The Tax Cuts and Jobs Act that passed in December 2017 created an important new incentive for certain types of real estate investment and development. At the heart of the program are Opportunity Zones—specific Census tracts in every state where investments receive huge tax benefits. These incentives are so powerful that many tens of billions of dollars are certain to be invested. Developers would be wise to educate themselves about how to take advantage of this new feature of the tax law.
How should developers of Opportunity Zone projects think about using non-bank financing to enhance returns and streamline execution of their projects?
5 issues to consider:
#1: Higher returns
As with any real estate project, using a loan can enhance returns as compared to completing a project without a loan. Rents tend to increase each year, but the loan amount is fixed. Suppose a property’s income and value increase 3% per year, and the owner uses a loan for two thirds of the purchase and renovation costs. In this simple example, the equity in the property increases about 9% per year, even though value only increases at 3% per year. Using loans responsibly makes sense for real estate investors because income tends to be quite predictable. For this reason, even the most substantial investors such as pension funds almost always use debt on income property investments.
#2: Speed of acquisition
Buying properties that fit Opportunity Zone investment criteria and are well-suited for redevelopment is very competitive. In order to have your offer accepted, you need to either close with all cash, or have a lender that is extremely reliable. Banks have adopted a “check every box” approach to real estate loans and they feature a long and uncertain process to final approval and funding. In contrast, the best non-bank lenders underwrite the sponsor first, and then stand ready to quickly make lending decisions soon after their client puts a property under contract. If you cannot close with all cash, having a non-bank lender ready and committed to meeting your closing schedule is critical. Bank lenders likely won’t be able to react fast enough, which could mean losing a great property, or even losing the security deposit for failing to perform on the purchase.
#3: Spend your time focusing on your business
If you have received a bank loan recently, you know the process only too well. You need to allow several weeks to get a reliable answer about whether the bank will make the loan. Funding will likely require at least a month or two of lead time, and frequently more, from when you start the process of getting the loan. The bank will likely ask for two, three or four rounds of information requests, and there will be multiple layers of hidden decision-makers. Your final loan proceeds will very possibly come in lower than what you originally discussed with your banker. When you borrow from a bank, you put your destiny into their hands--which means, you are now subject to their compliance with a thicket of regulations. This means you will spend a lot of time getting things that have nothing to do with the merit of the loan, but only “check the box” that the bank needs to check to complete the file. For many borrowers, it is better to pay a little more in order to avoid spending so much time and resources on a bank loan, which can easily take twice, three times or even four times the effort as compared with a good non-bank lender. With all the time saved by avoiding a regulated lender, the developer can find additional projects or invest more time optimizing his or her existing projects, not chasing and shuffling paperwork.
#4: Research, research, research
Opportunity Zone investments must be “substantially improved” in order to qualify for their very generous tax advantages. This means construction or heavy renovation. Light renovations, sometimes referred to as “paint and carpet,” are specifically excluded. The rationale is that, in order to provide wealthy investors with big tax breaks, these investors cannot simply be moving money around, but must actually create jobs and improve the neighborhoods where they invest. For many Opportunity Zone projects, this means a construction loan will be needed. In a construction loan, the lender agrees to fund not only the up-front loan amount, but also some or all of the future construction budget. These future funding events are known as construction draws. Suppose you borrow from such a lender, and midway through the project, you need to pay your contractors and your lender fails to fund a construction draw. Now the developer needs to unexpectedly come up with additional cash in order to keep the project on track. Failure to do so would mean the project gets stalled, which could result in damage due to rain for a project that is framed but does not yet have a roof, for example. In a construction loan, a high degree of trust is needed in each party’s ability to perform in a timely fashion. Many borrowers may not appreciate how much their project and livelihood depend on the lender’s ability to manage his or her own business in a prudent way. To mitigate this risk, every developer should research his or her lender extensively, including conducting background research on the key principals and their professional history. Have they moved jobs and companies frequently or had financial problems in the past? Or have they demonstrated consistency and focus over time? Do not be surprised to find that the lender offering the highest leverage may have a sketchier background. Those who have the least to lose are most likely to compete on this basis.
Just as getting a bank loan requires dedication and patience, changing anything in a bank loan after it gets approved can be grueling and is often impossible. This can present real problems for a construction project because of the unpredictable nature of real estate development. As just one example, we have a client who developed a 12-unit townhome project in Los Angeles. The local utility company placed a power pole for the project on the sidewalk abutting the project. However, the City of Los Angeles subsequently decided they did not like the placement of the power pole. This led to six months of negotiations between two giant, overstretched bureaucratic organizations, mediated and pushed forward by our very frustrated client--who has 20 years of real estate development experience including many complex projects. Busted timelines also lead to cost-overruns, since everyone including the lender needs to be paid along the way. As a non-bank lender, we were able to provide extensions and even offer some additional proceeds to cover cost overruns. We did not judge our borrower or punish him with punitive interest rates during the loan extension or make him provide 1,000 pages of documentation and beg for the loan modification. He was doing his best and building a great project, he just had some bad luck--which happens in one way or another on every project. Consider working with a lender who understands the rhythm of development and who is able to roll with the punches alongside you. For many lenders--especially banks--they simply can’t do so because of the structure of their organizations. If your lender is going to worry more about internal politics than he is about getting the project done right and taking care of the borrower, it is probably not the right lender for that project.
In conclusion, the Opportunity Zone investment incentives of the new tax law create a once-in-a-lifetime chance for wealthy investors to sell appreciated assets while deferring certain capital gains and avoid paying taxes on future appreciation. There will be hundreds or even thousands of Qualified Opportunity Funds established in the coming few years, and probably tens of thousands of projects. Developers can benefit by focusing on projects that fit Opportunity Zone investment criteria, and also by aligning themselves with expert non-bank lenders who understand their business. Together, the investors, fund managers, developers and their lenders can have a meaningful positive impact on many communities that have received limited investment to date.
For more information or to discuss any of your upcoming projects, don't hesitate to call (310) 554-8892.
ABOUT ARIXA CAPITAL
Arixa Capital is one of California’s leading private real estate lenders and fund managers, financing over 800 projects since 2010. The Company lends $250,000 to $10 million for single family, multifamily and small balance commercial real estate projects. For borrowers, Arixa is committed to providing white glove service, certainty of execution and rapid funding. For investors, the Company’s funds seek to provide steady income while preserving capital and maintaining a margin of safety.