The opportunity to defer and ultimately exclude capital gains on Qualified Opportunity Zone investments is drawing a lot of attention and speculation. While the merits and administration of this new program, created as a part of tax reform, continue to be debated, one component is clear. Like any other incentive program, it should not “wag the dog.” There must be a business case and sound due diligence to support the ultimate project decision. The fact that an investment is located within an Opportunity Zone will not alone guarantee success.
Site Selection Approach
With 8,700 designated Opportunity Zones throughout the United States, there are plenty of choices an investor has in terms of where to site a project, ranging from urban to rural. The question is, how does one find the right Opportunity Zone? While this may seem to be daunting task, the starting point is similar to any other comprehensive site search.
While the variables and factors evaluated ultimately flex to a project requirement, a typical site selection approach starts with evaluating location variables to refine the geography on which an investor will ultimately focus. Generally, these include items such as demographics, cost considerations, supply chain, customer access, community readiness, taxes, and business incentives. More recently, these variables have been enhanced to include the social impact of a project.
Once the geography is narrowed, more granular analysis is conducted to differentiate down-selected candidates to focus only on those where the project may be successful. It is at this point that an investor would likely evaluate the merits of an Opportunity Zone location, perhaps from a tax and ROI perspective.
As locations are qualified further, the effort then turns to identifying suitable real estate at a site level. While there are many models, data, and technology to assist with this process, it is this comprehensive approach which may be a good starting point to identify the right Opportunity Zone project location.
While the typical site selection approach may help address whether an identified location meets the overall project demand, there are some unique considerations and factors that must also be considered with respect to an Opportunity Zone.
Opportunity Zone regulations require investors to deploy capital over a specified period of time.
• Is the location compatible with targeted investment outcome?
One of the major components of the Opportunity Zone program is the opportunity to exclude gains on investments held for more than 10 years. That said, an investor needs to be patient, but also have some predictability of the future — will the project value ultimately increase, decrease or stay flat over time? This may be challenging to estimate, especially if the location analysis result is suboptimal as compared to competing non-Opportunity Zone locations. Bottom-line: critical attention must be paid to the long-term compatibility of the location with the targeted investment outcome in mind. Furthermore, investment returns on affordable housing or retail projects may be different than for office projects.
• Is the site capable of meeting the Opportunity Zone site constraints?
Like any other incentive program, there are rules and regulations. Opportunity Zone regulations require investors to deploy capital over a specified period of time. Real estate sites lacking the appropriate zoning, master plan, infrastructure, utilities, and permitting capacity will challenge the limits of the program. Investors considering an Opportunity Zone will need to seek assurances their investment and project schedule can be met within the timeframe of the investment. This judgement will come with risk.
• What are the state and local tax implications of investing in an Opportunity Zone?
While the Opportunity Zone program is a federal program, there are state and local tax implications that must be evaluated and that could impact the overall project economics, influencing the project location decision. Bottom-line: while the federal government is using this program to spur investment, states may still want their tax, so investors — whether in a captive or managed fund — will need to closely evaluate the state tax impact, not only from the perspective of where the capital gain is generated, but also from where it is realized on the back end.
• Can the desired social contribution be achieved?
The legislative intent of the Opportunity Zone program was to drive economic development to lower income communities and many investors will embrace this goal, while still seeking a return on their investment. The challenge will be measuring the outcome and potentially illustrating the social impact of the project over a long-term horizon.
• What is the exit strategy?
As mentioned previously, one of the main benefits of the Opportunity Zone program is to exclude gains, if said investment is held for at least 10 years. This does not work for the investor looking to buy and hold, as there must be a liquidity event to realize and exclude gains. This creates an interesting challenge, as an exit strategy must be planned for up front. Further complicating this prospect is projecting what the future may hold.
Developers at the state and local level understand the need to differentiate their community assets. To attract Opportunity Zone investments, it will not be enough to simply market a community’s attributes and available sites, as Opportunity Zone investors are looking for significantly “de-risked” project-ready sites with long-term economic promise.
The legislative intent of the Opportunity Zone program was to drive economic development to lower income communities and many investors will embrace this goal, while still seeking a return on their investment.
This means developers need to play more of an investment matchmaker role than they have in the past. While creating or leveraging existing incentives programs may be one way to support Opportunity Zone investments and potentially offset risk, economic developers must also be prepared to explain their project sites in a way they haven’t in the past. Again, it will not be enough to merely point out the site attributes identifying where electric, water, and sewer connections exist. Investors will be looking for prospectus-like investment reports to fully understand the prospects of a given site. This will challenge developers to support the due diligence process at a level many have not in the past, and to think like an investor.
Unfortunately, to prepare to meet investment demand, time is not on their side. For investors with 2018 gains, the clock is ticking, meaning there is little time to ready sites and material, if the work has not already started.
Location analysis and site selection for new investment projects is a complex task, and locating an investment in an Opportunity Zone is no different. In fact, it may be more challenging. Success will require a well-versed project team, the analysis of multiple factors, and the ability to make timely decisions. While many companies and investors have experience with analysis of locations and sites for new investment, the Opportunity Zone program will challenge this process. Developers will be challenged as well, but the sooner they start to develop the required Opportunity Zone investor mindset, the better chance they will have in securing investments.
The information contained in this article is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.
This article represents the views of the author or authors only and does not necessarily represent the views or professional advice of KPMG LLP.