How the Opportunity Zones program can help induce market-rate and affordable housing projects in your community.
As we noted in our previous article, “How EDOs can use Opportunity Zones to Promote Economic Development”, the Tax Cuts and Jobs Act of 2017 provides substantial incentives to invest in property in low-income communities designated as Opportunity Zones (OZs). In particular, we see the potential for OZ benefits to induce certain types of housing development, both market rate and affordable, depending on the circumstances of the proposed project.
Consistent with recently-issued draft IRS regulations and past practices in similar programs, such as the Gulf Opportunity Zones, it appears that rental housing would qualify as an OZ property and therefore entitle investors to the benefits of the OZ program if properly funded through a Qualified Opportunity Zone Fund (QOZF). We examine very briefly how the OZ program may work with both market-rate housing and LIHTC affordable housing projects.
In the case of market-rate housing, the role of the OZ program is very straightforward: it will serve as an additional return-on-investment, albeit indirect, to the equity investors in the project. For purposes of a highly simplified illustration, imagine a developer is proposing a rental project with a total budget of $40,000,000. Given the risk profile and lending conditions at the time, the bank will lend 75% of the project’s total costs. Therefore, the developer must find an investor willing to pony up $10,000,000, for whom we might assume a projected 8% internal rate of return. However, if we place the same residential project in an OZ, an investor with an unrelated realized capital gain of at least $10,000,000 would be able to capture significant benefits by investing those gains in the project via a QOZF. Without going through the math, the 8% projected return would rise to, say, 10.5%, when all the tax impacts are considered. Therefore, the developer would have a much easier time finding an investor to back the project, provided the investor was patient enough to allow the tax benefits to properly vest.
With respect to LIHTC affordable housing, the role of the OZ may take several possible forms. The first is the simplest: just like market-rate housing, an equity investor would be able to derive a tax gain, provided the investor held the investment for a sufficient period of time, which would push up the projected internal rate of return on the investment. Since LIHTC investors are typically “patient investors,” this should not create an undue burden.
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The second possible role of the OZ would be to actually make the projects more likely to win the state’s auction to allocate LIHTCs in the first place. Each state allocates LIHTCs according to its individual Qualified Allocation Plan which contemplates a host of factors. One aspect is essentially the amount of LIHTC allocation the developer is requesting as compared to the project’s other characteristics (such as composition, market dynamics, other recent LIHTCs in the area, etc.). If the developer is proposing the project in an OZ with associated tax benefits for the equity investors, the equity investors may require fewer LIHTC to meet their investment hurdle. Therefore, the LIHTC application to the state auction will appear stronger, as it is asking for fewer credits for the same project than a non-OZ project. Although the impact remains to be seen, we could anticipate seeing a portion of the LIHTC deal-flow move to OZ projects because they require fewer credits to bring to completion.
A third potential role of the OZ program in affordable housing projects is much more speculative in nature; if and how this could work remains in question. Without going into detail, there are multiple sources of project funding and financing for LIHTC projects, such as tax credit equity, grants/loans from state housing agencies, sometimes developer equity, private financing, etc. One little-discussed aspect of the OZ program is that the required equity investment can take the form of “preferred equity” and still count for OZ benefits. We speculate that it may be possible to structure a preferred equity tranche of financing to fit in the capital stack of the LIHTC project in such a way as to allow an investor to participate, gain tax OZ breaks, and exit the deal at the “ten years and a day” point. Likely, the preferred would require little in the way of a dividend, rather having a preference to realize the majority of its return as a capital gains upon exit, which would be entirely sheltered from tax under the OZ program. Again, exactly how this would happen has not yet been determined, but trust in the brainpower of Goldman Sachs and others to figure out the “deal” and replicate it across the country for its investor base.
 Of course, in the “real world”, that differential profitability would probably be split between a number of parties, such as the land owner (who would be able to command a higher price for OZ land than non-OZ land), the developer (perhaps a higher developer’s fee) and the investor. But the point is that the project in an OZ has a higher return and therefore a higher probability of being undertaken.
 Briefly, preferred shares in a company’s capital structure sit between the common equity and the debt holders, and are usually entitled to certain first-right privileges on cash flows, but typically have limited voting rights. In some respects, they can be considered to be a hybrid of debt and equity.