While many in the industry have been optimistic that the Opportunity Zone (OZ) initiative that came out of the 2017 Tax Cuts and Jobs Act would be a catalyst to create affordable and workforce housing in low-income communities, it’s been more challenging than initially thought.
“I know that everyone wants to hear that the market is hot or frothy and about to explode, but if one really takes a step back and analyzes the pieces of the market, especially the affordable housing piece, there are fundamental issues of why it’s not yet hot,” says John Gahan, a partner at Boston-based law firm Sullivan & Worcester.
Gahan says while the Treasury Department has issued key guidance, after a lengthy period, questions still remain, which are keeping deals on the sidelines. “That comes into play in a lot of different ways, both in the structuring of the transaction but also how it impacts some of the things traditionally done in low-income housing tax credit [LIHTC] deals.”
One area of focus is around carried interests. Initially, through the first guidance, everyone read that it allowed for carried interests. However, Treasury’s rules that were established in the second round of guidance this past spring made the carried interest piece less valuable in an OZ.
“While most thought the original legislation was fairly finite and simple, as we have drilled down into the details of the guidance, it is really quite complex,” Gahan says.
He adds that there are several other complications for LIHTC deals. First, the pipeline for LIHTC deals takes longer from start to end than that for many non-LIHTC transactions, with different application deadlines and award dates in every state, and that doesn’t match up easily with the timing of the investment and certain period of time for construction when using Qualified Opportunity Funds (QOF).
In addition, there are questions about how the QOF money gets into a LIHTC transaction. “Is it coming through a tax credit investor with one fund or is it coming through a separate fund?” Gahan adds.
One example that Gahan shares is an affordable housing owner who has generated capital gains or who decides to initiate a transaction to create capital gains, who then takes those gains to invest in its own upcoming project with traditional tax credit equity. If, post-allocation, the developer receives a new source of OZ money, the deal could become oversourced and the allocating agency could reduce the amount of tax credits, resulting in a lower amount of equity.
“All of these seem to be reasons inhibiting the frothiness of the market,” Gahan says.
While investors want the 15% basis adjustment that happens if the money is invested into a QOF by Dec. 31, 2019, Gahan adds that the smart investor is not going to chase that last 5%. “The question,” he says, “as you’re approaching December: Should I race into a deal or be more cautious and live with a 10% basis adjustment for money invested by 2021 with a better chance that the project is a good one?”
Affordable Housing Benefits
The National Affordable Housing Trust (NAHT), a nonprofit tax credit syndicator based in Columbus, Ohio, has been putting time and energy into understanding and educating others about the OZ incentive.
NAHT, which mainly works with members of Stewards of Affordable Housing for the Future—13 of the nation’s largest mission-based affordable housing developers—started by examining the nonprofits’ two-year portfolios and found significant overlap with deals in the pipeline in an OZ or the potential for being in an OZ.
“From our members and key sponsors, everyone is highlighting that they are in an OZ, and they are hoping to get the benefits of that,” says Paul Cummings, senior vice president and director of originations and capital markets at NAHT. “But it’s been a process understanding what that might mean.”
Cummings adds that NAHT’s modeling also has been compressed because of the Treasury guidance. “The benefit differential has been compressed so that yields a year ago today were double digit, even in some very strong markets, and now everything is much closer to what the Community Reinvestment Act pricing might be.”
But he adds that NAHT is persevering. “We believe the potential is significant,” he says. “We made this case to some investors. If we can compel you to invest in affordable housing, we think that the long term will be a win for people who don’t have access to this housing. We think there’s a great opportunity here if we can help educate. It seems pretty clear that investors are on a short fuse to move capital and have a number of places to put it.”
NAHT is in the process of closing its first two OZ deals with the Bank of the West.
One project that is expected to close around Thanksgiving is a 4% LIHTC acquisition-rehab in San Leandro, Calif., by Mercy Housing California. Bermuda Gardens is an existing 80-unit family development built in 1957 close to transit, shopping, medical, and recreational facilities. Twenty units receive rental assistance through project-based contracts while 58 units will serve families earning 50% and 60% of the area median income.
The other, a new-construction 9% LIHTC development for the homeless and the formerly homeless outside of Denver by the Colorado Coalition for the Homeless and subsidiary Renaissance Housing Development Corp., is expected to close by November. Veterans Renaissance Apartments at Fitzsimons in Aurora will include 60 units of permanent supportive housing for homeless and at-risk veterans and their immediate families. The development will be located near the newly constructed Rocky Mountain Regional VA Medical Center, located on the site of the former Fitzsimons Army Base, on a portion of land adjacent to the existing veteran nursing home.
Cummings adds that like many affordable housing developments, these are deals that could use more capital. “This provides an ability to get additional proceeds and put that into the quality of units and set-asides for services going forward. This is a way to take advantage of a program that could bring those additional resources to the table. But at the end of the day, the yield is quite low.”
But he remains hopeful: “We strongly believe if the OZ program continues to be a viable program going forward and tweaks are made to account for timing, the potential to direct quality capital to the creation and preservation of affordable housing is a very positive thing.”
Although a few OZ and LIHTC deals are starting to make it to closing, Gahan offers some warnings for developers looking to utilize QOFs. The first is, what controls of the developer does the fund have. “Who’s responsible for the OZ compliance? If it’s you, the developer, are you set up for it?” he asks, adding that it’s a very different mechanism than doing housing tax credit income certifications.
“OZ investors will have their own idea of when to exit a deal,” Gahan says. “Real estate developers who build housing also have their own idea when they want to exit, if ever. To what extent do these two plans work in tandem, or do they conflict? Who’s controlling the exit? Can investors get out any time? If developers are going to take OZ money, they ought to be spending as much time thinking about the exit as they do about LIHTC equity providers getting out after year 10 or year 15.”
And in all of this, Gahan says, language matters. “Great attention must be paid to the transaction and investment documents, both in the documents establishing the fund and the documents between the QOF and the developer.”