What Do Rising Interest Rates Mean for Opportunity Zones?

Brian Adams: For people who are uninitiated, if you could give just the elevator pitch on what an opportunity zone is, how they work, and maybe the timeline of when they were started and where we are relative to that?

Brian Duren: Absolutely. So the Qualified Opportunity Zones were an incentive that was born out of the Tax Cuts and Jobs Act in 2017. And so since that time, this incentive has been alive and is meant to attract certain types of investors in order to invest capital into designated zones. There’s over 8,700 of these designated census tracts throughout the United States and territories. Really what the incentive aims to do is give investors a deferral on income taxes for a capital gain that they would otherwise recognize and pay tax on. The deferral is obtained when a taxpayer invests that capital gain into an entity known as a Qualified Opportunity Fund. The Qualified Opportunity Fund then is tasked with deploying that capital in a manner that’s prescribed by the regulations. And typically, investors have about 180 days from the time that they recognize the gain, to invest it into a Qualified Opportunity Fund. And so there’s an element of timing, tax strategy and investment strategy that all come into play here with this incentive.

Brian C. Adams: Is there a sunset provision where this tax incentive goes away at some point?

Brian Duren: The program was originally set to expire in 2027. So investments are currently allowed to be made through the tax year ending December 31, 2026. I will note, however, that there’s proposed legislation that was introduced in a bipartisan bill in April of this year 2022, that seeks to extend the program for two years through the end of 2028. After that, investors can still hold their investment in a Qualified Opportunity Fund, because the largest incentive that they have is to hold that for 10 years. If they hold it for 10 years, cumulatively, they will be able to sell that investment and realize no income tax on the resulting gains. Ultimately, the program does permanently expire in 2047. So investors can hold on to investments for a reasonably long period of time, but ultimately, as it currently is written to allow the program to expire in 2047.

Brian C. Adams: The public markets are in bear territory, they suffered a correction then a lot of volatility. The biggest headline for real estate folks like ourselves, is this incredible rising interest rate environment that we are working through, what is the impact then within the qualified opportunity zone world from that huge uptick in rates?

Brian Duren: Now, there’s really a lot to talk about there. I think there’s a few important points to bring up outside of operational factors that affect a real estate deal. Importantly, we’ve seen a lot of Qualified Opportunity Funds that over the course of the pandemic, were delayed, applying their capital, and the IRS provided relief of what would otherwise be penalties assessed to those QOFs for failing to properly deploy the capital within a reasonable amount of time. Penalty calculations were waved through 2021 for certain qualified opportunity funds and as a result, we have a lot of QOFs out there that may have still not deployed capital, as we saw earlier this year with material costs and a number of other factors with logistics, really disrupting the marketplace for deploying capital and getting projects off the ground. So it’s possible that some of these QOFs that had experienced delays during the pandemic may still have not deployed that capital. The penalties that are associated with failure to invest the cash into a qualified project is tied to interest rates. And so at the beginning of the year, that penalty rate was effectively an annualized rate of 3%. But with the increases each quarter, that rate has ticked up to 4% and 5%, where it is currently for the end of Q3. Now, we’re waiting to see what happens here with Q4. But it’s possible that that rate could tick up again to 6%. And so if we look at what that has done over the course of the year, it’s effectively doubled – the penalty calculation on a QOF that fails to deploy its assets in a reasonable period of time. That reasonable relief that I talked about is over. And so in 2022, qualified opportunity funds are going to be subject to penalties unless they deploy into qualified projects as quickly as possible.

Brian C. Adams: So rising rates mean rising penalties for a lot of these operators?

Brian Duren: That’s right. And at the inception of their project, they likely did not have penalties built into their performance. And so they’re not insignificant when you take a penalty rate that’s equivalent to 6% of your uninvested assets. That equates to a high amount that can be charged, and it’s calculated on a monthly basis. We are advising clients that it’s in their best interest to deploy as quickly as possible, even if it saves them a few months of penalty for the remainder of the year.

Brian C. Adams: This rising trade environment, as well as overall volatility and geopolitical risk, has changed the timing on a lot of projects, especially in the developer world, where a lot of opportunity zone funds are oriented towards development deals. Could you maybe talk about some of the pressure that the fund operators and GPs might be facing, given the timing perspective where we are with race and the overall market?

