When Aptitude Development began working on The Marshall near the University of Louisville in Kentucky about two years ago, the $50 million, 591-bed student housing project was simply considered a sound development along a corridor undergoing urban renewal. But last spring, when one of the 8,700 newly designated “qualified opportunity zones” in the country happened to encompass The Marshall’s location, the project also became eligible for capital gains tax deferral for long-term property investors.
Consequently, as The Marshall’s October 2018 groundbreaking approached, the Elmwood Park, New Jersey-based student housing developer restructured the deal to leverage the valuable tax benefits. Sitting atop a 232-space parking garage and featuring a gym, study lounges and a 2,500-square-foot outdoor terrace overlooking Churchill Downs, the project may just be the first student housing opportunity zone development in the nation, declares Jared Hutter, a principal at Aptitude.
“Certainly it’s in the first group of opportunity zone developments, and it’s the first in Kentucky,” he says. And it won’t be the last, Hutter promises. “We have a number of other opportunity zone projects we’re looking at because the concept is complementary to our mindset of being long-term holders.”
Part of the Tax Cuts and Jobs Act passed in late 2017, opportunity zones are part of a program using tax benefits to incentivize economic development in low-income or working class communities. To establish the zones, cities generally recommended census tracts to their state’s governor, who then revised the list and submitted candidates to the U.S. Treasury Department and Internal Revenue Service for the official designation. Now commercial real estate investors are aiming to pour billions of dollars into them.
For student housing developers, the prospects are plentiful. Roughly 70 percent of at least 175 universities in the U.S. have an opportunity zone within one or two miles of campus, says John Philipchuck, founder of ImpactUs, a Chicago-based real estate research and consulting firm. Additionally, dozens of campuses themselves reside in opportunity zones, including the University of Southern California, University of Kansas and Texas A&M University, according to Learning from Opportunity Zones: How to Improve Place-based Policies, a report by the Washington, D.C.-based Brookings Institution think tank that largely criticized the opportunity zone selection process.
Student housing developers such as Core Spaces, the Annex Group, University Student Living, Kayne Anderson Real Estate Advisors and the Vecino Group all have projects in early stages of development in opportunity zones and are considering taking advantage of the tax benefits, according to officials with the firms. They declined to share details, however, and noted that they had been working on the projects or had targeted the locations prior to the opportunity zone legislation.
“There are a lot of campuses with rundown housing around them, and I think cities and states want to see it replaced with better housing to keep growth and the population around campuses,” states Tim Roth, president of student housing for Vecino Group, a Springfield, Missouri-based developer that’s focused on projects that contribute to the “greater good.” “So opportunity zones are a great deal for long-term holders, and they fit our mission.”
Rules and Unknowns
The opportunity zone concept is similar to a 1031 exchange, in which property investors can defer capital gains taxes after a sale by rolling the proceeds into comparable real estate within a certain period of time. However, opportunity zones allow investors to defer capital gains not only from the sale of properties, but also from the sale of stocks, bonds or other assets, so long as the gains are rolled into qualified opportunity funds within 180 days of the sale. The funds generally must finance development or operating businesses in the designated areas and create substantial
value, although certain entertainment activities, ranging from massage parlors to golf courses, are ineligible.
Investors also may receive a 10 percent or 15 percent reduction in the capital gains tax if the investment is held within the fund for five or seven years, respectively. (As the law stands now, the capital gains tax would come due in the 2026 tax year, so investors need to plow gains into funds by the end of 2019 to take full advantage of the discounted tax rate.) Moreover, investors can also escape paying any taxes on the increased value of their opportunity zone fund shares, which would reflect a property’s appreciation, if they hold the shares for 10 years.
The rules could represent a windfall for real estate developers who can build successful projects within the zones. U.S. households and corporations held more than $6 trillion in unrealized capital gains in stocks and funds at the end of 2017, according to estimates by the Economic Innovation Group, a Washington, D.C.-based organization that advocates for policies that promote entrepreneurialism and investment.
Yet lingering questions about the program have stymied some student housing and other developers. The U.S. Treasury proposed long-awaited guidelines in October and solicited comments through the end of 2018. It had planned to issue final rules after holding hearings early in 2019, but the government shutdown has delayed the process.
Consequently, clarity is lacking over opportunity zone fund structures, exits from funds, development fees and the eligibility of ground leases, among other critical elements of the law, says Jeffrey Bowden, tax principal with Anchin Accountants and Advisors in New York. For example, currently the guidance suggests that investors are eligible for the tax benefits when they sell their fund shares, so the sale of the physical asset itself may not satisfy the requirements. Additionally, uncertainty surrounds whether one fund can invest in multiple assets, even as some sponsors are marketing funds to do just that.
