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Which Office Markets Are Best Bets for Opportunity Zone Investment?

Investors have to keep in mind that to reap full tax benefits, the value of capital improvements has to match the value of the initial purchase price.

Opportunity Zone investments are a hot topic in the commercial real estate industry right now, but which office markets may be the best targets for this type of strategy?

The establishment of Opportunity Zones offers investors a way to defer and reduce taxes on capital gains, while building equity in real estate assets and improving low-income, distressed neighborhoods.

Common traits of Opportunity Zones certified by the U.S. Treasury are: a poverty rate of more than 32 percent, median family income about 37 percent below the area or state median, and an unemployment rate nearly 1.6 times higher than the U.S. average.

Across markets, it is too early to gauge the level of investor interest in opportunity zones since few transactions have closed, notes Darin Mellot, director of research, Americas, with real estate services firm CBRE. While its too early to fully understand the potential impact on property values, recent reports indicate some investors are paying a premium for properties in Opportunity Zones. For example, a couple properties in the Seattle metro commanded a 5 to 10 percent premium due to location in an Opportunity Zone, Mellot notes.

The capital gains tax on Opportunity Zone investments will be deferred until 2026, but the investor’s tax discount will depend on the length of the hold: 10 percent if the property is held for five years and an additional 5 percent if held for seven years, for a total of 15 percent of the original capital gains tax. The investor must acquire the property by the end of 2019 to cash out in 2026 and receive the full 15 percent.

The most intriguing aspect of the program, according to Jim Achen Jr., vice president and office broker based in the Phoenix office of real estate services firm Transwestern, is if investors hold the Opportunity Zone investment for at least 10 years, any capital gains realized from eventual sale of the property are tax-exempt.  While the program “sunsets” in 2026, the IRS will allow investors to continue claiming this tax benefit until 2048.

NREI asked industry experts to identify which Opportunity Zones hold the greatest promise for office investors. Opportunity Zones near existing, vibrant office markets are more likely to see the greatest leasing activity, says Mellot. But he cautions investors to consider both the asset’s and the market’s attributes, as the tax incentive is secondary to office market fundamentals. Occupiers make decisions based on availability of talent, existing infrastructure and office space desirability, Mellot notes.

Some urban downtown submarkets are designated as Opportunity Zones, but opportunities are limited, as the program requires that an equal amount of capital be invested in capital improvements as was paid for the property, notes Achen. Therefore, he adds, “The value-add play is a complete redevelopment.”

For example, downtown Phoenix has been designated as an Opportunity Zone, but most assets there are high-rise buildings that do not require significant renovation or updating, Achen says. As a result, Opportunity Zone deals in the Phoenix area so far have been land deals, where the cost to develop the site will exceed the value of the transaction.

LOCUS, Smart Growth America (SGA), a national network of responsible developers and investors, analyzed Opportunity Zones based on their smart growth potential and identified four metrics that make them attractive from financial, social and environmental standpoints: walkability, job density, diversity and distance to a top 100 central business district (CBD).

According to LOCUS and George Washington University (GWU)’s 2016 Foot Traffic Ahead report, walkable, urban places, or WalkUPs, command a 74 percent price premium over drivable, suburban locations and perform better in terms of social equity, health and climate resilience.

Only two percent of 7,800 Opportunity Zones (zones in Puerto Rico, Guam and Virgin Islands were excluded) meet these metrics, notes Christopher Coes, vice president of Smart Growth America and director of LOCUS. He and Tracy Loh, senior data scientist at GWU Center for Real Estate and Urban Analysis, co-authored the LOCUS National Opportunity Zone Ranking Report, which ranks Opportunity Zones by location, property type, asking rents and level of economic or social equity and vulnerability.

The majority of Opportunity Zones are low-density suburban, commuter locations, characterized by higher housing and transportation costs, a greater source of greenhouse gas emissions and lower quality of life than walkable urban environments, Coes says.

The report provides a triple bottom line filter to help investors identify Opportunity Zones that would deliver the greatest positive economic gains, along with environmental and social returns.

LOCUS’ top Opportunity Zone top five picks overall for smart growth investment include: Portland, Ore. CBD, downtown Oakland, Calif., downtown Seattle, Philadelphia’s Center City East and Baltimore’s Inner Harbor.

While Opportunity Zones in the New York, Los Angeles, Bay Area, Miami and Seattle metros dominated top rankings for office and retail asking rents and growth premiums, Kansas City, Mo.; Philadelphia; Silver Spring, Md.; and downtown Houston, Sacramento, Portland and Phoenix placed in the top 10.

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