism for qualified opportunity funds (QOFs) is capital gains and the stock market selloff by many investors created some unexpected gains. It’s not clear what that means for QOFs.
“There are two countervailing things at play,” said John Lettieri, president and CEO of the Economic Innovation Group, a bipartisan public policy organization that champions the use of the OZ incentive. “One is that because the market is coming off such a strong bull run, the selloff created a lot of realized capital gains that could be the basis for a new wave of OZ investment. The other is that the broader economic uncertainty will make many investors skittish about redeploying their capital–at least in the short term.”
It’s clear that many taxpayers sold stock and realized capital gains. The question is whether those gains will go into OZs.
“I think the biggest competition [for OZ investment] is people taking gains that were unplanned and triggered by the recent sell-off and considering whether they can find similar assets to what they sold,” said Stephanie Copeland, partner at Four Points Funding, a Colorado-based investor with a focus on development of real estate. “If the pandemic accelerated their sale of a particular investment, they may delay reinvestment until they have more clarity or they may invest into a similar asset class rather than simply putting it into a tax-advantage asset class.”
John Sciarretti, a partner in Novogradac’s Dover, Ohio, office and the head of the Opportunity Zones Working Group, said investors could benefit from both reinvesting in the stock market and in OZs.
“I expect there was an increase in realized gains due to the sell-off,” Sciarretti said. “It is interesting that the market has recently risen to 2017 levels (when OZ was enacted), signaling that much of the gain has been invested back into the market. However, investors only have to invest realized gains in OZs to benefit from the incentive, not the entire sales proceeds, so it is an opportunity for investors with liquidity to diversify their portfolio by investing in OZs, which could lead to more investment.”
Hot Summer for OZ Investment?
As the nation recovers from the effects of the pandemic and several deadlines converge, summer could be prime time for OZ investment. A major factor is that the IRS extended the 180-day deadline to invest capital gains for all taxpayers who faced a deadline of April 1 through July 14. They all now have a deadline of July 15. However, there were already investments coming this summer.
“A big chunk of OZ capital is capital gains from 2019,” said Steve Glickman, founder and CEO of Develop LLC, a leading advisory firm for OZs and a co-founder of EIG. “Anyone who gained from a partnership is reinvesting in 2019 before mid-August. Nothing about the market will have changed. A lot of people who sold in February and March had been long-term investors.”
Thomas said the combination of deadlines will create a hot spot.
“We’ve been talking to a lot of folks on the notion that there are important factors aligning, which could make OZs very attractive investment over the summer,” Thomas said. “There was the big market selloff in February and March. My sense was that it was panic selling, so people didn’t have a rational plan for tax deferral or reinvestment, they were just trying to get money. One of advantages to OZ investments is that you can take the cash and still have 180 days to decide where to invest without losing the tax-deferral benefits. A February-March sale takes you to August-September as the 180-day deadline for investment. That’s one reason we anticipate a big summer.”
Also in Favor of OZ Investment
Investment deadlines aren’t the only reason to think OZ investment will increase during the post-pandemic recovery.
“I think it starts with the assumption that people are interested in investing in alternatives,” Glickman said. “It’s about risk appetite and liquidity. Assuming that’s the case, the strongest caution for investors before the pandemic was that we were at the top of real estate cycle, so why invest? Post-pandemic, we’ll be at the start of cycle. The best way to mitigate risk is to buy in at the very cheap rate.”
Lowered labor costs and interest rates also work in favor of development.
“[Interest rates] are historically low and we are hitting the point where locking in at a very favorable interest rate and doing development at a lower-cost environment makes sense,” said Copeland.
Who Benefits? Who Is Hurt?
While OZs feature many areas for investment, most observers expect real estate to remain the most popular choice.
“A lot of asset classes that tend to be counter-cyclical are well-suited for OZs. Things like affordable housing and multifamily housing,” Thomas said. “People have to live somewhere and that might be more attractive than before as investment types, compared to a higher-end hotel. [Hospitality is generally] a higher-risk, higher-reward option.”
Patrick Jennings is the managing director of the Arden Qualified Opportunity Zone Fund LP, which focuses on multifamily, student housing, industrial and creative-type office buildings catering to the technology, advertising, media and information services sectors. Jennings said that with the sharp economic slowdown and what is expected to be a steady but modest pace of recovery, there will likely be a repricing of land, labor and construction materials. That may improve the project-level returns, given the overall repricing of risk.
“Student housing and multifamily assets aren’t necessarily correlated directly to the economic cycle, which is an appealing macro consideration when evaluating investments in those sectors,” Jennings said. “The millennial demographic is slightly less interested in home ownership as compared to prior generations and with what is projected to be steady enrollment at major universities around the U.S., both the multifamily and student housing sectors have macro tailwinds that should bode well for investment opportunities sourced and developed over the next 18 to 24 months.”
Some areas may struggle.
“Hospitality and retail will probably have a pause in investment until there’s more clarity,” Copeland said. “That, as a portion of what invested, is going to be greatly diminished. I think there’s going to be a bump in the road for multifamily housing, because banks are overwhelmed by demand. It’s not going to reduce demand, but it will delay it.”
One area that may be ripe for investment is OZ businesses.
“As an investor right now, you find the most opportunities, structures and funds have real estate focus,” Glickman said. “Real estate has a cap in rent you can charge, so it’s very unlikely for funds to have more than a two- to four-times multiple over 10 years. That’s not the case for operating businesses. This is a very interesting time to buy or invest in a distressed company. This may be the heyday for operating business and we’re already seeing a movement toward that after we got regulatory clarity. I expect OZ business investing to be extremely effective.”
As the nation emerges from the COVID-19 pandemic and the OZ incentive nears its third birthday, there remains optimism.
John Sciarretti, partner in the Dover, Ohio, office of Novogradac, said the slowdown could increase the value of OZ investment.
“OZ investments are long-term investments and since they require at least 10 years to realize the full benefit, I expect the COVID impact to be temporary on most if not all types of investment,” Sciarretti said. “As a result, this could be an opportune time to invest in OZs, assuming a temporary decline in prices caused by the pandemic would lead to more gain forgiven after 10 years when the pandemic is way behind us.”
Lettieri, who helped craft the legislation that created the OZ incentive, is upbeat.
“There’s reason to be optimistic,” Lettieri said. “OZs can be a counter-cyclical investment option that works well in a down market. I really expect to see that over the next 18 months, from mid-2020 until the end of 2021.”
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