Affordable housing developments utilizing LIHTC located within Opportunity Zones offer an ideal means for leveraging the program’s benefits.

Opportunity Zones (OZs) have been one of the hottest topics in real estate, and while much has been written about the program—established as part of the Tax Cuts and Jobs Act of 2017—little is known about its long-term implications.

On paper, the benefits are attractive to investors. They include:

• A deferral of tax on gains invested in Qualified Opportunity Funds (QOF)—investment vehicles set up to invest in eligible property—until earlier on the date of which the QOF investment is sold or exchanged, or Dec. 31, 2026.
• Exclusion of 10 percent of the deferred gain if the QOF investment is held for longer than five years. If it’s held for more than seven years, 15 percent is excluded.
• A stepped-up basis to the fair market value on the date the investment is sold or exchanged if the investment in the QOF is held for at least 10 years.
• Tax-free gains on profits generated by the investment.

Affordable housing developments utilizing low-income housing tax credits (LIHTC) located within OZs seem to offer an ideal means for leveraging the benefits of the OZ. Unfortunately, success has largely been elusive thus far.

What if a developer wants to combine the two programs, setting up the project financing to include both OZ and LIHTC investors, each investing as part of the project’s capital stack? While such an endeavor is theoretically possible—after all, the two funding sources should complement each other—in reality, combining them creates several thorny issues. Because so few OZ deals have been consummated, developers are still trying to work their way through the new regulations, with many learning as they go.

Consider Ogden Commons (pictured), a $200 million mixed-use project in Chicago’s North Lawndale neighborhood that The Habitat Company is developing in partnership with the Chicago Housing Authority, Sinai Health System and Cinespace Chicago Film Studios. When complete, the 10-acre development will include mixed-income rental housing, retail and commercial space.

Ogden Commons is in a Qualified Opportunity Zone (QOZ), which offered Habitat the opportunity to seek out a QOZ investor to finance approximately half the projected construction cost of the retail and office components. The development team hoped to attract investors willing to accept cash-on-cash returns in the 6 percent to 8 percent range, which, when including the OZ tax benefits, would increase effective returns of 9 percent to 11 percent. That goal was based on the assumption that investors would have community development motivations that guide their investment strategy. The development team recently executed a combined debt and equity commitment with the community development division of a major bank to accomplish this objective.

For the 300-plus apartment home mixed-income residential component of the project, which consists of a combination of affordable and market-rate apartments, Habitat intends to use LIHTC as the primary financing source and is working with the investor community in an effort to bring OZ funding to the project as well.

Dealing with Different Investor Needs

One main challenge when combining OZs with LIHTCs is that affordable housing projects, which are largely reliant on scarce government resources, do not generate the same level of returns that are available in the broader marketplace. Tax credit developers are not required to make long-term cash investments and earn a fee of 5 percent to 10 percent of project costs but must operate the project with limited cash flow during a 15-year compliance period. If an affordable housing project could generate IRRs of 15 percent to 20 percent, the government funders would not offer financial resources to the projects and the project would not be affordable to develop.

Compounding the problem is that OZ and LIHTC investors each have different motivations. LIHTC investors are primarily institutions, including banks, that invest in the housing tax credits for a number of reasons, including compliance with the requirements of the Community Reinvestment Act. But many OZ investments are more likely to be from funds set up by high-net-worth individuals, or families that generated a cash windfall through the sale of assets and are looking to shelter capital gains and defer or reduce taxes.

Further, LIHTC investors generally do not underwrite operating cash flow or a return of capital when calculating their expected returns. They may try to negotiate some type of back-end language to receive a portion of the equity if the project is worth more than anticipated, but they typically don’t include that assumption in their underwriting, which is based solely on the tax credits and depreciation deductions passed through to them on the project itself.

OZ investors, on the other hand, not only want their money back, but also want to realize tax-free gains and generate enough cash to pay the deferred taxes in year 11 and underwrite project cash flow from operations as well.

Making it Work

It’s worth remembering that it took many years for the LIHTC marketplace to mature to the point where it created an industry to support affordable housing development. In contrast, the OZ marketplace is very immature. At this point, every deal is a one-off project with little in the way of industry comparables. Creative minds throughout the LIHTC world are working to establish scalable structures that will permit these two important resources to complement one another.

To bring them together, several conditions will likely need to be present:

• The investors will have to be willing to take returns well below market rate real estate returns. In the current climate, that might be in the 5 percent to 8 percent range before tax benefits.
• The LIHTC industry will have to develop a tolerance for a second tranche of investors in the limited partnership position, which is typically 99.99 percent of the ownership of an affordable housing deal.
• Developers may have to find a financing structure that would allow an OZ investor to pay its deferred taxes in year 11 of a 15-year financing plan.
• LIHTC investors may look to expand their pool of equity to include capital gains or allocate bank generated capital gains to OZ projects with community development implications.

Weighing Risk and Reward

Despite the challenges of combining OZ and tax credits in one deal, the rewards are anticipated to be well worth it. As the marketplace develops, new vehicles will likely emerge that pair up socially motivated investors with community development and housing projects occurring within the OZ.

Today, an individual OZ investor who is looking to shelter capital gains may find it daunting to put resources in an investment as complex as a tax-credit investment. However, new means allowing for more diversity and flexibility in the marketplace are expected to emerge. The first projects will probably be executed by institutional players—particularly those working in the affordable housing industry—that view the OZ as value-added and are able to structure these deals successfully.

Investors interested in pursuing these opportunities should surround themselves with top accounting and legal professionals to ensure they have comprehensive advice and input. Additionally, it’s critical they also have a clear-cut strategy going into the deal that conforms with the requirements of both the OZ and LIHTC programs.

Most important, projects still need to pencil out. A bad real estate deal is a bad tax deal, and tax incentives won’t change that. That said, there’s no risk in exploring how OZs and LIHTCs might be combined to make otherwise profitable projects even more attractive to investors.