August 21, 2019
By Jenny Redlin
Opportunity Zones are a hot topic in the commercial real estate world. Our clients ask about them at conferences and CRE events, and even mainstream media outlets are covering this new investment strategy. With the current cycle long in the tooth, and a potential slowdown of development deals on the horizon, diversifying investment strategies is an excellent idea. But what exactly are Opportunity Zones, and what should you know before jumping in?
What Are Opportunity Zones and Qualified Opportunity Funds?
The Tax Cuts and Jobs Act of 2017 created Opportunity Zones to incentivize investment in economically-distressed communities. The program provides preferential capital gains treatment for investments within designated low-income tracts, also referred to as “zones,” in the hopes that these investments will spur investment in low-income communities throughout the country. Each of these zones has been nominated by individual states based on certain metrics established by the Internal Revenue Service, and that nomination has been certified by the Secretary of the U.S. Treasury.
In exchange for investing in Opportunity Zones, investors can access capital gains tax incentives available exclusively through Opportunity Zones specifically through Opportunity Funds. A Qualified Opportunity Fund (QOF) is an investment vehicle that is set up as one of several options: a partnership with interests in businesses that operate in a qualified Opportunity Zone, stock ownership in businesses that conduct most or all of their operations within a qualified Opportunity Zone, or the establishment of commercial real estate property located within a qualified Opportunity Zone.
The United States Department of Treasury has provided a resources site that includes a list of designated Opportunity Zones by state.
Choosing Sites for Optimal Business Objectives
Once you have targeted some qualified Opportunity Zones for real estate development, your first objective is to evaluate how and if that parcel can accommodate your business objectives and potential building use. You must consider whether the location is optimal, if the site will require structural modifications, and whether the development is geared towards short-or long-term gains. Can you physically make your building work on the existing property? For example, will the space allow for an office, a mixed-use retail development or a logistics center for e-commerce goods? Will your proposed asset require a significant capacity, and can you provide the parking and access to make that work?
Before breaking any ground, start with a feasibility study to see what is actually possible. You might need a zoning exception for parking requirements, or a special permit for a business classification change if there is a specified zoning use for that area. Understanding the zoning requirements and what changes can be made “over the counter” without triggering a lengthy entitlement process, avoids delays and additional fees.
Manage Environmental and Physical Building Risk
Be aware of the potential for environmental contamination, especially if your targeted property involves industrial, brownfield or long-abandoned assets. Indeed, the U.S. Environmental Protection Agency recently targeted 149 communities to receive $64.6 million in funding for brownfield cleanup, almost three-fourths of which were Qualified Opportunity Zones. To determine the extent of these contamination risks and liabilities, you will need to invest in an environmental assessment by an experienced consultant. Should the presence of environmental concerns be discovered, a remedial cost estimate plan can help you price in the cost of cleanup and provide guidance for state and federal regulation compliance. An environmental consultant can navigate a range of remediation concerns, from vapor intrusion, mitigating contaminated soil or water, or the removal of an underground features such as storage tanks or abandoned oil wells.
For renovation or rehabilitation of older buildings, it is wise to test for asbestos and other hazards such as lead paint and mold before and/or during construction.
If you plan to repurpose or renovate an existing building, a Property Condition Assessment (PCA) report will provide in-depth understanding of any necessary repairs or replacements, and the remaining useful life of the building’s systems. Big-ticket items like roofing, floors, and MEP (mechanical, electrical, and plumbing) systems must be assessed for capital planning. One of the distinguishing elements of Opportunity Zone investments is that you must improve the asset – often spending a significant amount of money – to qualify for the tax incentives. The PCA will provide a detailed opinion of costs for capital expenditures and immediate repairs necessary for transforming the asset and can even identify those items where your budget is best spent, to help you plan ahead for investment return.
If your Opportunity Zone asset is also located in a seismic zone, then certain developments or changes of use may necessitate seismic reinforcement or retrofitting to ensure building safety. Consult with a seismic expert to perform a seismic risk assessment. Engineers can help determine conditions and a scope for seismic strengthening, depending on your risk tolerance and use designation.
Manage Project Completion and Budget
Whether you choose to pursue a ground-up development Opportunity Zone or rehabilitate an existing asset, your Opportunity Zone project will involve some form of construction services. If not managed properly, rising costs of construction and a persistent labor shortage can drain the profit from even simple renovation projects and increase the likelihood of contractor failure or a default. Therefore, construction risk management is an important tool in managing cost and minimizing delays or defaults, particularly for projects where cost savings are priced into the return on investment.
Even when pursuing the most exciting Opportunity Zone developments, be wary of rushing a project on the front end or hiring general contractors that are overbooked or are developing projects outside their realm of expertise. Sometimes, renovation projects can incur even more risk than ground-up development because you don’t know what you are dealing with until you start demolishing and opening up structural elements. In these cases, making sure that the original budget is accurate and has enough contingency built in for any unanticipated costs is key. You can minimize these risks with construction risk management oversight measures, such as a pre-closing document and cost review, contractor evaluations before hiring staff, monthly progress inspections, budget monitoring and funds control to ensure contractors and vendors are paid on time.
Opportunity Zone incentives are an attractive avenue to pursue your investment objectives in a challenging market, at least until the program expires on December 31, 2026. Your degree of success will depend on optimization of site selection for use and occupancy, understanding and pricing in all environmental and physical risks associated with the site, and ensuring timely construction progress and budget. As such, a critical component of your Opportunity Zone strategy involves choosing a team of knowledgeable, experienced consultants who can help you manage risk, limit liability, and meet your business objectives.
Jenny Redlin is a principal with Partner Engineering & Science, Inc., based in Los Angeles.
For comments, questions or concerns, please contact Paul Bubny