As First Deadline Approaches, Still No Consensus On Opportunity Zones

As summer dragged into fall without regulatory resolution on opportunity zones, the political tenor around the program became more contentious and investor interest seemed to wane. But the book has yet to close on opportunity zones, at least in Philadelphia.

At year’s end, the deepest discount on taxes for capital gains invested into opportunity zone properties or businesses expires. While that may not be the deciding factor between making use of the federal program for most investors, it can provide a litmus test for how seriously the real estate industry takes the potential of its benefits.

Duane Morris partner Brad Molotsky, who co-leads the law practice’s opportunity zone group, said at Bisnow’s Philly 2020 Forecast event at the Wanamaker Building Dec. 5 that he has advised on the closure of 27 transactions involving qualified opportunity funds, and expects to close 35 more in the year-end rush.

But some are less than impressed.

“I am, unfortunately, 100% sure that OZs will ultimately have no larger impact than [Community Reinvestment Act] credits already do,” Post Brothers President Matt Pestronk said to murmurs of disapproval from the crowd. “And it’s unfortunate.”

Molotsky’s large deal volume isn’t representative of activity levels for the whole Philly market because he is the preeminent opportunity zone lawyer in the area, Pestronk said.

“Brad’s 27 deals might be more than half of all the opportunity zone deals that have been closed in Philly,” Pestronk said as, two chairs to his right, Molotsky shook his head in response.

Arden Group Chairman and CEO Craig Spencer, who partnered on the most expensive property acquisition in Philadelphia’s history early this year, touted the potential of opportunity zones to bring in gobs of capital across the country, citing the oft-repeated figure of $6 trillion worth of unrealized capital gains sitting in the economy.

“If the owners of 10% of that [$6 trillion] decide to sell assets and reinvest the gains in OZs, avoid tax for seven years on that gain and all of the tax on the future gain, you’re talking about $600B in capital,” Spencer said. “In private equity, we raise about $110B per year. So it’s an extraordinary amount of money that could come in.”

The bulk of that $6 trillion number is held and managed by the biggest institutional investors and private equity fund managers who seek large deals with the highest possible return. That breed of investor tends to shun the type of investments opportunity zones were designed for: early investment into high-risk neighborhoods, Pestronk said.

“The project was meant to draw in large swaths of investors with capital gains, and by and large those investors are looking for larger margins,” Pestronk said. “Some deals [Molotsky] is referring to are absolutely happening, but the larger, more impactful projects are not happening. The capital sources looking to fund major projects are so far not biting.”

The most compelling benefit of the opportunity zone legislation is not the deferral and tiered discounts on capital gains taxes that begin to decline on Jan. 1, which Molotsky called “nice bennies,” but the total exemption of tax on any capital gains from the sale of opportunity zone assets if held for at least 10 years. As of the most current regulations, that benefit does not change at the end of the year.

Armed with the notion that it isn’t now or never for opportunity zones, Council Member Maria Quiñones-Sanchez told the audience that she will continue to work on ways to bring in the type of investors and projects that the opportunity zones in her district need. As with the issue of property assessments, Quiñones-Sanchez claimed that Mayor Jim Kenney’s executive branch is not holding up its end of the bargain.

“Every city has a task force and is having conversations with banks, but we have an opportunity to shape the conversation toward what we can do to ask that a development also provide a public good,” Quiñones-Sanchez said. “We’re not having those conversations; we have the [Kenney] administration’s internal work group, a mediocre website, and no one saying that if OZ projects aren’t being built, what can we do?”

OCF Realty President Ori Feibush agreed with Pestronk and Quiñones-Sanchez that the Office of Property Assessment is in dire need of reform, but singled out low-density zoning as a more direct impediment to transformational change.

“If OZs can get a few dollars of benefit for a project, zoning reform can produce $100,” Feibush said. “There have been zero projects proposed that could actually fulfill the goal of the zones, and its benefits can’t be realized without progressive zoning.”

If nothing changes, opportunity zones may not be enough to entice hundreds of billions of investment, but they are drawing interest and generating deals. Many of those deals have been the source of controversy at the highest levels of government, since they appear to critics as tax breaks for projects that would proceed even without them, without requiring any public benefit.

For as long as such deals are allowed, they are essentially found money for investors like Spencer with the willingness and wherewithal to set up a qualified opportunity fund.

“About 10-20% of [opportunity zones] have phenomenal real estate that don’t need tax incentives, but have them,” Spencer said. “So there are real economic opportunities for investors. We’ve done $300M of deals this year, mostly multifamily and student housing, and there’s true economic viability in those deals that are running in the mid-teens, low-20s [initial rate of return] for long-term holds.”

Nowhere is the dichotomy of opportunity zones — those too risky for the tax breaks to be worth it, and those so enticing that the tax breaks are redundant — more stark than in Philadelphia.

Despite having the highest poverty rate of any major city, Philly also leads in its percentage of opportunity zones that are already gentrifying, according to a November report from the Federal Reserve Bank of Philadelphia. The report clarified that the zones selected had lower average incomes than other qualifying census tracts that were not picked.

In addition to his enthusiasm for opportunity zones in strategic locations, Spencer expressed optimism that more impact-based investment is coming, perhaps taking longer to bring together than market-rate projects but undeterred by the December deadline.

“There are a lot of people with money that want to invest into their neighborhoods, and there are deals they would not touch,” Spencer said. “And this program could help turn those projects around. Don’t dismiss this as [Pestronk] did.”

Though opportunity zones are the product of a federal program, the frustrations associated with it resemble many of Philadelphia's local policies: They are seen as insufficient by many, unfair by others and unlikely to affect the most destitute and in-need areas of the city.

“Why are we creating a city made of Swiss cheese, where some areas get benefits and some don’t?” Center City District CEO Paul Levy said. “Why don’t we focus on lowering our barriers, rather than trying to pick and choose certain areas to get around them?”