Brian Duren: Yeah, absolutely. And one of the things that the capitalization of opportunity funds makes that is so unique is the tax that the investors have deferred by electing to invest in a qualified opportunity fund. That tax is only deferred until 2026, at which point it does come back and is picked up on those investors’ tax returns. Now, since they’ve invested the full amount of their capital gains into a qualified opportunity fund, they do not have that liquidity to pay the tax. And so we have seen this throughout the course of the program, but a lot of operators have built into a pro forma the ability of the planned ability to refinance or have some sort of non taxable capital transaction at or near that 2026 timeline to be able to return some capital to their investors in order to supplement this tax liability. That way, the investors would not have to keep a separate cash reserve off the books for the tax liability, they could reasonably rely on the project to do so. Now, with the changes in not only the materials but cost delays, capital markets, all of these factors that are influencing the timing of projects, it’s very possible that a lot of these projects have been delayed, and we’ve experienced some of these delays. And so when these operators are intending to plan for that cash out refinance distribution to their investors, their timelines might have shifted. And there’s some important things to consider there is notably, when an investor makes a contribution to a qualified opportunity fund, there’s generally a lockout period of two years, which they cannot receive a return of capital distribution. There’s some very technical rules in the regulations that, if a capital distribution has been made during two years, it may go so far as to invalidate the original deferral election, causing them to not get the tax benefits they thought they were getting. So it’s really important that operators are making sure that they avoid making large distributions within two years. If, however, based on the timing of the project, they’re coming up to a point where they need to refinance in order to lock in a lower rate, it’s possible that their timeline might have shifted, and they might be getting closer to this two year mark. That would be very important to monitor. The timing and the pressure to attract the best rate is something really to be mindful of for the sponsors out there, because the investors are gaining this tax deferral by their investment. And if that investment is tainted, by distribution received within two years, that blows up their original gain deferral, and they no longer receive any OZ benefits.

Brian C. Adams: We mentioned a rising rate environment, the Fed wants things to slow down, and banks are responding in kind where many are risk off, many lenders have exited the market. What we’ve seen in our space are higher LTVs. What are you hearing and seeing from your operators in terms of setting up their capital stack or their capital structure in general?

Brian Duren: Yeah, a lot of the same thing. I mean, there’s been lenders, and to some degree equity participants that have been sidelined through all this, you know, people are taking a little bit of a “wait and see” approach to see how the capital markets land over the next few months. But when you talk about how the capital stack is structured, and with respect to initial LTVs that are structured at the beginning of a project, you know, initially, some opportunity zone funds were structured with a little bit lower than normal leverage in order to increase the capacity at this 2026 refinance date. But even so, with some of the lenders scaling back a little bit, and even having to adjust the pro forma to accommodate for a higher interest rate cost, these changes in the capital stack could be impacting how the equity is raised and the timing of that equity raise. Because if there’s already been funding made, the funding was used from games that have already transacted. And if equity investors are now in the middle of a project where they need to have additional capital calls, those same investors might not have the same sources of capital gains, they might not have new capital gains that they can deploy within the required 180 day timeframe. If they don’t, they might be left with what’s called a mixed fund investment. And that is one where an investor would contribute some capital gains and some non capital gains. And the resulting benefits of the opportunity zone programs, specifically the ability to exclude gains after 10 years, would be prorated based on the portion of their investment that’s related to an eligible capital gain. So these future capital calls may have an impact on the ultimate tax benefits that are realized by these investors. If the capital stack shifts, and more equity is needed. It’s something that really needs to be watched by sponsors so that if they are calling more capital, they have to understand and the investors have to understand the rules and the consequences for making a mixed fund investment. Another alternative might be to use subordinated member debt, but that generally requires lenders to give consent and carries a whole lot of other strings. And so these interest rate changes and the resulting complications in the capital stack have a far reaching effect. Beyond just the basics of getting the deal done. We talked about the changes to the possible opportunities and benefits that the investors would realize. It really requires a lot more thought into how to best balance that capital stack for the duration of the project.