The Untapped Promise Of Houston Opportunity Zones

When the opportunity zone program was announced in late 2017, Dosch Marshall Real Estate Vice President Tripp Rich received a lot of calls about the program, including from firms he was not familiar with. The initial prospect of the tax exemption was so attractive and unheard of that everyone wanted in.

Houston showed particular promise: The MSA has the highest concentration of assets in opportunity zones — 21.7% compared to the national average at 12.6%, according to the commercial real estate data platform Reonomy.

"Houston should attract more opportunity zone projects than any other city," Reonomy Vice President of Marketing Sam Viskovich said. 

But investment interest in the program has dwindled, and Rich said the number of firms talking to him about participating has dropped.

Qualified opportunity funds have raised less than 10 cents on the dollar of the program's targeted goal in 2019, according to CoStar.

In Houston, the percentage of total commercial investment within opportunity zones has dropped from 38.5% in 2017, which is the highest in a nearly 20-year span, to 16.4% for the first quarter of 2019, according to a report by Reonomy. 

There are at least three possible reasons for the slowdown, Viskovich said.

It could be related to the number of sites in high-targeted areas. Since the program used 2010 census data and input from local leaders, some zones were already experiencing an influx of capital. He also noted the maturing cycle could have some investors tightening the purse strings and focusing on the tried-and-true deals.

But some of the drop may just be that deals haven't happened yet, not that they won't happen at all. The initial obscurity of the program caused some to take a wait-and-see approach. Viskovich expects those who are satisfied with the new guidance (released by the IRS in April) will move forward with their projects. 

The pace of investment activity for the rest of the year will be a good indicator of the future traction of the opportunity zone program, Viskovich said. 

Rich expects a big rush to close on sites closer to 2020. Opportunity zone projects follow the traditional development timeline and process — the deals take time. It could take up to 12 months after the site is under contract to break ground. And until dirt turns, developers are keeping quiet about their plans.

"No one wants to talk about a project until they know it is about to happen," he said.

The rise in pricing in opportunity zones is one reason to stay optimistic about the program's future in Houston. Since the announcement of the OZ program, the average sales price for properties in Houston opportunities zones has increased significantly compared to properties not in opportunity zones, which have remained steady.

Multifamily development has been the go-to property type for opportunity zone investment in Houston, said JLL Senior Vice President Jonathan Paine, whose team arranged construction financing and equity for Hines' The Preston, a 373-unit luxury apartment project funded by Cresset-Diversified QOZ Fund in Downtown Houston. He is engaged with more than 10 opportunity zone projects across the country, made up mostly of multifamily developments.

A local developer is planning two apartment complexes in the Inner Loop, Rich said. 

A national QOZ fund plans to spend upward of $350M in Texas, Arizona, Colorado, Kansas, New Mexico, Oklahoma and Utah, according to Rich. The fund is targeting mostly multifamily development, while office and mixed-use projects are also being considered.

Developers are opting for apartments and hotels because they can be built quicker; the quality can be sustained over a long period; there is no pre-leasing required for financing; and, unlike office development, they are not dependent on long-term leases, Paine said.

He expects retail development to come in the next phase of investment as zones become more densified. Industrial development is also feasible; he is in talks with a fund to develop an industrial building in an opportunity zone out of state. 

More than a fourth of the properties in Houston's opportunity zones are categorized as commercial general and about 25% is multifamily, according to Reonomy. Retail and industrial come in as third and fourth in the share of assets in opportunity zones.  

Zones in Houston's Inner Loop, which includes already-revitalizing areas such as downtown, are expected to benefit the most under the opportunity zone program, Rich said. 

That is partially because all opportunity zone projects must pencil out. While the federal program was designed to stimulate commercial expansion in economically distressed areas by providing a tax benefit in exchange for a long-term investment, being in an opportunity alone doesn't make a project a safe bet. 

Investors and developers have become more mindful when selecting partners, as funds must hold properties at least 10 years to maximize the tax benefits of the program, Paine said. These projects will require a long-term commitment from both sides. 

Developers want to pick the fund early in the development process before designing and permitting the project, which helps to share the cost and provide input on the scope and viability of the project, Paine said.

For example, one opportunity zone partnership in Las Vegas is considering how the next owner will perceive the quality of the product, Paine said. They opted for higher-quality materials and exterior cladding that will provide durability and functionality in the long run. While the upgrades ultimately add 10% to 15% more to the budget, the idea is that the property will retain its value. 

"They were in agreement that was the best thing for a project that they were going to own for 10 years," he said. 

While the number of investors eyeing Houston opportunity zone deals has shrunk, that isn't necessarily concerning. Since the Treasury Department released the second round of guidance in April, sophisticated funds are moving forward with development plans while the delays and intricacies of the process have weeded out less experienced real estate investors.

The QOFs interested in building in Houston come from the same group of investors that have considered Houston in prior investment periods, Paine said. The most active groups are ready to deploy capital with the staff and the knowledge to meet and maintain the regulations set by the federal government.  

"In Houston, developers that have projects that make sense get them capitalized," Paine said.