The 2017 Tax Cuts and Jobs Act promises immense implications for commercial real estate investment over the next decade, particularly in Los Angeles County. Having created a national community investment program that seeks to connect private capital with underinvested communities called “Opportunity Zones,” the program applies to significant swaths of the County’s urban fabric, encouraging long-term investment in areas considered “distressed” by offering permanent exclusion from capital gains taxation for investments held over 10 years.
With U.S. investors currently holding more than $6 trillion in unrealized capital gains, the draw for investors lies in the opportunity to boost returns by transitioning funds from other asset classes and placing them into real estate and businesses in these special economic areas.
One caveat to the opportunity fund program is that capital must remain tied up within these opportunity zones for at least five years to see any deferment of capital gains, and permanent exclusion of capital gains is only possible after a decade, meaning investors must think carefully about where to place their funds to retain property value.
While the program is national in scope with opportunity zones occurring in all 50 states, certain areas are more likely to attract capital than others. In examining the potential for future investment, consider those areas where investors are currently placing their capital. Los Angeles, for example, is second only to Manhattan in terms of attracting capital for real estate investment, a trend that is likely to continue, especially for investors seeking capital gains exclusion under the opportunity zone program.
In 2018, Los Angeles County saw transactions for commercial real estate total more than $24 billion, which broke down to $8 billion invested in multifamily (33%), $6 billion in both office (25%) and retail (25%) and $4 billion in industrial (17%). Of that total investment in 2018, only about $4.2 billion (18%) was for properties within the boundaries of opportunity zones. Much of that, about $1.8 billion, went into multifamily assets, followed by $1.2 billion for industrial product. Such robust investment activity stems from the fact that Los Angeles County is a core real estate market capable of providing stable returns due to above-average rent appreciation coupled with low vacancy rates.
One common misconception is that opportunity zones, which tend to be made up of lower density census tracts near the urban core, are in impoverished and blighted neighborhoods. But the truth is that one in nine L.A. County residents already resides within an opportunity zone. This number is likely to increase as the economic development aspect of the program runs its course. To date, 68 housing projects comprising some 4,200 units are under construction within these opportunity zones, and another 230 multifamily projects have been proposed, bringing with them the promise of much-needed supply in an underserved housing market.
The opportunity zone program will likely accelerate such investment and development within these underserved areas of Los Angeles County by altering the incentives that drive private equity investors and smaller developers. Meanwhile regulatory uncertainty surrounding the evolving opportunity zone program has put pension funds and larger institutional investment firms on the sidelines, with most of the early interest coming from smaller investment companies and retail investors seeking to minimize taxes.
Larger institutional investors may still benefit from this program by purchasing assets and developing projects that were already in the pipeline and capitalizing on future price appreciation due to opportunity zone investment. Though while it is possible to benefit by purchasing assets early outside of the opportunity zone fund requirement, capital placed outside of authorized funds would still be subject to taxable gains and would come without the ten-year hold requirement.
Some businesses will face downsides to this new program. Sin businesses, for example, such as casinos and strip clubs, are ineligible for the program. Likewise, some residents and existing businesses in these zones will undoubtably be displaced by rising rents and land values. This would lead, in turn, to a changing makeup of existing land usage, with lower density multifamily and industrial users most likely to be negatively impacted.
The concept of opportunity zones remains new to many investors still trying to wrap their arms around the exact implications. It is not clear how the effect of opportunity zones will improve living standards of people located in economically distressed communities. What is clear is that real estate investors will continue to favor investment into Los Angeles County as a haven for placing capital and an option for smaller private equity and retail investors to eliminate taxes on capital gains.
Thomas Galvin and Caitlin Matteson perform regional research for Colliers International. Learn more at colliers.com/GreaterLosAngeles.