“I have a lot of clients that want to look into it,” Bowden explains. “But we’re still waiting for answers and guidance. It’s holding developers back.”
Still, enough guidance likely exists for a single investor targeting a single project to comfortably move forward, say Bowden and Bruce Baker, co-leader of the campus infrastructure and development team for the NixonPeabody law firm.
Some student housing investors, like Chicago-based Harrison Street Real Estate Capital, are still weighing whether opportunity zone funds can fit with their strategies and fund structures. “A lot of our partners who have boots on the ground and are the deal originators have certainly taken note of opportunity zones and are very interested,” says Justin Gronlie, director and head of education real estate in the transactions group at Harrison Street. “But we’re still in the early stages of determining whether this is attractive and workable for us, our capital and our investors.”
Toeing the Start Line
Observers are optimistic that Congress and the IRS will ultimately provide direction that lines up with the goals of developers, and many are preparing for that day. The Marlton, New Jersey-based Michaels Organization is raising two opportunity zone funds — one focused on $150 million to $250 million projects in large urban areas, and the other on $30 million to $50 million projects in smaller markets, says Joseph Coyle, president of University Student Living, a Michaels company.
While the funds will invest in a mix of residential developments, he suggests that student housing will be some of the first pursued. Currently Michaels is in the pre-construction phase on 11 opportunity zone projects valued at roughly $2 billion, Coyle acknowledged, and is awaiting guidance so that potential investors in the funds know the ground rules before moving forward.
“We think this is a great strategy for long-term holders of real estate,” he adds. “That’s of interest to us because part of our mission is delivering less expensive housing, and there are a lot of areas close to campuses that are very old and dilapidated.”
In addition to unfinished work by regulators, however, challenges such as a peaking property market, anticipation of a recession within the next 12 to 24 months, and high construction and labor costs also could make investors think twice about pouring money into an opportunity zone fund, Coyle and other observers add. What’s more, only a certain segment of developers will find the program’s long-term hold rules appealing, and investors that have harvested gains and face a limited time to invest will probably avoid deals that have entitlement risk. There’s uncertainty that typically accompanies a new type of fund structure, too.
“The mechanics behind how investors will commit funds to developers and how, in turn, developers can rely on investors is not a developed market yet — not like institutional capital where people have been doing deals for years,” says John Wieker, chief investment officer for Chicago-based student housing developer Core Spaces. “You’re dealing with a totally different beast with no precedent.”
Core Spaces is nevertheless exploring potential opportunities with investors looking to take advantage of the tax benefits, Wieker acknowledges. Opportunity zones are in about half of its target markets, and the developer was already focused on many neighborhoods within the zones prior to the law’s enactment.
“We have three projects that definitely fit the bill right now, and we’re exploring how to capitalize them either with existing or new institutional investors who may or may not be able to take advantage of the tax benefits, or with investors who are tax driven,” he explains. “So for us, it’s like one more arrow in the quiver. But if a project makes sense, we won’t necessarily hold it up just to structure it a certain way.”
Sweetening the Deal
That sentiment also rings true with other developers. “Ultimately, the investment opportunities have to be compelling on a risk-adjusted basis without the tax benefits,” says David Selznick, chief investment officer of Kayne Anderson Real Estate, a Los Angeles-based investor in alternative assets that is considering a handful of student housing projects in opportunity zones. “In our view, the tax benefits need to be the ‘icing on the cake.’”
The Annex Group, an Indianapolis-based student housing developer, has three projects in opportunity zones that were in the planning stages before the law passed, says president and CEO Kyle Bach. He also suggests that competition between developers has already diminished expected return thresholds in opportunity zones. Indeed, property owners in the zones are reacting to increased acquisition interest by hiking prices, which could thwart the economics of some deals, Roth points out. “Developers still have to hit their bank pro forma — opportunity zones don’t help cash flow or debt coverage ratio,” he says.
It’s possible that developers will be able to use low interest loans, tax abatements and other incentives to juice returns even more, and some policy experts are advocating for states and communities to use such programs to promote their opportunity zones. The Governance Project, a non-profit that helps state and local leaders attract private capital, suggests that states leverage universities as anchoring institutions for opportunity zones, according to its recently released white paper, How States Can Maximize Opportunity Zones.
In particular, the report notes that student housing can support small businesses, help revitalize neighborhoods and downtowns, and play a role in small college and university growth strategies. Some schools may even be able to leverage capital from alumni looking to reduce their tax exposure, Baker says.
“Universities have a lot of alums that have founded companies and have sold them for significant gains, and now they would like to give back to their alma mater,” he explains. “Opportunity zones are a way to do it. It’s a very intriguing concept.”
— Joe Gose
This article originally ran in the January/February 2019 issue of Student Housing Business magazine. To subscribe, please click here.