AMA - Qualified Opportunity Zones

Dr. Kevin Hsu from NYC asks

I like your idea of buying on the line and moving the line. Does that concept ever apply to what the US government calls “opportunity zones” as well , those designated areas generally which are considered bad and in need of development , Rehabilitation.

Supposedly they have significant tax incentives if selling after ten years?What are your thoughts on investing in Opportunity zones?

Kevin, this is a great question.

Over the years we’ve developed this strategy called buy on the line, move the line. What is that line? It’s that line between the hot fashionable neighborhood with coffee shops and art galleries. You go two blocks too far in the other direction and you’re in the hood. Wherever you live, I can virtually guarantee that every city in North America has that situation. The idea is to buy a property just on the wrong side of that line for pennies on the dollar and redevelop that property. Once you’re done, the line is now on the other side of your property. When you go to get an appraisal, your only comparable property is in the hot area next door. There are no comps in the hood.

A Qualified Opportunity Zone is something that was introduced in the Trump Tax Code of 2017, the single largest revamp of the tax code since Ronald Reagan was President. The idea is to stimulate development in some of the poorest and economically disadvantaged areas in the country. Each state had the opportunity to designate up to 25% of the lowest income areas as opportunity zones which would qualify for preferred tax treatment by sheltering capital gains from taxation.

The short answer is yes, Qualified Opportunity Zone investments can often dove-tail nicely into the buy on the line strategy. In particular, we’ve seen several cases where the boundary of an opportunity zone is actually in a good area, or across the street from a good area. How these maps were arrived at is anybody’s guess.

It’s not my role to provide you with tax advice. I’m not an accountant. I’m not a tax lawyer. Everyone’s tax circumstance is different and what I’m saying may or may not pertain to you.

If you take the time to do the math, what you will discover is that the rate of return for something that is fully sheltered from Capital Gains Tax for the full 10 years, will give you an internal rate of return that is 2% points higher than one that is not.

So if your investment would naturally give you a 12% IRR, then the equivalent project in an opportunity zone would give you 14%. If your IRR was 14% in a vanilla project, now you could expect 16%.

As you know, you need to assess the risk on that 14% IRR. After all, the 14% IRR is only a forecast, constructed by a financial model that has a number of assumptions and risks.

Finding the right opportunity requires extensive work and due diligence. If it’s a new development project, then you want to know that the developer who is developing the project has strong experience and track record. In my experience, the greatest risk is in fact the developer and not the project.

You want to perform due diligence on the deal sponsor, the project, and the submarket. The deal might look good on paper, but unless the sponsor can execute on it, it doesn’t matter how good it is on paper.